DeFi is the Wall Street of crypto, without the safety net

The promised rewards are huge, and the marketing makes it easy. “High APR, low risk” is PancakeSwap’s pitch for a “syrup pool,” where anyone can lend money. Annual percentage rates, APRs, are sweet: On Monday, a crypto token called Chase was promising more than 300% a year that was paid into Chase.

The pace of development is truly extraordinary, as DeFi barely existed until last year. According to CoinMarketCap, the total value of CAKE tokens issued by PancakeSwap and other DeFi competitors such as Uniswap and Aave is $120 billion. More than $7 billion has been locked in just one part of DeFi, the crypto jargon for funding market creation, “yield farming.”

DeFi is both wonderful and scary. The innovation—made possible by smart contracts, which can automatically transfer crypto based on rules contained in computer code—has allowed crypto enthusiasts to replicate all of Wall Street’s move to crypto without the need for Wall Street. is allowed.

Market making, or cultivating produce, is one of the most basic. Prime brokerages, bank entities serving hedge funds, have reappeared in the form of loans collateralized on DeFi, allowing speculators to pile on leverage or a token they wish to wager by borrowing and selling. Interest rate swaps and basis swaps are becoming increasingly common as people use loans to arbitrage between exchanges, DeFi providers, and various cryptocurrencies.

Even structured credit has appeared. The CHESS token that pays so much was created this summer as the core of Trench, which was designed to allow leveraged bets on bitcoin by splitting the fund into high- and low-risk tranches. The principle is similar to CDOs, or collateralized debt obligations—only that it holds bitcoin, rather than the subprime mortgage at the center of the 2007 CDO collapse.

The only way for the general investor to participate in Wall Street’s major brokerage, market making, structured credit or lending activities is to buy shares in an investment bank. DeFi offers the opportunity to do it yourself without the cost of investment bankers, authorities or regulators.

The flip side of being given easy access to Wall Street trading profit margins is that you can easily access Wall Street trading losses, often without warning, and, at least for now, no regulation. .

All DeFis come with two basic risks that most of Wall Street’s share is designed to mitigate: fraud and operational mistakes. Fraud is so common that there’s even crypto jargon for it: “rag pulls” occur when high-paying token issuers simply run away with money.

The operational risk is enormous, as the smart contracts that govern DeFi are often found to have flaws that allow scammers to make amends with assets, or design flaws that throw assets into a downward spiral.

It’s not just these two risks that matter of course. The client is on his own to navigate the other main dangers of DeFi: credit, liquidity and currency risk. These risks are mitigated or not even mentioned by the DeFi platform, forcing investors to rely on Reddit seeking advice. Sometimes that advice is great, sometimes not so much. Boosterism is inherent in the terms of DeFi: the calculated risk of losing money when the market is made is widely referred to as a “temporary loss”, even though it is money that is gone forever once you withdraw your funds. .

The liberals in me like the idea of ​​learning to make their own mistakes. I don’t like the spread of scams, and I hate marketing DeFi as a substitute for a bank account. Not so, because bank accounts come with federal insurance, whereas DeFi comes with bigger hidden risks. But I like the idea that ordinary savers are forced to figure out complex financial problems, rather than being driven into ignorance by the state.

The economist in me is troubled by the waste. DeFi is beautiful and innovative, but ultimately it is completely self-absorbed, all about providing different ways for people to bet on cryptocurrencies. Maybe one day DeFi will find real use when deployed alongside stocks, bonds or a central bank digital currency. However that has not happened yet.

It is my inner historian who is ready for disaster. Every major financial innovation brought a lot of leverage and a jolt before being subdued by regulators, and opening up Wall Street-style trades to the wider public is a major financial innovation.

For now, I am convinced of the minimal link between crypto and the real economy, and it is unclear how a major DeFi problem will return to mainstream finance. Even with its rapid growth, DeFi is probably still too small to pose a serious risk – except for those who lend their money without realizing that higher rewards are only possible because they come with higher risks. Huh.

This story has been published without modification to the text from a wire agency feed