22,740 BMJ Reward Tokens to date

Health, Wealth, and Happiness

February 22, 2023

“The most important quality for an investor is temperament, not intellect.”

- Warren Buffett

In today's issue: We have mixed feelings about DeFi lending platforms.

On the one hand, they are a true innovation. Overcollateralized smart contracts means the borrowers are good for it. If they can't pay back loans, the smart contracts sell the crypto they've locked up.

On the other hand, most people use DeFi loans to buy and trade more crypto, which is not a great plan for long-term financial success. You're one bad market move away from losing it all.

As value investors, we think the better opportunity is buying and holding tokens in the lending platforms or acting as a lender. Just don't take out loans yourself.

Today, we cover the state of DeFi lending in 2023. Just remember that taking out DeFi loans may be dangerous to your wealth.

Must Read

Today's most important story for crypto investors.

The 2023 Financial Advisor Crypto Survey(Bitwise/VettaFi)

Financial advisors are finally waking up to crypto.

That's the headline of this year's survey of about 500 financial advisors, which increasingly shows they can't afford to ignore crypto.

Among the findings:

Only 15% currently offer crypto investing to their clients, but about 60% know their clients are investing in crypto on their own (they want this business).

The vast majority of their clients (95%) keep their total exposure to crypto limited to less than 5% of their overall portfolios, keeping in line with our investment philosophy.

Regulatory concerns and volatility are two major roadblocks keeping most financial advisors from getting more involved.

Perhaps most surprisingly, only 1/3 of financial advisors are invested in crypto themselves. It's hard to see how the other 2/3 will be successful in recommending something they don't understand.

Investor takeaway: We continue to be unimpressed with the financial advisor industry. In our view, they're failing their clients.

There is an enormous opportunity to create a new kind of financial advisory that deeply understands crypto as part of an overall investing strategy, catering to younger generations. We hope it happens soon.

Sector Report: DeFi Lending

by Preetam Kaushik

Executive Summary: Decentralized finance (DeFi) is a rapidly growing subset of the cryptocurrency ecosystem that creates financial applications and services that operate on decentralized, open blockchain networks. Borrowing and lending have rapidly become some of the most-used DeFi applications.

Despite some troubles in crypto lending during the summer of 2022, DeFi lending continues to attract interest, with institutions pouring billions into the sector. Improvements to DeFi lending protocols and regulatory clarity will bring greater adoption, making this an interesting space for investors.

What Is DeFi Lending?

DeFi lending is about offering crypto loans on decentralized platforms through peer-to-peer decentralized applications (dapps). In DeFi lending, users can either lend their crypto assets to other users in exchange for interest or borrow crypto assets by posting collateral to reduce the risk of default.

Among dapps, DeFi lending has the highest growth rate globally. Zion Market Research shows the global DeFi market was valued at nearly $11.96 billion in 2021. It's expected to reach $232.20 billion by 2030.

Total Value Locked (TVL) in DeFi lending platforms. (Image via Token Terminal)

While Total Value Locked (TVL) in DeFi lending platforms is trending upward as of this writing, it still has a way to go to recover from its pre-crash levels of $45 billion in April 2022 (the crypto market moves in tandem).

Some of the encouraging developments in the crypto space are the rise of bitcoin Ordinals, the growth of liquid staking tokens, and the upcoming Ethereum Shanghai upgrade.

The primary risk factor is the SEC crypto crackdown, which has specifically targeted lending platforms (among others). So far, DeFi lending platforms appear to be safer bets, as it's not clear who the SEC could sue if there's technically no company.

How DeFi Lending Works

Like a traditional banking loan facility that relies on customer deposits to lend out money, DeFi lending mainly relies on lending pools where users deposit their crypto assets to ensure quick distribution among borrowers through smart contracts.

One of the key advantages of DeFi lending and borrowing platforms is they're open and transparent. Anyone with an internet connection and a crypto wallet can participate, and the code that governs these platforms is often open-source, meaning anyone can audit it to ensure it's secure and fair.

