DeFi’s Structural Weakness

DeFi has a structural weakness: Credit.

Without the ability to extend credit, demand for borrowing in DeFi is limited to a narrow set of crypto-native use cases where overcollateralization is an acceptable price to pay for access to funds. 

There are two primary use cases for crypto borrowing today. Accessing liquidity or getting leverage. 

Individual borrowers access liquidity by posting their crypto as collateral, borrowing stablecoins, and then converting those stablecoins to fiat. The APY on USD stablecoins is ~10%, which means this borrower is betting that their Ethereum will appreciate by over 10% per year. This borrower may also be using the loan in order to avoid selling their crypto, which would trigger a tax event, and therefore make the high APY an acceptable tradeoff regardless of how their collateral performs. 

Individual and institutional borrowers use DeFi borrowing in order to get leverage on their arbitrage and near-term futures trades.

The demand for these loans is huge as evidenced by the $26B of capital currently locked in DeFi lending pools. 

The global market cap for crypto is $1.3T so we have ~2% of that market cap contributed to lending pools which are only able to service borrowers on an overcollateralized basis. If we remove Bitcoin from these figures the story is even more compelling since bitcoin represents half of the crypto market cap but only ~10% of the DeFi lending TVL.

As long as the risk/reward of DeFi lending is favourable we will continue to see more capital chasing DeFi lending yields. DeFi front-ends and wallets will bring yield into the core of their experiences by automatically contributing to pools, and institutional investors will create new platforms to satisfy LPs that are looking for exposure to this emerging asset class. The supply side of this market is healthy and will continue to grow at least linearly with the overall crypto market.

On the demand side, DeFi lending has serviced a narrow set of needs very well and done so in a novel way by removing costly intermediaries while increasing speed and market transparency.

But for DeFi lending to grow exponentially from here we need to address the structural weakness on the demand side. Bringing credit into DeFi means any lending use case that exists off-chain can eventually be executed as a DeFi loan.  

With protocols like Maple and Goldfinch, DeFi is entering a new phase of maturity and this will set the stage for an explosion of consumer demand for DeFi services.

To date, DeFi has been about the removal of unnecessarily high cost intermediaries and redistributing that value to network participants. Most of the demand for DeFi lending is coming from borrowers who are already active participants in the crypto economy. These users are crypto-rich and require new types of financial products that are not available through traditional banks.

With the introduction of credit, we are adding knowledge processes to DeFi. In traditional finance these knowledge processes are inefficient human coordination efforts such as reviewing credit history, asset appraisals, financial disclosures, and understanding the use of borrowed funds. In DeFi, these off-line knowledge processes can be coordinated more efficiently using incentives. This should result in lower risk, lower borrowing costs, and easier to use financial products. 

Goldfinch (whitepaper)

Goldfinch works by creating senior and junior tranches, where Backers supply first-loss capital to the junior tranches at higher yields and Liquidity Providers supply capital at lower yields to the senior tranches. 

In this model, Backers actively allocate capital by assessing specific lending pools. Whereas Liquidity Providers earn passive yield as allocated by the protocol.

Borrowers are approved by auditors, who “secure the protocol with a human eye”. Those auditors earn rewards in the protocol’s native token (GFI) according to their performance.

Borrowers are incentivized to repay loans because all of this activity is attributed to the borrower’s public address, which acts as a credit history report for future borrowing. 

You can imagine that as more real-world assets are tokenized we will see Backers able to secure their positions with access to recourse such as real-property or future income.

Maple (protocol overview)

Maple is a decentralized corporate credit market. It’s primary borrowers are institutional actors seeking leverage on their trading strategies. 

The primary source of capital is Pool Delegates who are professional asset managers that conduct due diligence on borrowers and fund loans. 

Pool Delegates manage liquidity pools, which Liquidity Providers (the general public) can contribute to for passive yield generation. Unlike with Goldfinch’s Backers, it is unclear to me if Maple’s Pool Delegates must contribute a certain ratio of the total pool before the protocol allocates funds from Liquidity Providers.

These are the first of many protocols that will introduce decentralized knowledge processes on top of DeFi capital pools. Maple has only one active liquidity pool while Goldfinch claims to be servicing 10k+ borrowers in Mexico, Nigeria, and Southeast Asia. 

