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October 6, 2020

Governance & Guardrails

DeFi 101 & BTC Shows Rare Ten Week Strength Above $10k

The cryptocurrency space has been fixated on the differences between decentralized finance (DeFi) and centralized finance (CeFi) lately. David Olsson, managing director of Europe and Asia at BlockFi, broke down those nuances in an interview with Teana Baker-Taylor. 

BlockFi, for instance, is a CeFi company with shareholders and generates yield that is then paid to retail clients by investing in a loan portfolio. The loan portfolio’s yield is based on factors such as the risk appetite, supply/demand dynamic in the borrowing and lending market and the competitive landscape. 

DeFi operates less like a bank and more like a building society in the UK or a credit union in the US, with the depositors or people contributing assets representing the shareholders. The yield in this segment is generated from their borrowing and lending activities, for example. The risk method is completely tied to computer software rather than having a human element. 

The way that DeFi yields are generated depends on the type of protocol. Olsson suggested thinking of the protocols like companies, with the tokens issued to the community representing the shares. He goes on to explain that the profits from the activities of the protocol is the yield that is then distributed to the token holders.

Yield farming is one of the buzz terms in the DeFi space, but for those investors who have yet to try it, they might not understand what it’s all about. BlockFi’s Olsson explained that it’s borrowing, lending or the leverage of assets across various DeFi pools. He compares it to having a savings account at a bank and then moving the funds to a different bank for a higher interest rate. 

“Farmers basically move their assets from one pool to the other to optimize the yield that they’re getting. Except that in the blockchain environment, this can be done much more quickly and much more efficiently because there’s low barriers, there’s anonymity and there’s speed of execution on the blockchain,” he explained. 

The below chart illustrates how the yield farming dynamic works.

Of course, the DeFi space is still a very young market, which means that investors are taking on some risks, one of which involves smart contracts where the protocol doesn’t function as it’s supposed to. Olsson explained,
“We saw, for example, Yam earlier in the summer spectacularly implode. And people lost a lot of value in that project. There could also be loopholes in the protocol code so that hackers can extract assets out of the pool.”
Leverage is another ongoing risk.
Another characteristic that the DeFi market has managed to create is hype, which Olsson says is comparable to that of the ICO boom.
“We thought we were on a trajectory of a more stable, more thoughtful evolution in the market and now we’re coming back to the frenzy. But some of them are very exciting projects. It’s still a retail dominated market. And we think there’s definitely, out of all of this, there will definitely be some decent projects and opportunities despite all the irrational exuberance.”

Onchain Reaction

All eyes are also on the bitcoin price. Philip Gradwell, chief economist at Chainalysis, shared that bitcoin’s average price has been above the $10,000 threshold for 10 straight weeks. He calls this performance “pretty extraordinary,” saying that this type of trend has only emerged two other times in bitcoin’s history. The first time it was able to achieve this type of performance was in late 2017, when it traded above $10K for 13 weeks, followed by a similar trend in mid to late 2019.

“So we are getting close to one of the longest periods where bitcoin has maintained this high price,” said Gradwell.

He also noted that bitcoin’s longer-term fundamentals have been strengthening recently. He points to the liquidity of bitcoin, saying that illiquid bitcoin represents BTC that is being retained in wallets, while liquid BTC keeps bitcoin in circulation. 
Most of the bitcoin is in liquid wallets, but Gradwell described a “steady increase in bitcoin that’s being held in these illiquid wallets, which are typically investment wallets.” On the other side of the spectrum, the amount of liquid bitcoin is on the decline, which means there are fewer BTC to buy.

While bitcoin’s liquidity is on the decline, Ethereum’s is increasingly on the rise, which is a function of the opportunities in the DeFi space

“The fortunes of Ethereum are increasingly tied up with the fortunes of DeFi,” Gradwell said.

Most of the Ethereum, however, is illiquid and hasn’t moved for a long time.

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