The development of Bitcoin and thousands of other cryptocurrencies in a little over a decade has changed the definition of money — and spawned a parallel universe of alternative financial services, allowing crypto businesses to move into traditional banking territory.
Here’s what is happening in the fast-growing crypto finance industry, a sector that has officials in Washington sounding alarm bells.
What alternative banking services do crypto businesses offer?
Most notably, lending and borrowing. Investors can earn interest on their holdings of digital currencies — often a lot more than they could on cash deposits in a bank — or borrow with crypto as collateral to back a loan. Crypto loans generally involve no credit checks as transactions are backed by digital assets.
Who’s in this sector?
The market is quickly being flooded with businesses from the vaguely familiar to science-fiction-like entities. They run the gamut from BlockFi, which offers interest-bearing accounts like a bank and has state lender licenses, and Kraken Bank, which was granted a Wyoming bank charter and hopes to soon take retail deposits, to markets controlled by computer code and devised to be governed by users through a token distribution structure. Compound, a decentralized, automated lending and borrowing system began in 2018 and now has more than $18 billion in assets earning interest.
How do crypto offerings differ from bank services?
Superficially, some look similar. Take the BlockFi interest account, where consumers deposit cash or crypto and earn monthly interest, as if at a bank. But one big difference is the interest rate — depositors can earn a yield more than 100 times higher on BlockFi than on average bank accounts.
Those rewards come with risks. Deposits are not guaranteed by the Federal Deposit Insurance Corporation. “Cyberattacks, extreme market conditions, or other operational or technical difficulties” could lead to a temporary or permanent halt on withdrawals or transfers, the company cautions in fine print. Some regulators and lawmakers worry that those warnings are not prominent enough and that consumers need stronger protections.
What’s Decentralized Finance?
Decentralized finance is an emerging ecosystem of financial applications and protocols built on blockchain technology with programmable capabilities, such as ethereum and solana. The transactions get executed automatically through smart contracts on the blockchain, which includes the agreement of the deal.
“Anyone can actually build businesses on top of these protocols and using them the same way as we can today build an internet business on top of the HTTP IP protocol,” said Stani Kulechov, founder of a DeFi protocol called Aave.
Decentralized finance has captured only 5% of the crypto space, according to CoinGecko, but it has seen massive growth recently. There was $93 billion worth of DeFi assets in the crypto market as of June 2021, up from $4 billion just three years ago. To be sure, DeFi’s growth has slowed since the summer of 2020, and regulatory scrutiny from Capitol Hill has spiked over fears of crypto’s checkered past.
DeFi platforms are structured to become independent from their developers and backers over time and to ultimately be governed by a community of users whose power comes from holding the protocol’s tokens.
By comparison, centralized finance, or CeFi, businesses more closely resemble traditional finance, or TradFi, where consumers enter into an agreement with a company like BlockFi that collects information about them, requires them to turn over their crypto and also serves as a central point for regulators.