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What Happens When Cryptocurrencies Earn Interest?

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Cryptocurrencies have long been heralded as the future of finance, but it wasn’t until 2020 that it finally caught on to an old idea: making money with money. In the crypto world, decentralized finance (or DeFi) encompasses a wide array of blockchain-based applications intended to enhance cryptocurrency holders’ returns without relying on intermediaries — to earn the kind of passive returns an investor might get from a savings account, a Treasury bill, or an Apple Inc. bond.

The idea seems to be catching fire: Deposits in DeFi applications grew from about $1 billion in June to just under $40 billion by late January 2021, suggesting that DeFi could be a major element of crypto from here on out. In the tradition of disruptive innovations — as Clayton Christensen envisioned them — DeFi can be the evolution of blockchain technology that might launch it into mainstream.

The premise of DeFi is simple: Fix the longstanding inefficiency in crypto finance of capital being kept idle at a nonzero opportunity cost. Now, most investors buy crypto with the hope that the value of the currency itself will rise, as Bitcoin has. In general, that strategy has worked just fine. The value of cryptocurrencies has appreciated so rapidly that there just wasn’t much incentive to worry about gains of a few percent here and there.

But the recent rise of stablecoins, which are designed keep their value constant, has changed that calculation. The combined market cap of stablecoins such as Terra and USDC has more than quadrupled in 2020. Now, vast passive income opportunities are being awakened by DeFi.

The appeal of a lower-risk approach to crypto is obvious and has the potential to expand the pool of investors. For the first time, it’s possible to be compensated for owning cryptos (even in the absence of price appreciation), which brings real, tangible utilities to digital currencies and changes the narrative of an asset class whose sole purpose used to be about being sold at a higher price. Therefore, many of the DeFi protocols today might have the potential to become big and bold enough to rival their centralized counterparts, while staying true to their decentralized roots. Furthermore, with volatility out of the picture and the promise of more stable returns, institutional investors are now considering crypto as part of their investments in alternatives.

Yield Farming vs. Currency Carry Trading

The search for passive returns on crypto assets, called “yield farming,” is already taking shape on a number of new lending platforms. Compound Labs has launched one of the biggest DeFi lending platforms, where users can now borrow and lend any cryptocurrency on a short-term basis at algorithmically determined rates. A prototypical yield farmer moves assets around pools on Compound, constantly chasing the pool offering the highest annual percentage yield (APY). Practically, it echoes a strategy in traditional finance — a foreign currency carry trade — where a trader seeks to borrow the currency charging a lower interest rate and lend the one offering a higher return.

Crypto yield farming, however, offers more incentives. For instance, by depositing stablecoins into a digital account, investors would be rewarded in at least two ways. First, they receive the APY on their deposits. Second, and more importantly, certain protocols offer an additional subsidy, in the form of a new token, on top of the yield that it charges the borrower and pays to the lender.

Compound, for instance, has been rewarding users with a token that confers governance rights — the COMP token, which more or less represents a seat on the protocol’s board of directors — simply for using its service. While it costs Compound hardly anything to mint the coin, COMP is actively traded on the market and can be easily sold for cash should the owner so wish. As a consequence, those “bonus” tokens have been supercharging yields for both borrowers and lenders, often paying borrowers more than they have to repay lenders as COMP soars in price.

As peculiar as it sounds, the subsidy does make economic sense. Getting more people to use the Compound protocol increases the value of the native token, which in turn attracts more users to “farm,” creating a positive growth loop. Furthermore, distributing governance tokens to users also achieves the objective of decentralizing ownership and gives the most active users voting rights that, when exercised, will determine the direction of future development of the protocol.

While Compound has jumpstarted the crypto-lending trend and is growing in popularity, yield farming still requires expertise beyond the capability of an average investor. Succeeding in the game requires frequent trading, active monitoring, and meticulous risk management, not to mention contending with yields far more volatile than those in traditional finance.

There are more retail-friendly DeFi projects, however. Gemini, the cryptocurrency exchange founded by Tyler and Cameron Winklevoss, is launching a new service called “Earn” that lets clients deposit their holdings in bitcoin and other cryptocurrencies into interest-bearing accounts with no minimum balance required. Similarly, BlockFi, a crypto lender backed by tech billionaire Peter Thiel, offers rates of up to 8.6% APY on deposits, while bank savings accounts offer a meager 0.05%. Anchor, a savings protocol on Terra’s blockchain, provide more stable yields to depositors in an attempt to bridge the DeFi experience to that offered by traditional finance.

