Decentralized finance (DeFi) is a term used to describe the system of financial applications being developed on the Blockchain. These applications take advantage of the trustless and transparent design of blockchains to deliver financial services that are cheaper, less complicated, and more secure.
Rise of Lending Cryptocurrencies
As of June 22nd, Compound had locked up $583.5 million in cryptocurrency. This surpassed the $481 million that Maker had locked up. These are some serious figures and show that decentralized finance is beginning to command serious investment.
These cryptocurrencies are part of decentralized lending platforms that allow anyone to access them without any Know-Your-Customer (KYC) or other requirements. The interest rates on the platform are variable and are determined by the decentralized governance system according to the supply and demand for a particular asset on the platform.
Many DeFi platforms run on the Ethereum blockchain and rely on Ethereum’s smart contract functionality. The rise in DeFi has helped Ethereum beat Bitcoin this year in terms of price. The total amount of value locked in the entire DeFi space in terms of USD was $1.52B as of June 22nd.
Use Cases for Crypto Lending
The use cases and applications of cryptocurrency lending range from simple to rather complex. The simplest way to take advantage of crypto lending is simply by lending crypto to another person. The interest rates for stablecoins tend to be the highest, while cryptocurrencies like Bitcoin, Ether and Litecoin will have lower rates.
Another way to use crypto lending is for tax purposes. If you get in a bind and need some cash, you could sell your cryptocurrency. But this is considered a taxable event for tax purposes. This can be very significant if the amount of cryptocurrency is large. However, if you use your cryptocurrency as collateral for a loan, it would give you some liquidity without triggering a taxable event, not to mention you won’t lose the potential appreciation in value from the cryptocurrency that served as your collateral.
Rate arbitrage is a way to take advantage of differences in the interest rate that you pay a party to borrow and the interest rate that another party pays you to borrow. For example, you could borrow Bitcoin from Bitfinex for 4.27% and then lend it on Bitrue for 10.2%. This sounds like easy money, but there are risks to this. These rates shift with the market, so either one could change at any time. If they ever converge, your profit will disappear.
Future of Decentralized Finance
Decentralized finance offers a lot of exciting potential, but there are also some risks that must be vanquished before it becomes mainstream. Much like the financial crisis of 2008-2009, without transparency and solid risk management, bad practices can snowball into full-fledged systemic issues.
As long as cryptocurrencies remain grounded to fundamental activity, i.e., so long as the currency is being earned and representing value, then there will be no problem. But lenders could lend cryptocurrency and then repackage this debt into derivatives and then sell them or use them for collateral on a large scale. If they do this to such an event that the fundamental value of the cryptocurrency eventually comes into question, this could lead to a violent correction in cryptocurrency price once these abuses came to light.
This is what is popularly known as a bubble, where price continues to go up and up, but there is nothing fundamental or rooted in the real world to justify that price. The increase in price is like air blowing up a bubble. Doubts increase, tension builds and a sudden spike in selling pressure pops the bubble like a sharp pin.
With transparency, however, it would be obvious that this is what is happening. The price of the assets would reflect this transparency and there would be no sudden realization that the cryptocurrency’s value is anything other than what it seems.
Where risk management comes in is in determining how risky the loans are. Regulatory agencies do not like derivatives because they are inherently vulnerable to price manipulation. Price manipulation is something that cryptocurrency was created to avoid, so it seems an odd pairing. If the space ever becomes subject to regulation, it will be interesting to see how that is handled.
For simple decentralized finance, such as lending, borrowing and the earning of interest, the Census Note will soon be able to handle these options. The Census Note is a payment card-sized cold wallet. It is a hardware wallet that conveniently fits in your wallet. It’s easy to use with any smartphone.
Decentralized finance is taking the cryptocurrency world by storm. With billions of U.S. dollars worth of value tied up in it, it seems unlikely that decentralized finance is going anywhere. The future of decentralized finance will depend on how transparent everything remains and whether cryptocurrency continues to represent real value or a raffle ticket on the odds of whether loans are repaid.