Traditional crypto investors should thank DeFi-degens, with caution.
DeFi and the rise of a new crypto bubble.
I wrote this quick article as a guest for Dunamis Asset.
DeFi 101
DeFi stands for Decentralized Finance protocol. In practice, in the crypto space, it stands for any platform or project where you can interact through a smart contract and make financial operations with no central clearing. This includes lending, borrowing, insurance contracts, swaps or trading derivatives and other synthetic assets.
In short, DeFi projects code the settlement roles of financial instruments together with market incentives in a way that allows market participants to interact with a given market/instrument (smart contract) knowing that it will always work the way it was coded to. This is what crypto freaks refer to as “Code is law”.
Compound is a great example of a large DeFi start-up. It is a system of openly accessible smart contracts built on Ethereum and is invested by Andressen Horowitz. It allows you to lend and borrow crypto assets, using other crypto assets as collateral. It works in a simple manner, let assume that John deposits his ETH to Compound’s smart contract and borrows USDT (a tokenized dollar) against it. USDT is being provided by other users, such as Alice, who has also used Compound to deposit to it’s smart contract. There are incentives coded at Compound’s smart contract that govern a variable interest rate that John (and all borrowers) will pay Alice (and all lenders), according to market supply and demand. The more users are borrowing an asset, the higher will be the interest rate set by the smart contract.
Nice experiment, huh? Things get more interesting though and potentially more risky. The system allows , and the potential for some projects to give their own tokens to users, as an incentive to generate more transactions. Since these tokens can also be traded and swapped at exchanges and platforms, at market prices, this creates a compelling opportunity — allowing some users to earn 70% APY worth of Compound’s tokens for a 10% APY USDT borrowing cost. This phenomenon is similar to what cashback is doing to fintech apps, but on crypto steroids. You can likely guess the potential implications of that incentives.
Online wild west? Why this matter?
For most crypto investors, DeFi is an experimental field, a sandbox, where very early adopters — often referred to as“degens”: junkie degenerated crypto traders — are building the next open financial market structure, in the wild west of the crypto markets, a place full of opportunities, but far away from the maturity of the bitcoin sector. This, along with the incredible volumes and incredible rise and pace of growth is now impacting the whole crypto space. Everybody wants to earn 100%+ APY yields.
Since Ethereum is the preferred blockchain for DeFi projects, ETH’s growth has been impressive, with GAS usage skyrocketing. Most of this GAS is being used for transactions in the DeFi space.
Simultaneously, some DeFi projects have been “tokenizing” bitcoin to create a secondary market for synthetic BTC lending through the ETH blockchain. That means you can deposit your bitcoin in a ETH smart contract and get paid interest to lend it to someone else. There’s more bitcoin being locked in ETH contracts daily than is being mined.
Both trends are very interesting demand shocks that may be supporting bitcoin and ethereum prices. This creates opportunities but also increased potential for bubbles, that require a dynamic investment architecture based on experience, research, leadership, and careful risk management.
