A core function of the banking system is to enable people lucky enough to have some money to earn interest by lending it out to users who can afford to borrow it.
Banks are regulated principal intermediaries between the two groups. They take a margin between the cost of their own liabilities paid to depositors and the charges on their loans to borrowers. That margin pays for credit underwriting and other infrastructure, expected losses and, in theory, leaves a surplus for banks’ shareholders. The system has evolved over centuries.
It is now broken.
Many potential borrowers are excluded. Depositors are being paid nothing in nominal terms and charged negative real rates as inflation surges.
As institutional interest in digital assets accelerates, investors have a broader appetite for crypto assets
Guido Buehler, Seba Bank
That’s why decentralized finance (DeFi) has taken off in the last year and is steadily drawing more and more capital out of the conventional financial system with the new promise of yield, as well as hopes for capital appreciation in cryptocurrencies.
On October 13, Seba Bank, a Swiss Financial Market Supervisory Authority, FINMA, -licenced, Swiss, digital assets banking platform, launched Seba Earn, which it describes as an institutional-grade solution to enable investors to earn yield on their crypto holdings in permissioned DeFi protocols, as well as from lending Bitcoin and Ethereum directly with Seba Bank.
Guido Buehler, chief executive of Seba Bank, commented: “It is clear that as institutional interest in digital assets accelerates, investors have a broader appetite for crypto assets, with a particular interest in earning services like staking, DeFi and centralized crypto borrowing and lending.”
Seba Earn is designed to give professional and institutional players a flexible platform and a regulated provider to securely enter the space.
A lot of value locked
There is, as yet, no single reliable source of truth for the total value locked (TVL) in DeFi protocols. Most sources suggest that it was between $500 million to $1 billion as recently as May 2020, just before Compound launched its soon-to-be market leading token for an algorithmic protocol for decentralized, passive interest generation on Ethereum.
Today, most estimates for TVL range from $80 billion to $120 billion, with some claiming closer to $200 billion. Much of this relates to lending and borrowing. It is an extraordinary rate of growth that suggests DeFi is solving a problem in the traditional financial system, with Compound, Aave and Maker/DAI to the fore.
That does not, however, mean that the new system is problem free.
With no Fico scores or conventional credit underwriting by bank-like intermediaries in decentralized finance, the lending market is all about collateralization – and indeed over-collateralization.
A user may post as collateral an amount of cryptocurrency, such as say Ether, equivalent to perhaps 135% of another token, maybe one of the dollar stablecoins that he or she borrows, perhaps to buy a third token.
There’s a craving for stability in crypto. That comes through stablecoins, which account for a lot of the value in DeFi. Participants may take a long-term bullish view and not want to sell their Bitcoin and Ether. But they will use them to borrow stablecoins. Holders now increasingly seek interest through automated protocols.
Given the high volatility of many cryptocurrencies, the key question becomes: what happens if the value of the collateral plunges and threatens to fall below 100% of the loan that it is staked to repay?
Character and cashflow don’t feature in DeFi borrowing and lending, where code is law and the outcome on chain may just be that loans don’t get repaid.
Enter the liquidators.
Institutional and qualified investors used to dealing in conventional, regulated markets would do well to understand their role before rushing into DeFi.
Predators on the protocol
DeFi incumbents rely on their protocols’ solvency being preserved by this small group of sophisticated users. Liquidators often act in a predatory fashion, buying out under-collateralized positions at substantial discounts – often 5% or more – to the market price for collateral that has been falling, and then extracting value from the protocol for their own benefit by selling that collateral off and repaying associated loans.
Liquidators need an incentive to keep the whole show on the road, and most DeFi protocols must supply a substantial one.
It is hard to get a handle on exactly how much liquidators earn, compared with regular users locking their cryptos into borrowing and lending protocols. But there is certainly a suspicion abroad in DeFi that the liquidators make a lot and are the chief beneficiaries of the protocols.
They must be well-resourced to pay off loans coming close to under-collateralization and to pay all the gas fees for associated transactions that disincentivize smaller investors from participating actively on Ethereum-based protocols.
Today, users typically have limited insight into the particular risks in their own portfolios
Josh Rogers, Minterest
Josh Rogers, founder and chief executive of Minterest, a new digital investment platform, tells Euromoney: “When you look at Compound, you see an extraordinary concentration of value – maybe half the TVL – in a small number of wallets, perhaps 50 or so.”
Euromoney would be shocked, shocked to learn that DeFi is a market that mostly benefits a small, elite group of well-heeled insiders above everyone else, or that the developers of such protocols – and their backers – are somehow linked to the liquidators.
Keep an eye on Minterest, whose developers have worked on ideas for a new value capture mechanism and recently broke cover with a $6.5 million capital raise from investors such as Digital Finance Group and Digital Strategies.
Minterest will go into private beta testing soon, ahead of a full launch early next year.
Rogers explains: “We have built an auto liquidation process, run and managed by the protocol itself for the benefit of the protocol’s users, rather than by external liquidators which need their own incentives and rewards.”
Just as blockchain technology, built rather like Facebook, Google and Amazon on platform architecture and benefiting from network effects, is potentially hugely disruptive to conventional finance, so this new approach may disrupt DeFi.
Rogers says: “In most protocols, you have users that get paid an annual percentage yield (APY); developers, who receive most of the protocol’s own token and also clip a coupon from the protocol; and external liquidators, who get steep discounts on large liquidations. The incentives of the protocol are, by definition, misaligned with each of those groups.
“Our entire model is to align with the interests of users, leave nothing on the table and produce the highest sustainable APY over the medium term by, for example, having the protocol invest in its own token and distribute it to users and also return a share of liquidation fee income to all users.”
To contrast this approach with traditional finance, it is almost like rewarding depositors with a share of a bank’s profits from borrowing and lending.
Limited insight
Some DeFi protocols allow users to avoid the worst impact of liquidation by giving them the chance to sell off enough of the token they have borrowed to top up their pledged collateral back to compliance with over-collateralization levels set in the protocol.
It is a bit like dynamic margining in conventional finance, which can, as we were recently reminded, trip up even the experts.
Invited to offer more detail on liquidation on Minterest, Rogers says: “Today, users typically have limited insight into the particular risks in their own portfolios. We are building a customized dashboard that is user specific, applies to their own positions and gives new risk tools.
“If users approach a liquidation event, we will contact them. And we have no interest in maximizing liquidations to attract liquidators who may require the chance to take down 50% of a position. Our protocol only reduces positions to exactly the collateral level required to restore solvency.”
When it launches, Minterest will allow for borrowing and lending in all the main tokens and roll out others if it sees demand. The guiding philosophy is that platform technologies perform at their best when they authentically empower users.
It remains to be seen if it attracts new investor flows from mainstream finance into DeFi and whether $120 billion of TVL across all of DeFi today – or whatever the right number is – is just the start.
If it is, then conventional banks will have to respond much more forcefully. Offering a few research notes and exchange-traded products is simply not enough.
