DeFi, instead, has been built around two step-change innovations.
The first is algorithmically determined interest rates.
This is a radical re-tooling of the most basic building block of global finance. Central bankers are not required to set a cash rate (or embark on yield curve control, or large-scale asset purchases). Nor are bond traders required to intermediate flows.
Instead, interest rates are governed by the relevant DeFi protocol, and principally reflect the so-called utilisation rate.
This is a measure of the extent to which funds have been borrowed against the underlying pool of reserves. All else equal, higher utilisation translates into higher interest rates.
These interest rates as often quoted as an annual percentage rate (APR), or an annual percentage yield (APY), which adjusts for compounding.
They are not, however, annual rates. The interest is typically paid and accrued by block (roughly every 15 seconds for the Ethereum network). The rates can and do change a lot, including as between different DeFi protocols, and as between different cryptocurrencies.
While DeFi is yet to solve for term structure (ie construct a yield curve), it is now feasible to earn passive income in scale.
This has underpinned strong inflows to US dollar-based stablecoins over the past year, as a carry trade has been available against US Libor throughout the pandemic.
Most of the borrowing that has occurred is also of stablecoins, and often as a means of funding further speculation on the long side of crypto.
The second key innovation is the rise of automated market makers. These are algorithmic engines that displace the traditional broking role.
A popular subset is referred to as constant function market makers (CFMMs). In this iteration, the trade is against a pool of assets, rather than a specific counterparty.
Any trade that is executed alters the underlying reserves while keeping the product of the reserves unchanged (a mathematical constant). Arbitrage flows then ensure that the price between two cryptocurrencies is in line with the broader market.
For a CFMM to function well, it requires a deep pool of reserves. These are staked by liquidity providers (LPs). The commission that would typically be paid to the broker accrues to LPs, and in some cases, to the holders of the native token of the CFMM.
A decentralised, autonomous ecosystem is thus created, where changes to protocols often require a consensus to be reached by holders of governance tokens.
Importantly, there is no free lunch for LPs. Those staking are required to provide two coins, typically of equivalent value. They remain exposed to the risk that the value of these coins falls (or rises) as against fiat currencies.
Additionally, there is an opportunity cost incurred as against simply holding the two coins to the extent that their value diverges in either direction from the entry point.
This is referred to as impermanent loss. Still, those new to staking should be very much aware that the loss will become permanent when the liquidity is withdrawn.
Those new to decentralised exchanges should also take their time, as traditional guardrails do not apply.
Unsurprisingly, not everyone is thrilled by these developments, or where they might lead.
On June 8, Dan Berkowitz, the commissioner of the Commodity Futures Trading Commission provided an extensive critique of DeFi, and went as far as questioning its legality under the Commodity Exchange Act.
The rapid and profound innovation occurring in DeFi will continue apace.
He posed the threshold question as “whether the public will benefit from disrupting the current financial system that relies extensively on financial intermediaries”, and memorably declared that “a system without intermediaries is a Hobbesian marketplace with each person looking out for themselves”.
If the commissioner needs an example that DeFi can, in keeping with Hobbes, be “solitary, poor, nasty, brutish, and short”, he needs to look no further than the epic collapse of Iron Titanium token (TITAN) on Wednesday.
This was a popular DeFi project, offering very high APRs/APYs, that had been spruiked by US billionaire entrepreneur, Mark Cuban, among others. It was being bootstrapped by a partially collateralised stablecoin (IRON), that was pegged at $US1.
The project became dynamically unstable in the space of a few hours, with TITAN trading from a high of $US65 to zero, and IRON breaking its peg (the viable collateral was redeemable with a lag).
For those that lost out, there is no recourse. And they would not have taken much comfort from the post-mortem published by the (pseudonymous) core developers.
This included a glib reference to having “just experienced the world’s first large-scale crypto bank run”, and a dubious undertaking to “continue our journey with more products in the future”.
For the true believers in DeFi, this was little more than some Darwinian pruning of a structurally flawed project. But it did lead to more calls for regulation of DeFi, including, somewhat ironically, from Cuban himself.
Only time will tell whether US regulators make a move, and if so, how. In the meantime, the rapid and profound innovation occurring in DeFi will continue apace.