One of the benefits of writing a newsletter without a narrowly defined theme, is that I can cover whatever I’m interested in at any given time. This weekend, that has been decentralised finance, popularly known as DeFi.
DeFi refers to a wide set of crypto products and services that aim to replace offerings we all know from “TradFi”, or traditional finance. Savings accounts, lending and borrowing, interest rates, derivatives trading, credit scoring and all the rest of it – there is a DeFi equivalent to them all, plus a bunch of innovative DeFi-only services to boot.
So what, you say? Does non-bank banking sound a little dull?
Well, what if I said you can earn over 20% interest, almost risk free, on your savings? Or what if I told you you can take out a loan that repays itself? Or that you can borrow money by using your own personal reputation as collateral?
These are just some of the weird and wonderful things that are possible in DeFi right now. The speed of innovation in this space is utterly bonkers, and just keeping up with the most ground breaking news is almost a full-time job. I know most of you readers don’t have time to read up on all this, so this post is meant as a quick introduction to DeFi. If the future of finance is being built before our very eyes, this post is my attempt at removing your eye shades.
Let’s have a look.
Where Did DeFi Come From?
DeFi has been one of the promises of crypto from the very beginning – “digital gold”, aka Bitcoin, was just the first building block of what seems to become a full-fledged digital, internet-native financial system.
As Bitcoin slowly gained more and more legitimacy over the last 12 years, it paved the way, technologically, mimetically and philosophically, for the Cambrian explosion of DeFi products going on right now.
In other words, DeFi is just a natural stop on the evolutionary path of cryptocurrencies and blockchain technology. As these phenomena move through the technology adoption curve from innovators (like Satoshi and friends) to laggards (like boomers and hedge fund managers), we see a positive loop that feeds on itself: more people hear about DeFi, which leads more people to put money into DeFi. More money in the ecosystem leads to more legitimacy for DeFi, which in turn makes the slightly more skeptical people to take DeFi seriously, which leads some of them to put money in, and then the loop repeats again and again, building ever more momentum.
As more and more people show an interest using DeFi products, increasing numbers of extremely smart people enter the crypto space to build new DeFi products and services to cater to the rising demand. Which leads to even more people hearing about DeFi, and so on. You get the idea – the flywheel has been set into motion, and it shows no signs of slowing down.
What Can DeFi Do Today?
Loads of things! Some DeFi products are clones of TradFi products, while others are brand new concepts only made possible with crypto and blockchain technology. Here are a few examples:
Savings Accounts with Seriously High Interest Rates
The crypto-equivalent of “savings accounts” are popping up everywhere it seems. Just like in a traditional bank account, you put some money into these DeFi protocols, and in return you earn an interest on your money.
The notable difference is the amount of interest you receive. In TradFi, you’re lucky if you get 2-3% these days, but in DeFi, anything from 5-30% is pretty common, depending on which protocol you use and what kind of crypto asset you put in (100%+ interest rates are possible too, but these seem to be either sketchy, short-term, or both).
To mitigate risk, one might buy so-called “stablecoins”, and put these to work in “savings accounts”. Stable coins means cryptocurrencies that are designed to be stable, aka to keep the same value over time. Often, one stablecoin (like DAI, USDC or USDT) corresponds to the value of 1 US Dollar.
Loans that Repay Themselves
This is one of the wild things that seems to only be possible in DeFi. In a product like Alchemix, you can take out a loan that repays itself over time.
It took a while for me to wrap my head around how this works, but here is step by step explanation:
First, you put some crypto collateral into Alchemix, for example the stablecoin DAI.
When you’ve locked up your collateral in Alchemix, you can take out a loan of up to 50% of the value of your collateral. So if you put $10,000 into Alchemix, you can take out a loan of $5,000. You can now use that $5,000 to buy other crypto assets, or you can convert it back to US Dollars and spend it in the real world.
Now this is where the magic happens. Instead of you having to pay a centralised bank an interest on the loan the bank provided you, this dynamic is flipped on its head. Alchemix will now put your collateral to work in other parts of the DeFi ecosystem, where it will earn a yield of let’s say 7% a year. This yield is then used to automatically pay down your loan over time.
After a few years, your outstanding loan balance will go to zero, and you’ll then have both your original deposit of $10,000, and the $5,000 you borrowed and have paid down.
It is truly the exact opposite of how a loan typically works in a TradFi bank: instead of you paying the bank to get access to the bank’s capital (or, technically, the bank’s other customers’ capital) for a set period of time, Alchemix pays you to get access to your capital for a set period of time.
(Another DeFi product called Abracadabra has come along to do something similar, but since the stablecoin there is called MIM – Magical Internet Money (!) – I figured you might struggle to take an explanation of Abracadabra remotely seriously…)
Loans Based on Your Reputation
As the saying goes, a good reputation takes a lifetime to build, and two minutes to destroy. If you’re not planning to destroy yours anytime soon, you now have a chance to literally capitalise on it.
Sublime Finance lets you take our crowdfunded loans based on your social reputation. Do you have a loyal Twitter following? Borrow from your followers. Have loads of friends and acquaintances? Borrow from them.
