Over the past two years, there has been a signiﬁcant shift in the types of projects launching in the crypto world. As discussed in our Crypto/DeFi Primer, the budding development of the decentralized ﬁnance (DeFi) ecosystem represents a transition from the mostly speculative capital ﬂows associated with the bull/bear cycles in Bitcoin and other related coins into assets that generate real economic value for their owners.
These value-generating assets are referred to as protocols, (as opposed to companies or businesses) as they represent the application layer of the crypto ecosystem, and operate with a decentralized governance scheme.
There is one immediate investment implication that is observable from this transition-the vast majority of investors, including those that hold other more well-known crypto assets like Bitcoin and Ethereum have not yet recognized, let alone embraced, this transition. The world is largely anchored on the drawbacks that plagued early blockchain technologies and views them as being merely a vehicle for speculation, volatility, and inefﬁcient novelty transactions that have no real-world applicability. It is understandable that this psychological bias would be present — most of the available news related to the crypto ecosystem is related to Bitcoin, shock over its price, questions about its “real-world value” and other concepts that are largely irrelevant to the current state of affairs in DeFi, if such commentary is intended to educate at all, (rather than grab attention.) Furthermore, the pace of technological advancement is truly staggering in the space, such that considerable effort is required to stay abreast of the current state-of-the-art, as it were.
Leaving aside the question of whether Bitcoin and Ethereum are worth investment despite the above, (our view is that they are) here we are focused on discussing our intellectual framework for pursuing a structured research process around DeFi for the purpose of identifying and executing top-grade investments in protocols and related infrastructure.
Why do we care? Substantial return potential
Taking a moment to solidify that these efforts are certainly worthwhile, at least at current market prices, the top 50 most valuable DeFi protocols as of February 24th, 2021 are shown in the below chart:
The current market for seed round valuations for high-grade DeFi projects is around $30 million post-money, adjusted for additional token grants at launch. The above chart shows the market capitalization, on a log scale, of the top 50 DeFi projects, as well as the average and median market capitalization of those 50 projects. Using the chart data and assuming an entry valuation of $30 million, an investor’s multiple on invested capital (MOIC), if they had held their tokens through today, for a project with market cap equivalent to the median, average, and largest would be the following:
· Median — 13x MOIC
· Average — 30x MOIC
· Largest — 300x MOIC
These multiples are eye-catching, but are they truly different than what a great traditional venture capital portfolio in the ﬁat world might produce? In terms of MOIC, the potential is similar. However, it is important to note that a DeFi protocol project can build, launch, and scale in a fraction of the time that a traditional ﬁntech company can, primarily because of the code-based nature of the space as well as the ﬂuidity of capital ﬂows. So, on an IRR basis, the returns are signiﬁcantly higher, even compared to some of the most spectacular venture capital outcomes.
Without discussing the technological reasons for being able to construct a successful protocol so quickly, the social reasons for success, predominantly driven by capital ﬂows, is a segue into discussing our investment thesis.
DeFi Investment Framework
In our view, the development of the DeFi ecosystem will follow a path created by the intersection of three distinct elements. We seek to invest in projects that exist within the space created by the convergence of these elements.
Below we deﬁne what these elements are:
Element 1: Replication of the traditional fiat financial ecosystem;
The view held by most DeFi engineers is that each DeFi project exists to create a single building block that resembles an existing element of the traditional ﬁat ﬁnancial infrastructure. In order to create a fully
functioning ﬁnancial ecosystem within DeFi, each of these building blocks needs to be developed and stacked on top of one another — think Lego set, each piece acts as the foundation enabling the next piece to be layered on top. It’s easy to understand this element when you compare the current state of the world in ﬁat to the state of development in DeFi, and it will become obvious which building blocks already exist and which building blocks will be built eventually. However, some building blocks that have and will be created will enable similar actions to the ﬁat ﬁnancial ecosystem but will go about them in a completely different way. Furthermore, the order in which they are built is a signiﬁcant input for investment purposes — in the technology world, one of the most common forms of failure is the right idea built too early.
Element 2: Social need and interest within the DeFi ecosystem;
It must be accepted that the DeFi ecosystem is highly social, just like any other ﬁnancial ecosystem, albeit existing totally online. As a result, the social interactions and habits are more similar to those seen on Instagram or Twitter rather than those in the Wall Street Journal, CNBC, or a trading ﬂoor. The beneﬁt of these social interactions existing online is that they are readily observable publicly and in semi-permanent form, as opposed to the traditional ﬁnancial space. The observability of social discourse around projects drives a certain element of momentum and “reﬂexivity” to projects with strong social interest. Reﬂexivity is the phenomenon where hype creates success in a self-reinforcing feedback loop — as certain inﬂuencers in the DeFi space support a project, others are more likely to do the same.
