After exploring the world of traditional finance in our recent piece, we now understand lending, securitization, interest rates, and the markets that arise around tradable assets. It's time to dip our toes into some of the newer innovations in the world of finance.
As we established, traditional finance centers on large institutions that are supremely well capitalized. We saw that some of the largest banks in the world have more than one trillion dollars on their balance sheets. All of this money is rabidly searching for returns in any place it can find. The search for returns has become so desperate that we're seeing record amounts of negative yielding debt instruments.
This is where the new world of decentralized money and its friction-less payment rails comes into play. There has been a surge in something called "decentralized finance" (DeFI) over the past few months. DeFi exists in contrast to "centralized finance" (CeFi), which is the term that encapsulates any money transfers that take place through a centralized institution. Centralized financial institutions look like brokerages, exchanges, and banks. CeFi is another term for these entities in "traditional finance".
In CeFi, I deposit my money into a bank savings account and earn interest on that money over time. Or I take out a mortgage from the bank, and then slowly make payments over the next 30 years. If I want to buy stock in Apple Inc., I'll need go through a brokerage which can purchase and custody the shares for me. Some would argue that the worst aspect of CeFi is the draconian regulation. Take a look at how much regulatory compliance wastes each year, they say. When you do, you see that compliance costs large financial firms $200+ million per year. Do the benefits of such an extensive compliance system outweigh that cost? When applying that cost on a per employee basis, it comes out to be around $10,000. In other words, employees of financial institutions could be making an extra $10,000 per annum in a hypothetical world of fewer financial regulatory burdens.
But much more than the regulatory concerns, one might argue that it's the archaic technology of CeFi that's the real problem. SWIFT is the inter-bank pipeline that's used by financial institutions to settle payments in CeFi today. SWIFT was voted on in Brussels, and implemented across the West in 1973. From SWIFT's website:
SWIFT remains a truly global cooperative. Forty years on, the SWIFT community is stronger than ever before. Our global and neutral character is reflected in our increasingly international governance and oversight, including the SWIFT Oversight Forum. New offices continue to expand our global presence, bringing us closer to our users and underpinning our ambitious growth strategy. In 2014 SWIFT launched our first ever truly local joint venture (SWIFT India), delivering the benefits of our renowned financial messaging services for domestic traffic of our Indian user community. More than ever before SWIFT is creating value. SWIFT continues to lead in innovation, entering the real-time payments market with Australia’s New Payments Platform and pursuing new digital opportunities. We continue to reduce the cost of business for our users – for instance by reducing FIN messaging prices by 50% between 2010 and 2015. Meanwhile, we consistently exceed 99.99% availability for our FIN and SWIFTNet services.
This is a 47 year old technology that was implemented a decade before ARPANET adopted TCP/IP. In other words, SWIFT is a pre-internet solution to bank settlements. And it shows. Strict KYC, fees, molasses innovation, and 3-5 day settlement times are all features of such an outdated system - yet this isn't an indictment of SWIFT. You'd expect a generation-old technology to struggle in keeping up with the front runners of 2020 tech.
With the rise of cryptocurrency, some new CeFi firms have popped up to service the new markets. Larger and larger market participants are looking to make complicated bets on cryptocurrencies. Shorting a crypto asset, for example, requires significant liquidity. When markets are tiny, pools of liquidity are expensive.
To illustrate: If I'm a big institution that wants to make a bet that the price of Ethereum will be lower next month than it is today, I would express that opinion by "shorting" ETH. To short ETH, I need to find someone who is willing to lend me ETH today, sell that ETH that I've been lent, wait a month, and then buy the ETH back at a lower market rate and give the ETH back to its original owner. Just like the lender in the potato farmer example, the lender in this ETH example won't be willing to part ways with her coins for free. The institution borrowing her coins must pay for the amount of time that it's tying up the lenders ETH.
So let's say the institution borrows 100 ETH from the lender, and agrees to pay 1 ETH per month in return for the right to use that ETH. The institution will now sell the 100 ETH at whatever the prevailing market rate currently is, let's say $100/ETH. Now the institution has 10,000 USD instead of 100 ETH. It waits one month for its investment thesis to play out, at which point the price of ETH has now become $50. The institution uses the $10,000 it had from the original sale of its borrowed ETH to buy back 101 ETH. Remember it had to pay interest not in USD terms, but rather in ETH terms. At the conclusion of this transaction, the firm has sold 100 ETH for a total of $10,000 and bought 101 ETH for a total of $5,050: a profit of $4,950! The lender has also profited in terms of her base asset, earning 1 extra ETH over the course of the month.
Since there are still so few lenders of crypto assets, crypto lending markets are sometimes described as "illiquid" or "shallow". Any large influx of investors who desire to borrow crypto assets in order to go short (like in the example above) will immediately create a bidding war for the right to borrow the limited ETH available to lend. Think about it like this - if there were 10 institutions all trying to borrow the 100 ETH in our example, the lender could now charge 5 or 10 ETH for the month and still find one taker.
These are the market dynamics that have played out on CeFi crypto lending platforms like NEXO, BlockFi, and CoinLoan. Lots of people want to borrow crypto assets, and very few people are willing to lend their crypto assets, which is a mismatch that leads to interest rates in the range of 6% per year on BTC and ETH.
Borrowers are bidding the price of crypto assets over time (interest rates) higher so that more lenders will be drawn into the market. A slightly different underlying dynamic exists for stable coin lending markets, but suffice to say that there's even less supply of the crypto assets in those realms. Lenders of stable coins can earn upwards of 10% per year.
Although the crypto asset class remains trivial in size relative to real markets in global finance, it increasingly draws interest from the institutional world. As long as this trend continues, traditional companies will meander into providing things like crypto brokerages and high interest lending platforms.
If IOTA is able to implement a functional Coordicide, secure standardization, and ramp up industry utilization of the protocol, the IOTA token starts to become a compelling financial asset in the same vein as BTC and ETH. The new UTXO and signature scheme change will make it easy for exchanges and lending platforms to integrate a final-stage IOTA, ushering in a new era of IOTA liquidity access. There might soon be a day when you'll be able to earn 8% on your IOTA deposited in NEXO.