THE CRYPTO REBELS BEHIND “DECENTRALIZED FINANCE” WANT TO REMAKE THE WAY THE WORLD BORROWS, LENDS, AND SAVES. CAN WALL STREET KEEP UP?
[FORTUNE US=ROBERT HACKETT]
THIS SUMMER I TOOK MY FIRST STEP toward becoming a “degen.” The word—short for “degenerate gambler”—comes from the zany, $1.5 trillion cryptocurrency world, where cheeky speculators have embraced it as a term of endearment. My toe dip into the club? A pool party held by a digital-only organization that would be happy, someday, to replace your bank.
The event was a “loss-less lottery” run by an app called PoolTogether. Leighton Cusack, who cocreated the project two years ago, prefers a different name for the game: a prize-linked savings account. While traditional savings accounts spread meager interest among all depositors, PoolTogether regularly delivers a big payday to a handful of winners.
At the end of July, the app had almost $200 million in total deposits and was sharing nearly $100,000 in prizes per week. While that makes PoolTogether sound a bit like a casino, most of its activities involve acting like a bank. The app takes deposits, lends money, and pays interest. (Even the lottery is banklike: Many banks and credit unions use prize-linked accounts.)
But it isn’t a bank. There are no steel-and-concrete vaults, no tellers, and no executives in charge. Indeed, there is no company in control. The incredible thing about PoolTogether is that the system runs entirely on software. Cusack and a band of online collaborators whipped up the application using open-source code and cryptocurrency parts, built a pretty website, and launched it all into the ether. The program runs on Ethereum, a global network of computers that collectively tabulate a ledger, or blockchain, through which it dispenses interest, and jackpots, every week.
PoolTogether is a prime example of “decentralized finance,” or DeFi, a booming part of the neckbreakingly volatile crypto economy. PoolTogether and similar projects are drawing a generation of tech-savvy tinkerers, crypto-coin early adopters, outside-the-box thinkers, and, yes, occasional degens to an alternative and largely independent financial system, one where they can borrow, lend, save, and insure themselves—based on rules they make themselves.
While not the biggest DeFi project, PooTogether’s structure is typical of this burgeoning world. People who deposit assets earn loyalty points in the form of tokens— called “pool” in this case—that let them vote on PoolTogether’s direction. Savers accrue more tokens over time, even if they never win a lottery drawing. People can sell these tokens for a profit on crypto exchanges, an additional incentive to participate. (At the time of my dabbling, a pool token traded for about $10, down from a high of $32 in March.) It’s an all-crypto universe: In virtually all DeFi projects, deposits and earnings alike are denominated in crypto, never in fiat currency. Also, caveat DeFi-or: Assets aren’t covered by the federal insurance regime that protects “normie” accounts.
As a largely unregulated part of the economy, DeFi has exploded in tandem with demand for cryptocurrencies like Bitcoin and Ethereum. Most of the action takes place on Ethereum, the second biggest crypto network, whose blockchain comes with a built-in programming language, Solidity, that makes it easy to build so called decentralized apps. For now, the ecosystem is populated primarily by people who range from comfortable with to rabidly passionate about crypto—with all its risk and legal uncertainty.
But that insularity may not last. DeFi represents a concerted, crowdsourced effort to put digital coins to work, offering people financial reasons to hold crypto beyond merely speculating on price movements. Crypto “is finally not just about a new gold or a new kind of money,” says Olaf Carlson-Wee, one of the crypto market’s earliest major investors. He ranks DeFi as being of “earth-shattering level of importance” and adds: “This isn’t just about the assets”—like Bitcoin and Ethereum—“it’s about all of the financial instruments.”
And that fact, in turn, could pave the way to mainstream consumption. In the not-too-distant future, people expect the Federal Reserve to decide whether to mint digital dollars of its own, or to bless such issuances by private industry. Either move could open blockchain-based services to the masses—and today’s evolving DeFi infrastructure could shape a new financial order.
