DeFi Will Eat Traditional Finance and Active Investors Can Reap the Rewards

Hello Defiers! Today Arthur Cheong, one of the most active investors in DeFi, lays out his investment philosophy for public crypto markets. He combines fundamental research with an active strategy, where he works closely with the team and the community of the crypto-networks he invested in so that he can contribute to the token’s success. His philosophy, he says, has generated market-beating returns for his crypto and DeFi portfolio, which he has grown since August, 2018.

Cheong, who goes by the internet name of @Arthur_0x, also makes the case on why open finance will replace the traditional system. The bottom line is: It’s just better. It saves time and cost. It lowers the barriers of entry so that more people can have access, and it’s more transparent and auditable.

I dare you to not feel a a bit more bullish after reading this piece.

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As software ate the world over the last decade, DeFi will eat traditional finance during the next one

By Arthur Cheong, DeFi & Crypto Investor

My investment thesis on Decentralized Finance (DeFi) can be summarized with the quote below:

“As software ate the world over the last decade, DeFi will eat traditional finance during the next one”

Why DeFi will eat traditional finance

The structure of global finance has remained largely the same since the start of the Industrial era, with a heavy reliance on financial intermediaries. Despite major advancements in software technology, huge parts of existing financial infrastructure remain archaic and burdensome. While many fintech products have sprouted into existence over the last decade to fill the gap, they all need to be plugged into the existing financial system to function. For example, most popular e-wallet providers in the world need to be linked to an existing bank account for withdrawal and top-up.

Image source: Liberty Games

Today, however, all these are being revolutionized by the arrival of DeFi built on smart contracts permissionless blockchains.

The benefits of DeFi will be major across both developed and emerging markets. In developed markets, DeFi will provide greater choice to consumers, reduce the costs of the legacy financial system, and bring greater liquidity and product innovation to financial markets. For emerging markets, DeFi will provide a more secure store of value with the rise of stablecoins and offer financial services to billions of adults who lack access to the existing financial system.

Ultimately DeFi replaces the “trust layer” of finance, which are financial intermediaries such as banks, asset management firms, insurance companies with software and code.

By abstracting time and cost of financial intermediaries, the promise of DeFi is wide — broader access to financial products, programmable money, real-time risk transfer, and auditability of financial contracts. This represents a new phase of financial services development characterized by its transparency and open nature that will bring forward more financial inclusion.

Finance is the biggest product/market fit for Permissionless Blockchain

For those who have been paying attention, it is clear that DeFi is the biggest success story in crypto since 2019. It has grown into the most active sectors of blockchain, experiencing rapid growth by every measurable metric such as total valued locked, user growth, and volume. From stablecoins, decentralized exchanges, lending and borrowing platforms, payments networks, synthetic assets, and asset management— the DeFi ecosystem is flourishing.

The success of DeFi didn't come overnight, the groundwork has been laid since Satoshi Nakamoto created Bitcoin 11 years ago. However, it is difficult to build finance protocols on top of Bitcoin given its limited programmability. This is made possible with the arrival of Ethereum, a permissionless blockchain with Turing-complete, smart contract functionality that makes it possible to build more complex financial applications on top. Financial derivatives and stablecoins were mentioned in the Ethereum whitepaper as far back as 2014.

Over the years, there were countless attempts to use a permissionless blockchain for other use cases but none of these attempts have been successful except DeFi. More than 100 projects for each category such as media, entertainment, and even tourism are listed on ICObench. The boom of Initial Coin Offering (ICO) has led to a myriad of these attempts getting funded. Even the seemingly natural fit of integrating permissionless blockchains into supply-chain systems have struggled to gain traction, no matter how many big corporations threw their weight behind it.

Among projects that tried to build on top of permissionless blockchains, it’s no coincidence that only DeFi projects are thriving. Permissionless blockchains are distributed databases optimized for decentralization and openness while sacrificing performance ––a high cost to pay. Ethereum is a few orders of magnitude slower and costlier in computing and storing data compared to using a cloud infrastructure like AWS.

