Gravity-defying DeFi: Risk, Reward, Hype and FUD
DeFi stands for Decentralized Finance, an ecosystem of decentralized applications (dApps) that deliver financial services built on distributed networks without any centralized governing body.
Decentralized finance applications aim to become an alternative to the banking sector and to replace the traditional technologies of the current financial system with open source protocols. That is, giving a large number of people access to decentralized loans, new investment platforms and other basic and advanced financial tools.
Imagine having an employee in a primarily supportive role, demanding more and more maintenance, but failing to deliver adequate value to the productive parts of your team or your business as a whole. It seems obvious to part with this “passenger” and hire a more productive actor, for a fraction of the price, unless that employee has a deep relationship with the stakeholders …
Replace “employee” with “financial institution” and “company” with “global economy”, and it becomes a summary of the role of current financial institutions in the global economy. It is entirely possible that honest and serious players in the DeFi space could serve as viable candidates for the job at which current ‘too big to fail’ financial and banking operators fail, while also cashing in annual bailouts bonuses. financed by ordinary taxpayers.
UK banking sector assets as a percentage of GDP
Interest rates on current bank deposits are close to 0% or even negative, especially in Europe. Only two members of the European Union – Croatia (2.5%) and Romania (1.25%) – have interest rates above 1%; other euro zone countries have 0%. The interest rate in the United States is 0.25%. Additionally, trillions of dollars in global assets generate negative returns. The market value of the Bloomberg Barclays Global Negative Yielding Debt Index at the end of 2020 rose to $ 18.04 trillion.
This combination of low or negative interest rates and high liquidity makes alternative investment methods extremely attractive. DeFi services offer users a potentially significant interest in cryptocurrencies or stablecoins. This is why many people use or are considering using DeFi. Investing in DeFi also attracts crypto enthusiasts and hodlers, who believe the coin’s value will rise and wish to earn additional income from it.
DeFi apps allow their users to access efficient protocols to trade, transfer and lock in cash and earn additional income. Trusted and reliable DeFi projects work in a similar way to traditional surface banks: customers make deposits in crypto or stablecoins and the DeFi app invests this liquidity, then the income is shared with customers according to the relevant smart contract. .
DeFi’s unique value proposition is high rates of return. However, this tweet from Ethereum founder Vitalik Buterin offers vital insight:
Due to the inherent volatility of digital currencies, depositing stablecoins is a type of DeFi activity with less risk to the user, compared to the alternatives. There are different platforms that bundle existing offers, such as Staking rewards. Different services offer 3-4% up to 40% interest per year for stable coin deposits. In April 2021, the Binance cryptocurrency exchange was ready pay up to 37.36% in USDC.
Loan protocols like Maker and Compound earn income like traditional banks – they borrow and lend crypto. The compound borrowing rate for ETH is 3% and Tether is 2.9%. The ETH supply rate is 0.15%. Therefore, Maker users can earn significant returns in a bull market, locking in their ETH and getting some of its value back. This action can be repeated for a deposit and this is called the liquidity cascade.
Decentralized Exchanges (DEX) such as Uniswap, Sushiswap, and PancakeSwap pay a portion of their trading commissions to liquidity providers, who deposit liquidity into smart contracts. On some rare pairs, Uniswap can give up to 1% per day in crypto. For pairs with stable coins, it’s around 0.1-0.3% per day.
In addition to depositing stable coins, DeFi services offer the possibility of investing stable coins in yield farming. In this case, the risks increase, as do the returns. At some sites, the expected return in such pairs exceeds 100% and can reach 400% or more per year. Income from yield farming is not in stablecoin but in crypto, and only half of the deposit is safe (denominated in stablecoin) if the market goes down. The other half is denominated in the highly volatile cryptocurrency.
One of DeFi’s successes is making Cooper Turley, 25, a millionaire. He loaned his ETH via a DeFi loan protocol and invested the funds he obtained in yield farming. In bull markets, DeFi investors derive both income from the rising price of the crypto and their interest rate in that crypto, such as when the price of Uniswap went from $ 2 in October 2020 to $ 43 in May 2021. Combined with the interest rate to lock in liquidity in UNI, this is a significant profit that rivals top performing assets of any class. There is another famous anonymous DeFi millionaire, Razoreth, who described in his Twitter a story to turn $ 800 into $ 1,000,000.
