DeFi 101: How Are DeFi Yields So High?
Many people distrust decentralised finance (DeFi) because it offers such a high APY. There’s some irony in that.
The real question should be, ‘Why don’t banks pay you more?’
Because most centralised institutions can afford to pay you higher interest rates, they just choose not to. That said, decentralised finance has an unfair advantage over traditional banking for several reasons.
Today, we’ll break down how DeFi applications work, in turn, showing you how they can afford APYs that tower over those in traditional finance.
But let’s start with a reality check.
Most banks can afford to offer higher APYs
Let’s start by looking at how traditional banking makes money. Banks take your deposits and loan them out to borrowers.
The loans are for things like mortgages, and the banking sector’s profits depend on the interest earned on said loans (that is — their profits equal interest earned on the *minus* interest paid into savings accounts like yours).
This dynamic means a bank’s profit margin can increase if the interest it charges rises faster than the interest it pays, so you start to see why some banks consider keeping savings rates flat even if loan rates surge.
And many institutions do this because they know they can get away with it. You see, at the start of the 2008 financial crisis, interest rates fell almost to zero, yet depositors hung around. Now banks feel they can keep APYs low even if rates rise.
Making matters worse: there are no real checks and balances. A bank can choose if and when to raise interest rates, resulting in misaligned incentives.
In contrast, interest rates move in lockstep with the market in decentralised finance.
Here’s how that process works.
How does decentralised finance work?
On the surface, decentralised finance works much the same as traditional finance.
Take Compound and Aave as perfect examples. The protocols accept money from depositors and loan it out to borrowers, generating APY.
The crucial difference is the apps work using technology alone. No personnel, no physical infrastructure, no paperwork: they require nothing more than well-written computer code, eliminating most of the costs of financial services.
The computer code they use is smart contracts, programs that run according to predefined conditions. And as smart contracts follow a simple ‘if/when… then’ format, they enable blockchain apps to automate most financial services.
This is how lending and borrowing work on an app like Compound:
How to deposit money using DeFi:
Suppose you want to deposit money into Compound. All you need to do is create a crypto wallet (such as MetaMask), buy some ETH (to cover transaction fees), and then deposit money.
How to borrow money using DeFi:
Suppose you want to borrow money from Compound. Again, you need a crypto wallet and some ETH, and you also require collateral. That’s because, to borrow $50 on Compound, you need to collateralise your loan with $100 worth of crypto.
(DApps like Compound use collateralisation to protect depositor funds. You can learn how DeFi loans work in this blog post.)
As you can see: you never have to interact with a bank or loan manager. You just need a web3 wallet, and you’re good to go.
This is why DeFi can offer better APY than traditional finance, but that’s not all. Rates on dApps like Compound and Aave reflect real-time demand, meaning savers earn more interest as soon as more borrowers enter the market.
The smart contract takes control instead of waiting for a bank manager to boost rates.
DeFi APYs reflect what you deserve
The truth is that most DeFi APYs aren’t that high.
The yield simply reflects what savers deserve. More pointedly, it also underscores how traditional banking has kept rates too low for too long.
That said, smart contracts do put decentralised finance at a significant advantage. Protocols can operate on a significantly lower cost base, enabling them to return most of the interest to savers. Still, even the best apps are tricky to use, which is why Elitium exists.
Elitium makes it easy for people like you to access DeFi APYs without the hassle. We also offer enhanced platform security and dedicated client support, acting as your gateway to a world of digital assets.
So if you’re looking for a reliable way to build long-term wealth, why not open your Elitium account today?
You’ll get some of the best APYs across finance if you do.