The Rise of Decentralized Finance and Why Banks Should Start Paying Attention

Over the last two years, decentralized finance (“DeFi") has grown from a blockchain-based FinTech sandbox into a complex array of platforms on the Ethereum blockchain through which borrowers, lenders and investors can undertake bank-like transactions without banks.

 Importantly, Defi runs on accounts that are accessible to anyone in the world with an internet connection. They can store and transfer value and create and access any imaginable financial product on the same terms as anyone else.  No banks. No brokers.  No politics.  All you need is an open source digital wallet you can download for free from your favorite app store.  

Currently, the billion or so dollars tied up in  DeFi pales in comparison to the trillions of dollars in traditional, centralized finance. But, the excitement of rapid growth and the possibility of meaningful investment returns in a low interest rate environment are starting to pull some real money away from traditional investment.  Moreover, the largely unregulated space makes it easier to innovate and is attractive to individuals who feel like banks should be a little less stodgy given the taxpayer funded bailout of the great recession.  Banks don't need to be afraid, but they would be foolish not to be paying attention.

Over the last month, Compound, the second most popular DeFi platform in terms of volume, increased its amount of assets under protocol ("AUP") by 900 percent by ushering in a first of its kind governance model that cleverly incents users to its protocol by offering rewards denominated in "Comp" tokens which can then be used to exercise governance rights over the decentralized platform.  

Not surprisingly, the governance token, has traded as high as seven times its issuance price, and its method of issuance likely gives the token instant utility on a decentralized platform.  Utility, among other things, is a sought-after moniker because utility is one of the characteristics that tends to indicate the token is not subject to securities regulation in the US and elsewhere.   Another popular decentralized exchange, Uniswap, had more trading volume in June of 2020 than it had for all of 2019.

There are enough new and exciting things going on in DeFi right now that it seems like a watershed moment.  Cryptocurrencies as a whole are known for their volatility, and previous watershed moments have proven illusory -- witness the ICO boom in 2017-2018.  Boom or bust, there are still some real winners in the cryptocurrency space.  Bitcoin (BTC) (31%) and Ethereum (85%) have much better YTD gains than most traditional stocks and bonds.  More important, DeFi has become a real financial system, albeit one used primarily by crypto insiders to make more crypto so that they can speculate on yet more crypto.

But out of the DeFi soup that is comprised of borrowers, lenders and speculators, there have arisen some novel and brilliant ideas, and those ideas are likely to become the sophisticated investment vehicles and strategies of tomorrow.  The global financial services market is one of the most lucrative business opportunities anywhere, and if DeFi is really a FinTech sandbox, it has yielded some cool toys.  Most Defi transactions are denominated in stablecoins, tokens whose value is tied to a particular asset or currency such as the U. S. dollar, to avoid unpredictable fluctuations in value.

Profits are made by lending stablecoins at rates set by market demand or by borrowing stablecoins through overcollateralized loans, usually to reinvest the borrowed proceeds.  DeFi can accommodate pretty much every type of centralized financial instrument as traditional finance and often generates more favorable returns for smaller fees.  Depositors (lenders) can earn interest upwards of 10% depending on the crypto asset deposited, and sophisticated users can leverage their positions through a series of borrowing and lending transactions.

The new Comp governance model has given rise to speculators ("Yield Farmers") searching for the lending/borrowing token combinations that offer the best yield.  Often the amount of interest earned or paid is less important than the amount of governance tokens one can earn by lending or borrowing (or both!). In the high risk DeFi environment, losses can be dramatic, but knowledgeable Yield Farmers can earn 100% annual percentage rate ("APR") in a single day.  Not surprisingly, the potential for huge gains has attracted a lot of new money to DeFi in the last couple weeks, hence the dramatic increase in the amount of assets under protocol ("AUP").

All this new growth is likely to beget even more new growth.  In addition to the predictable onslaught of governance token issuances like Comp, another asset class experiencing rapid growth is the category of tokens clamoring to bring Bitcoin to Ethereum (and thus into DeFi). BTC is far and away the greatest store of value among digital assets, but it's primary use, like gold, is limited to storing value.  That is until now. Over the last several months, a number of tokens have started using smart contracts to allow the value of BTC to be represented in ERC20 tokens that can be traded on DeFi platforms.  Such tokens allow serious holders of BTC to lend or borrow against their BTC holdings with what are essentially BTC-backed stablecoins instead of just holding them.  As Defi continues to experience exponential growth, the sky is the limit regarding the addition of new investment plays and their derivatives.

So, what's the big deal about these new governance protocols, and why should we care? The new protocols and yield farming tokens are pushing DeFi into the mainstream. Many believe a substantial chunk of the new assets moving into DeFi are from institutional investors looking for high risk yields.

Institutional money usually avoids the taint of cryptocurrency investing, but in an era where centralized interest rates are moving into negative territory, there are not too many opportunities to earn dependable double digit returns or better, even for those willing to accept higher risk. Fifty to 100% daily APRs are not going to stay secret for long, and they're not going to last forever. Any investment fund, institutional or not, with a high risk tolerance that is not actively considering the DeFi markets is not doing its job.

Why should banks care? Because all of this investing and all of the cool new fintech instruments are being offered by non-banks. Traditional banks and investment houses should get on board or get left behind. I'm not saying invest houses should create their own blockchain protocols, but they should definitely be conversant in a new asset class with the potential of high returns and no bureaucracy. One of the most vocal early critics of bitcoin, JPMC's Jamie Dimon, was one of the first to harvest the power of blockchain through his JPM Coin which allows instantaneous financial transfers between institutional clients.

Let's be clear: DeFi carries significant risk. Many protocols are truly permissionless (decentralized) so there is no kill switch to shut down a platform if it starts to malfunction or becomes subject to an attack. Smart contract hacks still occur with some frequency, but several insurance carriers are stepping up to mitigate smart contract risk. Like traditional finance, the yield one earns is based largely on the amount of risk one is willing to take.

Undoubtedly, some rapid gains are the result of the inefficiency of early protocols. Yet some investors view DeFi investments as safer than ICO purchases because ICO valuations are often drawn from ether (pun intended) whereas DeFi returns, particularly yield farming returns, are incented by the value one receives by creating and using a new financial instrument. Instead of receiving value through the ownership of one or more tokens, DeFi investors create and receive value by helping to fuel and run the underlying DeFi protocol. In the current environment, they can also receive governance tokens for doing so which further incents them to safeguard the long-term health of the platform.

For the protocol, offering yields in the form of governance tokens is a clever way to drive rapid user adoption. Longer-term, the viability of the protocol will be determined by the degree to which it can hold the attention of its users in the face of future new and shiny fintech toys.

John Wagster, co chair of Blockchain and Cryptocurrency industry team at Frost, Brown and Todd