Decentralized platforms are to crypto finance what early hedge funds used to be to traditional finance. Swiss players like Swissquote aim to emerge as the regulated alternative in lending and staking. A comparison.
During the last two years, right after the Initial Coin Offering (ICO) craze, investors found yet another fad beyond just trading and holding cryptocurrencies. The game in crypto town has been yield farming, or earning passive income on coin lending and market making.
What we call Decentralized Finance (DeFi) has been mostly about lending digital currencies on speculative exchanges that pay interest. Accumulating yields on some DeFi lending app, or yield harvesting, took center stage next to the more basic spot and margin trading of coins at sometimes extreme leverage.
Blockchain apps that allow crypto asset holders to earn yields have grown exponentially. Signals of a dangerous hype in the sector became quite loud in August and September with the collapse of Shushi and Yam, two get-rich schemes that had been among DeFi’s star tokens.
«We are still at an early stage of a DeFi bubble», believes Chris Thomas, head of digital assets at Swissquote Bank. «The DeFi bubble is going to rebuild during the next months, and will eventually pop», adds Thomas. «Some average quality projects have received too much money, but the best projects should eventually survive.»
But what exactly is the craze about yield farming?
The point for cryptocurrency holders is to make their money work for them. With those decentralized protocols, all of them based on Ethereum, anyone can now earn passive income on their coins. In the past few months, we saw lending and market making activities taking off on protocols like Uniswap (the current leader), Aave, MakerDao or Compound.finance.
These platforms let users earn interest or borrow assets against collateral, or reward liquidity suppliers with continuously-compounding interest. As to lending coins, it happens when traders are not trading. They can store their coins in a wallet. The exchange will lend the deposits to other traders against interest. The rate can go from 1% to 30% per annum for bitcoin, depending if the wallet holder also actively uses his trading account on the same platform for margin trading. Staking yields (or interest earned on proof-of-stake based cryptocurrencies) can go as high as 100% on some staking platforms, depending on the coins staked.
According to the website DeFiPulse.com, the total value locked in the DeFi market shot up from $1 to 10 billion in just two months, from June to August, before adjusting in September to $8 billion.
In parallel, spot trading and margin trading also surged due to increased liquidity. Probably helped by the Covid-related general slowdown, over 3,5 million crypto wallet apps were downloaded in July 2020 alone, according to a report by Apptopia.
The number of active users saw a 110% increase between January 1st and August 19th. While spot trading is a promise to earn money only if coins appreciate, margin trading has developed in lockstep with interest-yielding activities because it makes it possible, even in a declining market, to make profits by shorting coins.
Another major feature of DeFi is leverage, or the ability for the trader to borrow and multiply his bet. «It enhances profits, especially in volatility stages, but also magnifies losses», says Swissquote’s Chris Thomas. The Scottish-born veteran in investing and crypto markets, who co-founded monito.com, estimates that leverage typically reaches 30 to 40x on some leveraged exchanges, while 10% of trading is even done at 100x leverage.
Costs are supposed to be low because of the absence of intermediaries, and security high, as platforms ensure security by using multiple signature access for all funds transferred from cold storage to hot wallets.
But that is not true. In reality, risks of hacking and bugs are permanent, as shown by the Yam protocol case, and of potentially fraudulent or dubious control transfer, as in the recent Shushi case. And costs shot up dramatically due to speculative hype and overbidding.
Yet another problem with DeFi is the absence of «Know Your Customer» (KYC) requirements, which some sites place on top of the list of user benefits. Registrations are done via email verification. No intermediaries, ID, or banking account required, which raises the risk of a high proportion of money laundering. «Start trading within a few minutes» is the typical promise.
«But you have to train several times on demos in order to ensure you really know how to use the platform and avoid transferring your coins to a wrong address. Because then, there is no customer support at hand: if you send your coins to the wrong address, they’re lost», warns Chris Thomas.
Today’s decentralized finance is a blend of speculative trading at the crossroads of Wild West shadow banking and computer-nerd coding. The fact that it is unregulated and with no call center support for you to turn to, tells that it is not for everyone.
Swissquote and other Swiss players like Bitcoin Suisse, Sygnum Bank and SEBA are emerging as regulated alternatives to DeFi. Bitcoin Suisse is not a bank but combines a compliant onboarding with expertise in staking, backed by «premium support».
SEBA and Sygnum don’t offer yield farming, but lend clients fiat loans to help them increase liquidity against crypto assets such as Bitcoin, Ethereum and XRP. Swissquote, hoping theirs will be the infrastructure of choice for institutional investors such as private banks and small banks, hedge funds, crypo funds or family offices, offers lending and staking on major coins, Bitcoin and proof of stake currencies. Investors can earn between 3,5% to 8% return per annum on their lending.
Sygnum has similarly built its own secure infrastructure. We’re seeing safe but centralized alternatives emerge to Binance, Kraken or Hitbtc.
Crypto funds and asset managers will also find a user-friendly environment with these asset managers, when non regulated DeFi exchanges are anything but user friendly. Intermediation here serves a purpose of selection of high quality projects.
The key selling proposition is risk-aversion, reputation and cleanliness. «FINMA’s guidance is one of the most stringent in the world and Swissquote implements those robust AML/ CTF processes», says Chris Thomas.
Swiss banks are also able to compete on price: fees are on a volume basis, so the larger the transactions, the lower the fees. Naturally, compliance and intermediation come at an added cost, which unregulated platforms do not have. High cybersecurity investments are also needed for centralized online intermediate platforms. «It is expensive to onboard clients. We are costlier upfront because of a higher standard than crypto exchanges», says Chris Thomas. «But the cheaper unregulated exchanges end up costing more when you have to multiply transfers from one exchange to another. At the end, it can be cheaper to stay within one ecosystem.»
All in all, Swiss players invest in protecting their brand by making sure every single customer is clean. «And we are also ready to give up revenues if we’re not totally sure about a client. It is a risk-reward treadeoff», says Swissquote’s Chris Thomas.
Similarly, Swissquote won’t offer leverage for its institutional products for just now. Some products sold through its platform do offer leverage (like ETF from 21Shares, Vontobel or Leonteq) but not the new crypto asset management service. «Imagine how prices plunge during a market liquidation event with such aggressive positions. When a trade goes sour, everyone passes on risk to others like a hot potato». But Chris Thomas isn’t an advocate of circuit-breakers and prefers price discovery: «At least in that respect, crypto markets are less manipulated than traditional financial markets.»
DeFi and regulated platforms don’t really overlap. Their clients are not on the same planet. To really make the most of DeFi, you have to be a mixture of an adventurer, a sophisticated trader and a computer programmer. It is fair to say that big institutions look for a different kind of service.