Fortune cover story: DeFi is taking over Wall Street

This article is sourced from Fortune magazine, authored by Robert Hackett, and translated by Hu Tao.

Today, Fortune magazine released a series of cover stories themed "Crypto vs. Wall Street," in which the author describes his personal experiences with DeFi products in the report titled "Crypto-Based DeFi is Taking Over Wall Street," investigates the impact of DeFi on traditional financial markets, and summarizes some responses from traditional financial institutions.

This summer, I took my first step toward becoming a "degen." This term—short for "degenerate gambler"—comes from the $1.5 trillion cryptocurrency world, where brazen speculators have embraced it as an endearing term. I stepped into one of the clubs, a "Pool" party hosted by a purely digital organization, which one day may gladly replace your bank.

The event is run by an application called "PoolTogether," a "no-loss lottery" project co-created two years ago by Leighton Cusack, who prefers another name for the game: a savings account tied to prizes. While traditional savings accounts pay meager interest to all depositors, PoolTogether often awards large prizes to a few winners.

As of the end of July, the total deposits in this app approached $200 million, with nearly $100,000 in prizes awarded weekly. While this makes PoolTogether sound a bit like a casino, most of its activities involve playing the role of a bank. This app can absorb deposits, lend, and pay interest.

But this is not a bank. There are no concrete arches, no tellers, and no managers. In fact, no single company controls this project. Remarkably, PoolTogether operates entirely on software. Cusack and a group of online collaborators quickly developed this application using open-source code and cryptocurrency, built a beautiful website, and launched it all. The program runs on Ethereum, a global computer network that collectively maintains a distributed ledger, through which interest and grand prizes are awarded weekly.

PoolTogether is a typical example of decentralized finance or DeFi, which is thriving in the volatile crypto economy. PoolTogether and similar projects are attracting a generation of tech-savvy tinkerers, early adopters of cryptocurrency, and out-of-the-box thinkers, who occasionally turn to another fundamentally independent financial system. In this system, they can borrow, lend, save, and insure according to rules they set themselves.

While not the largest DeFi project, PoolTogether's structure is emblematic of this emerging world. Those who deposit assets earn loyalty points in the form of tokens, allowing them to vote on the direction of PoolTogether. Over time, savers accumulate more project tokens, even if they never win a lottery draw.

People can sell these tokens on cryptocurrency exchanges to make a profit, which is another incentive to participate. (When I got involved, a token was trading at about $10, down from a high of $32 in March.)

This is a fully crypto world: in almost all DeFi projects, deposits and earnings are denominated in cryptocurrency rather than fiat currency. Additionally, it is important to note that assets are not covered by the federal insurance system that protects "normal" accounts.

As a largely unregulated economic sector, DeFi has exploded with the demand for cryptocurrencies like BTC and ETH. Most trading activity occurs on Ethereum, the second-largest crypto network, whose blockchain comes with a built-in programming language called Solidity, making it easy to build so-called decentralized applications. Currently, the users of this ecosystem are primarily those who are satisfied and enthusiastic about cryptocurrency—despite the risks and legal uncertainties.

But this state of isolation may not last. DeFi represents a coordinated crowdsourced effort aimed at making digital tokens work, providing people with financial reasons to hold tokens rather than merely speculate on price movements. One of the earliest major investors in the crypto market, Olaf Carlson-Wee, states that cryptocurrency "will ultimately be more than just a new gold or a new currency." He believes DeFi has "earth-shattering importance," adding, "It's not just about assets; it's about all financial tools."

And this fact may, in turn, pave the way for mainstream consumers. In the not-so-distant future, it is expected that the Federal Reserve will decide whether to mint a digital dollar itself or have the private sector support such issuance. Both initiatives could open blockchain-based services to the public, and the ever-evolving DeFi infrastructure today may shape a new financial order.

This possibility is attracting more and more established financial firms to venture into the DeFi space. Initially just a plaything—fans refer to DeFi tools as "money Legos" because they are easy to assemble—it is now pulling the broader business world into its orbit. In this massive wealth reorganization, the nerds have taken the lead. They are trading in Brooks Brothers suits for blockchain. Software is finally starting to eat finance.

DeFi uses blockchain as a slingshot, hurling stones at the giants of Wall Street. The promise of this technology has always been to lower transaction costs, increase efficiency, and create fairness by replacing intermediaries with a shared, instantly updated distributed ledger that anyone can monitor.

While banks have office hours and observe holidays, DeFi never sleeps. Institutions use paperwork and committees to make decisions, while DeFi relies on algorithms. While "OldFi" wire transfers and stock trade settlements can take days, Ethereum-based transactions are relatively instant, typically taking about five minutes to finalize.

"It’s fast, open, permissionless, and transparent," says Mike Novogratz. He was previously a hedge fund investor and now runs a crypto investment and financial services company called Galaxy Digital. He states that fewer intermediaries also mean less systemic risk. "If we could look at the information shared on the blockchain and see Bear Stearns' mortgage risk exposure, we wouldn't have had the mortgage crisis in 2007."

