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Wave Financial Group Executive Warns of Risks in DeFi Loans

September 12, 2020

Loans? Warranty? In the crypto world? Ryan Anderson, Head of Trading at Wave Financial Group, shared with Cointelegraph en Español a comprehensive and detailed analysis to demystify and delve into a growing area of ​​the crypto market: the one that has to do with credit.

“Very often very conspicuous investment opportunities are offered that have heralded in traditional markets that are not so well known. In particular, we are thinking about the “Representative Markets” and “Stock Lending” and how they were re-presented in the crypto markets, ”said Anderso. Part of his goal is to clarify these questions.

The analysis has also been influenced by the “DeFi” opportunities that have recently emerged in the crypto markets.

Wave Financial Group Executive Warns of Risks in DeFi LoansWave Financial Group Executive Warns of Risks in DeFi Loans

But let’s take a look at Anderson’s perspective below to understand how cryptocurrency-backed crypto loans work. Furthermore, the important questions remain the same: who are the lenders and who are the borrowers? Why are they participating in these operations? Which forces shape the market and how do the actors involved in these forces react?

“There are some places in the world where borrowers can borrow cryptocurrencies like BTC with a different type of cryptocurrency as collateral. Half of Genesis Capital’s loan book contains terms on BTC, and alternative cryptocurrency loans make up a small but real part, ”he explained

(Genesis Capital loan pending payment per asset by Q1 2020. Source: Genesis Capital)

He also reported that Bitrue, a foreign exchange market, has also diversified into cryptocurrency-backed crypto loans.

(Source: Bitrue)

“In the traditional world, such operations are probably best compared to some form of stock lending. In this way, individuals who own BTC and other desirable cryptocurrencies can receive an additional return for lending their assets to the counterparties who need the loan. In general, this operation makes it easier to sell short, but the loan could be used in the same way to fund a futures operation or similar operation, ”he explained.

“With stocks, short interest, or the percentage of stocks outstanding that were borrowed as part of stock lending, is often a signal of the market trend for a particular stock. The list of the highest short interest stocks on the New York Stock Exchange (NYSE) is a grueling line of underperforming companies, ”he added.

(Stocks with the highest short interest in NYSE trading. Source: highshortinterest.com)

As far as we know, there isn’t a similar metric for cryptocurrencies, likely due to the fact that most altcoins aren’t worth much compared to BTC, but maybe we can examine similar numbers for help in the future. for evaluation.

The biggest story when it comes to crypto-backed crypto lending can be found in the world of decentralized finance (DeFi).

“DeFi” is a general term for the activities of a booming industrial sector that uses the power of smart contracts to automatically process complex financial transactions. As an aside, this topic can get pretty complicated as it mostly deals with essential distributed computing, and even people like Vitalik Buterin have trouble communicating precisely and clearly what is happening.

A smart contract is a type of application developed using a programming language created by the founders of Ethereum.

In contrast to Bitcoin, Ethereum is more useful in this way: “At the same time as the founders were developing a cryptocurrency, they also created a way to communicate and interact with cryptocurrency-based functions. Good uses for smart contracts would be applications such as fiduciary services in real estate transactions. The smart contract can be programmed to accept funds from a buyer, hold them, and automatically deliver them to a seller according to certain conditions set when the application was created. “

MakerDAO pioneered a model that is very present today: “It allowed anyone to borrow cryptocurrencies from a smart contract, with a guarantee of 150% of the loan. In particular, MakerDAO allowed stock traders to deposit ETH and receive a stable coin (DAI), the value of which is algorithmically linked one-to-one to the US dollar. The smart contract created this DAI currency and saved the collateral while additionally handling functions like requirements to adjust the collateral. The collateral was repaid even if the borrower did not recapitalize the loan. Since its inception, merchants have provided more than $ 500 million in guarantees to take out DAI loans from smart contracts. “

(Source: DeFi Pulse)

Anderson then explained, “The next development at DeFi was a project called Compound that turned the MakerDAO business on its head. It enabled a reciprocal market of borrowers and lenders to participate in the smart contract. In addition, it enabled a wide range of liquidation assets. ”

He explained: “Borrowers could borrow stable currencies such as DAI and USDT, but also basic crypto currencies such as ETH, BAT or 0x and offer any combination of these currencies as security. In addition, lenders could lend any of their assets. To balance the incentives, the smart contract behind Compound varies the interest rates (independently for depositors and borrowers) and the collateral multiples between assets. “

(An example of the compound dashboard: interest rates on deposits and loans in different currencies, plus the option to activate any combination of assets as collateral. Source: Compound)

It is important to note that the interest rate differential between the depositor and the borrower (APY, pictured above) is not paid out as profit to the compound owners. In fact, there really are no compound owners in the sense that we would be thinking of another business. The spread is intended solely to stabilize the credit markets.

Thanks to DeFi Pulse, we can visualize the development of these rates over time. The rate on Maker has been the benchmark since at least 2017, but from time to time smaller platforms have offered much higher rates for short periods.

In the past year, the average annual rate recorded by DeFi Pulse after the big crash in March fell from an average of around 10% to less than 5%.

(Source: DeFi Pulse)

(DeFi Pulse composite measure for loan interest rates on DeFi platforms as of June 2019. Source: DeFi Pulse)

Recently, however, interest rate changes have changed the interest rate market. As of June this year, the total of assets on deposit and on loan with Compound averaged approximately $ 100 million. In June that number rose to over $ 600 million.

