What On Earth Is Going On In DeFi?

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All fall, we’ve heard the hype. Everyone is excited about DeFi! Well, at least until they aren’t anymore. I don’t necessarily see what the buzz is about. Sure, you’re working with stablecoins for the most part and they don’t fluctuate in terms of value the way other crypto tokens can, but it’s a bull market even despite all of the cataclysmic ongoings in the world today. It isn’t the most rewarding bull market thus far, and who knows where we might be if the pandemic hadn’t struck, but despite all of these external bearish indicators, we’re still looking at growth. That signifies strength.

But there are some strange things going on. For one, the transactions cost too much to make small plays in DeFi. The only person who should be putting money into DeFi is someone who has a substantial amount of it and is willing to either get creative and take risks to increase the return, or someone who is comfortable at a low return on the investment.

This hasn’t stopped the hype from exploding, and I must confess that I do not pretend to understand what’s going on here. I’ve done a few experiments, though, and in this article I’ll explain what happened and try to wrap my head around this market. Any and all comments are welcome, as it’s confusing stuff and I’m definitely still just starting out too.

DeFi Hype Hits Coinbase

Earlier, COINBASE paid me about $20 in 3 different cryptocurrencies to lock $3 of USDC into a Compound smart contract that will earn me 2.2% APY on that money. Shrugging, I followed the steps to earn the $10 COMP prize that I was promised, and I was pleasantly surprised to see gas prices dip dramatically between the time Coinbase estimated my gas fee and sent me ETH to make the transaction with and the transaction’s actual execution moment, which resulted in about $6 in ETH remaining in my wallet, an unintended bonus perhaps.

The transaction fee for my $3 smart contract deposit was only about $1, ultimately, which would seem reasonable aside from the fact that the money will have to remain in the contract for the rest of my working life to earn back the transaction fee.

My experience with Curve was very similar. I believe I spent about $80 in transaction fees to make $2 on a small investment of $150. I just wanted to try it out, compare it against my inflated bag of ATOM tokens, and see what all the buzz was about. My conclusion? Not much.

The UIs on most of these things are clunky and old school. Curve in particular reminds me of Windows 95 or something, but the main goal is to make money, so who cares what it looks like? Assuming the transaction fees would have been the same if my deposit had been $15,000 instead of simply $150, I’d have made $200 by exercising the transaction along the same lines as I did. From this $200, we subtract the $80 in fees, for a tidy profit of $120 for loaning out my $15,000 for about six weeks. This rate of return is better than what we can hope for in a savings account, but not as good as the stock market on average.

Scenarios

Why is DeFi so hyped, if it’s not relevant to every situation? I have a few theories here. And, believe it or not, it does actually seem to be a real financial vehicle worth investigating. I’m still not sure that ordinary people will ever hold enough BTC to buy a car and wait for appreciation to pay the note off, but for early adopters there are definitely some financial hacks that can help us make money in the markets and increase our spending power courtesy of DeFi protocols.

The first theory is that DeFi is a place to keep earning between big, well-thought-out moves in other crypto tokens. If you hold a bunch of ATOMs and actually sell them when the price has tripled, you may not see another growth opportunity in the market right away even if it’s a bull market. So you throw the profits into DeFi smart contracts and wait for the price to come back to earth, completely safe from any asset depreciation no matter how rocky the market gets. Then, when it’s at the bottom, you close out of the liquidity pools and putting the money back into the market to ride the escalator up again.

I wish I were a solid enough trader to continuously do this sort of thing. I hit about 50/50 on my day trades and switched to months-trading, and then became sort of a believer in the Cosmos ecosystem and am simply waiting for that to pan out in the mid to long term.

The second theory is that crypto-based lending is allowing people to overleverage their assets by taking out loans against them. I’ve used Nexo Wallet to do this a few times since August and I’m 0/3 or 4 at the moment, but my most recent play may turn out fairly well. I keep thinking I see short-term plays and staking my ETH and BTC to borrow 50% of its value and then losing some money on whatever I buy with it. Sometimes, this is my goal. I turn the USDC I get from Nexo into XLM, then head over to Stellarterm to buy TERN with it, then spend the TERN from my Blockcard to buy things I need.

Ideally, the price of BTC and ETH would rise while the loan was out, and I would be able to repay the loan by selling only a portion of the crypto that I staked against it when I took it out. One good beat there, say if BTC hits $20k again, could really help me out. I could even begin purchasing BTC and ETH with the leveraged loans and simply ratchet up my exposure to the assets. If you have 1BTC, without selling your BTC, you can actually acquire a second BTC via Nexo’s lending protocol.

How this works:

You can borrow about half your money each time, and if you do it enough times, you end up with about 1 BTC you started with and a second that you borrowed money at a set price to purchase. It probably takes half a dozen transactions, but you can actually gain double exposure to an asset. The problem is that you risk liquidation if the price dips too far.

If the price increases, say it doubles during the time period we’re looking at. If you don’t wait after your initial purchase and you take the loans immediately, you’ll owe 1BTC’s worth of USD to Nexo at 6%. So assuming BTC doubles immediately thereafter, you’re out the money you paid for your initial BTC AND the money borrowed against it to purchase a second BTC. So, 2 BTC in the red column. If you sell your 2 BTC at double the starting price, you will receive 4x the value you started with in return, but you’ll have to pay back 1BTC worth to Nexo, plus interest.

So, you started with 1, and you end up sitting +200% instead of just +100% when the market price of BTC doubles. The downside is that you’ve doubled your exposure to risk as well as to reward, so when BTC doesn’t double, you’re on the hook to a troubling degree: if it goes down 50%, you own 2 BTC but you have to sell them both to pay off the loan that bought the second one! You’ve lost your initial investment!

Ideally, we watch the market and try to mitigate any downward potential by selling, but any loss — 10% or 40% — will be doubled by our insidious risk multiplication machine here.

Conclusions

That’s about the best I can do to really try to understand the appeal of DeFi, even as it wanes just a bit in terms of volume. The simplest explanation for the DeFi boom is that, in a bull market, people really like measures such as these which allow us to overleverage and gain that added exposure because the trendlines all point up and we would rather make more money than less money. The novelty of the technology piles onto that possibility of benefit to create excitement and, suddenly, a thriving market exists where none was before.

Still, none of these measures are without a certain element of risk. I never give anyone any advice in these essays, but if you choose to take something away from this article please choose this: tread lightly in DeFi. Applies to markets in general, in fact. Nobody really knows what’s about to happen, and that uncertainty is a thing full of both danger and opportunity.

Regulation and Society adoption

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