CWC Newsletter #15 (February 24, 2020)
By Taylor Ryker, Analyst
Decentralized Finance: What is it and How do Cryptos Fit in it?
What is decentralized finance? And how are cryptocurrencies implicated in this new financial trend? This is an important issue because last week saw the first true stress test (i.e. hack) of the value proposition of decentralized finance on the second largest cryptocurrency network by marketcap, Ethereum.
Decentralized finance is a financial system that is not reliant on a single financial authority, such as the traditional banking system, Wall Street, and the Federal Reserve. Centralized finance and legacy financial systems are prone to hacks, which erodes trust and confidence of the public. Capital One and Equifax hacks have demonstrated the pain points in the centralized status quo.
Blockchain technologies, which underpin cryptocurrencies, are ripe to support and develop decentralized finance. One key asset of blockchain technologies is the value of decentralization. For example, bitcoin's decentralized protocol allows for no one entity to control the network. Decentralization allows the elimination of middlemen or in the case of financial markets, banking institutions. In short, the user is in control of their financial assets and do not have to rely on financial institutions.
Cryptocurrencies' decentralized finance allows the unlinking of financial capital from traditional financial institutions. Users and investors are able to provide other users with p2p loans, collateral, credit, rental interests, and trading leverage.
Many smart contract blockchain protocols, such as Ethereum, EOS, Tezos, and Tron, are competing to provide the best experience and financial products within decentralized finance. Developers are currently attempting to find the most optimal way to tokenize digital and physical assets. Although the space of decentralized finance is growing within the larger cryptocurrency, not everything is rosy and safe.
Hacking Decentralized Finance on Ethereum
On February 14, 2020 and February 18, 2020, a decentralized lending platform bZx experienced two successful hacks that totaled a loss of around $954,000. bZx is the 7th largest decentralized financial platform on the Ethereum network. The hack exposed the fragility and illiquidity in the current landscape of decentralized finance on Ethereum. For a more in-depth analysis of what happened, click here.
This is alarming because Ethereum's decentralized financial ecosystem is by far the largest of any other cryptocurrency network. Within Ethereum's decentralized financial sector, Decentralized Autonomous Organizations (DAO) are at the heart of the matter. DAOs are organizations that are entrusted by computer code to be transparent, controlled by stakeholders and not controlled by central governments or institutions.
The strength of a DAO is that no one entity can control or dictate the direction of the DAO. However, many DAOs on Ethereum have revealed that they are truly not really decentralized because the team behind bZx was able to unilaterally pause the network to patch up the vulnerable code. Pundits have shown the perils of centralization within cryptocurrencies.
MakerDAO, the largest decentralized financial DAO on the Ethereum network, also experienced a potential hack in December 2019. A developer discovered a big loophole that could steal all of the Ethereum in MakerDAO, which amounted to $300 million.
MakerDAO was susceptible to another hack of $700 million on Thursday February 20, 2020 where a developer found a glaring loophole that prompted MakerDAO coders to write a fix in 24-hours.
This indicates that Ethereum's decentralized financial products are not ready for primetime. If I were Wall Street, I would take another hard look at other protocols that provide better security for digitized assets and collateralized loans.
A potential consequence of the hack of bZx would be heavier regulations to protect investors from the lost of their funds. Last week, Treasury Secretary Steven Mnuchin announced that they would release cryptocurrency regulations in the coming weeks to prevent money laundering. With the US government ramping up on crypto regulations, I can foresee the U.S. Securities and Exchange Commission (SEC) also implementing more regulations on decentralized financial products in order to prevent another bZx-type hack. Stricter US regulations would be great for investors but would be detrimental to innovation and competition.
Other Cryptocurrencies and Decentralized Finance
Looking to other cryptocurrency protocols that provide decentralized financial products, staking is one way that investors are profiting. With the advent of Proof of Stake (PoS), an evolution to Bitcoin and Ethereum's Proof of Work (PoW), investors are able to make money by helping to secure the network.
