In today’s local interest rate environment, many investors have come across DeFi staking or cryptocurrency yield farming promising interest rates earned in the high single digits, double-digits, and even triple-digits.
Compared to the paltry interest rate earned in most mainstream asset classes, conventional wisdom would suggest that those rates are too good to be true.
DeFi, or decentralized finance, has become a new catchphrase to describe an industry within finance that relies on distributed ledger technology such as those used by cryptocurrencies.
DeFi is very broad, but it has become synonymous with a popular money-making method called yield-farming and staking. Those two terms describe different things, but both promise high interest rates on cryptocurrencies.
Staking is easier to describe. Early coins such as Bitcoin relied on a system called “proof of work” to validate transactions, a process that involved solving algorithms and using a tremendous amount of energy, which you no doubt have read about in the media. Later digital currencies are using a system called “proof of stake,” where holders of the coins delegate their tokens to a pool where validators work to confirm transactions and create new blocks.
And in turn, the validators earn a reward for their work.
Over the last few years, many of these validator “companies” cropped up and promised investors high interest rate rewards for the cryptocurrencies they deposit with the validator companies.
Investors who “stake” their digital assets with these companies are promised great returns—from 5 percent to 25 percent, and sometimes even more—and these returns are marketed as “passive income” on the digital currencies they “deposit” at these institutions, similar to interest earned on savings accounts.
This is where the narrative doesn’t always hold up and investors need to do their research. Some of these platform companies do validate crypto transactions and earn tokens for their efforts. Some of these companies take your deposits and lend them out to hedge funds and other institutions that may borrow the tokens in order to short them, in turn paying interest to the platform.
But do their business models support such high interest rates to be paid to the customers? It’s unclear what the spread or margins are on their activities. And if these companies go out of business or if the regulators such as the SEC shut down their businesses, how will investors be repaid?
There’s great risk in earning these promised returns, yet often their marketing slogans make these products appear very similar to interest earned on savings accounts. Their websites even compare their interest rates (very high) to prevailing interest rates on bank deposits (very low). Of course, none of the crypto assets deposited are insured by the Federal Deposit Insurance Corporation. So customers’ deposits are purely in the hands of these platform companies with little to no recourse should something go wrong.
A different strategy—yield farming—is even riskier.
This involves depositing your cryptocurrency (say, bitcoin or ether) with a startup platform and instead of earning interest in kind (i.e., interest in the form of bitcoin or ether), your earnings accrue in the form of a completely new token created by said platform.
And often, this platform has no discernible operating activities such as lending coins or validating proof of stake. Its only purpose is minting more of the newly created tokens.
In a recent Bloomberg Odd Lots podcast, billionaire FTX CEO Sam Bankman-Fried described this business model as someone creating a new box and declaring the box has value and then promoting the box attracting investors to this box, thereby creating more artificial value.
“Describe it this way ... that in like five minutes with an internet connection, you could create such a box and such a token, and that it should be worth like $180 or something market cap for that effort that you put into it. In the world that we’re in, if you do this, everyone’s gonna be like, ‘Ooh, box token. Maybe it’s cool. If you buy in box token,’ that’s gonna appear on Twitter and it’ll have a $20 million market cap,” he said.
“Maybe there haven’t been $20 million dollars that have flowed into it yet … but I acknowledge that it’s not totally clear that this thing should have a market cap, but empirically I claim it would have a market cap.”
In other words, the platform has value because of marketing and people claiming that it has value. And when it is promoted and there is marketing behind it, and more people send money into this platform, the hype around it generates a high market capitalization because people clamor for it. And therefore the newly minted token—whatever it may be called—also has “value” ascribed to it, and the box owner can continue to mint new tokens. Over time, the tokens gain some acceptance and can be traded on crypto exchanges, attracting even more attention and people send even more cryptocurrencies into the box in exchange for this new token.
Conceptually, this sounds awfully like a Ponzi scheme. The utility of this new box or platform is unclear, but its value—and the value associated with its tokens or currencies—is derived from hype and the marketing behind it. As more people buy into it, the more valuable it becomes.
Of course, it’s also rather easy for the creators of this new box or platform to create a utility. Write up a white paper or business plan or a solution to a potential problem and you have some good window-dressing for the box.
We’re not concluding that all such yield farming protocols are scams or Ponzi schemes. Some may ultimately have utility and a business purpose. But investors looking into such opportunities should keep in mind the old adage that if something sounds too good to be true, it usually is.