For every traditional centralized financial product, there is a DeFi version related to cryptocurrency that has either been launched or is in development. New to the crypto market? Buy some tokens on the decentralized exchange Uniswap. Need to borrow money? Check out AAVE's "flash loans." Insurance? Nexus Mutual has your coverage plan. Want high-yield savings? Utilize Compound lending, one of the lending protocols PoolTogether relies on.

At the center of these operations, there is no JPMorgan chase, nor is there a Nasdaq. It’s all just code. A community of software developers and token holders—those who possess virtual tokens distributed by various crypto projects—operates the show. Aave's legal advisor, Rebecca Rettig, states that the promise of DeFi is "to give individuals autonomy over their financial situations."

DeFi is still largely experiencing growing pains, especially since it is built on the foundation of cryptocurrency, which is notoriously volatile in price. The total value locked in DeFi projects peaked at $90 billion in May, then plummeted as cryptocurrency prices crashed.

Nevertheless, as of late July, the total deposits in these blockchain-based projects exceeded $60 billion, compared to less than $1 billion at the beginning of 2020. If all DeFi applications were considered a bank, based on managed assets, it would rank among the top 50 in the U.S.

It is difficult to say exactly how many people are participating in DeFi activities. Creating a blockchain wallet is a passport to any project, requiring no identification (a feature that has shocked many regulators), and many users have multiple wallets. Nonetheless, according to Dune Analytics, the number of wallets interacting with DeFi protocols has soared from nearly 300,000 to over 3 million in the past year. Crypto wallet provider MetaMask reported over 8 million active wallets globally in July.

Brian Brooks, CEO of the cryptocurrency exchange Binance.US, states that given how much capital DeFi has attracted from hedge funds, deep-pocketed investors, and retail enthusiasts, "it can no longer be ignored." Brooks, who served as the top bank regulator in the U.S. during President Trump's last year in office, believes that the impact of blockchain applications on banks and brokers will be akin to the impact of the internet and Amazon on brick-and-mortar retailers—forcing them to either compete in a new tech-driven game or perish.

"This raises the question of whether we really need these institutions to perform these intermediary functions," Brooks says. "If I were the CEO of a major bank, I would be worried."

If the CEOs of big banks are worried, they aren't saying so publicly. But established institutions are beginning to explore DeFi—assuming that younger customers are satisfied with both crypto and application-driven financial services and will eventually demand it. Fintech companies have already believed in the call to come. In a blog post in June, Brian Armstrong, CEO of the largest cryptocurrency exchange Coinbase, wrote, "The products that crypto users are using today will be used by mainstream customers in a year and by institutions in a few years." Payment giant Square announced in July that it is building a DeFi business focused on Bitcoin. PayPal CEO Dan Schulman stated, "We are in the midst of a major transformation." The time is ripe for modernizing the financial system using crypto technology.

Old conservatives are also getting in on the action. Companies like JPMorgan, Wells Fargo, and Goldman Sachs have hedged against a potentially bankless future by injecting millions into crypto startups. Visa, a giant of the credit card era, has partnered with one of the latest federally chartered banks, Anchorage, to accept commercial payments made with privately issued digital tokens, such as dollar tokens pegged to the U.S. dollar. Companies may begin to increasingly engage in reverse transactions with such portals, even if their own businesses are entirely settled in dollars.

Diogo Monica, co-founder and president of Anchorage, states that banks "want to build relationships with these millennials, who are about to inherit trillions of dollars from the baby boomer generation… This age group has a significant distrust of these traditional, centralized financial institutions." He concludes that banks will have no choice but to understand the law: "It's just a matter of how, when, and where they enter."

In dollar value, P2P lending accounts for about half of the DeFi market. It also drives one of its most enticing selling points: offering higher yields to depositors whose funds are converted into loans. DeFi interest comes from a combination of nominal accrued income and passive loan income, which can reach double-digit percentages. Even single-digit yields exceed the national average interest rate for traditional savings accounts, which is just 0.06% per bank.

Stuart Sopp, CEO of Current Bank, tells Fortune that his business plan aims to achieve higher yields by integrating Compound's business. For Sopp, this is a straightforward decision, unrelated to the crypto wave, but entirely about mathematics. "Money is profit-driven," he says. "It will go where the returns are best. If you can get a 5% yield, and it's relatively safe, then the funds will shift."

However, the mechanics behind these debt yields are somewhat convoluted. The astonishing rates are primarily due to banks' risk aversion, technological lag, and regulatory concerns regarding cryptocurrency. To a large extent, banks do not extend credit to cryptocurrency borrowers. Even Bitcoin billionaires struggle to use digital tokens as collateral. This creates an imbalance of supply and demand—especially considering that many crypto "whales" are eager to leverage more cryptocurrency.

