2022 has been a perfect mirror to 2018. Will 2023 mirror 2019?

We have bypassed the lowest point of the bear market. As for BTC, we see that the price level at ~$16,000 in Nov 2022 mirroring the same movements as that in Dec 2018 when the price was at $3,200.

We are not too positive about the market in 2023 because the market still needs about 1 year to gather momentum while fluctuating up and down repeatedly based on cyclical analysis. But it will bring more short-term windows for tactical opportunities like event-driven and cigarette butts trading. Then we just wait for the next mega-trend patiently. That is what veterans in this industry would call “echo bubble”.

We have deployed about half of our liquid assets on BTC at $17,000 and ETH at $1,250 on a long-term holding basis. Our deployment strategy was driven by four indicators:

1. Cost basis of ST&LT holders
2. Market sentiments
3. Money flow
4. Macro Risks

Detailed analysis is as follows:

1. Cost Basis of ST&LT Holders

Net Unrealized Profit/Loss(NUPL) is an indicator to describe the micro holder structure of BTC.

NUPL well depicts the cost basis of the market by color. The line in red represents a period when the market is under capitulation. It also depicts the bottom of the cycle(2012, 2015, Nov 2018, Mar 2020, and Nov 2022). We don’t see a high probability that BTC will fall below $15,000 and ETH below $900 in the next few years.

We can also observe the user structure of the market by analyzing HODL waves.

As we can see in the chart, users who hold BTC for about 1 month to 3 months are likely liquidated at the bottom such as in 2015, Dec 2018, and Mar 2022. Bubbles of the last cycle will be fully squeezed out with the short-term speculators exiting the market.

The following years (2016, 2019, and likely 2023) came with a rising percentage of long-term believers(who hold BTC for 1 year to 2 years) when smart money gradually flows in and accumulates token holdings, leading to price rebouncing. This is what we call “echo bubble”.

Currently, we are in the stage of accumulation when the number of 1y-2y holders starts growing. But make no mistake, we won’t see the market enter its next bull run until short-term speculators are convinced that the bull market is not imminent and exit the market. Our best guess remains that the next cycle will begin no sooner than 2024.

2. Market Sentiments

The best indicators for observing holder sentiment are volatility and open interest.

At the end of 2022, the volatility of BTC hit an unprecedented all-time low. Market sentiment seemed to have been devastated by several back-to-back FUD events such as the Luna collapse, 3AC, FTX, and Genesis, leading us to the rock-bottom of this cycle.

Recently even after +30% re-bounce in price, the volatility remains at an unbelievably low indicating that token holders are still skeptical and fearful. That’s why we believe there exists a short-term echo bubble. Once again, when we start observing volatility spikes after April or May, we expect to see this bubble burst and push prices down, mirroring the trend in 2019.

On the other hand, the open interests tell quite a strange, yet interesting story.

The OI for BTC is really low but the OI for ETH is extremely high, and we’re unsure as to why there exists this large gap between the two. But since most takers are short orders, shorts will be the gas for longs. We will carefully monitor how the OI of ETH shall be washed out. It will be the tipping point of the recent echo bubble.

3. Money Flow

We constructed an indicator called “Crypto Leverage Multiple” which equals: Total market cap divided by USD stablecoin market cap (USDC+USDT).

It’s similar to PB ratio in the equity market and is used to describe how much of a bubble is backed by one stablecoin.

You could see the leverage multiples hit its lowest in July 2022 and Nov 2022. This would indicate that the valuation of crypto market is extremely cheap at these periods of time. But as the echo bubble persists, the bubble gradually grows to a medium level.

Once the leverage multiple hits the upward benchmark, like it did in April 2021 or Oct 2021, we will sell most of our positions.

4. Macro Risks

Most investors would be concerned about the recent tense debates of CPIs, inflations, interest rate raises and cuts, and BOJ’S YCCs(so-called the last safe haven of global liquidity and risky assets).

We won’t pay much attention to macro economics this year because we believe this is the year where crypto and macro will lose their tightly coupled correlation.

While we anticipate a number of macroeconomic changes, predicting what exactly they are is an exercise in futility and therefore our best approach remains to react and not to predict. This being said, we do appreciate the fact that while history doesn’t repeat, it does rhyme. Given the extreme 2022 we had where we observed painful interest rate hikes, crashes in risky asset markets and most importantly a negative M2 growth rate, we believe 2023 is the year of ‘mean reverse’. We have faith that the crypto market will lose its tight correlation with the macros this year and we need to maintain focus on the internal structure of the crypto market.

Everything that’s happening in the market right now is very reminiscent of the 2019 market where tokens like SOL, AVAX, AXS and MATIC all began to make their mark. The tenbaggers of this cycle are yet to have their moment in the sun, but we do anticipate them showing their potential in the following six months. Although we’re not positive about having a bull run in 2023, we remain highly optimistic in being able to witness the rise of the next 100x winners and, most importantly, monetize from their growth

All in all, we believe the era of de-leveraging will come to an end this year and 2023 will still be a PvP market. The market is anticipating the next innovation such as DeFi, to kickstart a new cycle. So, when the recent echo bubble bursts, we’ll have a once in a blue moon chance to invest in innovative technologies at a relatively low price.

Where we see the opportunities?

We strongly believe that the new run will be boosted by application layers with new format of asset distribution, leveraged model, and followed by the infrastructure that support these Applications.

1. DeFi: will stay as the main use case of blockchain and bounce back from its bottom, but with new tokenomics

The previous bull run started with the DeFi summer of 2020 and we have seen a robust user base ever since. We believe that with users having learned the lesson of “not your key, not your coin” from the recent FTX collapse and additional regulatory pressure, the DeFi user base is going to further grow.

Despite rapid innovation in capital efficiency, routing algorithms, and gas efficiency in the trading/lending protocols, we expect the old DeFi kings to remain strong. Just as users trust financial institutions, the consecutive number of blocks a DeFi protocol operates without significant attacks will become an moat for its business. Protocols that only make minor feature improvements will find it difficult to capture market share from their established counterparts.

While the fundamentals for DeFi protocols remain solid, there is a significant gap between their products and tokenomics. The DeFi summer opened up a new era with the incentive model of liquidity mining, causing their tokens to keep “bleeding”. Pure governance tokens spread through liquidity mining have become a “marketing cost” to attract buyers with impressive “TVL numbers”, but secondary buyers are paying the price. They hardly found a way to convert the TVL into real revenue.

We believe that the first movers to close the tokenomics gap will stand out. Two feasible approaches to revise their tokenomics are:

• Fee Business Model: This model generates revenue from transaction fees and provides token holders with real yield. Token holders can share in the transaction revenue by staking the governance token (e.g. GMX model). This model is suitable for products that can charge juicy fees from their users with a scalable transaction volume base. Some protocols, like Mcdex, Popsicle Finance, and Pendle Finance, have been slowly revising their tokenomics to fit this model.
• AUM Business Model with LTV-backed algorithmic stablecoins: This model earns revenue from interest rates and secondary buying power is generated from stablecoin minting and redeeming (e.g. Curve & AAVE model).

Here, we borrow the words from our friend GBV to further validate this approach:

Instead of deriving revenue directly by charging users of the protocol a fee, protocols like AAVE and Curve are launching stablecoins in which interest payments accrue to the protocol itself. The stablecoin serves as the tool for liquidity provision, thereby alleviating the pressure on the protocol to incentivize liquidity. Liquidity becomes fully owned and controlled by the protocol.

2. NFTs

NFTs have established themselves as a solid type of asset with a diverse group of consumers, collectors, and traders, and with complete infrastructure support (such as on/off ramps, wallets, and marketplaces). There is a strong possibility that the next wave of growth in assets, traffic, and leverage will come from NFTs.

• PFPs will be divergent. The ones that manage to extend their IP outreach (into fashion, anime, games) will survive, while those that lack sustainable content generation will fade.
• Crypto-native NFTs, such as Cryptopunks and Artblocks/Generative Art, will have stronger longevity in the long term. On the one hand, they possess a strong uniqueness, as the process of creating and displaying these works requires the support of blockchain technology and represents crypto-native culture. Additionally, there is strong support from powerful collection DAOs like FlamingoDAO, who have kept buying pieces on-chain and built their impact into the traditional collector communities.
• NFTs on social protocols like Lens Protocol will become the new treasure trove of assets. We expect to see the creator economy boom on social protocols and new “Ponzi” engines that combine NFTs and governance tokens to boost the creator economy on social protocols.

3. Gamefi

We believe that games serve as leading indicators of each technology revolution and provide insights into how users will interact with future digital systems. We also believe that the gaming sector will continue to play a key role in onboarding new users into the world of cryptocurrency.

Account abstraction, which supports a web2-like login experience with features such as social recovery, session keys, and bundled transactions, will be a standard feature of Gamefi. The wallets will mostly be in SDK format, and the value of the wallets will be captured by layer 1 and layer 2 they work with. Leading layer 2 players, such as zkSync and Starknet, are committed to incorporating native account abstraction.

Mini Games + Game Publisher > On-chain Games > AAA Mega Makers

It will become a normal practice for game studios to use NFTs to drive initial traffic during publishing. We may see NFT-version “Curve War” appearing on publishing platforms like TreasureDAO ($MAGIC).

One of the challenges faced in the Gamefi ecosystem is that many game tokens have a strong dependency on the lifecycle of the game, and as the game reaches its end, the value of these tokens may also diminish. But publishers can capture traffic throughout the lifecycle. We believe that a new form of P2E tokenomics will incentivize players with the publisher token, and the games will compete for emission gauge through NFTs and their own native tokens.

We expect to see a typical Web3 publishing procedure, such as:

• Build a CC0 NFT and open the IP for the community to build content around it. Freely launch the governance token $ABC of the platform with NFT staking/NFT-related quests.
• Build the games themselves or introduce gaming studios to the platform.
• Each game launches its own token and pairs it with the platform token on a native swap.
• Incentives are distributed through the platform token with a weighted gauge, where the gauge is weighted by staked NFTs/staked platform token $ABC and staked game tokens.

Onchain game: Dark Forest has been growing into a wild ecosystem with multiple teams building up plugins on top of DF and making money from it. We could see more Permissionless Composability become a new game development paradigm and more on-chain games in 2023.

Dark Forest is a EF lead on-chain game completely run on blockchain where smart contracts / codes / AIs are the key players battling for reward instead of human beings.

Onchain games are popular among Degens and crypto OGs as all the gaming rules are stored in smart contracts instead of traditional backend servers. It allowed both developers and players to do something fundamentally different that they could not do in the Web2 paradigm: Permissionless Composability. With all the gaming data on open database, players/ developers will add new features or even publish a “fork”version without complicated procedures.

But practically speaking, the current on-chain games are too hardcore for even crypto traders who don’t master smart contract well to create wider group of hype and speculation. And it’s super expensive, each move in the game is currently consuming millions of gas on Ethereum, so we’d prefer to look more games scaling solution like layer2s. Also, on-chain games need better front-end and educational-orientated guilds to bring in wilder group of players/ traders. We are also expecting “vault” like products to serve as agents to help retail users to interact with the gaming smart contract.

