The “DeFi” movement promises high interest but high risk

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Earlier this year, San Francisco start-up Compound promised yield-hungry investors something rarely seen in the United States: interest rates sometimes exceeding 10%, just to transfer money to the lending platform of its application.

Compound is not a bank, in the colloquial sense. Rather, it is one of dozens of new groups in Silicon Valley developing so-called decentralized finance – or “DeFi” – projects aimed at disintermediating traditional financial institutions.

To date, digital currencies and their underlying blockchain technologies have been widely used for speculative trading. But DeFi start-ups are trying to build a nested financial system denominated in cryptocurrencies, offering a wide range of lending and derivative products available worldwide, peer-to-peer and without any middlemen.

The movement accelerated in 2019, with investments from traditional investors such as Andreessen Horowitz and Bain Capital Ventures. Even former UK Chancellor George Osborne has shown his support as a partner in his brother Theo Osborne’s venture capital group 9Yards Capital, which backs several DeFi startups.

“2019 will be known as the year of DeFi for crypto,” said Monica Desai, an investor at venture capital firm Kleiner Perkins. “Some of the best talent in the space right now is in DeFi. And because they see the use, more people are building there.

But DeFi is still nascent, freewheeling, and largely unregulated. Most companies only launched their initial products last year, and total assets have yet to exceed $1 billion. Meanwhile, critics warn that the industry’s technological limitations and untested economics may not work when handling larger trading volumes.

“[DeFi] is a sign of things to come and a super interesting sandbox,” said Simon Taylor, former vice chairman of Barclays and co-founder of fintech consultancy 11:FS. “[But] it is both very dangerous and the Wild West.

What is DeFi?

DeFi gained traction in late 2018 as an umbrella term for a loose collection of blockchain projects focused on eradicating all human involvement in financial services. For promoters, this promises a faster, more inclusive and transparent financial system.

The movement encompasses, for example, “decentralized” exchanges and lending platforms. Here, one does not depend on a central intermediary to hold funds – instead, transactions and loans occur directly between participants through automated processes.

“Over time, you have the ability for anyone to access savings accounts, access loans, and earn income in a stable currency that’s not tied to where they live,” said Ms. Desai.

The apps run on blockchains, the immutable public ledgers that record transactions in cryptocurrencies such as bitcoin. Most are built on the Ethereum blockchain because it can be used to create smart contracts – essentially computer code that automatically triggers when certain conditions are met. Ether, the associated currency, is the second-largest cryptocurrency by market capitalization behind bitcoin, trading at around $130.

But several other protocols, such as Tezos, Algorand, and Dfinity, are also being developed to support DeFi applications.

Who are the key players?

While the amount of money locked up in DeFi products is relatively small – around $700 million, according to data compiled by DeFi Pulse – it has nearly tripled this year, with outsized returns and a flurry of new initiatives helping to propel the growth.

DeFi Prime, an industry-tracking website, has over 200 related projects offering everything from prediction markets to margin trading.

The most popular applications have focused on peer-to-peer lending markets backed by stablecoins, cryptocurrencies that are heavily pegged to fiat currencies such as the US dollar.

In the case of Compound, the largest of the lending platforms, stablecoin holders provide their assets to a “liquidity pool” from which borrowers can draw. Compound’s algorithm, or “protocol”, automatically sets interest rates based on supply and demand.

Transactions occur continuously, so lenders earn frequent but fluctuating interest. On the other hand, borrowers must pledge more collateral, in the form of other crypto-assets, than the value of their loan, providing additional protection for the system in the event of default. Compound says it has more than $120 million in interest on its app.

“When the borrowing demand for an asset is very high, the interest rate is high, and when the borrowing demand for an asset is low, the interest rate is low,” said Robert Leshner , founder of Compound, which raised more than $24 million in a fundraising round led by Andreessen Horowitz in September.

Maker DAO, which is responsible for the Dai stablecoin, is another well-known project. Billed as “the world’s first unbiased currency,” users obtain Dai by opening a secured debt position with Maker, which provides the tokens as a form of debt backed by Ether and a growing list of other cryptocurrencies.

Dai holders have locked nearly $350 million in Maker’s protocol, according to DeFi Pulse, more than any other similar app, though the project has been plagued with infighting.

How lucrative is it?

Like other speculative ventures, DeFi startups have focused on building their technologies and user bases rather than profitability. This means that low fees coupled with high returns have attracted the space for users.

“What is happening more and more in DeFi is not wild speculation but saving dollars with a nice return and relatively limited risk,” said Brendan Forster, COO of Dharma, which acts as a digital bank depositing user assets on the Compound protocol.

But that could change in the future.

Dharma does not charge users anything, although Forster said the company would likely introduce fees next year.

Compound collects more than 10% of the interest charged to borrowers on its application, which it sets aside as reserves.

Some worry that lower interest rates — as more users flood the space — don’t compensate investors enough for the risks of the platform.

“One of the big questions hanging over DeFi is the sustainability of economic returns for participants lending your crypto,” said Garrick Hileman, academic and head of research at Blockchain.com, a cryptocurrency holding company.

How likely is it to revolutionize finance?

It’s too early to tell, although early adopters are predictably optimistic about DeFi’s long-term prospects.

“Fifty years from now, I don’t see us still depending on trusted intermediaries to resolve [foreign exchange] transactions,” Mr. Forster said. ” That does not make sense. . . Why use humans when we have code that can do it perfectly? »

But even some proponents acknowledge that DeFi is highly experimental and exists in a regulatory gray area.

“It’s not ready for consumer use and it’s not ready for human consumption. . . This first phase is really for very sophisticated researchers, professionals, speculators,” Leshner said, adding that he believes DeFi will become a mainstream technology over the next decade.

There are also practical barriers to widespread adoption. Ms. Desai noted that users must first purchase existing cryptocurrencies such as Ether to access DeFi products, adding that “tax regimes are confusing.”

And like everywhere else in the cryptocurrency space, there are risks of scams.

“It in some ways echoes the peer-to-peer lending space [and] there are challenges in this space that could be instructive,” Hileman said, pointing to the crisis in China’s P2P lending industry, where a series of fraud and negligence cases have shocked investors in recent years.

“In 2020, it will still be ill-defined and overrated,” said Tim Swanson, research director at Post Oak Labs. “Regulators will increasingly learn how, in many cases, DeFi is often fundamentally non-compliant. . . with the fight against money laundering and know the rules of your clientele. »

Some also pointed to systemic risks. The initiatives all rely on the protocol on which they are based, such as Ethereum, which faced early difficulties as it began to handle larger transaction volumes. They are also tied to the cryptocurrencies that power these protocols – which remain vulnerable to price fluctuations.

“You need to address the underlying technology issues of the protocols so that users can safely deploy these decentralized applications,” said Steve Kokinos, managing director of smart contract protocol Algorand.

Meanwhile, DeFi’s economy has not been tested on a large scale. And without human intermediaries overseeing the settlement of transactions, users have to trust the software completely, which means any problem could completely upset the system.

“What excites me is where we could be if most products could be made without requiring the paper [and] expensive legacy tech banks do it,” Taylor told 11:FS. “Anyone could create financial products. That doesn’t mean anyone should.

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