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Defi Investment Thesis — Part 1

In my last post, I discussed the rise and fall of Defi 2.0. I talked about the key structural defects of Defi 2.0 & the areas we need to improve for a more robust and resilient Defi 3.0. In this article, I use a first principle approach to identify potential opportunities in Defi over the next 7 to 8 years. (Please note I’m not into short-term trading, shilling, etc. and like to take a fundamental, long term view on the Defi ecosystem)

Post Terra debacle, a large section of the Twitter community seems to have lost faith in Defi. Even the likes of Michael Saylor seem to think that Defi, as it exists today, is unsustainable.

Source: Twitter @saylor

While there is a lot of truth to such a sentiment, it is equally valid that all innovative projects look like ‘Ponzi Schemes’ at an early stage.

Let’s explore why…

Early investors reap huge rewards from risky innovations and such outsized returns lure new investors who (often) end up investing at an ‘unreasonably’ high valuation that simply doesn’t justify the current maturity level of the underlying technology.

The upside of this ‘Ponzi’ is that these incoming investors (often, ‘dumb capital’) provide a lifeline to good, high-risk projects by funding them with capital. Without the hype/euphoria around innovation catalyzed by unusually high initial returns, it is often impossible for tech entrepreneurs to have the necessary resources to execute a bold vision.

Current Ponzi Cycle in Defi

Unfortunately, hype also attracts a lot of ‘fly-by-night’ projects that want to capitalize on that euphoria. The average investor cannot accurately estimate the value of a project and doesn’t possess the tools to separate good projects from bad. Dumb capital flowing into such projects eventually flows into the hands of smart people who can accurately estimate the long-term value of projects being built.

When reality sinks in, weak hands are forced to fold & exit after taking heavy losses. This creates panic, dejection, and a massive drop in prices & value. It is at this stage that we see a major negative sentiment, predominantly among late-stage investors.

The only antidote to this is to build your own long-term hypothesis, DYOR, and keep adjusting that hypothesis based on objective data (not the ‘he said, she said’ data but actual data that includes transaction volume, TVL, developers, git commits, competition, market growth etc.)

One of the approaches I use is to assume an ‘end state’ and then roll back to the present to identify the missing blocks/problems to solve to achieve that end state.

Since I define my own end state, I spend very little time predicting the outcome and a lot of time predicting the most likely path to reach that outcome. At the very least, this approach cuts out cynicism from the analysis.

As a long-term believer in Defi, I will start with my fundamental hypothesis —

“Defi will survive in 2030. Defi will be 10X more efficient, cheaper, and faster than Cefi”.

Between today & 2030, there are plenty of unknown unknowns that can invalidate my hypothesis. Governments can ban Defi, CBDCs can kill Defi, etc.

In this article, I just assume that my hypothesis is true (I strongly believe it will be true) and predict the lego blocks needed for it to be true.

Before we move further, here is my disclaimer

Nothing in this article is ‘investment advice’ — I’m just stating my personal opinion. I am unqualified to make any investment advice & please read this post only as educational content.

So let’s dive deeper.

As an engineer, I fall back on my ‘first principle’ approach to solving this problem.

Let me first lay out the key building blocks of Defi that are needed to achieve this end state. I have listed them in the chart below

Defi Lego blocks & eco-system

I will go into each lego block to explore the ‘alpha’ opportunities in that space.

In this article, I’ll cover crypto-fiat ramps, wallets, and cross-chain DEXs. Over the next few articles, I’ll cover the remaining segments.

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The first lego block needed for a Defi investor is the ability to convert fiat to crypto & vice versa via fiat-crypto ramps. An on-ramp is where we convert fiat to crypto (buy crypto) and an off-ramp is where we convert crypto back to fiat (sell crypto). For Defi to grow, the fiat-to-crypto rails to enter and exit the crypto-verse must be cheap and seamless.

Crypto-Fiat Ramps are a key lego block for Defi

Traditionally, ramps are being provided by Centralized exchanges (CEX). CEXs are the first port-of-call for investors buying crypto using fiat. But with the expected rise of decentralized exchanges, DEXs (more on this later), Defi will probably get its ‘Stripe’ equivalent in the crypto-verse.

Companies that take care of all documentation/KYC, back-end reconciliation, payments & settlement needs and provide simple APIs/front-end widgets that can handle on-ramp/off-ramp transactions will be of massive value.

