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DeFi Is Crypto’s Wall Street, Without a Safety Net

Decentralized finance allows crypto enthusiasts a do-it-yourself version of investment banking, bringing high rewards and huge risks.

9/15/2021 2:20:00 AM

Streetwise: DeFi, or decentralized finance, is a do-it-yourself crypto version of investment banking, with high rewards and huge risks

Decentralized finance allows crypto enthusiasts a do-it-yourself version of investment banking, bringing high rewards and huge risks.

“Trade. Earn. Win.” Thehappy bunny flipping a pancakeand the double- or triple-digit interest rates on offer are closer to the marketing style of Las Vegas than Wall Street. Don’t be fooled: PancakeSwap and its competitors in what’s now known as DeFi, or decentralized finance, are bringing casino capitalism to the crypto masses.

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The promised rewards are huge, and the marketing makes it easy. “High APR, low risk” is the pitch for PancakeSwap’s “Syrup Pools,” where anyone can lend money. The annual percentage rates, the APRs, are sweet: On Monday a crypto token called CHESS was promising more than 300% a year, paid in CHESS.

The speed of growth is truly extraordinary, as DeFi barely existed until last year. The CAKE tokens issued by PancakeSwap and others from DeFi competitors such as Uniswap and Aave are together worth $120 billion, according to CoinMarketCap. More than $7 billion has been locked up just in one part of DeFi, “yield farming,” the crypto jargon for financing market making.

DeFi is both wonderful and scary. The innovation—made possible by smart contracts, which can automatically move crypto around based on rules enshrined in computer code—has allowed crypto enthusiasts to replicate pretty much all the functions of Wall Street for crypto, without needing Wall Street.

Market making, or yield farming, is among the most basic. Prime brokerage, the bank units that serve hedge funds, has reappeared as DeFi’s collateralized lending, allowing speculators to pile on leverage or short a token they want to bet against by borrowing and selling it. Interest-rate swaps and basis swaps are increasingly common as people use debt to arbitrage between exchanges, DeFi providers and different cryptocurrencies.

Even structured credit has appeared. The CHESS token that pays so much was created this summer as the core of Tranchess, designed to allow leveraged bets on bitcoin by splitting up a fund into high- and low-risk tranches. The principle is similar to CDOs, or collateralized debt obligations—only instead of the subprime mortgages at the heart of the 2007 CDO collapse, this holds bitcoin.

The only way for the ordinary investor to take part in Wall Street’s prime brokerage, market making, structured credit or lending activities is to buy shares in an investment bank. DeFioffers the opportunity to do it yourself, without the cost of investment bankers, executives or regulators.

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The flip side of being given easy access to Wall Street’s methods of making trading profits is you also get easy access to Wall Street’s trading losses, often without any sort of warning, and,at least for now, no regulation.All of DeFi comes with two basic risks that much of Wall Street has been designed to minimize: fraud and operational mistakes. Fraud is so common that there’s even crypto jargon for it: “Rug pulls” are when the issuers of high-paying tokens simply abscond with the money.

Operational risk is huge, with the smart contracts that govern DeFi frequently found to have loopholes that allow scammers to make off with the assets, or design flaws that throw the asset into a spiral of decline.It’s not only these two risks that matter, of course. The customer is on their own in navigating the other main dangers of DeFi: credit, liquidity and currency risks. These risks are played down or not even mentioned by DeFi platforms, leaving investors to rely on asking for advice on Reddit. Sometimes that advice is great, other times not so much. The boosterism is embedded in the DeFi terms: The calculated risk of losing money on market making is widely known, bizarrely, as “impermanent loss,” even though it is money that’s gone forever once you withdraw your funds.

The libertarian in me likes the idea of people learning to make their own mistakes. I don’t like the proliferation of scams, and I hate the marketing of DeFi as though it is an alternative to a bank account. It isn’t, because bank accounts come with federal insurance, while DeFi comes with large hidden risks. But I love the idea that ordinary savers are forced to understand complex financial problems, instead of being cosseted into ignorance by the state.

The economist in me is bothered by the waste. DeFi is beautiful and innovative, but ultimately it is totally self-absorbed, all about providing different ways for people to speculate on cryptocurrencies. Maybe one day DeFi will find a real use, being deployed with stocks, bonds or a central-bank digital currency. That hasn’t happened yet, though.

SHARE YOUR THOUGHTSHow do you think DeFi will affect mainstream finance? Weigh in below.It is my inner historian that’s braced for disaster. Every major financial innovation led to far too much leverage and a blow-up before being tamed by regulators, and opening up Wall Street-style trades to the wider public is a major financial innovation.

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For now, I’m reassured by the minimal links between crypto and the real economy, and it isn’t obvious how a major DeFi problem would rebound back to mainstream finance. Even with its rapid growth, DeFi is probably still too small to pose a serious threat—except to those lending their money without understanding that high rewards are possible only because they come with high risks.

Write to James Mackintosh atBitcoin, Dogecoin, Tether: Cryptocurrency Markets Read more: The Wall Street Journal »

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