Finance, however, is built on the foundation of trust which is historically placed on the intermediaries like banks, exchanges, insurers, asset managers, and custodians etc. The whole industry had remained structurally unchanged since the industrial revolution, until fintech came into existence over the last decade. While many fintech startups have further improved the efficiency of finance they are still not universally accessible and tend to operate within a nation-state border.

Compared to other use cases, the trade-off of using permissionless blockchain for finance is worthwhile, as financial service providers have always competed on the trust layer instead of the cost layer. By transferring the trust layer from financial intermediaries to software and code on the blockchain, DeFi can provide universal access to financial services. This represents a paradigm shift where trust-minimized user experience is possible. In an era where control of users’ data and digital activity might be a liability, DeFi will be able to provide much better products and services at scale than traditional finance.

A good example to illustrate this is the rise of stablecoins, which solve the biggest obstacle that prevents crypto from being widely used as a medium of exchange due to its volatility. The total market capitalization of stablecoins has grown 5 times over the last 2 years reaching close to $10billion in total supply. Total value transacted on-chain of stablecoins on Ethereum have also overtaken the native asset Ether itself.

Image source: Nic Carter & Coin Metrics

Stablecoins also fill a massive gap of demand for US Dollars which can’t be satisfied with traditional channels. The largest stablecoin by supply, USDT, is especially popular outside of the US. Total stablecoins supply will continue to grow rapidly in the near term riding on zero interest rate tailwind which lowers the opportunity cost of holding stablecoins.

The interoperability and composability of DeFi further accelerates its growth as different financial primitives can be built on top of each other to offer superior products and services compared to the siloed, walled-garden nature of centralized counterparts. For example, stablecoins form a majority of value locked in various DeFi protocols be it lending and borrowing platforms like Aave or automated market maker liquidity pools such as Uniswap or Curve Finance. This enables users to generate yield on their stablecoins which is increasingly hard to attain in the post-COVID-19 zero interest rate environment.

In less than three years, Total Value Locked (TVL) in DeFi applications has grown to over $800m, reaching $1.2b at the peak. It is likely to grow even further from here as more audiences are exposed to DeFi and gradually adopt it.

All the factors above point to the fact that DeFi is the main product/market fit for smart contract enabled permissionless blockchain and will likely remain so for the foreseeable future.

An Investment Philosophy for DeFi

All successful investors have a guiding philosophy that leads to investment decision making. It is even more important to have one that can help us navigate this rapidly changing DeFi scene. My investment philosophy can be summarized in the following way:

Fundamentals- focused investing, combined with active participation generates the most sustainable returns in crypto.

Most cryptos are mispriced, but fundamentals are gradually gaining significance in price discovery.

In traditional finance, public markets have less informational asymmetries and wider access, leading to fairer price discovery and a liquidity premium. However, the situation might be the exact opposite of this nascent sector.

Public markets in crypto, beyond the top few, are dominated by non-professional investors. Combined with a lack of widely accepted valuation methodology, this signals most public crypto market investors do not apply a rigorous approach when it comes to making investment decisions. More often than not, prices are determined by speculative fervor and memes, with major announcements and exchange listings driving lion share of directional movements.

Given the nature of public crypto markets, many listed cryptos might be more mispriced than their private market counterparts, which are dominated by professional investors. This is especially true for publicly listed crypto with market caps of less than $500million. The illiquid nature of these low market cap coins makes them unattractive to established crypto hedge funds, as most need to maintain a liquid portfolio to face potential investor redemptions. On the other end, crypto venture funds tend to ignore them because they’re focused on primary markets and equity where their perceived edge is stronger.

Undervalued crypto that offers a high probability of additional 3x upside and limited downside potential (<30%) are ideal investment targets for most investors, but not for venture funds, due to venture economics. This creates a dearth of professional investors that actively research to enable efficient price discovery of these cryptos.