It's also possible to see all the deposits, loans, and repayments made by examining the blockchain ledger. Because there's no centralized intermediary, users don't have to go through the lengthy and cumbersome process of credit checks.

Instead, borrowers typically have to put up more collateral than the amount they’re borrowing. Collateralization rates often range between 120% and 150% on major lending platforms.

Why put down 1.5 ETH to borrow 1ETH, you ask? Because there's no credit check. We can trust the borrower because we’ve already got his/her money. Overcollateralizing also allows a cushion if the price of the underlying crypto drops unexpectedly.

Platforms also have a "liquidation ratio" relative to the borrowed amount. For instance, a 100% collateralization rate could be accompanied by an 80% liquidation ratio. If the collateral falls below this rate, anyone can liquidate the amount minus the lender's deposit and pocket the rest. For this reason, many borrowers lock up more than the required collateral.

DeFi lending is primarily used to leverage bigger trades (i.e., to buy and trade even more crypto). For this reason, taking out DeFi loans can be dangerous to your wealth. Serving as a lender, however, can be quite profitable.

DeFi lenders have raked in over $50 million per month in fees.

Investment Thesis

There are two ways to invest in most lending platforms: acting as a lender or buying and holding the platform token.

Acting as a lender: Investors who deposit their crypto assets into these DeFi protocols receive lending tokens in return (aTokens for Aave, cTokens for Compound, and Dai for MakerDAO). Think of them like “receipts.”

These lending tokens are embedded with both the interest and the principal. They can be redeemed any time. The exchange rate between the crypto asset and the native coins is called the annual percentage yield (APY). This is how the lenders make money, and the interest rate is determined by the ratio between the supplied and borrowed tokens in a particular market.

Buying and holding the platform token: Most DeFi lending platforms have their own tokens (AAVE for Aave, COMP for Compound, and MKR for MakerDAO). In our view, buying and holding these platform tokens is the long-term investment opportunity.

At Bitcoin Market Journal, we believe holding the native tokens of promising crypto projects is like owning “stock” in the “company.” We buy and hold great projects that are earning real revenue and run by capable leaders. They also have good long-term growth prospects.

Reasons to be long-term bullish on DeFi lending:

Because DeFi lending takes place on a blockchain, all transactions are recorded on a public ledger, which can be viewed and audited by anyone. This transparency helps prevent fraud.
DeFi lending platforms are automated (no credit checks needed), so they're more cost-efficient and speedy.
The process is totally digital. Hence, analytics are easy as the open data gives insight into the borrowing and lending market.
DeFi lending protocols allow interoperability and programmability.
Some investors maximize savings by investing in different lending platforms. They then deposit the lending tokens in interest-bearing accounts.

Reasons to be wary of DeFi lending:

Regulators have their sights on lending services and could find a way to shut down DeFi lending as well (or choke its access to TradFi banks).
Because they have to be overcollateralized, they're not really loans for people who need them.
Smart contract risk: the lending platforms are at risk of being targeted by hackers looking to exploit bugs.
Considering the volatility of crypto markets, overcollateralization and liquidation are continuous risks for users. The collapse of Terra/Luna and FTX are cases in point. Borrowers are vulnerable to losing all their crypto if prices drop suddenly.
Users need to be extra cautious with wallets and addresses. Losing your private keys means your funds are lost forever. There are no regulations to cover such losses.
DeFi loans can encourage bad behavior. Loaning out crypto to buy more crypto on a repeated basis builds a dangerous Jenga tower of risk.

Top DeFi Lending Platforms

Aave (AAVE) is an open-source, non-custodial, decentralized protocol for lending and borrowing crypto. Users deposit their digital assets to earn interest or borrow assets with customizable interest rates. Aave has some innovative features like flash loans that have to be paid back within single Ethereum blocks (~12 seconds).

Aave Arc is a liquidity pool specifically designed for institutions. Unlike the retail Aave platform, which requires no KYC, the Arc platform includes KYC requirements to maintain regulatory compliance.

Several institutional investors have invested in Aave. Grayscale has a DeFi fund, with AAVE forming over 12% of the portfolio. Aave has a 14% presence in Bitwise’s DeFi Crypto index fund.

