Core Question

Lending USDC is an "easy" way to earn passive yield. Or is it?

What is USDC lending?

Lending USDC means that you put your USDC in a pool where investors looking to collateralize or leverage their positions borrow your USDC. They put up BTC, ETH, or other cryptocurrency as collateral on the platform and get USDC in return, having to pay interest on it to the platform. The platform then pays that back to you while keeping a small share of it to keep running.

The danger

We all know the typical danger with this. If the platform goes into a default or code exploit, then your funds are gone. No support to turn to. Just crypto lost in the abyss.

So, in order to minimize this risk, investors pay for insurance. They give up a portion of their earned yield in order to have their amount insured. Now, this seems relatively safe, but there is something hiding beneath the surface. 

In order to understand what this risk is, we have to look at how these insured protocols work. Usually, when you decide to lend it out, you get asked whether you want a higher yield but without insurance, or whether you accept a lower yield but with insurance.

When the platform gets code exploited, then the platform will take all the money from the high earning pool and pay it out to the insured earning pool. Now, this seems safe, but we have to second guess this and scrutinize it further.

There are multiple problems with this sort of insurance. And they all end badly for both pools.

•  1. The first risk and the most obvious, is that the insured pool is almost always greater than the uninsured one. So, the moment you choose insured yield, your capital is not truly fully backed

• 2. The second risk is that in a code exploit, both pools get drained. It is not like the attacker(s) think, "Ok, this is lent out without insurance so let me leave that alone while I steal this insured account's funds." They just want to hurry on up and get everything they can, so with an initial smaller uninsured pool compared to insured, there is even less, if at all, of an uninsured pool to pay after this attack.

• 3. If all cryptos just crash in price, then the platform will then liquidate a lot of positions, and in extreme cases, they won't get enough money back from selling. So when you try to withdraw your USDC, you won't be able to, as the platform has defaulted (ran out of money/liquidity).

• 4. The fourth problem is that in many insured earning protocols, the amount you earn in the insured pool either matches inflation/is slightly above. So, you are mostly just keeping your position as is without any meaningful growth. Inflation, am I right.

So, these seem to be bad for both pools, so why not just go with the higher yield one if you are losing your capital no matter what? Well, that is because in order to double your purchasing power (so that you can withdraw that and have your original investment back with all future gains at 0 risk), you need roughly 20 full years assuming nothing changes (like policies, platform rules, interest rates, etc.). This 20 years is assuming a generous 7% yield minus 3.4% inflation, so a net increase of about 3.6% a year. So, you have to trust that over 20 years, not a single bad thing will happen. And keep in mind that code exploits have happened multiple times, and the entire crypto ecosystem is only about 18 years old since it has been created (not even since USDC lending became a thing).

Final Thoughts

If you don't mind having capital at risk for some passive money and keeping up with inflation, then go ahead, but, I would not recommend lending out too much USDC. Or holding too much USDC for that matter if government control was what got you into crypto, because Circle can freeze your USDC at any time upon request from a government or from a court order. But rest assured, they do not freeze wallets at their own discretion. 

If you disagree or have any pointers, then feel free to comment. Just be nice :)