A perfect example to illustrate this would be comparing Kyber Network and OmiseGo. Both were launched in mid-2017 to build a decentralized exchange & liquidity protocol, albeit with different approaches. While Kyber Network went live in Feb 2018 and has processed more than $1billion in volume, OmiseGo has yet to launch anything on production level and has pushed back its milestones multiple times. Yet for the majority of the last twelve months, the native crypto of OmiseGo‒OMG was trading at a much higher valuation than native crypto of Kyber Network‒KNC. This is despite a clear upgrade of Kyber Network soon which will grant KNC better value accrual through fee reward or token burning through governance participation.

As of May 24, 2020, OMG is still trading at almost twice the market cap of KNC. Even taking into account that the market is forward-looking in discounting growth prospects of individual protocols, most savvy investors would disagree that OmiseGo has a better growth prospect than Kyber Network.

However, we are seeing signs of fundamentals playing an increasingly important role in the price discovery of crypto. Newsletter focusing on on-chain fundamentals of various crypto is widely read. Major partnership announcements alone don't drive price as much as it used to, while major improvements and actual traction in measurable numbers are driving more positive price movement recently. For example, KNC started to outperform the market when the trading volume on Kyber Network recorded a huge growth and gained more market share. While native crypto of Aave ‒LEND has rallied significantly YTD with more investors noticing the rapid growth of its platform.

This is especially true for DeFi protocols that generate rewards for its holders in various forms such as buyback and burn or direct reward distribution, which makes it more straightforward for investors to conduct valuation exercises. The emergence of crypto analytics tools like CoinMetrics and Token Terminal also help to elevate the importance of fundamentals in price discovery of crypto.

Active participation is crucial in DeFi investing

Crypto also comes with a diverse spectrum, while some mature crypto networks like Bitcoin and Ethereum are closer to commodity in nature, most DeFi protocols are more similar to early-stage equity, even though they might be publicly traded.

These young DeFi protocols require active support, including liquidity provision, product feedback, governance, and other community inputs to succeed. But such collaboration might not exist or be lacking for some crypto. An active investor can bridge this gap by stepping in to provide value in various ways.

The biggest defensible moats for any DeFi protocol are the liquidity and balance sheet it can attract to its platform. Good liquidity is paramount for decentralized exchanges (DEX) since most cryptos are fungible so the price is usually the biggest differentiating factor for users. Lending & borrowing protocols with a bigger balance sheet can attract more borrowers which in turn increases the interest rate paid to lenders.

However, the perennial chicken and egg challenge of bootstrapping demand & supply at the same time for a two-sided marketplace applies to DeFi protocols as well. This is where active investors come in.

For example, a DEX that utilizes an automated market maker strategy needs significant liquidity provision at the beginning to be usable. Investors that can provide the first pool of liquidity will add significant value by removing the first major obstacle. Similarly, for lending & borrowing protocols where the balance sheet is paramount, investors who can inject additional capital into the lending pool are significantly improving the odds of generating returns from this investment.

Positive fundamentals of crypto might be overlooked due to a high level of information asymmetry in this space. An active investor who is widely followed can also elevate the DeFi protocol’s exposure through endorsement and thought leadership. Most importantly, there is significant credibility to investors who are also power users of the DeFi protocol they invest in. A dogfooding DeFi investor can broadcast her product review to followers with similar interests. This is often one of the best ways to build a dedicated group of users and community members. An investor that uses the DeFi protocol will also understand its various intricate details and might be able to capitalize on the information asymmetry that presents from time to time.

DAO is re-emerging in DeFi but requires active stakeholder participation to be effective. Voter apathy in a DAO will likely lead to plutocracy which gradually erodes the trust in the crypto network. Therefore the presence of diverse investor groups significantly bolsters the credibility of the protocol’s governance.

It is thus my view that the crypto investing approach that combines fundamental research with active participation presents the biggest source of sustainable return. We are only beginning to realize the vast potential of this overlap between users and investor groups.

If you are building an exciting DeFi protocol and want to reach out to a potential power user and investor, I am always happy to discuss.

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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.

About the founder: I’m Camila Russo, a financial journalist writing a book on Ethereum with Harper Collins. (Pre-order The Infinite Machine here). 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.