Wed. May 12th, 2021

Credits: www.coindesk.com

This week’s congressional hearings, as well as the appearance of new institutional onramps, point to growing investor interest in a new type of capital market.

It wasn’t so much the power of memes that made his remark feel important, nor was it just the humor that made us sit up. It was more the deadpan delivery, staring at the screen, addressing some of the most powerful people in the world. To me, it synthesized a loud shift in attitudes toward authority. With that throwaway remark, Gill demonstrated loyalty to his tribe rather than to the establishment, a sentiment we see playing out not only across social media but also in classrooms, culture, startups and even in the intimidating world of finance.

The surge in value of “anti-establishment” bitcoin (BTC, -10.34%), which broke $1 trillion this week, as well as of meme coins such as dogecoin (DOGE (-10.95%)), are to a large extent an extension of this. The lack of trust in the establishment’s judgement, and the visible weakening of its influence, make alternatives more viable.

This goes beyond individual crypto assets. The congressional hearings highlighted a growing awareness of structural risks in our capital markets. This, combined with recent industry trends, points to strong potential growth in an area of digital assets we have not yet talked much about in this column: decentralized finance, or DeFi.

The concept is about so much more than high investment returns, although there are potentially plenty of those to be had for those willing to take on high risk. It’s about the emergence of a new type of financial market, not created with professional investors in mind, but which will end up benefiting from their interest. This week, that got a strong boost.

Under the hood

The GameStop drama awakened a greater interest in financial market plumbing, something that very few had bothered to care about before. When we see what looks like institutions trampling on the retail investor, we have questions. Few congressional hearings have been as eagerly followed as this one, in the hopes of getting answers and of seeing the beginning of change.  

This is happening at the same time as an explosion of interest and development in DeFi applications.

The term “DeFi” refers to self-executing programs that fulfill the functions of centralized financial services such as borrowing, lending and trading, but in a decentralized, peer-to-peer manner (here’s a more detailed primer if you need it). This week, Bloomberg reported that approximately $359 million worth of GameStop shares failed to deliver on Jan. 28. In the world of automated crypto asset trading, that couldn’t happen. Also, trades can’t be frozen, all traders have equal priority, and there is no authority who can change the rules or middleman who can prioritize some orders over others.

The concept started a few years ago in an experimental corner of the Ethereum ecosystem, with open-source “smart contracts” deployed to execute trades, interest payments and collateral swaps. Last year saw the rise of “yield farming,” which refers to hopping from platform to platform in search of the highest yields. These sometimes reached triple digits, at a time when official interest rates were near zero.

The returns were significant, but so were the opportunities for things to go wrong. Many platforms were constructed on hastily written code, and last year we reported on numerous bugs and losses that had no recourse. Mistakes are not unexpected at the start of an innovation spurt, however, and the creativity and output were (and still are) astonishing.

Given the high yields, it was only a matter of time before institutions started to take notice. In its Q3 2020 report, Genesis Trading (a subsidiary of DCG, also the parent of CoinDesk) reported that much of its lending growth was to institutions looking to finance yield opportunities.

Fast forward a few months, and the ecosystem feels different.

The economic value riding on DeFi platforms has almost tripled since the beginning of the year, to $41.9bn at time of writing. These platforms are usually powered by tokens which confer access and governance rights – the aggregate value of the 100 largest tokens by market cap currently stands at $83 trillion (yes, with a “t”), with over $16 trillion in 24-hour trading volume. The DeFi Pulse Index, which tracks 10 of the largest tokens by market cap, has risen over 260% year-to-date.

What’s more, Ethereum, the base blockchain for most DeFi applications, has entered a new phase of development with the launch of the first step in the migration to a more scalable and less energy-intensive consensus system. This will solve for the soaring fees on Ethereum which threaten to choke off some of the transaction volume. It will also give DeFi applications a viable platform from which to one day integrate with traditional finance.

Institutional onramps are spreading. Coinbase Custody has offered institutional clients trading and custody services for DeFi tokens for some time now, and has listed four new DeFi tokens so far this year. BitGo facilitates the conversion of bitcoin into a DeFi-friendly token. Digital asset custodian Trustology helps its institutional clients vet DeFi projects. But so far access to the potential returns has been largely limited to buying individual tokens. This is changing.

This week, crypto fund manager Bitwise launched a DeFi fund, which tracks the weighted value of a basket of tokens. And some U.S.-listed trusts may be on the way: over the past few weeks, Grayscale Investments, the largest fund manager in the industry (owned by DCG, also parent of CoinDesk), has filed for authorization of investment trusts based on tokens for DeFi protocols such as yield optimizer Yearn Finance, money market Aave and data oracle Chainlink. (Note that filing for authorization does not indicate intent to launch, but the possibility is there.)

New territory

The returns on DeFi assets may be high so far this year, but so are the risks. There’s the possibility of a technological glitch, or a hack – we’ve reported on a few just this month. There’s regulatory risk: the controversial FinCEN proposal presented in December of last year, which suggests that exchanges require identifying information for receiving addresses, would damp DeFi innovation and make some functions unviable. There is also liquidity risk: even a small institutional order could distort the market, and it may be difficult to exit when necessary. What’s more, the high volatility of DeFi assets means the downside could be brutal.

Nevertheless, given the public support for examining structural inefficiency and fragility in traditional capital markets, and the increase in DeFi activity and innovation, the growth in mainstream interest is likely to accelerate.

This will be positive for those building the capital markets of tomorrow, and for those that invest in these projects. So far this month, we’ve reported on three new venture funds targeting DeFi startups.