Why you should care about crypto finance
Crypto finance (commonly referred to as DeFi or open finance) is a rapidly growing sector of the crypto economy that consists of mainly Ethereum-based financial protocols and applications. At a high level, these protocols and applications seek to replicate existing products from the traditional financial system, but with the improved functionality and differing risk properties inherent in crypto systems.
Points I will cover in this post:
- The attractive properties of crypto finance
- Forward looking use cases for existing protocols and applications (don’t @ me)
- How businesses can be built near the top of the crypto finance stack
- Go-to-market ideas and trends for the space
- The missing identity piece and guarantor networks
- Which crypto finance niche excites me the most
As a quick side note on the emerging nomenclature around crypto finance; “decentralization” is a notoriously difficult term to break down, and it is already becoming evident that end-user financial applications built on Ethereum might not be totally “open”. So in a way, both of these are flawed categorizations for many of the applications already coming to market. In order to muddy the waters further, and avoid semantic debates, I’m going to stick with “crypto finance” as a catch all.
I think about crypto finance as a parallel financial system that is open and global by default, where financial protocols interoperate to deliver the full range of services we have become accustomed to through one main piece of infrastructure: the Ethereum network. This is not meant to be an Ethereum puff-piece, however at this early stage Ethereum has the lead (theirs to lose!) and I see significant network effects and cross-dependencies growing in the crypto finance space.
Let’s start with why this matters. The value proposition around using any crypto finance application is going to depend on who you are, and how you are served by the legacy financial system. Billions of people in developing countries are barely served by the incumbent financial system (the “unbanked”), while many individuals and businesses in Western countries have a plethora of options when it comes to financial services, ranging from big banks to tech-focused startups. The same applies in the B2B or wholesale financial services industry.
Here are a few of the generally attractive properties of crypto finance products:
- Native to the internet: beyond a regular internet connection, crypto networks do not require any additional infrastructure for users to participate in the ecosystem. The lack of proprietary payment and messaging networks mean that crypto finance products enjoy global distribution and a footprint that covers most of humanity.
- Borderless: crypto finance products can be offered seamlessly across borders as they run on a universal infrastructure layer. For example, there is nothing to stop a user posting ETH as collateral in a MakerDAO CDP and receiving a loan in Dai, regardless of where they live.
- Trust-minimized/lower counter-party risk: most crypto finance products are non-custodial, meaning a third party is not given arbitrary control over your funds, and a third party cannot unilaterally transact on your behalf (unlike, for example, when your funds are stored in a bank).
- Economic freedom: crypto finance products can be highly censorship resistant, meaning the user has total control over their funds, and transactions cannot be blocked by anyone.
- Low cost, rapid settlement: transactions can be settled in seconds or minutes, with transactions costing 0–50 cents depending on the network and demand for capacity. Settlement conditions can be arbitrarily complex.
- Live 24/7/365: crypto networks never sleep.
- Asset and monetary interoperability: crypto networks enable the trading of any currency against any asset, as well as the manipulation of any currency or asset by a smart contract (e.g. to collateralize an asset within a debt agreement).
- Automated compliance: massive efficiency gains can be reaped using this technology. From KYC/AML to pre and post-trade compliance, otherwise monotonous functions can be automated, saving cost and growing market access.
- Greater liquidity: crypto networks have an abundance of latent capital waiting to be deployed; this results in a low cost of capital for borrowers (enjoy it while it lasts!).
- Smarter underwriting/auditing/risk: as more of an individual or entity’s financial data lives on-chain, it can be leveraged when executing unsecured credit agreements or otherwise underwriting risk. This may eventually be possible while preserving privacy (e.g. using zero knowledge proofs).
- Developer accessibility: one of the main advantages this ecosystem enjoys over traditional financial services is the open and accessible nature of the technology. While it is difficult for developers to integrate with banking and legacy payment systems, there is no hurdle for building an application that leverages other crypto finance applications and protocols. The network effects are significant.
This is not an exhaustive list, but these are some of the high level properties that developers and entrepreneurs can leverage when bringing a crypto finance product to market. Some of these properties need more time to mature before they will provide any meaningful edge.
Again, the value proposition to the end user is going to depend on their customer profile. Let’s look at a few examples, based on a potential user’s age and location.
