In late 2017, cryptocurrency prices went crazy as Bitcoin brushed $20,000 and the value of other digital tokens—many of them fly-by-night projects—soared inexplicably. Today, something similar is underway, albeit on a smaller scale.
In recent months, speculators have rushed to snatch up digital coins with names like COMP and LINK that are now among the most popular cryptocurrencies, with market caps suddenly worth billions of dollars. And earlier this month, a novelty currency called YAM began trading at over $100 right after it appeared, only to crash to around $1 days later.
This new wave of investment—or bubble if you prefer—has echoes of the 2017 craze, but also represents a new phase for the rapidly maturing cryptocurrency industry. This time around, more players from the traditional finance world are participating, while two new buzzwords—DeFi and yield farming— are driving a new surge of investment.
The rise of DeFi and Yield Farming
If you take even a casual interest in cryptocurrency markets, there’s a good chance you’ve heard the term DeFi, which is short for decentralized finance. The term is relatively new but the underlying idea is not: For more than a decade, Bitcoin supporters have touted it as decentralized form of money overseen by blockchain software rather than a central bank.
What’s new this time around is that a set of equally decentralized infrastructure has grown up around Bitcoin, Ethereum and other cryptocurrencies. This includes exchanges and websites that broker crypto loans, letting crypto holders earn interest on their stash.
Like Bitcoin, these services don’t require anyone’s permission to use, and can be accessed around the world. Trading and lending arrangements are overseen by so-called smart contracts, which serve to enforce whatever deal—perhaps a 6 month loan at 5% interest—two parties have struck on the platform.
“The simplest way to describe DeFi is as an open financial network. If you want to send, lend or borrow money you don’t need to join a private network like PayPal or Fedwire or a bank” says Peter Johnson, a former Morgan Stanley banker who is now an executive at Chicago’s Jump Capital, a firm that specializes in fintech and cryptocurrency.
Like Bitcoin, the broader world of DeFi is fueled by a libertarian worldview, and a thirst for money. But unlike the crypto mania of 2017, savvy traders don’t have to rely on swings in asset prices to earn a return. Instead, they can turn to a variety of websites that let people loan out their cryptocurrency, often for high rates of interest.
Most of these sites—notably Compound and Maker—rely on a decentralized network of lenders and borrowers, who use smart contracts to arrange collateral and payment terms. At first, the sites amounted to experiments on the outer edges of the crypto universe, but in 2020 they have started to attract real money. As of August, more than $4 billion in loans were locked up in smart contracts.
All of this has given rise to the newer phenomenon of “yield farming” in which traders lend or borrow cryptocurrency not just to receive interest or a loan, but to receive new types of digital tokens. The most prominent example came in June when Compound issued a new cryptocurrency called COMP.
The new COMP tokens have the nominal purpose of giving owners a say in how Compound is run, but the tokens quickly became the subject of a speculative mania. In June, the price of COMP soared to $350 but has since leveled off to around $175.
Colleen Sullivan, an attorney who is CEO of the crypto trading firm CMT Digital Holdings, likens yield farming to obtaining airline miles. In recent weeks, she says some traders have been clamoring to obtain bonus tokens in the same way veteran travelers might take an extra flight to obtain extra status.
This has also led DeFi traders to hop around to different exchanges in their yield farming quest, sometimes with disastrous results. In the case of the new token YAM—a novelty coin driven by a meme (much like the older Shiba Inu coin Doge)—traders poured a reported $400 million into farming YAMs on an exchange called Uniswap. But soon after, YAM’s creator acknowledged a bug in the token’s code that made it worthless. The price now reflects that.
Despite such setbacks, cryptocurrency veterans believe yield farming and DeFi are part of a massive and permanent expansion of their industry.
2017 all over again?
The 2017 crypto meltdown—in which Bitcoin lost over 80% and many other cryptocurrencies became worthless—reinforced the negative views held by many that cryptocurrency has no real value or, in the harsher words of Warren Buffett, is “probably rat poison squared.”
Since then, the crypto industry’s two flagship currencies, Bitcoin and Ethereum, have bounced back significantly, though both are currently at around 60% of their all time highs, and the industry as a whole has proved resilient. But the recent resurgence and spike in prices for DeFi tokens raise the question of whether this is just another bubble waiting to pop.
Sullivan of CMT Digital acknowledges that the recent frenzy of DeFi-related trading has a 2017 feel to it. But she says that this isn’t necessarily a bad thing. While the price gains in currencies like COMP have been driven by traders looking for arbitrage opportunities, Sullivan notes that such activity helped mainstream cryptocurrencies like Bitcoin gain a foothold years ago.
Sullivan also points out that, compared to the early days of Bitcoin and Ethereum, the cryptocurrency industry has attracted a greater share of people from the world of conventional finance. While radical libertarians —including Bitcoin’s pseudonymous creator Satoshi Nakamoto—defined the first generation of crypto, the face of DeFi includes the likes of Compound’s founder, Robert Leshner, a CFA who used to oversee bonds for the city of San Francisco.
And while the price spike for certain DeFi tokens feels like a sugar high brought on by yield farming, this is not the case for other tokens. A price surge for the DeFi token LINK—now the sixth most valuable cryptocurrency—has been driven by the value of its issuer, Chainlink, which acts as a data provider to the crypto industry.
But even if the Defi boom of 2020 is built on sounder fundamentals than the 2017 crypto bubble, it’s also more inaccessible to ordinary investors. Making money in DeFi not only requires a familiarity with an exotic market, but a high degree of technical savvy. Even Compound, which is becoming DeFi’s best known platform, has a daunting user interface.
“If you want to participate in DeFi and yield farming, you need to know what you’re doing. It’s mostly technical folks who have been in this for a while,” says Johnson of Jump Capital.
This may not be a bad thing. The technical barriers could prevent millions of amateur investors losing their shirts, which is what happened when the 2017 bubble popped.
Meanwhile, cryptocurrency giant Coinbase has been working to make a small corner of the DeFi market accessible to amateurs. The company has developed a digital wallet where consumers can earn interest on a handful of cryptocurrencies through a simple interface.
Sid Coelho-Prabhu, who is leading the Coinbase wallet initiative, says any loans consumers make on the platform are secure, since they are backed by borrowers’ collateral. But he notes that investors could still face risks in the form of faulty code for some of the tokens, or a large-scale meltdown across the crypto industry.
For cautious investors, Coelho-Prabhu recommends investing in USDC, a so-called stablecoin this is backed by a full reserve of U.S. dollars. Currently, investors can make returns on cash starting at 3 percent—a relatively high figure at a time when even “high yield” savings accounts are paying under 1 percent.
A final question for the nascent DeFi industry is whether regulators will take steps to snuff it out. While the idea of a bank open to anyone in the world may appeal to crypto libertarians, it’s unlikely the U.S. Treasury Department shares this sunny view—especially if DeFi, like other corners of crypto, becomes a haven for money-laundering or terrorist financing.
Sullivan of CMT Digital is optimistic that the DeFi industry will be able to avoid regulators’ ire, in part through the self-regulation efforts of groups like the Chicago DeFi Alliance, a group of industry veterans with ties to the regular finance industry.
For now, though, the emerging industry’s biggest challenge may not be regulation, but proving it is built to be more than a bubble.