AAA games are hard to achieve in this cycle, as the majority of gamers are satisfied with the offerings provided by established Web2 studios. Web3 studios need to differentiate themselves and offer unique value propositions to gain market share, which will be focused on technology, paradigm shifting, and community building instead of content generation.

4. Layer 1, Layer 2, Infras

We’ve learnt from Solana that Alt layer 1 was a VC game with low MC and high FDV (and backed by CEX users’ money). While Alt layer 1s like Solana still have their users / developers, we anticipate that layer 2s will gain significant market share from the Alt layer 1s, especially after the Ethereum Cancun Upgrade later this year, which has the potential to significantly lower costs for layer 2s.

We have a positive outlook on the Cosmos ecosystem. On one hand, Interchain security is poised to open a new chapter in interoperability. On the other hand, our thesis is that the Application layer will capture more users in the upcoming cycle. As a result, we anticipate that well-established DApps will seek to have more control over their “economic policy” and set their own gas fees. Additionally, current Layer 1s are using the Cosmos SDK to build sidechains and tap into the growing App-chain ecosystem as well. Polygon, with Lens Protocol, will outperform the majority of zk-EVMs that currently rise in the primary market.

BNB Chain, despite remaining strong and having the largest user base in the industry, has many improvements to be made both on the product and infrastructure side. It also still requires strong native DeFi infrastructure like a native lending market and algo stablecoins. We believe by concentrating our efforts on BNB DeFi, we can both contribute and capitalise on the future growth of the BNB chain.

5. Others

We see a raising trend in TIPIN projects (Token Incentivized Physical Infrastructure Networks) projects.

The miners have always played an integral role within the industry and the sales of mining rigs have also served as a crucial source of fiat revenue. We’ve noticed that some PoW miners have been forced to change course on account of declining mining returns and ETH’s shift from PoW to PoS and are therefore in search of hardware-dependent mining targets. In the last cycle, Helium and Filecoin unfolded a narrative around Web3’s open infrastructure and we believe there will be more projects like these that are dedicated to building out the next generation of decentralized infrastructure and collaborating with old miners and thereby promoting the development of TIPIN projects. Here are some reasons why we believe this to be the case:

• Decentralization: TIPINs aim to build decentralized networks, meaning that they are not controlled by any single entity, but rather by a decentralized network of nodes. This results in a more resilient and secure network, and reduces the risk of centralization and censorship.
• Token incentives with hardware sales: By providing token incentives, TIPINs can both subsidize hardware purchase costs, acquire users and distribute the tokens to a wide user base. This will then encourage participants to contribute to the network and receive token incentives for contributing resources such as bandwidth or computing power, or for participating in consensus mechanisms. This incentivizes participants to actively contribute to the network and helps to ensure its continued growth and development.
• Network effects: TIPINs benefit from network effects, meaning that as more people participate in the network, the network becomes more valuable to each participant. This creates a positive feedback loop that drives growth and adoption.
• Monetization opportunities: TIPINs offer monetization opportunities for both the network and its participants. For example, the network can charge fees for using its services, and participants can earn tokens for contributing resources or participating in consensus mechanisms.
• Sustainable revenue: TIPINs offer a sustainable revenue model, as they are not reliant on a single source of revenue but instead have multiple streams of revenue from fees, token incentives, and network effects. This helps to ensure the long-term viability of the network.

Despite being in its early stages, the TIPIN sector is worth watching and has the potential to offer substantial alpha opportunities.

Closing Words

In conclusion, the outlook for 2023 presents a unique set of challenges and opportunities. Our analysis suggests that the market de-leveraging will come to an end this year, and the market will continue to navigate opportunities in DeFi, NFTs, Gamefi, and L1/L2 infrastructure. We believe that the indicators and trends outlined in this report will significantly impact the coming year and that those who are proactive and forward-thinking will be best positioned to succeed. As we move into 2023, we are excited to see what the future holds and stand ready to support those who are looking to capitalize on the opportunities ahead.

Thank you for reading this outlook and we wish you all the best in the coming year.

Witnessing the potential of the web 3.0 game market, game studios are exploring potential tokenization of their games. Many have impressive backgrounds, outstanding achievements, and Web 3.0 pioneer advisors. However, some of the discussions and initiatives ended in vain. We would love to share our view on web 3.0 game and its tokenization models, and open up more room for discussions between game makers, investors and guild / professional league members.

Our key observations are:

1. Not all game genres are suitable for Web3.0 tokenization at the current stage — we will probably see successful tokenization cases from light to mid commitment games such as SRPG (strategy role-playing games), SLG(simulation game) and casual games first;
2. Directly introducing NFT assets, utility and governance tokens to a popular Web 2.0 game will not add icing on its cake. Rather, it will disappoint the original target customers and do damage to the existing game economy;
3. The “utility token + governance token’’ dual-token model won’t work for most web 3.0 games in the long run. Web 3.0 game economists should look at classical monetary theories and understand one can’t have free flow of capital, independent monetary policies and stable FX rate at the same time. Treat web 3.0 games economies like real economies with international political economies theories in mind, too;
4. Given such framework, web 3.0 games should introduce more than just utility token and governance token — in-game currencies with stablecoin-like design, loot boxes, NFT battle passes and tokens should be considered altogether to build robust economies;
5. Numerical engineers for games (not to be confused with game economists) in China are especially skilled at designing sustainable, inflation / deflation resistant game economies — but building a large existing user base is the prerequisite.
6. Using the right token and NFT incentives to bootstrap crypto native user base and then expand to web 2.0 gamers would be an ideal go-to-market strategy.

Get in touch with us to discuss more on game design, hiring, game economy design and bootstrapping communities.

Below are ten common questions from our recent discussions with game developers. We will also share our potential answers and solutions.

Question 1: How did GameFi 1.0 games such as Axie Infinity lose traction overtime?

Transaction & Account volume change of Axie Infinity

Source: https://dune.com/zhai/Axie-Infinity-(AXS)-onchain-analytics

The market has passed the earliest FOMO stage. Here are some of the common causes of how some GameFi 1.0 star projects have fallen in popularity:

• Lack of gameplay
• Lack of in-game asset consumption mechanism
• Fast token emission speed
• Abnormal game equipment price and production output, caused by excessive fluctuation of token price, inflation destroying the game economic system

We are looking at these games using the economy model.

The game projects that fell in succession in GameFi 1.0 are like the countries that failed in the 1997 Asian financial crisis: South Korea, Vietnam, Malaysia, Russia, and so on. These countries have all enjoyed a short-term economic boom, with huge external debt growth and an influx of foreign capital.

Source: https://www.rba.gov.au/speeches/2007/sp-gov-180707.html

Capital markets in the region were underdeveloped, so the capital inflow tended to be intermediated through the banking sector. These countries spent a lot of foreign reserves to support the exchange rate of their currencies when hot money flowed in without capital control. They are forced to suffer the consequences of currency depreciation, and asset price decline.

The gamefi 1.0 projects are experiencing this process followed by their brief glory. We believe that the biggest failure of GameFi 1.0 is the neglect of the “impossible trilemma”- a classical monetary theory.

The impossible trilemma theory simply suggests that countries cannot simultaneously maintain the below three:

1. Free flow of capital
2. Independent monetary policy
3. ​​Stable exchange rate

The original design for most GameFi 1.0 projects is to :

1. Guarantee the free flow of capital: Players can freely buy or sell SLP/AXS and NFT in the game with ETH
2. Independent monetary policy: Each game has its own rules for token circulation, which is equivalent to the country’s desire to implement an independent monetary policy.
3. Therefore, these game projects naturally give up a stable exchange rate, which causes the token price to inevitably fluctuate wildly as players and hot money move in and out. In the end, it fell into a financial crisis and ended up with nothing.

Therefore, the answer to Q1 also answers the question we threw out earlier: A successful Web 3.0 game is by no means a successful Web 2.0 game and simply replacing equipment or resources with NFTs or issuing the original points pass of the game into tokens.

With the perspective that blockchain games are national economies, traditional games can basically be understood as a “closed economy” or a “planned economy”, while Web 3.0 games are naturally “open economy” due to the nature of the crypto market.

The design of NFT and Token is essentially a process of “opening up”. Issuing NFT or Token is like a closed and self-sufficient economy trying to open up industries, introduce foreign capital, bear foreign debts, price exchange rates and modify monetary policies, which is a brand-new impact on the game economic model which was originally complete in a closed state after all. Simply replacing the original currency or points in the game with token will cause the economy to be severely impacted and out of balance by freely circulating capital.

Question 2: What will GameFi 2.0 games be like ?

We believe that MMORPG games will be the mainstream type leading to GameFi 2.0 and the most suitable game to be tokenized in Web 3.0.

Let’s classify games according to cost, content depth and gameplay difficulty, we roughly categorize them into heavy commitment games, moderate commitment games and light commitment games.

Heavy commitment games (competitive) mainly include familiar AAA masterpieces, such as GTA, which are often dubbed Game Takes Ages by players. Moderate commitment games can cover most role-playing, sports competition, strategy SLG, real-time strategy RTS, card games and so on. Light commitment games are casual games such as mobile tennis, card games and blitz games.

It is too early for web 3.0 game experiences to compete with traditional AAA heavy commitment games produced by big game studios.

Light commitment games are mainly aimed at fragmented entertainment needs, which consume less time, money and attention of players, and lack the circulation of multi-layer assets in the system. It is also difficult for light games to transform Web 3.0 games at the current stage.

Moderate commitment games is the remaining category that is still suitable for Web 3.0 game innovation at the current stage. To be specific, it is the MMORPG games that are most suitable for tokenization into Web 3.0 games.

MMORPG games have a rich world outlook, strong playability, full social experience and mature game development and economic mechanisms. As mentioned above, games such as World of Warcraft and Dream Western Journey have been popular for nearly 19 years, some MMORPG games in Roblox also have lasted around 10 years. Trading is at the essence of MMORPG games, emphasizing the concepts of assets and in-game economy. We have observed a significant trading volume of virtual assets in games. This characteristic makes MMORPG games naturally meet the need of crypto native players.

MMORPG (Multiplayer Online Role-Playing Game) games can be divided into approximately moderate games and some heavy games. The birth of MMORPG type games can be traced back to the 1970s, with gameplays like time rounds, sandboxes, open world and other games. The overall gameplay of MMORPG is relatively mature, which is deeply loved by the majority of players.

Many popular world games, such as World of Warcraft, Final Fantasy 14, Star Wars Eve or Dream Westward Journey, etc., are classic and long-lasting games.

Referencing the development of traditional games, we think GameFi 2.0 is closer to the stage of MMORPG games explosion in the 21st century. The most important thing is to find a balance among input cost, attention and game experience.

P2E (Play To Earn) is not a trendy word for traditional MMORPG gamers, nor is it some kind of original creation of Web 3.0 games. Ten years ago, a large number of players of World of Warcraft or Dream Westward Journey have already started farming in games.

We were amazed by a website that shows the price chart of WoW Gold against the US dollar. Players could sell WoW gold coins they farmed in games to make real cash. However, games officially encouraged players to earn gold coins in the game, and this RMT (Real Money Trading) was severely suppressed. We will expand our discussion on this specific point in detail later in Question 3.

