Kucoin and the strange case of high APYs

Several screenshots circulated on Twitter yesterday reporting APRs on Kucoin. 

#Kucoin offering staking up to 200%+ APR on USD Tether #Bitcoin #ETH.
I don’t get too excited when I see this. In fact, this worries me.
I think this is a red flag, cash grabs. pic.twitter.com/xUuD143waY

— Eunice D Wong 🦄 (@Eunicedwong) November 29, 2022

Some of them even exceeded 200%, particularly those involving Tether (USDT). 

It is worth mentioning that APR and APY are similar percentages, although there is a difference. 

The difference between APY and APR

Usually, APY (Annual Percentage Yield) is used to indicate the annual return on investment including compound interest. This is obtained by adding interest to the principal on which the interest is paid. Hence if, when these are paid, they are added to the principal on which future interest will be paid, the interest thus obtained is called compound interest, and is obviously greater than simple interest. 

In contrast, the APR (Annual Percentage Rate) represents the annual percentage rate of simple interest on the principal, and it depends solely and exclusively on the value of the initial investment, without compound interest. Thus it turns out to be lower than the APY. 

All the more reason then that APRs of 200% should be considered abnormal, if not absurd. 

The cause of the anomalous APRs on Kucoin

The cause of these absurd APRs is not yet known, but it may be due to a lack of supply. 

In fact, APRs on lending and borrowing platforms such as Kucoin’s are not fixed, but vary according to market dynamics. 

The higher the demand for loans, the more APRs increase, but it is very unlikely that APRs of 200% are consequences of increased demand. 

A similar thing can be achieved with a large reduction in supply. That is, if there are very few people willing to offer to lend their funds on Kucoin, the supply of, for example, USDT being lent may plummet, and if demand remains high all that is left is to raise APRs by a large amount to entice new bidders as much as possible. 

Chances are that something similar has happened. 

The crisis of exchanges

The fact is that after the recent failures of FTX and especially BlockFi, and that of Celsius in June, fewer and fewer holders are trusting to leave their tokens in custody on third-party wallets. 

In fact, those who had funds deposited on FTX, BlockFi, and Celsius have lost them all for now, and do not know either when they will get anything back or, more importantly, how much they can get back. 

In contrast, those who have kept their tokens in proprietary wallets, that is, whose seed or private keys they own exclusively, continue to be in possession of the same amount, unless they have lost their private keys or they have had them stolen. 

Usually, those who trade are forced to leave their funds on exchanges in order to trade them, but those who just hold them can safely store them instead in proprietary wallets, such as hardware wallets that keep their private keys offline. 

Lending services like that of Kucoin 

Kucoin is an exchange that primarily allows for cryptocurrency trading, but it also offers a lending service (borrowing and lending). 

Borrowing consists of users borrowing tokens by paying interest until they pay them back, while lending consists of lending their tokens in exchange for interest. 

In addition to trading, Kucoin also allows those who hold tokens on their wallets to do lending, which is to lend them to other exchange users in exchange for interest. The annual interest rate paid by borrowers corresponds precisely to the APR mentioned above. 

The problem is that Kucoin’s wallets, like those of all centralized exchanges, are custodial, meaning that the private keys are held exclusively by the exchange and not by the users. This means that if withdrawals are suspended or shut down, or even if the exchange goes bankrupt, users lose possession of their tokens because they can no longer use them. 

As a matter of fact, they cannot even be certain that their funds are still in the possession of the exchange, as for example happened in the FTX case where customer funds were spent by the exchange itself as if they were their own. 

In light of this, it is not surprising that many exchange users are withdrawing their funds and instead storing them in non-custodial, i.e., wholly owned, wallets. 

If this is precisely what is happening to Kucoin, or other crypto lending services, it is more than fair to expect that the number of lenders and the volume of capital offered for lending is dropping sharply. 

Market fears

But the question on many people’s minds is: are these absurd APRs only on Kucoin? 

In fact, the dynamic just described should apply somewhat to all crypto lending and borrowing services. 

However, it is possible to imagine that, in order to avoid liquidity problems like the one that is allegedly occurring on Kucoin’s lending and borrowing services, other similar services might go in search of capital to lend elsewhere as well, i.e., not limiting themselves to the funds that clients themselves voluntarily make available for this purpose. 

On the other hand, with such earnings, it turns out to be particularly attractive to lend some of one’s capital if one is assured of getting it all back with interest. 

The doubt lies precisely in the fact that such high APRs seem to suggest a shortage of liquidity on Kucoin, to the point where there is not enough capital available to take advantage of such simple and high potential gains either. 

In other words, there are those who believe that such high APRs suggest that Kucoin has liquidity problems. 

Kucoin’s response

The CEO of Kucoin commented on the issue on Twitter saying that it is just FUD. 

We've been getting many questions regarding the Dual Investment Product, which differs cordially from other high-interest guaranteed products. This is a clear introduction about the product and I urge users to understand the risks involved before trying new trading products. https://t.co/1nT6VPoDQR

— Johnny_KuCoin (@lyu_johnny) November 29, 2022

In fact, these would be APRs related only to so-called Dual Investment, which is a service that differs from other high-interest guaranteed products. 

Dual Investment is an unprotected, high-risk financial product with high returns that can also be found on other platforms. 

Therefore, it is not simply a low-risk lending and borrowing service. In fact, in the case of lending, the biggest risk is that the platform is not liquid enough to be able to repay lenders, while in the case of Dual Investment there are also risks due to price movements. 

Hence the possible insolvency of Kucoin would have to be analyzed by examining the APYs of the real lending service, and not the APRs of the Dual Investment service. 

However, despite this clarification by the CEO of the exchange, there are still people concerned about the possible insolvency of Kucoin and other exchanges. 

The reaction of the crypto market

At this point, it is clear why the crypto market seems to have not reacted to these speculations. 

On Monday, for example, the price of Bitcoin had actually dropped from $16,400 to $16,000, but probably not only due to the rumors that were beginning to circulate about the hypothesis of a lack of liquidity in Kucoin. In fact, that very Monday the news of BlockFi’s bankruptcy was released. 

Instead, yesterday it returned to $16,400, whereas tonight it also rose as high as $16,800. None of these movements seem to coincide temporally with the news that came out about Kucoin or the clarification of its CEO. 

So it certainly seems that the crypto market did not react at all to Kucoin’s assumption of insolvency, probably because the issue of high APRs from Dual Investment’s services was already well known to professional traders.