One of the main risks of investing in DeFi is the same as with crypto in general: the bear market. Many investors have recently discovered the unfortunate implications of this risk for the value of their portfolios.
Overall, according to the report “Defi Demystified: The Investor’s Guide to Decentralized Finance” by Daniyal Inamullah and Jacob Stelter (Sarson Funds, February 2021), the main types of DeFi risks include:
- smart contract functionality risk
- risk of external call function
- risk of “run-on-the-platform”
- leading risk
- human risk
- risk of opacity, and
- risk of temporary loss.
For example, according to the regulatory risk portion of this report, “KYC, AML, and taxes are critical regulatory hurdles that some jurisdictions will face for the future of DeFi. As we see massive growth in developed and emerging markets, regulation can have a chilling effect on capital allocation. In the United States, outgoing Comptroller of the Currency Brian Brooks noted that “our current banking regulations exist primarily to prevent human failure …” and that “in the absence of federal regulatory clarity, US states are rushing to fill emptiness and create a patchwork of inconsistent rules that hinder the orderly development of a national market ”.
Some DeFi protocols have already lost liquidity due to hacks, tech issues or bank runs, and affected DeFi investors have suffered, including billionaire Mark Cuban in the case of Iron Finance. According to Cypher Trace, $ 156 million has already been stolen from DeFi protocols this year.
Moreover, the rate of any DeFi smart contract is not technically stable. The high rate of return from staking, yield farming, and cash blocking may be real, but it is likely to last for a very short time as most rates are floating. Additionally, any DeFi investor should understand that their income is dependent on trends in the crypto market, as most DeFi is crypto. Additionally, if the crypto market falls, some DeFi institutions may lose cash and default in one way or another.
Let’s take a look at the potential risk / reward scenarios to lock in liquidity in pools on the PancakeSwap DEX. One of the most popular options for trading liquidity on this exchange is trading it for pools of syrup. If the user exchanges Pancake’s native coin – CAKE – with 108% APR, that means for one year of depositing 100 CAKE, a user will get 108 CAKE income, for a total deposit of 208 CAKE. Of course, doubling the deposit in crypto does not mean that its fiat value will also increase; it depends on the price of the CAKE. Two months ago it was over $ 40, but now it’s only $ 12. This means that an investor’s profit and loss depends on when he enters the market.
The key metric for DeFi is TVL – Total value of funds blocked on smart contracts. By the way, the ETH price correction played a positive role in DeFi adoption, as transaction fees dropped from $ 10- $ 40 to $ 2-3.
Despite the listed risks and the volatility of crypto prices, the demand for DeFi and the resulting TVL, which increased exponentially in 2020, remains very large and remains between 100 and 150 billion dollars. And this is only the first run for this technology and its business model.
“The experience of all ages and nations, I believe, shows that the work done by slaves, although it seems to cost only their upkeep, is ultimately the most expensive of all.
Adam Smith, Wealth of Nations (1776)
Adam Smith explains that slavery is, in general, very inefficient. According to him, the net product under freedom is 12 times greater than under slavery. However, he observes that, despite its inefficiencies, slavery at the time of his writing persisted in much of the world.
Why did the elite – owning slaves and wielding political control – fail to improve themselves by freeing their slaves?
Smith gave two answers to this riddle:
- The first is psychological: Smith argues that people have a fundamental desire to dominate others, and slavery provided that opportunity for the slave elite.
- The second explanation concerns engagement issues. Freeing the slaves would deprive the slavers of their property. How would they be compensated? The masters could not be assured that they would in fact do better to free their slaves. The slavers therefore rationally avoided emancipation despite its ineffectiveness.
Similar to Smith, I think the work done by existing financial institutions, although it seems to cost only their maintenance (now very heavy), is ultimately the most expensive of all, due to friction. hidden and enormous inefficiencies, which plague all major sectors of the economy.
It is likely that DeFi – done right – could replace traditional banks and other financial institutions. It is also very likely that the fundamental desire of the global elite to dominate others and their interest in maintaining the status quo will be an obstacle to the evolution of the economy to a more efficient state.
However, this analogy should keep a cautious optimism, since slavery was globally abolished a few decades after the publication of Smith’s book. Hopefully we will soon see a fair and efficient state of the global financial system powered by DeFi.
This article does not provide any personal financial advice, please do your own research before joining DeFi or any other project as an investor.