How to develop these closed economies of MMORPG games into open economies of Web 3.0 games is the key question we need to answer.

Question 3: How many tokens should be issued in Web 3.0 games?

After decades of development, traditional games have basically formed a classic triple-currency or quadra-currency model in closed economies:

• gold coins
• silver coins
• gems (and points)

Most importantly, the flow of different currencies was kept one-way, i.e. only a one-way exchange mechanism from fiat money to gold coins to silver coins to gem can be formed.

Fiat such as the US dollar can be added into games and swapped for gold coins first. Gold coins as the first currency in the game, is the purchasing power of fiat units, gold coins can not be reversed back to fiat.

Gold coins can be converted into silver coins at a certain ratio. Silver coin is the most important and major circulating currency in the game, which can be farmed by playing in the game, and it is also the consumption currency of the main behaviors such as upgrading, repairing and refining in the game. Silver coins bear the most important monetary medium in the economy, and silver coins cannot be exchanged for gold coins.

Silver coins can be exchanged for gems, which can be used to draw for treasure, buy the best props in a limited time in the official market of the game. Once silver coins are exchanged for gems, gems cannot be exchanged back, gems cannot be transferred out, and can only be used in shops.

Some games will have the fourth currency as points, which can be gained through daily active tasks, such as logging in and meeting certain game duration, then exchanged to gems. Points can not be converted into gold or silver coins, can not be transferred to others, and can not be sold to fiat.

RMT (Real Money Trading) mentioned in Q2 refers to the process that users swap silver coins earned in games into fiat in the real world. The reason why the game officials are strictly against RMT is to prevent hostile gold farmers from leading to inflation in the game, which not only disturbs asset prices, but also destroys the game economy.

At the same time, silver coins flow to gems in one direction, which is also to encourage the consumption of silver coins by introducing scarce high-end equipment, and to combat the deflation of output by diversified means of consumption.

In particular, points cannot be swapped for silver coins or gold coins, so as to prevent players from earning points by logging in a large number of trumpets and swapping points for silver coins, thus generating a lot of selling pressure.

Web3.0 game economy is very different from traditional games. We will share the conclusion first then explain the reasoning behind it:

All attempts to “simply” replicate the traditional game economy model in Web 3.0 games cannot last.

We can abstract a similar game economy framework for Web 3.0 games:

1. The unit of account (ETH/SOL) in Web 3.0 games will play the role of fiat. Users generally need to trade ETH or SOL for some kind of NFT to enter the game, such as hero characters or shoes. Therefore, credits such as ETH/SOL or stable coins approximately replace the role of gold coins;
2. The silver coins in the game mainly include SLP in Axie, THC in Thetan Arena and GST in STEPN, which are generally called game consumption coins. There is no total limit on the supply and bears the most important function of circulating medium in the game;
3. Gems in traditional games have been replaced with governance tokens with upper supply limit, such as AXS/THG/GMT. Governance token is an important innovation in Web 3.0 games. Compared with the role that gems are only used to buy the best time-limited props in official marketplace, governance tokens also have the functions of treasury governance, consumption of specific utility, and game revenue sharing;
4. Most of the points function in traditional games is absorbed by silver coins (SLP/THC/GST) in Web 3.0 games.

Web 3.0 games seem to be able to map or copy the token design of traditional games, but the seemingly simple mirror process is exactly the reason most easily leads to the collapse of Web 3.0 game economy.

The traditional games mentioned above strictly set the one-way circulation of funds. It is impossible to prohibit the free trading of Eth/Sol and NFT in Web 3.0 games, and it is also impossible to restrict the trading of SLP/GST. Many exchanges have launched silver coin trading pairs (although I think this is not a good thing for games), and governance tokens have been overly hyped.

As you can imagine, a large amount of hot money freely impacts the economic system of Web 3.0 games, which is equivalent to seriously destroying the law of “impossible triangle”.

If the game wants to maintain free capital flow (players cannot be prohibited from trading tokens and assets in the blockchain) and independent monetary policy (the game has its own inflation control mechanism), it can only be forced to give up the stable currency exchange rate or say stable token price. Finally, game consumption coins and governance tokens can only usher in the end of large-scale depreciation.

We can also brainstorm this: if the game changes the gold farming reward from their own tokens to USDC or Eth/Sol, so that players can earn real money, is it better for Web 3.0 games? Who is paying the bills of the real money earned by players?

Our token design for Web 3.0 games is mainly three kinds of tokens:

• a game consumption token,
• a game governance token
• and a volatility adjustment token (stable token)

The design of active points can also be added as appropriate, and the specific design will be discussed in the following issues. Welcome to discuss with us in detail.

Question 4: Are Web 3.0 game tokens doomed to depreciate?

Unfortunately, our answer is YES.

Whether it is a Web 2.0 game or a Web 3.0 game, the game consumption coin is doomed to depreciate in the long run. The only thing we can control is the rate and paths of the depreciation.

Many reasons will lead to the final depreciation of game consumption coins, for example:

1. No matter how subtle the economic model is, it can’t rule out some self-owned defects, such as imbalance between the gold farming ways（supply） and consumption utility of coins（demand）；or there are multiple currencies in the game that can replace each other, resulting in long-term oversupply of game consumption coins and falling prices;
2. The long-term operation of the game is insufficient, the gameplay is weakened, and a large number of players leave the pit, resulting in the depreciation of gold coins and various game assets;
3. Too many professional gold farmer guilds enter the game, resulting in an excessive short-term output of game consumption coins, etc. In crypto, we see a rising trend of dilemma on co-operation with guilds

Just like there is a macro-economic cycle, the more games people play the more high-level players are promoted, and the disparity widens. Productivity then slows down, and soaring prices and currency depreciation may be inevitable.

Of course, we also see many MMORPG games that have lasted for more than ten years and are still economically stable; this will not happen without the precise calculation and control during the process of game development. We believe that Web 3.0 games can also explore a token economic model with a long life cycle.

Question 5: How do Web 3.0 game tokens circulate?

​​There are three kinds of token utilities in Web 3.0 games:

• Consumption tokens (SLP/GST…)
• Governance token (AXS/GMT…)
• and volatility adjustment token

among which game consumption tokens are the most important circulating medium in the whole economic system.

The circulation of game consumption tokens is mainly realized through supply and consumption:

• The supply of the game consumption token is mainly determined by the gameplay. The common gameplay mainly includes the growth system (upgrade) and social system (marriage, sworn or gang formation);
• The consumption (demand) of game consumption tokens mainly comes from the cultivation of players, and the main cultivation methods include the cost of upgrading grades, equipment, and skills. A healthy game economy system needs to achieve a relative balance between the supply and demand of game consumption tokens.
• The supply and consumption of games need to be calculated by numerical planning. However, the biggest challenge of Web 3.0 game design is to shift from “closed economy” to “open economy” and introduce many exogenous variables. We believe that the healthiest Web 3.0 games should pursue the following core goals.

We suggest game studios and investors that are interested in Web 3.0 games should consider below as their main target when designing the tokens:

1. The value of all assets in the game is determined by the player’s “Socially Necessary Labor Time”. Instead of relying solely on players’ online time, the most important economic mechanism is to have a variety of asset classes (time, money, resources, etc), and then maximize players’ game consumption. A depreciation mechanism for in-game assets is also helpful;
2. Game consumption token, the most important circulation medium in the game, should adopt a certain mechanism to ensure the stability of the token price. A large fluctuation of consumption currency can harm a game deeply. It would be best to maintain the token price with a slight deflation or relatively healthy inflation level.
3. Follow the rule of impossible triangles. Foreign exchange control policies are mandatory and necessary in the game. Try to increase the transaction friction like timelock or high trading fees when the tokens are exchanged for Eth/Sol and flow out of the system, to achieve the goal of “all the money earned by the game is spent in the game”;
4. Governance tokens should be empowered with natural utilities, and enlarge the leverage effect of governance tokens for gamers.
5. The team must have continuous operation capability, strong project management, and delivery capability to oversee the in-game economic conditions.

Question 6: How to achieve the goals above, and how to stabilize the game consumption token price?

According to the impossible triangles theory in economics, a country can’t achieve three goals at the same time: stable exchange rate, independent monetary policy, and free circulation of capital.

As it came to the Web 3.0 games tokenomics, the main goal should be to ensure the stability of consumption token prices and implement an independent monetary policy.

First of all, games need to strictly control the capital, set limits on the capital flow in and out of the game, and create friction costs. For example, lock up withdrawal periods of the player’s farmed consumption token, increase the transaction fee of NFT assets, or limit the upper amount of maximum tokens players can hold in their bags.

Secondly, games need to control the supply and consumption of games. Set output constraints, such as setting a new user invitation code in STEPN, decreasing marginal output of running shoes, wear and tear of running shoes, etc., which are typical ways to control the output of game consumption tokens.

The essential means to maintaining game consumption token price is to improve the consumption level of gameplay.

For example, the wear repair, upgrades, and new shoe synthesis of running shoes in STEPN can effectively increase the consumption of game consumption currency. If the game itself is entertaining and addictive enough, it may make players spend more than output, which is more conducive to a virtuous circle.

On this basis, games need to set some special consumption mechanisms for higher-level players. For example, many create new instances like dungeons, PVP battles, and cross-server arenas for higher-level players.

These designs are set to continuously strengthen the consumption of tokens by high-end players and slow down inflation in the game economy. On the one hand, they can improve the game experience, on the other hand, they can maintain the ecological balance of players.

At this point, one may realize that “X-To-Earn” is not the reason for STEPN’s success.

If we explore STEPN’s token economy, the token consumption in various gameplay scenarios and the steadily rising effect of GST is the secret to its success. You will find that although Stepn is a healthy lifestyle APP, its essence does not seem to be very different from MMORPG games like World of Warcraft.

Question 7: Key components for Web 3.0 games?

In order to facilitate the in-game token circulation, we believe that each Web 3.0 game should have sophisticated in-game capital markets with at least key infrastructures as set forth below: .

NFT Marketplace

First of all, Web 3.0 games need to have a built-in NFT Market Place.

The idea is mainly to provide services for players to trade in-game NFT assets, and the marketplace should have two features：

• One is a p2p trading place for players that can only be traded with game consumption tokens, which can be understood as eBay.
• The other is an official marketplace that serves the initial launch of rare assets. The main purpose is to trade scarce game assets such as limited edition equipment, pets, and props in a limited time. Trades can be settled in the volatility adjustment token.

For the in-game assets, we also think that there is no need to make every asset in the game (such as stars and fragments) into NFT standard. For those low-end resources which are not scarce at all. It is even better to make them as normal in-game wearables / tools to lower the entry barrier of players or put them into fungible tokens that could be fit into the existing AMM liquidity framework to facilitate frequent trade.

Volatility adjustment token (Stable token)

We suggest that the volatility adjustment token should be designed as a stablecoin-like token similar to Dai or sUSD mode.

