Most investors are comfortable with stocks and bonds, but cryptocurrencies are a different story. While they’re built on a solid cryptographic foundation, many projects rely on a team of volunteers with a startup mentality of pushing boundaries.
Despite these concerns, there’s no denying that blockchain technology is reshaping the financial industry. CoinMarketCap lists nearly 12,000 different cryptocurrencies traded across over 400 exchanges with a market capitalization of over $2 trillion.
Let’s look at decentralized finance, better known as DeFi, and its potential to reshape the nearly $120 trillion fixed income market.
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What Is DeFi?
Decentralized finance, or DeFi, enables anyone to lend, borrow, trade, or save without using a financial intermediary. Instead of a conventional underwriting and approval process, smart contracts carry out the terms of the agreement.
For example, Compound provides borrowing and lending services for many cryptocurrencies. After connecting your wallet, you can unlock assets and lend them at a predefined interest rate. In exchange, you’ll receive interest-bearing cTokens.
Aside from lending, DeFi can help provide liquidity to exchanges. For instance, Uniswap is an automated liquidity protocol that enables anyone to provide liquidity in exchange for trading fees, either passively or professionally.
DeFi Pulse estimates that there’s about $90 billion locked up in DeFi smart contracts. However, that’s only a fraction of the $120 trillion fixed income market. There’s ample room for growth over the coming years as DeFi continues to mature.
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Innovative Examples
There are many projects and companies seeking to disrupt conventional fixed income and derivatives markets with DeFi products. While some of these projects have well-established protocols, there are many startups in the space, too.
Some of the latest projects include:
- Strips Finance is building a decentralized interest rate trading platform that enables anyone to swap variable APY for fixed APY instantly (e.g., interest rate swaps).
- Exactly Finance recently raised a $3 million seed round to build and open source, non-custodial fixed income solutions for lenders and borrowers.
Many large companies have also been exploring the possibility of using blockchain technologies for their own products and services. For instance, BMO Capital Markets launched a pilot project to mirror transactions on the blockchain.
Hurdles to Adoption
Institutional investors have begun to dabble in DeFi given today’s yield-starved environment. However, significant risks remain that could dampen enthusiasm. DeFi’s long-term potential hinges on how companies and governments address these risks.
The biggest hurdles to adoption include:
- Gas Fees. The Ethereum blockchain charges fees to execute smart contracts. These fees reflect the cost of proof-of-work mining activities, which have risen in response to the growing popularity of DeFi.
- Regulations. Cryptocurrencies have caught the attention of regulators in recent years. For instance, New York’s Attorney General alleged that Tether overstated its reserves and hid about $850 million in losses around the world.
- Taxes. The IRS hasn’t provided specific guidance for DeFi income. For instance, it’s uncertain whether incentive tokens are capital gains or ordinary income. The lack of clear guidance could trigger significant back taxes.
- Security. DeFi smart contracts are still relatively new, and theft remains a risk. For example, in August 2021, hackers stole $600 million from Poly Networks. These heists could result in unpredictable losses for investors.
The good news is that companies are working to overcome these hurdles. For instance, Ethereum is implementing a proof-of-stake model to reduce gas fees while the IRS has promised to provide crypto guidance in the near term.
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The Bottom Line
Decentralized finance, or DeFi, is one of the hottest subsets of the cryptocurrency market. While more than $90 billion is locked up in DeFi contracts, the figure represents just a fraction of the $120 trillion fixed income market.
Most institutional investors will likely remain on the sidelines until regulations, tax codes, and security issues resolve themselves. In the meantime, investors willing to assume the risks may look to DeFi as a way to increase their portfolio yield.
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