Maple is targeting a market of crypto-native use cases that are currently serviced by centralized lending firms like Genesis, which is the largest crypto-lender in the World at $9B in outstanding loans.

Goldfinch is targeting retail borrowers in regions that are underserved by traditional lenders. 

As these protocols mature and others are built in their image I expect to see an expansion in the number of borrowers that can access credit via DeFi. I also expect to see diligence processes optimized for speed and efficiency. Risk tolerance will grow as losses are absorbed by a much larger pool of successful repayments.

With the addition of credit, DeFi lending becomes a viable alternative to most traditional lending processes. 

With this new capability, DeFi front-ends and wallets will push further into “primary bank” territory, meeting user demands in ways that traditional lenders cannot. 

In the next post, I’ll cover the current landscape of wallets and front-ends, and why we are about to see an explosion in the number of these services.

Escaping the Walled Garden… again

In the mid to late nineties my family had a Gateway PC sitting on a giant banker’s desk in the front room / office of our suburban home. At that time, our version of the internet was AOL discs, a 56k modem, and seemingly endless pathways to get from one part of the walled garden to the next. 

AOL introduced millions of people to the internet by providing a simple and safe way to adopt a new technology platform. It was a beautiful re-packaging of all of the communications technology before it. 

For the better part of a decade many people assumed that media on the internet would manifest the same way it had for centuries. That we would continue to want a small number of trusted parties to create and curate content for us, and that any content outside of these trusted networks would be of low interest and likely low quality.

In reality, there is infinite demand for an infinite supply of content. Each day as new content is created it becomes a composable piece of whatever we want to create in the future. The increased supply makes it easier to compose higher quality new content for increasingly smaller niches.

Retail financial services today are much like AOL’s walled garden. 

Last week, John Street Capital published compelling piece about fintech 3.0 as a complete replatforming of global financial infrastructure. The authors point to a number of examples where slow, opaque financial rails have resulted in massive inefficiency and near-catastrophic failure of one or more institutions. There is no doubt that the coming decades will see the largest financial asset markets and trading venues reshaped for transparency and efficiency. 

Believe it or not incumbents want to see this change as much as anyone. Financial institutions already operate real-time ledgers on top of batch settlements. Bringing settlement into alignment with ledgers removes operational friction and therefore cost. Moreover, increased transparency will serve as a bargaining chip for further regulation. 

All of this amounts to a further concentration of power, albeit with systemic risk growing linearly with the size of the global financial markets, instead of exponentially with the scale, opaqueness, and greed of the people writing the rules.

Fear not though. The next wave of innovation in money will be more broad and more people-centered than John Street Capital and others have described. Much like the early days of the web, “we’re on the cusp of something exhilarating and terrifying”.

DeFi (decentralized finance) describes a new financial ecosystem that is permissionless, programmable, and composable. A subset of these characteristics would represent a new way to deliver the existing system, but not a new system itself. Only a fully permissionless, programmable, and composable financial ecosystem will give us a new financial system to match our new coordination system (the internet). Anything less than this is the equivalent of AOL’s walled garden. 

DeFi will give us agency over money in a way that we have never experienced in the modern world. Imagine going to any bank in the world, logging in with credentials from any other bank, and having access to your entire financial profile. Now replace our current notion of a bank with a program that facilitates the discovery and execution of money functions between any two parties. Also, everyone has equal access to that program and equal permission to build new programs on top of it. As a result, that program gets remixed into an infinite number of new programs to serve every conceivable money related interaction.

This is the promise of DeFi. If you want to feel it for yourself, create an Ethereum wallet with wallet provider like Metamask. Then take your seed phrase and import that wallet address into any other Ethereum wallet app (I like Rainbow). Take note of how it feels to possess this control over your own assets.

In the four years since the first DeFi protocol (MakerDAO’s collateralized debt position) was created, we now have hundreds of DeFi protocols representing ~$50B in value ($100B at it’s peak just a few months ago). Each protocol is a composable building block that will be used to create an ever increasing number of relevant financial products for ~5B global internet users.

For some, DeFi will represent lower costs. For others, basic market access. For all, a more emotionally satisfying way to interact with the world around us. 

