Crypto finally has a reason to exist

I have news from the world of cryptocurrency: After many years of doubt and uncertainty, a killer app has finally been found. That's why crypto prices, in spite of numerous plunges, have remained much higher than many skeptics expected.

The core use case for crypto is called DeFi, a recently coined abbreviation for "decentralized finance." DeFi doesn't have a formal definition, but it typically includes the use of the blockchain to borrow and lend using auction markets; to trade in unconventional derivatives; to trade one set of crypto assets against another; and for unusual forms of insurance. The profit opportunities arise in part because the blockchain eliminates the need for traditional financial intermediaries, with their fees and associated regulations.

An example: Say you have some money to invest, but government bond rates are too low and you already have plenty invested in publicly traded stocks. You might allocate some of your portfolio to the loan auction markets built on Ethereum, in essence tossing some crypto into the market and seeing at what price it will be lent out. You could end up with yields of 6% or more, though some of these opportunities are very risky.

There could be $100 billion invested in DeFi right now. More important, these systems are growing rapidly. Reliable numbers are difficult to come by, but by one account DeFi grew sevenfold in just a few months in 2020, to a total value of $7 billion. It's not surprising that investors would find DeFi attractive, especially in a world of low yields and pricey assets. Think of them as decentralized markets in a very junky form of junk bonds.

To be clear: I am not arguing that these uses of DeFi are socially beneficial. It is simply too early to say. One criticism of DeFi is that it is effectively regulatory arbitrage, bypassing useful laws and restrictions in the quest for higher private gain. The longer-run result could be a financial economy more fragile and more vulnerable to conditions of recession, especially as DeFi attains larger scale. DeFi loans often go to non-mainstream borrowers of uncertain quality.

But it's also important not to confuse different criticisms of crypto — that it's useful only for speculation, for example, or that it's bad for the environment. The crucial thing is not to let your attitude toward crypto (positive or negative) affect your analysis. Instead, focus on answering one question at a time.

And if the question is whether crypto is good for anything, there is now at least one clear answer: Crypto enables DeFi. You don't have to like every consequence of that reality, but a reality it is.

You could say that crypto is a Trojan horse of a new and quite different financial system. If you have ever dealt with U.S. banks, and suffered through their bureaucracy and mediocre software, you might conclude that they are ripe for disruption. Banks in other countries may be even more vulnerable.

Tyler Cowen. Illustration: TBS

Obviously, as DeFi grows, questions of government oversight and control will come to the fore. Still, it seems unlikely that DeFi institutions will be regulated out of existence. DeFi can be run on platforms outside of the U.S., and American and European regulators cannot shut it down any more than they can prevent me from placing an online bet on a Mexican soccer game.

Keep in mind that significant swaths of the developing world currently use micro-credit, where borrowing rates of interest are often 50% or 100% on an annualized basis. It is likely that some of those countries will experiment with DeFi as an alternative method of credit allocation, regardless of whether those new institutions satisfy U.S. regulators in every regard.

If you are baffled by a lot of DeFi, well … welcome to the club. The confusing and ever-changing nature of DeFi helps explains why the prices of crypto assets are so volatile. If DeFi lies in part behind the demand for crypto, and you don't know exactly where DeFi is headed, the future for crypto is also highly uncertain. It is very unusual to have such a highly visible window on what is essentially the value of a bunch of startups.

Finance is about to get even stranger — and crypto is just the beginning of that.