Entering a new Paradigm? Perspective on the Crypto (DeFi) market
This article was made for educational purposes. This does neither constitute financial advice nor trading advice. Do not invest more than you can afford to lose. This is not financial advice; always do your own research.
The last year was largely characterised by one of the long sought use-cases for blockchains — decentralised finance (Defi). Defi kicked off real revenue streams and adoption accelerated. The total value locked (TVL) YoY growth of 2600% and the nearly 1BN$ burned in ETH fees since early August and implementation of EIP1559 shows the incredible speed and traction with which the market is moving forward. And that’s only the beginning if we look at the gigantic potential market size of this segment. The size of derivatives market is $640 trillion, global debt is $250 trillion and equity markets are closing-in on $90 trillion in aggregate value. Traditional capital markets have massive potential. Synthetic assets, fractional ownership, equity-like tokens (governance tokens), prediction markets, lending/borrowing protocols etc. as well as completely new innovations like Flashloans (allow someone to borrow funds and repay the loan in the same transaction; if it’s not repaid in the same transaction, then the transaction will fail) and perpetual swaps getting lined up and are in their early stages of trust, quality and adoption. As so, protocol layers like Ethereum are getting real traction coming from value adding applications on top of it.
Beside DeFi another future growth vector is the banking and auditing segment. Committing on a decentralised, immutable ledger as a transaction layer can significantly reduce costs, because data analytics and backtracking can be implemented very easily. Tools like chainanalysis and nansen getting better and better, and with them, tracking and tracing of transactions is becoming much easier. Auditing is a huge market. As Arthur Hayes pointed out, if Ethereum can capture some percentage of the 5-year average earnings of banks and the big four audit firms, the numbers will be quite extraordinary. In addition to the usage fees accrued by Ethereum’s base layer protocol, the Dapp that sits on top will also charge some fee to use its service. Below is a table depicting a hypothetical scenario where for the next 12 months a certain percentage of revenue is diverted from a centralised to a decentralised service.
DeFi vs TradFi
The delta in DeFi to TradFi is higher than for decentralised services to centralised services in other sectors. E.g. writing a message via centralised services is fast, cheap and nearly instant. Sending 100$ all over the world is not.
The speed in DeFi is showing the lack of innovation and digitalisation in the financial system. One of the reasons why DeFi found this much response in the market is because financial legacy systems suck the most. International bank wires via centralised providers are slow and expensive because of the high friction in the system. The current financial architecture has not adopted technology at the rate it should have, and even fintech startups are only building on top of a legacy mindset (centralisation) with new technology. I would rather put that into the box “improvements” instead of “disruption” and that’s totally fine but if we are really in the “early internet” stage of things, I prefer betting on disruptive players with high upside potential, even if the future is not clear with all the regulatory uncertainty.
Composability by Design
One of the biggest drivers for innovation and speed is composability — to leverage existing services to build new services on top. Composability is the ability for applications and protocols to interact with one another in a permissionless way — meaning they are constantly talking to one another and leveraging each other’s code and therefore each other’s utility. This is possible due to the high transparency (code is public), standardisation and tokenisation. Standards can be used as building blocks (e.g. approval function). By tokenising investment strategies, the outcome can be used and new applications can be built upon it. This is where blockchain applications and DeFi really shine. As a result apps are leveraging one another and create synergistic effects. For example ribbon.finance’s T-YVUSDC-P-ETH automated put selling strategy leverages yearn.finance yield bearing yusdc token−>enabled by DeFi composability. This strategy generates ~10% higher return because it leverages yearn.finance yusdc strategy but comes with higher risk through risk stacking (if interested in that topic please check out my other post about risk stacking: https://bit.ly/3rWTfBB).
Centralised entities like Paypal, Facebook, Twitters are closed off because the user is the asset and no one wants to share this asset. If you want to send money via Paypal, you can easily do that, as long as your counterpart is a Paypal customer. f you want to drop a photo to friend using Facebook Messenger or Instagram DMs you have to make sure your friend has already signed up.
