"It's not just about money; it's touching a very primal desire to connect with others:" ParaFi's Santiago Roel

Hello Defiers! Sharing last week’s podcast and interview —apologies for the delay! I spoke with Santiago Roel, partner at ParaFi Capital, one of the most active investment funds in DeFi. Before going full crypto, Santiago worked at JPMorgan’s investment banking arm, and then invested in fintech and software at a venture fund.

He now uses his more traditional VC frameworks to analyze open financial protocols and finds that even by those metrics, DeFi comes out ahead. Amid growing sentiment that DeFi protocols should distribute their tokens to a broad community and not concentrate them among early investors, Santiago argues VCs can play a positive role in the growth of their investment, from providing connections to actual liquidity. Roel spoke about ParaFi’s investment thesis and opportunities he’s seeing in the firm’s venture and arbitrage funds.

We also talked about the seemingly crazy new DeFi meme tokens and Santiago says to not underestimate their value. Maybe part of the reason traders are pouring millions into these tokens comes from the human desire to connect with others. Bonding with people from all over the world over something that seems like an inside joke, and actually owning that protocol, is proving to be extremely powerful.

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🎙Listen to the interview in this week’s podcast episode here:

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Santiago Roel: My background is in traditional finance. I was at JPMorgan and that's where I first discovered Bitcoin in 2012. For me, what really drew me in was the remittance use case. I'm from Mexico and so really being able to move money cross border continues to be a big pain point. People are being charged 5-10, even more cents on the dollar to send money cross border. That to me was a killer use case of Bitcoin. I really got my hands dirty on it, started buying Bitcoin and sending it to Mexico to my family. For me, that's where it really clicked, that was an aha moment.

It really comes from the perspective of asking, there ought to be a better way to do things. That's a guiding principle for investing is, if you were to redesign a financial system from scratch, how would it look like? I think we certainly can agree that the financial system as it stands today has a lot of gaps and hasn't really caught up to the internet. That was always in the back of my mind, nagging at me.

“That's a guiding principle for investing is, if you were to redesign a financial system from scratch, how would it look like?”

When Ethereum launched, as you do a great job narrating in your book, it was fascinating to see the programmability of money. I was investing in open source software and fintech at the time at a fund called Sageview Capital. That's where I really started getting more involved in projects like Ethereum and other applications being built on top.

I joined ParaFi with my partner, Ben, to really double down on this thesis that blockchains are going to totally transform how we think about finance, how we think about money, how we think about value. It is very exciting to see, I think the early signs of that.

CR: Super interesting to hear how you were drawn into Bitcoin because of the remittance use case and how you were using it firsthand in Mexico with your own family. At the time you were at JPMorgan, were you able to influence any of your own work there and bring Bitcoin in or was it just something you were doing on the side?

Going Full-time

SR: I had to go to the local Bitcoin hubs in New York to buy my first Bitcoin. There was very rudimentary infrastructure at the time, small meetups. I would show up at suit and tie and people look at me in a very weird way. JPMorgan has been very active in crypto as you know and now recently with ConsenSys. But at the time, it was not even on the map.

Over time, I think a lot of investors in this space now are full-time. You struggle to really sell the vision of blockchain, of crypto, at your fund or at your company. That just really puts in perspective, we are so early here. Because I think, there are a lot of different narratives and stigmas associated with crypto and I think that at some point, you realize I have to do this full- time.

This space has so much innovation, so much talent, that it's hard to keep up even on a full- time basis. It's been sort of an uphill battle. I talked a lot of fund managers and they all come to that realization that you can't do it from a traditional organization. You have to part ways and I came to that conclusion and joined ParaFi.

CR: When was it that you left and went to go full-time crypto?

SR: I've been investing in a personal capacity kind of crypto by night, over the last seven years and then I fully decided to start running my own staking, operating nodes to validate. That was like over a year ago. My background is in investing, that's what I love to do. Over the last year and a half, I was contemplating raising a fund, joining a fund and that's where I landed with ParaFi. Sort of how I think about the world, how I think about investing in crypto is very much aligned with how ParaFi as organization looks at the world.

CR: Let's talk about that. What is ParaFi about? What is the investment thesis, how do you go about finding opportunities?

Finance as Killer Use-Case

SR: The core bet that we're making is that one of the most killer use cases of blockchain technology is to transform financial infrastructure. We are investing in, think of it as the next wave of innovation of fintech combined with open source and really powered by blockchain technology. That includes all the different money verbs, you can think of lending, borrowing derivatives, insurance.

For us, the bet that we're making broadly is that this is a secular trend, finance is going to be transformed probably from the outside in. Then we start saying, okay, what are the immediate, different pieces of infrastructure that need to be built to provide what we call DeFi. A lot of it is copying, I think parts of silos of the traditional finance world into DeFi, porting those over, but then also mashing up different combinations to create new primitives. We have a good pulse on what has worked in traditional finance and copying that over, plus also new primitives that are uniquely enabled in this ecosystem.