First, a user must stake a certain amount of governance tokens for a certain time to pledge loyalty, then users could mint the volatility adjustment token: the “stablecoin”, through excess collateral of game consumption token. The excess collateral ratio can be dynamically adjusted.

This stablecoin should have strict outflow restrictions and as an intermediate to absorb volatility of the game consumption token. It is mainly used to support the transaction, and can also be used to support certain limited use cases that have no numerical influence on the game such as buying some achievements or medallions. In addition, users should be encouraged to purchase stable coins directly with external currencies (Eth/Sol) or other stable currencies, but they cannot sell them in reverse, and the game studio should encourage players to use the stablecoin within the game (with access to special edition NFTs or with discounts) .

Scenario 1: over supply

Too much supply of game consumption tokens will result in price depreciation, the official marketplace can introduce more advanced equipment, encourage users to burn their consumption tokens and mint stablecoins, and provide more purchasing power and less liquidity for circulating consumption tokens. Or we could directly switch the token reward farmed by players from full consumption tokens to partial control tokens to ease the selling pressure.

Senario 2: excessive demand

Excessive spending on game consumption tokens leads to an appreciation in a short time, then the system could lower the collateral ratio or increase minting cost, encourage the users to hold more consumption tokens, and increase the supply of consumption tokens. Or we can launch a limited-time welfare campaign to encourage everyone to spend in some gameplay use cases to obtain the income bonus of consumer tokens.

In the future, loans in the official marketplace can even be provided to cushion the movement of the token price.

The volatility adjustment token (the stablecoins), should have a non-linear reward curve for each player, making marginal revenue for each player going at a decreasing rate, to keep encouraging user consumption and to keep easing inflation in the game economy.

The total supply of volatility adjustment tokens (the stablecoins) should also anchor a certain multiple of the GDP of the game. When the leverage ratio in the system accumulated to a certain level, token minting should be shut down to prevent potential impact on the game economy. It is just like every government should put a limit on its total budget deficit.

Game Governance Token

At present, the ve-model is a relatively popular token economy design, but we believe that the token holders’ rights and interests need to be more closely aligned with the total wellbeing of the game economy.

The Game Industry requires high investments, long term development and also results in a higher possibility of failure. A significant portion of the total investment will be spent on customer acquisition costs. Today, traditional games must spend nearly 30–50 us dollars to acquire a new customer.

Governance token is a unique innovation of Web 3.0 games to replace CAC. Game studios could use governance tokens for user acquisition, activation, retention, and referrals. Some games even collect a part of the total cost in advance by land NFTs presale. The business model of the game industry is shifting.

We believe that the utility of governance tokens should be more aligned with the game economy, in addition to simply revenue sharing, repurchase, and lock-up incentives.

For example, if high-level players who meet the requirements want to open a store in the official marketplace, they must pay governance tokens as store maintenance fees and promotion fees, which will consume a considerable amount of governance tokens. Governance token holders could also be rewarded with certain titles or enhanced attributes.

Most importantly, holders should participate in governing and voting to set parameters in the game.

A successful Web 3.0 game with abundant users could be characterized as a giant crypto exchange just like Binance or Coinbase. They have rights like listing, collecting trading fees, or some rent-seeking powers. Normally users cannot be involved in running the crypto exchange business, not to mention making decisions for the exchange policies. But in the game, with the help of governance tokens, users are going to share the joy of rent-seeking on their decision-making powers with their governance tokens.

The governance token is the most innovative tool to tokenize all the rent-seeking rights into crypto assets, holders who possess the governance token could vote to benefit themselves selfishly and thus magically maintain a sustainable game economy through game theory.

All game studios should think carefully to maximize the leverage effect of governance tokens.

Question 8: What are the innovative ways to reform Web 3.0 games besides DeFi?

Here are some mind-blowing problems, we don’t have the right answers but are happy to conduct a dry run.

In the previous questions, we actively discussed the monetary policy of the game. There is another important pillar of the game economy, is fiscal policy.

In the national economy, fiscal policy is an important way to intervene. There will be fiscal revenues, such as tax, land sales incomes, governance expenditures, or policies of transfer payments.

The concept of trading and assets is the core of MMORPG games.

There will be a large number of token transactions, NFT sales, resource production, and capital circulation, which will bring great financial revenue to the games, such as property tax, transaction fees, withdrawal fees and other tax revenues, and asset sales revenue.

The fees and revenues will be a huge fiscal income for the game, and its profitability and margins may be even higher than a mediocre crypto exchange.

These huge economic benefits are seized by game studios in traditional games. In Web 3.0, the income should be included in the treasury DAO, governed by the community, and shared with the holders of governance tokens.

In addition, the game studio can also reallocate the fiscal revenues to balance the game ecosystem, adjust the gap between the rich and the poor, and provide financial support to some highly active small players or guilds.

In addition, we also observed that many MMORPG games have local servers. The economic model and inflation level of each server can be different. We think the game studios should allow whale players to build a new continent in the ecosystem. Whales could buy a big land in the game, find their states, and self-define various monetary policies and output parameters differentiated from the original game. This will bring more fun and unique experience to the game.

At the same time, all the new continents founded by whale players need to pay taxes on part of their income settled with governance tokens. It’s a concept similar to a federation.

Game studios should also pay more attention to the need for customization.

For example, players should be allowed to customize character NFTs. The game should provide powerful mods, and encourage users to create UGC content or customize exclusive props. All customization processes should consume governance tokens. Now that UGC props are NFTs bearing royalties, we believe UGC would inspire the game’s creativity.

Question 9: What is the best user profile and population structure for Web 3.0 games？

A healthy user population structure is generally a pyramid structure in the traditional game business.

The high-ranked players who are rare at the top only spend money but not time (they have scholars to grind for them), the mid-tier players spend both money and time, and the bottom players only spend time but not money. These games rely heavily on the purchase and consumption activities from the high-ranked players as a major source of income.

However, for the Play-to-earn model that has generated tons of hype and debate in the past 2 years, one contrasting fact is that everyone is playing to earn. A curious gamer should ask this question — who is really paying for the money I made in these Web 3.0 games?

In GameFi 1.0, there is only one group of people who actually paid the bill. They were the traders and speculators that bought the tokens on the secondary market.

In the transition process from GameFi 1.0 to GameFi 2.0, we envision more users will play the game because of its engaging story, quality production and exciting gameplay. More experienced and sophisticated game studios will combine NFT and token-driven incentives with the traditional game model in their production, and gradually create a healthy pyramid structure as we have previously mentioned. We also think that in the next 3–5 years, the Free-to-play and Skill-to-earn model will take the main stage when it comes to blockchain games.

We also envision that there will be three groups of game participants paying for the “earn” part of the Play-to-earn model for GameFi 2.0.

The first group will of course still be the open market trades by speculators and traders. The second group will be the players paying for advanced gameplay, experience and status (skins, for example). The last group will be third-party participants paying for exposures such as advertisers, esports event agencies and mainstream media platforms.

However, as we talk about this user profile idea with other game studios, there are two inevitable problems that trouble both operators and investors.

First, what are your targeted player groups and go-to-market strategies?

The main concerns expressed in this question is that the users of the so-called Web 3.0 games in the current market stage are mainly speculators and scholars.

A game that considers itself to be of excellent quality and immersive gameplay experience may not be what the native Web 3.0 users want. High quality gameplay, complicated worldview and lore may be exactly the reasons why play-to-earn gamers don’t want to participate in such quality blockchain AAA games.

The same backlashes hold true for traditional gamers too. Ubisoft and other leading game studios have also introduced NFTs in their games, but they have faced heavy resistance by existing players. These gamers hate the emergence of NFT ideologically and think that NFT will lead to unsustainable hype and price inflation of in-game assets.

MIR4 DRACO / HYDRA Price Chart

We think that launching a Web 3.0 game with AAA quality gameplay without carefully considering the nuance in preferences of both existing Web 2.0 players and scholars / speculators will result in drastic failure. This will not satisfy users on either side.

At this particular stage of GameFi 2.0, the entire Web 3.0 game user group don’t have much consumption power for in-game purchases, but they have considerable strength and potential for bootstrapping initial traction and funding for the game.

In the early go-to-market stage, the game should use PFP (profile picture NFTs), land NFT, battle pass NFTs and other means to attract pre-alpha stage users, building solid communities, vibes and some hypes for the game.

After the pre-alpha test and bootstrapping of the game is done, governance tokens should be distributed to early community members as rewards. As mentioned above, user acquisition and activation should be more easier leveraging governance token designs.

However, the real player groups should still be the mass, traditional gamers. The positioning of the game itself should be helping traditional game users enter the Web 3.0 world more smoothly, so the central idea for blockchain games go-to-market strategy should be “building core community in Web 3.0 first, and then going mainstream and monetizing in Web 2.0”.

The level of activity and effectiveness of the professional player community of Web 2.0 games are even far better than many Web 3.0 guilds.

The second question is, how do you collaborate with Web 3.0 game guilds?

Intuitively, the necessity of cooperation between Web 3.0 games and guilds is relatively low.

In traditional games, we need to make some distinctions between guilds. For professional player guilds, the game studio will give official support, while for gold farming workshops, severe restrictions will be taken such as account bans, play time restrictions etc.

Currently, almost all the guilds in the GameFi market are essentially gold farming workshops, which is not healthy to the overall game economies across games. Guilds prefer to buy NFT at high discount, quickly farm loot and dump tokens instead of consuming tokens in the game. It is easy to see that guilds are not necessarily good for game economies.

Not only that, the game also needs to have a certain anti-whale player mechanism, so as to avoid the excessive wealth gap between players that hurt the game experience, and also prevent whale players from hoarding more means of production to accelerate the output of game consumption tokens.

GameFi 2.0 games should still follow the principle of restricting gold farming workshops and encouraging professional player guilds and professional trading guilds.

The living space for the gold farming workshops will be more and more narrow.

Those guilds that have the ability to invest, participate in governance, provide operational assistance, carry out user education or data-driven ones that combine the in-game achievement data with digital marketing skills and help expand the game community will still have value in the early bootstrapping stage for the game.

These guilds can also receive official financial or in-game policy support from the game companies. For MMORPG games, if a guild can cultivate more players who are good at running business and operations, the partnership may be far more tight-knit. Guilds that can build their own in-game sub-economies that are separate yet connected to the main servers are also what we have envisioned in the near future.

Question 10: Open questions?

The beauty of Web 3.0 games is that they cannot be defined, and even cannot be imagined in their entirety. We still have many questions to answer, such as:

• Game-making is a highly complex, interdisciplinary business and the skill set of game practitioners is completely different from that of blockchain project entrepreneurs. Will web 3.0 games eventually be born out of spin-offs from traditional game giants?
• Or will Web 3.0 native communities grow native game companies?
• Across different levels of interoperability for NFT loots and characters, what are the various cases of on-chain vs. off-chain balance trade-offs?
• Will there be a myriad of game-native stablecoins taking over the mainstage in the next bull cycle? If so, what are the missing mechanics?
• What are some of the brand new game genres that web 3.0, NFT and token-driven communities will build?

If you want to make a Web3 game, please contact us at contact@incuba.capital to discuss.

