DeFi - a reward worth the risk?

Decentralized Finance (DeFi) has grown 10x in 25 months.

This $54 billion industry offers eye-watering rates of return, but are the risks worth the reward?

What does Decentralized Finance (DeFi) actually mean?

DeFi is a series of permissionless systems. Unlike other financial tools (banks, brokerages, credit cards, etc.) which require you to create an account, DeFi allows anyone with a digital wallet to interact with the platforms.

Why the massive growth? And what's the appeal to users of DeFi?

Two main factors come to mind:

1. For the past decade, certificate of deposits (CDs) have yielded less than 2%, even for 5-year durations. Investors are yield-starved and this has necessitated taking on more risk. DeFi offers rates of return that far exceed other options.
2. Those holding crypto - instead of selling their assets - can earn yields. Effectively, this transforms a "dead" asset into one producing a series of cash flows.

What kinds of returns are possible in DeFi?

This answer, like all other investments involving risk, vary widely. Let's look at one of the largest platforms - MakerDAO.

DAI is the native stablecoin (pegged to the US Dollar) for the Maker protocol. It's collateralized by other cryptocurrencies and held within smart contracts rather than in institutions.

In this example, investors holding DAI can earn a 7 day net APY of 3.51%.

As we discussed, anyone holding the DAI cryptocurrency in their digital wallet can utilize the platform. No KYC (Know Your Customer) and AML (Anti-Money Laundering) account-opening procedures are used.

Where do the returns in DeFi come from?

MakerDAO, or any other DeFi platform, offer loans to the users. There's a major difference between these loans and more common loans (vehicles, mortgages, business lines of credit, etc.), however.

Many loans originate because people/companies don't have the capital necessary to buy a car or house, or to finance the growth of their business. These undercollateralized loans are underwritten using credit histories, personal guarantees, or other assets.

DeFi loans are overcollateralized. These loans are backed by the crypto assets someone already owns. Instead of selling their crypto, many choose to take loans against the asset.

Again, from MakerDAO:

In this example, a person/organization holding 175 ETH (the cryptocurrency from the Ethereum blockchain, the second largest crypto by market cap) can pledge their crypto and get 150,000 DAI to use as they please.

The min coll. ratio cited in the graphic (170%) is the threshold a borrower must maintain. If it drops below 170%, the borrower is liquidated. The ETH they pledged is taken by the platform.

The major difference in DeFi - governed by contracts only

DeFi consists of a series of smart contracts. These contracts execute automatically based on the provisions contained in them.

In the case of the aforementioned liquidation, the borrower knows exactly what will trigger the event. If the underlying asset (ETH, in this case) falls in value, the borrower can top-up their loan with more Ether.

How DeFi platforms make money, then, is very simple:

• Gather deposits from those who want to earn yield on their investments
• Provide loans to those who wish to pledge their assets

What are the risks of DeFi?

Two major risks to DeFi are prevalent:

1. Crypto assets are extremely volatile. Liquidations can happen extremely quickly if a borrower isn't keeping tabs on the price of their pledged crypto.
2. Smart contracts are computer code, and only as secure the programming used. DeFi protocols have lost $4.75 billion in total due to scams, hacks, and exploits. Depositors are vulnerable to smart contract programming oversights, and can lose their entire balance.

Summary

We've only scratched the surface of what's possible in DeFi with this brief article. MakerDAO is considered one of the more stable protocols while other nascent platforms offer rates of returns in the mid to high double digit APYs.

If you're willing to accept the risks involved with DeFi options, you can be handsomely rewarded by using the protocols.

In future content, we may discuss staking, liquidity pools, slippage, Automated Market Makers (AMMs) or myriad other topics.

I hope this brief overview of depositing/borrowing on DeFi platforms gives you a brief glimpse into a market that will probably 10x again (to $500 billion) in the near future.

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Next week's newsletter preview

If equity is a claim on future cash flows,
and debt is a claim on assets,
what do crypto tokens really represent?
The answer will surprise you
...        

Thanks for reading! - Spence

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