Fund manager Vladimir Vishnevsky can achieve a negative interest rate on European government bonds. He can also get an annual return of 20% through a new face of the cryptocurrency market known as decentralized finance (DeFi). Among these two options, he has already chosen the 20%, a return unattainable from traditional markets, according to Vishnevsky, a co-founder of St. Gotthard Fund Management, based in Switzerland, which manages a portfolio designed to generate income from cryptocurrency assets. This strategy is so new that it's difficult for Wall Street professionals to understand.
### Data and Cryptocurrency Codes
To grasp the situation well, first take what you know— and perhaps don’t know— about Bitcoin. It is a cryptocurrency that exists only within closed online databases, controlled by special computer codes. To further understand this strategy, make the matter a bit more complex. Imagine that these computer codes are not only used to record transactions but are also used as lending platforms, insurance companies, and financial markets, all through software, with minimal human intervention. This is what's called DeFi.
Traders like Vishnevsky can make profits through financial commitments in the form of cryptocurrency tokens representing the necessary capital to operate virtual financial institutions, largely unregulated. According to DeFi Pulse data, DeFi programs peaked last month when investors pumped up to $86 billion into these various programs, compared to less than $1 billion a year earlier. It is a new, volatile system subject to hacking. One of the first decentralized financial projects, the DAO fund, fell victim to a hack that resulted in the theft of $55 million by someone who exploited a vulnerability in the cryptocurrency code. Today, after building a world of encryption that everyone can benefit from, decentralized lenders can use deposits of cryptocurrencies to offer loans to individuals looking to borrow to fund their bets on cryptocurrencies, using decentralized trading to trade cryptocurrencies, with decentralized insurance companies also covering hacking risks.
### Regulatory Challenges
The large returns that investors can earn are not priced in dollars or euros but are often priced in cryptocurrencies. Critics of the DeFi system say that some projects can resemble Ponzi schemes, as early investors rely on the accumulation of cryptocurrencies from other investors in those currencies, which still have limited use in the real world. The significant gains from such types of cryptocurrency operations coincide with investors' voracious appetite for owning more crypto assets. As there are no physical DeFi projects, it is difficult to regulate them, leaving the field susceptible to fraud and money laundering schemes. Nonetheless, DeFi proponents believe that the technology has the potential to open new markets and create new types of financial products.
To see how a DeFi program works, look at SushiSwap, which represents a decentralized cryptocurrency exchange that started working last year, as DeFi relies on another clearing token called Uniswap. Like any exchange—from known cryptocurrency trading applications like Coinbase to stock markets like Nasdaq—SushiSwap depends on the liquidity of the buyer and ensuring that this buyer can access the currencies they wish to purchase. On the other side, sellers can obtain the price they believe is fair. To do this in a decentralized manner, SushiSwap creates a liquidity center that aggregates any two coins traders might want to exchange—for example, Ethereum, the second most popular cryptocurrency and the backbone of DeFi, traded against its unique token, Sushi.
### Returns of 20%
Investors like Vishnevsky buy both coins, which are then temporarily listed in the liquidity center, making them available to traders. An algorithm adjusts the prices of both coins to reflect relative changes in demand. The trading platform also charges fees for trading. When Vishnevsky recovers his coins, he also receives a share of the fees generated from trades in the liquidity center, in addition to additional Sushi tokens representing the value of his gains. (Sushi tokens can be earned on another trading pair, not just those involving Sushi.) The annual returns from the trading program are estimated at about 20%.
Other DeFi protocols allow individuals to lend their cryptocurrencies to someone else to borrow, to achieve gains. For example, traders might wish to borrow stablecoins linked to a traditional currency like the dollar to purchase more Bitcoins on platforms that do not allow trading in traditional currencies.
### Yield Farmers
It appears complicated, and it indeed is. Expected gains in DeFi are largely based on current market trends and can decline swiftly. Some investors who call themselves yield farmers continuously move their money in an attempt to generate income, but the costs associated with trading cryptocurrencies, called GAS fees, can eat into those gains. Furthermore, the value of the cryptocurrencies obtained from these returns can be very volatile. For instance, when Bitcoin dropped by up to 10% in a single day recently, popular DeFi tokens like Uniswap fell by almost 20%.
There are still risks associated with cryptocurrencies; regulatory scrutiny could increase, potentially leading to the closure or hindrance of some projects, and the value of the digital currencies tied to them could diminish. Founders of DeFi projects who have stored the generated cryptocurrencies can suddenly convert them into cash, which may lead to price declines. Chef Nomi, the creator of SushiSwap, sold cryptocurrencies worth roughly $13 million in September before backtracking due to outrage from the cryptocurrency trading community.
### Warnings and Collapses
The history of cryptocurrencies is replete with cautionary tales of investments accompanied by hype that then collapse. In 2018, initial coin offerings raised billions of dollars to fund these projects, only for it to be revealed later that most were worthless. Advocates for DeFi suggest that the difference now is that applications resemble trading markets, allowing lenders to earn profits even if it is solely from speculation on cryptocurrencies. Trading volume recently reached $813 million in a single day, resulting in fees of $1.8 million earned by those placing their cryptocurrencies in the liquidity center, according to Uniswap, which reports its user statistics in real time.
What about the value of the cryptocurrencies relied upon by many DeFi projects? These currencies do not typically provide equity rights and do not always grant any direct claim to the profits of projects. However, they often grant voting rights on the future of the project. Investors may hope for increased popularity of the protocols associated with them, as well as increased popularity of the associated cryptocurrencies.
Some DeFi platforms may not be as successful as they appear. Alexander Kloda, who co-managed DeFi programs at Nickel Digital Asset Management, says that the interest in participating in liquidity centers may be driven by the value of "fees" rather than getting free cryptocurrencies. Kloda adds: "In the short term, reading the picture is more difficult, and the logic is not entirely correct if participation is solely motivated by the additional incentive offered by the protocol."
### The Idea is Still in Its Infancy
Proponents of DeFi believe that the idea is still in its infancy and that it can ultimately be expanded to reach traditional financial domains. They dream of an online financial system that does not include a credit officer at a bank branch, such as JPMorgan or Credit Suisse. It is an investment in an infrastructure that heavily relies on technology, ensuring liquidity flow for stock trades. However, Eliane O, a blockchain technology engineer at Global Financial Access, says that there is no harm in using DeFi solely for trading cryptocurrencies. "Look at Vegas and Macau; part of their value lies in allowing you to do what other judicial authorities have prohibited." As O states in her Bloomberg opinion piece: "It is possible to build an entire industry associated with speculation."