That possibility (bulls would say it’s a certainty) is drawing a growing roster of established financial players to dabble in DeFi. What began as a mere plaything—fans call DeFi tools “money Legos” because they’re so easily assembled—is wrenching the broader business world into its orbit. In this grand rewiring of wealth, the nerds are taking charge; they’re swapping out the Brooks Brothers suits for blockchains. Software is finally eating finance.
DEFI FLINGS ROCKS at the Goliaths of Wall Street, using blockchain as its slingshot. The tech’s promise has always been to make transactions less costly, more efficient, and more equitable by replacing intermediaries with a shared, instantaneously updated ledger that anyone can monitor.
While banks have office hours and observe holidays, DeFi never sleeps. Whereas institutions use paperwork and committees to reach decisions, DeFi relies on algorithms. Whereas “OldFi” wire transfers and stock-trading settlements can take days, Ethereum-based transactions are comparatively instantaneous, usually taking about five minutes to reach final confirmation. “It’s fast, it’s open, it’s permissionless, it’s transparent,” says Mike Novogratz, a former hedge funder who now runs Galaxy Digital, a crypto investment and financial services firm. Fewer intermediaries also means less systemic risk, he says. “We wouldn’t have had a mortgage crisis in 2007 if we could have just looked on chain”—at information shared on a blockchain—“and seen Bear Stearns’s mortgage exposure.”
For every traditional, centralized financial product there is a crypto-related, DeFi version either available or in the works. Just getting into crypto? Buy some e-coins on Uniswap’s decentralized exchange. Borrowing money? Check out Aave’s “flash loans.” Insurance? Nexus Mutual has you covered. Seeking high-yield savings? Tap into Compound, one of the lending protocols PoolTogether relies on.
At the center of these operations, there are no JPMorgan Chases, no Nasdaqs; it’s all just code. Communities of software developers and token holders—people who own the virtual coins dispensed by various crypto projects—run the show. The promise of DeFi, says Rebecca Rettig, general counsel at Aave, is “to give back autonomy to individuals over their own financial well-being.”
DeFi is still very much undergoing growing pains—not least because it’s built on digital currencies whose values are notoriously volatile. The “total value locked” in DeFi projects reached a $90 billion peak in May, then plummeted as cryptocurrency prices tanked. Still, deposits into these blockchain based programs—called “smart contracts”— amounted to more than $60 billion as of late July, up from less than $1 billion at the start of 2020. If the totality of DeFi apps was considered a bank, it would rank in the top 50 in the U.S. by assets under management.
It’s difficult to tell exactly how many people are participating. Creating a blockchain wallet, the passport to any project, requires no ID card (a feature that alarms and appalls many regulators), and many users own multiple wallets. That said, the number of wallets interacting with DeFi protocols has soared from nearly 300,000 to more than 3 million in the past year, according to Dune Analytics; MetaMask, a wallet provider, counted more than 8 million active wallets worldwide in July
Given how much capital DeFi is attracting from hedge funds, deep-pocketed investors, and retail enthusiasts, “it can’t be ignored anymore,” says Brian Brooks, chief executive of the crypto exchange Binance. US. Brooks, who was America’s top banking regulator during Donald Trump’s last year in office, believes blockchain apps will do to banks and brokers what the Internet and Amazon did to brick-and-mortar retailers—forcing them either to compete in a new tech-driven game or perish. “It raises the question of whether we truly need those institutions anymore to perform those intermediary functions,” Brooks says. “If I were the head of Bank of America, I’d be worried.”
If big bank CEOs are worried, they aren’t saying so publicly. But established institutions are beginning to explore DeFi—under the assumption that younger customers, comfortable with both crypto and app-driven financial services, will eventually demand it. Fintech companies are already convinced of the clamoring to come. In a June blog post, Brian Armstrong, CEO of Coinbase, the U.S.’s biggest crypto exchange, wrote, “The products that the most crypto-forward people are using today will be used by mainstream customers in a year, and by institutions a few years after that.” Payments giant Square announced in July that it is ginning up a DeFi business focused on Bitcoin. “We are in the middle of a major shift,” says Dan Schulman, CEO and president of PayPal. “The time is ripe to modernize financial systems” using crypto tech.
