In the context of cryptocurrencies, “The Flippening” generally refers to the point if and when ether (ETH) overtakes bitcoin (BTC) in terms of total market capitalization. You’ll find a great deal of discussion about this on podcasts and crypto Twitter. In this article, we examine a different flippening, one that has occurred over the past year, i.e., the flippening of interest rates earned on short-term US Treasuries versus decentralized finance (DeFi).

Let’s start by examining what has happened in traditional finance (TradFi) over the past year. In TradFi parlance, the nominal risk-free rate is the nominal interest rate on risk-free securities. Typically, short-term US Treasuries are considered to be the risk-free asset. In October 2022, the yield on a one-year US Treasury bill was 4.50%. According to the Fisher effect formula, the real risk-free rate is the nominal risk-free rate less the expected rate of inflation. Using the University of Michigan “Surveys of Consumers” one-year expected rate of inflation of 5%, the real risk-free rate in October 2022 was 4.50% - 5.00% = -0.50%, meaning that we almost broke even investing in risk-free assets in October 2022 after taking expected inflation into account. Things weren’t quite as rosy in October 2021 when the yield on a one-year US Treasury bill was 0.12% and the one-year expected rate of inflation was 4.80%, resulting in a real risk-free rate of 0.12% - 4.80% = -4.68%.

Now let’s look at the crypto markets. If anyone tells you there’s a risk-free asset in crypto, don’t believe them. Even if you custody your own funds to protect them from Celsius or FTX or (insert your favorite bankrupt centralized crypto company here), there are smart contract risks and oracle exploits and plenty of other risks inherent to crypto. However, for the sake of making a comparison between decentralized finance (DeFi) and TradFi, let’s use Curve’s 3pool (USDC/USDT/DAI) on the Ethereum blockchain as the risk-free crypto asset. According to Yield Samurai, the yield on the 3pool on October 15, 2021, was 2.73%, including CRV rewards (assuming a 1x boost). On October 15, 2022, this yield was 0.44%.

Leaving inflation out of the equation (in other words, everything is nominal in the following discussion), the TradFi risk-free yield went from 0.12% in October 2021 to 4.50% in October 2022, while the DeFi risk-free yield went from 2.73% to 0.44% during that same period. The astute reader will notice that these yields moved in opposite directions. Furthermore, we can observe that, assuming the DeFi risk premium equals the DeFi risk-free yield less the TradFi risk-free yield:

Oct 2021: DeFi risk premium = 2.73% - 0.12% = 2.61%.

Oct 2022: DeFi risk premium = 0.44% - 4.50% = -4.06%.

In other words, in 2021, you would have been rewarded with an extra 2.61% for taking the risk of DAI depegging or USDT not being fully backed or a Curve smart contract exploit or your mom accidentally shredding your seed phrase. That extra 2.61% isn’t huge, but it’s positive. In comparison, in 2022, you would have taken a 4.06% hit for accepting those crypto-related risks. Huh?

For US customers, it’s not terribly difficult to open a Treasury Direct account to earn 4.5% on one-year US Treasury bills. Getting money into the 3pool takes considerably more effort. So why the recent negative DeFi risk premium? The hassle of getting money into the 3pool also applies to getting money out of the 3pool. You would need to withdraw from Curve and then send your crypto to an exchange and send that money to your bank that would connect to your Treasury Direct account where you could earn 4.5%. In this process, your money is sitting on the exchange for a while, which makes people nervous these days, and then your bank gets an incoming wire from the exchange, reminding them that you are involved in crypto, which might raise some eyebrows given the recent headlines.

Taking all of this into account, here’s a theory describing this bizarre “flippening”: In 2021, the 0.12% TradFi nominal risk-free rate was so low that investors were willing to accept the friction of moving funds to DeFi along with the risks of DeFi to earn an additional 2.61%. In 2022, investors are willing to accept the risks of DeFi and forgo earning 4.06% to avoid the friction of moving crypto funds back to TradFi.