Crypto Banking And Decentralized Finance – A New Frontier In Financial Services

Cryptocurrencies heralded as the future of finance are finally catching up to the centuries-old idea of ​​making money from money. The global low-yield environment is luring professional and amateur investors to allocate billions of dollars into high-yielding crypto banking products. The emerging digital currency market is creating an alternate universe of finance, commerce, investment, and speculation, which could profoundly transform the global economy and disrupt industries. It is starting to reshape the way people borrow and save and is remaking banking as we know it.

Crypto Banking

The rapidly growing crypto finance market is foraying into the traditional banking sector. Crypto banks are provisioning interest-bearing accounts, term deposits, credit cards, collateralized loans backed by crypto asset deposits, and other services similar to the product offerings from traditional banks, albeit delivering much higher interest rates/yields. Crypto banking platforms lure customers by offering annual percentage yields (APYs) orders of magnitude higher than yields offered by traditional bank accounts. APYs ranging from 7 to 12 percent for coins such as bitcoin and stablecoins are typical. Usually, niche coins and newer crypto projects carrying higher risks offer the highest yields. The allure to attain outsize returns in a low-yield global environment is attracting mainstream attention as well.

Why are the yields so high?

Traditional banks lend out pooled deposits and, in exchange, pay their depositors a piece of the earnings as interest. However, traditional banks are highly regulated and mandated to safeguard consumer deposits. They must keep reserves for bad loans and refrain from highly speculative lending, resulting in muted returns on capital and hence meager yield payouts on the bank deposits.

Crypto finance platforms, akin to traditional banks, pool crypto deposits to provide loans and pay interest to depositors. They offer incentives to depositors/investors to provide liquidity in the crypto-assets market through staking, a process of locking cryptocurrencies to receive rewards, and lending services. Crypto finance platforms are primarily unregulated, do not have any reserve requirements, and engage in opaque lending, ie, loaning to unidentified third parties and institutions that can make risky bets in order to generate outsized returns on crypto deposits.

Underlying crypto finance is crypto trading and speculation.

There is a strong demand for crypto borrowing because speculative trading in crypto assets can garner high returns. Primary borrowers include hedge funds involved in leveraged trading and market makers or exchanges that require crypto liquidity or want to lend to their trading clients. Hedge funds and speculators exploit market flaws to make highly lucrative bets on discrepancies between crypto market prices and crypto futures prices. These speculators pay the crypto banking platforms high returns on the crypto borrows. The superlative payments, minus the crypto banking platform cut, flow to primary crypto holders as yields, far exceeding what is available from the traditional bank deposits. High yields are feasible primarily due to the existing market inefficiencies and increased demand for cryptos borrowing for speculation.

The emerging crypto banking industry encompasses a broad range of platforms; Centralized Finance (CeFi) platforms, with roots in Traditional Finance (TradFi), and novel Decentralized Finance (DeFi) platforms.

Challenge is a global, peer-to-peer ecosystem of smart-contract-powered apps that allow algorithmic lending, saving, yield farming, flash loans, trading, and more while eliminating human intermediaries like brokers, bank clerks, traders, and institutions such as banks or payment processors. The complete approval process overseeing the financial transactions is executed via smart-contract algorithms layered within blockchains.

Yield farming

Under the DeFi umbrella, yield farming, also known as liquidity farming, is an investment strategy for earning interest and other rewards in exchange for lending or staking cryptocurrency. At these DeFi platforms, users can borrow and lend any cryptocurrency on a short-term basis at algorithmically determined rates. To optimize gains and increase yields, yield farmers employ complex tactics, such as shifting their cryptos between multiple liquidity pools or loan platforms, constantly chasing the pool offering the highest APY. A Harvard Business Review article states, “Practically, it echoes a strategy in traditional finance — a foreign currency carry trade — where a trader seeks to borrow the currency charging a lower interest rate and lend the one offering a higher return.” The high yields offered in DeFi yield farming entail considerable risks that are under-appreciated by unsophisticated investors, making the underlying risk-return tradeoff difficult.