What Needs to be Built

As it relates to how do we form a thesis, how do we go about finding opportunities. It really comes from sort of first identifying ‘what are the applications that need to be built?’ What are the use cases that are missing in this ecosystem? For instance, we say, hey, look, we ought to be able to borrow at a fixed rate. That is not typically possible today. But we look at traditional markets where the notional amount of fixed-rate borrowing versus variable is 25 times larger. Someone's going to solve that, someone's going to crack that nut. We'll go out and find and then once we build that pieces, we say let's go on and find the best operators that are going to execute and place bets or a bet accordingly.

“As it relates to how do we form a thesis, how do we go about finding opportunities. It really comes from sort of first identifying ‘what are the applications that need to be built?’ What are the use cases that are missing in this ecosystem?”

Another opportunity is, hey, how do we do under-collateralized loans? Everything right now in the system is over-collateralized for a reason. There's no reputation layer in crypto. How do we think about insurance? That's from first principles, we go back and say, this is how the system should look like and then from there drill down and say, okay, let's find the best operators to execute.

CR: So you look at traditional finance and say, these are the main pieces that make things work and so, what needs to be built in this parallel financial system for it to work? That's how you come with this thesis like, okay, we need under-collateralized loans, we need a fixed-rate loans, we need insurance, and then go after the people building those things?

SR: Correct. Different from a lot of funds, what really informs our thesis as well as that we’re power users of these networks, so, we're actually interacting with a lot of these protocols. It's coming from a pain point. It's like ‘God, I wish that if the collateralization ratio wouldn't be 150%,’ maybe it could be lower. I wish I could borrow at a fixed rate. I wish I could buy more cover on Nexus or more insurance for my portfolio on how we think about risk management. We're actively interacting with these networks and from that vantage point, we'll say we identify the areas of opportunity that need to be built in this system.

“We're actively interacting with these networks and from that vantage point, we'll say we identify the areas of opportunity that need to be built in this system.”

CR: What about those things that are outside the box, which aren't even in traditional finance, how do you arrive at those pieces?

Novel Opportunities

SR: No, certainly, it's super exciting. Our investment on Aave was predicated on that to some respects. You look flash loans and just for the audience, flash loans allow you to borrow and repay on the same block. That is a trader’s dream. Imagine that you're really good at finding real estate. Say, you walk around, you see a house, and you say that's worth $2.5 million. You can buy for a million and you have another buyer that's willing to buy it at 2.5. You see this delta because you're good at real estate, you have an eye. But what's the problem? If you don't have the capital to buy the house and then resell it, none of this works in traditional finance. With flash loans, you can. You don't need the capital.

All of a sudden, it creates so much efficiency in the system, because it allows smart developers or anyone in the world really to take advantage of these arbitrage opportunities and in this case, would be able to borrow a million, to buy the house and then sell for 2.5 and get 1.5.

You might argue, well, what's the value of all that? It creates more resiliency in the system. It creates more efficiency in the spread. It incentivizes more market participants. It lowers the barriers to entry that you don't need to have capital to interact in that system.

When you think about traditional finance, you need to have a prime brokerage account and only the big boys can play, are invited to the big poker tables. Right now, the smartest guys in the room might be a very smart individual that has a really good pulse for finance. It's totally transforming the way that we think about giving access to more players in the system and democratizing access to capital.

CR: For sure. I think that's what's so exciting about decentralized finance, which is really I think better described as open finance, just this system that's open to anyone who can and wants to use it. Definitely, tools like flash loans make it even easier, because you don't need to have that much capital to start playing.

Granted it is super risky —or not that risky, because you can just return the loan within the first block if the trade doesn't work out. But, for it to be profitable, you need to find all the pieces to match in a very short period of time. I guess, it reduces the barriers of entry in terms of capital, but you still need to be very technically savvy and an experienced trader to use many of these protocols.

Hobbyists

SR: Absolutely. I think that really conceptualizes how early we're on this system. It's a lot of hobbyists if you will, that are interacting with these protocols and testing them out. But that's a good thing. That's a natural evolution of technology.

SR: The other primitive is collectibles. Broadly, a lot of people tell us well, how do you think about DeFi? It's very niche. It's very small. Why just specialize in DeFi? Why not touch everything in blockchain, all the different use cases that we were promised but still haven't shipped? In response to that, it's like, well, it has most the most product-market fit. Actual earnings, traction, users. The value proposition is too hard to ignore; it fulfills this characteristic of 10X better than the traditional finance and I think you alluded to it earlier.

