Gettin’ DeFi’ed with Melons
December 17, 2019 | Max Hinchman and Eric Choy
Part 1
The Melon Protocol positions itself to be the frontier to Asset Management 3.0, in the same manner of the Web3 movement, one could say. But to take a step back what was Asset Management 1.0 and Asset Management 2.0? If you look through Melon’s online media outlets, you will come across these two terminologies every so often without a clear-cut definition to them, but if we had to delineate between the two:
-Asset Management 1.0 could be characterized as the era BEFORE prime brokerage services were available.
-Asset Management 2.0 could be characterized as the era AFTER prime brokerage services became available.
(I would love to hear any other interpretations between the two)
During Asset Mgmt 1.0, the stone age era as some wall street veterans might put it, trades were literally jotted and passed through pieces of paper. All of the administrative processes and costs were borne by the fund itself. Fund managers had to keep records of their own trades, manually calculate their period performances, and a host of other tedious tasks (without the help of Microsoft Excel, painful, I know).
The post prime brokerage era, colloquially Asset Management 2.0, which is noted to have started in the 70s, allowed funds to focus on their core business, investing (Although it is debatable as to who is credited with starting these services, Wikipedia is quoted by attributing this to a US broker dealer called Furman Selz) All of the other administrative processes were lifted off of their shoulders by these emerging prime brokerage services by providing custodian services, securities clearing, portfolio reporting, etc. Basically, they helped freed these fund managers from the more time consuming and tedious aspects of running a fund so that they can focus on what they were meant to do. This time period was also supported by the emergence of electronic trading and the internet messaging, making things a lot easier and faster, but still all very centralized and prone to human error. And in fact, the prime brokerage business is very loosely regulated allowing these middlemen a lot of flexibility in terms of services and prices. About 80% of the primer brokerage industry is dominated by, you guessed it, the largest banks in the world.
As of 2006, the most successful investment banks each report over US$2 billion in annual revenue directly attributed to their prime brokerage operations (source: 2006 annual reports of Morgan Stanley and Goldman Sachs). The financial crisis of 2008 was when we really started to see a restructuring of the prime brokerage business as fund managers realized that no prime broker is too big to fail.
In a 2014 PWC report, titled Asset Management 2020, its already inevitable that “…alongside rising assets, there will be rising costs. First, the costs of complying with regulation will remain high. Commercial cost pressures will rise as firms grow their distribution networks. Fees will be under continued pressure amid the ongoing push for greater transparency and comparability.”
Well one could say that the intermediaries are there to protect investors’ interests…
“however, all it has really done is added huge layers of cost base to the industry without really providing much more additional transparency… the current system is inefficient, complicated, expensive, labour intensive and not secure.” — Melonport
As we embark on this new dawn of the blockchain era, Asset Management 3.0 will most likely develop into an era where prime brokerage services won’t be needed. This book is probably an omen to that.
Or at least they will evolve in a manner where intermediary solutions are no longer needed, but other services might be presented. Investors will be able to see real time, instant information regarding their funds they’ve invested into probably without ever having to speak to the fund manager at all.
The 2014 PWC report even goes on stating “The creation of new regional blocks and new fund platforms to service those blocks will place the emphasis on cost and efficiencies as never before. Economies of scale will become paramount.”
Those new fund platforms is exactly where the Melon Protocol fits in.
There’s probably a lot of questions as to why Melon? And what can Melon do for the asset management industry? But wait….if asset managers in the traditional world were created to bridge investors and investable assets…and if crypto/blockchain were created to eliminate the “middleman”, so to say…why do we even still need asset managers??
To put it simply, because not everyone knows how to invest. Despite the fact that information has become so much more transparent and accessible to retail investors, there is still a market demand for investment professionals to carry that duty for their clients, as easy as it may sound to the more financially savvy people out there.
And then the next question goes, when will the traditional asset managers, using traditional asset management procedures, come to fruition of the simplicity of the Melon Protocol? Where all you need is less than $50 and about 20 minutes to set up a fully functional, transparent, secure digital asset fund.
The answer is fear.
1. The fear of making setting up a fund being too easy.
2. The fear of security of assets.
3. The fear of being too transparent.
Let’s start with the first point. Setting up a fund on the Melon Protocol makes the whole notion of fund creation look too easy…easy enough for the average Joe to set up a crypto fund. It is estimated that you need at least $200 million in AUM in order to survive the first year as a fund manager in the traditional venue versus $50 in the Melon world. Although the premise does sound nice to the retail investor and everyday crypto enthusiast, the big boys sitting on millions of dollars backed by big name boutique firms don’t want it to seem too easy. Or else they are going to be challenged and exposed. But eventually, when technology and adoption accelerate, those big boys are going to have to eventually accept reality. In the same way how governments all over the world are accepting digital currencies as a legitimate tool, 10 years after Bitcoin was created. We are literally only in year 1 of the Melon Protocol being live.