At the time of writing, Aave has a significant Twitter presence with over 522.8K followers, a Reddit community with over 16,000 subscribers, 15K Telegram followers, and 22K Discord members.

Compound (COMP) allows users to earn interest or borrow assets using their crypto as collateral. It operates on the automated market maker (AMM) model and enables seamless transactions between lenders and borrowers. COMP is an ERC-20 native token and is also the governance token for the protocol.

Compound has been widely recognized as a pioneer in the DeFi space and has attracted a large and active community. Compound has over 242,000 followers on Twitter, a Reddit community with over 45,000 subscribers, and a Discord channel with over 19,000 members.

Compound has become a popular choice for users with its user-friendly interface and transparent governance. Compound Finance is the 6th largest dapp and the 3rd largest lending protocol in the DeFi space.

MakerDAO (MKR) allows customers to borrow DAI (a stablecoin pegged to USD) using their crypto holdings as collateral. MKR token holders govern the Maker protocol.

As DeFi continues to mature, MakerDAO is well-positioned to play a significant role in the space and provide users with access to stable, decentralized lending and borrowing options.

MakerDAO has over 240,000 followers on Twitter, a Reddit community with over 34,000 subscribers, and a Discord channel with over 7,000 members.

Alchemix (ALCX) is an interesting take on DeFi, offering loans that pay themselves off through yield-generating strategies.

Alchemix allows users to deposit tokens, then take loans against them at a 1:2 ratio. The deposited tokens are put into Yearn vaults to earn yield, which is then used to pay down the loans. Currently, you can use ETH, WSTETH, RETH, DAI, USDT, or USDC as collateral for loans.

Alchemix is not as active on social media as other DeFi projects. It boasts just 72,800 Twitter followers, 10,000 members on its Discord channel, and 1,100 members for its subreddit.

C.R.E.A.M Finance (CREAM) is a decentralized lending protocol for accessing financial services with the goal of pushing the boundaries of what DeFi can do.

C.R.E.A.M is an acronym for “Crypto Rules Everything Around Me.” It's a part of the yearn.finance ecosystem and is a permissionless, open-source, blockchain-agnostic protocol serving users on Ethereum, Binance Smart Chain, Polygon, and Fantom.

Users holding ETH or wBTC can deposit their assets on C.R.E.A.M. to earn yield as they would through a traditional savings account. On Twitter, the protocol has 80,500 followers. On the subreddit, however, there are just 329 members.

DeFi Institutional Investments

The volatility in the crypto market has not dissuaded investors from their continued interest in DeFi projects. A recent surveyfound 20% to 50% of crypto-related pitches were focused on DeFi. Decentralized money markets issue billions of dollars in loans, while DeFi platforms like Uniswap trade volumes roughly 30% those of Coinbase.

Institutional interest in DeFi is also rising:

Banks are beginning to venture into crypto custody firms.
Barclay’s bought a stake in Copper.
Standard Chartered has partnered with Northern Trust to launch Zodia, a cryptocurrency custodian for institutional investors.
Bank of New York Mellon has partnered with Chainalysis to track and analyze cryptocurrency products.
BlackRock and Citigroup invested over $1 billion each in DeFi platforms in 2022.
Recently, Nomura's subsidiary Laser announced its investment in Infinity, a decentralized finance (DeFi) protocol for institutional lending and borrowing.

Investor Takeaway

If DeFi lending wants to be a part of the "real" economy, it needs to expand beyond crypto assets and tokenize real-world assets, while relying less on collateral. Over-reliance on crypto collateral means dapps are accessible only to asset-rich borrowers, limiting financial inclusion benefits.

Though institutional crypto investment is increasing, DeFi's progress going forward will largely hinge on regulatory outcomes. In June, the World Economic Forum released a policy toolkit for fair and efficient DeFi regulations. In the U.S., the Stablecoin TRUST Act has the potential to make stablecoins fully regulated and accepted as part of the traditional financial system.

Anyone looking into DeFi should know it's still early times for the sector, with the potential for great risks and even greater rewards.

ICYMI