This might just be the beginning. The head of digital assets at Goldman Sachs recently stated that he envisions a future in which all of the world’s financial assets reside on electronic ledgers, and activities that today require squadrons of bankers and lawyers like initial public offerings and debt issuances could be largely automated.

Automated Market Makers vs. Electronic Exchanges

Electronic exchanges like the ones used by the NYSE or NASDAQ are a prime candidate to be at the forefront of this disintermediation. Markets function properly because there are mechanisms to set prices. While the NYSE and NASDAQ use order books (electronic lists of buy and sell orders) to do so, automated market makers (AMMs) — one of DeFi’s core building blocks — rely on algorithms to determine prices based on real-time supply and demand of each crypto asset in the market.

AMMs have a number of desirable properties. The first is simplicity: AMMs only support market orders — orders to buy or sell immediately at the current price — not limit orders, which are set to execute at a specific price. Users, whether buying or selling, supply assets at quantities of their choosing and the AMM calculates the price. Second is transparency: The pricing mechanism, as well as all transactions, are available on a public ledger for anyone to inspect, so traders have confidence that the system is fair. Third, AMM pricing is continuous and is able to accommodate all order sizes without the “gaps” — orders that can’t be filled — often found in order books. Small orders barely move the price, while large orders become prohibitively expensive, making it impossible to deplete the pools. In other words, AMMs achieve a near-infinite market depth with finite liquidity. Finally, there are no counterparties in the traditional sense, because trades happen between users and contracts, which self-execute.

Despite their advantages, AMMs have an important downside: There are a lot of hidden risks. Specifically, liquidity providers lose money when the value of a currency changes, where the bigger the change, whether up or down, the bigger the loss. To make the deal worth it, liquidity providers collect transaction fees, giving them a steady stream of income in exchange for the liquidity they supply — and hopefully offset any loses.

The rapidly changing environment for AMM is exemplified by the Uniswap protocol, which has quickly become the most popular and attracted about 10% of all assets invested in DeFi. Built on top of the Ethereum blockchain, Uniswap recorded $58 billion in transaction volume over the course of the year. But for all of its success, a new competitor, SushiSwap, piggybacking on the open-source nature of the Uniswap codebase, was able to quickly pull users — and liquidity — onto their platform by offering users a SUSHI governance token. This is just an example of the risks of developing free software in a bitterly competitive new market space.

As AMM platforms try to gain a foothold, the key question is: Can projects find the right mix of incentives to make their users loyal and their liquidity sticky, or are they forever at risk of disruption by competitors?

A Wider Audience

In the wake of the near-zero interest rates across almost every major economy, DeFi has made cryptos an appealing choice for profit-seeking capital. Even institutions that have limited risk tolerance and prioritize passive income over capital appreciation, e.g. university endowments and institutional investors, are starting to dip their toes in. Goldman Sachs, JPMorgan and Citi are considering entering the crypto custody market following the OCC ruling on the topic. Visa is working with a digital asset bank, Anchorage, to allow customers of banks to purchase bitcoin. Also, traditionally risk-averse institutions such as the insurance company MassMutual and the California Public Employees’ Retirement System (CalPERS) are looking to get exposure to crypto.

This growing interest might meet further demand for democratizing finance by retail investors. For instance, the aftermath of the Gamestop debacle — with Robinhood halting trading in the Reddit-promoted stocks — has suggested that there might be demand for investment platforms that allow retail investors to trade directly while being shielded from the fury and censure of corporations and regulators. DeFi has already seized this opportunity in the form of Mirror Finance and Synthetix, decentralized applications that allow investors to trade synthetic or “mirrored” assets, such as stocks, free of interruption or censorship. The ripple effects of the Gamestop saga may take a long time to fully materialize, and it appears that DeFi is in prime position to benefit from it.

Nonetheless, the fundamental law of the risk-return tradeoff might shed some light on why the interest rates are so tantalizing: At the end of the day, DeFi is still a far more dangerous spot to park your money with risks not well-understood by the average investor. All DeFi protocols run the risk of software bugs and/or copycats that can, in the worst case, drain liquidity completely. In addition, there is obviously no FDIC insurance protecting the deposits: Lending protocols like Compound or savings accounts like BlockFi can be subject to runs, while AMMs such as Uniswap require an entirely different risk tolerance for providing liquidity.

In sum, not all DeFi products are for savings, and those that are surely are not for retirement savings. Not yet at least. But as its audience expands and institutions that are used to navigating the perils of a highly regulated industry join in, we expect DeFi to herald the long-awaited era where every household has cryptocurrencies working for it. After all, if money never sleeps, why should the cryptos?

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