Unchained Capital and the future of crypto lending

This morning I listened to one of the back-episodes of The Flippening Podcast during which host Clay Collins interviews Dhruv Bansal, founder of Unchained Capital.

Unchained Capital is a company that will lend you US dollars, using your bitcoin holdings as collateral. Why would you want to do that? A key motivation is to avoid the tax liabilities one faces when selling highly-appreciated bitcoin.

Unchained require you to provide twice the amount of the loan value in BTC, and charge an interest rate, including all fees, of between 10% and 14%. The default terms allow you to make interest-only payments during the loan period, with a balloon principal at the end. If the value of your BTC drops to 150% of your loan value, they ask you to provide more collateral—what they refer to as “collateral maintenance”—and if BTC drops to within 110% of your loan value, they have the right to consider the loan in default, sell your BTC, return the principal, and pay you anything left over.

So this all sounds great.

I became particularly intrigued, however, when the conversation turned to the advanced custodial systems that Unchained Capital are developing. A while back, I posted an article outlining my ideal cold storage solution—something that doesn’t exist today.

Considering those two things together, I began imagining the ideal Unchained Collateral product I’d love to have available:

  1. I would hold two wallets with Unchained, a personal wallet and a collateral wallet.

  2. The personal wallet is where I keep all my personal bitcoin holdings. It’s my cold storage solution, and checks as many of the boxes in my previous post as possible. Unchained holds one of the keys to this M-of-N multisig wallet.

  3. Based on my personal holdings, Unchained extends a pre-approved line of credit to me.

  4. Whenever I need US dollars, I simply make an online request that involves signing a transaction to transfer the required amount of bitcoin to the collateral wallet.

  5. My Unchained account is ACH linked to my bank account, so that once I complete the request process, my funds can be immediately transferred into my bank account.

  6. Since my bank account is linked, I have an option such that my interest payments are auto-debited from my account.

  7. When I want to pay off the principle of my loan, I login to my Unchained account, and can initiated a “settlement” transfer precisely for the outstanding principle and interest (the amount of which, is conveniently pre-calculated for me.)

  8. If collateral maintenance is ever required, I get an email asking me to sign into my personal wallet, and authorize the necessary transfer to the collateral wallet.

  9. As my track record on the platform builds over time, I earn improving interest rates, incentivizing me to become a long-term customer.

This would be a beautiful solution, that solves my cold storage challenges, while at the same time providing me a line of credit, the use of which couldn’t be more convenient.

Earn passive income through staking, masternodes and lending

If you’re a long-term investor in cryptocurrencies, you’re probably holding some coins that you don’t intend to sell for many years. In this article, I’m going to discuss three ways you may be able to put those coins to work earning passive income, through staking, masternodes and lending.

I’m going to organize this article into an introduction to the concepts of staking and masternodes, then dive into the details of my approach to both, and conclude with a description of how I earn interest through lending.

Introduction to Staking

Readers will probably be familiar with Bitcoin’s consensus approach, called “Proof-of-Work” (PoW), in which miners spend energy computing hashes in order to validate transaction blocks and earn rewards. A more energy-efficient alternative to PoW is called “Proof-of-Stake”, in which the actors who validate blocks can be anyone who holds the blockchain’s token and is willing to “stake”, or lock-up, those tokens.

In a Proof-of-Stake network, the staker’s local wallet joins the global pool of stakers who are available to validate the blocks of transactions. When the network has a block of transactions to be validated, a staking wallet will be selected deterministically. The frequency with which a given wallet will be selected, is a function both of the number of coins being staked, and how long those coins have been staking, such that the stakers most dedicated to the network are chosen more often.

What’s in it for the stakers? Unlike PoW systems, there is no “block reward”. Instead, the staker that is chosen to validate a given block of transactions gets to keep the fees associated with the transactions in that block. For someone holding a PoS coin for the long-term, staking can be a source of passive income.

Introduction to Masternodes

Another interesting concept is the Masternode. In Bitcoin, the network is secured exclusively by miners. Networks like DASH, however, which involve additional functionality beyond validating blocks, add a second layer of “nodes”, called masternodes.

Masternodes, like miners, are permanently-available servers that provide second-layer functionality to a blockchain’s network. In the case of DASH, masternodes provide services such as its “Instant Send” feature, and “Private transactions”, in which the masternode mixes (obscures) transactions, like traditional bitcoin tumblers.

Masternode systems also require their operators to stake coins, and for their services, masternodes receive a percentage of the network’s mining fees, resulting in another potential form of passive income for the masternode coin holder.

