Bitcoin was born with an ambitious goal: rendering fiat currencies such as the U.S. dollar obsolete. Although bitcoin has yet to succeed—mostly due to transaction costs and price volatility—visionaries have built on bitcoin’s underlying technology, the blockchain, to take on another target: Wall Street.
Decentralized finance (DeFi), the ecosystem of cryptocurrencies, exchanges, and shadow banks, is heralding a new era of digital investing. The rising deposits locked in DeFi lending or claims, $55 billion, are the tip of the iceberg of what is to come. Four clear trends point to a future where cryptoassets host a momentous swath of global finance.
Low Rates Drive Search for Alternatives
Developed economies have entered uncharted waters with a low-yield environment for fixed-income assets. Bonds are falling out of favor with individual investors and institutions such as pension funds that must meet financial obligations.
Even before the pandemic, central banks were driving interest rates down to zero, or even negative, to encourage borrowing and spur economic activity. The COVID-19 upheaval has cemented that trend and made sure rates stay low for the near future. In the United States, the Federal Reserve has been clear it will not change course for years.
Hedge funds, where investors often turn for higher returns, no longer justify the rising cost. They have been converging on a costly 3 percent management fee for assets under management plus 30 percent of gains.
With no end in sight, there’s time for investors to acquaint themselves with cryptoassets that can compete by disrupting bureaucracy and regulations.
Mainstream Adoption Already Happening
Years ago, getting into cryptocurrencies required technical savvy and venturing to shady, foreign-based websites. Now, anyone in the United States with a smartphone and a PayPal, Robinhood, or CashApp account can buy bitcoin.
As for institutional players, they’re creating investment funds and exchange-traded funds (ETFs) dedicated to cryptoassets. Holdouts are becoming a stubborn minority, missing out on the opportunities.
A survey conducted in Europe by the Crypto Research Report and Cointelegraph Consulting in October 2020 revealed 61 percent of professional investors had bought or planned to buy cryptoassets. In December, for example, Massachusetts Mutual Life Insurance made a $100 million bet on bitcoin. Even renowned hedge-fund managers such as Paul Tudor Jones are dropping their skepticism and turning bullish.
Stablecoins Overcome Use Concerns
Bitcoin’s meteoric rise has been making headlines since the turn of the year. It doubled its price in less than one month and recently surpassed $63,000. JPMorgan has argued it could go to $146,000 and dethrone gold as the premier safe-haven asset—and that is a conservative prediction. Bitcoin’s market cap has surpassed $1.1 trillion.
Dramatic price swings, although exciting and lucrative for speculators, impede use and scare risk-averse investors. Enter stablecoins. Relatively new to the crypto-space, these cryptocurrencies have values pegged to some other currency or basket of currencies. As their name says, they aim for price stability. For instance, one USD coin (USDC) tracks the value of the U.S. dollar.
Stablecoins lessen the worry about price volatility and serve as a parking venue between trades. Investors no longer need to exit the crypto market and pay unnecessary fees by converting their digital assets to fiat currencies. They can just use stablecoins and wait for the next investment opportunity.
New Opportunities for Yields
The vast cryptocurrency market capitalization of $2.2 trillion begs the question: Why leave funds in an idle wallet when you can lend them out? Decentralized exchanges cater to that exact market, connecting cryptocurrency holders with startups and people needing them for different purposes. Developers, for example, need ether to create the self-executing contracts and software that power peer-to-peer lending platforms.
No longer are cryptocurrencies mainly vehicles for payments or speculation. Now investors can add a new use: earning a yield.
Although the space is still in its infancy, dozens of firms now allow holders of cryptocurrency to lock it in lending pools with annual yields that easily run in the double digits. Compare that with the meager returns on savings accounts or certificates of deposits in traditional U.S. banks (spoiler: they are under 1 percent).
Platforms can even connect lenders with buyers automatically. Neither knows—nor needs to know—who is on the other end of the deal. When repayment is due, funds go from one wallet to the other. Contrast that with the personal information, credit scores, and other requirements one must go through in traditional finance to merely apply for a loan.
Although borrowers in DeFi must pledge more than enough cryptocurrency to cover for default scenarios, entrepreneurs are busy working to enable uncollateralized loans in the future.
Middlemen Need to Learn to Code
The running theme across DeFi’s competitive advantage is the cutting out of middlemen such as banks, stock exchanges, and bureaucrats by setting up permissionless systems. These remove barriers to entry so that virtually anyone can benefit from financial assets and invest in promising startups, not just the walled community of accredited investors.
Writing for Forbes, economists Benedikt Christian Eikmanns, Isabell Welpe, and Philipp Sandner argue that “DeFi has reached an important intermediate step to become a substitute for traditional finance solutions” that “will be more efficient, convenient to use, and secure than traditional finance.”
Granted, cryptoassets are no run-of-the-mill investments. At present, they remain riskier and exhibit less market efficiency, which means more responsibility on the individual participant. Regulators have barely scratched the surface of this market, succeeding only in applying anti-money-laundering requirements at the fiat-to-crypto exit points. This means the probability of fraud or self-serving schemes is higher, and there has been no shortage of both.
There’s an upside to this freedom, however. It allows entrepreneurs to innovate and quickly dislodge inefficient products or services without having to wade through regulatory red tape; the dizzying amount of altcoins, projects, and exchanges is testament to the vibrancy of this industry.
The trade-off between risk and reward ultimately lies with every investor. When the trodden Wall Street path offers mediocrity and cronyism, the excitement of DIY-finance can be hard to pass.
Fergus Hodgson is the founder and executive editor of Econ Americas, a Latin American intelligence publication and financial consultancy. He is also the roving editor of Gold Newsletter and a research associate with the Frontier Centre for Public Policy.
Daniel Duarte contributed to this article.