Why We Invested in Solv Protocol
By Kirill Naumov, Research Analyst at HASH CIB (k.naumov@hashcib.com)
Special thanks to Yuan Han Li from the Blockchain Capital team for the feedback on the ERC-3525 token standard.
The influx of talent and capital into the cryptocurrency space has led to a boom in blockchain-related innovations. Numerous projects have raised millions to expand operations and promote services. Despite the push towards decentralization of the financial sector, most venture capital deals are made on paper. Usually, developers and investors sign a Simple Agreement for Future Tokens (SAFT), which states the terms of the investors’ allocation in the project’s tokens after the Token Generation Event (TGE). A SAFT typically involves a vesting schedule and other unlock-specifics.
With the banning of ICOs, the process of raising funding for a lean cryptocurrency startup is overly complex, exclusive, and centralized. Currently, prior to the public sale, projects lack an effective mechanism for raising funds. Apart from legal and regulatory challenges, developers and early-stage investors must keep track of their agreements, the record of which is stored solely on paper. Furthermore, long-term lockups and vesting schedules reduce the liquidity of such investments. Ultimately, this is out-of-pace with advancements in the traditional FinTech sector.
On the other end of the spectrum, for established projects with projectable cash flows, fundraising options are often limited to significantly diluting the token holders with a centralized sale to institutional investors at a considerable discount and with a long lockup period. Ultimately, the project raises fewer funds, and the investors buy into an illiquid asset that may be worth nothing by the end of the lockup period.
The rising popularity of Decentralized Autonomous Organizations (DAOs) further complicates fundraising. Once a startup is decentralized, it can no longer sign a SAFT or raise funds in the traditional way. Because of this, DAOs are centralized until all development is complete and the platform is in a steady state. This delays decentralization and defeats the purpose of creating a DAO in the first place. Going forward, it makes perfect sense for DAOs to fundraise through crypto-native financial instruments.
Project overview
Solv Protocol aims to improve project fundraising via financial NFTs called Vouchers. Vouchers take advantage of the fundamental principles of ERC-721 NFTs to record investment allocations, bond issues, deposit receipts, and cover notes. However, vouchers are built on the ERC-3525 token standard, allowing them to be split and merged freely. Solv Protocol developed and published the ERC-3525 token standard, allowing it to be used for all future financial NFTs, unlocking countless possibilities for innovation in DeFi.
ERC-3525 is a Semi-Fungible Token Standard which is fully compatible with ERC-721, in that every ERC-3525 token can be represented as a unique ERC-721 entity with its respective properties. By adding the “units” property, the developers managed to create semi-fungibility — individually unique assets which can be split and merged at will. For certain applications, especially gaming or financial, ERC-3525 is the perfect solution, because otherwise achieving their goals would require either creating countless ERC-20 contracts (for each individual property or asset) or coming up with a solution for the illiquidity and indivisibility of ERC-721.
Solv Vouchers, built on the ERC-3525 token standard, bring liquidity to locked-up assets. For example, by selling a Vesting Voucher that promises an allocation of future tokens, a fund or an investor effectively sells their share in the project before the project is publicly traded.
Solv Protocol provides simple and customizable tools for startups and DAOs to raise funds. For example, vouchers can be split and merged at will if they have the same underlying qualities, such as lockup period, vesting schedule, APY, etc.
Solv Protocol Vouchers are currently used by Perpetual Protocol, Unslashed Finance, Paragons, DODO, Highstreet, ColdStack, ClearDAO, and others. With a current total value locked (TVL) of $69 million, Solv Protocol continues to introduce innovative products and rapidly onboard projects.
Solv Protocol recently introduced Convertible Vouchers, the convertible bond of decentralized finance. This powerful NFT structure enables high-risk DeFi protocols to raise financing without dilution or the risk of liquidation, and it protects investors from the price volatility of the project’s tokens. The design of the Convertible Voucher retains all the convenient elements of a Solv Voucher (splitting / combining, adjusting release modes, and customizable settlement date). Moreover, it adds an acceptable trading range for the underlying token. If the token falls below or rises above the trading range, the holder of the Convertible Voucher receives tokens as payout, equivalent to the par value of the Voucher. This design protects the project from excessive token dumping by early investors when their allocations unlock, and it significantly reduces the volatility for risk-averse investors.