But broadly speaking, how we define DeFi is transfer of value, full stop. When you think about what value means, when you have digital scarcity, which you've never had before, then you start seeing the possibilities. This system where the way we think about money has been really around for 80 years since Bretton Woods. If you look over time, there was a time that been whale bones fulfilled the moneyness property. I think we're seeing a really interesting confluence of trends from metaverse like Fortnite and video games and eSports combined with everyone is online, and the way we think about value, I think will radically change.

Is it crazy to think that you can use your crypto kitties as collateral for a house in five years? Because you have AMMs, you have system to provide good price discovery on digital scarcity and I think that's a new primitive that is going to unlock so many different applications, so many different use cases with composability.

“… broadly speaking, how we define DeFi is ‘transfer of value’, full stop.”

CR: It's so interesting. How do you think our idea of money is changing because of these technologies? Is it something like, anything can be money, you can tokenize anything and put it on an exchange or put it on a lending platform and use it to take out a loan or open a savings account and do things that before could only be done with actual currency?

Redefining Money

SR: It is fascinating, I think that you have to think about what defines good properties of money, what money is. It's recognizable; there are market participants that recognize the value in this. It's tangible, it's divisible, and there are certain properties of authenticity, if you will. I think blockchain checks a lot of those boxes: you have digital scarcity, you have provability by code, that there's only X amount of Bitcoin or X amount of crypto collectibles or X amount of whatever token.

You also have a very fluid market where anyone can provide a market on any token. I think, you've never had global untethered pools of liquidity that are interacting in a very explosive way. Historically, if you had a baseball card, well, the baseball card could break, how do you prove the authenticity of the baseball card well, you have experts that look at the card and then well, it's very localized. How do you sell, maybe eBay or maybe PayPal allowed you to put your collectible on there and sell your baseball cards. Massive markets, wine, art.

Now you have digital representations of these things with provable certainty that they're authentic with price discovery at a global scale and so that I think checks a lot of the boxes of money.

CR: I want to get back to how you're investing at ParaFi. Because you said you're very active in these protocols yourselves. Besides tokens, are you investing in the platform's equity as well or are you only doing tokens?

Aligned Incentives

SR: Both, really. We think tokens are probably the best coordination mechanism to reward participants in the system, to bootstrap capital-efficient networks. If you think of Uber, as opposed to just giving equity to a few investors, now you have the possibility to give in these networks like Compound, Balancer, now but you're giving tokens to everyone in the mix. You’re giving tokens to employees, founders, investors, drivers, passengers.

“… we think tokens are probably the best coordination mechanism to reward participants in the system, to bootstrap capital-efficient networks.”

The coordination of all Uber required a lot of capital to bootstrap and expand geographically and acquire drivers and incentivize them, but a token totally shifts that on its head and says, hey, I'm going to incentivize everyone in the system to use the system and have skin in the game. I think that's why we think tokens are super powerful coordination mechanism to bootstrap these networks that otherwise would be super capital intensive. That's why you see a 0 to 1 moment of a lot of these networks. Well, when you align incentives, it's very, very powerful.

But we approach it as, our philosophy is to find the best operators, we find the best companies, we try to get them at the earliest stages and a lot of times, that's in equity. I think most of the market is realizing that issuing a token for a lot of these companies makes a lot of sense. Not all of them, but for most of them it's effectively a way to scale very efficiently.

CR: Are there cases where the equity and the token are misaligned? What's good for token investment isn’t good for the equity investor and when are cases when that happens?

Token Vs. Equity

SR: It's a good question. I think you either have one or the other. At a different evolution of the company's lifecycle, you might have equity and then you migrate to tokens and everyone is incentivized to accrue value of the token layer. If you have dual structures or dual tokens, it just introduces a lot of complexity and misalignment of incentives.

An example would be Binance, for instance, has equity and Binance and then it has the BNB token, which is a burn on the fees. We don't consider that the product because I guess, it's centralized, but that could create a whole host of different incentives. Because if you have the burn tied to gross profit, then Binance might want to have more operating expenses to not burn as much tokens and then it creates a weird set of incentives. We like to look at it, the cleaner the structure, the simpler the monetary policy, the better.

Everyone under who had equity, in Compound, for instance, everyone migrated to tokens, the team, the cap table, the investors and liquidity providers and borrowers in the system are earning COMP and it creates governance and everyone is a stakeholder in that system. I think the incentives are very clear and aligned.

CR: But when you say that you've migrated to tokens, you're still holding equity?

SR: Yes.

CR: In what way do you feel that's a migration?

SR: I think most of the value will just accrue to the tokens. We sort of think like the equity at that point, it loses value, it's deprecated. There may be an instance like where Compound might act as a development shop or the Comp system and there might be some residual equity value. But the real value in the system is in the token that accrues fees.

“I think most of the value will just accrue to the tokens. We sort of think like the equity at that point, it loses value, it's deprecated.”

