Thoughts on Decentralized Finance Instruments

Decentralized finance is the new buzzword of 2020 and very many projects popped up. There is a common consensus and even talked about in traditional finance, SEC & CFTC offices and banks that this is the way to the future and I do agree. Financial products should be digital and transparent and potentially worldwide. Why shouldn’t I be able to borrow from a bank in Shangai against my collateral cryptocurrencies for example? Collaterals with real world assets are much harder but in the future with decentralized registries it should be possible. I am specifically interested in the staking and I will talk about about some projects here and some problems later:

Blockfi

This is a centralized lender but in the cryptospace. They are backed by big investment companies and they operate in the States with regulatory approval. Note that deposits are not FDIC assured but neither are in any other staking platform for now. USDC is a stable coin that is backed by Coinbase and quite secure. They are not easily hacked and even if their cold storage fails (which BTW handles also institutional investors) they have the money to cover up the loss. Along with GUSD from Gemini they are the best and most trusted stable coins there. At press time Blockfi has ~8.6% APY or ROI for leaving your USDC there. Compare this to traditional 0% interest rates across the world in dollar deposits! Not so fast though, scroll down to the risk section.

Celsius Network

This is a project with similar APY for USDC and other coins. It is more “decentralized” and run by someone well known in the space, he invented voip and worked in many of the biggest companies back in the day. Military grade security they claim.

Uniswap

This literally kickstarted the craze. It’s a liquidity pool that means that you deposit your coins to help the system be liquid and you get paid from fees. They have a higher APY than the other two but it operates only on ERC20 tokens (which are most to be honest).

Risk Problems

The real problem with staking your coins in these DeFi instruments is the unknown risk. Even Vitalik said:

“DeFi is still fine, but don’t act like it’s a place where you should advocate for a lot of regular people to put their life savings into.” – “It’s a short term thing. And once the enticements disappear, you could easily see the yield rates would drop back down very close to zero percent.”

Vitalik Buterin, Ethereum Founder

The correct way to approach this risk scenario is calculating Expected Value by making it easier on yourself asking “Will I bet on the outcome that Uniswap isn’t hacked once in 12 years”? Because if it is hacked or the smart contract fails and there is 1/12 chance of losing 100% of your capital then the 8.6% APY doesn’t matter at all. In reality there is much embedded risk in it. My very wild guess would be that the real risk-free rate would be around 2-3% APY.

It’s not sustainable

For anyone that understands even a little bit of finance money doesn’t grow on trees, only the US Gov can expand the money supply. Since we are mainly talking stablecoins and denominations in USD for other crypto that means that money needs to somehow come from the outside. The promise of DeFi for lending is that lenders pay back more by inserting more money in the system. If that’s the case we are talking normal lending for people to buy products in the real world. But that’s not what’s happening at all. Nobody is taking crypto loans to buy cars. Everyone is lending and “yield farming” and making more money, so they think. As an example, Compound protocol which is one of the first DeFi instruments dillutes regularly the investors holding its token to sustain all the complex interactions that “yield”. Someone is always losing money in this zero-sum free game unless as previously said many people bring in money from the outside.

Conclusion

Be very careful with this DeFi craziness. In my opinion this is both a blessing and a curse like ICOs were in 2017. They both provided capital to startups and investment opportunities to the masses but also had structural problems (the tokens we mostly useless in most projects and/or they were outright a scam). A probable scenario that could play out but not with certainty is that a new bubble is created which brings knowledge to the masses that there is this new economy available that has a ton of innovation but at the same time, the illusions and scams of the past which will make for a bitter sweet taste once again.

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