New Defi protocols, wallets & DEX’s should be able to activate ramps on their websites/mobile apps by simply adding a few lines of off-the-shelf code (ie. Stripe model).

In my last article, I discussed the need for Defi 3.0 to support real-world lending and borrowing activities. Since most real-world transactions will be in fiat currencies in the foreseeable future, on/off ramps will be crucial for the growth of real-world use cases in lending, trading, investments, insurance, etc.

Ramps of the future also need to be integrated with a range of CBDC’s (Central Bank Digital Currencies) and need to support integration with payment providers and banks. There is a lot of pending innovation in this space…

Unfortunately, this is the easiest attack vector for governments to keep a check on crypto-activity. Companies building these on/off ramps have to deal with a ton of regulations, anti-money laundering, and foreign-exchange compliance from local central banks and governments.

My personal philosophy is to stay as far away from governments/regulators as possible because I consider them to be a net ‘value’ destruction machine.

While crypto-fiat ramps are a necessary lego block with tremendous growth potential, I don’t see it as a high ‘alpha’ opportunity primarily because of the regulatory & compliance risk involved.

Wallets are the gateway into crypto (and its subset, Defi) for average users. The first piece of software that a new crypto investor will interact with is a ‘wallet’. Market leader, Metamask has more than 30 million users and is immensely popular among the crypto community.

Users confirm transactions and pay, receive and swap coins/tokens via Metamask — Metamask alone has generated over $200 million in revenue in 2021.

Metamask is the default application for crypto (Source: decrypt.co)

Even with all the success of wallets, they still have a long way to go. Here are some issues with current-day wallets

  1. High fees: Most wallets are running on L1’s and impose a large gas fee on users. A $40–50 gas fee is very common on Ethereum & such high transaction costs tend to edge out small retail investors. With major execution set to be shifting to L2s with ultra-low gas fees, the next generation wallets will be built on top of L2 chains.
  2. Poor UX: An average Defi user today has to navigate at least 10 different websites to stake/farm/lend crypto. While this is OK for early adopters and enthusiasts, the next billion users will not be happy moving from one website to another. Next-generation wallets should have a simple & intuitive UX designed for the needs of the Average Joe. From investing to borrowing to staking to farming to trading, wallets should provide everything in one place.

It is still early days for crypto, and monthly active users for the largest wallet is just ~1% of total credit card users. Assuming Layer 2 payment networks scale, there is a very high likelihood that credit cards and debit cards become obsolete.

Wallet users are a fraction of potential users

Since wallets control retail users, wallets will command a ‘commission’ for every transaction on any Defi protocol. Every Defi protocol has to pay wallets to get access to retail investors. Regardless of which Defi protocol wins, as long as Defi wins, wallets will wing.

I am super bullish about wallets such as Metamask and Argent — both of whom have communicated plans to launch a token. This is a big ‘alpha’ opportunity that I will keep an eye on.

Defi cannot succeed without the mass adoption of wallets. Future wallets will have intuitive UX and will run on L2s. A big-time alpha opportunity —Metamask and Argent are 2 potential opportunities.

The third lego-block is a ‘cross-chain decentralized exchange’ — An exchange is a place where a crypto investor can buy or sell his assets. As mentioned above, these are usually the first port of call for any investor holding fiat currency.

The first wave of crypto adoption was led by centralized exchanges (CEX) such as Coinbase, Binance, FTX, Kraken etc. Centralized exchanges made it easy for investors to buy and sell crypto for a reasonable transaction fee. By being the primary market maker platforms in crypto, CEXs have created huge liquidity for thousands of new crypto projects.

CEXs have a number of advantages over a DEX (as it exists today). I have highlighted points in red where DEX is worse than CEX and green where DEX is better than CEX. Major advantages of CEX are high liquidity (low slippage), a diverse token universe, and order-book style market making that is preferred by big traders.

CEX v/s DEX

Let’s look at some numbers that highlight this:

Source: The Block Crypto

The above chart shows that total DEX volume is only around 10% of total CEX volume in spot markets. The overall trend-line of DEX/CEX volume is clearly increasing.

If we look at the most famous DEX (Uniswap) v/s top CEXs, we see that Uniswap now does almost similar volumes as Coinbase.

UniSwap has caught up with Coinbase (Source: The Block Crypto)

Incoming DEX dominance

I predict that in the next 5 years, DEX spot volumes will reach up to 50% of CEX volumes. The next wave of DEX innovation will have 3 components — robust order-book-based market-making, deep liquidity, and multi-chain asset trading.