CR: Now, what's most valuable is the open protocol, and the token is what's linked to that protocol, while the company itself is losing its control over the protocol and becoming a more separate structure to it. That's interesting to see how even at the investor layer, these two pieces are separating. It's not just philosophically, we're becoming more decentralized, it's actually, happening for those who invested in the company.

Single Instrument Accruing Value

SR: I almost think of them as cooperatives. Everyone has skin in the game to make this system work and you wrap it around with a token that in this case, has governance rights, you're voting for proposals to change parameters in the system. But everyone is voting and everyone is very incentivizing the team, the investors, the community, the liquidity providers, the borrowers, they all have the same instrument that accrues value and that's very powerful.

CR: How active is ParaFi in governance of these protocols?

SR: Quite a bit. I think we have a view on some, we've been quite active in Maker, we've been active in Compound and we've been helping other protocols design their governance and their token mechanics. I think that is a core part of investing in crypto. It's no different than I think being active at the board level. You have a much wider board in the shareholder meeting. But there still are stewards and anchors at the governance layer that guide the community. We've put forward some proposals in the systems that we think are beneficial.

CR: I wanted to ask you about how this level of participation of VCs or funds and the stake that they have in tokens is being seen in an increasingly bad light in the broader DeFi community, at least, if you go by crypto Twitter. But not just crypto Twitter, but also in the projects that have been launched recently have very explicitly said we're not taking VC investments and this project is going to be open to everyone. What's your take there? What’s the role of VCs and funds in this world where the tendency is to become the most decentralized possible at this time?

Transparent and Democratic

SR: We think that we bring a lot of value to the table in helping a company. We take some of this private equity mindset. My partner Ben was at KKR, I was at a fund that is started by KKR partners. It's really once we make an investment, we apply a lot of resources to help the team on the go to market token design and being active in governance. I think you look at historically political systems, I think offer a good analogy to how things work. You have representative democracies, whether it's how we exist in the US. Or we think of it more of a parliamentary system where you have elected representatives that act on behalf of the network.

In the UK, for instance, at any moment's notice, if the crowd is unhappy with parliament, they can dissolve parliament through a referendum. When you combine that with a transparency of how we're voting, how we're interacting, it creates the sort of Heisenberg principle because ParaFi, we know that everyone can look at how we're voting in Compound, everyone can look, there is a level of accountability, ownership skin in the game and vested interest in these systems that I think align incentives to the selling point around let's make this grow and let's make this the most robust, stable system.

I think the fact that we are held accountable, even though we may have a lot of economic weight to vote is very powerful, because we know that at the end of the day, this level of transparency is just we’d never had before. If someone is delegating their vote to me as a large COMP holder, they can delegate at any given moment time. I think that everything that we vote is on chain is visible and so it creates a level of ownership and accountability that aligns incentives very well.

Mind you, I think there's also this concept of, there's a very typically vocal minority that is extremely vocal, but not necessarily representative of the broader view. I think there's a little bit of that dynamic when you look at crypto Twitter and you look at forums.

I'm not making broad statements, I think, case by case, fund by fund, there are instances where a fund may not add value or may have different incentives. We like to take a more holistic view and look at the end of the day, there’s nothing like game theory. When you play an iterated game and you take the long view, one, it's so early and too, I think we all have an alignment of incentives to grow the systems in a way that are anti-fragile, in a way that really becomes scalable, usable by as many people as possible. We take the view that we are creating a lot of value here. It's not that the VC wins and a traditional other investors might not win. I think that's not how we think. We'd like to help teams as much as possible.

Sometimes it's not getting in the way, right, other times it's redesigning a token or helping them connect with market makers or CFi, that's looking to get more into DeFi things like that. There's a lot that happens under the hood that I think is not visible and that's fine.

I would encourage, go talk to our founders. We live and die by our reputation. Anyone that's criticizing funds, at least our view is, we live and die by that and that's the most important thing that we have from a deal sourcing perspective.

“I would encourage, go talk to our founders. We live and die by our reputation. Anyone that's criticizing funds, at least our view is, we live and die by that and that's the most important thing that we have from a deal sourcing perspective.”

CR: Talking with DeFi specific funds like yourselves, framework, Ikx and others it's really remarkable to me how active you need to be in DeFi or at least how active many of these DeFi specific funds are. It doesn't seem like, it's something that you can buy and hold these tokens and forget about it and come back in 10 years and see what they did and try to make an exit. It's you buy and then you're actively trading and providing liquidity and I don't know, lending, borrowing or whatever needs to be done. It's such a huge change, how do you experience it coming from the other side?

SR: You're absolutely right. This is sort of the fundamental premise of why I think at a personal level have decided to join and start crypto native fund. I think, investing in crypto specifically, DeFi is a totally different game and was not convinced in traditional funds, the sequoias of the world, are well equipped to win in this space, because it requires active management at a whole new level.

