Insight & Analysis

Can crypto investments ‘DeFi’ the market?

Published: Sep 2022

The promise of enhanced returns from investments in decentralised finance should be treated with extreme caution.

Cryptocurrency coins on persons laptop

It is impossible to ignore the hype around decentralised finance or DeFi. One of the key elements of this ecosystem is automated protocols on blockchains to support trading, lending and investment of cryptoassets.

A number of financial technology companies reacted to traditional bank deposits offering very low or even negative rates by targeting the treasury market with the promise of dependable and low risk returns from DeFi investments.

One example is Valour, which says it is ‘bridging the gap between traditional capital markets and decentralised finance’ by providing ‘trusted, diversified exposure across the decentralised finance ecosystem’.

Meow describes itself as the ‘future of modern, compliant investing for corporate treasuries’. According to co-founder and CEO, Brandon Arvanaghi, it offers corporate treasuries direct, cash-in-cash-out access to the most trusted digital trading desks and protocols, to potentially yield them return on cash sitting idle in savings accounts.

Charles St Louis, Chief Operating Officer at Element Finance, describes participation in DeFi for allocation of assets as a huge opportunity for growth.

However, neither Valour, Meow nor Element Finance responded to requests for information on the types of investment options they offer or the level of returns they are generating for treasury clients.

One of the most popular DeFi strategies is yield farming, which is not dissimilar to foreign currency carry trading where traders aim to lend currencies offering the highest returns and borrow those with the lowest interest rate. Farmers move their crypto from one liquidity pool or loan platform to another in search of the maximum annual percentage yield.

One of the risk factors here is impermanent loss, which occurs when the price of one of the assets moves significantly compared to the other half of the pair. Another issue is changes to lending interest rates caused by supply and demand where a suddenly plentiful asset will see its lending value fall.

Another contentious issue in yield farming is the extent to which investors are given sufficient information on risk and adequate guidance as to where exactly they should allocate their capital. Many experts believe DeFi platforms have not educated investors enough about the risk of investing in yield aggregator pools and specifically the possibility of loss due to fluctuations in the price of the underlying assets.

Another widely used DeFi investment option is staking – supporting a blockchain network and participating in transaction validation by committing crypto assets to that network. Investors earn interest on their investments while they wait for block rewards to be released.

But again there are many potential downsides, such as the possibility of a cybersecurity incident that could result in the loss of tokens held within a certain exchange or online wallet or the inability to utilise coins until the expiration of the staking contract, which means funds could become illiquid for the entire duration of the lock-in period.

Single-sided staking is usually lower risk (and lower return) as it allows users to deposit one asset – such as USDC or USDT. In the dual-sided model, two tokens are used to provide liquidity on a decentralised exchange. The downside to this model is that if the price of one asset appreciates versus the other, the staker’s share of the staking will have less of the higher valued asset and more of the lower valued one.

There is also the question of whether more dependable returns are available elsewhere.

This time last year, UK government bonds (the safest form of investment) were offering little if any yield. Now with interest rates having risen and expected to rise further, a one year bond is returning more than 3% – comparable to the annual percentage yield offered by many DeFi schemes.

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