(Source: DeFi Pulse)

“The decisive factor for this drastic increase was the decision of the team behind Compound to bring a trading currency, COMP, onto the market, with which the acceptance and success of Compound as a platform should be followed. This makes it similar to Binance’s most famous coin, BNB. Although the BNB started with Binance before it started trading on the stock exchange, it has done quite well and currently ranks 11th in market capitalization among all cryptocurrencies, “said Anderson.

(Price and volume of the BNB in ​​foreign exchange trading since July 2017. Source: CoinMarketCap)

“The Compound team took those words seriously when they launched COMP and decided to introduce some kind of dividend or reward on their platform,” he said.

In a May 27 Medium post, Compound founder Robert Leshner outlined the terms of his plan: “All users and all applications developed on Compound will automatically and continuously receive free government rights to shape the future of the protocol.”

(Diagram to explain COMP’s sales program. Source: Link)

In the days following the announcement, DeFi enthusiasts realized how lucrative rewards in the form of tokens such as those offered by the COMP program were. In particular, they realized that these token rewards could be earned at a higher rate through the use of leverage that they could earn on the network of decentralized lending platforms.

More skeptical voices have emerged in response to rumors about productive agriculture. Leshner, the founder of Compound, described the activity as “self-organizing anarchy,” while Vitalik Buterin, the founder of Ethereum, shared his own concerns:

(Source: Twitter)

(This composite source code calculates the “APY” which is often quoted in discussions about Yeld farming. The document adds: “Please note that the value of supplyRatePerBlock can change at any time.” Source: Compound Documents)

Anderson went on to compare: “When the yield on a Coca-Cola bond goes up, which in itself would only happen if unexpected events like a factory explosion or an FDA investigation occurred if you were attracted to the bond for the If you buy the highest yield offered, you get this yield guaranteed for the remaining term of the bond, provided that Coca-Cola does not default. If the yield later falls back to previous levels, investors who bought at high yields actually benefit because their bond is worth more than it was before. That doesn’t mean your cash flows will change: a bond with a 2% coupon will have a 2% coupon paid out to maturity. However, over time, they will receive the performance described at the time of purchase. ”

And he said, “This is not the case for the same investor lending a loan in a lucrative DeFi contract. You will only get this high rate of interest as long as it stays in the market. Hence, there is no way to really gauge the profits of any particular forex trade. If, at the time of the exchange, the compound for ETH loan interest rate is 20% on an annual basis and an investor borrows 1,000 ETH, they will receive the value of one block with an annual interest rate of 20%. The average time between blocks for ETH was around 15 seconds, which means very little time for this high rate of interest to accumulate. “

Then he explained, “We will find that for operations like the one described by Shimron (…) there are really significant amounts of tokens that will be delivered in the form of rewards at the time of the exchange operation. Remember, however, that the 100% APY numbers reported are annualized rates, which means that it is assumed that the same rate can be guaranteed over a period of a full year. The COMP just started on June 15th. This should be taken as a warning to investors looking to accumulate with Yeld farming, which is drawn to incredibly high rates. It’s hard to expect these prices to last long enough to get close to the prices advertised. Finally, it should be noted that the rewards that lead to these ‘100% APY’ numbers are still expressed in volatile alternative cryptocurrencies. There is no guarantee that even if the amount of tokens needed to achieve a ‘100% APY’ were reached, those tokens would be worth it all when all is said and done. “

But it doesn’t stop there, and so Anderson remarked, “Even though the maturity of the loans and the crumbly leverage they rely on weren’t enough to get smart investors to spend them and live for another day There is one more core component that needs to be considered: the type of borrower on the other side of the loan. When a deposit is made with a bank, it is also a short-term, floating rate loan. Since the Great Depression, the Federal Deposit Insurance Corporation has backed these banks’ deposit portfolios with a government guarantee, making them essentially risk-free. When a cryptocurrency lender requests deposits from investors on their platform, the investor can make their own decision on whether to lend or not based on the lender’s creditworthiness, their borrower book, and the interest rate offered. When a stock trader deposits stable coins or other cryptocurrencies on a DeFi platform, they have to make their decision in a vacuum, using only the price offered as a guideline for their thinking and no real information about the reliability of the other’s smart contract or borrowers . Page on which the system is running “.

Conclusion

“According to our reading, the risks of DeFi loans are quite high at any level and the returns are uncertain. In particular, earnings risks increase with the leverage enabled by smart contract implementations, and returns become even more uncertain due to their reliance on the volatile price of token rewards. Investors interested in using their capital or the capital of their clients in these endeavors should drastically limit the funds allocated to them. “

About Ryan Anderson

He is the Chief Operating Officer of the Wave Financial Group. Prior to joining Wave Financial Group in 2019, Ryan was a research associate with Bridgewater Securities and a trader with Goldman Sachs. Ryan received his BA from the University of Pennsylvania.

Important: The views, thoughts, and opinions of Ryan Anderson do not necessarily reflect or represent the views and opinions of Cointelegraph. No part of this material should be construed as an offer or recommendation to buy, sell or hold any value or any other type of financial product. Ryan Anderson’s analysis contained in this publication is intended to provide general information and opinions. However, nothing in this discussion is intended to constitute investment advice, recommendation, or introduction to any particular financing or capital resource.

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