Explain the economic model of defi. Why is the interest of encrypted banks ten times that of banks?

Published on 8/29/2021   680 views   0 Comments  

Kevin webach is a professor of legal research and business ethics at the Wharton School of business at the University of Pennsylvania. As a world-renowned emerging technology expert, he studied the impact of the development of artificial intelligence, broadband, Gamification and blockchain on business and policies. Webach worked in the Obama administration's presidential transition team, founded the supernova group (a technical conference and consulting company), helped formulate American Internet policy methods during the Clinton administration, and created one of the most successful large-scale open online courses, with more than 500000 registrations.

Cryptocurrency and the blockchain it runs promise enthusiasts a lot.

For them, these technologies represent a rescue from corporate power on the Internet, government violations of freedom, poverty and almost everything else that puzzles society.

But so far, the reality mainly involves the financial speculation of popular cryptocurrencies such as bitcoin and dogcoin, which soar and plummet with amazing regularity.

As an emerging technology expert, I believe that decentralized finance, i.e. defi, is the first reliable answer to this question. Defi refers to financial services that run entirely on the blockchain network, rather than through intermediaries such as banks.

But defi also brings many risks, which developers and regulators need to address in order to become the mainstream.

What is defi?

Traditionally, if you want to borrow $10000, you first need some existing bank assets or funds as collateral.

The bank staff will review your financial situation and the lender will set an interest rate for your loan repayment. The bank gives you money from its deposit pool and charges you interest. If you can't repay it, you can seize your collateral.

It's up to the bank: it's in the middle of the process and controls your money.

The same is true of today's stock trading, asset management, insurance and basically all forms of financial services. Even if financial technology applications such as chime, confirm or Robin Hood automate this process, banks still play the same intermediary role. This increases the cost of credit and limits the flexibility of borrowers.

Defi revolutionized this arrangement by reimagining financial services as a decentralized software application that can run without keeping user funds.

Want a loan? You just need cryptocurrency as collateral to get it right away. This will create a "smart contract" to find your money from others who provide a pool of funds on the blockchain without asking the bank's credit staff.

Everything runs on the so-called stable currency, a token similar to a currency, which is usually linked to the US dollar to avoid fluctuations in bitcoin and other cryptocurrencies. Transactions are automatically settled on the blockchain - essentially a transaction digital ledger distributed on the computer network - rather than apportioned through banks or other intermediaries.

Economic model of defi - reward

Compared with traditional finance, transactions in this way can be more efficient, flexible, safe and automated.

In addition, defi eliminates the difference between ordinary customers and wealthy individuals or institutions, which can use more financial products. Anyone can join the defi loan pool and borrow money from others. The risk is greater than bond funds or certificates of deposit, but the potential return is also greater.

And this is just the beginning. Since defi services run on open source software code, they can be combined and modified in almost endless ways. For example, they can automatically switch your funds between different mortgage pools based on the current situation that provides the best return for your investment configuration. Therefore, the rapid innovation of e-commerce and social media may become the norm of traditional stable financial services.

These benefits help explain why defi is growing so rapidly. At the recent market peak in May 2021, cryptocurrencies worth more than $80 billion were locked in the defi contract, compared with less than $1 billion a year ago. As of August 3, 2021, the total market value was USD 69 billion.

Compared with the $20 trillion global financial industry, the amount of funds in the field of defi is still a drop in the bucket, indicating that there is still a lot of room for growth.

At present, most users are experienced cryptocurrency traders, not novice investors pouring into platforms such as Robin Hood. Even among cryptocurrency holders, only 1% have tried defi.

Crypto bank's high savings rate?

Leading encryption banks such as blockfi and NEXO are attracting a lot of attention. Customers can get up to 12% apy (annual yield), which dwarfs bank savings accounts with interest rates below 1%. But before you rush to transfer your hard-earned savings, there are some important things to pay attention to.

First, you need to understand the interest provided by these banks. Although crypto banks pay up to 12% interest, they only allow customers to save with cryptocurrency (such as bitcoin and Ethereum) or deposit stable currency (such as usdc or usdt), which is linked to the US dollar for 1:1.

The highest interest rate of crypto bank is the deposit of stable currency: for example, NEXO pays up to 12% interest on usdc and usdt, but 8% interest on bitcoin; Blockfi pays 8.6% interest on usdc, 9.3% interest on usdt and 5% interest on bitcoin. In other words, you can convert 1000 US dollars (720 pounds) into 1000 stable US dollars, and then keep it in your blockfi account for one year. In theory, you can finally withdraw 1086 US dollars.

Since most crypto banks only deal with cryptocurrency or stable currency, you must first turn your funds into this form. This can be done through cryptocurrency exchanges such as coinbase or binance, or through cryptobanks in a more limited way: for example, you can transfer dollars to blockfi, and they will automatically convert them into another stable currency called Gemini USD (which will also pay an annual interest rate of 8.6%).

Most crypto banks offer trading opportunities - from Gemini USD to bitcoin, for example. However, although these encryption banks are boasting that the fee is zero, the rate is not necessarily the best. For example, blockfi points out that the cost of purchasing cryptocurrency may be 1% higher than the market price.

