Why you’ll soon be using crypto without even realising it

Bankers, lawyers, accountants and a whole raft of costly professionals are hired to ensure the process runs smoothly. If something goes wrong, the liability lands in someone’s lap, somewhere.

DeFi engineers, on the other hand, have taken these banking functions, whether that’s borrowing and lending, derivatives trading or even mortgage lending, and are trying to simplify these activities, strip out the middlemen, and make the whole operation transparent and public.

At its core, DeFi aims to directly connect people and their money using blockchain-based “smart contracts”. These programmable tokens, or cryptocurrencies, do the work of making markets, settling trades and ensuring the process is secure.

Although DeFi projects can vary a great deal, borrowers and traders generally put up collateral in the form of other assets worth much more than what they’re borrowing. That collateral is “locked” into a giant money pool controlled by the DeFi platform that automatically connects borrowers and lenders, binding that collateral to the lender and releasing it only once the money has been repaid.

Banks catching up

Kain Warwick, the founder of a derivatives trading platform called Synthetix, which has been running as a DeFi protocol for several years, says the banks are catching on to these new technologies, realising the efficiencies have driven costs sharply lower while also reducing counter-party risk.

“As it stands, [the banks] get a stamp of approval from the government to maintain databases which show who owns what,” Warwick says. “And these magical proprietary databases give them the ability to control where the money goes across their balance sheets.”

Warwick says the emergence of a parallel system in cryptocurrency is currently disconnected from the traditional economy, but every day more and more crypto-based businesses that want to borrow, lend, and trade are signing up to fund their activities through DeFi rather than banks.

The amount of money “locked up” in DeFi projects has ballooned to $US79 billion ($105.7 billion), a 652 per cent increase since January 2020. When it comes to running a lending business, one of the largest banking functions, there are two main costs: the cost of funding and the cost of acquiring depositors, or customers.

Sidney Powell, co-founder of Sydney-based DeFi business Maple Finance, which facilitates corporate lending, says these costs have plummeted thanks to blockchain technology.

“It’s so much easier to attract and pool capital because you’ve got people from different financial centres across the world,” Powell says. “There’s effectively no marginal cost increase if I’m serving someone in Hong Kong versus someone in Sydney.”

He also says the cost-to-income ratio has dropped sharply, as lending businesses have traditionally hired people to run operations that range from reporting disbursements to servicing loans to managing queries.

“But we’ve effectively packaged the loan management, loan origination and loan reporting into software,” he says. “So it’s all natively happening on the blockchain that dramatically reduces your cost-to-income ratio.”

The lending value chain has four parts: get capital in, process loans, distribute them to borrowers, and then receive repayments. Powell points out that programming that value chain to “tokens” that execute and release capital once conditions are verified and have been met has made the entire process cheaper.

Fellow Australian-based DeFi operator Patrick McNab, co-founder of Mycelium, a decentralised derivatives trading platform, says that because the costs of operating these banking functions have dropped so low, more of the yields can be returned to lenders.

“People have never had access to this kind of banking activity when they’re just a customer of the bank,” McNab says. “You might get a corporate credit card that has loyalty points associated with it, but now people can get meaningful yields as well as governance rights by putting their money to work like this.”

Where the risk lies

The higher yields, higher than interest rates, have sparked a rush of money into DeFi projects, but McNab warns that there are plenty of unsustainable, and ultimately, dodgy protocols.

“There is a yield generation component that is completely unsustainable for a lot of protocols that aren’t generating value,” he says. “So those yields will probably dry up.”

That’s where it’s risky for investors jumping from protocol to protocol, only chasing short-term yields on platforms that aren’t dedicated to genuine lending.

But it’s the underlying technology driving banking costs down, and that has traditional banks raising their eyebrows. If customers are happy to deposit their money in an automated environment where they can earn a higher yield than a traditional interest rate from a bank, safe in the knowledge the programmed smart contract will ensure their money is returned, won’t the banks begin to lose customers?

ANZ clearly thinks so, and has made firm strides into the DeFi space, launching its own stablecoin last month. A stablecoin is a cryptocurrency, meaning it can transact across blockchains and can sometimes be programmable, backed by other assets.

Stablecoins can be pegged directly to a fiat currency such as the Australian dollar, or they can be backed by a basket of other assets or even commodities. ANZ’s new stablecoin is pegged directly to the Australian dollar and is designed to give retail customers a way to begin interacting with DeFi and crypto projects.

The ANZ stablecoin was designed so Victor Smorgon Group, the investment company of Melbourne’s billionaire Smorgon family, could avoid converting Australian dollars to US dollars and then buying a US-dollar stablecoin known as USDC.

Victor Smorgon Group was able to send $30 million to digital asset fund manager Zerocap, which could begin interacting with crypto markets and DeFi protocols on behalf of the family. Reducing this double-handling has given ANZ a useful function in the crypto world, which seems bent on disrupting and eating its traditional banking lunch.

Synthetix’s Warwick says banks that are willing to connect to those systems will have an edge in the emerging world of decentralised consensus. “Forward-thinking banks can start to think about stablecoins and start to out-compete,” he says.

“But like some banks took a lot longer to get on the internet, those that get on to decentralised consensus technology more broadly and become that on-ramp, off-ramp provider will move with the times.”

As it stands, accessing DeFi is a complex process in itself with crypto-native users among the early adopters. Even so, start-ups are popping up to build simple, familiar interfaces for everyday users to begin tapping into the cheap banking functions DeFi offers.

Sydney’s Block Earner has banked $6.5 million in venture capital to build a front-end platform for mass DeFi use, and fellow start-up Tiiik has raised $5.2 million to launch a crypto savings product with DeFi technology underpinning the strategy. It is a trend some in the scene call the “crypto mullet”: fintech at the front-end, and DeFi at the back.

Central banks are also acknowledging that DeFi networks are performing useful banking functions. The Reserve Bank of Australia is experimenting with ways it can provide secure fiat-currency-backed digital money that can interact with this decentralised finance world.

But while central banks around the world grapple with the technical side of decentralised tokens, they also face an enormous challenge: if, for example, the RBA issued an Australian-dollar backed digital currency that could interact with the DeFi world, what would be the need for banks at all?

“These are the kinds of questions that are going on around the world right now,” Pirovich says. “It’s really a very different way of thinking.”