DeFi money market will eventually attract institutional investors: miracle or nightmare?

Bitcoin’s bull run that began last year has softened even some of its biggest skeptics. From economists to hedge fund managers, the field is opening up to the technology, and at the center of the movement is decentralized finance, or DeFi. While the total market value of cryptocurrencies has reached $2 trillion, comparable to Apple’s market value, it is the promise of DeFi — a small corner of the blockchain industry today — that has attracted the attention of institutional investors.

As Bitcoin's bullish trend continues, interest-earning crypto products have become all the rage. Some services offer up to 8% return on Bitcoin investments. For investors who are already expecting appreciation, this can be very useful to maintain cash flow without selling any assets.

The three main factors that sustain institutional investor interest in Bitcoin are the current historically low interest rates, inflation rates, and geopolitical instability. With interest rates expected to remain close to zero for the foreseeable future, investors are preparing to move their funds elsewhere to gain wealth.

The 2% inflation target set by the U.S. Federal Reserve has raised concerns among investors about the depreciation of the yuan. As tensions between China and the U.S. teeter on the edge of instability, dollar-denominated portfolios are increasingly risky.

Money Market

Safely buying, storing and using cryptocurrency remains a fairly complex ordeal — far more complicated than setting up a bank account. However, according to Larry Fink, CEO of BlackRock, a global investment management fund with nearly $9 trillion in assets under management, Bitcoin could evolve into a global market asset and hit new highs in the coming years.

In the traditional financial system, money markets are the part of the economy that issues short-term funds. They process loans with maturities usually not exceeding one year and provide services such as lending, buying and selling, with wholesale transactions taking place over the counter. Money markets consist of short-term, highly liquid assets and are part of the broader financial market system.

Money markets have traditionally been very complex, with expensive management fees and hidden charges that have driven most investors to hire fund managers. Yet their existence is essential to the functioning of the modern financial economy. They encourage people to borrow money in the short term and allocate capital to productive uses. This improves overall market efficiency while helping financial institutions achieve their goals. Basically, anyone with some spare cash can earn interest on their deposits.

The money market consists of different types of securities, such as Treasury bills, certificates of deposit, repurchase agreements, and mutual funds, which are usually made up of shares priced at $1.

Capital markets, on the other hand, are dedicated to the trading of long-term debt and equity instruments and include the entire stock and bond markets. Using a computer, anyone can buy or sell an asset in just a few seconds, but companies that issue stocks do so to raise funds for longer-term operations. These stocks fluctuate, and unlike money market products, they do not have an expiration date.

Since money market investments carry little risk, they typically carry meager interest rates. This means they don't generate huge returns or show big growth compared to riskier assets like stocks and bonds.

DeFi Vs. The World?

Institutions have begun using Bitcoin to hedge against currency risk, and retail investors are following suit. With more than 60% of Bitcoin's circulating supply unchanged since 2018, the price of Bitcoin is expected to be well above $100,000 in the next 24 months.

If current trends continue, investors will continue to hoard Bitcoin. However, while much of the world’s first Bitcoin supply remains in storage, the DeFi industry is continually developing alternative platforms that pay interest through smart contracts, which improves transparency by allowing investors to view and track on-chain funds.

The average return rate of DeFi products is also much higher than that of traditional money markets, and some platforms even offer double-digit annual deposit yields. From asset management to smart contract audits, the DeFi field is creating decentralized infrastructure for scalable money markets.

Stani Kulechov, co-founder of the Aave DeFi protocol, said that during the bull market, interest rates were higher because funds were used to leverage more capital, and margin costs pushed up yields. New innovations in DeFi are consuming more stablecoins, which further increased returns. Unless there is new capital injection, these interest rates may remain for some time.

The Ethereum network currently hosts the majority of DeFi applications, which has prohibited tokens that are not available on the network from participating in decentralized finance. Take Bitcoin, for example, although it is the largest cryptocurrency by market capitalization, it has only recently entered the DeFi platform.

Through Kava’s Hard Protocol, investors can use Bitcoin and other non-ERC-20 tokens (such as XRP and BNB) for liquidity mining. Backed by some well-known companies (Ripple, Arrington XRP Capital and Digital Asset Capital Management, etc.), these platforms allow users to pledge their cryptocurrencies into a pool of assets that are loaned out to borrowers to generate interest.

The Kava team also plans to add support for Ethereum-based tokens in the near future. Due to the lack of the required number of voters, the upgrade of the Kava 5.1 network has been postponed to April 8. The network will also introduce Hard Protocol V2, bringing powerful incentive schemes and optimizations to its governance model.

Most loans in DeFi are overcollateralized, which means there is always more money in the pool than is lent out. If the value of the issued token drops, the funds in the pool will be liquidated to compensate.

Anton Bukov, co-founder of decentralized exchange aggregator 1inch, said blockchain is the first impartial enforcer in human history — very limited, but ultimately fair — and that new services and interactions may be enabled in the future. “Developers are doing their best to address potential dishonesty in existing money flows and to create new ones by replacing middlemen,” he said.

By creating an automated asset lending and borrowing platform, decentralized finance enables money markets without the high fees that come with intermediaries, custodians, or high infrastructure costs.

Honest work

Among the many trends that DeFi has sparked over the past few years, liquidity mining has attracted a lot of attention. Liquidity mining refers to the network rewarding liquidity providers with tokens, which can be further invested in other platforms to generate more liquidity tokens.

In simple terms, liquidity providers are among the most vigilant traders, constantly changing strategies, maximizing their yields, and tracking interest rates across all platforms to ensure they are getting the sweetest deals. The potential returns could become very high, but it is unclear whether liquidity mining is a fad or a phenomenon in the making. Kulechov added:

“Yield mining is just one way to distribute governance power to users and stakeholders. What really matters is whether the product itself fits the protocol market. Most successful distributions of governance power in liquidity mining are finding protocol market/protocol fit before such projects.”

Liquidity mining has an incredible positive feedback loop, where participation increases the value of its governance token, further driving growth. Kava CEO Brian Kerr said that while this feedback loop can produce very positive results in a bull market, it can have the exact opposite effect in a falling market:

“It will be up to the governance teams of individual projects to effectively navigate the bear market, reducing rewards before a full-blown death spiral occurs. Regardless of whether the market is bullish or bearish, liquidity mining will be a mainstay of blockchain projects for years to come.”

Money markets are the backbone of the global financial system, but most of its trading occurs between financial institutions such as banks and other companies in the time deposit market. However, some of these transactions do find their way into the hands of consumers through money market mutual funds and other investment vehicles.

Decentralization is the next frontier in finance, and as prominent investors continue to participate in the DeFi space, the decentralized economy seems inevitable. Participating in this rapidly evolving environment may be a risky gamble today, but what decentralized finance platforms learn now will become the foundation for robust DeFi applications in the future. Bukov believes that the high interest rates on DeFi platforms are "absolutely sustainable." He added:

“The higher the profit, the greater the risk. So the risk-return model for all these opportunities is always close to equilibrium. Normalizing the risk reduces the profit because more players will be involved in sharing the returns.”

From smart contract glitches to unauthorized withdrawals of community funds, the DeFi space is both a wonder and a nightmare. DeFi-based liquidity mining platforms are still in their early stages, and while sometimes the numbers are too tempting, it is crucial to do your own research before investing in any platform or asset.