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An Avalanche of DeFi, Part II

Hopefully you’ve made it through Part 1 of the AVentures take on DeFi, and have been waiting patiently for Part 2 of my deep dive.

In Part 1, I covered the evolution of DeFi primitives on Ethereum and Avalanche, and where the ecosystem now stands with respect to token trading infrastructure. Remember: 80% of the entire DeFi ecosystem, as measured by total value locked (TVL), consists of DEXs, lending/borrowing (including CDP stables), bridging and yield aggregating . A good portion of the liquid staking TVL is also driven by borrowing/lending (Lido’s bLUNA on Anchor), so the DeFi basics account for nearer 90% of all capital allocated to DeFi.

There is of course more to TradFi and crypto capital markets than just trading facilitation, however, and every chain that claims to offer a full DeFi ecosystem needs to build on top of the primitives. A full product suite of DeFi Dapps beyond the primitives covered in Part 1 would need to include options, perpetuals, price and smart contract insurance, and structured products. This second layer of DeFi — a small, yet crucial part of the whole ecosystem–allows users to seamlessly access all aspects of crypto capital markets from any layer 1 blockchain.

The primitives for trading (excluding liquid staking, which is less relevant for AVAX)account for over 90% of DeFi TVL. Source: DeFi Llama

Indeed with effective bridging, even assets native to other chains can easily be utilized on Avalanche if the tools exist. Once on Avalanche, there should be little need to move on.

Of course, there are other needs DeFi can meet that don’t relate to replicating the TradFi financial system for crypto-native assets. In Part 4 I cover entirely new use cases for DeFi, including facilitating real world assets.

Here in Part 2, and again in Part 3 of this four part series, I outline Avalanche’s ongoing needs as it replicates and expands on Ethereum’s full DeFi offering, and then develop AVenture’s DeFi investment thesis, illustrated through the latest AVentures-backed DeFi projects.

DeFi continued: Where are the customers’ yachts?

Once in the dear dead days beyond recall, an out-of-town visitor was being shown the wonders of the New York financial district. When the party arrived at the Battery, one of his guides indicated some handsome ships riding at anchor. He said,

“Look, those are the bankers’ and brokers’ yachts.”

“Where are the customers’ yachts?” asked the naive visitor.

Fred Schwed originally published his book on the disintermediation of investors in 1940. For the most part, present-day markets demonstrate remarkable continuity, except on two fronts: the markets are much bigger and the fees are much higher.

Indeed, the TradFi system is heavily centralized, trusted and lucrative. Broker-dealers and the largest fund companies stand in between investors and financial products, issuers and markets. Information is gated: Much of the best is private or, at the very least, very difficult to access. Aggregated public and some private data are for sale by the giant fintechs of the markets, such as Bloomberg. Gatekeeping in financial services, in almost any form, is highly profitable. Goldman Sachs, just one such intermediary, earned over $20 billion on $60 billion in revenues in 2021, a record year.

Goldman and others gatekeep a wide variety of products and services that range far beyond the DeFi primitives in Part 1.

Having so many intermediaries with pricing power generates huge inefficiencies that the financial industry can exploit. Two examples are indicative of the power asymmetry in TradFi: the practice of repackaging assets into structured products for a fee, and shutting down Robinhood’s right to trade Gamestop. Additionally, a lack of transparency allows risks to build up until they eventually threaten to collapse the system.

Source: Financial News. Twitter. Creative Commons

Expanding trading infra and tools

DeFi promises to disintermediate markets, reduce friction, and remove the need to rely on custodians and brokers as trusted parties. The first primitives replicated the basic TradFi tools for investing, offering a more secure environment to trade, leverage and short cryptoassets than the rickety and often fly-by-night earliest exchanges.

Though the basic primitives dominate TVL in DeFi, there are many other financial instruments that need to exist for the cryptoasset markets to be complete. Ethereum and, occasionally, other layer 1s have been leading the way with:

  • order-book DEXs
  • options markets
  • fixed rate and tranching protocols
  • indexes and managed fund platforms
  • structured products
  • insurance providers
  • investment tools
  • incubators
  • liquid staking

All of these sectors are big business on Ethereum and select other chains (e.g. order book DEXs on Solana). DeFi insurance, for example, is over $1 billion in TVL. Yet on Avalanche, there are few successful DeFi projects beyond the primitives. But they are (mostly) on their way.

Our fundamental investment thesis for DeFi on Avalanche is to back high-quality teams, that are themselves supported by the community, in each of the DeFi sub-sectors we identified above.

