On June 16 of this year, crypto startup Compound Finance launched its lending protocol. The buzz was immediate, and decentralized finance (DeFi) suddenly became a hot topic in the media again.
The meteoric rise of Compound Finance should also cause bank executives to take note, because crypto startups are beginning to recreate banking functionality - only without banks...or bankers. All of this falls under the umbrella term 'DeFi' - applications that enable cryptocurrency to recreate the functionality of banks and other financial institutions without the need for intermediaries.
Before we dive into Compound Finance, let's go back to last week's piece about core banking. This is the graphic I used to illustrate all the basic functions of a generic bank.
There is a lot of infrastructure required to do everything a bank does, but in talking about the early stages of crypto, it's more helpful if we zoom in and focus only on the most basic functions.
But this still isn't basic enough. Before you can work on things like lending or deposits, you need a fundamental ingredient: accepted units of currency.
This is what Bitcoin, Ethereum, and other tokens accomplished during the first phase of their development. While we have no idea what will happen in the future, Bitcoin has proven to be a resilient unit of currency so far.
We got the currency. Sweet. Now, we can slowly start building a bank.
Compound Finance is focused on a very simple form of lending. By using crypto tokens as collateral, borrowers can get loans; and by lending out their crypto tokens, lenders can earn interest. All of this is much more automated than it would be at a bank.
The end product looks a lot like a money market account from the perspective of the lender. I put 20 BTC into an app that uses the Compound protocol. I then get back 20.01 BTC the next day. Like a savings account or money market fund, my BTC isn't just sitting there, it is flowing through the economy, doing things - which is why it generates yield. Of course, so much of crypto is still highly speculative, which should still give inexperienced crypto investors plenty of reason to think twice.
Compound built its functionality on Ethereum, which is where you will find the vast majority of 'banking' apps in the crypto ecosystem today. Ethereum enables decentralized apps (dApps) to leverage smart contracts that automate the functionality of banks, only without the sophisticated systems and small army of employees that banks require to accomplish the same things.
It is important to note that Compound is a ‘protocol’. This means that a variety of third parties can leverage their functionality, which they do. Current partners include Coinbase (also an investor), Binance, and Bitgo. The protocol is open source, which also means that different flavors of the protocol are likely to emerge. This is what makes the whole ecosystem full of potential: when all you need to do is fork some code, the speed of innovation is exponentially faster.
Compound offers a number of tokens via its protocol, and rates fluctuate constantly. This allows investors to change their concentration of tokens in order to generate the highest possible returns. This is a process commonly referred to as 'yield farming' or 'liquidity mining'.
Crypto is still in a very early phase of development, but this is an exciting development...and one that should puts banks on notice. Matt Levine likes to say that "Cryptocurrency markets keep rediscovering financial history for themselves."
Of course, that seems to be the entire point: to rebuild the entire financial system from scratch, only without the banks this time.