Investing for income in today’s markets is like searching for a cold drink in the Sahara.
For bank savings accounts with an annual return of around 0.04% based on the national average, it would take more than a millennium for your money to double. No wonder so many investors are desperately looking for returns.
Some even go so far as to consider websites and apps that urge you to buy and borrow the hottest good in the world: digital currencies like Bitcoin and Ether.
Cryptocurrency trading platforms pay you 6%, 8%, even 12% or more for what some of them call “savings accounts”.
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The intelligent investor
Jason Zweig writes on investment strategy and how to think about money.
From this name, you might think that this is very similar to making deposits at a conventional bank. You are not.
In these arrangements, an online trading or credit company will lend your cryptocurrency and then in turn lend it to hedge funds or other investors and traders. You earn a portion of what these borrowers pay your broker as interest.
In essence, this is no different from what stockbrokers refer to as a fully paid loan program. You can earn interest by letting your broker borrow your stocks. Likewise, if your mutual or exchange-traded funds lend some of their securities to hedge funds or other borrowers, you can earn a split of income.
For the many investors who don’t want to own virtual currency at all, the whole idea of using it for income should be a no-starter. If you already own Bitcoin or some other cryptocurrency, borrowing it can be an option – if you weigh the risks.
These alleged “savings accounts” are nothing more than what a traditional bank offers.
First of all, you deal with cryptocurrency. That is the asset that is in your account. And unlike a bank deposit, your balance in bitcoin or other digital money is not handled by the Federal Deposit Insurance Corp. protected. The Securities Investor Protection Corp. Nor does it protect you from losses in the event of liquidation, as would be the case with a conventional broker.
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The rate you earn when a company borrows your digital money can vary widely over time and from one trading platform to another. You may only earn simple and no compound interest.
Businesses typically pay their income in units of the same virtual money, not dollars. There may be delays, withdrawal fees, or conversion fees when converting to greenbacks or another currency.
Most importantly, by lending your digital assets to the platform on which you trade or hold them, you become an unsecured creditor of that company. If it or any other company it lends your assets to has a problem, so can you.
If your bitcoin broker goes bust, in plain English, you could be at the end of the line in bankruptcy court. “The returns come from real counterparty risk,” says Ari Paul, chief investment officer at BlockTower Capital, a digital asset management company. By lending your virtual assets to a broker, “you are effectively investing in a startup debt,” he says. A single digit return may be too low to compensate for this risk.
Hence, borrowers have to pay high interest rates in order to attract virtual money holders to finance. Returns are also high as fledgling companies struggle to attract clients who trade in them and hold assets, says Campbell Harvey, a Duke University finance professor who studies the market.
Additionally, a certain broker may offer high interest rates to entice customers into using their unique currency, which otherwise could have difficulty finding users. The higher the interest rate you get on borrowing your virtual assets, the riskier the transaction.
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All of this explains why the returns on these currencies are so generous, even though crypto finance companies have much lower operating costs than traditional banks.
What about the ultimate techno nightmare? Could a digital currency go to zero and negate all of your interest income by wiping you out? This is always a possibility given the inherent volatility of cryptocurrencies, but some, like Bitcoin, have also seen stratospheric returns recently.
If you’re a risk taker who enjoys the ride when an asset goes up and can laugh at the losses when it crashes, you might want to consider letting a broker borrow your cryptocurrency at a generous rate.
If you are not affected by the extraordinary volatility of virtual money, you can earn interest on it too.
If the price continues to rise, the income increases along with your rate of return. Instead, if the price goes down, your interest income should at least mitigate your losses.
On the other hand, if you are investing in income, security is probably most important to you – not just the return on your capital, but the return as well. Bitcoin and other novel currencies are among the most volatile financial assets in the world. If you don’t want to take the risk of holding them, it doesn’t make sense to take the risk of lending them either.
Write to Jason Zweig at firstname.lastname@example.org
Corrections & reinforcements
The Duke University finance professor who studied cryptocurrency savings accounts is called Campbell Harvey. A previous version of this article incorrectly stated his name was Cameron Harvey. (Corrected March 5th)
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