I’m sure by now that you’ve heard people talk about how cryptocurrencies can “overthrow” the big banks in the near future. Well I’m here to tell you that the Decentralized Finance (Defi) movement has the best shot at this wild, but much needed endeavor. With interest rates hovering around record lows causing the bond market (mainly government bonds, which has been looked at as the safest and most reliable investment for decades) to hit negative yields, more and more people are parking their capital in the Defi space due to them being able to consistently generate a much higher ROI due to higher APY’s. In this article, I’m going to explain to you what Defi is, how its implications can change the world forever, why I think it will spark a 2017 like bull rally, and my opinion on the role it will play in our future.
To better understand DeFi, let’s first take a quick look at how traditional finance came to be. Although it may seem like money has always been around, that’s actually not the case. Humans originally bartered for the goods and services. But as human societies formed and developed, so did our economies. Currency was invented to make exchanging valuable goods and services easier. Subsequently, currency helped pave the way for new innovations and higher levels of economic productivity to what we know today as “Capitalism”. However, this progress came as a double edged sword.
Historically, central authorities such as the Federal Reserve and governments have issued the currencies that are the foundation for our economies. Central banks were expected to carefully manage and regulate the supply of currency in circulation with the two main tools they have on their toolbelt, quantitative easing and controlling interest rates. As the size and complexity of our economies grew, central banks gained more power as more people placed trust in them.
We trust our government to not print too much money so as to not devalue our savings. We trust our bank to safely store our money. And, when it comes to investing, most of us trust our assets to a financial adviser. We hope to earn a profit by handing over control of our money to others. Unfortunately, the reality in regards to our current financial system is that the power that comes along with this trust isn’t always rewarded.
We often have very little control in how corporations handle our investments, or even how our governments manage the economy. And in most cases, investors only receive a fraction of the returns generated from the risks taken by these central authorities. The problem is compounded further by the fact that banks are allowed to loan out more money than they receive in deposits (earlier this year, the banks were granted the freedom of being able to loan out 100% of deposits instead of the usual 90%). Historically, banks have always printed more money than they had in Gold which is the foundational reason why so many great nations have had currency collapses time and time again.
Defi on the other hand, is aiming to create a censorship resistant financial system that’s open to everyone and minimizes one’s need to trust or rely on central authorities. Technologies like the internet, cryptography, and blockchain give us the tools to collectively build and control a financial system without the need for a middleman to dip their hands in everyone’s pockets. There’s a saying in the digital asset space: “Don’t trust, verify.” Because with a blockchain, you as an individual can verify any and every transaction that occurs on the blockchain in close to real time depending on the consensus mechanism utilized by that blockchain.
While there are a few competitors, most DeFi applications are built on the Ethereum blockchain, the world’s most popular programmable blockchain. Instead of a central authority, the participants that comprise the network control the issuance of Ether (ETH), the network’s native cryptocurrency, in a decentralized manner. Developers can program applications on Ethereum that can create, store, and manage digital assets, also called tokens, on the blockchain. These are called smart contracts or decentralized applications (DApps). They’re applications or scripts that run only as programmed on the Ethereum network meaning, you can program complex irreversible agreements without the need for a middle man.
There are many different DeFi products and services, some of which you’ll find familiar to existing financial services but with a decentralized kick to it. For the purpose of this article, we’re going to focus on arguably the most popular and fastest growing sector of Defi, which happens to be borrowing and lending platforms. Similar to a bank, users deposit money and earn interest from other users borrowing their assets. However, in this case the assets are digital and smart contracts connect the lenders to borrowers, enforce the terms of the loans, and distribute the interest. These decentralized protocols establish money markets with algorithmically set interest rates based on supply and demand, allowing users to frictionlessly exchange the time value of Ethereum assets. The best part about it is that it all happens without the need to trust one another or a middleman bank. And, by cutting out the middleman, lenders can earn higher returns and more clearly understand the risks thanks to the transparency the blockchain provides.
According to the F.D.I.C., the national average interest rate on savings accounts currently stands at 0.06% APY. This applies to both average and jumbo deposits (balances over $100,000). That means that the average interest rate on a savings account is too low for your savings to be able to keep pace with inflation. And it’s not just here in the U.S. Globally, we are experiencing a time of historically low-interest rates. Infact, in some countries, they are paying people to take out mortgage loans for houses. That’s great if you want to buy a house, but what if you want to store or save your money? Not only will interest rates not yield decent returns, but at some point you could realistically have to pay your banks to hold your money for you. And all this is happening when trust is at a near all-time low with banks.