Behind the scenes, new wealth, including crypto-friendly hedge funds, pays a premium to obtain loans from DeFi protocols like Compound and Aave, as well as specialized lending institutions like BlockFi and Celsius, which direct those loans toward DeFi projects for liquidity. For borrowers, paying relatively high interest—such as 10%—is far better than selling crypto assets and facing a 37% or higher short-term capital gains tax hit. Meanwhile, high-interest loans mean that depositors' returns are far above normal levels.

Here lies a paradox. As cryptocurrency and DeFi mature, such high yields may not last: as banks become more comfortable with digital token assets, crypto investors will find it easier to borrow at lower rates. Meanwhile, in a world where "yield farmers" rapidly act to seek the highest returns, there are no risk-free rewards. In the crypto world, fast-moving funds can mean significant price volatility for tokens.

Advertisements promising super high yields from bad loans are not uncommon, often driven by supply and demand dynamics and frenzied price speculation. A project called Iron Finance showed astonishing returns this year. But on June 16, the token TITAN mysteriously collapsed within 16 hours, plummeting from $64 to nearly zero. Iron Finance claimed it was a victim of "the world's first large-scale cryptocurrency bank run," blaming whales for initiating mass withdrawals. However, chat forums like Reddit, Telegram, and Discord were rife with accusations of foul play.

Cryptocurrency and misconduct are no strangers: according to blockchain analytics firm CipherTrace, $6.5 billion was lost to cryptocurrency-related fraud and cybercrime from 2019 to April 2021. Massachusetts Democratic Senator Elizabeth Warren referred to cryptocurrency as "the wild west of investing," telling Fortune that the risks are amplified when it comes to DeFi. "There, anonymous developers can deceive investors through scams like rug pulls without transparency or accountability."

In a community that uses decentralization as a philosophical pillar, accountability is a significant issue that needs to be addressed. As early as 2019, Compound co-founder Robert Leshner often woke up in a cold sweat, worrying about his responsibilities. If there was a bug in the code, could he and his team cover the losses? "I was afraid to leave the house because I thought someone would kidnap me and try to steal all the money in the yard," Leshner told Fortune.

Leshner's solution was akin to retirement. His team created a governance token, Comp, and handed control of the protocol over to the Compound community, to those who earn and hold COMP tokens. Now it is collective responsibility.

For most DeFi projects, Compound's model is standard: the basic unit is not a registered company but a DAO, or decentralized autonomous organization. What these projects have in common is that no one is in charge, or rather, everyone is responsible to varying degrees. Each token holder has the right to vote on governance decisions for the protocol, such as updating code, setting parameters related to interest rate calculations, or providing funding to developers to build new features.

In practice, it is often full-time enthusiasts and institutional investors who participate in most voting, rather than ordinary users. In any case, they share a common goal: as more people use the protocol, the digital tokens behind the protocol become more valuable. The idea is that by building a better project, everyone involved will become wealthier.

However, these tokens themselves also carry risks. Their volatility increases the risk of any DeFi project: if your cryptocurrency earns you 9% interest but the value of your principal drops by 75%, you are not a winner.

There is also an unresolved legal question about whether tokens are just another name for securities. The U.S. Securities and Exchange Commission has made determinations in several instances that this is the case. Ripple and its executives were sued by the SEC for allegedly selling unregistered securities in the form of the XRP digital token. The same logic, if applied to DeFi, could significantly alter how it operates.

"I think the fall of 2021 will be very similar to the regulatory investigations we received in 2017 and 2018, when a large number of information requests and subpoenas were sent from the SEC to early crypto innovators," says Michelle Gitlitz, head of blockchain practice at Crowell & Moring law firm. People may have done their best to comply with the law, while the government and regulators may fundamentally disagree.

Meanwhile, DeFi pioneers continue to experiment in an atmosphere where technological maturity meets "degen."

When I deposited 15 DAI (a token pegged to the dollar) into the PoolTogether fund pool to participate in the lottery, digital confetti and rainbow streamers fell like raindrops on the screen in celebration. I was alongside $35 million in other deposits. I had a 1 in 468,660 chance of being one of the five winners sharing $25,000.

While I waited for the results, I joined a Discord community call, a chat application that many DeFi projects use as a virtual headquarters. PoolTogether's Discord group has nearly 6,000 members, and dozens were on the call that day. At one point, the conversation turned to marketing efforts. Collaborators were looking for a way to explain to ordinary users why they should invest their "baby boomer money" into PoolTogether. A participant using the pseudonym Oops explained that he was trying to convince his father of the benefits of DeFi savings. "I’m trying to persuade him to change some things," Oops said.

As the chat continued, I checked the lottery. A message popped up on the website: "Uh-oh! An error has occurred, and we have been notified." The note read, "Don't worry! Your funds are safe; it's just a user interface issue."

Back in the call, someone asked if Oops's dad had been convinced. "I need to educate myself further," the father said skeptically.

As for me? When I checked back later, I knew I hadn't won. But it was still too early, and maybe next time I would get lucky.