The old guard is joining in too. JPMorgan Chase, Wells Fargo, and Goldman Sachs are some of the companies hedging their bets for the possibility of a bankless future by funneling millions of dollars into crypto startups. Visa, the credit-card era behemoth, has partnered with Anchorage, one of the newest federally chartered banks, to accept business payments made in privately issued digital coins, like the dollar pegged USD Coin. (Mastercard has inked similar deals.) Companies may start increasingly transacting with such portals to the DeFi-verse, even as they keep their own operations entirely in U.S. dollars.
Diogo Monica, cofounder and president of Anchorage, says banks “want the relationship with these millennials, the next generation that is about to inherit I-don’t-know-how-many trillions of dollars from baby boomers...That age range has a big distrust of these traditional-finance, centralized institutions.” Banks will have no choice but to get DeFi-literate, he concludes: “It’s just a matter of how, when, and where they enter.”
PEER-TO-PEER LENDING accounts for about half of the DeFi market in dollar value. It also drives one of its most alluring selling points: higher yields for the savers whose deposits get converted into loans. DeFi interest derives from a combination of token accrual and passive income from lending, and it can reach into double-digit percentages. Even yields in the single digits trounce the national average rate on traditional savings accounts, which is just 0.06%, per Bankrate.
Stuart Sopp, CEO of Current, a challenger bank, tells Fortune that his business plans to get higher yield savings by integrating with Compound. For Sopp, it’s a simple decision that has nothing to do with crypto buzz and everything to do with math. “Money is mercenary,” Sopp says. “It goes where it’s treated best. If you can get a 5% yield and it’s pretty safe, then money will move.”
The mechanism behind those DeFi yields is, however, a little chaotic. The eye-popping rates are mainly due to banks’ risk aversion, tech lag, and regulatory apprehensions when it comes to crypto. For the most part, banks won’t extend credit to crypto borrowers; even a Bitcoin billionaire has trouble using digital coins as collateral. That puts supply and demand out of whack—especially given that many crypto “whales” are eager to make leveraged bets on more cryptocurrency.
Behind the scenes, the nouveaux riches, including crypto-friendly hedge funds, pay a premium to take out loans from DeFi protocols like Compound and Aave—and from specialized lenders, like crypto businesses BlockFi and Celsius, that turn to DeFi projects for liquidity. For the borrower, paying relatively high interest—think 10%—is a far better deal than selling crypto holdings and getting hit with short-term capital gains taxes of 37% or more. A high-interest loan, meanwhile, means a far-better than-normal return for DeFi depositors.
There’s a paradox here. As crypto and DeFi mature, such high yields likely won’t last: Crypto investors will find it easier to borrow at lower rates as banks grow more comfortable with digital coin assets. In the meantime, in a DeFi world where “yield farmers” move fast to hunt down the juiciest rates on offer, there’s no divorcing reward from risk. Rapidly moving money, in the crypto world, can mean major fluctuations in token prices.
It’s not uncommon to see advertisements for outsize gains from DeFi lending, often fueled by supply-and-demand quirks and screwy price speculation. One venture, Iron Finance, recently showed stupendous returns on its “titan” token. But titan collapsed, mysteriously, over the course of 16 hours on June 16, its price crashing from $64 to nearly zero. (The victims of the crash included Mark Cuban, the crypto-loving Shark Tank star, investor, and owner of the NBA’s Dallas Mavericks. “I got hit like everyone else,” Cuban later lamented on Twitter. “Bam.”) Iron Finance claims it was the victim of “the world’s first large-scale crypto bank run”—blaming whales for initiating mass withdrawals. But forums for crypto chatter like Reddit, Telegram, and Discord brimmed with accusations of mischief.
Crypto and misbehavior aren’t strangers: People have lost $6.5 billion to crypto-related fraud and cybercrime from 2019 through April 2021, according to data from CipherTrace, a blockchain analytics firm. Sen. Elizabeth Warren (D-Mass.) calls crypto “the Wild West of investment.” The perils are magnified, she tells Fortune, when it comes to DeFi, “where anonymous developers can scam investors with rug pulls, pump and dumps, and other schemes without transparency or accountability.”
