What Is DeFi? Inside the Wild West of Cryptocurrency.

Welcome to decentralized finance, or DeFi—the new frontier of crypto and one of its fastest-growing areas. DeFi encompasses freewheeling marketplaces where thousands of tokens are listed and traded, without any oversight from a central authority. Other DeFi networks consist of giant lending platforms that are like crowdfunded money markets or order books for trading. Users add their crypto to a liquidity pool in exchange for fees paid by borrowers who might trade the tokens. Interest rates can top 10%, depending on the crypto and size of the pool.

It’s a fast-growing area. DeFi networks now hold $240 billion, up from $13 billion a year ago. Fortunes are being made—or lost—as traders swap tokens that can surge 1,000% overnight, or pledge their coins to liquidity pools in return for high yields. DeFi is also affecting centralized exchanges, which see both threats and opportunity in the technology. Regulators aren’t pleased, though. They view DeFi as crypto anarchy that needs to be reined in, although no one is sure how to do it.

Traders swap all kinds of digital assets on DeFi markets. Along with the major cryptos, legions of “alt coins” trade on decentralized exchanges, or DEXes, which are like automated market makers, matching buyers and sellers with algorithms. Liquidity pools create the markets and order books, and “smart contracts” set the terms of a trade and settlement.

The biggest DEX markets include dYdX, Uniswap, PancakeSwap, and SushiSwap. (Food is a popular crypto meme.) The prevailing ethos is that you can swap any token, assuming you can find a counterparty and drum up some liquidity. PancakeSwap’s motto: “Trade anything, no registration, no hassle.”

In theory, anyone with some coding skill can mint a token on a blockchain like

Ethereum,
talk it up on social media, and try to build a market on a DEX. Dozens of tokens tie their names to

Tesla

CEO Elon Musk and his dog Floki. All aim to become the next Shiba Inu or

Dogecoin,
tokens that Musk has touted on

Twitter
.

“It’s pure peer-to-peer,” says John Wu, president of Ava Labs, the company behind the Avalanche blockchain. “You don’t have to rely on the Nasdaq or NYSE to get approval for a token.”

Some major exchanges, notably Binance, offer their own DeFi platform and provide access to networks like PancakeSwap. Coinbase acts more like a traditional brokerage and exchange, matching buyers and sellers with order books and market-making. The big exchanges handle far more volume than DEXes. Binance leads the industry with 24-hour volume around $46 billion, compared with $6.5 billion for dYdX and $2.6 billion for Uniswap.

But new networks are sprouting up fast. Avalanche went from a few hundred million in total value on its blockchain to $10 billion in the past six months, says Wu. “DEXes are the future,” says Emin Gün Sirer, a computer scientist at Cornell University and founder of Ava Labs. “They have inherent technology advantages compared with centralized exchanges.”

More than $8 billion worth of cryptos changed hands on DeFi networks during a recent 24-hour period, accounting for about 4% of global trading, according to CoinGecko. A year ago, their trading volume was less than $1 billion, according to CoinDesk.

DeFi also offers ways for crypto owners to earn interest on their digital assets. If you add your crypto to a liquidity pool, you earn interest on it based on your stake in the pool and its total interest. Some of the bigger pools include Aave, Curve, and Compound. Lenders of DAI tokens earn 1.26% on Aave, for instance, while borrowers pay 1.56%. Rates are set by supply and demand for tokens and the size of a pool; smaller, less liquid pools earn higher rates than larger ones. And smaller tokens can generate high yields for owners willing to stake them (potentially giving up any price gains by doing so). Pools include mechanisms, or smart contracts, that automatically liquidate a borrower’s collateral if prices breach certain levels.

One of the more intriguing features is “flash loans”—a way of borrowing money and repaying it within a split second. Traders use it to arbitrage crypto prices fast, without any capital requirements.

“It’s like walking into a bank, saying I want to borrow $10 million and don’t have collateral. I won’t tell you who I am, I want it for a day, and I assure you I’ll pay it back,” says Ari Juels, chief scientist at Chainlink Lab, a crypto developer. Thanks to the “atomized” nature of transactions, “if you fail to repay the loan, the whole thing aborts.”

While it all sounds great for crypto-adventuring, it’s turning into a nightmare for regulators. The head of the Securities and Exchange Commission, Gary Gensler, has indicated that he would like a regulatory ring around DeFi. The SEC is looking at whether DeFi platforms are operating as unregistered exchanges and whether tokens qualify as securities under the Securities Act of 1933, according to attorneys in the industry. The SEC declined to comment.