Bits of Value

More equitable network participation

One of the most exciting things decentralization enables is the transfer bits of value alongside bits of information. For two decades we’ve been using forums, contributing to Wikipedia, crawling the Web, and exchanging files. When you stop and think about it, it’s shocking that our ability to transfer bits of information hasn’t created an equally open and permissionless way to transfer bits of value.

In the shadow of NFT-mania, there is an incredible amount of innovation happening around protocol governance, community building, and DAOs. 

Some of this experimentation is related to and in support of art-focused NFTs; some takes more recognizable forms akin to investment clubs or cooperatives. In all cases the goal is to create a more equitable relationship between the employees, investors, and users of a network.

Here are a few of the ways we’re transferring bits of value through decentralization. Some of the examples below include governance rights alongside a transfer/share of value. I’ll cover governance in a future post.

Community Access Tokens

Artblocks is one of the pioneers of generative art on the blockchain. It’s first project was Chromie Squiggle which includes just under 10,000 unique works represented as NFTs on the Ethereum blockchain.  As of mid-April, Squiggle owners, verified by the address that holds the NFT, can join the non-affiliated (but likely blessed) SquiggleDAO. The DAO aims to become the largest collector of generative blockchain art in the world and two weeks after launch is reported to have over $1M in its treasury. Those treasury contributions have come in the form of multi-Squiggle owners donating a Squiggle, which presumably gets resold on OpenSea. The newfound utility of Squiggles, plus the recycling of Squiggle’s to fund the treasury correlates to a near doubling of the floor price of a Squiggle from ~0.25E to ~0.5E. 

$SQUIG is not asset backed, meaning holders have no claim to the treasury and there is no plan to distribute financial rewards to $SQUIG holders. Presumably the value of $SQUIG will rise in correlation to SquiggleDAO’s assets and influence, however, the primary incentive to own $SQUIG is its access rights. Access to what? We’re not quite sure and that’s part of the fun.

Usage Tokens

Usage tokens are distributed to participants in protocols like Uniswap and Compound. Usage tokens are meant to explicitly recognize the role users and other participants play in the success of a protocol. They incentivize behaviour that benefits all users and in doing so act as a sort of bootstrap and backstop for the desired network effects of the protocol. Incentives are Web3’s carrot, while lock-in is Web2’s stick.

Usage tokens require careful implementation so that speculators and other bad actors don’t assume control of the narrative and community. If you thought Bitcoin and Telsa were a religion wait until you see some of the communities pumping the value of tokens that have no obvious utility or traction beyond speculation. There is a reason terms like apeing, bag, and degen are common lexicon within crypto. 

Investment Return Tokens

These are tokens that represent a principal investment and the expectation of positive returns. These tokens are an on-chain version of an index fund, investment club, venture fund, or other return-seeking structure from traditional finance. Because these structures are represented on a blockchain they can be open to anyone, funded anonymously, and governed transparently. 

For example, the Set Protocol allows anyone to create an index fund of tokens. The most popular of such funds in the DeFi Pulse Index which is made up of tokens with high community engagement as measured by the total value locked in their protocol. For example, the usage tokens I mentioned above, $UNI and $COMP, are represented in the DeFi Pulse Index. Anyone can buy the DeFi Pulse Index and there is no cap on the number of participants or contribution amount.

Neptune DAO is registered as a Delaware LLC and exists to generate yield for members. Yield is primarily generated through lending, staking, and providing liquidity. As a Delaware LLC the Neptune DAO is limited to 99 accredited investors and therefore doesn’t share the access and openness of some of the other structures discussed above. Neptune DAO, leverages a framework developed by Open Law. The Open Law framework seeks to use existing legal and organizational frameworks to advance digital community governance and the tokenization of assets. It’s sort of like the difference between the Coinbase approach (ask to be regulated) and the Uniswap approach (autonomous software with no regulatory precedent). Open Law and other DAO frameworks are a topic I’ll explore here in the next few weeks.

It’s important to understand that what is enabling the transfers of value above is of course imperfect. Governance models, crypto-wealth, high transaction fees, speculation, and a variety of other forces are shaping our experiments and impacting our ability to transfer bits of value in more accessible and equitable ways. What we are learning today will not only inform our experiments in the future but will be a composable layer upon which we can build those future experiments. It’s still early.