DeFi Assets: Equity For The Decentralised World
In the early days of crypto assets it was extremely hard to find genuine economic value being created outside of Bitcoin. Many of the earliest crypto assets were either meme’s (DOGE) or variations of Bitcoin (Litecoin) with different experimental use cases. The launch of Ethereum in 2015 has enabled crypto assets to have greater utility and ultimately create economic value in various forms.
In this article we will look at how decentralised finance (DeFi) assets are increasingly becoming the equity for the decentralised network economy that is powered by blockchain and crypto. We will outline the similarities and differences between traditional equity instruments and crypto assets as well as explain why crypto assets will drive a new age of economic expansion as the digital economy roars forward.
We are mainly referring to DeFi governance tokens such as SNX, SUSHI, CRV, UNI & AAVE but there are various other crypto assets that also have economic value and utility e.g. liquidity pool tokens.
In traditional finance, financial products are developed, sold and managed by a small number of large institutions such as banks, fund managers etc. In decentralised finance, financial products are developed, deployed and managed by software developers and distributed communities who are wholly incentivised to help the software succeed and become economically valuable.
As more talent pours into the crypto asset space, token value accrual models are becoming more sophisticated, meaning that teams are more capable at creating value for their token holders and investors. Crypto investors such as Apollo Capital and firms such as Delphi Digital and Saxon Advisors offer tokenomics consulting for DeFi protocols, helping DeFi assets find the right tokenomics model is key for their future success.
The fact that DeFi assets have an on-chain cash-flow means they have an intrinsic value and traditional valuation metrics become relevant. For a Decentralised Exchange like Sushiswap, part of the trading fee goes to the stakers of the SUSHI token. Some analysts have applied the dividend discount model to SUSHI to arrive at an intrinsic token price that is well above market price. Synthetix has a similar model where stakers of SNX earn Synthetix exchange fees as well as inflationary rewards.
Token Terminal is an example of a website that is tracking yield and value creation of DeFi assets. The below graph depicts the exponential rise in total revenue generated by some major DeFi assets.
Yield can be tokenized by creating ‘yield bearing tokens’, these tokens represent a right to the underlying asset pool, they are yield bearing because this asset pool is constantly being added to with fee revenue. This creates another layer of abstraction and composability across DeFi (more on that later), examples include xSUSHI, cUSDC, ibETH and imMUSD.
Decentralised finance protocols are open source software that have very low overhead due to their purely digital nature. As an example, Uniswap has 13 core contributors while their centralised counterpart Coinbase has 1,249 employees. In some cases, part of the cash-flow for DeFi assets is used to fund the development of the protocol. In other cases, founders are compensated purely by their initial share of tokens in the protocols, thus all top-line revenue flows to the bottom line of token holders.
DeFi protocols are hyper efficient because they replace humans with software, it is automation of the financial sector. We believe that DeFi’s disruption of traditional finance will bring a vast amount of economic prosperity to all corners of the globe. The financial sector makes up a very large portion of the GDP of almost all countries in the world. The market capitalisation of the global banking sector is estimated at around US$100 trillion with the AUM of asset managers being another US$100 trillion. Replacing parts of that infrastructure with automated software protocols would be akin to a financial revolution.
A core value proposition for many DeFi assets is the ability to use the token to vote in governance proposals, these governance proposals allow the community to shape the future of the protocol from the ground up through Decentralised Autonomous Organisations (DAOs). The DAO is the on-chain incorporation of this new emerging decentralised world.
The website DeepDAO aims to track all the activity going on in this new world of DAOs:
An example of this is the YFI governance token that is used to vote in Yearn-improvement-proposals (YIP’s) for Yearn Finance. In the 8 months since the release of YFI there have been 60 YIP’s, 15 have been implemented, 4 have been approved and the rest have been rejected, with not all YIP’s going to a vote. Compared to the voting power of being a shareholder, the governance is much more direct in DeFi.
Inflationary rewards are a common strategy that DeFi protocols use to attract and bootstrap liquidity. By doing this, protocols are able to spread their governance token to the community in order to further align incentives. The customers of Coinbase didn’t receive shares in the company, instead there is a small group of well connected Venture Capitalists who hold most of the shares in Coinbase. In contrast, Uniswap airdropped 400 UNI to each unique that had ever used the decentralised exchange, 400 UNI is currently worth US$14,800. According to Dune Analytics, 215,037 addresses have claimed UNI tokens for a total value of US$4.7bn. The users and the owners of governance tokens become one and the same, forging a strong network effect.
One major way DeFi assets are different from equity in private companies is that there is a liquid market for DeFi assets. The long tail of DeFi assets are increasingly traded on permissionless decentralised exchanges where liquidity is incentivised.
Creating a governance token for a DeFi product is similar to accessing public liquidity for your private equity. There is no barrier to entry for creating a market on a decentralised exchange like Uniswap. If you create a great DeFi product and successfully launch a token with genuine value, liquidity will come.
As an example, there are currently 123 tokens with over US$2 million in liquidity on Uniswap alone.
While Coinbase and PayPal are not open protocols that you can build directly on, DeFi assets exist on open platforms like Ethereum and other blockchains. These are powerful lego blocks that anyone building in DeFi can use, reuse and leverage. The open nature of blockchains is in our opinion this is a key reason why we have seen the Cambrian explosion of innovation in DeFi.
This composability enables a greater level of capital efficiency to be achieved as liquidity can be ‘unlocked’. An example of unlocking liquidity is MakerDAO accepting Uniswap liquidity pool tokens as collateral for minting DAI. Users can take their USDC & ETH, deposit it into Uniswap to earn a yield, deposit that liquidity pool token into MakerDAO, Mint DAI (debt) and then deposit that DAI into KeeperDAO to earn 46% per year (variable).
The ability for investors to carry out strategies that involve multiple transactions to increase capital efficiency is a game changer. While these strategies do not come without added risk, they create a powerful network effect that pushes innovation and collaboration forwards. At Apollo we closely monitor our exposure to this ‘composability risk’ for both of our Funds to ensure that our strategies have the optimal risk/ return profile.