We approach it from, we have a whole vehicle that provides liquidity to these networks, which is the lifeblood in DeFi. It requires active management. We're extremely busy. Investing is just one part of the tip of the iceberg and everything else that we do. That's honestly the more fun part of this game. I think being in a team where collectively we have a multidisciplinary approach, you have to think of a system like Maker, you have to understand economics, monetary policy, incentives, governance and political systems, cryptography, engineering. It requires a whole host of skill sets that individually, none of us may have but collectively we think that we bring the bare like that package of the ParaFi package. It's fascinating.

Stablecoin Arbitrage

CR: This is a more tactical question but interested to understand how something like this is structured. Is there one fund that's for your DeFi equity investments, another one for the tokens and then a separate one that's trading on yield farming and deals with that sort of piece of investing?

SR: We have two funds, yes. One is the main fund which invests in both tokens and equity. The second one is a credit fund, which provides liquidity and it started off as a stable coin arbitrage fund and it since gravitated more towards yield opportunities, but market-neutral effectively.

CR: How do you remain market neutral?

SR: Well, most of what we deal with is stablecoins. You're not taking a directional view on the price of Ethereum or some other digital asset, you're just taking a view on stablecoin arbitrage opportunities. Because when you think about each system like DAI is subject to monetary policy in Maker, so changes to that monetary policy might cause a DAI to deviate from its peg. The stablecoins are meant to maintain a peg, but they deviate from that peg and so any movement around that due to monitor policy or imbalances in supply and demand, we're able to capture algorithmically. When you compound that and it creates a very interesting yield and we've been doing this for quite some time before sort of the agricultural revolution of sorts. But literally, when Compound issued token and opened up this whole explosion of liquidity mining, we looked at what Synthetix did way back and that's sort of like the OG of liquidity mining.

CR: What interesting opportunity so you're seeing now in that fund?

Cross-Blockchain Explosion

SR: There's a fascinating rotation of capital that's happening very rapidly and across networks to capture to optimize yield. We're seeing synthetic Bitcoins come into DeFi which is, I think you're barely scratching the surface. Something like Ren has seen an explosion of volume as of last couple weeks, especially since they open source their code. I think, we're seeing a gold ETF of sorts, you have Bitcoin which is gold, but now you can utilize it, you can energize it by interacting with Ethereum. A lot of Bitcoin folks have been hesitant to interact with DeFi, but I think the opportunity cost is coming to a point where it's too hard to ignore. You can layer with insurance and you can have more Lindy effect with a system like Ren to give more confidence that the system actually works and it's battle-tested and it's secure.

That’s a big opportunity when we're seeing Ren is now, I think it the 0.1% of all Bitcoin is now secured in Ren in a matter of weeks or called it a month. Now, when you really zoom out and say, well, what percentage of Bitcoin do you think is going to interact in Ethereum and DeFi? What percentage of DOTs, atoms, all these different systems? I think, we're starting to see that cross-blockchain conductivity that I think it's early and I'm quite excited to see where that goes and grows.

“We're starting to see that cross-blockchain conductivity that I think it's early and I'm quite excited to see where that goes and grows.”

CR: How do you take advantage of that? If you think you'll get more non-Ethereum assets on Ethereum?

SR: It's a great question. I think something like Ren VM is quite interesting or keep. What are the projects that are creating these bridges?

CR: Like buying the token?

SR: From the main fund, we would say, hey, well, let's put a position and have exposure to this secular trend that we see, connectivity across blockchains. Whoever is going to do it is going to create meaningful value.

CR: Interesting. What other interesting opportunities you're seeing for your main fund?

Trusted Pools of Liquidity

SR: Well, I think synthetic representations of real-world assets is something that I'm quite excited about. You have a couple of projects like Centrifuge or even Synthetix that can do this. With more robust oracle designs, we'll start to see more and more digital assets being ported over and have a digital representation of that. They’re starting to get into this territory where you have tokenized mortgages. Pretty interesting.

They also announced under-collateralized loans like this credit delegation, very interesting. You have an arguably very inefficient system because it's over-collateralized. But the moment you have a reputation layer, something like Tellor or a couple other products that are trying to build a better reputation system to create trusted pools of liquidity that are whitelisted —say that I know you Cami and I think you have some certain creditworthiness — think micro loans, Muhammad Yunus— and I say, I have land and you can borrow from me at a lower rate and under collateralized because I trust you.

Initially, the system had to be over-collateralized because no one trusts anyone, that's sort of the fundamental premise of blockchain is that it works because you don't need to trust anyone. But there is an opportunity to create trusted pools of liquidity that reduce collateralization ratio and build a reputation layer. I think that makes sense and I think that's a big opportunity that we'll see this year and the next year.

