It’s the summer of DeFi! (AKA decentralised finance). But is something revolutionary happening or is it just another crypto bubble?
People have been proclaiming alt season from the rooftops recently, but it’s probably more accurate to call it DeFi season instead. From a relatively fringe pursuit whose products were considered years away from primetime, crypto’s decentralised finance ecosystem has, over the last couple of months, experienced the sort of explosive growth most commonly associated with major cosmological events.
If you’re anything like me, this begs a few questions. What the hell is DeFi? How are people actually making money from it? And why did nobody tell me to invest in DeFi pioneer Aave (LEND) before it pulled an actual 100x?
What am DeFi?
In a broad sense, the whole premise of decentralised finance is pretty simple: how can we leverage the power of blockchain technology to offer financial services that don’t require mediators such as banks?
The most obvious example is a loan. In traditional finance, you require a trusted intermediary (i.e. a bank) to both offer the money for the loan and then provide the platform for repaying it. In DeFi the bank is replaced by a decentralised marketplace where anyone can provide loans to anyone else, using smart contracts to ensure that the terms of the loan are met.
The unusual suspects
When we talk about DeFi, we’re talking about a complex ecosystem of intersecting blockchain projects, each carving out their own niche in the making-money-from-money space. There’s the aforementioned Aave, which allows people to build their own money markets. There’s Compound, which algorithmically invests cryptocurrency in different interest-bearing markets to maximise yield; it currently holds more than US$1.5 billion in digital assets. Ampleforth looks to mitigate crypto’s famed volatility (an impediment to loans denominated in bitcoin) by continuously changing its circulating supply. 0x (available on CoinJar) facilitates the peer-to-peer exchange of digital assets.
The list is extensive and the financial concepts often mind-bending, yet right now DeFi projects are the hottest thing in crypto, with valuations that have increased 5-, 10- or even 100-fold over the last six months. So what’s driving the frenzy?
Promise and execution
In theory, DeFi is the next step in crypto’s utopian promise to disintermediate money and bank the unbanked. In practice, at least so far, it’s an excuse for high functioning crypto nerds to engage in high-risk, multi-stage lending practices known as “yield farming”.
Yield farming is basically a way of leveraging different decentralised money markets to compound the interest you receive for lending out your cryptocurrency. It goes something like this:
I’ll be honest. I’ve spent the last few hours trying to understand exactly how yield farming works and I still feel like someone’s trying to explain quantum computing to me in Yiddish.
And therein lies the problem with DeFi right now. It’s not surging because it’s solved a clear and present real world need for decentralised finance products. It’s surging because it’s created a circular network that rewards people for joining by shifting capital from one person to the next. (I’ll take “Ponzi scheme” for $400, thanks Alex!) But when the pool of available investors is exhausted and there’s no more yield to farm? Hoo boy.
Don’t get me wrong. The DeFi mission is laudable and at some point it could well fulfil its promise of eliminating some of the injustices and inefficiencies of centralised finance. But the skyrocketing valuations, frantic shifts of capital from project to project and general sense of disbelief in the air is very reminiscent of the ICO frenzy in 2017.
And, sure, that frenzy was immensely profitable to those who played it right. But just keep its primary lesson front and centre in your mind: it’s all fun and games while the bubble is inflating, but when it eventually explodes you do not want to be the one holding (or should that be HODLing?) on.
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