If DeFi will devour traditional finance in the next decade, how should we invest in DeFi?

Written by: Arthur Cheong, DeFi & Cryptocurrency Investor
Compilation: Johnny

Regarding DeFi’s investment theory, my summary is as follows:

“In the past decade, software has engulfed the world; in the next decade, DeFi will devour traditional finance.”

Why will DeFi devour traditional finance?

Since the beginning of the industrial era, the global financial structure has remained basically unchanged, relying heavily on financial intermediaries. Despite major advances in software technology, a large portion of existing financial infrastructure is still outdated and overwhelmed. Although many fintech products have emerged to fill this gap in the past 10 years, they all need to be integrated with the existing financial system to work. For example, the world’s most popular e-wallet provider needs to connect with an existing bank account in order to withdraw and recharge.


Source: Liberty Games

However, today, with the arrival of DeFi based on the smart contract blockchain without permission, all of these are undergoing revolutionary changes.

The benefits of DeFi will spread throughout developed and emerging markets. In developed markets, DeFi will provide consumers with more choices, reduce the cost of the traditional financial system, and bring greater liquidity and product innovation to the financial market. For emerging markets, with the rise of stablecoins, DeFi will provide a safer means of value storage and provide financial services to billions of adults who cannot use the existing financial system.

Eventually, DeFi replaced the “credit layer” of finance with software and codes, namely financial intermediaries such as banks, asset management companies, and insurance companies.

By eliminating financial intermediaries and related costs, DeFi brings the promise of wider access to financial products, programmable currencies, real-time risk transfer, and auditability of financial contracts. This represents a new stage in the development of financial services, which is characterized by transparency and openness, which will promote more financial inclusion.

The financial sector is the largest product / market for blockchain without license

For those who are concerned about this field, it is clear that DeFi is the biggest success story in the field of encryption since 2019. DeFi has grown into one of the most active areas of blockchain: through every measurable indicator, such as the total value locked in DeFi, user growth and transaction volume, DeFi has experienced rapid growth. From stablecoins, decentralized exchanges, lending platforms, payment networks to synthetic assets and asset management, the DeFi ecosystem is booming.

DeFi’s success did not come overnight. Since Satoshi Nakamoto created Bitcoin 11 years ago, it has laid the foundation for DeFi. However, due to the limited programmability of Bitcoin, it is difficult to build a financial agreement on top of it. With the advent of Ethereum, this became possible. Ethereum is a license-free blockchain with complete smart contract functions that can build more complex financial applications on it. As early as 2014, the Ethereum white paper mentioned financial derivatives and stablecoins.

Over the years, there have been countless attempts to use unlicensed blockchains in other use cases, but with the exception of DeFi, these attempts have been unsuccessful, such as the more than 100 projects listed on ICObench, including media, entertainment, and even travel Waiting for various categories, although the initial ICO boom has enabled countless such attempts to obtain funding. In addition, even the practice of integrating a license-free blockchain into a supply chain system is difficult to obtain support, no matter how much support it has received from large companies.

Among the projects trying to build on the permissionless blockchain, only the DeFi project is booming, which is no coincidence. The license-free blockchain is a distributed database optimized for decentralization and openness, while sacrificing certain performance-this is a high price: Compared with the use of cloud infrastructure such as AWS, The speed of storing data is several orders of magnitude slower and more expensive.

However, finance has always been based on trust, which has traditionally been built on intermediaries such as banks, exchanges, insurance companies, asset management companies, and custodians. Since the industrial revolution, the structure of the entire industry has remained unchanged until the emergence of financial technology in the past decade. Although many fintech startups have further improved financial efficiency, they are still not generally available and often operate within the boundaries of a single nation-state.