“Initially, the system had to be over-collateralized because no one trusts anyone, that's sort of the fundamental premise of blockchain is that it works because you don't need to trust anyone. But there is an opportunity to create trusted pools of liquidity that reduce collateralization ratio and build a reputation layer.”

Options generally are a fascinating space. You talk about, I will say there's still a lot of risk in the systems and so being able to insure against smart contract risk, being able to buy options is still very nascent. Nexus has done a good job to some respects. Every time they issue cover, it just gets gobbled up by the market. There are trade-offs in their design, it's KYC and a number of things. The way the premium is priced is like a black box, but options are more elegant market-driven mechanism for risk. Opyn or Hegic or a couple of projects are trying to crack this nut. There's a number of projects in the space that I think will have different, interesting design features.

CR: Interesting to see all these pieces being built from the ground up, something prevalent as options in traditional markets, a trillion-dollar market that’s been around for ages. And we're just seeing the very first projects rising in DeFi. It's crazy.

SR: We're so early in this space and there's so much infrastructure that needs to be built. DeFi alone is less than 5% of the entire crypto market cap, but more so the level of talent, the level of innovation, the quality of the builders that are joining the space keeps going up and up and up. I think that is the primary leading indicator of where we're going.

CR: On that I wanted to talk to you about this topic that we've touched on before, where you've compared DeFi with traditional fintech and how far ahead DeFi comes out when using traditional fintech’s metrics, which is pretty surprising, considering what we're talking about right now, how early DeFi is, but you're already seeing things like revenue on these protocols, which is something that many fintech’s have years and years without, still having unicorn valuations. Would love for you to dig into that.

Better than Fintech

SR: That's a core premise of what we invest in. If we were to send our investment memos to traditional investors, they would understand there are tangible metrics by valuation frameworks that they can understand. That's sort of a guiding principle of our investing and things that have product-market fit, that have traction in the way of earnings.

It’s explosive. Something like Synthetix for instance, is generating like $10 million of 24 hour volume, charging 30 basis points. You run that on a yearly basis, you're generating, call it $15 million of run-rate fees and it's trading at a 30-40 times forward PE ratio, not assuming any growth. You look at the roadmap, you get conviction, but on a conservative basis, if you say, okay, it's trading at 30-40 times forward PE ratio, you look at to your point, traditional fintechs, many of them don't even have earnings, but they're public and they trade out pretty nosebleed valuations. You've never really had this high growth and profitability.

I think it goes back to the initial point, which is these networks in traditional finance are very hard to bootstrap, very hard to scale, but the token design of Synthetix allowed it to get to scale in a very capital efficient manner. You look at their treasury, they're sitting on $180 million of treasury that they've managed. The network is worth $780 million on a circulating supply, call it a billion on a fully diluted basis. That war chest is controlled by a DAO and that will incentivize an ecosystem of players like dHedge and other participants to build on top of this protocol. Which I think is fascinating where you really have this base DeFi layer where anyone can create synthetic assets. Then you have on top of it, participants in use cases that are being built like Options and Neo social trading and a number of others.

“Traditional fintechs, many of them don't even have earnings, but they're public and they trade out pretty nosebleed valuations. You've never really had this high growth and profitability.”

That just is very interesting from a fat protocol thesis but applied to DeFi, where value accrual to the Synthetix layer is explosive because you incentivize people to build front end applications on top of your protocol.

CR: Those applications building on top of Synthetix will end up paying fees to Synthetix so Synthetix will also capture part of that value that’s being built on top?

SR: That's right. There's a very clear value accrual connection between anything that’s being built on top of Synthetix, like dHedge, for instance, it creates a social mimetic trading, like eToro or Set Protocol. Anytime you trade, there's a revenue share of the fee between dHedge and Synthetix -based protocol.

CR: Why do you think it's been easier for different protocols to achieve this level of profitability so quickly? Is the system more efficient, are protocols able to get to this level of volume with fewer people, the teams are smaller, is it lower costs, what's enabling all this?

Operating 24/7/365

SR: Let me put an example right, let's compare Coinbase and Uniswap. Coinbase trades, I don't know, $24 billion each day, it has a lot of overhead, employees, offices just a lot of overhead to manage these operations. Any revenue channel by Coinbase gets eaten up by a lot of this sort of fat in the middle, which is required to operate and power Coinbase.

You have Uniswap, which is a protocol, it’s just code and allows anyone to list your token, trade tokens on a bonding curve. It's a five-person team. I think they've now hired Mateo from The Block, he’s great, but it was Hayden and a few others for a long time. But it collapses this sort of requirement and it's sort of it deployed a code and then there's certainly development Uniswap v1, v2, but it doesn't have the overhead, it doesn't have the drag that Coinbase has. It also operates cross border, it's permissionless, it's open to anyone.