A bright future
Solv Protocol’s ERC-3525 token standard, a universal standard for financial NFTs, opens the door to numerous potential implementations, such as decentralized bonds, structured products, and accounting systems for pool-based DeFi projects.
DeFi bonds
In traditional finance, sustainable businesses raise funds by issuing corporate debt rather than diluting equity. As decentralized finance matures, stable decentralized applications will explore opportunities for fundraising through debt, which is not currently feasible in the DeFi ecosystem. Solv Protocol’s ERC-3525 Semi-Fungible Tokens could be used as a registry of bond ownership and as a guarantee for payments. For example, a project would lock a multiple of the debt’s value in team tokens as collateral for the issuance of their Vouchers and, if a regular interest payment or principal repayment is missed, the lenders automatically receive the locked collateral. Bond terms would entirely depend on the project’s growth stage, sustainability, and security. We estimate the market of DeFi bonds to be worth tens of billions of dollars by 2024, assuming DeFi project valuations remain stable.
For example, let’s explore the case of Yearn Finance. Virtually all the supply of YFI has already been generated, and the project has no means of attracting investment via token dilution. If Yearn developers wanted to expand, they would explore options of raising capital. As a late-stage established project with sustainable cash flows, Yearn offers a perfect illustration for the potential application of Solv Vouchers for debt fundraising.
To implement Solv vouchers, the Yearn community would need to:
- Put forward and vote in favor of a governance proposal including the parameters of the capital raise through Solv.
- Establish a Solv pool that earns a percentage of protocol revenues and distributes income among voucher holders. The Solv coupon payment would have priority in the distribution of protocol revenues, and once that is covered, the protocol continues its token buybacks, similar to how bonds and equity work in traditional finance.
- After fundraising and a period of coupon payments, the protocol would repay the principal.
For the tenor of the bond, collateral in YFI sourced from the Yearn treasury (which currently holds approximately 4000 YFI) would be locked, to be released in case of failure to cover the coupon payment.
Bonds by Solv Protocol would allow established projects with real and projectable cash flows to attract much cheaper and more stable financing while simultaneously improving the capital structure of the protocol and eventually increasing their own valuations.
Structured products
We expect to see the rise of structured products in DeFi in the next few years. Solv Protocol’s divisible NFT standard could be used as the platform for their development. Vouchers could be used to combine assets and allocations into lockup-based structured products that offset volatility risks. The creation of structured products for cryptocurrency investments has vast market potential due to the interest from qualified investors and hedge funds looking to gain exposure to cryptocurrency without its volatility. Some of the instruments feeding into complex structured products are ERC-20 tokens, long/short tokens, fixed income allocation tokens, and weighted index fund tokens. While projects like Ribbon Finance is already trying to disrupt this market, we see untapped potential in employing Solv Protocol Vouchers to create structured products that offset risks.
For example, the Solv NFT standard would be the perfect platform for investment vehicles that protect DEX liquidity providers from impermanent loss. A combination of out-of-the-money put and call options could be created to offset any loss incurred by a liquidity provider from price fluctuations within a specific range. As the market matures and institutional clients deploy capital into AMM liquidity pools, demand for decentralized hedging instruments will increase. We expect the Solv Protocol divisible NFT standard to prove perfect for the development of hedging via options, among other applications of complex structured products.
Accounting systems
Finally, the ERC-3525 standard could be used to develop accounting systems for complex pool-based DeFi projects. The ability to split and merge NFT tokens would allow for the creation of a liquid market for user pool allocations. Many newer DeFi accounting systems cannot employ ERC-20 or the original version of ERC-721 to satisfy the requirements. Instead, projects like Uniswap V3 develop accounting system solutions in-house, spending time and capital, and taking on substantial risk. As more decentralized exchanges adopt concentrated liquidity and more complex DeFi protocols emerge, the ERC-20 standard will be replaced by one that can store more information. Using a universal framework, a common standard throughout DeFi, that Solv would build would be much more efficient (and native for both users and DeFi developers) than developing accounting systems in-house using the old ERC-721 standard.
Final thoughts
As the pioneer in the market of financial NFTs, Solv Protocol has an extensive number of potential implementations of their technology. We are not alone in this opinion — Solv Protocol’s strong strategic partnerships are a good illustration of the market leaders’ thoughts regarding the project and its future.