Flash loans

Powered by decentralized finance protocols, flash loans are uncollateralized loans with an obligation to pay back immediately within the same block transaction. The smart contracts execute the instructed loan and principal payback, plus interest and fees within the same transaction. If the borrower fails to payback, the original transaction is reversed. Flash loan is a unique, innovative, and useful tool to create higher levels of liquidity for arbitration trading and debt refinancing. It is a niche financial tool for technically savvy DeFi users. Flash loans are also highly susceptible to smart contract exploits, scamming, and hacking.

DefiLlama, a DeFi Total Value Locked (TVL) aggregator, lists the overall value of crypto assets deposited in DeFi protocols at $220 billion. Defi players include crypto banking platforms such as Compound, Aave, MakerDao, MeanFi, and more, which are decentralized and use automated lending and borrowing systems. With almost $7 billion in TVL, Compound uses different liquidity pools for each supported crypto asset and allows lenders to deposit cryptocurrency into these liquidity lending pools for access by borrowers. Aave has over $14 billion, and MakerDao has over $15 billion in TVL. MeanFi.com, powered by Money Streams, a real-time finance protocol that helps businesses set up payroll and banking in crypto, is bridging TradFi and DeFi. “Mean DAO is ushering the future of real-time finance with the Money Streaming Protocol to power a new wave of real-time finance applications. We are doing to money what Spotify did to music,” said Michel Triana. Founder & CEO, MeanDAO.

CeFi offers the yield benefits of DeFi and, additionally, the ease of use and security of traditional financial-services products. It provides the potential to earn much higher yields via crypto-based accounts and is functionally similar to a traditional savings account, offering crypto debit cards and more. The responsibility of safeguarding the deposits is with the CeFi platform but without the backing of the traditional Federal Deposit Insurance Corporation (FDIC) insurance. CeFI players include large platforms such as Nexo, Celisius, BlockFi, Genesis, and more, offering yields from 8% to 18%. These platforms manage billions of dollars in crypto-assets, compete aggressively for capital, pitching bonuses and token rewards, and are now attracting regulatory scrutiny.

Is Crypto lending safe?

The complex yield-generating strategies that DeFi and CeFi platforms implement do not highlight the underlying risk exposures to the crypto customers. Clients/depositors contributing to the liquidity pools often have very little visibility into what the platforms are doing with their crypto assets – opaque lending. Even though many lending platforms retain high levels of collateral, opaque lending in highly volatile crypto assets can expose the depositors to significant hidden risks. In the quest for attractive yields, cryptocurrency investors can be blindsided by the underlying risks in the primarily unregulated crypto banking world, baited into extreme volatility and manipulative scams. Converting the crypto coins back into traditional currencies can entail hefty fees, reducing the overall yield.

The cryptocurrency could experience sudden bouts of volatility. While it is staked or loaned, its price could crash or surge, creating temporarily unrealized gains or losses, also called impermanent loss. These gains or losses become permanent when one withdraws the staked coins, and the earned interest and rewards may not offset the losses stemming from the price drops of the locked crypto. Yield farmers may unknowingly invest in fraudulent projects or scams. In a scam called Rug Pull, cryptocurrency developers gather funds for a project and then abandon the project without returning funds to the investors. The smart contracts powering the DeFi lending platforms can have bugs, faulty protocols, or be susceptible to hacking, putting the investment at risk. Finally, crypto lending risks may spark a serious regulatory oversight and crackdown.

Institutional attendees

Crypto banking is an attractive alternate choice for yield-seeking capital in the present near-zero global yield environment. Risk-averse institutions such as university endowments, insurance firms, retirement funds, and more are beginning to dip their toes in crypto. Traditional financial institutions, ie, Goldman Sachs, JPMorgan, and Citi, are starting to enter the crypto market. Both Visa

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and Mastercard

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partner with crypto platforms to have their footprints in the emerging crypto finance world.

DeFi and CeFi products are not made for traditional passive low-risk investors. These products do offer alternate options for savvy investors seeking higher yield, albeit at unquantifiable speculative risk. The crypto financial services space is a hotbed for innovation. As the traditional banking institutions accustomed to operating in the highly regulated finance industry join in, crypto banking could broaden its acceptance, and every household could have crypto assets working for it.

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