Coinbase explains why DeFi interest rates rose during the COVID-crash

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In brief

  • Coinbase issued a report exploring why DeFi rates stay relatively high.
  • Rates are expected to sink over time as DeFi becomes more mainstream.
  • Stablecoins have an opportunity to benefit from financial volatility, says Coinbase.

The crypto market crashed last month when the coronavirus pandemic began its sweep through the US. Coin prices have since stabilized—despite some pre-weekend bleeding—but the flash crash showed exactly how the industry starts to tear apart at the seams when placed under pressure: The crypto lending market, on which lenders accept crypto as collateral, struggled to keep up and became incredibly expensive to use. 

The reason, explained crypto exchange Coinbase in an “Around the Block” blog post on Friday, is because crypto is far more volatile than cash and riskier than other forms of capital. Accordingly, crypto lenders demand much higher rates from borrowers. Add a global financial crisis into the mix, and rates get even higher. 

Specifically, the interest rate hike was partly down to an increased demand for stablecoins—cryptocurrencies pegged to fiat currencies (like the US dollar), said Coinbase. Stablecoins are easily and quickly traded for, say, Bitcoin, perfect when attempting to profit off a last-second trade. So when the market crashed, stablecoins were traded for a premium; more stablecoins were issued to meet demand; and there was plenty of activity as traders moved holdings between exchanges. 

Traders rushed to lending markets to borrow stablecoins. But bad luck for borrowers: popular lending desks, like Compound, Dharma, and Dy/Dx, are niche, and come with their own “smart contract risk,” said Coinbase. “DeFi platforms are a collection of smart contracts and potentially vulnerable to exploits. More risk demands a higher interest rate,” it wrote. And so the prices soared.

 

Coinbase expects interest rates “to ultimately compress over time as crypto adoption grows,” it wrote. “More lending desks will accept crypto as collateral, stablecoins will grow in adoption, crypto to fiat bridges will be more efficient, and DeFi will become more mainstream and have better protections against smart contract risk.”

Hopefully in time for the next coronavirus crash.