There Are No Free Lunches, Capital Has A Cost
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DeFi projects are popping up daily, and to sustain them, they require investors to stake their coins. Frequently, investors will be offered high-interest rates to stake their cryptocurrency, sometimes as much as 20% or more. However, before making these investments, investors should consider some of the factors in the staking process.
There is no industry in which the adage of "no risk, no reward" is more accurate than investing. The reason that you make money when you invest is because of the risk you are taking on. When you carry zero risk, you get paid 0.1% — or even less — in interest.
What are these "zero-risk" investments? Investments like the 10-Year Treasury Note carry minimal risk because the only risk is the government not being able to pay you back. Even more secure are FDIC-insured bank deposits. In the worst-case scenario, like a bank run, were to occur, your deposits are still protected by the government up to a certain amount.
How risk and interest correlate
When offered a supposedly "low-risk" investment at a high-interest rate, the first thing an investor must do is ask why the interest rate being offered to them is so high. What is the risk? The best thing to do is think about where else you could invest your money at a similar rate of interest because the riskiness of those investments may reveal just how risky this investment actually is.
Cannabis companies tend to borrow working capital at rates around 20%. These companies operate in a gray area under the law and, therefore, do not have access to the federal banking and credit system. As a result, they are high-risk investments since they are in an industry defined by its instability.
Mezzanine debt (also known as junior debt) is borrowed at rates that range from 16–20%. This type of debt is uncollateralized and heavily dependent on the company's success. If the company goes under, it is unlikely that this debt will be paid back because of the nature of the debt and its low place on the repayment ladder.
Similarly, revenue-based loans for small businesses seek 20% or higher interest rates. There is no collateral to secure these loans, so they present a high level of risk to the lender. Shorter-duration unsecured working capital loans follow the same principle; the lender charges more interest because they are theoretically less likely to be paid back.
And, of course, one of the most common types of debt — credit card debt — is borrowed at rates of 15% or more. About 44% of Americans say that they use credit card debt to meet their basic needs. Credit card debt is so risky because if people are struggling to make ends meet with their basic needs, they will likely struggle to pay off their credit card debt.
With all of these high-risk/high-interest investments in mind, if you are involved in a DeFi project and offered 15-20% interest for staking your coins, is the project really as low-risk as it is claimed to be? Why would they be offering you 20% interest if there truly is little to no risk to you? They wouldn't.
There are no free lunches in finance
What tends to happen in the capital market is that money is borrowed at a lower interest rate and reinvested at a higher rate of interest. It's a process called risk-free arbitrage, and that is what Wall Street does. The finance world is all about making a quick buck. For investors, that means that someone is always trying to make money off you.
A fundamental principle of investing is that you should not invest in something you do not understand. If you follow people blindly into investments, you are putting a lot of trust and money into their hands, which should be scary for any investor. Especially when you're inexperienced in the field and don't get it, you need to think twice about that prospect.
People often tend to trust people they think are smarter and savvier than them, but even that is not a metric by which you should determine what is or isn't a good investment. There might be a great team behind the project and the interest rate may earn you lots of money, but if it sounds too good to be true, it probably is.
The lesson that people need to learn about finance is that there is no free lunch in this world. It is essential to think about every aspect of an investment before determining whether it is a wise way to allocate your money. If you are being offered high interest to invest, chances are there is probably a pretty significant risk involved. It is up to you to determine whether or not the potential reward is worth the risk.
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