So, you mix that with the fact that the Federal Reserve increased their balance sheet by a whopping 75% in 2020 alone, and it becomes more clear why people would want to park their capital in the Defi space instead of in traditional banks. They won’t have to worry about inflation or at least it’ll be predictable, and they’ll be able to generate better yields with the higher APY offered in the Defi space. However, as with any investment opportunity, there are risks involved with Defi that you should be aware of. First off, given that the lending protocols are completely operated by smart contracts instead of a centralized entity, there is a chance that a smart contract bug can malfunction causing your funds to be locked up, or stolen from hackers.
An example of something like this happening is when the notable 2016 hack people like to refer to as the “ DAO-saster” resulted in 3.6 million Ether tokens being stolen worth $50 Million at the time. This encouraged Ethereum to roll back its blockchain in an effort to recover stolen funds, which caused the Ethereum hard fork into Ethereum Classic. Remember, Defi is still in its infancy stages and the percentages of this happening will decrease as time goes on, just as long as developers are constantly coding out the kinks. The good news is, this risk can be mitigated and almost completely avoided. You can insure all of your crypto assets that you loan out in the Defi space so that if something happens you can recover your losses. Nexus Mutual offers decentralized insurance. They’re currently charging 1% per month of the dollar amount of assets that you insure with them.
Another risk to be aware of in Defi borrowing and lending is illiquidity in the markets, causing the possibility of suppliers to not be able to withdraw their crypto assets. To dive into more detail, let's look at one of the most promising Defi lending companies, Compound. In a nutshell, Compound allows users to supply crypto assets to money markets to earn interest, and to borrow crypto assets from money markets. In Compound, what are considered “money markets” are just different crypto assets. Currently Compound allows these services for WBTC, BAT ,DAI, SAI, ETH, REP, USDC, WBTC, and ZRX . Suppliers are free to withdraw their principal and interest earnings at any given point. However, just as borrowers are limited by the size of the liquidity pools, so too are suppliers. Each loan shrinks the pool of liquidity. The total amount of loans that can be taken out and the total amount of supply that can be withdrawn are capped at the size of the liquidity pool.
Illiquidity events will most likely be inevitable from time to time and it’s not necessarily a bad thing, as it’s simply a symptom of pronounced trends in supply and demand. Compound has already anticipated that moments of illiquidity would occur. Their solution is that the protocol would respond by modulating supply and demand for lending markets through dynamic interest rates. The algorithms that drive these dynamic interest rates are encoded into the money market smart contracts. In a given money market, when liquidity is low, supply APR increases, incentivizing users to supply tokens, while borrow APR increases, incentivizing users to repay borrowed tokens. When liquidity is high, Supply APR decreases, providing less incentive for users to supply tokens, while borrow APR decreases, incentivizing users to take out cheap loans.
In a decentralized fashion, the protocol’s dynamic interest rates are intended to counteract illiquidity. However, what could potentially be harmful to users of such an open financial application is a “bank run”. A bank run happens when suppliers, suddenly fearful about a market’s stability, attempt to rapidly and simultaneously withdraw more funds than are available on the platform, causing further panic and distrust of the system. Given that Defi is a free market and that its protocols are decentralized, in the event that a bank run does happen, the natural laws of supply and demand will eventually help bring markets back to equilibrium. This is another good reason why insurance should always be considered when you’re loaning out crypto assets in the Defi space.
So as you can see, Defi has the opportunity to bring about a more resilient and transparent financial system. As of 8/1/2020 there is $4.19 billion locked in the Defi space, and it's most likely going to continue to grow in the long-term. But what I can tell you now is that the big banks aren’t just going to lay down and let Defi steal all of their customers, they’re going to continue to put up a fight.
As of 7/22/2020, all national U.S. banks can now legally offer crypto custody services. The Green light was given by The Comptroller Of The Currency (our nation's top banking regulator position) Brian Brooks, the former Chief Legal Officer at Coinbase. This means that the banks can now start making money with crypto. Not only that but now, regulation is set up so that in order to be a crypto asset custodian, you need to have a banking license, which can take over a year to get.