By putting your good name on the line, you’ll have strong incentives to pay the loan back – arguably even stronger incentives than in a regular TradFi loan, where you’ll “only” lose your house if you don’t repay. After all, most high-integrity individuals would rather lose a house than their good name, so the latter could be a better form of collateral than the former.
Crypto-Native Credit Scoring
If you were to take out a Sublime loan as mentioned above, but not repay it, you’ll only get away with it once. Why? Because your past loan, and your failure to repay it, is of course tracked on the blockchain forever.
Similarly, all your past on-chain activity is, well, on chain. Therefore services like ARCX can give you a form of credit score with a single click, by just analysing your past activities in DeFi and the other parts of the crypto ecosystem. If you’ve borrowed money and always paid back on time in the past, you’re more likely to get new loans, and so on.
Gone are the extremely tedious processes in which a TradFi banker considers every aspect of your financial life to decide whether or nor to lend you any money – all of that can now be done using hard-coded, unfalsifiable proof by just looking at your on-chain history.
Where Does the Yield in DeFi Come From?
With all that said, this fundamental question has to be addressed.
The first and most obvious point is that DeFi protocols are run by software instead of by expensive bankers in suits and ties. This means they are practically free to operate – instead of paying those bankers’ insane wages, all of that money can instead be returned to the people who provides liquidity and capital to the DeFi protocols and ecosystem.
The second place yield comes from, is also fairly obvious: borrowers. Just as in TradFi, some people want to borrow crypto assets. These borrowers pay an interest rate to the lenders on the other side of the trade. Pretty straight forward.
Third, DeFi protocols need liquidity in order to function smoothly. Therefore, the people who provide this liquidity by so-called “staking”, also known as providing liquid assets to a protocol, get paid in yield for doing so. For this to be sustainable long-term, however, we must presuppose that the protocols create enough value to be able to pay liquidity providers substantial yields in the future. This does not seem to be proven yet as far as I understand things, so there is a good chance that yields might dramatically reduce as the DeFi ecosystem matures. This is indeed my primary hypothesis: I believe we have a few years ahead of us with unsustainably high DeFi yields relative to TradFi yields, and that this arbitrage opportunity will slowly be competed away as it gets easier and easier to channel capital from TradFi into DeFi.
Fourth, we must acknowledge that there is some degree of Ponzinomics going on here at the moment. Capital is flushing in to the DeFi space, and some protocols probably just pay out the new money to cover old “liabilities”. In a few years, we’ll be able to see what was legit and what wasn’t, but right now, this is honestly quite unclear. Do you own research!
What Are the Risks in DeFi?
There’s no such thing as a free lunch, not even in crypto, and you need to be aware of the risk involved in these things if you consider exploring the DeFi world.
With all DeFi products, you run the risk of the entire product blowing up due to a technical error, hacker attack or some other black swan event. If this happens, your entire DeFi savings might go to zero. Not fun. To mitigate against this, you could pick DeFi products that have been around for some time, but since the entire space is new, you won’t find anything that has proven itself stable or trustworthy over decades. The parallell to new, “innovative” financial securities that nobody really understood which lead to the TradFi blowup in 2008 seems apt, but the prevailing “this time is different” narrative is also appealing: this time anyone can see under the hood and evaluate the underlying logic of these new financial products – at least anyone who understands the technical workings of blockchain technologies (which I frankly do not, so take my analyses here with a big dose of salt).
If you deal with volatile assets, like most cryptocurrencies are (like Bitcoin, Ether, Solana and so on), you obviously run the risk of serious drops in the price of your assets. To avoid this risk, you can opt for stablecoins like DAI or USDC and use DeFi protocols to gain a yield on those. However, even then there is some blow-up risk involved – we don’t know how stable these stablecoins will actually be over the long term, even though the big ones have worked well so far despite various market crashes.
Then there is the risk of you losing what’s known as your “private keys”, which are the passwords you use to enter your DeFi wallets and accounts. This is probably a bigger risk than the previous point of dramatic technical blowups, at least if you stick to serious DeFi products. Literally billions of dollars worth of crypto has disappeared because people lost their keys – you don’t want that to happen to you, so make sure you take security seriously.
To add to the fun, there is some regulatory risk, plus loads of uncertainty about the tax implications of these things. DeFi loans may for example not be considered loans in the eyes of the tax authorities, and so on. Again, do your own research!
Where Can You Learn More?
If you’re curious about DeFi, I recommend spending some time researching this space. A brand new financial system is being built before our very eyes, and it’s frankly fascinating to watch.
Twitter and Youtube are great places to start. You could for example follow Route2FI, Kevin Rose, Justin Bram and Vitalik on Twitter (Justin also has a great channel on YouTube by the way). On the podcast front, Bankless is your best bet, followed by Modern Finance.
If you find anything interesting, let me know via email or Twitter 🙂
Have a great evening,
Is Any of this Investment Advice?
Duh, no. Absolutely not.
Also published on Medium.