As AVenturesDAO co-founder Tamer has put it,

We believe the next wave of growth in DeFi will be from Options, Perpetuals and Structured Finance.

To date, AVenturesDAO has facilitated Avalanche’s expansion into many of these new products and services, by funding and supporting Dexalot, Struct, Pollen, and Colony.

Source: AVenturesDAO. Bloomberg

Two others we have our eyes on are Valk and Arrow. In addition, we backed Platypus, an innovative stableswap DEX on Avalanche.

Facilitating Avalanche’s expansion into new DeFi sub-sectors

Each platform offers Avalanche a much-needed native element in its DeFi ecosystem.

Source: DeFi Llama. Coingecko

There remain some gaps in the AVenturesDAO DeFi portfolio, mirroring the gaps in Avalanche DeFi. Avalanche is currently lacking an insurance protocol, though two Avalanche-native projects are being seeded as I write. While insurance protocols on Ethereum have been rather disappointing, it’s hard to dismiss the potential impact that effective and capital-efficient smart contract, de-peg and even IL cover could have on a space where hacks and algo stable collapses are commonplace. Someone should be able to get this business right. Perhaps that will happen first on Avalanche?

Derivative DEX volumes are booming on ETH layer 2s, with over $4 billion in volume last week alone. Avalanche also has no native algo USD-stablecoin. Fiat-backed stables USDC and USDT, however, are now native, and there is talk of a partnership with UST. FRAX is also on the way.

Source: DeFi Llama. Coingecko

“DeFi on new layer 1s” is a common thesis throughout crypto, but it’s really this second generation of DeFi that is one of the targeted areas for AventuresDAO on Avalanche. Certainly, some parts of the market are crowded. Just how many Sushiswap/Uniswap DEX forks does an “alt” later 1 need? But for now there are opportunities for Avalanche to catch up to Ethereum in terms of the range of offerings in DeFi. In some cases we expect Avalanche to leapfrog its competitors.

The addressable markets for new Avalanche DeFi are enormous, whether measured against Ethereum DeFi or TradFi. Options, insurance and indexing are billion dollar or near-billion dollar businesses on ETH, and trillion dollar opportunities in TradFi. We are still early on in Avalanche’s evolution.

Below I begin listing the next generation of AventuresDAO-backed Avalanche DeFi, with Dexalot first. More will follow next week.

1. Dexalot — A native order book DEX

The advantages of an order book exchange…

All centralized exchanges (CEXs), in both crypto and TradFi, use central limit order books (CLOBs). The Automated Market Makers (AMMs) such as Uniswap v2 or any Uniswap forks that appeared during the last cycle, and remain a critical source of liquidity for traders, offer compromises that are needed because of Ethereum’s limitations: slow finality and high costs.

CEXs such as Binance offer order books and immediate finality. “Market orders” where traders accept the “market” price are immediately matched with limit orders, often from professional market makers.

…trustlessly…

But CEXs have their downsides. Not only have they been historically fragile and prone to failure and manipulation, but they require traders to trust the exchange. That trust has often been broken. Exchanges can censor users. They can run off with the money or simply delay giving it back to you. They can be hacked.

What many users want, it seems, is an order book exchange where assets are self custodied and control rests with the users and the community. Dexalot offers just that.

Dexalot makes use of Avalanche’s fast finality and cheaper-than-Ethereum transaction costs to host an order book DEX on-chain, trustlessly. The result is a UX that is remarkably similar to the top CEXs, such as Binance. This is not by accident.

Binance v Dexalot UI

… and with improved capital efficiency.

The downsides of using a CEX, and being KYC’d and risk losing control of one’s keys, has driven users to DEX AMMs in spite of the latter’s capital inefficiencies. AMMs have two significant weaknesses that order book DEXs and CEXs do not have.

Firstly, for liquid markets traditional AMMs (as opposed to Uniswap v3) need massive amounts of liquidity. How much? Well Curve’s AMM pool for USDC/FRAX has TVL of $2.845 billion, and currently trades $21 million per week. Volume is less than 1% of total capital committed. On Uniswap v3, which is more efficient than a passive AMM but less efficient than an order book, one tenth the capital generates twice the volume of Curve. So why do liquidity providers still deposit to Curve? Because of the inflationary token incentives.

Secondly, passive AMMs are effectively dumb, and make markets even in the face of overwhelming buy or sell pressure. The result is impermanent loss, which can easily turn permanent without, once again, inflationary token incentives.

Dexalot tokenomics are not diluted in the same way as other DEXs that have huge incentive requirements. It is true that around 50% of issuance will go to users. But it’s not the passive yield farmers who gain. Tokens will go to limit order traders, professionals and retail alike, directly incentivizing active liquidity at the current market price.

