With Decentralized Finance (DeFi) Loans Can Pay Themselves Back

Disbelief followed by skepticism should be your first reactions to this title. It does indeed look like clickbait. It’s not.

This article is a follow up to a previous article I wrote on DeFi. If you haven’t read it yet, read it first before reading this one.

Alchemix is a DeFi app that launched a few months ago and that claims on its website to provide “highly flexible instant loans that repay themselves over time.” With such a bold statement of course I was intrigued and decided to investigate. I wanted to understand how it worked.

Before moving on to the mechanics of Alchemix, it is important to understand what is a “stablecoin.” A stablecoin is a token representing the value of a fiat currency—like the US Dollar — on a blockchain. Unlike Bitcoin or other crypto-assets, its value is not supposed to fluctuate.

  • USD Coin (USDC) is a US-regulated stablecoin managed by Circle, backed by US Dollars and redeemable in US Dollar on platforms like Coinbase.
  • DAI is a synthetic (algorithmic), decentralized stablecoin backed by crypto-assets such as ETH (Ethereum’s native currency).

As of early May 2021 there is more than $15 billion worth of USDC and $4 billion worth of DAI outstanding. It’s a corner of the crypto ecosystem that is growing very fast.

The Collateral Repays the Loan

To get a “loan” on Alchemix, you first need to deposit twice the amount you wish to borrow. The deposit has to be made using the stablecoin DAI. The amount deposited serves as collateral, but more importantly, also serves as investment capital yielding a return, which is used to repay the loan. I know, you must be very confused right now. Why deposit, say, $200 to borrow $100?! It’s because I forgot one critical piece of information: the loan is interest-rate free. More confused? Let’s see how it works:

1. A user deposits the equivalent of $100 equivalent in the form of 100 DAI on Alchemix.

2. Alchemix then allows the user to borrow up to the equivalent of $50 in the form of the Alchemix stablecoin, alUSD. This is where the magic happens:

  • The alUSD stablecoin is created by Alchemix and represents $1.
  • alUSD is 200% overcollateralized by the DAI deposited by its users.
  • Alchemix doesn’t have any funding cost, it just creates alUSD tokens when its users provide collateral, so it doesn’t charge any interest.
  • “But, isn’t it creating money out of thin air?” Not quite, it’s what commercial banks do every day. But instead of 200% collateral these banks do it with only 10% collateral. For each $1 of deposit, banks can create $9 in loans (click here if you want a detailed explanation of how money creation works).

3. The user can withdraw the 50 alUSD tokens, swap them for USDC, send them to an exchange such as Coinbase and convert them to $50, which can be freely transferred to her bank account.

4. In the meantime, the 100 DAI deposit made on Alchemix is invested with Yearn, where the yield on DAI deposits is currently in the 15–25% range. It’s the return on the deposit that is used to repay the loan over time.

5. Once the 50 alUSD loan is repaid, the user gets its 100 DAI collateral back. The user can also prepay the loan at any time using the collateral already deposited on Alchemix.

With the current return on DAI deposited by Alchemix on Yearn at about 25%, the 100 DAI collateral should repay the 50 alUSD loan in about two years. Since the yield changes every day in real time, however, it’s impossible to know exactly when the loan will get repaid. All the user has is an estimate based on the current yield. But since the loan is interest rate free and that it can be prepaid at any time, it doesn’t really matter.

The whole scheme is attractive because yields in DeFi are currently high. If the return on DAI deposits were to drop to just 5%, the value proposition of Alchemix would change dramatically, as it would take 10 years for the collateral to repay the loan.

Withdraw the Future Return on Your Investment

In a nutshell, Alchemix allows you to withdraw the future return on your investment. You can either use it to pay for expenses now (option 1 below) or use it to get interest-free leverage. Since your collateral is invested with Yearn and that you can invest the 50 alUSD how you want, you can have $150 of exposure on $100 of capital (option 2 below).

Because the alUSD stablecoin is backed by 200% of DAI — another stablecoin — the loan can’t get liquidated, unlike other types of margin loans collateralized by assets that are not stable.

We are still in the early days of DeFi, so using Alchemix requires an advanced level of knowledge of the crypto ecosystem, which currently keeps it out of reach to 99.9% of the population. To illustrate this complexity, the chart below shows the steps required to execute the trade described previously.

While the first and last steps (1, 2, 16 and 17) involve Centralized Finance (CeFi) institutions, the rest is done using DeFi protocols. All of this is made possible the killer feature of DeFi: composability.

The Legos of Finance

Composability is the ability to combine any number of DeFi apps in as many ways as you want. Think of a DeFi app as a Lego brick. Because DeFi apps are permissionless (i.e. you don’t have to create an account with them or request permission to use them), any DeFi app can connect to any other DeFi app and use it. This is impossible to do with traditional finance. The consequence of composability is that each DeFi app increases the value of the whole ecosystem, because other DeFi apps can use it.

The example above combines the following protocols:

What About Risks?

As you can imagine with so many layers, it’s clearly not risk free. But the whole system is transparent as everything is observable on the public Ethereum blockchain. Below are some of the main risks involved with the steps described above:

  • Peg risk: DAI peg breaks and falls below $1 (the alUSD peg breaking would not hurt borrowers as it would make it cheaper to repay the alUSD loan)
  • Composability risk: Catastrophic failure of Yearn and/or one of the underlying lending protocols — where the DAI deposit has been invested — which would result in the loss of the DAI collateral
  • Regulatory risk: none of this is regulated

A New Paradigm

DeFi is reinventing finance and forcing everyone — especially those with a finance background — to reevaluate their beliefs and understanding of finance. Alchemix has already attracted more than $1 billion of deposits just two months after being launched. This gives you an idea of how fast the DeFi ecosystem is growing and how much capital is flowing into it.

It’s still early days, but not a week goes by without new innovative concepts being launched. Some will fail, so be very careful if you want to experiment with DeFi. That said, the genie is out of the bottle and change is coming faster than you think in the world of finance.

The information in this article does not constitute any form of financial advice or investment recommendation related to DeFi protocols. The mention of DeFi platforms in this article does not constitute any endorsement of any kind.

World Banker, Investor, Blockchain enthusiast