With claims of significantly higher interest payouts than traditional banks, the development of crypto banks and yields have seen a rapid rise these past few months. This ascent begs the questions: how is this possible? How are these digital financial institutions able to pay their users such high interest rates? And, more importantly, what really is a crypto bank?

How Crypto Banks Work

To understand how a crypto bank functions, one must understand how a traditional bank functions. 

Typically, people associate banks with brick and mortar buildings that hold physical cash backed by governments, precious metals, or another representation. Crypto banks, alternatively, aren’t associated with any physical locations or currency. Rather, crypto banks hold consumers’ crypto holdings, backed on the blockchain with a public ledger that anyone can access. Given that the blockchain is powered by a decentralized network of computers and secured through smart contracts, crypto banks are more transparent than traditional banking institutions.

Interest and Crypto Banks

Crypto banks and normal banks both lend currency to individuals or institutions. A normal bank, for instance, will take a customer’s deposits and use it to lend to another customer with a specified interest rate. Consumers who use these banks will receive a small portion of the interest banks earn as a payout for lending their capital. 

Crypto banks work similarly, but unlike normal banks, crypto banks do not have the same reserve requirements normal banks do. Reserve requirements limit the amount banks can lend out by requiring them to have a certain amount of currency in storage. As such, crypto banks are able to offer users interest payouts as high as 8-12% annual percentage yield (APY).

Such interest rates are not without drawbacks. Unlike normal fiat currency, cryptocurrency is volatile. The value of a cryptocurrency held by a DeFi bank can drop to zero overnight. Withdrawing cryptocurrency and converting it to normal fiat currency can likewise result in gas fees, tapering the return amount markedly. 

Conventional Banks vs. Crypto Banks

At first glance, it may appear that crypto banks are superior to normal banks given their high yields. But crypto’s instability may defeat the entire purpose of housing funds in a central digital location. Conventional banks provide utility for their security; one can invest their capital and be assured with certainty that their money will remain secure for some period of time. This same sort of security does not exist in DeFi banks. Depositing one’s currency within a crypto bank is an investment into the currency, a belief that whatever coin—Bitcoin, Etherum, Solana, or any other crypto—will maintain its value such that the yield will prove beneficial.

Are Crypto Banks the Future?

As with most innovation within the realm of cryptocurrency, the ubiquity of a new technology relies on stability. For a normal consumer with limited capital, placing one’s money into a crypto bank for higher yields is a risky decision. However, these banks also represent increased accessibility to finances and economics—federal regulations aren’t as prominent, and interest rates are more reliant on consumer supply and demand. Regardless of whether crypto banks become the new norm, the innovation is playing a significant role in democratizing finance. 

Jibran Khalil is a computer scientist and entrepreneur from the University of Texas at Austin. He is a Tech Innovation Fellow at Identity Review and creator of My Workout Group, an iOS app that uses social accountability to help people workout. 

Contact Jibran at jibran@identityreview.com.

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