  1. Rise of L2 based DEX’s

Thanks to the rise of layer-2 rollups, order books that were earlier a sole privilege of centralized exchanges will now be accessible to decentralized platforms. With on-chain & off-chain zk-rollups (validiums), the cost of placing multiple failed bids/offers will not be a crucial factor anymore. A case in the point is dYdX which used StarkWare Layer 2 technologies to build its perpetuals trading platform.

2. Rise of cross-chain DEX’s

Another key drawback of DEXs is their inability to communicate with tokens on another chain. DEXs such as Uniswap, Curve can only handle ERC-20 tokens on Ethereum chain.

Unlike a CEX user who could sell his ETH to buy BTC or AVAX, a DEX user was restricted to dealing with tokens compatible with the chain (s)he is using. Wrapped assets (WBTC, WETH, etc) are more of a ‘hack’ and not truly scalable solutions. And these wrapped assets are usually managed by centralized custodians which defeats the purpose of a DEX anyway.

This is where truly battle-tested cross-chain DEXs come into play. Players such as THORChain are building non-custodial platforms that help exchange native assets in a decentralized manner. As cross-chain communication technologies (discussed in the next section) improve, many more cross-chain bridges will emerge that allow users access to a large universe of coins/tokens.

3. Rise of cross-chain messaging platforms

Another major limitation of DEXs is the fragmentation of liquidity across multiple chains. Every chain today has its own AMM-based DEX (Uniswap and Curve on Ethereum, TraderJoe on AVAX, SpookySwap on Fantom etc). This has led to ‘islands’ of liquidity that cannot handle a huge transaction without causing significant slippages.

Slippages have unintended effects such as forced liquidations of collateral etc resulting in a poor user experience. Users might as well buy/sell on highly liquid centralized exchanges where they are assured the best price.

Next wave of DEX innovation

Big Opportunity

We are talking big numbers here — let's use some rule of thumb calculations to quantify the market opportunity.

Block Research estimated a $14 trillion in assets traded on centralized exchanges in 2021, a 689% increase from the previous year. At an average market capitalization of $1.6 trillion, the volume/market cap ratio comes to ~9X. Assuming 2021 was a bullish year, let’s go with a volume/market cap multiple of ~6X.

If we assume a conservative 50% CAGR in market cap, we end up with a 2030 market cap of ~$30 trillion. That gives us $180 trillion in assets traded overall.

Assuming 50% of this is traded on DEX, we hit a figure of $90 trillion. If we go with a transaction fee of 0.1%, we end up with yearly revenue for DEXs at $90 billion.

Compare that with the current revenues and Price to Sales of DEX. Uniswap does ~900 million in revenues with a price/sales multiple of 6. A truly cross-chain DEX built on layer 2 and powered by cross-chain bridges that pool liquidity can easily earn $25 billion. With a P/S of 6, we are talking of a market cap of $150 billion, a 100X growth opportunity even for Uniswap.

Source: Token Terminal

To conclude, here are the main points of this article:

  1. Crypto-to-fiat ramps are huge opportunities but run a risk of bumping into regulations. There can be opportunities here when CBDCs go live. I will personally stay away from this due to high regulatory & compliance risks
  2. Wallets are a gateway to the crypto-verse. If crypto wallets can replace credit cards, we can see at least 100X growth in active users. Next-generation wallets will run on Layer 2’s and will support all Defi primitives. All Defi protocols will rush to partner with wallets and will pay them for providing access to users. I see Metamask and Argent as huge potential Alpha opportunities in the wallets space (both are expected to launch their native tokens soon).
  3. DEX is currently doing 10% volumes of CEX. I see the next wave of DEX innovations increase the DEX-CEX trading volume to 50% over the next 3 years, thanks to the emergence of L2s, cross-chain DEXs, and cross-chain messaging platforms. I expect a potential $90 billion revenue opportunity for DEXs by 2030. I see platforms such as Thorchain, dYdX, Uniswap, Curve and Cosmos DEXs (Gravity, Osmosis) as potential alpha opportunities in the DEX space.

In my next article, I discuss the next set of lego blocks in my Defi hypothesis. Subscribe and don’t miss future updates.

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Defipi Guy

Defi investor and researcher. Macro analyst. Believe in first principles thinking. Believe in humility, open-mindedness and long term positive sum games.