Special thanks and credit to

Alex (@looksrare_eth), our Web2 friend F, Sarah from Impossible Finance and MixmarvelDAO Venture for the input and feedback.

We imagined DeFi expansion “horizontally” in the balance sheet and “vertically” in interest rate market about three months ago. In less than a quarter, many ideas and predictions that were once daring are being tested quickly.

As interest-bearing underlying or synthetic asset classes become richer, more and more lending protocols begin to support all kinds of LP Token collaterals, a diversified DeFi financial system is becoming systematic and multi-dimensional.

Still, DeFi can never grow without assets, and we see three main ways to generate excess returns: leveraging, expand durations, and bring in new types of credit.

DeFi users are generally proficient and familiar with leveraging. Longer duration requires sophisticated interest-rate market instruments. The fastest growing trend is to bring more types of credit into the blockchain as on-chain assets, adding these assets to eligible collaterals, and expanding the DeFi balance sheet by introducing more collateral to free up liquidity.

In addition to the aforementioned innovations in the native crypto assets as eligible collaterals, along this line, we are pleasantly surprised to see that DeFi started to be adopted by new users by connecting real world assets. MakerDAO’s acceptance of Real World Assets as collateral signals the rise of a new race track.

DeFi startups like Centrifuge, NAOS Finance, ShuttleOne, and Persistence are working to bridge the gap between DeFi and CeFi, bringing all sorts of yield-generating real-world assets on-chain, such as consumer loans, supply-chain finance, corporate credit, and real-estate rents, significantly extending the boundaries of the DeFi world. Bringing real-world assets into the DeFi world would make the current market size of DeFi assets seem unbelievably insignificant.

The business model for these DeFi startups is not complicated. In the real world, many CeFi FinTech companies are providing financial services based on underlying assets with specific yield stream, which mirrors the logic of “structured finance” in traditional financial markets.

In the traditional structured finance business, we need financiers to package the underlying assets with future yield streams into SPVs (some kind of trust or asset management product), and issue senior tranches and junior tranches, whereby the junior tranches provide a safety cushion for repayment of the principal of the senior tranches.

If the senior or junior tranches are listed on any public trading exchanges, these tranches will become relatively familiar to asset-backed securities. During this process, the FinTech firms will be responsible for due diligence, asset management, operation, information disclosure, risk control, settlement etc.

DeFi protocols such as Centrifuge and NAOS Finance map the positioning of FinTech firms in CeFi structured finance on blockchain, replace the off-chain business process with “NFT + DeFi” : tokenize the asset with NFT and mapping them into the Defi protocols.

The NFT will be generated by tokenization of the underlying assets with yield streams (such as receivables, etc.), and the excessive collateralization of NFT (such a TVL of 70%, where loan value is at 70% discount on asset par value) is given to lending protocols such as Compound or MakerDAO. Then the dealers convert the stable coins or other cryptocurrencies into US dollars and lend it to real world borrowers. Investors can then obtain interest by investing the corresponding assets through DeFi protocols.

In this process, Centrifuge and NAOS Finance is to conduct the whole cumbersome business chain of packaging SPVs, structured financing through DeFi. They play the structured finance in a decentralized way, and makes full use of the capital pooling feature of DeFi to convert P2P(peer-to-peer) transactions into peer-to-pool, which changes the structure of risk management and improves the efficiency of capital matching.

We see DeFi’s efforts to connecting to real-world assets should be the closest to the original vision of Internet Finance. We are looking forward to see that the following short-term development of DeFi were expected to quickly replicate the early barbaric phase of P2P’s growth just like few years ago, and bring significant business opportunities and unfamiliar risks for DeFi users.

The breakout opportunities are obvious.

For the native DeFi market, on-chain real world assets essentially introduce a new credit class that is completely different from the current native crypto assets, and creates a total new asset class that provides DeFi users with a richer choice of asset management, thereby driving the expansion of DeFi balance sheet.

In CeFi financial markets, similar structured finance products require qualified investors. With NFT + DeFi, investors can get a non-threshold return from structured finance markets. This significant investment opportunity will further increase DeFi market penetration and user adoption.

Second, similar underlying assets have fixed maturities and interest rates. With the introduction of real-world assets, the DeFi interest rate market we’ve been expecting will have the foundation to develop. Users will need to invest in new asset classes through various types of interest rate protocols, catalyzing simultaneous increases in penetration and TVL. It is only a matter of time before the DeFi fixed-income market erupts.

The most innovative idea is the combination of protocols like Centrifuge and NAOS Finance with other stable coin protocols like MakerDAO, whereby MakerDAO mints more stable coins DAI to DeFi economy with real world asset NFT as collaterals and the stable coins will actually flow into the real economy, embracing real payment, lending and commercial scenarios. This is a surprising monetary policy instrument for all stable coin protocols. Stable coins naturally circulate across borders, with physical assets tokenized into NFTs. We expect to see global financial assets swapping values in a single borderless blockchain network.

The risks of introducing real-world assets to DeFi will also present a huge challenge to current DeFi world.

Given the complication of structured finance business and the large gap between the risk-return characteristics of underlying assets and those of the native crypto assets, many investors are still wary of the past turmoil in the P2P crush, including self-financing, debt capital pooling, duration mismatches, and frequent default events. Investing in real-world assets in the DeFi market will inevitably face similar risks.

In the early stages of P2P, P2P firms often pool short-term funds and invest in long-term financial assets with high credit risk in the form of a black box. This kind of debt capital pool makes each investment made by a user unable to correspond to a specific single underlying asset, and the risks borne by the user change from the default risks of a single underlying asset to that borne by the P2P firm itself as a whole. In addition, the duration mismatch leads to risks of accumulating liquidity vulnerability of P2P firms. Once a single underlying assets default, there may be a series of thunderous liquidity crisis.

Unlike P2P in traditional Fintech, however, DeFi runs on public ledgers.

In the design of protocols such as Centrifuge and NAOS Finance, a single user investment can be matched to a single underlying asset NFT, which can reduce the occurrence of debt pooling risks and duration mismatch, and greatly reduce the possibility of the overall liquidity crisis of the protocol.

In addition, because the business involves real-world assets, it is inevitable to face the credit risk of the underlying asset itself and the moral hazard of asset managers, which is also the biggest risk of the P2P industry.

For example, supply chain assets have very complicated risk of right confirmation and verification, this kind of receivable assets has the highest default rate of all financial assets, some small corporate loans may face 50% default rate, and some underlying assets even cannot be liquidated, resulting in bad debts. Apparently DeFi users are vulnerable to large losses and unfamiliar risks they have never dealt with before.

Under extreme circumstances, a traditional P2P firm will also adulterate junk assets into the asset package, fabricate non-existent underlying assets, and even set up a shell company for self-financing or misappropriate users’ funds to personal accounts of founders, which are totally financial fraud events. However, because of the asymmetry of information, and the lack of legal compliance and regulatory jurisdiction, investors basically have no control over the underlying assets and off-chain business. DeFi can not eliminate these core risks fundamentally and technically.

As a result, we need to rely heavily on Centrifuge, Naos, ShuttleOne, Persistence’s expertise comes from limiting moral hazard and controlling the authenticity and quality of the underlying assets off-chain. Secondly, in the event of breach of contracts, investors can only rely on DeFi protocols and its partners to dispose and liquidate collaterals in real world.

Therefore, users should carefully consider the risk-return characteristics of the underlying assets when choosing such real-world assets. Protocols may advertise low default rates of their assets, but this argument is hard to prove and is not sufficient as a valid reference, so we need to pay more attention to the risk control measures introduced by DeFi protocols for these risks.

Centrifuge has introduced the over-collateralization of NFT value and mitigate the credit risk of the senior investors in a structured finance way; and Naos has introduced the design of Insurance Mining Fund to insure the underlying real-world assets and carried out the credit enhancement. Moreover, Naos has obtained the licenses in Southeast Asian countries to adapt to the compliance and regulatory requirements of business development. These risk measures can help both DeFi and investors control risks in the early stages of development.

In summary, the competition among these new DeFi players will be extremely complex. Beyond the technology, product, and asset management expertise, it will require competition over the access to users and capabilities to acquire assets, the quality and credit risks of the assets, and the ability to cope with regulation, compliance, and risk management. We firmly believe that DeFi must embrace real-world assets. When DeFi and CeFi collide in FinTech realm, it will be the Big Bang for the next generation of mobile finance infrastructure.

Disclaimer: Incuba Alpha was an early investor in NAOS.Finance, holding an interest in NAOS.Finance

If credit creation and balance-sheet expansion are DeFi’s “horizontal expansion”, the tools and ways to enrich the DeFi market to leverage is a “vertical expansion” — as underlying assets become more complex, the asset-end of the DeFi protocols will face more demand for fixed-term and fixed-rate financing. Accordingly, the debt end of the DeFi protocols will require interest costs, duration management, and risk management, resulting in a “vertical expansion” based on the interest-rate dimension, bringing about a whole new dimension of DeFi market capacity and more possibilities of great imagination.

The interest-rate market is becoming the hottest topic in the DeFi world recently.

As we have explored above, our view of the DeFi world is to answer the question “how to achieve credit expansion and leverage accumulation more effectively in financial markets.” More diversified credit will be introduced into the blockchain as assets, driving a whole new kind of credit expansion, which is the “horizontal expansion” of DeFi’s balance-sheet expansion. At the heart of the interest-rate market is the need to locate more efficient paths to increase financial leverage in the DeFi market, which is the “vertical expansion” of the DeFi market. We believe that such a new dimension of expansion will bring more interesting possibilities to the DeFi market.

Although different from that of traditional financial institutions, the core of the DeFi protocols is to manage its own balance sheet. The difference after deducting the cost of capital from the asset returns is retained as earnings. Purely from a business perspective, this is not substantially different from the profit model of financial institutions. This provides the most basic business logic for constructing the DeFi interest rate market.

At the same time, as DeFi’s balance sheet expands, more and more assets will require fixed term and fixed interest rate, and require more financial instruments and marketplace to increase financial leverage. This will make DeFi protocols generally face the pain points of managing financial cost, capital duration and interest rate risk. Similar to the traditional financial market, these pain points will give rise to a large number of DeFi protocols that undertake the positioning of “non-banking financial institutions” (such as investment banks, insurance companies, asset management companies, etc.).

We have noticed that some very innovative DeFi interest rate, insurance, risk management and derivative protocols are emerging in the market at the moment. The interest rate market is a new track in the layout of new ecosystem. There is no doubt that these innovators will potentially grow to be new market leaders at the level of Uniswap, Maker and Aave.

The interest rate market shall make financial leveraging more efficient

While the concept of interest rates may seem simple, it would be as difficult to build feasible financial solutions as the decentralized derivative racetrack. In the traditional financial concept, interest rates are the key factors in pricing different risky assets, and the term structure of interest rates can also reflect people’s expectations of future interest rate changes.

The interest rate itself is a very complex system. Central banks can set policy rates, including benchmark rates, interest rate on excess reserve, and interest rates for various monetary policy instruments; the money market has Libor, repurchase rates, etc.; the credit market has interest rates for deposits and loans; and the bond market has different interest rates for treasury bonds, municipal bonds and corporate bonds.

