Boom or bust? The freewheeling world of crypto lending
It looks like a win-win bet. You lend money to a borrower who provides collateral in excess of the loan amount, and then you receive interest of about 20%.
This kind of proposal provide DeFi, or decentralized finance, peer-to-peer cryptocurrency platforms that allow lenders and borrowers to transact without traditional providers loans – banks.
Loans on such platforms have grown more than sevenfold since March this year to $ 3.7 billion, according to industry website DeFi Pulse, as investors seek new opportunities to generate more profits while central banks around the world cut interest rates to bolster economies hit by the pandemic.
Supporters of this technology say DeFi sites, which are open source with algorithms that set real-time rates based on supply and demand, represent the future of financial services by providing a cheaper, more efficient, and more accessible way for people and businesses to receive or offer credits.
But the promise of high rewards comes with huge risk.
Lawyers and analysts say such sites are vulnerable to coding errors and hacks, and most are not properly tested or regulated, which is typical of much of the global cryptocurrency sector distrustful of the financial establishment..
Critics warn that the technology could be the next bubble in the cryptocurrency world, similar to initial coin offerings (ICOs), with particular risks for inexperienced investors. In 2017, billions of dollars were invested in ICOs, where companies raised capital by issuing new virtual coins. Most of the projects did not work, and many investors lost their money.
«These are experiments in finance», – said Preston Byrne from the law firm Anderson Kill located in New York. «In many cases, they do not necessarily comply with the laws.», – he added. «But this does not mean that they have there can be no room in the future».
Nevertheless, the popularity of decentralized financial technologies is growing..
Seven years ago Brice berdah dreamed of retiring at the age of 30. He calculated how much he would need to save: «The exact amount was 1.7 million euros. My plan was to earn 5% of my capital».
However, reality canceled out his plans. Low interest rates meant his savings were stagnating.
«By the age of 27, I have accumulated only about 0.5% of the required amount», – said Berdach, who works at a startup that makes digital wallets to store digital coins. «It was an obvious failure».
To resurrect his dream, Berdach, now 28, turned to DeFi.
«Now I use DeFi, I adjusted my retirement plans», – said a young man from Paris who has invested 90% of his capital in DeFi. «The return is around 20-25% in the last six months … and now I’m on the right track».
While DeFi has its roots in a crypto sector hostile to mainstream traditional finance, some of its goals – such as reducing costly transactions and paperwork in financing – have caught the attention of companies whose DeFi businesses trying to undermine.
According to fans of this technology, in the future, bonds or stocks will be issued and traded directly on their blockchain-based platforms, rather than through investment banks or centralized exchanges. According to them, the processes will be monitored by code, not people..
For their part, large banks are exploring how such technology can be used to complement rather than modify the existing financing system. For example, Goldman Sachs has hired a new head of digital assets to see how these assets can exist and grow on blockchain technology, a company spokesman said earlier this month..
«There is real value in what builds on these protocols», – said Maya zehavi, blockchain consultant and board member of the Israeli blockchain industry group. «Ultimately, this can become an ecosystem for instant financing of any project. These are the promises».
Most DeFi platforms are based on the Ethereum blockchain, which is the second largest cryptocurrency after Bitcoin. Unlike Bitcoin, the Ethereum blockchain can be used to create digital contracts, and it is easier for developers to create new software or applications on it..
Loans are registered, disbursed and managed by blockchain-based contracts. Borrowers must offer collateral also in cryptocurrency, which is usually worth more than the loans they take.
DeFi is not for the faint of heart. Borrowers are usually traders who take out loans, for example in Ethereum, and then use coins to trade on various exchanges against other cryptocurrencies. They then seek to repay the loan and pocket their profits comparable to short selling in the stock markets..
One of these borrowers is Antoine mouran, student of the Faculty of Computer Science at the University of Lausanne.
Muran borrows USD Coin cryptocurrency from Aave lending platform and then uses credit to trade credit coins.
Profit from a typical trade? According to Muran, depending on the starting price, it can reach up to 30%.
«My portfolio is a couple thousand dollars», – added 18 year old guy. «I trade for fun to discover new technologies such as decentralized finance».
Aave has benefited greatly from the recent DeFi boom, according to DeFi Pulse, with loans surging nearly 7,000% to $ 1.4 billion since June..
Stani kulechov, the founder of the platform, said that the interest of users was «huge» in recent months, but he admits there are many pitfalls in the fledgling lending industry.
Kulechev said the code behind DeFi lending can regulate itself without the need for oversight from centralized bodies such as financial regulators – but only as long as everything is working properly..
«The problem is that smart contracts don’t behave the way they should and when things go wrong».
However, glitches in the code – from bugs to hacks – are common..
For example, on March 12, major lending platform DeFi Maker, with around $ 1.4 billion in loans, was rocked by a sudden drop in the price of ETH..
Nearly 1,200 lenders suddenly liquidated their positions for next to nothing, despite the precautions Maker took to protect lenders from a sudden market downturn.
Some industry players such as Kulechev from Aave, advocate for self-regulation of platforms to create standards for smart contracts aimed at preventing hacks or code glitches.
However, the decentralized finance industry is still a long way off..
Many DeFi proponents oppose any oversight by individuals or organizations, preferring to trust communities of users to improve smart contracts by fixing bugs through open source programming.
What’s more, some users are turning to a more traditional industry for a degree of protection against DeFi platform failures: insurance. Some firms, such as London-based Nexus Mutual, offer special insurance coverage losses, incurred as a result of failures in smart contracts.
A British financial watcher told Reuters that it regulates some cryptocurrency-related transactions on a case-by-case basis. Last year it was separately said that even «decentralized» platforms may be subject to regulation.
Until regulation is achieved, the risks associated with using the code may outweigh the benefits, critics say..
«People who are losing have no way to ask for help», – said Tim swanson from the blockchain payments company Clearmatics. «Code is not law».