- Usman, Nigeria, 30: Usman wants to save some of his wealth in USD to avoid Nigeria’s >10% local currency inflation rates. He does not have enough funds to enter a term deposit denominated in USD at a local bank (he also lives many miles away from the nearest branch), and he is seen as a low value customer by local financial intermediaries. Usman downloads a mobile app (a localized interface layer delivering crypto finance applications and protocols) which is integrated with a local Nigerian cryptocurrency exchange. He goes through the on-boarding process and receives an NFT representing the fact that he has undergone KYC/AML checks, which he can then re-use to access other centralized and decentralized financial services seamlessly (this becomes his ‘passport’ of sorts). The local cryptocurrency exchange accepts NGN-denominated deposits from a popular mobile payment provider of which Usman is a user. Through his mobile app he purchases Dai (Wyre Capital is an investor in MKR) and deposits it in a Compound Finance money market account, accruing 2.2% APY. While using the mobile app to check his balances, he notices an ability to purchase US listed equities like AMZN using Market Protocol derivatives (Wyre Capital is an investor). Unlike his local stock broking services Meritrade and mytradebook, Market Protocol gives him access to global asset markets and has no minimum investment requirement.
- Ana, Venezuela, 40: Ana is preparing to emigrate from Venezuela due to a collapsing quality of life. She has approximately $2,000 in USD saved but is concerned about cash being confiscated by corrupt authorities. Ana is familiar with cryptocurrency due to its rising popularity in the region. She purchases Dai in a peer to peer exchange (this trade involves a hefty spread, but is similar to other black market transactions), storing it on her mobile device. She then sends half of it to family in the US who are able to liquidate it for USD, being charged minimal fees and spreads. Ana emigrates to Colombia and liquidates her remaining Dai for Colombian Peso.
- Chris, United States, 16: Chris spends a lot of his time gaming. The currency used in his favorite game is an ERC20 token which has real USD value. His parents complain a lot about his gaming habit. Little do they know that he has been compounding his in-game savings for the last 5 years by lending out his coins on Compound or Dharma (depending on the prevailing rates). He has also been earning and trading in-game items for a nice profit. When he turns 22, he liquidates all of these gaming items and builds a diversified portfolio of bitcoin, ether, security tokens (representing some high cap rate properties) and Market Protocol S&P 500 positions. Using advanced cryptography, Keep (Wyre Capital are investors) creates a trust-minimized solution for bringing BTC onto the Ethereum network, allowing Chris to leverage his BTC savings in crypto finance applications. He puts all these crypto assets into MakerDAO CDPs, and borrows against his portfolio at a rate of 1.5% APY. He uses this borrowed Dai to pay for most of his college degree, effectively arbitraging the interest rates on student loans.
- Rune, Denmark, 45: Rune is a Danish businessman running a company that operates on thin margins and is working capital intensive. He is used to factoring his accounts receivable in order to manage the company’s cash flow. He is offered a product through a major trade finance solutions provider that allows him to tokenize his invoices and borrow against them using MakerDAO CDPs, at a third of the usual interest rate. While his CDP is still open, one of Rune’s major distributors goes into administration and defaults on a material portion of the collateralized invoices. The default is reported to an oracle (invoice payments are made on chain and the terms of the invoice are known, and thus non-payment is easily detected). The CDP is now under-collateralized due to the oracle marking down the accounts receivable. A hedge fund that specializes in purchasing this kind of asset bids on the CDP and buys the remaining good invoices at a discount. (ok, this is a pretty whack example, and Rune might be ruined from this situation, just one to get you thinking!)
So there’s are a few forward looking examples of how different people may extract value out of the crypto finance ecosystem. At this stage, it is hard to see older generations in Western markets extracting much value out of crypto finance. The real opportunity comes with the generational shift towards the digitally native. Most of the above is possible today (though there are a lot of operational questions and requirements for the last example). However, all of the borrowing/lending that occurred in the above examples are fully secured/over collateralized. In order to underwrite unsecured debt, you need to be able to assess the borrower’s creditworthiness.
Not always a puritan’s paradise
You may have noticed that not all of these examples purely rely on trustless bearer assets and entirely trust-minimized economic relationships. Security tokens were mentioned, as were oracles, and even the esoteric receivables from a random business in Denmark… the horror! As suggested by the properties listed above, there is more to crypto finance than trust-minimization. The ease of creating efficient global markets is an important tenet of this phenomenon. There is value in bringing parties living on the other side of the world into a single liquid market built on a common standard of public infrastructure. Operational and regulatory hurdles can be overcome by placing money, assets, identity and contracts on a universal, programmable technology paradigm such as distributed crypto networks, regardless of the trustful links required to onboard them into this parallel world. Smart entrepreneurs will be able to access a global market of customers with unprecedented ease.
Global markets at your fingertips
The crypto finance economy has a unique ability to connect a light, localized front end or interface layer with a global liquidity pool and wholesale financing market, with zero barriers to entry. Anyone can build an interface that extracts yield from Compound, leverage from Maker, risk from Market, and lets you trade assets on Uniswap. All of this functionality can be built into one unified UX; Zerion provides an example of aggregating crypto finance protocols to dramatically improve their usability. In fact, with Balance, InstaDapp, Zerion, Veil and others, we are seeing a good amount of experimentation at the interface layer.
