Digital Assets: A Liquid Investment that Generates a Yield!
In the previous article we’ve seen that, like shares, the value of digital assets is driven by the fundamental value drivers of the underlying business. We’ve seen that there are parallels between analysing sales prospects in digital asset protocols and analysing them in traditional smallcap company shares investing. But there are two other important attractions of investing in digital assets that few people outside this sector grasp. Firstly, UNLIKE shares in early-stage companies which are often unlisted, most crypto tokens trade 24/7 so you as an investor benefit from liquidity. Perhaps more surprising is the fact that these fast-growing digital asset projects not only offer the prospect of high capital growth but in fact also offer a yield too!
Why is it a big deal that crypto projects — despite their early-stage exponential growth characteristics — are listed and therefore liquid? The reason: we now have an environment where most companies in the traditional market go public considerably later in their growth cycle, so ordinary investors don’t get to participate in the exponential growth stage of the business. However, even if you are lucky enough to have access to high-flying private early-stage deals, you are locked into illiquid investments for years and risk losing your entire stake if things go wrong. That’s not the case when you invest in digital assets: you have liquidity should things start to turn for the worse even though these are young fast-growing businesses.
*LP = liquidity provider
*Validator = a node operator that processes transactions on the blockchain
Source: Token Terminal
As I said, the other incredible advantage of investing in digital asset tokens is that they pay a yield too (similar to a scrip dividend) which clearly boosts investment returns. You may ask where is this yield coming from? The easiest analogy is to be found in the gig economy of Web2. Just like in the Web2 Gig Economy where tech giants such as Airbnb, Uber, and Glovo reside, DLT projects match users and service providers to fulfil consumer needs in exchange for a fee. Do you need to make near-instant transfers or payments at a fraction of the cost? Stakers will verify and execute the transactions. Do you want to exchange digital assets? Service providers supply the liquidity. Do you need to take a loan? Lenders offer readily available capital. This fee represents the basis of the yield generated by the protocol that is paid to their tokenholders.
But who are the stakers, liquidity providers, and lenders? That’s early investors like you and me. We fulfil the supply side of the equation and not only benefit from compounding returns arising from the high growth potential of the asset class but also the yield obtained for the services provided. And it flows seamlessly, powered by smart contracts that programmatically enforce the contractual obligations of both users and service providers.
Examples of Web3 Businesses that Generate Real Value
MakerDAO
MakerDAO is a lending protocol allowing borrowers to deposit funds and receive stablecoin loans. The protocol requires its borrowers to provide 150% in collateral, making it liquid and solvent, and it’s now pretty sizeable, with $7.7bn in liquidity reserves as of mid-October 2022. MakerDAO generates its revenue from interest on borrowed capital and asset liquidation — which it splits between its own treasury and protocol lenders. While MakerDAO extracts the bulk of its revenue from ETH and BTC lending to the $83bn DeFi market, the end game in terms of addressable market is the $11.3tn traditional global lending sector.
Source: MakerDAO Financial Report 2022–09
We can see that MakerDAO’s business is going from strength to strength despite the harsh bear market conditions. In July 2022 it made history when it issued a $30m stablecoin loan to SG Forge, a blockchain-focused subsidiary of Societe Generale, which is the third largest bank in France with $1.5T in assets under custody. This enabled SocGen to refinance €40m of digital bonds (OFH tokens). The loan is backed by the OFH tokens, issued by SocGen and supported by corporate obligations and a pool of French home loans — both of which have AAA credit ratings by Fitch, Moody’s, and S&P. Shortly after, MakerDAO also offered Huntingdon Valley Bank — a lender with $550m+ in assets under custody — a $100m loan.
*RWA = real world assets
Source: MakerDAO Financial Report 2022–09
What makes MakerDAO an attractive source of capital for banks is its low cost of capital — afforded by disintermediation — and its sound business practices, and this means that it has attractive prospects to grow its participation in the gigantic real-world asset loans market.
Lido Finance
Another example of a successful protocol that generates sizable revenues and yield is Lido Finance. Lido is a liquid staking protocol. This means stakers deposit funds into Lido and receive a return on investment in the form of ETH and LDO ‘token rewards’. Lido removes the risks and challenges of managing staking infrastructure, allowing users to delegate their assets to professional node operators, without a minimum deposit requirement. The protocol gives stakers liquid staking derivatives that can be used to obtain additional yield too. Lido generates its revenue by charging stakers 10% of their staking rewards — 5% goes to professional operators (i.e. the yield they generate), while 5% goes to Lido’s treasury.