Choosing your strategy

Let’s now think about staking and masternode strategies. Here are some considerations:

  • Opportunity cost — The total return you’ll receive on your investment is the sum of the coin’s annual price appreciation plus any returns you receive from staking or masternoding. Therefore, an investment in a coin whose price appreciates 15% per year is a better investment than a coin which provides 5% staking returns, but whose price is declining over time.

  • Minimum investment — While most staking systems don’t impose a minimum balance, all of the masternode systems I’ve seen do. The minimums vary by coin. In the case of DASH, it’s 1,000 coins, or at today’s prices, almost $500,000 USD. In the case of PIVX, it’s 10,000 coins, or about $50,000 USD.

  • Complexity — Staking involves leaving your GUI wallet open at all times, and can be achieved by anyone. Masternoding, on the other hand, involves running masternode software on a server that’s always connected to the internet—e.g. a hosted VPS at DigitalOcean—and therefore requires expertise of Unix-based system operation and administration. (Note that there are services available that will run a masternode for you, for a fee, but these are not covered in this article.)

  • Annual return — There are websites such as Masternodes.online that rank blockchain projects by the ROI of their masternodes:

As you can see, some master nodes offer annual returns in the four digits! Any student of history or economics, however, will know such returns are not sustainable. For the most part, I would ignore lists like these, and only stake or masternode a coin in which I would invest without any potential for passive income.

(An aside before moving on — In reporting returns of staking and masternodes, I commonly see the term ROI, return on investment, misused. ROI is a measure of total return, and what we’re interested in is the annual return. That measure is called IRR, or internal rate of return. If you have a savings account paying you 5% per year, its IRR is 5%. If you put money in that account, and leave it there for 5 years, your ROI will be 27.6%, or 1.055-1.)

In light of the above, here are coins that I masternode or stake:

  • DASH — For the next handful of years, one focus-area for me will be coins that address the use-case of money, and in that realm, I believe a small set of anonymous/privacy coins will flourish. I believe one of those will be DASH, based on its momentum and funding. Since I don’t hold 1,000 DASH coins, running my own masternode is out of the question, but I did find a great shared masternode service that I’ll describe in detail below. I’m currently earning around 7.5% IRR with DASH.

  • PIVX — PIVX is another anon/privacy coin that I like, on the basis of its technology and community. By design, there’s not a lot of economic benefit to masternoding with PIVX versus staking, and so for simplicity I just stake my coins and am currently earning around 5.0% IRR.

  • BLOCK — Blocknet is an interoperability project that I was turned on to by @notsofast, which I like based on its role—I believe cross-chain interoperability will be increasingly important—and by the pace of work I’ve observed from the project. I’m currently staking Blocknet, and am seeing an IRR of over 30%. I didn’t choose the project for that return, and I don’t imagine it will be sustainable for too long, but while it lasts, I’m not complaining!

What I do…

At this point, I’ll now dive into the details of DASH shared masternoding, PIV staking on Mac OS X, and then conclude with a discussion of margin lending at Bitfinex.

DASH Shared Masternoding

In a shared masternoding system, the masternode operator funds the masternode—1,000 coins in the case of DASH—from the contributions of multiple people, and then distributes the rewards pro-rata to the participants, minus a fee for providing the service. A critical difference between operating your own masternode, and participating in a shared service, is that in the latter you have to send the operator your DASH, rather than retaining them in your wallet. So shared systems require that you trust the operator.

For DASH, I was able to find two such services, Masternode.me, run by “Moocowmoo”, and Dashmasternode.io, run by “Splawik”. Both of these individuals have good reputations in the community. Moocowmoo charges 15% for his service, while Splawik charges 10%. Despite paying more, I went with Moocowmoo for the following reasons:

  1. Automation — Moocow has completely automated his service. Upon signing up, you receive a PGP signed welcome message containing a unique DASH deposit address assigned to you. You can, at any time, deposit DASH to this address, in multiples of 25 DASH, i.e. your deposits can be 25, 50, 75 DASH, etc. Upon deposit, you receive a PGP signed deposit receipt, indicating the address of the masternode to which you are contributing, the percentage of the masternode’s payout you will receive, and the address to which you will receive those payments. To redeem you DASH, you simply return the welcome message by email, and all your deposits are returned to their sending addresses. (For that reason, it’s important to deposit from a local wallet, and not an exchange.)