Tezos's protocol grants users and investors to stake their Tezos cryptocurrency for an interest rate. Similar to government bonds, Tezos users lend their coins to the network and in return receive a timely payout in Tezos cryptocurrency. Currently, the Tezos staking APR is 5.79% as of February 19, 2020.
On the EOS mainnet, decentralized finance can be found on leasing platforms and decentralized exchanges. Chintai, Resource Exchange (REX), and Newdex are a few of the leading decentralized applications that facilitate users to rent, buy, and sell digital assets.
REX and Chintai are both decentralized leasing platforms that allow users and developers to obtain EOSIO-based cryptocurrencies to aid in decentralized application development and to use the network. Currently, REX has a EOS-leasing market worth $270 million and pays out an APR of 0.5%.
Newdex is a decentralized exchange where users are able to trade cryptos with others without the need of a central authority to match orders. The exchange currently allows users to trade cryptos primarily on the EOS mainnet and EOSIO-based sisterchains, such as Telos, BOS, Meet.One, Lynx, and Wax.
A couple of sisterchains of the EOS mainnet are specifically geared towards a decentralized marketplace of digital assets, such as Wax and Ultra. Both Wax and Ultra are bridging the multibillion-dollar gaming industry with cryptocurrencies and blockchain technologies.
Wax, which uses a similar source code to the EOS mainnet with some modifications, is growing into a leading marketplace for digital assets. Due to the high costs to conduct business on the EOS mainnet, gaming developers have been drawn to the lower-costs on Wax. On the Wax marketplace, users are able to buy, sell, and rent digital assets for online games with each other.
Popular online game, Counter-Strike Global Offensive (CS:GO), uses the Wax platform to trade CS:GO digital assets, such as skins, guns, and accessories. With an active global user base of around 18 million, CS:GO is one of the most widely-played online games in the world. This exposure to Wax and blockchain technologies makes it easier for larger adoption by different other gaming communities due to the fact that Steam, a video game distributor, banned other trading platforms.
Competing with Wax is another EOSIO-based blockchain called Ultra. With a developer team consisting of seasoned veterans from Blizzard Entertainment and other well-known gaming studios, Ultra is poised to disrupt the online gaming industry. Recently, Ubisoft and AMD partnered with Ultra to support its gaming network, and these large corporation-sponsorships indicate growing support by the gaming industry.
These developments reveal that the decentralized finance space is not solely exclusive to the Ethereum network and it would be wise to take a hard look at other blockchain platforms that may have the potential to address Ethereum's shortcomings and provide a more superior product and experience.
Future of Decentralized Finance
Although the hack of bZx was an unfortunate event, the decentralized finance space within cryptocurrencies is still very young and new. There will be undoubtedly more hacks in the future, but I have hope that blockchain developers will find solutions.
In the future, I see a bigger push to decentralize other financial products and instruments. Tokenizing real estate is a promising area that could possibly unlock more liquidity in the real estate industry while allowing average users the ability to own equity in reasonable-size real estate investments. By owning a small holding of real estate tokens, a user could hypothetically receive a stream of rental revenue and have the option to trade those tokens on a secondary market.
Finally, Ethereum's current hiccup with decentralized finance is not a zero-sum game; rather, the entire blockchain space benefits when competing platforms are able to grow, evolve, and expand concurrently with each other. Decentralized finance is still a nascent industry that has the potential to have a market cap worth in the trillions of US dollars. I remain optimistic about this future and gladly welcome it. And I hope you do too.
Disclaimer: KJ Kingsley is not a financial advisor and holds the digital tokens or cryptocurrencies represented in the content above. This content is for informational purposes only, you should not construe any such information or other material as legal, tax, investment, financial, or other advice. Nothing contained in this post constitutes a solicitation, recommendation, endorsement, or offer by myself to buy or sell any securities or other financial instruments in this or in any other jurisdiction in which such solicitation or offer would be unlawful under the securities laws of such jurisdiction. The opinions expressed in this publication are those of the author. They do not purport to reflect the opinions or views of any of the author’s employers.