Compared with other use cases, even if there are tradeoffs in computing and storing data, it is worthwhile to use unlicensed blockchain for financial changes, because financial service providers are always at the trust layer (not the cost layer) Compete. By transforming the trust layer from financial intermediary to software and code on the blockchain, DeFi can provide universal access to financial services. This represents a paradigm shift in which a user experience with minimal trust is possible. In such an era, controlling users’ data and Crypto activities may be a burden, and DeFi will be able to provide better products and services than traditional finance.

A good example is the rise of stablecoins, which solves the biggest obstacle to the widespread use of cryptocurrencies due to the volatility of cryptocurrencies. The total market value of stablecoins has increased fivefold in the past two years, and the total supply is close to US $ 10 billion. The total value of stablecoin transactions on Ethereum also exceeds the ETH asset itself.


Source: Nic Carter & Coin Metrics

Stablecoins have also filled the gap in dollar demand that traditional channels cannot meet. In terms of supply, USDT, the largest stablecoin by market value, is particularly popular outside the United States. The total supply of stablecoins will continue to grow rapidly in the short term.

DeFi’s interoperability and composability further accelerate the growth of stablecoins, as different financial primitives can be built on top of each other, thereby providing better-than-centralized, similar products and services.

For example, whether it is a lending platform like Aave or an automated market maker liquidity pool like Uniswap or Curve Finance, stablecoins account for the vast majority of the value locked in various DeFi agreements. This allows users to obtain profits through stablecoins, which is increasingly difficult to achieve in the zero interest rate environment after COVID-19.

In less than three years, the total locked asset value (TVL) of DeFi applications has exceeded US $ 800 million, with a peak value of US $ 1.2 billion. As more users come into contact with DeFi and gradually accept it, this field may further develop.

All the above factors indicate that DeFi is suitable for the main product / market of license-free blockchain driven by smart contracts, and will remain so in the foreseeable future.

DeFi’s investment philosophy

All successful investors have a guiding philosophy that guides them to make investment decisions. As far as DeFi is concerned, it is more important to have an investment philosophy that can help us enter this rapidly changing DeFi field. My investment philosophy can be summarized as follows:

Fundamental-centric investment, combined with active participation, will produce the most sustainable returns.

Most cryptocurrencies are mispriced, but fundamental factors are gradually becoming more important in price discovery.

In the traditional financial field, the degree of information asymmetry in the open market is low, and the scope of access is wider, resulting in fairer price discovery and liquidity premium. However, this situation in the traditional market may be completely opposite to the new industry of DeFi.

The cryptocurrency open market is mainly dominated by non-professional investors, coupled with the lack of widely accepted valuation methods, which shows that most cryptocurrency open market investors do not adopt strict methods when making investment decisions. Usually, prices are determined by speculative enthusiasm and memes, and major news and exchange listings tend to drive a lot of directional movement.

Given the nature of cryptocurrency open markets, the pricing of many cryptocurrencies listed on exchanges may be more unreasonable than the pricing of private markets dominated by professional investors. This is especially true for cryptocurrencies that are listed on exchanges and have a market value of less than $ 500 million.

The lack of liquidity of these low-market-value cryptocurrencies makes them unattractive to established cryptocurrency hedge funds, because most hedge funds need to maintain a liquid asset portfolio to deal with potential investor redemptions. On the other hand, cryptocurrency venture funds tend to ignore these low-capitalization cryptocurrencies because these funds focus on the primary market and stocks, and in these areas, their perceived advantages are stronger.

For most investors, undervalued cryptocurrencies are an ideal investment target, because such cryptocurrencies provide a three-fold rise probability and limited fall probability (<30%), but for venture capital funds This is not the case (because of venture capital economics [1]). This has led to a lack of professional investors in these types of cryptocurrencies, and professional investors can often actively study how to effectively discover the price of cryptocurrencies.

A good example is comparing Kyber Network (KNC) and OmiseGo (OMG). Both were launched in mid-2017, with the goal of establishing a decentralized exchange and liquidity agreement, although the two used different approaches.

