The DeFi movement promising high profit and high risks
This movement, according to Coinmarketrate.com, gained momentum in 2019, when bets were made by such large investors as Andreessen Horowitz and Bain Capital Ventures. Even former British Chancellor George Osborne has shown his support as a partner in his brother Theo Osborne’s venture capital group 9Yards Capital, which supports several DeFi startups.
DeFi is still a nascent, independant and largely unregulated industry. Most companies released their first products last year or the year before, and the total amount of assets already exceeds $99 billion.
Meanwhile, critics warn that a number of technological and economic constraints mean that these platforms may not work when it comes to processing large volumes of transactions.
“DeFi is a taste of things to come and a very interesting proving ground,” said Simon Taylor, former vice chairman of Barclays and co-founder of 11:FS, a financial technology consulting firm. “But, it’s very risky, and a bit like the Wild West.”
What is DeFi
DeFi first became widespread at the end of 2018 as a common name for a number of blockchain projects focused on eliminating any human involvement in financial services. Proponents of this concept promise a faster, more inclusive and transparent financial system.
This movement encompasses, for example, “decentralized” exchange and lending platforms. These platforms do not rely on a central intermediary to process funds. Instead, transactions and lending take place directly between participants using automated processes.
Eventually, anyone will be able to access savings accounts, loans and receive income in a stable currency, regardless of the country of residence. These applications run on blockchains – public immutable databases in which transactions in cryptocurrencies such as Bitcoin are recorded. Most of them are based on the Ethereum blockchain, which is especially suitable for creating smart contracts – computer code that is automatically activated when certain conditions are met.
Ether, the native currency of the Ethereum blockchain, is the second largest cryptocurrency by market capitalization after Bitcoin, trading at around $4,000. But several other protocols, such as Tezos, Algorand and Dfinity, are also being developed to support DeFi applications.
Who are the key players
As we said above, the amount of money locked up in DeFi products is $99 billion (according to data collected by DeFi Pulse). The DeFi Prime website, which specializes in this sector, lists many projects offering everything from forecasting markets to margin trading.
The most popular applications focused on peer-to-peer lending markets backed by stablecoins – cryptocurrencies whose value is 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 funds.
The Compound algorithm or “protocol” automatically sets interest rates according to supply and demand. Transactions occur constantly, so lenders receive frequent but fluctuating interest. For their part, borrowers should offer more collateral in the form of other crypto assets than the value of their loan, providing additional protection to the system in case of default.
Compound claims that there are more than $10 billion in its application. “When the demand for a borrowed asset is very high, the interest rate is high, and when the demand for a borrowed asset is low, the interest rate is low,” says Robert Leshner, founder of Compound, which raised more than $24 million in September 2019 alone, as part of an investment round led by Andreessen Horowitz.
MakerDAO, the creator of the Dai stable coin, is another well-known project. Dubbed “the world’s first non-partisan currency,” users can get Dai by opening a collateralized debt position with Maker, which provides tokens as a form of debt backed by Ether and a growing list of other cryptocurrencies.
According to DeFi Pulse, Dai holders have invested almost $18.6 billion in the Maker protocol, which is more than in any other similar application, although the project suffers from infighting.
How profitable is it?
Like other financial companies, DeFi’s emerging firms have focused on developing their technology and user bases rather than profitability. Low costs combined with high profitability proved to be very attractive to users.
“What is increasingly happening in DeFi is not wild speculation, but dollar accumulations with attractive returns and relatively limited risk,” said Brendan Forster, chief operating officer of Dharma, which acts as a digital bank that places user assets in the Compound protocol.
But that may change in the future.
Dharma doesn’t charge users any fees, although Forster said the company will probably start charging next year. Compound charges more than 10% of the interest received by borrowers, and it holds it as reserves. Some fear that lowering interest rates as users enter the space will not be enough to compensate investors for the risks of the platform.
“One of the main issues hanging over DeFi is the sustainability of economic profits for participants who lend their cryptocurrencies,” said Garrick Hileman, an academic and head of the research department Blockchain.com, a company providing cryptocurrency wallets.
How likely is it that DeFi will revolutionize the financial sector? It’s too early to talk about this, although users are predictably optimistic about the long-term prospects of DeFi. Everything will depend on the regulator.
“In 50 years, I don’t think we’ll still rely on intermediaries to make deals”, Forster says. “It’s pointless… Why rely on people if we have code that can do it perfectly?”
But even some of its supporters admit that DeFi is highly experimental and currently operates in a regulatory gray area.
“It’s not ready for general use. This early stage is really intended for researchers, practitioners and very sophisticated speculators. And look at the number of hacks and lost funds?”, said Leshner, adding that, in his opinion, DeFi technology will still become mainstream over the next decade.
There are also practical obstacles to widespread adoption. “It’s 2021 and the sector is still wild and untamed,” says Tim Swanson, director of research at Post Oak Labs. “Regulators will go out of their way in regulatory matters, as in many cases DeFi does not comply with anti-money laundering and KYC rules”.
Some also point to systemic risks. All initiatives are based on some protocol, for example, Ethereum, which faced the first difficulties when it began to process large volumes of transactions.
Other risks arise from the cryptocurrencies on which these protocols are based. They remain vulnerable to price fluctuations. “It is necessary to solve the main technological problems of the protocols so that these decentralized applications can be safely implemented,” said Steve Kokinos, executive director of the smart contract protocol of Algorithand.
Meanwhile, the economics of DeFi have been proven at scale. And without intermediaries-people who control the settlement of transactions, users can fully rely on the software. Yes, any failures can completely disrupt the system, but if everything is done conscientiously, and without errors in the code, then there will be no problems
“I’m concerned about what we could come to if most products could be created without the use of paper and expensive legacy technology banks,” says Taylor. “Anyone can create financial products. Well, of course, this does not mean that everyone should do it, but still”