Drixx Academy/Interest Rates and Yield Generation in Crypto Explained/

Interest Rates and Yield Generation in Crypto Explained

Edwin Munyui
Head of Content
March 24, 2021

Interest rates are common jargon in financial markets - in fact, they are used by monetary authorities to keep economies in check. This concept has been a fundamental pillar of modern day markets, although the origin of interest rates can be traced back to 3,000 BC. Clearly, we are not the first civilization to interact with interest rates or the associated dynamics. To get a better picture, let's delve deeper into how interest rates work, why they are beneficial and what are the emerging trends in the crypto market.

For the purpose of this article, we will be using 'yield' to mean interest rates as well - however, the two terms are technically different when it comes to fixed income math. Yield/Interest rate is basically the extra amount that a loan borrower pays to the lender as a charge or fee on the advanced loan. Take for instance, John borrows $100 from Peter at an interest rate of 10% - this simply means that John's interest payment is $10. Therefore, he would owe Peter a total of $110 if the loan is granted at that rate.

In traditional financial markets, interest rates have proven to be a major indicator of return on investments (ROI) and the general economic performance. Unsurprisingly, more people across the globe are now after investments that are better placed to yield higher returns. Such stats are normally presented as the Annual Percentage Yield (APY) - this is the interest that an investment can yield within a year. In simpler terms, interest/yield informs market participants on the possible investment returns.

Types of Interest Rates

Being a wide and advanced niche, interest rates take various forms - this variation creates more room for participation across the board. Ideally, taking a loan or making an investment can attract different types of interest which include simple, compound, fixed or variable. These are just some of the popular types of interest rates that exist in traditional finance settings. Otherwise, there are more sophisticated types, especially in fully developed financial markets.

Fixed Interest

Just like the name suggests, fixed interest loans or investments apply a specific rate to the principal amount. For example, an investment worth $1,000 at a fixed interest rate of 10% will attract an interest payment of $100. This type of interest is pretty simple to calculate and easy to understand for both lenders and borrowers in any financial market.

Variable Interest

A variable interest rate is the opposite of a fixed one - in this case, interest payments on the principal amount can vary between time periods. The variation is normally informed by other metrics which may include base interest rates for commodities. In markets like the U.S, some banks tie the variable interest rates to prime rates - this is basically the inter-bank rate/U.S federal fund rate. It is the interest rate which banks use to borrow and lend to each other.

Simple Interest

Simple interest is a basic type of interest rate - the calculations on loans borrowed or investment returns are quite straightforward. To put this into perspective, assume that an individual named Jane wanted to save their $100 in a bank so as to earn interest over time. If they go to an institution that offers a simple interest on bank savings, it means that interest will only be paid on the initial principal amount ($100).

Assuming that the bank pays 5% on saving deposits - Jane will have realized $5 as interest at the end of year 1. If she keeps her deposit for another two years, the simple interest paid will simply be (principalinterestperiod). In this case, the period will be 3 years in total - therefore, Jane's cumulative simple interest can be calculated as ($1000.053=$15).

Compound Interest

Unlike simple interest, this type of interest rate uses both the principal amount and accumulated interest payments to calculate how much interest should be paid in consecutive periods. In Jane's case, the return figures under compound interest rates would be much more after the first period. This is because the initial interest payment would have been included as part of the principal in the following time periods. Here's what a compound interest savings account would have yielded for Jane in 5 years:

Compound Interest Example

1st year = $100*0.05=$5

2nd year = ($100+$5)*0.05=$5.25

3rd year = ($105+5.25)*0.05=$5.5125

4th year = ($105+5.25+5.5125)*0.05=$5.788125

Final year = ($105+5.25+5.5125+5.788125)*0.05=$6.07753125

Total Interest = $5+$5.25+$5.5125+$5.788125+$6.07753125=$27.63

As you can see, the yield on a compound interest account would have been considerably higher than that of a simple interest account. In this example, Jane would have received 2.63$ more, which is around 8% more than with the simple interest. This is because of adding interest as part of the principal, after each interest payment.