The second point, security. Although the blockchain community preaches the word security in its everyday language, there are instances of loopholes in the coding language building these blockchain infrastructures. Just take the Parity bug mishap for example, in which a user “accidently” wiped out a wallet library resulting in over $200m of ether being locked up. You could search dozens of other instances of coding hiccups, centralized exchanges being hacked, etc…but to give Melon credit, they have done an enormous amount of work to perform due diligence and audits on their code. Their auditors sit on the Melon council.
To continue on the security topic, this year has flourished the crypto custodian business into fruition. Although having a custodian to custody assets of a crypto asset management firm is not in law, a lot of the large asset management firms continue to utilize these services in anticipation of future regulations that might mimic the traditional regulations such as the SEC regulation, as part of the Dodd Frank Act, requiring institutional investors holding customer assets worth more $150,000 to store the holdings with a “qualified custodian.” And that’s how you get World War 2 like military bunkers being used to store crypto keys in the Swiss mountains. And it’s perfectly normal for large investors to want that secured assurance of their assets, regardless if the Melon protocol can provide the same security. It’s a psychological thing. If they can afford it, why not right?
The third point is the fear of being too transparent. Let’s face it, transparency is what we want to see in our investments. Transparency is what we value in keeping our fund managers accountable. But do fund managers really want to expose everything about their investment strategies, rationale, and performance? Although their public answer maybe yes, but internally, they still want to hide as much as possible. They don’t want to give away the secret recipe so to say.
Throughout history we have cases of money managers hiding up their practices; Stratton Oakmont, Bernie Madoff, Lehman Brothers, Enron, and the continuous host of “centralized” crypto hedge fund managers we still see play out to this date. Or you have a host of crypto funds refusing to go through the proper due diligence in adhering to their jurisdiction’s regulations. Below are examples of the SEC clamping down on some crypto funds for misrepresentation or failing to register. Maybe they carelessly forgot to go through the procedures or purposely refused to in hopes of making them less transparent?
They want to seem like they hold the magic key when in fact, it’s as easy as 1–2–3. Well not that easy but you get my point, I hope. All these reasons listed out is exactly what we want to overturn and make them realize that there fear is true. Is Melon the answer? Time will tell. Melon is just a small part of the DeFi movement. If DeFi can continue to progress, Melon could have a strong correlation to that growth.
Part 2
Decentralized Finance.
Note: We do support DeFi projects and what they are trying to achieve collectively. However, it is important that everyone understands clearly the current limitations and issues. This portion is going to focus on the issues facing the decentralized finance and really the crypto-space as a whole. This is not directed towards Melon but more so the issues that the entire DeFi space is facing.
I am sure that anyone that has been following the crypto space has heard of decentralized finance and how blockchain technology is set to disrupt finance. Like most things in crypto/blockchain everything is said in such a broad manner that it is hard to understand just exactly what the term “disrupt finance” means. The basic goal of decentralized finance is for anyone to create financial service applications that allow for financial activity to take place without the need for centralized institutions. Why do you need a centralized institution for financial services when you can program your own smart contract to do the same thing? The current system best serves the wealthiest and leaves an estimated 1.7 billion people without any access at all to financial services. Things obviously need to change so DeFi entrepreneurs are currently targeting ten fields within finance: payments, custodial services, infrastructure, exchanges and liquidity, investing, KYC, derivatives, marketplaces, stablecoins, prediction markets, insurance, and credit/lending.
Finance has always been a walled-off mysterious industry that carries a sense of elitism and complexity that made the average person feel like they are not able to understand finance. In reality, this is mostly a façade created in order to justify the excessive fees that financial institutions charge. While the current system has played a key role in generating global wealth, the downsides are obvious. The massive disparity in wealth is partially due to the way the current financial system is structured. In addition the current financial system is delicate to say the least. The very fundamental nature of the global financial system is based on a mismatch of time frames, facilitating long-term lending while the operations are dependent short-term financing. Financial crisis are usually caused by sudden a liquidity crisis more than anything else.
So on paper blockchain technology, cryptoeconomics, and traditional finance seems to be the match made in heaven. It is almost as if you created the financial dream team that is set to resolve many of the major issues that we see in the status quo system. Unfortunately, things are never that simple and progress has been….well slow. I have seen articles talk about how the current DeFi projects need to go through a catastrophic event in order to restructure into something more robust. I don’t think the break it and make it stronger approach is the right way to instill more confidence in projects that don’t really have a user base. While I am a fan of decentralized finance, it currently has 3 major issues that must be addressed first: lack of organization, immature technology, and the need for a large network. The DeFi movement only has one try to get this right but still doesn’t have the clear answers for these issues.
