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Evaluating the DeFi Option: Are the Rewards of Decentralized Finance Worth the Risks?

Global Investing

Decentralized Finance (DeFi) has grown by a factor of 10 in the last 25 months. This $54 billion industry offers eye-watering rates of return—but are the rewards worth the risks? What does Decentralized Finance actually mean?

DeFi is a series of permissionless systems. Unlike other financial tools (e.g., banks, brokerages, credit cards, etc.) which require you to create an account, DeFi allows anyone with a digital wallet to interact with the platforms. Why the massive growth? And what’s the appeal to users of DeFi? Two main factors come to mind:

1. Until very recently, over the past decade, certificate of deposits (CDs) have yielded less than 2%, even for 5-year durations. Investors are yield-starved, and this has necessitated taking on more risk. DeFi offers rates of return that far exceed other options.

2. Instead of selling their assets, those holding crypto can earn yields. Effectively, this transforms a “dead” asset into one producing a series of cash flows.

What Kinds of Returns Are Possible in DeFi?

This answer, like all other investments involving risk, varies widely. Let’s look at one of the largest platforms: MakerDAO.

DAI is the native stablecoin (pegged to the U.S. dollar) for the Maker protocol. It’s collateralized by other cryptocurrencies and held within smart contracts rather than in institutions. Holding DAI can earn a 7-day net APY of 3.51%.

As noted above, anyone holding the DAI cryptocurrency in their digital wallet can utilize the platform. No KYC (Know Your Customer) or AML (Anti-Money Laundering) account-opening procedures are used.

Where Do the Returns in DeFi Come From?

MakerDAO, like any other DeFi platform, offers loans to the users. There’s a major difference between these loans and more common loans (e.g., vehicle, mortgage, business lines of credit, etc.), however.

Many loans originate because people or companies don’t have the capital necessary to buy a car or house, or to finance the growth of their businesses. These undercollateralized loans are underwritten using credit histories, personal guarantees or other assets.

DeFi loans are overcollateralized. These loans are backed by the crypto assets someone already owns. Instead of selling their crypto, many choose to take loans against the asset.

For example, a person or organization holding 175 ETH (the cryptocurrency from the Ethereum blockchain, the second-largest crypto by market cap) can pledge their crypto and get 150,000 DAI to use how they’d like.

The minimum collateral ratio is the threshold a borrower must maintain. For the sake of this example, if it drops below 170%, the borrower is liquidated. The ETH they pledged is taken by the platform.

How do these interactions between user and protocol work?  DeFi consists of a series of smart contracts. These contracts execute automatically based on the provisions contained in them.

In the case of the aforementioned liquidation, the borrower knows exactly what will trigger the event. If the underlying asset (ETH, in this case) falls in value, the borrower can top-up their loan with more Ether.

How DeFi platforms make money, then, is very simple:

1. Gather deposits from those who want to earn yield on their investments.

2. Provide loans to those who wish to pledge their assets.

Read more commentary by Spencer X Smith here.

What Are the Risks of DeFi?

Three major risks to DeFi are prevalent:

1. Crypto assets are extremely volatile. Liquidations can happen extremely quickly if a borrower isn’t keeping tabs on the price of their pledged crypto.

2. Smart contracts are computer code, and thus only as secure as the programming that is used. DeFi protocols have lost $4.75 billion in total due to scams, hacks and exploits. Depositors are vulnerable to smart contract programming oversights, and can lose their entire balance.

3. The current regulatory environment is very muddy. Recently, the CFTC declared both Bitcoin and Ethereum commodities. That runs counter to SEC comments stating that Ethereum is a security. Before DeFi is adopted by the masses, clear regulations need to be codified.

We’ve only scratched the surface of what’s possible in DeFi with this brief article. From a yield standpoint, MakerDAO is considered one of the more stable protocols while other nascent platforms offer rates of returns in the mid to high double-digit APYs.

If you’re willing to accept the risks involved with DeFi options, you can be rewarded handsomely by using the protocols.

If you’d like to research DeFi further, you’ll learn more about staking, liquidity pools, slippage, Automated Market Makers (AMMs) or myriad other topics.

I hope this brief overview of depositing/borrowing on DeFi platforms gives you a brief glimpse into a market that will probably increase tenfold again—to $500 billion—in the near future.

Spencer X Smith is the founder of AmpliPhi Social Media Strategies. He’s a former 401(k) wholesaler, and now teaches financial services professionals how to use social media for business development. This column first appeared in the Winter issue of NAPA Net the Magazine.