Decentralized Finance (DeFi) is network based finance based on blockchain technology. The first part of this article explains why the world of traditional finance was ripe for disruption. I then outline the types of DeFi protocols and take a deep-dive into the lending space with Aave, MakerDAO, and Compound. My next article will examine opportunities in decentralized exchanges and synthetic asset protocols.
The Old System
Firstly, digital money transfer infrastructure is archaic to say the least. It is faster to physically mail cash overnight in an envelope than it is to send an international wire transfer. In some instances, as Erik Voorhees of ShapeShift points out, it is faster to physically strap cash to an anvil and express mail it overseas than send wire transfers to certain banks - a farcical fact given that most communications technology today is instant.
Additionally, roughly 22% of the global population does not have banking access. Physical proximity to a bank should not prevent individuals from sending and receiving money over communications channels.
Lastly, the world of traditional finance is ridden remittance fees, transactions fees, brokerage fees, and more. Anyone using centralized financial services must pay these tolls. Remittance payments make up 23% of the El Salvadoran economy. With fees from Western Union (WU) and MoneyGram (MGI) as high as 9%, remittance intermediaries have clipped 1.5% off of El Salvador's GDP annually. The decision to accept Bitcoin as legal tender seems less risky when the starting point is -1.5% GDP from third party fees alone.
Types of DeFi Protocols
Initial coin offerings are themselves an example of decentralized finance in that an individual or group can raise capital for a blockchain project without the need of a venture capital firm or angel investor. However, examples such as ICOs are not within the scope of this article. DeFi tokens will usually have one of four value propositions: lending, stablecoins, exchanges, or synthetic asset tokens. The decentralized hedge fund is a runner up, with Enzyme Finance as the only leader in the space.
There are three ways to make money from decentralized lending: investing in the individual governance tokens, investing in the Ethereum blockchain, or yield farming with stablecoins.
Lending Protocols
Aave, MakerDAO, and Compound are three of the most popular lending protocols as shown below. These are decentralized, peer-to-peer lending systems. When a lender decides to deposit tokens to garner yield, those tokens enter a pool. Borrowers requesting a loan receive funds from this liquidity pool. Because the collateral is verified on the blockchain as belonging to the borrower, background checks and credit scores are not required. All loans are over-collateralized due to the volatility of digital assets-commonly at 150%. This means that to borrow $10,000 worth of a token, the borrower must post $15,000 of collateral.
(Source: DeFi Pulse)
Since January 2020, debt outstanding in lending protocols has exploded from $150 million to $24.6 billion. This constitutes a 16,300% increase in less than two years as borrowers realize the simplicity of decentralized asset backed loans and investors continue to provide liquidity in search for yield. Lending protocols pay $820 million of interest annually for liquidity providers, a topic further explored later in the article.
(Source: Ibid)
How to Profit
The first way to make money off of the lending space is through owning the governance token. Aave, MakerDAO, and Compound tokens are all governance tokens, meaning token holders are allowed to vote on the future of the protocol and influence decisions. Decentralized Autonomous Organizations challenge the traditional corporate structure, and I believe the logic of purchasing governance tokens is simple: as lending protocols continue proliferating into mainstream finance, these governance tokens will become worth more as institutions and individuals desire to influence these projects. Below is an example of Aave's active proposals that tokenholders can vote on. Each proposal has a corresponding in-depth explanation.
(Source: app.aave.com/governance)
The second way is through Ethereum itself. Aave, Maker, and Compound are all ERC-20 tokens created and issued on the Ethereum blockchain. Though value does not automatically accrue to the Ethereum token when an investor buys a Maker governance token, Ethereum supply is reduced when locked away in a lending smart contract. A smart contract is an "if-then" statement that locks and releases collateral once the conditions of the contract are met. A growing Ethereum-based smart contract ecosystem means less liquid supply as tokens get locked for the duration of the contract. Currently, 23% of ETH are locked in smart contracts. As the chart below shows, lending protocols account for nearly half of the total value locked in smart contracts. Therefore, a way to bet on the decentralized lending space without investing in a particular protocol is by being long Ethereum itself.
(Source: theblockcrypto.com)
The final method involves yield farming in decentralized liquidity pools. The yield offered to savers and interest rate offered to borrowers acts no differently than a bank under free market conditions. When there is high demand for loans and low available supply through savers seeking yield, the protocols offer higher APY for deposited funds and higher interest on loans to incentivize more savers and less borrowers to achieve equilibrium. The opposite is also true. Those who argue of systemic risk in the decentralized lending space should know that these protocols are non-fractional reserve banks. One could make the case that there is less systemic risk in MakerDAO than in the global banking system.
Currently on Aave, an investor can achieve 5.25% APY for depositing USDC, a fully dollar-backed stablecoin, into the liquidity pool. As the second chart shows, this is 1.21% higher than the yield on junk bonds. I believe an investor is taking less risk for more yield on DeFi protocols. Furthermore, with consumer, commercial and industrial loans just off their all-time highs, the yields on bonds of all types and duration would be much higher than the yield for dollar-backed stablecoins without Fed intervention pushing rates lower.
(Source: app.aave.com)
(Source: FRED)
(Source: Ibid.)
Conclusion
DeFi is creating a parallel, blockchain based financial system that settles transactions in minutes, provides more access, and generates more yield. For those who complain that Central Bank largesse is suppressing yields and creating wealth inequality, here is the solution. Governance tokens, Ethereum itself, and yield farming are the three ways to profit from decentralized lending. I personally engage in the latter two.
This article was written by
Ariel Santos-Alborna
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Ariel writes about crypto and global macro. Featured in Forbes and Finnotes.org.
Analyst’s Disclosure: I/we have a beneficial long position in the shares of ETH-USD, USDC-USD either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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