Similarly, Maker’s interest rate policies include stable rate and DSR (Dai Savings Rate), the rates of Aave and Compound include interest rates on deposits and loans, and liquidity mining like Curve or other DeFi protocols that provide expected APY rates. These interest rates obviously have different credit ratings, all of them are floating rates, open-ended maturities and strongly impacted by centralized party on interest rate pricing.

When we discuss interest rates in the context of DeFi, the real question needs to be discussed is

1. What interest rate market will be built in different credit ratings
2. What fixed income products are created to serve financial leveraged demand; and
3. How to set and price the fixed interest rates with different maturities, i.e. the term structure of interest rate (yield curve)

Three ways of constructing decentralized interest rate market

In traditional financial markets, the Treasury bond yield curve is the benchmark for the pricing of all fixed income products.

1. A benchmark yield curve is formed through zero-coupon treasury bonds with different maturities.
2. Yield curves are formed through various fixed-income products based on benchmark yield curves and risk spreads.
3. Based on the spot interest rate yield curve, the forward interest rate curve is calculated, and then the swap yield curve is formed, which provides a pricing benchmark for interest rate derivatives such as forward, futures and swaps. Finally, the entire CDO product issuance process can be realized in the DeFi market, and the whole interest rate market system can be perfected.

All of the emerging protocols that build the DeFi interest rate market cannot be divorced from this fixed income product pricing logic, and all DeFi interest rate protocols basically follow this logic, but each makes a single-point breakthrough at a certain point in the business line, leading to three typical directions:

One is the construction of zero-coupon bonds, such as Yield’s ytoken, UMA’s uUSD, and Notional. These protocols take the form of the issuance of fixed-maturity zero-coupon bonds with ETH as collateral (such as yETH-DAI-3month). The most intuitive form of the product is interest-bearing stable coins with fixed maturities, in which the implied interest rate is set by trading or through AMM tokens for such bond tokens.

This is simply the definition of a benchmark yield curve in traditional financial markets, which rely on the credit of zero-coupon bonds. In the DeFi market, zero-coupon token bonds with ETH as collateral, similar to the credit of Treasury bonds, can be used as an approximate alternative to zero-coupon bonds, to construct a basic benchmark spot yield curve for the DeFi market.

The other is Token securitization of yield tokens with future cash flow returns, such as Barnbridge, Benchmark and Centrifuge. These projects draw on the aforementioned CDO product issuance model, essentially creating new fixed-income products that package cash flow from Aave or Compound for structured securitization financing. Senior tranche Token with fixed interest rates and Junior tranche Token with floating interest rates are issued.

As the Token securitization model matures, such DeFi protocols can consolidate cash flow returns from more underlying asset pools, issue more tranche (such as the introduction of mezzanine or more tiers of senior tranches), and allow users to pricing appropriate interest rates of different maturities through trading, AMM, or quotes, thereby creating a yield curve for the fixed-income products. The yield curve for these fixed-income products need to be backed by the credit of the underlying asset, cToken or aToken, the credit rating of which is similar to financial bonds of commercial banks and subordinated to ETH-DAI bonds.

The third is to introduce interest rate swaps, such as Horizon, Swap.rate, DeFiHedge, and so on. An interest rate swap is a forward contract in which one stream of future interest payments is exchanged for another based on a specified principal amount. Interest rate swaps usually involve the exchange of a fixed interest rate for a floating rate, or vice versa. By having access to such an interest rate swap contract, DeFi users can swap floating interest rate into a fixed interest rate with a fixed term. Interest rate swaps can be fixed or floating rate in order to hedge, arbitrage or manage exposure to fluctuations in interest rates. The yield curve in this dimension is mainly to hedge, arbitrage, or trade interest rate by observing the structure of spot and forward interest rate curves.

But even with the introduction of interest rate swaps, different DeFi protocols tend to construct fixed interest rates in very different ways. DeFiHedge and Swap.rate are order-book based interest rate swaps trading platforms, but the design of the trading mechanism is slightly different. Horizon adopts a combination of Token securitization and interest rate swap, which allows users to bid the fixed interest rates they want. The cash flow of underlying asset returns is distributed according to the users from the lowest bid to the highest bid, and a yield curve is formed through game theory.

The above three ways to construct the DeFi interest rate market are not simply good or bad, because different interest rate protocols have different positions on the business lines targeting on segmented interest rate market and credit rating. Most importantly, the pricing mechanism is different even if the same financial instrument is used, such as interest rate swap, so the DeFi interest rate protocols are not directly competitive, and facing different constraints at present.

Zero-coupon bonds, for example, take up a lot of over-collateral, involve complex borrowing and clearing activities, and rely on Uniswap trading or AMM for interest rate pricing. In the early and illiquid stages of the market, it is difficult to effectively price interest rates through trading. The benchmark yield curve is likely not to reflect the actual interest rate structure. This bond product is expected to be more suitable for BTC, ETH, and assets with relatively high credit ratings such as aToken and cToken, which can not meet the financial needs of long-tail erc-20 tokens.

In the case of token securitization, the first step is to find a yield asset pool that can generate cash flow. Obviously, the options are relatively limited. This type of protocols will grow with the expansion of DeFi eligible collateral. Moreover, if the implied interest rate of senior tranche tokens need to be valued through trading or AMM, there are similar drawbacks to zero-coupon bonds. If the protocol sets a given fixed interest rate, the pricing is not fully market-oriented and difficult to consider it decentralization.

In the case of interest rate swap derivatives, the pricing of such derivatives relies on credible spot curves and forward curves. Currently, trading of such swaps may be inactive under the constraints of the absence of the yield curves in the DeFi market and the lack of liquidity. Such derivatives may be priced more skewed than the fair price, but swaps are relatively the most direct paths for users to lock in the risk of interest rate volatility.

If we compare the issuance of CDOs in traditional financial markets, we can see that DeFi only meet the needs of packing credit into financial assets like loans or bonds.

The following steps are still blank:

1. asset securitization and derivatives,
2. structured financing and interest rate pricing,
3. interest rate hedging or speculation.

Only after these three steps are completed can the DeFi interest rate market be constructed in a closed loop and DeFi could answer the proposition of “how to increase financial leverage more efficiently”.

But the potential market size of interest rate market may be more than 10 times larger than the underlying credit market. DeFi interest rate protocols such as Token securitization, zero-coupon bonds, and interest rate swap derivatives can each occupy certain segments of this market, and there is a very good chance to grow into a new group of DeFi leading players. As the interest rate market grows, there will be more demand for risk management protocols such as insurance, asset management&liquidation and so on.

Even if DeFi interest rate market is still facing a lot of challenges. DeFi has its own characteristics in keeping with the objective laws of financial business. We are looking forward to more novel ideas beyond what traditional financial market has built.

Will interest-bearing stable coins become the first use case of the zero-coupon token, or will they capture the market share of the stable coins, or will they form a totally original DeFi bond market?

When the DeFi interest rate market has a decentralized anchorage for interest rate pricing, will Aave, Compound and other lending protocols be willing to introduce long-term liquidity lending designed to improve their basic interest rate incentive models; will DEXs like Uniswap release the redundant assets in the liquidity pool to provide more liquidity to the market, thereby further expanding the multiplier for DeFi credit expansion?

When DeFi protocols encounter a short-term liquidity shortage such as huge redemption and sharp increase in loan demand, will they be willing to issue zero-coupon bonds for short term borrowing in order to avoid a run on the market or improve the efficiency of capital, so as to form a brand-new market similar to the inter-bank lending market?

Will the emergence of new fixed-income products continue to stimulate the development of various types of investment banking and asset management business, so as to create a super platform protocol with diversified financial service capabilities similar to JPMorgan in the era of mixed financial business?

DeFi’s cutting-edge experiment has only just opened the door to the interest-rate market, and behind it, possibilities are limitless.

Hell is empty, and all the devils are here.

“Is it possible for DeFi to continue to grow? ”

We are very optimistic about the answer to that question. The reason why we are optimistic has to start with the real change brought by DeFi.

“Asset” is of the most scarcity for a world of value exchange that blockchain hopes to create. The explosion of DeFi responds to the desire by introducing “Credit” as an asset to the blockchain world for the first time.

The so-called “Credit” is the debtor-creditor relationship based on the demand for financing. Credit is the cornerstone of the financial market, and the rapid development of the financial market has always been inseparable from the expansion of credit and the accumulation of leverage. Whether in the traditional financial market or in DeFi, top players have succeeded in answering this question, either by introducing or creating a new type of credit as an underlying asset or by creating a financial product or marketplace that provides a more efficient way for leveraging positions.

The concept of “introducing credit as an asset” is still in its infancy for the DeFi world. Our investment themes followed two directions:

• introducing new credit as assets
• introducing a new approach to financial leverage

We referred to the development of the traditional financial market and found some transformative possibilities for DeFi.

The Process of Credit Expansion and Leverage Accumulation

The landscape of the traditional financial market is rich and complex, consisting of a wide variety of credit and a dazzling array of leveraging tools:

The financing needs of the State are packaged as sovereign debt.

The financing needs of the private sector, such as housing, automobile, health care, education, and consumer industry, or of the corporate sector, such as working capital and capital expenditure, are packaged as debts of all kinds.

Those credits formed the backbone of the financial markets. Financial institutions have created financial assets upon them such as bonds (such as Treasury bonds), loans (mortgages, credit card loans), and so on, and leverage is continuously created through a variety of derivatives.

The result of credit expansion and leverage accumulation is that the balance sheets of all the participants in the entire financial markets continue to grow.

Consider the most radical era of financial liberalization before 2008. From the issuance of the Collateralized Debt Obligation, we can see how all the participants in financial markets are linked through their balance sheets.

Given the complexity of financial markets’ structure, we have abstracted the core in the above for reference.

In the above case, credit is generated and circulated among various parties through the following path:

1. Credit is generated at the liability end at the time an individual wants to buy a house (at the asset end) but needs financing.
2. A commercial bank issues loans or purchases bonds at the asset end to support housing financing, and on the liability end packaged various types of bond assets and securitized underlying assets into structured products.
3. A non-bank financial department buys structured products with credit ratings, and the bank can still provide mortgage loans after getting the funds back, thus completing the financial leveraging process.

The entire process of credit expansion and leverage accumulation can continue until credit sinks (people with poor credit get enormous financing) and leverage ruptures (subprime debt defaults, collateral prices plummets, and insolvency leads to the impossibility of liquidation of creditor’s rights), resulting in a financial crisis.

At the onset of the financial crisis, it is the central bank that prints money on the liability end and buys various types of debt assets on the asset end to bail out the market — that is, through quantitative easing, the central bank’s balance sheet expands to pay for the collapse of the system. The CDO example illustrates the path of credit expansion, leverage accumulation, and organic growth of balance sheets at every stage of the system.

DeFi has grown to be a primitive financial system

The DeFi market can learn from the world view of traditional financial markets, but there are significant differences in market structure.

The DeFi system is simple.