Source: Token Terminal
It is clear from Lido’s growth that investors value and are attracted by the yield in the sector. During 2022, Lido Finance paid out ~$90M in token rewards to its users, while its competitor Rocket Pool paid ~$15M. Even if Lido has spent 6x more compared to its main competitor, it has also managed to acquire roughly 30x more in user deposits (an average monthly TVL of ~$10B vs. Rocket Pool’s ~$0.3B).
A high and sustainable yield is however just a part of Lido’s superior business offering. Compared to its competitors who allow anybody with 32 ETH to spin up a validator node, Lido curates its service providers, whitelisting only professional node operators that meet stringent requirements. This gives stakers peace of mind regarding their assets. Equally, as well as its dominant market position in ETH staking, Lido is now on track to deliver new avenues of growth by aggressively expanding to other major blockchain networks.
It is important to note that Lido’s Ethereum staking business still remains a high-growth area following the implementation of the Merge. With staked supply expected to grow at least as high as the industry average — that’s a 5x growth from here — and with Lido collecting a 10% commission on staking rewards, the massive anticipated wave of ETH inflow could see Lido becoming one of the most lucrative DeFi applications in Web3.
The Graph
The third protocol I have chosen as an example is The Graph. The Graph — like Google — is an indexing and querying protocol that makes blockchain data easily accessible. The protocol uses service providers such as indexers, curators, and stakers to map blockchain data in exchange for a share of the revenues.
The protocol holds a virtual monopoly on the market for blockchain data indexing and querying. Like Lido, The Graph uses aggressive token rewards to acquire service providers, while (initially at least) subsidising the cost of data indexing for blockchain protocols and applications. This strategy saw the Graph add 30,000+ clients to its data indexing and querying services. These applications now all depend on the Graph for sourcing business-critical information to run their products and services.
Source: Messari
Following its successful landgrab strategy to become the leading indexing and querying protocol, The Graph is looking to capitalise on its unique market positioning. In Q2 2022, the core team announced that they will move their data indexing clients to a metered usage costing structure. Since the announcement, the protocol saw a 53x increase (!!) in quarterly revenues despite the prevailing bear market. To me, this is a clear sign that, having established its market leadership, The Graph can now start to move away from subsiding its data indexing services and generate sizeable recurring revenues.
The Graph also announced it’s moving its operations to Arbitrum, an Ethereum scaling solution that is orders of magnitude faster, cheaper, and more scalable than many current solutions. The core team estimates the move will reduce the operational costs of service providers by 99.95% (!!). This is one of the most exciting positive fundamental developments in Web3, expanding the size and scope of data indexing and unlocking new features and use cases across the entire Web3 sector.
Final Thoughts
Most people remain oblivious to the incredible investment opportunity that digital assets represent given that they offer not only exponential growth but also yield and liquidity too. Despite the narrative pushed by sceptics that “crypto has no intrinsic value”, digital assets represent in fact a fast-growing sector where talented business leaders are creating sizable and sustainable revenue streams.
We believe it is very likely that this negative view of the sector will slowly change as the investment advantages of the sector become more widely understood. Investors don’t need a Ph.D. in computer science to understand why there is value creation in digital assets: like any investment, it’s all about their ability to grow their revenues and/or generate yields. The reason they are growing is the reason that the Web2 gig economy businesses grew to gigantic proportions: Web3 businesses are removing the friction of doing business in their respective niches and generating value for both customers and investors in the process.
Ultimately, the value that successful Web3 businesses accrue will be passed on to the investor through higher token prices which are ultimately driven by the project’s exponential revenue growth and also an attractive yield. The fact that digital assets offer both these attractive characteristics makes them a uniquely attractive investment opportunity!
RMP is a Co-founder of Dragonfly Asset Management.
DISCLAIMER: This content is for EDUCATIONAL AND ENTERTAINMENT PURPOSES ONLY and nothing contained in this blog should be construed as investment advice. Any reference to an investment’s past or potential performance is not, and should not be construed as, a recommendation or as a guarantee of any specific outcome or profit.
