Analyst Insights
Cryptocurrency and blockchain technology has garnered plenty of media attention in the past 2 years, particularly due to the incredible bull run of Bitcoin. Blockchain technology, which underpins cryptocurrencies can be considered as a digital ledger, which records and validates transactions and has been touted as a disrupter of intermediary roles played by the traditional financial sector. One such application of this technology is De-Fi or decentralized finance.
From our assessment, our conclusion on De-Fi is that the technology is currently in the initial stages and as such, there exists little regulation or oversight through which to protect the average investor. This coupled with the number of high-profile hacks and protocol vulnerabilities on several De-Fi applications means that this is not an investment venture that would be recommended to the unsophisticated investor, particularly ones that are new to the cryptocurrency market. Let’s explore the arguments supporting this conclusion.
Decentralized Finance (De-Fi)
De-Fi is a fin-tech protocol that allows users to utilize financial services such as borrowing, lending, trading, buying insurance, and scheduling payments without the need for traditional intermediaries. De-Fi gained prominence in 2015 when the application MakerDAO allowed users to get loans in their own “DAI”, which is a stable coin cryptocurrency that is pegged to the US dollar. The mechanism through which De-Fi works is the utilization of “smart contracts” written on a blockchain network that executes coded instructions once specific conditions are met. Imagine you wish to establish a fund that pays out a monthly allowance once the beneficiary turns 18. De-fi applications (Dapps) would be able to validate the current date to ascertain the age of the dependent and to schedule payment to the beneficiary through the blockchain, eliminating the need for a third-party and the associated fees; in other words, this could disrupt the role of traditional custody services providers, both in the context of the administration of Trusts as well as in the context of registrar services for financial securities.
Another popular use of Dapps is the ability to “yield farm”. Holders of cryptocurrencies such as Ether, for example, may commit their coins to a liquidity pool, becoming liquidity providers, who are paid a portion of the fees charged by platforms that use this pool to facilitate lending, borrowing, and exchanging of tokens by other users. According to De-Fi pulse (A De-Fi analytics provider), the total value committed to lending pools, in the top three lending Dapps (Maker, Aave, and Compound) was US$25.91 billion as of May 26th with yields as high as 8.45% per annum. Other common popular uses of De-Fi protocols include the collateralization and tokenization of assets, derivative trading, and lottery and auction systems.
Pros and Cons
There are several touted benefits of the De-Fi applications. This includes them being immutable (that is they cannot be changed), transparent (smart contracts code can easily be audited), durable (they are active and available for as long as the blockchain remains running), and inclusive. Technically anyone with an internet connection would be able to deploy capital into a Dapp either with the intention to invest or to make payments.
Despite these benefits, there are also several drawbacks. Firstly, the immutability of the contract means that the code will only be as good as the coder. Errors are difficult to correct and when a system of Dapps interacts with each other, this can compound and cause larger disruptions. A high-profile example of this was a one-line coding error that caused the Yield Farm Dapp, YAM, and its associated cryptocurrency to fall from a market Cap of US$65 million to US$0 in a couple of hours in August 2020. A second major consideration is that the transparency of the code makes Dapps targetable by hackers looking for vulnerabilities. This is inclusive of several attacks in 2020 on De-Fi protocols that involved code exploits. Lastly, there exist risks associated with the transparency/identity of founders in some De-Fi projects as well as the rules underlying their protocols. According to Cipher trace, De-Fi-related hacks in 2021 already exceed the entirety of 2020 with “rug pull” attacks making up 47.4% of major fraud and misappropriation thus far. A rug pull is a maneuver in the crypto industry whereby developers abandon a project and illegally appropriate users’ funds. Currently, the largest news in the De-Fi space which involves transparency is the current audit of the Dapp Tether which provides the USDT stable coin which was allegedly backed 100% by reserves of US dollars. After an investigation by the New York Attorney General, this was proven to be false, with the tether stable coin being backed by only 75.9% Cash and Cash equivalents, of which only 3.87% was Cash.
Going Forward
De-Fi is not likely to replace traditional finance in the near term; in fact, traditional players are looking to incorporate these technologies to disrupt themselves from within. But fundamentally, the primary reason is that currently, De-Fi cannot compete with the security and potential recourse/redress that is afforded by traditional finance. This security includes both legislative/legal protection for participants in the financial market and the existence of regulation, which offers some protection from fraudulent schemes. The real-life use cases for De-Fi however remain relevant as shown by several active applications and will likely continue to grow in the future. With widescale adoption and acceptance by financial Intermediaries themselves, De-fi can serve to integrate with traditional banking services to offer more efficient solutions to issues. This is a space in which only sophisticated investors should tread carefully; beginner investors should, at this stage, invest in their learning and understanding of the space.
Written by Peter-George Simon, Senior Investment Strategy Analyst |
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