by Alex Broudy, Technical & Financial Writer
Oct 31, 2022
This week, the Federal Reserve will announce new interest rates for the United States. With more rate hikes expected, long-term investors are beginning to look at digital assets that have the potential to earn yield. While some investment strategies like digital asset lending and staking offer investors alternative ways to earn passive income potential, not all are created equal. Let’s review how these new investment solutions stack up, so investors can make more informed decisions.
Digital asset lending follows traditional financial lending principles but is managed via smart contracts. A borrower connects with a lender to secure a loan, and a smart contract is set up to establish when the borrower will repay the loan, plus interest. Lenders receive interest payments over the course of the loan and receive the principal when it comes due. This simple arrangement provides borrowers with liquidity and a regular revenue stream for lenders. While digital asset loans operate similarly to traditional lending services, there are a few key differences.
One key difference is that digital asset loans are bound by smart contracts, which automate interest and principal payments so that borrowers and lenders know exactly what they’re getting and when. This automation removes many of the frictions that both lenders and borrowers experience using traditional financial services. While these benefits are significant, digital asset investing retains elements of risk that investors should keep in mind, including market, liquidity, and regulatory risks. For this reason, active management is also available.
Other, new digital asset services like staking offer similar opportunities for yield generation by a different means. Instead of relying on financial services to generate an annual percentage yield (APY) by lending out individuals’ savings, staking enables individual investors to lend their own digital assets out to a protocol that helps keep the digital asset ecosystem secure in exchange for receiving redemptions on a regular basis. This process has several advantages.
Staking is similar to lending in that assets are lent out with the expectation of returns, but the way they operate differs. Staking enables investors to self-custody their digital assets or participate in custodied, active management solutions. Lending relies on custodians and active management to administer investment funds. For investors seeking to minimize risk, finding an asset manager that can balance active management with automation can make a significant difference.
While both digital asset lending and staking offer potential yield generation, some liquidity risks remain. By using additional financial services like options trading, it becomes possible to mitigate these risks. This is known as "beta plus," an active management strategy that optimizes return potential by providing beta exposure, plus the ability to hedge.
When lending and staking are combined, the yield generated has the potential to offset possible devaluation of the underlying digital asset. If the underlying falls in value and the desire to borrow follows suit, then options trades can help mitigate investors’ losses. This actively managed type of yield fund combines the advantages of traditional financial services with the benefits of newer, digital services like staking.
As the next Federal Reserve interest rate decision approaches, investors seeking to earn potential yield now have new alternatives to consider. To learn more about digital asset solutions like yield funds and staking, subscribe for updates below.
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