[Part 2] Why DeFi is not a Ponzi Scheme

We previously saw four specific places DeFi yields are coming from. Here’s now the more interesting (multi)-trillion dollar question - what’s underpinning the entire DeFi ecosystem as a whole? 

On What’s Driving DeFi 

Driving DeFi is the amount of activity in the crypto ecosystem. There are two places activity comes from - 

1. New participants joining crypto (institutions, unbanked, retail, miners, etc.) 

2. Solving problems for people 

The first point is obvious - as more people participate in DeFi protocols, it increases overall demand and liquidity. And we see this playing out by just looking at the exponential growth in active addresses interacting with DeFi projects - 

The second point is more subtle. As you solve more problems, you make the pie grow bigger and create wealth. As PG writes - 

“What leads people astray here is the abstraction of money. Money is not wealth. It's just something we use to move wealth around. So although there may be, in certain specific moments (like your family, this month) a fixed amount of money available to trade with other people for things you want, there is not a fixed amount of wealth in the world. You can make more wealth.

[...] Suppose you own a beat-up old car. Instead of sitting on your butt next summer, you could spend the time restoring your car to pristine condition. In doing so you create wealth. The world is-- and you specifically are-- one pristine old car the richer. And not just in some metaphorical way. If you sell your car, you'll get more for it.

While DeFi on the surface looks like just money being moved around, if it solves real problems for people, it is actually creating long term value. 

What problems does DeFi solve? There are a few straightforward ones when looking at financial systems - 

• Inefficiency - Banks and financial institutions spend billions on opex (ex. BoA spent $53 billion on SG&A and occupancy/equipment in 2020). Well written protocols and decentralized trust can increase efficiency and collapse this number 

• Permissioned access - For better or for worse, anyone can create financial products and a whole market for it without asking the SEC

• Opacity - Instead of using paper/hidden digital ledgers, open source contracts lets one easily follow money flow through code and transactions 

• Access  - Turns out the world is very big and lots of people are either locked out from traditional financial institutions or their preexisting ones just really suck. 

We can get even more granular and look at problem sets being solved now for those who are crypto native and underbanked. 

For example, many newly-rich crypto whales want to have spending money without selling their assets. The solution that has emerged is borrowing stablecoins on platforms like Aave using ETH or other crypto assets as a collateral (not unlike how founders/homeowners borrow against their stock/home). Other problems being solved for crypto native folks tend to be more of the entertainment/speculation variety. Which is okay! Casinos, horse racing, and Netflix exist in the normal world for similar reasons. 

We’re also starting to see problems being solved for those in the “real world” too with DeFi liquidity and rails as the solution. As yields dry up in traditional areas, people are searching for new places to put their money to work - a massive problem in itself. And this is not just hedge funds or asset managers, but normal people too (and institutions serving the average person) - if you were retired and planning on relying on a 2-5% rate to provide cash flow to pay for things, you’re kind of screwed if those rates drop to zero. Similarly, if you’re in a place with very high interest rates because of poor infrastructure (looking at you Brazil), you may look longingly at the amount of liquidity available in DeFi projects. 

The solution set for this class of problems is starting to emerge. Eco is a new bank/currency with 10x higher rates, and Goldfinch is giving loans to companies in emerging countries who would have to pay incredibly high rates otherwise. While both of these projects are built on DeFi rails/liquidity and have a strong crypto community behind them, they are also helping people who don’t care about crypto at all and just want their problems solved (higher yield and lower costs of capital respectively). 

On Regulation

A cynical take - that I actually agree with parts of - is that DeFi is just regulatory arbitrage. 

Isn’t it great that I can go and trade my entire life savings on an anonymous decentralized exchange (DEX) with no KYC requirements, accreditation rules, or consumer protection guardrails whatsoever? 

And as a builder, I can build this DEX and not have to read Section 6 of the Securities Exchange Act of 1934 and go through a multi-million dollar process over a decade with the hopes of being just the 15th national security exchange in 90 years. I can just fork Uniswap on Github, choose a sick name like ParthSwap, and launch1 🤓

Of course this is not always good - regulations were invented in the first place to make things more stable and reliable, and usually come because someone in the past screwed things up. But sometimes too much regulation can stifle innovation and lead to inefficiency. 

And so then predictably, when you deregulate a market - whether it’s airlines, banks, telehealth etc. - you have a Cambrian explosion of competition and innovation as the full force of capitalism takes place. This is essentially what’s happening in DeFi right now because regulation is so tricky to both create and enforce in a decentralized ecosystem. There is a fine balance to be maintained. 

So is some of the growth and value of DeFi just coming from what I’m calling “unregulated deregulation”? Absolutely, and it’s also true that regulators will eventually (try) to crack down. But I personally don’t think this regulatory arb is (a) entirely bad and (b) where most of the value is truly coming from anyways. Instead, as mentioned above, I think it’s primarily driven from new entrants and solving problems.  

What DeFi Needs To Do Next 

What really helped click it all for me is listening to Su Zhu and Hasu talk about the topic of DeFi yields (and inspire these posts). They mention how in traditional finance, profits are earned through peer-to-peer interactions. I deposit money into a bank, which is then lent out to someone trying to do something, who then pays it back. The value (or wealth) generated in the exchange is split three ways - some for the bank, some for me as the lender, and some for the borrower who now could do what he or she wanted to do with the funds (and usually earlier than saving for it). The underpinnings of finance relies on peer-to-peer interaction. 

The natural question then becomes, where is the next set of P2P interactions going to come from? 

If we look at DeFi right now, most of the goals have been towards getting liquidity into the ecosystem with new participants, increasing TVL, frictionless exchanges, etc. That’s where a lot of the infrastructure and energy is going towards - facilitating the initial P2P interactions among financial actors - and I can understand why it can sometimes look like yield-chasing MLM schemes in the process (and many times it truly is just that!). But having this core infrastructure is necessary for what comes next. 

I believe (and hope) that the next big unlock will come from redirecting the global DeFi liquidity into productive projects around the world and solve a different class of problems for a broader user base. 

As long as DeFi continues to solve problems, long term value will be created, and the natural next step is to take what has been (and being) built and apply it to new areas for new sets of users. 

We’re seeing the signs of this already and I for one am excited for even more projects to be created over the next decade that take advantage of this. Let the roaring 20s begin 💥

Share

Special thanks to Rob, Kenton, Nikhil, Rahul, Tyler, and Vishnu, for reviewing the post and providing their feedback! Also to Su Zhu & Hasu for their podcast talking about DeFi yields which got the wheels turning.

If you have comments/want to chat more, feel free to DM me on twitter or shoot me an email - would love to hear from you :)