One concern is that DeFi platforms—which don’t impose anti-money-laundering or know-your-customer rules—have become havens for anonymous trading. Traders gain access by linking a digital wallet to an exchange; wallets like MetaMask, with 11 million users, don’t verify identities. Law enforcement can still follow the money trail, but it’s more complex than matching income on a 1099 form with a tax return. “There would be no way to know that wallet XYZ belongs to me,” says David Shuttleworth, an economist at ConsenSys, developer of MetaMask. “You’re virtually encrypted and anonymous.”

Whether the authorities could rein in DeFi markets is debatable. Once the code for a protocol is unleashed, it can be used by anyone as a foundation for smart contracts and other projects. Suspicious activity can be traced, but the code and community are the main supervision mechanisms. “The problem the SEC faces is that you can shut down a website, but the protocol lives on,” says Stephen Palley, chair of the crypto practice at law firm Anderson Kill.

The SEC recently initiated a probe of Uniswap Labs, the company behind the Uniswap protocol. The agency is looking at whether Uniswap is operating an unregistered exchange or as a broker/dealer, and whether the tokens it issued should be registered as securities, according to attorneys in the industry.

Uniswap Labs declined to comment and referred Barron’s to a statement in which it said that it’s “committed to complying with the laws and regulations governing our industry.” The SEC declined to comment.

The problem for regulators is that financial laws written in the 1930s and ’40s don’t apply to 21st century crypto. Open-source code and protocols have replaced broker/dealers and exchanges; digital wallets provide liquidity and make markets rather than large companies like Citadel Securities. Gensler recently told Congress that many tokens may qualify as securities, but not everyone agrees. The Commodity Futures Trading Commission views them as commodities.

Even if regulators could join forces and agree on how to police the industry, it’s unclear what the end game would be. Regulators can crack down on companies or foundations that oversee the networks. But the technology itself may jump across national borders, popping up overseas if it’s shut down in the U.S. “These are unstoppable technologies,” says Sirer. “Regulators could try to get them under control, but a truly decentralized exchange can’t be stopped.”

One solution, of course, would be fashioning new rules for crypto. The SEC hasn’t issued any public rule-making, though it has released frameworks. And Congress appears split on many aspects of crypto. Democrats want more investor protections and tax-reporting rules, while Republicans say that companies should be granted “safe harbors” to develop new products and services.

For now, the SEC appears to be regulating by enforcement—launching investigations and trying to coax companies into registering their business or tokens. But companies argue that they would need clear rules to make the registration process worthwhile. Securities exchanges would need rules, as well, to list and offer crypto-securities.

The U.S. isn’t the only government concerned about DeFi. The underlying blockchain technology poses a threat to authoritarian regimes such as China, where crypto transactions are increasingly viewed as a subversive activity. Several DeFi tokens surged right after the latest crackdown in China, a sign that traders in the country may have switched to DEXes.

Newcomers to crypto shouldn’t dabble in DeFi without knowing the risks. Sophisticated apps are now scouring DEXes for high-yield opportunities and trades, putting small investors at a disadvantage. DEXes may be teeming with market manipulation as tiny “meme” coins are pumped and dumped. And fees can be steep, depending on the size of the liquidity pool and token being traded.

Individuals also have to contend with legal bribery of blockchain miners, says Juels. Blockchain operators, who validate and record transactions, can be paid to prioritize transactions, allowing for front-running. One way it happens is with Flashbots, which is an auction system used by front-runners to bid for the right to have their transactions sequenced before others. Unwitting users can wind up paying a higher price for their crypto, compared with the market price they saw a split second earlier.

“If you trade in a naive way, you’re guaranteed to be front-runned,” Juels says. “Bribery of miners has become institutionalized.” Front-running has gotten tougher with a recent upgrade of Uniswap, but it’s still prevalent on DEXes, he adds.

Even so, the lines between DeFi and centralized exchanges are blurring. Companies like Coinbase now offer digital wallets so that investors can tap into a DeFi platform. Binance is much further along with its own underlying blockchain, tokens, and DeFi services. Platforms like Aave also aim to develop products that comply with standard know-your-customer rules, opening DeFi lending to institutional investors.

“It’s an important initiative to follow,” says BTIG analyst Mark Palmer. “If it succeeds, it could open up DeFi to institutional investors.” They might even try trading some Squid Game, assuming it still exists a year from now.

Write to Daren Fonda at daren.fonda@barrons.com