Boom or bust? Welcome to the freewheeling world of crypto lending
LONDON (Reuters) – Sounds like a sure-fire bet. You lend money to a borrower who puts up a guarantee that exceeds the loan amount, and you then earn about 20% interest. What could go wrong?
This is the proposition presented by “DeFi,” or decentralized finance, peer-to-peer cryptocurrency platforms that allow lenders and borrowers to transact without the traditional custodians of loans: banks.
And it exploded during the COVID-19 crisis.
Loans on these platforms have more than sevenfold since March to reach $ 3.7 billion, according to industry site DeFi Pulse, as investors seek returns at a time when central banks around the world have slashed prices. interest rate to support economies affected by the pandemic.
Supporters say DeFi sites, which run on open source code with algorithms that set prices in real time based on supply and demand, represent the future of financial services, offering a cheaper way, more efficient and accessible for people and businesses to access and offer credit.
But with the promise of high rewards comes high risk.
Lawyers and analysts say these sites are vulnerable to coding bugs and hacks, and most are untested and unregulated – the latter typical of much of a global crypto industry. -currency suspicious of the financial institution.
Critics warn that technology could be the crypto world’s next inflated bubble, similar to initial coin offerings (ICOs), with inexperienced investors particularly at risk. In 2017, billions of dollars poured into ICOs, where companies raised capital by issuing new virtual coins. Most of the projects failed to gain traction and many investors lost their money.
“These are experiences in finance,” said Preston Byrne of the New York law firm Anderson Kill. “They are not necessarily in accordance with the law in many cases,” he added. “But that doesn’t mean they can’t be in the future.”
DeFi is nevertheless gaining popularity.
Seven years ago, Brice Berdah dreamed of retiring in his mid-thirties. He calculated what he would need to save: “The exact amount was 1.7 million euros. My plan was to earn 5% on my capital.
Reality, however, thwarted his plans. Low interest rates stagnated his savings, while investigations of real estate companies and parking lots failed.
“At 27, I had only saved about 0.5% of the amount required,” said Berdah, who works at a startup that makes digital wallets to store digital coins. “It was an obvious failure.”
To resuscitate his dream, Berdah, now 28, turned to DeFi.
“Now that I’m using DeFi, I’ve readjusted my retirement plans,” said Paris-based Berdah, who bet 90% of his net worth on DeFi. “The returns are around 20-25% over the past six months … and I’m on the right track right now. “
While DeFi’s roots lie in a crypto industry hostile to traditional finance, some of its goals – like reducing costly steps and paperwork in funding – have caught the attention of the companies it seeks. to undermine.
In the future, say lenders, bonds or stocks will be issued and traded directly on their blockchain-based platforms rather than through investment banks or centralized exchanges. Code, not humans, will oversee the processes, they say.
For their part, the big banks are studying how such technology can be used to complement, rather than disrupt, established finance. Goldman Sachs, for example, has hired a new digital asset manager to examine how assets can exist on blockchain technology, a spokesperson said earlier this month.
“There is real value to what is built on these protocols,” said Maya Zehavi, blockchain consultant and board member of an Israeli blockchain industry group. “It could become an instant financialization ecosystem for any project. This is the promise.
Most DeFi platforms are based on the ethereum blockchain, the backbone of ether, the second largest cryptocurrency after bitcoin. Unlike bitcoin, Ethereum’s blockchain can be used to create digital contracts, while developers can more easily build new software or applications on it.
Loans are registered, issued and managed by blockchain-based contracts. Borrowers must offer collateral, also in cryptocurrency, of a value that is usually greater than the loans they take out.
DeFi is not for the faint hearted. Borrowers are usually traders who take out loans, for example, ethereum, and then use the coins to trade on various exchanges against other cryptocurrencies. They then aim to repay the loan and pocket their profits, comparable to short sellers in the stock markets.
One of these borrowers is Antoine Mouran, a computer science student at the University of Lausanne.
Mouran borrows the USD Coin cryptocurrency on the Aave lending platform and then uses the loan to trade Lend coins.
Profits on a typical trade? Depending on the starting price, they can be as high as 30%, Mouran said.
“My wallet is worth a few thousand dollars,” the 18-year-old added. “I trade for fun, to discover new technologies such as decentralized finance.
For a chart on Boomtime for crypto loans:
“THE CODE IS NOT THE LAW”
Aave has been a big beneficiary of the recent DeFi boom, with its loans skyrocketing nearly 7,000% since June to $ 1.4 billion, according to data from DeFi Pulse.
Stani Kulechov, founder of the platform, said user interest had been “huge” in recent months – but he recognizes the pitfalls of the nascent credit industry.
Kulechov said the code behind DeFi loans was able to self-regulate without the need for oversight by centralized bodies such as financial regulators – but only as long as it was functioning properly.
“The problem is when smart contracts behave in ways they shouldn’t, and when things go wrong.”
However, code failures – from bugs to hacks – are common.
On March 12, for example, the leading lending platform DeFi Maker, with around $ 1.4 billion in loans, was rocked by a sudden drop in the price of ethereum.
About 1,200 lenders have seen their positions suddenly liquidated for next to nothing, despite guarantees Maker put in place to protect lenders against sudden market downturns.
Some industry players, like Aave’s Kulechov, advocate platform self-regulation to create standards for smart contracts, aimed at preventing code hacks or malfunctions.
The DeFi industry is still a long way from that point, however.
Many purists oppose any control by humans or institutions, preferring to trust user communities improving smart contracts, fixing bugs through open source programming.
More immediately, some users are turning to a more traditional industry for a degree of protection against DeFi platform failures: insurance. Some companies, such as London-based Nexus Mutual, offer specific coverage against smart contract failures.
The UK financial watchdog told Reuters it regulates certain crypto-related activities, looking at them on a case-by-case basis. Even “decentralized” platforms can be subject to regulation, he said separately last year. U.S. securities regulators did not respond to requests for comment.
Until regulation catches up, critics say, the risks of relying on the code may outweigh the rewards.
“Losers have no recourse,” said Tim Swanson of blockchain payment firm Clearmatics.
“The code is not a law.”
Reporting by Tom Wilson; Editing by Pravin Char