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I have news from the cryptocurrency world: after many years of doubt and uncertainty, a killer app has finally been found. This is why crypto prices, despite many drops, have remained much higher than many skeptics expected.
The main use case for crypto is called DeFi, a recently coined abbreviation for decentralized finance. DeFi does not have a formal definition, but this typically includes the use of blockchain to borrow and lend in auction markets; to trade unconventional derivatives; exchange one set of crypto assets for another; and for unusual forms of insurance. Profit opportunities arise in part because blockchain eliminates the need for traditional financial intermediaries, with their associated fees and regulations.
An example: let’s say you have money to invest, but government bond rates are too low, and you’ve already invested a lot in publicly traded stocks. You can allocate a portion of your portfolio to the loan auction markets built on Ethereum, essentially by throwing crypto into the market and seeing at what price it will be loaned. You could end up with returns of 6% or more, although some of these opportunities are very risky. There could be $ 100 billion invested in DeFi right now. More importantly, these systems are growing rapidly. It’s hard to get reliable numbers, but according to one account DeFi has grown sevenfold in just a few months in 2020, to a total value of $ 7 billion. It’s no surprise that investors find DeFi attractive, especially in a world of low yields and expensive assets. Think of them as decentralized markets in a very junky form of junk bonds.
To be clear: I’m not claiming that these uses of DeFi are socially beneficial. It is simply too early to tell. One criticism of DeFi is that it is in effect regulatory arbitrage, bypassing laws and restrictions useful in the pursuit of higher private gain. The longer-term result could be a more fragile financial economy and more vulnerable to recessionary conditions, especially as DeFi reaches a larger scale. DeFi loans often go to non-traditional borrowers of uncertain quality.
But it’s also important not to confuse the various crypto reviews that are only useful for speculation, for example, or that are bad for the environment. The main thing is not to let your attitude towards crypto (positive or negative) affect your analysis. Instead, focus on answering one question at a time.
And if the question is whether crypto is good for anything, there is now at least one clear answer: crypto enables DeFi. You don’t have to love all the consequences of this reality, but it is a reality.
You could say that crypto is a Trojan horse of a new and quite different financial system. If you’ve ever dealt with US banks and suffered from their bureaucracy and mediocre software, you might conclude that they’re ripe for disruption. Banks in other countries can be even more vulnerable.
Obviously, as DeFi grows, issues of government oversight and control will come to the fore. Still, it seems unlikely that DeFi institutions will be regulated and disappear. DeFi can be run on platforms outside of the US, and US and EU regulators can’t shut it down any more than they can stop me from placing an online bet on a Mexican soccer game.
Keep in mind that much of the developing world currently uses microcredit, where interest rates on loans are often 50% or 100% on an annualized basis. It is likely that some of these countries will experiment with DeFi as an alternative method of credit allocation, whether or not these new institutions satisfy US regulators in all respects.
If you’re confused by a lot of DeFi, welcome to the club. The confusing and ever-changing nature of DeFi is why crypto asset prices are so volatile. While DeFi is partly behind the demand for crypto, and you don’t know exactly where DeFi is heading, the future of crypto is also very uncertain. It’s very unusual to have such a visible window into what is essentially the value of a bunch of startups.
Finance is about to get even weirder and crypto is just the beginning.
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