Money manager Vladimir Vishnevskiy can earn a negative interest rate for holding a European government bond. Or he can pocket the annual equivalent of a 20% yield for locking money up in one of the wilder corners of the crypto market, known as decentralized finance, or DeFi.
He decided to go for the 20%. “You can’t get those yields in the traditional space,” says the co-founder of Swiss-based St. Gotthard Fund Management, which runs a portfolio designed to squeeze income out of crypto assets. The strategy is so new that even Wall Street pros may have trouble wrapping their heads around it. Take what you might know about Bitcoin—that it’s a digital currency that exists only on an online ledger governed by computer code. Now make it even more mind-bending, and imagine the code isn’t just recording transactions. It’s running lending platforms, insurers and financial markets with little human intermediation. That’s DeFi.
Traders like Vishnevskiy can collect yields by committing in the form of crypto tokens the capital that’s needed to make these disembodied and largely unregulated financial institutions run. At the peak last month, investors put in as much as $86 billion into various DeFi programs, compared with just under $1 billion a year ago, DeFi Pulse data show.
It’s a young, volatile, and hack-prone system. (One of the first decentralized projects, a fund called the DAO, was the victim of a spectacular $55 million theft by someone taking advantage of a flaw in its code to siphon off funds.) And for now, it’s mostly a crypto world built for the crypto universe. The decentralized lenders are largely taking crypto deposits to make loans to people looking for leverage on crypto bets; the decentralized exchanges are used for trading crypto coins; the decentralized insurers cover crypto hacks.
The big yields investors can earn are denominated not in dollars or euros but in often-obscure tokens. Critics of DeFi say some projects can resemble a Ponzi scheme: Early investors depend on others piling into tokens that still have limited real-world utility. If returns are high, it’s largely because of investors’ voracious appetite for more digital assets. And since DeFi projects don’t need to live in any physical location, they’re difficult to regulate, making the space vulnerable to scams and money laundering schemes. Still, DeFi’s advocates think the technology has the power to open up markets and build new kinds of financial products.
To see how a DeFi program works, look at SushiSwap, a decentralized cryptocurrency exchange that started last year. It’s based on the code of another DeFi exchange called Uniswap. Like any exchange—from better-known crypto trading apps such as Coinbase to stock markets like Nasdaq—SushiSwap depends on liquidity, or the ability to make…