The promised rewards are huge and the marketing is making it easier. “High APR, Low Risk” is the talk of PancakeSwap’s “Syrup Pools”, where anyone can lend money. Annual percentage rates, APRs, are soft: On Monday, a crypto token called CHESS promised more than 300% per year, paid in CHESS.
The rate of growth is truly extraordinary, as DeFi barely existed until last year. CAKE tokens issued by PancakeSwap and other DeFi competitors such as Uniswap and Aave are together worth $ 120 billion, according to CoinMarketCap. More than $ 7 billion has been stranded in a single part of DeFi, “yield farming,” the crypto jargon to fund market making.
DeFi is both wonderful and scary at the same time. The innovation, made possible by smart contracts, which can automatically move crypto according to rules written into computer code, has allowed crypto enthusiasts to replicate just about every function of Wall Street for crypto, without having to need Wall Street.
One of the most fundamental is market making, or yield farming. The main brokerage, the bank units that serve the hedge funds, has reappeared as a secured loan from DeFi, allowing speculators to accumulate leverage or short sell a token they want to bet against by borrowing it and by selling it. Interest rate swaps and core swaps are becoming more common as people use debt to arbitrate between exchanges, DeFi providers, and different cryptocurrencies.
Even structured credit has appeared. The high-earning CHESS token was created this summer as the core of Tranchess, designed to enable leveraged betting on bitcoin by dividing a fund into high and low risk slices. The principle is similar to CDOs, or secured debt securities, but instead of the subprime mortgages at the heart of the CDO collapse in 2007, this one contains bitcoin.
The only way for the ordinary investor to participate in the brokerage, market making, structured credit or lending activities of Wall Street is to buy stocks in an investment bank. DeFi offers the ability to do it yourself, without the cost of investment bankers, executives, or regulators.
The flip side of having easy access to Wall Street methods of making trading profits is that you also have easy access to Wall Street trading losses, often without any sort of warning and, at least for the sake of it. instant, without regulation.
Any DeFi carries two basic risks that much of Wall Street was designed to minimize: fraud and operational errors. Fraud is so common that there is even crypto jargon for it: “rug pulls” occur when high paying token issuers simply run away with the money.
The operational risk is enormous, the smart contracts that govern DeFi frequently have loopholes that allow crooks to get away with assets, or design flaws that plunge the asset into a downward spiral.
It’s not just these two risks that matter, of course. The client is the only one to manage the other main dangers of DeFi: credit, liquidity and currency risks. These risks are minimized or even not mentioned by DeFi platforms, leaving investors to rely on seeking advice on Reddit. Sometimes these tips are great, other times less so. Boosterism is built into DeFi terms: the calculated risk of losing money on market making is widely known, weirdly, as “impermanent loss”, even if it is money that disappears. forever once you withdraw your funds.
The libertarian in me loves the idea that people learn to make their own mistakes. I don’t like the proliferation of scams and I hate DeFi’s marketing as if it were an alternative to a bank account. This is not the case, as bank accounts come with federal insurance, while DeFi comes with significant hidden risks. But I like the idea that ordinary savers are forced to understand complex financial issues, instead of being lulled into ignorance by the state.
The economist in me is hampered by waste. DeFi is beautiful and innovative, but at the end of the day it is totally self-centered, while still offering different ways for people to speculate in cryptocurrencies. Maybe one day DeFi will find some real use, being deployed with stocks, bonds, or a central bank digital currency. This has not yet happened, however.
It is my inner historian who is prepared for disaster. Every major financial innovation has led to far too much leverage and an explosion before being tamed by regulators, and opening up transactions on Wall Street to the general public is a major financial innovation.
For now, I’m reassured by the minimal ties between crypto and the real economy, and it’s not clear how a major DeFi problem would rebound in mainstream finance. Even with its rapid growth, DeFi is probably still too small to pose a serious threat, except for those who lend their money without understanding that high rewards are only possible because they come with high risk.
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