Kyber Network went live in February 2018, and has processed more than 1 billion US dollars in transaction volume, but OmiseGo has not yet launched any products at the production level, and has repeatedly delayed its milestones. However, for most of the past 12 months, OMG’s transaction value is much higher than KNC.

However, Kyber Network will soon be upgraded, through transaction fee rewards (after upgrade, users will be able to pledge KNC to participate in governance and get transaction fee rewards) and KNC token destruction to allow KNC to obtain better value growth.

As of May 24, 2020, the market value of OMG is still nearly twice that of KNC. However, considering that the market is forward-looking on the growth prospects of individual agreements, most savvy investors disagree that OmiseGo has a better growth prospect than Kyber Network.

We see some signs that fundamental factors play an increasingly important role in the price discovery of cryptocurrencies. Current affairs news that focuses on the fundamentals of various cryptocurrencies is often widely read: Recently, only major partnership announcements have not pushed prices up as they have in the past. Traction is driving more positive price movements.

For example, when Kyber Network’s transaction volume increased significantly and gained more market share, KNC began to outperform the market; so far this year, as more and more investors noticed the rapid growth of the Aave (LEND) platform, the LEND generation The currency has rebounded substantially.

This is particularly true for DeFi agreements that can reward token holders through various forms (such as buybacks, destruction, or direct reward distribution). In addition, cryptocurrency analysis tools such as CoinMetrics and Token Terminal also help to increase the importance of fundamentals in the cryptocurrency price discovery process.

When investing in DeFi, active participation is essential

There are also different spectrums between cryptocurrencies. Some of the more mature crypto networks (such as Bitcoin and Ethereum) are closer to commodities in nature, and most DeFi protocols are more similar to early equity, even if they may be publicly traded. of.

These young DeFi agreements require active support, including the provision of liquidity, product feedback, participation in governance, and other community inputs to be successful. But for some DeFi protocols, such support and collaboration may not exist or be lacking. Active investors can provide value in various ways to fill this gap.

For any DeFi agreement, the most defensive moat is the liquidity and balance sheet that its platform can attract. Good liquidity is crucial for decentralized exchanges (DEX), because for users, price is the biggest difference factor. A loan agreement with a larger balance sheet can attract more borrowers (borrowers), thereby increasing the interest rate paid to lenders.

The long-term challenges of both “demand” and “supply” in the bilateral market (ie, supply and demand challenges) also apply to the DeFi agreement, which is the entry point for active investors.

For example, DEX (such as Uniswap) that uses an automated market maker strategy needs to provide a lot of liquidity in the beginning to use. Investors who can provide the first liquidity pool can capture significant value by removing the first major obstacle for the exchange. Similarly, for loan agreements that are critical to the balance sheet, investors who can inject additional capital into the loan pool will be able to significantly increase the chances of getting a return from this investment.

Due to the high degree of information asymmetry in the DeFi field, the positive fundamentals of cryptocurrencies may be overlooked. An active investor who has been widely concerned can also increase the exposure of the DeFi protocol through support and ideological guidance. Most importantly, for those investors who are also senior users of the DeFi agreements they have invested in, these DeFi agreements are trustworthy.

Investors who try DeFi can also spread comments and feedback on the DeFi agreement to followers who have similar interests in the agreement. This is usually one of the best ways to build users and community members. Investors using the DeFi agreement often also understand the complex details of the agreement and may use occasional information asymmetry to profit.

In addition, DAO is re-emerging in the field of DeFi, but requires the active participation of stakeholders to be effective. The indifference of voters in a DAO (not actively participating in governance) may lead to problems of rich rule, which will gradually erode people’s trust in the crypto network. Therefore, the existence of different investor groups can greatly enhance the credibility of agreement governance.

Therefore, I believe that a cryptocurrency investment method that combines fundamental research with active participation is the largest source of sustainable returns. We are just beginning to realize the huge potential of this overlap between ordinary users and investors (ie DeFi token holders).

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