We can think of :

• MakerDAO as the central bank(+ Repo), in a decentralized financial world of lending
• Protocols such as Aavesome and Compound (Robert Leshner) as the commercial banking sector,
• and of some yield aggregation protocols as non-bank financial institutions.

We can construct a simple analytical framework to explore the possibilities on how DeFi will evolve next.

In the blockchain world, the most fundamental asset is BTC/ETH. Later the creation of stablecoins, especially USDT, began to create credit in the blockchain world, making Finance possible in crypto. USDT pioneered the introduction of dollar credit through the peg to US dollar fiat, thereby creating the USDT of BTC collateral lending to meet the demand for credit expansion(margin trading). Similarly, MakerDAO issued DAI with ETH as collateral, creating a prototype of financial markets similar to that of central bank printing money.

Once the foundations of credit expansion are laid, markets will need more efficient ways to leverage. Lending protocols like Aavesome, Compound, and others began to emerge in the form of commercial banks. The rise of lending protocols has also expanded the paths of credit expansion. On the asset side of lending protocols, more ERC-20 tokens are being used to lend, and exploding liquidity mining has fueled a surge in lending demand; on the liability end, yield aggregators such as Yearns Finance, Pickle Finance, and Harvest Finance, absorb more capital and increase the efficiency of leveraged capital flows.

In terms of the core business logic of the credit expansion in DeFi market, in less than three years, a relatively complete basic financial system has been formed:

• Creation of underlying assets based on BTC/ETH as collaterals (such as MakerDAO and Synthetic assets)
• Oracles (ChainLink)
• Trading Platform (UniSwap, Balancer, Curve)
• Lending protocols (Aavesome, Compound)
• Aggregators (Yearns Finance, Pickle Finance, APY…)
• Wallets (MetaMask, Mask Network)

has formed a complete business line with relatively market leaders developed at each stage.

We believe that the leading players have occupied a predominant position, which is not friendly to new entrants and competitors, and the existing racetracks are obviously crowded.

But comparing the above CDO product example, it is clear that DeFi is still very rudimentary compared to traditional finance. There is still a big gap in the abundance of credit and the complexity of the leveraging tools, which implies the possibility of the next phase of change in the DeFi market.

Where will the next leading position opportunity come from?

Opportunities lie in providing the market with the highest quality of credit and a more efficient leveraging path.

The next step in DeFi development is, first and foremost, an urgent need to expand the balance sheet of the entire crypto world, which means that the emerging DeFi protocols need to unleash the current ecological credit expansion potential and to introduce new underlying assets that can expand the narrative of credit.

To unleash the potential for credit expansion, we can start with the credit ratings of different assets.

In the traditional financial market, we can see that the public sector, the banking sector, the non-banking sector, and the private sector naturally exist in the main body credit rating from strong to weak. As central bank’s liabilities, fiats needs to be backed by the national debt and other safe assets, and if further expansion is needed, lower level of eligible collateral such as MBS will be needed.

As a decentralized protocol, DeFi does not have a subject-based credit rating, but it has gradually formed a credit rating for the assets in the business. Looking at the balance sheet of MakerDAO as the “central bank,” DAI’s liabilities are issued with eligible collaterals. The highest ratings on the asset side of Maker are ETH and BTC, followed by stablecoins such as the TUSD(TrustToken)/ PAX(Paxos)/USDC (Circle) . If DeFi needs more DAI, Maker will need to expand its balance sheet. The first possibility, but also the limitation, is the lack of eligible collateral in the DeFi market.

In our view, in the overall balance sheet of the DeFi market, BTC and ETH play the role of gold or Treasuries, with stablecoins such as USDC and DAI in the second tier in the form of foreign-exchange reserves or central bank liabilities; yToken, atoken (aUSD), ctoken (cUSD), stoken (sUSD) and utoken (uUSD) in the third tier in the form of commercial-bank liabilities; and Altcoins, other LPToken in the fourth tier in the form of corporate liabilities.

Currently, the biggest potential for unleashing credit expansion in the DeFi market lies in the second tier (stable coins) and the third tier (income certificates).

For example, stablecoins such as uUSD, yToken, aToken, cToken and other assets with characteristics of future earnings can be incorporated into collaterals or packaged into debt derivatives for financial innovation. The circulation of these income certificates can release more liquidity to increase the leverage level of the whole system.

In addition, it is also a big opportunity to expand the inclusion of the fourth tier (corporate liabilities) form of assets. For example, it will introduce real-world financial assets such as supply chain or consumer finance into blockchain world (Centrifuge, NAOS Finance) and make loans based on off-chain asset collaterals, or further try to explore financing without collaterals(Truefi), and thus expand the balance sheet by introducing new credit.

Vertical Expansion: Increase leverage in DeFi with time value

If credit creation and balance-sheet expansion are DeFi’s “horizontal expansion”, the tools and ways to enrich the DeFi market to leverage with time value is a “vertical expansion” — as underlying assets become more complex, the asset-end of the DeFi protocols will face more demand for fixed-term and fixed-rate financing.

Accordingly, the debt end of the DeFi protocols will require interest costs, duration management, and risk management, resulting in a “vertical expansion” based on the interest-rate dimension, bringing about a whole new dimension to DeFi and more possibilities of great imagination.

The interest-rate market is becoming the hottest topic in the DeFi world recently.

As we have explored above, our view of the DeFi world is to answer the question “how to achieve credit expansion and leverage accumulation more effectively in financial markets.” More diversified credit will be introduced into the blockchain as assets, driving a whole new kind of credit expansion, which is the “horizontal expansion” of DeFi’s balance-sheet expansion. At the heart of the interest-rate market is the need to locate more efficient paths to increase financial leverage in the DeFi market, which is the “vertical expansion” of the DeFi market. We believe that such a new dimension of expansion will bring more interesting possibilities to the DeFi market.

Although different from that of traditional financial institutions, the core of the DeFi protocols is to manage its own balance sheet. The difference after deducting the cost of capital from the asset returns is retained as earnings. Purely from a business perspective, this is not substantially different from the profit model of financial institutions. This provides the most basic business logic for constructing the DeFi interest rate market.

At the same time, as DeFi’s balance sheet expands, more and more assets will require fixed term and fixed interest rate, and require more financial instruments and marketplace to increase financial leverage. This will make DeFi protocols generally face the pain points of managing financial cost, capital duration, and interest rate risk.

Similar to the traditional financial market, these pain points will give rise to a large number of DeFi protocols that undertake the positioning of “non-banking financial institutions” (such as investment banks, insurance companies, asset management companies, etc.).

We have noticed that some very innovative DeFi interest rate, insurance, risk management and derivative protocols are emerging in the market at the moment. The interest rate market is a new track in the layout of new ecosystem. There is no doubt that these innovators will potentially grow to be new market leaders at the level of UniSwap, MakerDAO and Aavesome.

The interest rate market shall make financial leveraging more efficient

While the concept of interest rates may seem simple, it would be as difficult to build feasible financial solutions as the decentralized derivative racetrack. In the traditional financial market, interest rates are the key factors in pricing different risky assets, and the term structure of interest rates can also reflect people’s expectations of future interest rate changes.

The interest rate itself is a very complex system. Central banks can set policy rates, including benchmark rates, interest rate on excess reserve, and interest rates for various monetary policy instruments; the money market has Libor, repurchase rates, etc.; the credit market has interest rates for deposits and loans; and the bond market has different interest rates for treasury bonds, municipal bonds and corporate bonds.

Similarly, MakerDAOinterest rate policies include stable rate and DSR (Dai Savings Rate), the rates of Aavesome and Compound include interest rates on deposits and loans, and liquidity mining like Curve or other DeFi protocols that provide expected APY rates. These interest rates obviously have different credit ratings, all of them are floating rates, open-ended maturities and strongly impacted by centralized party on interest rate pricing.

When we discuss interest rates in the context of DeFi, the real question needs to be discussed is

1. What interest rate market will be built in different credit ratings
2. What fixed income products are created to serve financial leveraged demand; and
3. How to set and price the fixed interest rates with different maturities, i.e. the term structure of interest rate (yield curve)

Three ways of constructing decentralized interest rate market

In traditional financial markets, the Treasury bond yield curve is the benchmark for the pricing of all fixed income products.

1. A benchmark yield curve is formed through zero-coupon treasury bonds with different maturities.
2. Yield curves are formed through various fixed-income products based on benchmark yield curves and risk spreads.
3. Based on the spot interest rate yield curve, the forward interest rate curve is calculated, and then the swap yield curve is formed, which provides a pricing benchmark for interest rate derivatives such as forward, futures and swaps. Finally, the entire CDO product issuance process can be realized in the DeFi market, and the whole interest rate market system can be perfected.

All of the emerging protocols that build the DeFi interest rate market cannot be divorced from this fixed income product pricing logic, and all DeFi interest rate protocols basically follow this logic, but each makes a single-point breakthrough at a certain point in the business line, leading to three typical directions:

One is the construction of zero-coupon bonds, such as Yield’s (Yield.is) ytoken, UMA’s uUSD, and Notional (Teddy Woodward). These protocols take the form of the issuance of fixed-maturity zero-coupon bonds with ETH as collateral (such as yETH-DAI-3month). The most intuitive form of the product is interest-bearing stable coins with fixed maturities, in which the implied interest rate is set by trading or through AMM tokens for such bond tokens.

This is simply the definition of a benchmark yield curve in traditional financial markets, which rely on the credit of zero-coupon bonds. In the DeFi market, zero-coupon token bonds with ETH as collateral, similar to the credit of Treasury bonds, can be used as an approximate alternative to zero-coupon bonds, to construct a basic benchmark spot yield curve for the DeFi market.

The other is Token securitization of yield tokens with future cash flow returns, such as Barnbridge(Tyler Scott Ward), Benchmark Protocol. These projects draw on the aforementioned CDO product issuance model, essentially creating new fixed-income products that package cash flow from Aavesome or Compound for structured securitization financing. Senior tranche Token with fixed interest rates and Junior tranche Token with floating interest rates are issued.

As the Token securitization model matures, such DeFi protocols can consolidate cash flow returns from more underlying asset pools, issue more tranche (such as the introduction of mezzanine or more tiers of senior tranches), and allow users to pricing appropriate interest rates of different maturities through trading, AMM, or quotes, thereby creating a yield curve for the fixed-income products. The yield curve for these fixed-income products need to be backed by the credit of the underlying asset, cToken or aToken, the credit rating of which is similar to financial bonds of commercial banks and subordinated to ETH-DAI bonds.

The third is to introduce interest rate swaps, such as Horizon Finance, Swap.rate, Defihedge, and so on. An interest rate swap is a forward contract in which one stream of future interest payments is exchanged for another based on a specified principal amount. Interest rate swaps usually involve the exchange of a fixed interest rate for a floating rate, or vice versa. By having access to such an interest rate swap contract, DeFi users can swap floating interest rate into a fixed interest rate with a fixed term. Interest rate swaps can be fixed or floating rate in order to hedge, arbitrage or manage exposure to fluctuations in interest rates. The yield curve in this dimension is mainly to hedge, arbitrage, or trade interest rate by observing the structure of spot and forward interest rate curves.