In my opinion, another weapon they’re most likely going to choose to fight back with will be an attempt to rehypothecate the narrative surrounding crypto by using fear campaigns against holding your own private keys and using Defi. Wall Street has done this seductive marketing trick throughout history in order to pump market prices to crazy levels in an effort to dump their supply at the top so that they can cash out while destroying the wealth of naive investors. Let me give you some examples.
In the early 1990s, investors believed we had entered a “new era of permanent prosperity.” Wall Street swore that the internet would unleash a new paradigm of endless growth. Wall Street claimed that you could pay any price for a stock if the underlying business had “.com” in its name, while also ensuring you got a cut of the profits from this brand-new technology. This narrative was bought into by the majority of the investing public. Cisco and AOL traded at 235 and 193 times their earnings. And there were plenty of companies like Webvan, which reached a valuation of $1.2 billion with literally no earnings at all. As this narrative gained mainstream popularity, more than $5 trillion in institutional money poured into internet stocks before the narrative was stretched too far and prices collapsed. Don’t fall for their games!
Now I’m finally going to go over why/how I think Defi will be the catalyst to a 2017 like bull rally. If you look back at the 2017 bull rally, you’ll see that there were two catalysts. The first one was when Bitcoin (BTC) went through its 3rd halving in July 2016, which cut the supply of BTC coming into the market in half, creating scarcity. The second catalyst was the ICO bubble that influenced investors to speculate on any crypto ICO thinking they would make money once shares of their crypto assets went on sale to the public. Now, fast forward to May 2020, BTC just had its 4th halving. Just like in 2017, the market will follow BTC. After BTC rallies, the altcoin market will rally shortly after and then endup outperforming BTC in terms of percentage gains. Instead of ICO’s causing wild market speculation (ICO’s are now illegal in the U.S.) I think the second catalyst that will spark the next bull rally will be the release of Ethereum 2.0, allow me to explain.
Currently, BTC’s and Ethereum’s blockchain have the same consensus mechanism, which is proof of work (POW). POW operates by allowing miners to compete with their computing power resources in order to guess the next block so that they can receive the block reward. The launch of Ethereum 2.0 will mainly involve switching from a POW consensus mechanism to a proof of stake (POS) consensus mechanism. With (POS), Ethereum miners will be able to mine or validate block transactions based on the amount of Ethereum a miner holds. (POS) was created as an alternative to (POW), which is the original consensus algorithm in Blockchain technology, used to confirm transactions and add new blocks to the chain. (POW) requires huge amounts of energy, with miners needing to sell their coins to ultimately foot the bill; (POS) gives mining power based on the percentage of coins held by a miner.
But here’s the kicker, in order to be able to stake Ethereum, you have to own a minimum of 32 shares of Ether tokens. At the time of me writing this, Ethereum is priced at $392 which means 32 Ether tokens is worth $12,544. This will most likely cause a buying frenzy of people trying to accumulate 32 Ether tokens in an effort to stake so that they can make money from doing pretty much nothing but letting their Ether tokens sit in smart contracts. This will most likely cause investors to speculate into other altcoins as well. Especially the ones that offer staking rewards, even if they don’t understand the value proposition or utility of the crypto asset.
Before I wrap up this article, I want to share some interesting information with you. If you look across most industries throughout history, the pendulum of power swings back and forth between centralization and decentralization (The Starfish And The Spider: The Unstoppable Power Of Leaderless Organizations is a great book that covers this concept). For example, let's look at the music industry; in the beginning it was most profitable to be the musical artist. The artist was the commodity because you could only hear the music directly from them (centralization). That wasn’t until Thomas Edison invented the phonograph that enabled the music from artists to be recorded. At that point, it became most profitable to sell the records. This caused hundreds of thousands of record shops to pop up in different cities (decentralization). Then it became most profitable to own a record label, this led to the founding and domination of a few large corporations such as Sony, Warner Bros., Universal Music Group, etc (centralization). Then came along companies like Napster and Limewire that allowed individuals to share and download music illegally without having to buy it from the big record labels or the artists (decentralization). Now you have companies like Apple and Spotify that brought the record label companies to their knees (centralization).
My reason for sharing that with you is because now we’re literally witnessing the pendulum of power in the technology/internet and the banking/finance industry finally swing from centralization to decentralization. And in my opinion, I think it’s one of the most beautiful things to watch and be a part of. As usual, I’ll end this article with one of my favorite quotes as it pertains to this topic, “Change is inevitable, but growth is optional.”