If you deposit cryptocurrency, the more you hold, the interest rate will drop significantly. For example, on blockfi, the bitcoin interest rate of 5% only applies to deposits with up to 0.5 bitcoins. For higher amounts, it fell to 2% and eventually to 0.5%.

Some crypto banks also offer the best interest rate for their own cryptocurrency interest payments. For example, the 12% annual interest rate of usdt and usdc from NEXO only applies to those who pay with NEXO tokens. The NEXO token is not a stable coin, and its value fluctuates up and down. For interest paid in usdt or usdc, the interest rate is 10%.

Finally, the interest rate of cryptocurrency banks cannot be guaranteed for any length of time. Therefore, when observing the annual interest rate, it may fluctuate every day.

Business model and risk of encryption bank

Nevertheless, the interest rate offered by cryptobanks is very high. So how do these banks do it?

The basic model of cryptobanking is to borrow funds at the interest rate paid to depositors, and then lend funds at a higher interest rate. Cryptobank seeks to maintain its position in two key ways. First, lending is less than deposits. Second, they let borrowers provide collateral for their loans. This involves the loan to value ratio (LTV), which will be used to calculate the amount of collateral required to obtain the loan. For example, blockfi reserves the right to liquidate collateral immediately after reaching 80% LTV.

To borrow $5000 from blockfi, you currently need to invest 0.25 BTCs, which is currently worth $12250. If the value of bitcoin falls to $6250, the bank will sell some of your collateral to restore LTV to a healthy level.

In times of prosperity, this is a business model that can bring considerable income. There is no doubt that real banks can also provide higher savings interest rates, but they will use some of their savings to improve the competitiveness of loan interest rates.

However, as far as cryptocurrency banks are concerned, it is not clear what will happen if the cryptocurrency market collapses suddenly or for a long time, resulting in the deposit value of these banks being far lower than the value of their loans, or their loans drying up.

If one of the above situations occurs, unlike your savings account in the bank on the street, your encrypted savings are not insured. For example, blockfi is headquartered in the United States and is not insured by the Federal Deposit Insurance Corporation (FDIC) and the Securities Investor Protection Corporation (SIPC), which means that it will be much more difficult to recover funds if the bank is insolvent.

Blockfi also points out in its terms of service that if it or third-party partners encounter network attacks, extreme market conditions or other operational or technical difficulties, they may immediately temporarily or permanently stop transferring or withdrawing cryptocurrencies.

They shall not be liable for any loss or damage arising therefrom. This is particularly troublesome because it gives encryption banks great discretion to return your funds without requirements and retain them when market conditions require (it should be said that blockfi depositors' funds are stored in the cold storage by Gemini, the main exchange, and should be at least relatively safe hackers). Other operators such as Celsius and NEXO do not have such terms, but it just makes their position on this issue unclear.

There are also some disputes about some stable currencies. For example, it is worrying that some people question how many dollar reserves the operators of usdt (tether) have to ensure that the one-to-one interest rate of usdt to the dollar remains unchanged.

Like the broader encryption market, the willingness to participate in the field of defi seems to depend on individual risk appetite. If you are willing to give your cryptocurrency to the bank for profit, it means that you can bear the consequences of losing it forever. If you are prepared to accept this risk and are willing to hold your funds instead of treating them as a current account, an encrypted bank savings account may be suitable for you.

What are the risks of defi?

Although I believe that the potential of defi has not yet been realized, there are serious problems worthy of attention.

Blockchain cannot eliminate the inherent risks of investment, which is the inevitable result of potential return. In this case, defi can amplify the already high volatility of cryptocurrency. Many defi service providers have developed leverage. Under the role of leverage, investors essentially borrow money to amplify earnings, but face greater risk of loss.

In addition, no defi service provider or regulator can return mistransferred funds. When hackers find vulnerabilities in smart contracts or other aspects of the defi service, there may not be a defi service provider to compensate investors. In the past two years, nearly $300 million of cryptocurrency has been stolen. The main protective measure against accidental losses is to warn "investors to be careful", which has never proved sufficient in the financial field.

Some defi service providers appear to have violated regulatory obligations in the United States and other jurisdictions, such as not prohibiting terrorists from trading or allowing any public to invest in restricted assets such as derivatives. It's not even clear how to implement some of these requirements in defi without traditional mediation.

Even the highly mature and highly regulated traditional financial market will suffer impact and collapse due to hidden risks. As seen in the 2008 financial crisis, the global economy nearly collapsed due to an insignificant problem on Wall Street. Defi makes it easier than ever to create hidden interconnection problems that can lead to a series of financial accidents.

Regulators in the United States and elsewhere are increasingly discussing ways to control these risks. For example, they began to promote defi services to comply with anti money laundering requirements and consider regulations regulating stable currency.

But so far, they have only begun to touch the surface of the regulatory field, and the regulatory road in the field of cryptocurrency and defi is still very far away.

From travel agencies to car salesmen, the Internet has repeatedly weakened the bottleneck power of intermediaries. Defi is a protocol based on open standards and another example of potentially changing the rules of the financial game in a dramatic way. However, both developers and regulators need to improve their performance and responsibilities in order to realize the potential of this new financial ecosystem.

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