Increased Efficiency with Decentralized Finance

I’ve written a few articles about the promise of, and future of Blockchain and other Decentralized Ledger Technologies. I’ve also written about Decentralized Finance…taking the technology borne from Bitcoin, and applying it to raising money via equity and debt, and further investing.

Discussing the promise of a new technology is fun, trying to determine how it will be used, and trying to tell EVERYONE to use it. Then we tend to sit around and wait for everyone to come use our awesome new technology. What we really have to determine is why anyone would want to change what they’re doing now. What is really the appeal, and is that appeal worth the pain and risk of a new technology. The old technology (which is actually relatively new) works just fine.

Before we look at how Blockchain and Decentralized Finance might be a better method of doing roughly the same things, let’s look at how some other technologies in the recent past have impacted the economy and investing.

Books on the Web

First, we’ll look at the early days of the early days of the World Wide Web. A guy named Jeff did a bunch of research, and determined that the best thing he could sell via this new medium would be books. He quit his job, borrowed some money, and wrote a bunch of code. He figured that we didn’t need to go to a bookstore to buy the book we wanted, and he could stock so many more books, and offer them at a potentially lower price, since he didn’t need a physical storefront. One of the biggest issues at the time was that, believe it or not, we weren’t really comfortable giving out our credit card number over the internet.

Eventually we got over that hurdle, and we haven’t stopped buying things on Amazon since. The efficiency that was unlocked was that there was no longer a need for expensive retail space close to people. Having less expensive warehouse space meant Amazon could stock more books. Amazon put retail sales together with real estate that had never previously been used for retail.

Someone Will Buy This

Around the same time, Pierre Omidyar decided to start a marketplace on the new Web. Different from the Amazon market, this marketplace, called eBay, would allow buyers and sellers to find each other. Now I could sell my old electronics, baseball cards, etc., and do so in a way that I felt garnered me a decent price.

Now we have more unlocked value — all the items I have in my home that might have value to someone else but no longer have value to me. To make things better, I don’t have to go to a flea market to sell them, nor do I have to worry about someone having to make a profit or consignment. eBay built the marketplace, and eventually built the payment system so we could feel comfortable selling our stuff to each other.

An ancillary benefit I noticed…I felt comfortable buying a new digital camera (before my phone had an amazing camera built in) because I knew that in a year or two, I could sell it on eBay and get the latest camera. I probably owned twice as many digital cameras in ten years as I would have otherwise.

The Internet, software, and cybersecurity…and very smart and driven people, opened these new efficiencies. Eventually businesses learned how to trade goods, track shipments, make payments, etc. via the Internet.

Data, Data, Data

With all the new commerce on the Internet came the proliferation of data. Data was, and still is, everywhere. And now there was a race to find it, analyze it, and utilize it. The problem was data storage and processing power.

Several companies realized that, with the Internet speeds getting faster, cybersecurity more secure, they could rent out space and processing on existing servers. Now if I want to gather data, and process it, I don’t need to buy my own huge server, and find a place to house it. I can just rent space.

With that comes the ability to store so much more data — music, pictures, files, etc. Since I can now store my data on some server in the cloud, I don’t need a beefed up computer, with a drive that kills my power. I can have a light machine that allows me to store some software, and access the Internet, but doesn’t need a monster hard drive. All sorts of new efficiencies here. Much like Amazon and retail…we have been able to dislodge me personally from my data storage.

Let’s Share

Another big leap forward in the idea of economic efficiency came with the growth of AirBNB. This has been documented again and again, but it was a big step. I could now take not only some vacation home I owned (there were already plenty of sites for that), but also just an extra room in my home, and receive some value in rent for it. If there is a big event in town, like the Super Bowl, I could now receive several months of mortgage payments in exchange for a one week rental (if only my wife had agreed).

Along similar lines, Uber and Lyft created huge leaps in added economic efficiency. I can take two items that are currently not being fully utilized — my car and my time — and easily receive some monetary gain. These services have helped those that might otherwise be struggling financially to earn extra money.

Maybe more importantly, Uber and Lyft have changed how we look at automobiles altogether. Depending on how much driving I do in a year, it might be best for me to use Uber to get around all the time. Transportation to different cities was previously looked at as a service — using airlines, trains, buses, etc. Now I might look at transportation within my own city as a service. Auto manufacturers and retailers are now having to understand this new model, and price and build their production and distribution accordingly.

All this gets us to the now and near future. Why would we want to see the Decentralized Finance economy work? Where are the efficiencies?