When you really touch on pools of liquidity on a global scale, it's explosive, whereas Coinbase is siloed first in US, in the UK and Ireland and so it's very fragmented and it's very capital intensive. I think of it as the margin on Coinbase might be, I don't know, 40%, 60%, maybe 80% if you get software-like margins. The margin on Uniswap, any fee that's generated by the protocol, most of that's going to, well, in this case, there's no token, but in other systems like Aave or Kyber, most of that fee is actually going to the token holders.

To put it bluntly, you have very capital efficient systems that are paying effectively most of the fees to token holders because they don't have any sort of requirements other than a team that sure might be deploying the code and maintaining it and upgrading the protocol but it's toward a magnitude difference. But Uniswap has never been down, operates 24/7/365. Coinbase, can't say that, you know?

“To put it bluntly, you have very capital efficient systems that are paying effectively most of the fees to token holders.”

CR: To be fair, Coinbase still has a lot more trading volume than Uniswap. In general, centralized exchanges do for now.

SR: For now, yeah. I think we're seeing, there may be a flipping.

CR: I believe that. If it continues to grow at this rate, it's been really exponential. On the fees being accrued to these open protocols, there's still the risk of there being a race to the bottom eventually, someone else will come and build a cheaper protocol beside and then a cheaper one and cheaper one and maybe those margins will start to compress?

Community is Key

SR: I don't know if I fully agree with that. I think, there is a parameter of fees like, Synthetix, so there’s 30 basis points, other protocols charged in a similar neighborhood. I think there is a point by which if you're too rent-seeking, you'll lose users. But mind you, I think in these networks around community, around the Lindy effect of being battle-tested. Certainly, when you introduce a liquidity mining program, it's very reflexive. More liquidity attracts more users, draws more volume increases, catalyzes this user acquisition and also liquidity acquisition. Flywheel effect.

Now not all programs are designed equally, but I thinkat the end of the day, you have to come at it from a first principle. At least we do, which is, you know, no amount of financial engineering will solve for a bad product. If you have a really good product, if your slippage is tighter than a centralized exchange, if you have more liquidity, people are going to use your protocol and are willing to pay a fee. I think there may be someone who might try to undercut you on the fees, but at the end of the day, it becomes harder and harder, I think.

“If you have a really good product, if your slippage is tighter than a centralized exchange, if you have more liquidity, people going to use your protocol and are willing to pay a fee.”

CR: I think you have a great point on the network or the community that these protocols have built, they're not easily replicable via competitor that's just offering a little bit lower fees. Also, the UI, all of that may also play a role as well.

I wanted to talk about the latest hot thing in DeFi with liquidity mining and you've touched on it, about how incredibly effective these programs have been in driving activity and liquidity to these protocols. But it does seem like all of this frenzy can't last for long. It's starting to feel like these meme tokens and unaudited protocols just be here to just take advantage of this trend. What's your view on this mechanism, going forward? Will it start to get a bad name because other people are just jumping into the liquidity mining bandwagon or will it be here for the long term?

Farm and Dump

SR: I guess, I can take that a million ways. But I think we're seeing the early signs of liquidity mining, I think Synthetix started a year, year and a half ago, Compound, Balancer, UMA. Some protocols are starting to wake up to this notion that you need it from a user acquisition perspective and I think it becomes a very powerful mechanism.

Not all systems are designed the same. I do agree with you to a certain extent, some programs are unsustainable, others have a more clear sustainable approach to creating value. Compounds issued over four years. But it has some flaws. Anyone can farm and dump, which is I think what you're getting at. There are other systems where you're incentivized to not do that and get rewarded for being a long-term user of the protocol.

We saw this in startup land. You had direct to consumer companies like Blue Apron and Uber and a lot of these companies just threw money at consumers to acquire users at all costs, that never ends well. Similar manner, anytime you give people the opportunity to earn what seems to be free money, there's risks attached to it, then they're going to take it and then they may do farm and dump.

“Anytime you give people the opportunity to earn what seems to be free money, there's risks attached to it, then they're going to take it and then they may do farm and dump.”

But I think, the teams that really get it are the ones that design a program that is sustainable, that keeps in mind acquiring the right type of user. The question is, would you rather have a million users that might stick around for two days and then go to the next thing? Or would you rather have 1,000 core users that are going to be so engaged, so involved in the community to drive this protocol forward?

In many ways, Synthetix got this from the beginning. You had to lock your Synthetix rewards for a year. There is a capital cost, so, there was an opportunity cost associated with that. But meanwhile, Synthetix is created, look at where it is now. It has perhaps one of the strongest communities that I can think of. The community is very active in governance, it’s progressively decentralized until recently where it created three different DAOs and the community has evolved. It might not have the most total value locked, vanity metric. But if you take the long view, I place my bet on that type of program working, that is incentivizing the right user.