  2. Security — Moocow has engineered a “dead man’s switch” system that will ensure all customer funds are returned in case something happens to him. The way his system works is, should any of his session logins remain idle for 30 days, his dead man’s switch monitor will assume something has happened, and will automatically dispatch pre-signed transactions to return customer funds.

So far, so good. I’ve made a couple of deposits, and am regularly (roughly weekly) receiving payments and payment receipts, and earning about 7.5% IRR.

PIVX Staking

The PIVX network applies a dynamic algorithm that shifts the proportion of rewards between stakers and operators of masternodes. An estimation of rewards between the two options can be found at this convenient online calculator. In my case, I chose simplicity over rewards maximization, and went with staking. Following are the details.

One begins by downloading the wallet from the PIVX site. After downloading and installing the wallet, here’s how you get going:

  • From the PIVX-Qt → Preferences → Main area, enable “Start PIVX on system login”—since your wallet can only stake coins when it’s open!—and set “Preferred Automint zPIV Denomination” to a large number like 5000.

Why the 5000 number? Starting in version 3 of the wallet, PIVX introduced their next-generation zPIV “Zerocoin”. At some point in the future, staking zPIV coins will be more profitable than staking PIVX, but at the time of this writing, it’s not possible to stake zPIV at all. So for now, we only want PIVX in the wallet.

By default, the wallet will auto-convert 10% of your received PIVX coins to zPIV, and by entering 5000 in the above setting, we can prevent that from happening. (There’s also a setting you can enter in the pivx.conf file to disable the conversion altogether, but I didn’t want to risk forgetting about that in the future.)

  • From the PIVX-Qt → Preferences → Wallet area, enable “Coin Control”, the purpose of which I’ll explain later in the article.

  • Now do Settings → Encrypt Wallet... and create a password for your wallet.

  • Create a new receive address from the Receive tab, and transfer some PIVX into your wallet (from an exchange, or wherever.)

  • Click (or toggle) the lock icon in the bottom right corner, enter your wallet password, and enable “For anonymization and staking only”. This will allow your wallet to safely keep the wallet unlocked for staking.

After unlocking your wallet for staking, and after the coins in your wallet have received something like 101 confirmations, you’ll see the staking icon (next to the lock icon) become green, indicating that you’re currently staking your coins.

Within a day or so, you should start seeing staking rewards flow in. Yeah! The value of the reward will be a more or less a constant, corresponding the block transaction fees, but the frequency with which you receive them will be a function of the number of coins you are staking and how long you’ve been staking them.

Before concluding this section, there’s a couple of important things to notes:

Backups — If you’ve used an HD (hierarchically deterministic) wallet in the past, like Exodus, you’ve probably gotten accustomed to backing up your private key or mnemonic once, knowing that any time in the future you can recover the wallet, and all its derived addresses, from that original backup. That’s not the case with the current PIVX wallet. In principle, each time you receive staking rewards, or add a new receive address, you should backup your wallet, by doing File → Backup Wallet and giving the backup file the extension “.dat” (e.g. wallet.dat).

I wish that could be automated, but for the moment, I try to remember to backup every week or so.

Input consolidation — Each time you receive a staking reward, it will create an “Unspent Transaction Output”, or UTXO, on the address holding the staked coins. Over time, as the number of UTXOs grows, your wallet file will grow in size, and the wallet software itself may lose stability. This requires some periodic maintenance, called “inputs consolidation”, and here’s how you do that.

  • In the Receive area, create a new receive address.

  • In the Send area, click the “Coin control” button. This will open a window listing all your UTXOs. Click “Select all”, and then then “OK”, to close the window.

  • Back in the Send area, you’ll see the number of selected UTXOs indicated at the top left. At the top right, you’ll see a value representing something like “total value minus transaction fees”. Precisely type that into the “Amount” field. (Maybe the Qt team will pre-fill that in the future.)

  • In the destination field, paste in the receive address you created in the first step, and then click “Send”.

So what we’re doing is sending ourselves the value of all our UTXOs, and consolidating those values into one single address. You’ll have to wait for that self-send transaction to confirm something like 101 times, after which staking will again be enabled, and you’ll have a nice, squeaky-clean wallet (for the time being).

Margin Lending at Bitfinex

In this section, I’m going to discuss the third and final way in which I earn passive income—margin lending.

Bitfinex is one of the world’s largest exchanges, and like many, provides margin to its traders, allowing them to access up to three times the funds they have on deposit. Rather than funding this margin using the exchange’s reserves, Bitfinex have implemented a peer-to-peer system in which Bitfinex customers themselves can provide margin funding, thereby earning interest.