Subnets are coming

If you’ve traded on Dexalot’s Beta version, you might be aware that finality is not always as fast as promised. Indeed, when there is a big NFT drop/mint, the chain — like any others — can get slow and expensive. Dexalot’s team, however, has a solution in sight: Subnets.

Much as the major order book spot and derivatives platforms such as dydx, PERP, GMX and Loopring have migrated to Ethereum layer 2s to take advantage of lower fees and faster confirmations, Dexalot is destined to be Avalanche’s equivalent.

Avalanche Multiverse, a $290 million incentive program, has already begun incubating the latest generation of blockchains that will, like Polkadot or Cosmos, have their own DApp-specific validator set. Once Dexalot has its own chain by Q3 2022, finality should be consistently fast, and costs even cheaper.

There is more to Dexalot than just an order book DEX. Dexalot Discovery uses its market for non-custodial secondary trading to provide a fairer launch process for new token issuance.

Dexalot Discovery is an auction-based, transparent and barrier-free listing solution for projects that are coming to market. Projects can utilize this transparent auction to allow both buyers and sellers to participate simultaneously (unlike alternatives) and let the market define the fair price for their token, similar to how real world assets are auctioned.

The first successful test case of their approach was with its own ALOT token, with many more to come.

Product and market are not enough

Dexalot’s TAM is huge. It offers the same UX as a CEX and better capital efficiency than most DEXs. Just one exchange, Coinbase, trades more than $3 billion weekly. Solana’s order books traded $300 million last week.

Coinbase 7-day volume. Source: The Block

The secret to successful start-up investing is to identify a solid team and ensure its support within the community at large. Dexalot has both of these.

The experienced team is advised by Avalanche OG Firestorm, an expert in trading systems and exchanges. The team are no slouches in the space, of course. The co-founder and key team members are experts in electronic trading platforms, and know what it takes to build and launch an order book exchange.

Firestorm with the Dexalot axolotl mascot at the Avalanche Summit in Barcelona (left) and the founders’ profiles (right).

When it comes to community, we aim to support those that are already supported, or help them integrate into the ecosystem. We offer support in many areas, including tokenomics, marketing and strategy. Dexalot is already established in Avalanche. It was seeded by the Avalanche Foundation, while Avalanche’s native growth accelerator Blizzard, founded by the Foundation, led the strategic round that raised $7 million in February. No lesser an Avalanche veteran than Ava Labs CEO Emin Gün Sirer commented on the raise, stating that,

[While] most chains lack the capacity and velocity to maintain an on-chain order book, forcing users to settle for poor trade execution,… Dexalot capitalizes on Avalanche’s speed to deliver a peerless user experience.

Dexalot aims to be community owned and controlled, with all operational parameters to be controlled through governance proposals and voting, built on top of OpenZeppelin. Blizzard and the Avalanche Foundation are already investors. As Dexalot users earn rewards, they too will be part of the decision-making process.

Dexalot fits AVenturesDAO’s investment thesis perfectly:

  • Huge TAM — Providing a needed primitive for DeFi on Avalanche, with the potential to compete with other chains and even centralized exchanges
  • Proven market on other chains and layer 2s — Volumes on other chains skyrocketing
  • Innovative products — Dexalot discovery is leading the way in fair launches, in the first instance with its own token
  • Experienced team — Founders and the leads are experienced builders of order book technology
  • Strong community — Respected Avalanche-focused investors fill the cap table and are keen to support the project as it moves out of Beta, and beyond.

Next week, in Part 3, I will cover our other DeFi investments in depth, before using my crystal ball to predict the future of multichain DeFi, and what it means for Avalanche and AVentures, in Part 4.

About Rasheed

Rasheed Saleuddin, PhD CFA is an ex-hedge fund manager and experienced crypto angel, currently investing and advising with AventuresDAO, TheBoringDAO and the Cosmic Cartel. He is also a researcher at the University of Cambridge Judge Business School, where he is co-chair of the Cambridge Centre for Alternative Finance (CCAF) DeFi research steering committee.

About AVentures

AVentures is an investment DAO composed of OG Avalanche community members on a mission to support the ecosystem. The team boasts multiple successful blockchain developers and project owners, content creators, advisors and domain experts that have come together to channel our expertise to support the Avalanche ecosystem.

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Rasheed

Rasheed

Blockworks.co head of research. VC at AventuresDAO, TheBoringDAO, CosmicCartel. Academic at the Cambridge Centre for Alternative Finance