DeFi Deep Dive

Decentralized Finance (“DeFi”) is a hot topic in the crypto space. The idea from crypto maximalists is that banks are old school institutions and earn too high a profit by ripping off the little guy. Hey, it’s a popular concept that plays well with most people. DeFi tries to take the bank middleman out of the picture and connect borrowers and lenders directly through smart contracts. There are no easily available numbers for the size of this market, but a good estimate right now is somewhere around $100Bn in loans have been done this way so far. Cool idea, right? Hang tight. If you are my target reader in the finance industry, this is going to blow your mind.

The first thing to know about these DeFi lending or interest-bearing protocols is that they offer really high short-term interest rates. Circle is one of the bigger players in this space. They are fairly conservative and still offer savers a 4.25–5.25% APY right now. Want something more aggressive, take a look at BlockFi which offers rates up to 9.5% APY. If this yield isn’t high enough for you, you can check out Binance, which is not available in the United States. They offer yields and staking rewards up to 25% per annum.

I have spent over 25 years in the fixed income markets. When someone is paying these types of yields, my Spidey Senses start going crazy. Interest rates have been zero for a while, high quality borrowers are able to access capital at 1–2% right now. Why are these big crypto exchanges paying such high interest rates to attract cash to fund these types of operations? Obviously, the answer is that these programs entail high risks to the lenders/depositors.

I spent hours digging through the websites to try and figure out what was going on here. I have worked on some of the most complex fixed income structured products in the world, and I have read thousands of prospectuses for those transactions. I couldn’t believe how little these crypto organizations were disclosing about the risks of their lending programs. Because the crypto exchanges argue these are not “securities”, they don’t prepare prospectus, offering documents, or even detailed risk disclosures. The SEC may disagree with this in the future, but so far they haven’t. More on this topic later in this post.

The basic concept is that DeFi programs from crypto exchanges entail their customers lending crypto to others that want to buy on margin or borrow for short sales. This is easily compared to stock loan programs in the traditional equity markets. On a stock loan, an investor that holds shares can lend them to their broker and get paid a yield. The broker is required to maintain typically 102% collateral with a custodian, typically in cash or US government securities. The counterparty on these transactions is a FINRA regulated broker-dealer who is subject to reviews of their financials and their operations by the FINRA. Look, I get it, FINRA ain’t perfect, but at least someone is looking at these broker dealers and their lending operations. The risk on these stock loans is reflected in the low yields, averaging something less than 1% APY currently. For certain stocks that are in high demand for short sellers, the yields can occasionally get up to 5–7%. Also note that these programs have been around for decades and have withstood major market volatility with minimal losses to investors over this time. The SEC has taken actions to tighten up the risks here, and massive asset managers participate in the market and keep an eye on the biggest counterparties.

So now let’s flip back to these DeFi lending programs. It works in much the same way. An investor holds Bitcoin or Ethereum or a stablecoin like USDC in their account. They lend this coin to the crypto exchange, who turns around and lends it out to someone else that wants to buy on leverage or short the token. Here is how Circle describes their program on their website: “Allocate into a crypto-based investment that is fully secured by bitcoin collateral and earn higher yield compared to traditional bank rates and many fixed income markets**” The comparison to bank rates is laughable here, these folks at Circle have made it too easy for the future plaintiff’s attorneys. I won’t bother to comment more on this.

Let’s breakdown the two big differences between Circle’s program and traditional stock lending. First thing is that Circle is not an FINRA regulated broker dealer. They are registered with the state financial services agencies for the states they operate in. These entities do not have the resources of FINRA and have less oversight capabilities. Second, Circle is taking back highly volatile $BTC as collateral for their lending program and not cash or US government securities. They do use a much higher collateral haircut around 25–50% to cover for this additional risk, but it still meaningfully increases the exposure of investors.

As it relates to the first point on securities regulation, the state of New Jersey has stepped up and taken action against one of the biggest players in the space — BlockFi. On July 19, 2021, the New Jersey Bureau of Securities issued a summary cease and desist order stating that BlockFi’s Interest Accounts (“BIAs”) are unregistered securities under New Jersey law. The order sought to stop BlockFi from opening new BIA accounts worldwide. Within the order it says that “BlockFi held the equivalent of $14.7 billion from the sale of these unregistered securities in violation of the Securities Law.” Yikes. BlockFi has gotten NJ to postpone the effective date of the cease and desist order multiple times, so the program has continued operating while the two sort out the details here.

Another red flag for these lending products is the dispute between Coinbase and the SEC. The only publicly traded crypto exchange was looking to launch a relatively conservative lending product with yields up to 4% this fall. The SEC sent Coinbase a Wells Notice stating their intention to sue Coinbase to stop the product from launching. While I agree with Coinbase CEO Brian Armstrong that it is crazy for the SEC to selectively regulate in this way, it gives a clear window into the thinking of current SEC Chair Gary Gensler. Gensler has been a big public critic of the crypto markets, and this was an important shot across the bow from him and the SEC.

I don’t feel the need to spend too much time talking about the volatility of the collateral on crypto exchange lending. This one is obvious. The more volatile the collateral, the higher the risk of loss. I do want to briefly state that DeFi lending is a new business. This type of operation is only a few years old. So far, it has withstood the volatility of the market fine, with no major losses reported to date. However, the risk management policies of the exchanges are not well disclosed, and these entities are lightly regulated for safety and soundness. They are also mostly young companies, with only a few years operating history and with limited equity relative to the size of their borrow/lend programs.

I expect that we will see big changes on the regulatory front for these types of programs in the near future. Disclosures of risks will likely improve in a meaningful way. These factors will bring the yields available to investors down as the DeFi markets attract bigger players. Want to chase today’s high yields? Do the research, pick your counterparties carefully, and be prepared to shoulder meaningful losses if something goes wrong.

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