Assuming you trust the platform, the risks associated with margin lending are relatively low. I was affected by the Bitfinex hack a few years ago, and was impressed by the innovative recovery model they put in place, socializing the losses and issuing the BFX tokens with a par value of $1, which they eventually paid back.

Due to that experience, along with observation of the technology and UI innovations they regularly push out, I trust the platform, to an extent at least. However, we should never forget that exchanges are continual targets for hackers, and should weigh that fact when deciding how much of your funds you want to keep lent out on any exchange.

As you can see below, it’s possible to lend everything from USD to any of several cryptocurrencies. The interest rates indicated are daily, so USD loans are currently paying about 5%, while ETC loans, for example, are paying about 18%.

What I’ve observed is that when the price of bitcoin is increasing, the USD lending rates increase, as traders borrow USD to purchase bitcoin now, with the expectation of selling those bitcoins for USD at a higher price later. Upon returning the lent USD, they’re left with a USD profit. Inversely, when the price of bitcoin is dropping, bitcoin lending rates increase, as traders want to borrow bitcoin to sell now for USD, with the expectation of buying them back at a lower price. After returning the lent bitcoin, they are left with a profit in bitcoin.

Since the lending rates of bitcoin and the USD move in opposite directions to each other, I keep some of both continually lent out on the platform. When times are quiet, the lending rates tend to drop to around 5%, and when there are sharp moves in the market of bitcoin, the rates of one or the other can suddenly increase to 50% or more.

There is an area in the left-hand side of the platform where one can make a lending offer:

You can enter a specific daily interest rate, or you can specify to use the “flash-rate”, or FRR, which is a dynamic market rate computed by the platform. As a consequence of most people auto-renewing their loans (see below), the manual offer form provides a “variable FRR” feature allowing you to place an offer for an interest rate that’s some discount to the FRR. The terms of the loans can be anything between two and 30 days.

If you make a manual offer that’s accepted, you’ll need to remember to return to the site when the term expires if you want to try to renew it. There’s a few problems with this. First, your offer might be taken in chunks, by multiple traders. Second, a trader can return the loan at any time. He or she doesn’t have to wait for the term to expire.

For this reason, most people use the auto-renew feature, and set the lending rate to the FRR, in order to allow the platform to determine the current market rate.

With an auto-renewing loan, set at the FRR, you can start lending your money and/or coins, and then forget about it, as the platform will attempt to keep your funds continually lent out at the FRR.

The only downside to auto-renewed lending, is that since most people use it, there is usually a lot of money on offer at the FRR. And those offers are consumed on a first-in-first-out basis, which means your auto-renewing funds will sit un-loaned for a period of time while working their way to the front of the queue. Not the end of the world, of course, but that does result in a slight drag on your potential returns. (To address that problem, and optimize the lending term, I run some custom software that I developed.)

The average interest rate you’ll earn over the period of a year can vary greatly, depending on factors like the market dynamics of the coins, the total availability of funds, and behavior of the lenders. On average, one should expect something between about 5% and, say, 10%.

Update — The CryptoLend service can fully automate lending not only at Bitfinex, but other exchanges as well.

Crypto Lending at Celsius & Compound

Since publishing this article, some new options for earning yield have emerged:

  • Celcius — Celsius loan cryptocurriencies like Bitcoin and Ethereum to hedge funds who want to short the currencies, and require USD collateral of around 120% to 150%. To source the crypto for the loans, they allow their own customers to deposit crypto with Celsius, and they share the yield with their customers. At the time of this writing, they are paying about 3.5% APR on deposited Ethereum, and 3.75% APR on deposited Bitcoin. Currently they pay interest in the deposited currency, but plan to pay in their own token, CEL, at some point in the future. The risks, as I see them, are two-fold: (1) You’re handing over custody to a third party, who in theory could simply run off with it, and (2) if a Celcius customer defaults on their loan, you have to hope Celcius have enough collateral to make you whole.

  • Compound — Compound is a Smart-Contracts based lending platform on the Ethereum network. It seems the yield on various ECR-20 tokens is quite low at the moment (c.a. half a percent). In this case, one would hope the custody risk is less than with a centralized organization like Celcius, but you’re also exposed to the risk of bugs in the smart contracts.

Conclusions

If you’re a long-term investor in cryptocurrencies, there are opportunities to put those held funds to use earning passive income. This article has discussed staking, masternoding and margin lending. I hope you’ve enjoyed it.