In theory, the concept of an app or a company that no one owns/controls is great, but in reality there is a reason why centralized institutions exist. Centralized organization is effective and it gets things done. Companies need to have organizational and leadership structure in order to make decisions. This is what has lead to the successful development of any company. The crypto world has committed itself to the decentralized ideology at the expense of actual utility. The unfortunate truth is that the products that have been developed are nowhere near the level of which they need to be in order to displace the centralized alternatives. A lot of the product issues can be attributed to the fact that there is a lack of organization in decision making. Ethereum, the foundation blockchain for a majority of the DeFi projects, is probably the most notable example. Lane Rettig, one of the core developers of Ethereum was quoted as saying, “You need a centralized process to invent a decentralized governance mechanism.”
But why is the crypto world so averse to a centralized decision making process? I think we tend to forget that there is a fine line between the new shiny decentralized blockchain system and a legacy centralized database system. It is very easy to cross that line. The whole point of the blockchain is the elimination of a centralized authority and more robust security. But this currently comes at the expense of scalability and speed. If you end up creating a product that only reduces the centralization points in a few areas, then what is the draw for switching over from a centralized version?
Blockchain technology itself is not new. The concept of distributed ledgers in computing has existed for over 30 years. So why did it take 30 years to become applicable? Because blockchain needs to be used in conjunction with cloud computing, cryptography and cryptoeconomics in order for it to make sense. In order for a self-functioning system to sustain itself, it needs to have proper incentives in place for the network participants. Bitcoin was revolutionary because it created an unhackable system that combined the three components listed above. The Bitcoin network doesn’t have an owner and has been completely maintained by its network participants since inception.
Building an application specific blockchain like bitcoin is one thing. Building a turing-complete do-anything “world computer” like Ethereum is a completely different animal. It is just a technical behemoth of a concept to bring to fruition. I get it, creating a network that can be programmed to do anything is just insanely difficult. But maybe this whole DeFi movement happened too quickly from the height of the Ethereum boom in 2017. CryptoKitties happened and then people actually realized the severe limitations of Ethereum in its current form. But even after CryptoKitties, many of the DeFi apps continue to develop on top of the Ethereum blockchain because it is still the least worst option out there. You can make the argument that the success of the DeFi space in its current form is completely dependent on the success of Ethereum. The unfortunate truth is that Ethereum is still a long ways away from even a satisfactory level of technical capabilities. How can we reasonably expect for people to resort to financial services built on an extreme beta version of a foundation?
Crypto projects need people to adopt and use the network in order for it achieve all of the potential security benefits that blockchains are praised for. Otherwise you are at risk for things like 51% attacks. But I think there are some projects that current institutions can literally copy and implement themselves. Crypto exchanges can also do the same exact thing. For example, what is to stop Binance from forking a DeFi protocol and offering their own Binance version if they see a certain protocol’s user base is actually growing? The question then becomes, are these DeFi startups providing real value to the finance value chain? If not, then they are never going to be able to attract and sustain network participants.
Another good analogy that I recently heard describing the current state of Ethereum is Vitalik Buterin comparing the current system to a Nokia phone from the late 90’s playing snake. DeFi finds itself in the ultimate Catch 22 situation. It needs to gain user adoption and start making money in order to continue to development but it needs an iPhone and not a Nokia level of a product in order to gain user adoption. Which begs the question, is it ethical to offer financial products to people knowing that not all of the bugs have been addressed?
Bloomberg wrote an article 2 years ago on Keishi Kameyama, the Japanese founder of DMM.com. He has aggressively expanded his holdings into various media and tech companies and has become one of Japan’s wealthiest men. However, he made his first fortune in pornography and so he has faced ethics related issues his entire career. He was asked in the Bloomberg interview how to build a company that is profitable while contributing to society. His reply, “Start by building a company that lets a few people feed their families, instead of trying to tackle global hunger.” Many DeFi projects are the difficult moonshot type projects, which is not a bad thing. You gotta shoot for the stars. But maybe the best way, in this case, is to start by building small profitable and sustainable businesses.
Investing in cryptocurrencies and Initial Coin Offerings (“ICOs”) is highly risky and speculative, and this article is not a recommendation by the writer to invest in cryptocurrencies or ICOs. Since each individual’s situation is unique, a qualified professional should always be consulted before making any financial decisions.