Buyer beware. Anytime it feels too good to be true, there's either a lot of risks associated with it. You're right, there are some protocols that are launching these programs that are not audited. And it's important to factor that and take that into account.

CR: With these programs that feel a little bit more not thought out to be for long term holders, like Synthetix or Compound, what's the risk there? Because it feels like, okay, so you're a trader, you’re putting in tokens to get these new farmed token, at 100% APY or whatever, but somebody has to be on the other side. I'm just trying to understand in these projects, who are the winners and losers? Is the loser the guy who ends up buying the token at the top? Who's taking the risk?

Seeing What Sticks

SR: Certainly. That's a good way to look at it. There's always that dynamic where there's market incentives. For something like farming, you have effectively no cost, and you're earning these tokens. Think of YFI, fascinating experiment, YAM, you're depositing idle assets and earning this token in a protocol.

A lot of these are like let's just throw it in the wall, see what sticks and create a community around it. I will say though, to be fair, YAM went from zero to $600M in total value locked in 24 hours. You saw it took Maker two years, Synthetix two years, one day. Now, you could argue well, there's still 300 million there in earning YAMs. I look at that and that's a very interesting experiment.

“A lot of these are like let's just throw it in the wall, see what sticks and create a community around it.I will say though, to be fair, YAM went from zero to $600M in total value locked in 24 hours.”

Look, drama aside, audit, whatever, no comment on that. I think there ought to be more formal review and create a Gitcoin program to audit these things and make sure they’re battle-tested before they go live. Fair point.

But I will say, it's a very interesting experiment, where it felt like a video game. It felt it was addicting. It created a community, it sucked the energy out of the room in a way that is hard to ignore. Now what do you do with that? You have all this energy to harness, then what do you do with that? I think the value prop of that is, well, let's create a nice community and what other things can we build on top of that? I think it's a little bit of, hey, let's come together. YFI, for instance, has been a fascinating experiment.

“But I will say, it's a very interesting experiment, where it felt like a video game. It felt it was addicting. It created a community, it sucked the energy out of the room in a way that is hard to ignore. Now, what do you do with that?”

SR: Not every program is the same. But I think it's really interesting to see this community-driven approach and how quickly these networks can scale and there'll be a lot of experimentation. Maybe we'll revisit this in 6 months and criticize it or what have you, or this is a new paradigm to create communities and communities build a lot of value, right?

CR: It's interesting, because you're right, that it does shift the traditional roadmap on its head. It's like, let's create community first, and drive liquidity and volume as quickly as possible, and then we'll figure out a way to make it useful and safe.

SR: Don’t forget this: Creating a community of enthusiasts is extremely powerful. Look at video games. It sounds trivial, but this is what we think about value. It's not just about monetary incentives, it's about being part of something that you feel attached to, that you have an affiliation towards. At the end of the day, it's touching a very primal desire to connect with people, to connect with others.

“Don’t forget this: Creating a community of enthusiasts is extremely powerful. (…) At the end of the day, it's touching a very primal desire to connect with people, to connect with others.”

It's going to sound like a stretch, but I do believe that really transformational technology touches a primitive human need, desire, emotion and as humans, we have a desire to connect with others. If people don't see the… maybe it's a stretch, but owning YAM or owning YFI and being part of governance for anyone from their dorm room, you don't care about their age, their race, where they are, what credentials they have, it's who has the best ideas to create a system. Honestly, I think of the sovereign individual, power is shifting from experts to broadly anyone in the ecosystem. It's about what value do you bring?

I'll say this, you asked me the question. As VCs, as investors, as I mean, everyone, it's competitive, it's like what have you done lately? How relevant are you in the space? It's a constant game. It's competitive and it's open source. You know what, that I think introduces a level of healthy competition to create systems that the intellectual firepower and a discussion around YFI or YAM in different designs is, skip school and just go directly to the community and interact with people. Seriously.

We're all in this space, because we've learned so much and the smartest people that I've met are in crypto and that to me is the most rewarding thing and I think, it will only continue to attract better talent. We need better builders. I think we're seeing that and that is the primary proxy of how much potential this space has.

The Defiant is a daily newsletter focusing on decentralized finance, a new financial system that’s being built on top of open blockchains. The space is evolving at breakneck speed and revolutionizing tech and money. Sign up to learn more and keep up on the latest, most interesting developments. Subscribers get full access at $10/month or $100/year or 70 Dai/year, while free signups get only part of the content.

About the founder: I’m Camila Russo, author of The Infinite Machine, the first book on the history of Ethereum. I was previously at Bloomberg News in New York, Madrid and Buenos Aires covering markets. I’ve extensively covered crypto and finance, and now I’m diving into DeFi, the intersection of the two.