To start this, I’ll look at a couple use cases that are in my backyard — Real Estate and Oil and Gas.

Invest in Texas

Here in Texas I know several very good real estate developers and investors. One in particular has an expertise in buying C-Class apartments in areas of town that have increasing jobs. He fixes them up, gets the rent and occupancy up, and then looks to sell them when the value is higher. We’ll call him George.

George currently has to first find the available apartment projects to purchase. He then has to look at all the numbers, and possibly put it an offer. In the meantime, he also needs to line up his investors for the project, and line up any debt capital he will be using. After that comes inspections, and confidential memorandums to the potential investors. If everything works out, he can then go through the closing, if the property is still available at the same price that fits his numbers.

Once he buys the project, he needs to start the rehab work, while continuing to manage the property, collecting rent, etc. Hopefully there is enough cash flow to make distributions to the investors.

After a few years, once rents and occupancy have both increased, and maybe it is now a B-Class property, he can look to sell the project for a nice gain. This potential liquidation is the only time his investors will receive their original capital back. Since there is no liquidity for the investors, they require a 7–8% return on their investment. Also, the investor pool is really limited to those with which George has a relationship already, as he doesn’t have the time to go all over the country trying to find investors for a relatively small project.

George is very good at finding the properties that fit his model, and he is good at rehab, management, increasing rent, increasing occupancy, and increasing value. Therefore, it is most efficient for his time to be spent in those areas. Raising capital is an inefficient use of his time. Likewise, having to find new investors for every project is inefficient, as it increases legal fees, and other transaction costs. George doesn’t see the best deals available from the Real Estate brokers, because they know he will have to go find the capital before he can close. It also doesn’t allow the investors in one project to necessarily be diversified.

The alternative today would be for him to start a REIT or a Private Equity real estate fund. Both of these are costly, and still may not offer liquidity for the investors. Due to the costs, he would have to raise a large sum of money — greater than $20 million probably. He’s not sure he could even put that much money to use right away.

However, it would possibly give George the ability to raise more capital one time, and then purchase more projects and put the funds to work more efficiently. He might also be able to raise money from people he doesn’t necessarily know.

It would be great, and more efficient economically, if George could raise maybe $10 million and do 3 projects at a time. If one gets sold in a couple years, he could make a slightly larger distribution, and use the rest of the funds to purchase another project. This perpetual fund really only works if the investors can have some liquidity at some point.

This is how the promise of Decentralized Finance increased economic efficiency. If George can raise the money for a small fund, and operate it well, he can certainly provide investors with good returns. George can concentrate on doing what he does best — finding good projects and increasing their value. He can potentially do so with projects that only show a 5–6% return, because there is the ability for the investors to liquidate if there is a gain in the value of the fund.

The overall economic efficiency is also increased since investors from anywhere in the country, and maybe even the world, can now invest with George. Investors in New York or California, who can’t find good value in their own region, might like to invest in a growing economy like Texas.

Drilling for Money

Investments in Oil and Gas have similar issues. Many Oil and Gas drilling projects are sold to investors because of the promise of huge income tax deductions and credits in years 1 and 2. The investors make these investments, but are then beholden to whatever is pulled out of the ground, and whatever prices are in place at the time the oil is extracted. There is virtually no ability to liquidate the investment and get their capital back.

Likewise, there are investors that don’t need the tax deduction as much, and can’t afford to take the risk on drilling a “dry hole.” However, they would like to invest in an oil and gas income stream once the well has been proven.

A potential secondary market for these investments, facilitated by Decentralized Ledger Technology, would help both parties, and make for a more efficient economic system overall.

These oil and gas investments can be made even more efficient as they could be structured as funds, just as the real estate example above. In addition, they would have an easier time raising money from all over the country or world, rather than just from the friend or former investors of the operator.

We may be years away, and definitely not ready from a technological perspective, regulatory perspective, or liquidity perspective. There needs to be enough trust to provide the demand that will drive the liquidity.

These are pretty basic and obvious examples of the increased efficiencies to be gained through DeFi. However, just as with the examples with the Internet, smart phones, etc., we don’t know what will happen when he first dip our toes in to using Security Tokens, decentralized exchanges, smart contracts, etc., and then smart people figure out how to gain even more efficiency from the processes. When Jeff Bezos started selling books over the World Wide Web, and the first people had the guts to give their credit card numbers and expect a book in the mail, no one predicted Uber.

I’m excited for the technology, and the next wave of economic efficiencies in the financial world.