In a community where decentralization is a philosophical pillar, accountability is a major issue to iron out. Back in 2019, Robert Leshner, cofounder of Compound, used to wake up in a cold sweat, worried about his liability. What if the code had a bug? Could he and his team cover losses? “I was afraid to leave the house because I thought there was a risk that somebody would kidnap me to try to steal all the money in Compound,” Leshner tells Fortune.
Leshner’s solution was to retire, sort of. His team created a governance token, Comp, and turned control of the protocol over to the Compound community, to people who earned and owned Comp tokens. Now liability is a collective concern.
For most DeFi projects, Compound’s model is the norm: The fundamental unit isn’t an incorporated company but a DAO, or “decentralized autonomous organization.” What these projects have in common is that no one is in charge—or rather, everyone is in charge, to varying degrees. Every token holder has the right to vote on decisions governing the protocol, like updating code, setting parameters related to interest rate calculations, or funding developers with grants to build new features. In practice, it’s often the full-time devotees and institutional investors, rather than ordinary users, who do most of the voting. Regardless, there’s a common aim: As more people use a protocol, the digital token underlying it becomes more valuable. Build a better project, and everybody involved gets richer, so the thinking goes.
Those tokens, however, carry risks of their own. Their volatility increases the hazard in any DeFi project: If your digital coin earns you 9% interest but the value of your “principal” drops by 75%, you’re not coming out a winner. There’s also the unresolved legal question of whether a token is just a security by another name. The Securities and Exchange Commission has decided on multiple occasions that it is. Ripple and its managers are being sued by the SEC for allegedly selling unregistered securities in the form of a digital coin called XRP. The same logic, if applied to DeFi, could drastically change how it operates. And questions abound over whether tokens used in DeFi projects, like Uniswap, also flout the law.
“I think the fall of 2021 is going to be very similar to the regulatory inquiries we got in 2017 and 2018 when a whole slew of requests for information and subpoenas went out” from the SEC to early crypto innovators, says Michelle Gitlitz, head of the blockchain practice at the law firm Crowell & Moring. “People may have tried their very best to comply with the law, and the government and the regulators just may fundamentally disagree.”
IN THE MEANTIME, DeFi pioneers keep experimenting in an atmosphere in which technical sophistication meets degen informality. When I deposit 15 Dai, a dollar-pegged coin, into PoolTogether to join its lottery, digital confetti and rainbow streamers rain down in celebration on screen. I am in the pot along with $35 million in other deposits. I have a 1-in-468,660 chance of being one of five winners to split about $25,000.
As I wait for the results, I tune into a community call on Discord, the chat app that many DeFi projects use as a virtual headquarters. PoolTogether’s Discord group has nearly 6,000 members, and a couple dozen are on the call today. At one point, the conversation turns toward marketing efforts. The collaborators are looking for a way to explain to normies why they should put their “boomer bucks”— crypto-speak for dollars—into PoolTogether. One participant, who goes by the alias Oops, explains that he’s pitching his dad on the virtues of DeFi savings. “I’m trying to convince him to move something over,” says Oops, his neon-outlined Pikachu profile picture flashing as he speaks.
People chime in. Some folks mention the lure of outsize returns—at the time, the app’s Dai pool, for example, is advertising a 7.5% annual yield, on average. That’s because even if you don’t win a PoolTogether jackpot, you earn tokens for participating. It’s “kind of an equity play at the same time,” someone adds. (Left out: discussion of securities law, tax policy, FDIC or SIPC insurance, and transaction fees; my $15 raffle ticket cost an extra $30 in Ethereum “gas.”)
While the chat churns along, I check in on the lottery. A message pops up on the site: “Uh-oh! An error has occurred and we have been notified,” the note reads. “Don’t worry! Your funds are safe, this is just a UI issue.” A benign website bug—phew.
Back on the call, someone asks whether Oops’s dad is convinced. “I’ll have to educate myself further,” the father offers, skeptically.
And as for me? When I check back later, I learn I didn’t win. It’s still early days for DeFi, though. Maybe next time I’ll get lucky
[FORTUNE US=ROBERT HACKETT]