Now imagine if you could send money from your Instagram account in whatever currency through whatever network or just send a tweet and reach instagram users. Composability by design allows these solutions.
This capability of composability is not talked about enough more broadly, yet it’s one of the most powerful aspects of crypto.
High yield?
Besides these strategies DeFi, at the moment, is a yield driven ecosystem which is based on token emissions.
Token emission is used to attract new users/kickstart the network effect, incentivise the community/team/developers, bootstrap the protocol and attract liquidity. Token emission is a way to decentralise the governance of the project and to engage and build a community around it. Yield farming/liquidity mining via Tokens, is a brilliant innovation in bootstrapping liquidity in two-sided market places. Even though it is great to earn high yield, blockchain applications already expanded beyond DeFi.
Whats next?
The big bottleneck transaction speed and costs are now to the biggest extent, through L2 and Rollups, alleviated and thereby other segments beyond finance can be now addressed .
- NFTs — People and Corporates (Visa bought a punk for 88.48Ξ or $293,276)buy original traceability, which leads to social prestige, e.g Cryptopunks.
Snapshot 24.08:
Current Lowest Price per Punk: 75 ETH ($248.595 USD)
Number of Sales (Last 12 Months): 12,613
Total Value of All Sales (Lifetime): 274.21K ETH($870.97M)
Even when I think a token can bring a huge benefit for moving rightful ownership, especially for digital art, all discussions about the value of NFTs are meaningless as long as the token is not inseparable from the artwork itself. Without any doubt there is value in distributing ownership. Just the token itself is not the artwork. But with Ethereum, mapping is impossible and with centralised cloud offerings there is no independence. All that is stored is metadata that contains the name of the image, a short description, and a link that refers to a place in the web where the image is stored. This link could be a variable too, so that you could add an additional link to a file that you store somewhere (host on your own server, Google Cloud, IPFS — whatever). The IPFS network enables you to address content based on the content itself -> The Name/hash gets assigned to the content itself. If the image changes, the hash changes. With IPFS you cannot change or delete the image unnoticed.
Soon, we might see the linking between the NFT and the decentralised domain names. Copying Images/Art won’t give you “social prestige” then. Service providers could scan for NFT ownership and only allow these as profile pictures for example.
2. Social Media — Centralised systems suffer through arbitrary censorship and manipulation, low quality of discourse and engagement is often misaligned with quality. Decentralised systems could potentially, if designed well (and that’s the very hard part), improve the discourses. But there is always one big concern coming up: Content Moderation. If the protocol is decentralised how will there be any content moderation? On the protocol level that’s not possible, but on the application level people could be incentivised through cryptocurrencies/tokens to report fake accounts or illegal content. Blockchain networks have inherent economic layers which make it easy to implement mechanism design. Social networks with built-in cryptocurrency payments could introduce such incentives, which would provide an alternative method for keeping social networks clean. Social Media composability could be next after DeFi composability.
3. Infrastructure (Storage, Network) — Cloud storage solutions like Filecoin, Sia, IPFS and LoRaWAN networks like Helium developed the infrastructure for fully decentralised applications. The backbone for todays web3 application were developed in the last 4 years. The next step is to evolve from centralised architectures to decentralised (e.g. host NFTs and Games on Arweave, IPFS, SIA or other decentralised file storage solutions).
4. Gaming/Metaverse — What started with World of Warcraft gold farming is now play-to-earn. Idea is not new but transacting on a decentralised value layer is and it is going mainstream now. Hold to play, share or curate to earn and play for keeps, could become the primary income for millions of people as a form of financial emancipation rather than digital feudalism with sweatshops.
Building on top of novel solutions like Automated Market Maker (AMMs) and a Token economy, allows to capture value for applications beyond pure defi use cases (value layer backed in other apps). Crypto is extremely good for setting up and designing incentive systems which leads into a bigger and higher involved community. I think the best applications will combine elements of finance and non-finance by leveraging crypto incentive options.