But even with the introduction of interest rate swaps, different DeFi protocols tend to construct fixed interest rates in very different ways. DeFiHedge and Swap.rate are order-book based interest rate swaps trading platforms, but the design of the trading mechanism is slightly different. Horizon Protocol adopts a combination of Token securitization and interest rate swap, which allows users to bid the fixed interest rates they want. The cash flow of underlying asset returns is distributed according to the users from the lowest bid to the highest bid, and a yield curve is formed through game theory.

The above three ways to construct the DeFi interest rate market are not simply good or bad, because different interest rate protocols have different positions on the business lines targeting on segmented interest rate market and credit rating. Most importantly, the pricing mechanism is different even if the same financial instrument is used, such as interest rate swap, so the DeFi interest rate protocols are not directly competitive, and facing different constraints at present.

Zero-coupon bonds, for example, take up a lot of over-collateral, involve complex borrowing and clearing activities, and rely on Uniswap trading or AMM for interest rate pricing. In the early and illiquid stages of the market, it is difficult to effectively price interest rates through trading. The benchmark yield curve is likely not to reflect the actual interest rate structure. This bond product is expected to be more suitable for BTC, ETH, and assets with relatively high credit ratings such as aToken and cToken, which can not meet the financial needs of long-tail erc-20 tokens.

In the case of token securitization, the first step is to find a yield asset pool that can generate cash flow. Obviously, the options are relatively limited. This type of protocols will grow with the expansion of DeFi eligible collateral. Moreover, if the implied interest rate of senior tranche tokens need to be valued through trading or AMM, there are similar drawbacks to zero-coupon bonds. If the protocol sets a given fixed interest rate, the pricing is not fully market-oriented and difficult to consider it decentralization.

In the case of interest rate swap derivatives, the pricing of such derivatives relies on credible spot curves and forward curves. Currently, trading of such swaps may be inactive under the constraints of the absence of the yield curves in the DeFi market and the lack of liquidity. Such derivatives may be priced more skewed than the fair price, but swaps are relatively the most direct paths for users to lock in the risk of interest rate volatility.

If we compare the issuance of CDOs in traditional financial markets, we can see that DeFi only meet the needs of packing credit into financial assets like loans or bonds.

The following steps are still blank:

1. asset securitization and derivatives,
2. structured financing and interest rate pricing,
3. interest rate hedging or speculation.

Only after these three steps are completed can the DeFi interest rate market be constructed in a closed loop and DeFi could answer the proposition of “how to increase financial leverage more efficiently”.

But the potential market size of interest rate market may be more than 10 times larger than the underlying credit market. DeFi interest rate protocols such as Token securitization, zero-coupon bonds, and interest rate swap derivatives can each occupy certain segments of this market, and there is a very good chance to grow into a new group of DeFi leading players. As the interest rate market grows, there will be more demand for risk management protocols such as insurance, asset management&liquidation and so on.

Even if DeFi interest rate market is still facing a lot of challenges. DeFi has its own characteristics in keeping with the objective laws of financial business. We are looking forward to more novel ideas beyond what traditional financial market has built.

Will interest-bearing stable coins become the first use case of the zero-coupon token, or will they capture the market share of the stable coins, or will they form a totally original DeFi bond market?

When the DeFi interest rate market has a decentralized anchorage for interest rate pricing, will Aavesome, Compound and other lending protocols be willing to introduce long-term liquidity lending designed to improve their basic interest rate incentive models; will DEXs like UniSwap release the redundant assets in the liquidity pool to provide more liquidity to the market, thereby further expanding the multiplier for DeFi credit expansion?

When DeFi protocols encounter a short-term liquidity shortage such as huge redemption and sharp increase in loan demand, will they be willing to issue zero-coupon bonds for short term borrowing in order to avoid a run on the market or improve the efficiency of capital, so as to form a brand-new market similar to the inter-bank lending market?

Will the emergence of new fixed-income products continue to stimulate the development of various types of investment banking and asset management business, so as to create a super platform protocol with diversified financial service capabilities similar to JPMorgan in the era of mixed financial business?

DeFi’s cutting-edge experiment has only just opened the door to the interest-rate market, and behind it, possibilities are limitless.

Hell is empty, and all the devils are here.

To understand the meaning of DeFi — decentralized finance, in a narrow sense, is “using decentralized networks to transform traditional financial products into a disintermediated, trustless, and transparent protocol”. We think the more ambitious vision of DeFi is to realize a “universal market access”, which allows anyone in the world with access to the internet to own or trade any financial assets openly.

From the recent explosion in DeFi market, we can see some significant features. From DEX, stable coin, leveraged lending, synthetic assets to emerging insurance products. With the strong momentum of liquidity mining, DeFi is transforming traditional financial products into protocol forms a hundred times faster than we used to see. We are also seeing more complex principles and structured financial tools have begun to penetrate the DeFi market. But the current DeFi is still incomplete as a “decentralized financial market” because of the lack of some basic products and services.

Similar to the development of traditional financial products, the current DeFi market boom is a typical expansion based on “debt-on-debt”, including the well-known over-collateralization rate and the nested multi-layer asset which is mostly seen in liquidity mining. In such a market, we can only rely on over-collateralization to circumvent the evaluation of the subject’s credit. However, collateralized-debt is essentially the least info-sensitive product in the financial market.

In the DeFi boom of the past several months, the basic underlying assets that support liquidity mining can be roughly divided into three categories: transaction fees, lending spread income, and collateralized governance tokens. We have already witnessed that when revenues of fundamental assets (or “productivity”) are not persistent enough to support credit prosperity, a risk backlash similar to traditional “financial crisis” will appear. Therefore, if the DeFi industry is to strive for real developments, rich and solid fundamental assets are still the most important cornerstone.

Whether in traditional financial markets or in DeFi, demands for “SAFU” assets and liquidity are lasting and stable. In the traditional financial market, we find at one side a large group of monetary assets collateralized by short-term debt, long-term debt based on sovereign credit, quasi-currency created based on the repurchase or asset securitization, or MBS, ABS, and other assets. But on the other hand, there are large-scale financial derivatives products with rich tools that has been formed on this basis, set to play a role of risk management, asset pricing, and market liquidity enhancement, forming a systemic financial market as a whole.

Whether we expect that the DeFi market eats the CeFi (centralized finance)market, or a convergence of these two parallel universes, DeFi users’ demand for “SAFU” assets, liquidity and risk pricing are equally urgent. We do not expect DeFi to produce absolute riskless assets, but expect to produce substitutes like asset-based securities as near-riskless assets by derivative protocols, and so forth.

In the current DeFi market, we can see that there are assets pegged to fiat like USDC and debt collateral debt position “DAI” as near-risk-free assets. But we still yearn for a more comprehensive yield and volatility structure. However, the market is still lack of essential financial tools and pricing mechanisms. In the process of mapping traditional financial market products, it is inevitable to break through the challenge of constructing a comprehensive decentralized financial derivatives.

DeFi lacking derivative products and markets is always immature.

We have been paying strong attention to synthetic assets that mimic positions for financial assets, some synthetic assets themselves are performing well as tokenization of financial derivatives. At the same time, we are looking forward to native decentralized derivative protocols to support Defi with tools for structuring “SAFU” assets, trade and hedge risk/volatilities, and complete the Defi universe with richer risk management and liquidity enhancement tools.

The concept of financial derivatives is actually quite broad, ranging from swap, forwards to futures and options. The underlying assets cover interest rate, equity, foreign exchange, commodities, and other asset products. They are widely used to balance position risk, liquidity, hedging, leverage, and other needs of portfolio and liquidity management. According to statistics from the Bank for International Settlements BIS, the scale of the global financial derivatives market is beyond imagination; its size can be more than 10 times of the global GDP and continues to maintain a rapid growth level.

Source: Greenwich Associate and FIA 2020 Derivatives Study

We are firmly positive on the decentralized derivatives sector, not only because from a short-term business perspective, decentralized derivatives protocols can share a cut of the profits from centralized derivatives giants such as BitMEX, OKEX, and Deribit; more importantly, from the perspective of creating long-term values, the decentralized derivatives market has huge potential and sits at the core of the entire DeFi ecosystem. It will be the most difficult part to overcome and complete within the DeFi industry, but it is also the most lucrative jigsaw puzzle piece.

The vigorous development of the decentralized derivatives protocols will break the islanding of DeFi protocols; Combining the Defi LEGOs can give birth to more promising trend opportunities.

Several trends we believe that will happen soon:

1. The combination of derivative protocols will create financial products with a rich risk-return profile

The decentralized derivatives protocols can enrich the structure of the underlying financial products available in the DeFi world. More standardized investments and wealth management products based on these protocols will emerge to meet the investment needs of users. At the same time, more customized products or strategies that adapt to specific risk and profit structure requirements can be developed through the combination of derivative protocols.

For example:

• MCDEX plans to launch structured products based on decentralized perpetual swaps, allowing users to gain exposure for leveraged trading profits.
• the FinNexus option protocol plans to launch an option trading strategy to help liquidity providers hedge against impermanent loss in the AMM market making;
• the emergence of IRS (Interest Rate Swap) protocol (such as Horizon.Finance) can be combined with options/future protocols to replicate the classic OBPI (Option Based Portfolio Insurance), providing fixed-income enhanced products for the DeFi market.

These mappings of the traditional financial market will offer a richer asset class for the DeFi world, smoothing out the current volatile yield curve in the DeFi world.

2. The specialization and complexity of decentralized financial derivatives will redefine the business model of asset management

Traditional financial markets generally face problems such as the fiduciary challenges and moral hazard of investment managers. With the non-custodial nature of DeFi and decentralized financial derivatives, the business model of traditional financial institutions with asset managers and third-party custodians will be revolutionized.

In the short term, DeFi vaults, which is now acting a role as “investment managers” will be facing the challenges of being homogeneous and decreasing the expected rate of return, will soon start to compete with each other on the capabilities in product design.

Vaults limited to plain-vanilla liquidity mining “farm and dump” strategies will lose market competitiveness soon. We can see vaults like DFI. Money, SashimiSwap, and other communities have already been discussing richer investment strategies and planning to launch strategies based on financial derivatives to provide users with richer risks return matrix.

In the long run, the enrichment of financial products in the DeFi market and the improvement of market depth will further increase the demands for specialized investment advice and services. Decentralized active asset management protocols and investment advisory protocols such as dHedge and Set Protocol will show great development potential.

Merely mapping the financial products from traditional financial markets in a decentralized way is not the true meaning of DeFi and decentralized protocols. The development of decentralized derivatives protocols will be unprecedented and will redefine the nature of asset management, a business model that has been unchallenged for more than hundreds of years, and thus realizing our ambitious vision of “allowing anyone in the world with access the internet to openly own or trade any financial assets”.

Incuba-alpha is a fund empowering talents building an open digital society. We are searching for entrepreneurial teams who want to create transformative decentralized financial derivatives protocols and will actively deploy resources and invest in this field. If you want to participate in the decentralized derivatives sector, we will be happy to get in touch with you.

Find us on Twitter @incuba_alpha or investment@incuba-alpha.com.