This reﬂexive feedback loop is backed by capital — the inherent behavior of DeFi, which makes it distinct in a social sense from Twitter or Instagram, is that supporters vote with their capital, not just their likes and comments.
Reﬂexivity coincides with a second important factor to consider about DeFi. As capital accumulates within a project, the likelihood of the success of that project increases. This is also true for ﬁat businesses, up to a point — eventually too much capital creates excess and overvaluation. In DeFi, the “economic physics” are different. More capital creates stronger network effects for a protocol by increasing the value proposition of that protocol’s use case by increasing liquidity.
Tying this to Element 1, an investment strategy that blindly follows the ﬁat replication philosophy without considering what the ecosystem wants will fail. In essence, a project that is necessary to create the next ﬁnancial building block must have social support in the crypto ecosystem to be successful. Often the intersection point of Element 1 and Element 2 traverse the same path through time — the ecosystem wants what the ﬁat world already has — but the order in which those building blocks should be created is commonly more clearly deﬁned by social factors than by the historical path of development traced by the ﬁat ﬁnancial system.
Element 3: Technological Development;
The ﬁnal element is technological development. Blockchain technology is relatively nascent when compared to other disruptive technologies — the underlying infrastructure of the internet took decades to reach global adoption and has taken many different forms as it has evolved through this adoption process. Blockchain security and decentralized trust as a fundamental concept is slightly more than 10 years old, and its implementation is evolving rapidly.
We have seen two generations of Blockchain technology reach large-scale adoption, and with each generation, new capabilities (and challenges) are added. The bitcoin blockchain was the ﬁrst to create trustless global transactions over the internet. Ethereum created the ﬁrst virtual machine. Third-generation blockchains are being developed to enhance Ethereum’s transaction throughput capabilities.
Underlying blockchain fundamentals are not the only factor of technological development to consider — identity, real-world legal interfaces, crypto to ﬁat on/off ramps, and regulation are a few of the other technological elements of the ecosystem that are developing in real-time that create constraints for project development.
This overview is important to give context for locating the frontier on which DeFi technology is being built and, as a result, the technological limitations that must be considered when designing a new project. As mentioned above, a project that is developed too early for the underlying technology to enable key project features is likely to lose social interest as those features fail. Thus, despite the project in question ﬁtting within Element 1, ﬁnancial development, and potentially Element 2, social interest, being outside of technological possibility will doom the project to failure and is accordingly an equally important consideration.
Testing the Model
The most useful proof for the model we describe is to highlight a successful project, Compound Finance, to show how the project was situated within the space created by the three Elements described above.
Compound Finance was one of the earliest DeFi projects, in fact, the founders began the project before “DeFi” was even coined as the term describing the ecosystem we see today.
At the time, making an investment in Compound Finance was driven entirely by the framework discussed here. As a project that was groundbreaking in the functionality it proposed to enable, there was no certainty of product-market ﬁt and the technological potential was untested.
However, Compound Finance was situated squarely within the space created by the three Elements. First, traditional ﬁnance is built upon the ediﬁce of risk-free interest rates, and the short end of the yield curve is anchored by money-market type instruments. Compound addressed the need for this building block.
Second, the social interest from the crypto ecosystem was also present — traders were seeking to borrow crypto assets, and investors holding crypto assets were seeking to generate yield on their holdings without liquidating their positions. A market was born, and sufﬁcient hype was built prior to the launch of the project, thanks in part to well-known investors and its novelty as a project.
Third, the technological capabilities were present via the Ethereum blockchain, particularly the concept of over-collateralization of borrowing, while not yet proven, conceptually was possible.
Stratos invested in Compound Finance in February of 2018 at a valuation below $50 million. The current market capitalization of the COMP governance token is $1.4 billion, with nearly 300,000 lenders supplying almost $10 billion of liquidity to the protocol.
The same model-testing analysis as the above can be shown for Uniswap, Chainlink, Yearn, and Dapper Labs, all of which are seminal DeFi projects, but the Compound Finance example is sufﬁcient to show our thought-process in action for an early DeFi Project.
We plan to release additional research as we continue to explore the space and ﬁnd attractive opportunities. If you are interested in learning more, please contact me: email@example.com.