Cryptocurrencies have long been heralded as the future of finance, but it wasn’t until 2020 that it finally caught on to an old idea: making money with money. In the crypto world, decentralized finance (or DeFi) encompasses a wide array of blockchain-based applications intended to enhance cryptocurrency holders’ returns without relying on intermediaries — to earn the kind of passive returns an investor might get from a savings account, a Treasury bill, or an Apple Inc. bond.
The idea seems to be catching fire: Deposits in DeFi applications grew from about $1 billion in June to just under $40 billion by late January 2021, suggesting that DeFi could be a major element of crypto from here on out. In the tradition of disruptive innovations — as Clayton Christensen envisioned them — DeFi can be the evolution of blockchain technology that might launch it into mainstream.
The premise of DeFi is simple: Fix the longstanding inefficiency in crypto finance of capital being kept idle at a nonzero opportunity cost. Now, most investors buy crypto with the hope that the value of the currency itself will rise, as Bitcoin has. In general, that strategy has worked just fine. The value of cryptocurrencies has appreciated so rapidly that there just wasn’t much incentive to worry about gains of a few percent here and there.
But the recent rise of stablecoins, which are designed keep their value constant, has changed that calculation. The combined market cap of stablecoins such as Terra and USDC has more than quadrupled in 2020. Now, vast passive income opportunities are being awakened by DeFi.
The appeal of a lower-risk approach to crypto is obvious and has the potential to expand the pool of investors. For the first time, it’s possible to be compensated for owning cryptos (even in the absence of price appreciation), which brings real, tangible utilities to digital currencies and changes the narrative of an asset class whose sole purpose used to be about being sold at a higher price. Therefore, many of the DeFi protocols today might have the potential to become big and bold enough to rival their centralized counterparts, while staying true to their decentralized roots. Furthermore, with volatility out of the picture and the promise of more stable returns, institutional investors are now considering crypto as part of their investments in alternatives.
Yield Farming vs. Currency Carry Trading
The search for passive returns on crypto assets, called “yield farming,” is already taking shape on a number of new lending platforms. Compound Labs has launched one of the biggest DeFi lending platforms, where users can now borrow and lend any cryptocurrency on a short-term basis at algorithmically determined rates. A prototypical yield farmer moves assets around pools on Compound, constantly chasing the pool offering the highest annual percentage yield (APY). Practically, it echoes a strategy in traditional finance — a foreign currency carry trade — where a trader seeks to borrow the currency charging a lower interest rate and lend the one offering a higher return.
Crypto yield farming, however, offers more incentives. For instance, by depositing stablecoins into a digital account, investors would be rewarded in at least two ways. First, they receive the APY on their deposits. Second, and more importantly, certain protocols offer an additional subsidy, in the form of a new token, on top of the yield that it charges the borrower and pays to the lender.
Compound, for instance, has been rewarding users with a token that confers governance rights — the COMP token, which more or less represents a seat on the protocol’s board of directors — simply for using its service. While it costs Compound hardly anything to mint the coin, COMP is actively traded on the market and can be easily sold for cash should the owner so wish. As a consequence, those “bonus” tokens have been supercharging yields for…
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