And since compounding effect has exponential growth, the accrued interest has a bigger and bigger effect on the overall growth of the interest account with every additional time period - whether it's a week, month or year.

Why Interest Rates are Important

Interest rates inevitably affect you in one way or another - this is partly because of their role in monetary policy alongside other functions such as fractional reserve banking. Let's take a look at each in detail to get a better perspective of the value proposition:

Monetary policy

Interest rates are monetary policy tools - central banks and federal authorities across the world can alter them to ensure that their economies remain sustainable. In cases of high inflation, central banks can increase interest rates to make it more expensive to borrow while making it lucrative to lend/save with financial institutions. This ultimately reduces the amount of money in circulation and eventually lowers inflation - a decrease in interest rates would have an opposite effect on inflation.

Fractional Reserve Banking

Fractional reserve banking is the main business model for most traditional banks that exist today. This simply involves the process of accepting deposits and issuing loans - the banks create a money circulation cycle. To do this, banks pay interest on deposits and charge interest on issued loans, of which the latter is usually much higher. Such flexibility is facilitated by the fact that they only have to be holding a part of the deposits as opposed to the full amount - fractional reserve banking.

Yield Generation

Drixx Yield Platform

Source: Drixx Yield Platform

Having broken down how interest rates work, the various types and their value proposition, we can now look at their correlation with yield generation. This involves the creation of additional wealth through interest payments on a principal amount. Notably, there are a number of ways to generate yield in both traditional and nascent markets like crypto.

Today, you can simply walk into any financial institution that offers investment products or savings accounts to start earning interest on your capital. This is one of the most popular ways that financial market investors and participants generate 'income' from their deposits. Most importantly, it is pretty seamless to set up an investment account that can generate some extra yield.

As expected, the possibilities of yield generation are dependent on prevailing interest rates or those offered by a product provider. Currently, the interest on a U.S bank FDIC-insured savings account is around 0.01% - this is still on the lower side compared to other financial products. Junk bonds which are considered as high risk offer up to 5%.

It is quite noteworthy that each market prices interest differently - this is because of varying factors such as risk, inflation and consumer price indexes. Developed countries like the U.S have lower inflation rates while the developing counterparts experience more inflation. Interest rates in the latter economies could go up to 8% on short-term government bonds. Similarly, interest rates on risky assets like crypto are much higher compared to the offerings in traditional finance.

Crypto as an Emerging Niche

For long, the main source of yield generation has been traditional financial products - the trend is now changing with the emergence of cryptocurrencies. These digital assets have brought new ways to generate significantly higher yields than what is offered in traditional finance. Interest on crypto investments can yield up to 30% while some riskier opportunities could go up to 500%. With such stats, it is not surprising that this market is on a steep rise - both retail and institutional investors are keeping close tabs on the developments.

So, what are some of the ways that you can generate yield in crypto? The simple answer is that there are quite a number of avenues to do so. Some of the most popular ways include crypto lending, perpetual funding, liquidity mining and yield aggregators. All these channels offer an opportunity to generate some yield, although the returns defer - here is a detailed feature of how each yield generation method works. The Drixx yield aggregator is also one of the ways that you could start generating interest through our USDT and USDC stablecoin interest accounts.

Summary

As we have seen, interest rates have an important role to play in the stability of financial markets and opportunity creation. They are basically the yield drivers since they determine how much value you can create within a particular market. That said, interest rates are largely determined by the macro outlook - this means that a misguidance from monetary authorities could result in serious economic problems. However, it might not be the case for crypto assets which have shown little correlation with the traditional financial ecosystem. This upcoming market continues to be a lucrative niche for significant yield generation.

Disclaimer: The information presented here is for educational purposes only and should not be construed as investment advice. Cryptocurrency trading involves high risk. Drixx will always strive to do it’s best in educating customers and providing high quality products but will not be held responsible for their trading and investment decisions, losses or profits.