Decentralizing finance can unlock capital in cryptocurrencies, but will it last?

Author: Craig Mellow

Death, taxes and expensive financial intermediaries seem like immutable facts of life. Banks bury clients in paperwork and extract mysterious fees to cover huge overheads. Investment bankers grow rich orchestrating often-opaque capital markets. “Decentralized finance,” or DeFi, offers a better way, its growing army of devotees claim.

“Square and PayPal have disrupted payments,” says Kevin Dougherty, founding partner of US-based Atma Investment Group, which is scouring for DeFi startups in payments that it can invest in. “DeFi will disrupt everything else: lending, exchange, derivatives, infrastructure.” 

That boast is a long way from being fulfilled. But DeFi’s explosive growth—from zero to a $100 billion-ish market over the past year—and structural evolution merit a look before scoffing.

DeFi is the latest iteration of the cryptocurrency/blockchain movement, which grew from revulsion at the 2008 global crisis caused by traditional finance off the rails. It’s happening mostly on the Ethereum network rather than Bitcoin, because Ethereum is open to outside application developers—rather like Linux compared to Windows.

The system is a direct relationship between borrowers and lenders/investors, who are linked through algorithmic, self-adjusting “protocols” rather than financiers. Such an open network could allow new kinds of assets to be securitized, and for investors to reap better returns than the meager offerings of today’s savings or money market accounts.  Unlike peer-to-peer lending, DeFi markets are designed to be liquid; lenders can withdraw their funds at any time. In theory.

In practice, DeFi allowed holders of cryptocurrency to borrow for further cryptocurrency speculation. That’s not quite as risky as it sounds. Leading protocols like Aave and Maker limit borrowers to about 65% of the collateral they put up, so lenders should at least get their principal back. But a floating interest rate system, driven by funding supply and demand, has already produced some wild rides. When Bitcoin prices crashed by nearly 50% this May, borrowers lost their risk appetite, and DeFi interest rates plunged from more than 12% to nearly nothing, reports Mathieu Hardy, Brussels-based chief development officer at OSOM, which offers a crypto investment app. The average over the market’s short career has been about 6% interest, he says.

Awakening Crypto Assets

This circumscribed and volatile structure still marks a breakthrough, though. Investors in crypto can now lend and borrow it, not just put it in a virtual vault and hope the price rises. “This unlocks otherwise sleeping capital in crypto,” Hardy says.

Perhaps more important, the protocols are building a bridge between crypto and the fiat currencies that most of the world calls real money. Aave, Maker and their competitors create their own media of exchange, known as stablecoins or tokens, which are generally pegged to the fiat dollar. Borrowers put up collateral in stablecoin, and take the risk that their underlying crypto holdings devalue. Lenders don’t need to deal in crypto at all. They redeem their stablecoins for actual greenbacks. At least it has worked that way so far. As a sweetener, the protocols have started issuing additional stablecoin to lenders on their platform, a sort of dividend.

This “tokenization” technology can open broad, new money-saving horizons in finance, adherents claim. One example: Limited partners in a private equity fund might market their stake, or slices of it, via DeFi rather than waiting out the seven-to-10-year maturity period, says Philipp Pieper, co-founder of Swarm Markets, a fledgling DeFi exchange headquartered in Berlin.  “Asset holders can create their own markets out of something that was illiquid,” he says. “It’s struck a chord.”

Old-school Dutch bank ING published a mildly enthusiastic white paper on DeFi in May, finding promise in its “flexibility” and “borderlessness.” The institution found “reason to believe a mixture of traditional financial methods and DeFi might be a winner to reduce cross-border transaction times and costs. Centralized and decentralized financial services will converge at some stage.”  

DeFi has some hurdles to clear first, however, some are technical. The Ethereum network is close to being maxed out, and a project to add capacity will take another year or two, says Roberto Talamas, research analyst at Messari, a publisher that aims to be “the Bloomberg of crypto.”

Current DeFi transactions are anything but clickable and user-friendly, OSOM’s Hardy adds. “The DeFi space is a little convoluted for mere mortals,” he observes. “If you want to get your hands on some tokenized dollars, you’ll spend most of the weekend reading up on it.” His firm’s goal is to tame this tangle into “something about as complicated as a wire transfer.” 

But the biggest challenge by far is governance and regulation. US Securities and Exchange Commission Chairman Gary Gensler channeled most of the financial establishment when he recently dubbed all cryptocurrency dealings a “Wild West...rife with fraud, scams and abuse.”

ING expressed DeFi-specific concerns in more bankerly language: “One glaring area that is holding DeFi back from adoption is the lack of clarity on where liability lies if a DeFi protocol does not work as intended.”

One protocol that definitely did not work as intended is Poly network, which reported in August that hackers had stolen more than $600 million worth of tokens. The thieves returned $260 million of it the next day, apparently finding unforeseen difficulties laundering their swag.

 Also this summer, US prosecutors leaked to reporters that they were investigating bank fraud among executives at Tether, a leading stablecoin provider. That won’t help DeFi’s reputation either,  even though the suspected crimes occurred years before DeFi existed. “I wouldn’t say we are the most responsible people yet,” Talamas quips.

At least part of the flegling industry is moving toward regulation, literally.  Pieper and his Swarm Markets partner left Silicon Valley for Germany, where the Federal Financial Supervisory Authority, or BaFin, worked out a way to license their DeFi exchange. One requirement: participants ditching crypto-world anonymity and submitting to standard know-your-customer checks.  “It’s very clear that the market is going to a regulated infrastructure,”  Pieper says. “We’ve spent a tough two years getting out ahead of that.”

Switzerland licensed the Taurus digital exchange in April, a step toward nurturing “crypto valley” in picturesque Zug canton. Taurus, according to its website, “allows clients to digitalize and tokenize any type of private asset.” In Singapore, the establishment is looking to get out ahead of the startups. DBS, the city-state’s biggest bank, got regulators’ green light for its own crypto exchange in August. 

San Francisco-based startup Compound Labs is looking to take DeFi mainstream through another route: guaranteeing a 4% interest rate on liquid deposits from corporate treasuries. Fiat dollar deposits are converted to a stable coin called USDC, then loaned on DeFi markets. It sounds like a good deal compared to negative yields elsewhere, though the company does not indicate just how much volume it can handle.

Thirteen years have passed since a recluse going by the pseudonym Satoshi Nakamoto published a nine-page paper titled “Bitcoin: A Peer-to-Peer Electronic Cash System.” The crypto world it introduced has fallen well short of its more fervent supporters’ expectations. But the same was true 13 years after 1978, when two US professors published “Network Nation,” positing a future of mass computer communication.

That’s an analogy DeFi enthusiasts like. “A lot of people were asking what you would do with the internet in the early 1990s,” Kevin Dougherty notes. DeFi may never match the significance of the worldwide web. It’s still worth keeping an eye on.