In a recent speech Amazon CEO Jeff Bezos remarked on how his business was able to grow so quickly; because they were able to leverage existing infrastructure such as credit cards for payments, the internet for telecom and USPS for fulfillment, they didn't have to build it all out themselves. Bezos cited Facebook as another example of how a half-trillion dollar company could be started in a dorm room when it’s bootstrapped on existing, accessible infrastructure. By providing this base of infrastructure for financial innovation, crypto finance protocols lower the barriers to entry for entrepreneurs hacking together innovative products in manner not yet seen in the financial services industry.
There are two solid test markets ready to roll
So how does a commercially oriented crypto finance team drive their protocol or application forward? What's the first achievable test market for this stuff and what's a reasonable go-to-market plan? There are two obvious distribution channels at the top of my list:
- Centralized exchanges
Crypto wallets have millions of users. At the moment, most wallets allow you to send, receive and store crypto. Some allow you to buy crypto with fiat through services like Wyre. A wallet could easily integrate Compound money markets into its UI, allowing users to seamlessly earn interest on their holdings (they are already doing this with ImToken).
There is significant scope for clever, highly scalable businesses that enjoy significant operating leverage to be built through finessing the delivery of crypto finance products and services. Returning to the wallet example, adding crypto-to-crypto trading capability to a wallet brings significant value to users. Totle (Wyre Capital are investors) aggregates DEX liquidity to provide non-custodial trading through an API which can be integrated seamlessly into a wallet’s user interface. They can charge fees while still offering a better overall price to the end user through smart order routing between Kyber, Oasis, Uniswap, 0x and others. Wallets make money when their users trade and transact, so introducing this functionality is a no-brainer, revenue accretive move. This is a good example of how a clever business can drive meaningful adoption by leveraging the strengths of crypto finance while minimizing its current drawbacks.
Totle also demonstrates how businesses built at the top of the crypto finance stack benefit from agnosticism and optionality with respect to the protocols they utilize, significantly reducing the technology risk faced in the highly crowded DEX landscape. Wyre enjoys a similar position in the industry, as we can provide fiat ramps to the dapp market as a whole. Bloqboard is another solid example that I am a fan of, aggregating the various crypto finance lending protocols into a sweet UI — awesome stuff!
Centralized exchanges provide an interesting early market for crypto finance products. A contradictory point you say? Tell me why adding Compound money markets to Coinbase or Kraken doesn't make sense? There is a decent chunk of latent capital sitting in crypto exchanges waiting to be utilized. That sounds like good bootstrapping material to me! Getting liquidity off the ground should be the number one concern of new crypto finance products.
There’s already healthy competition and cooperation
Here's a list of players that’s not even close to exhaustive:
I’m already seeing interesting competition brewing between Dharma Lever and dYdX, a zillion DEXs eating each other, MakerDAO vs fiatcoins and so on.
Smart underwriting could provide the ultimate edge
There is one key piece that is missing from the amalgam of apps and protocols utilized in these examples: identity and reputation data that can be used to assess creditworthiness. While Wyre has been trail blazing with regard to issuing the users we KYC with a non-fungible token (ERC721) that allows them to effectively re-use that verification and avoid cumbersome on-boarding procedures for each service they use (which risks personal information), there are currently no real credit rating solutions that can be used to underwrite unsecured debt on crypto networks.
In the legacy financial system, individual credit history is mostly comprised of previous credit activity and high-level assessments of an individual’s income and assets. In the B2B setting, banks have only recently started to ingest data directly from accounting software in order to get a more granular understanding of a potential debtor’s cash flows and financial position. Crypto finance applications have an opportunity to leverage the rapidly growing history of on-chain data to inform lending decisions. Once a sufficient amount of economic activity is occurring on public crypto networks, the combination of identity information and a financial profile built on a debtor’s on-chain transactions and balances could actually give lenders on protocols such as Dharma an edge over traditional banks in accurately assessing the creditworthiness of a debtor.
Fraud in traditional credit applications is rampant, and financial data is not easily verified using legacy technologies. It will be up to creditors to determine what on-chain activity represents genuine commercial interactions as opposed to those spoofed to inflate the economic profile of a creditor (sybil attacks). I don’t see this as an impossible task.
Kraken pioneered the cryptographic proof of reserves audit as far back as 2014, and there is great potential for this kind of process to be honed and improved. It may be possible in the future to verify an individual or company’s financial position without revealing sensitive financial data. Moreover, in the legacy financial system, often the assets that are used to secure debts will find themselves in some kind of centralized register, which is another field that is begging for some blockchain innovation. Ultimately a combination of on-chain and other cryptographically verifiable data, plus legacy data from traditional ratings agencies should provide a more complete picture than either data source viewed in isolation.
With actionable identity and credit rating data, the range and scope of financial products that can be offered in the crypto finance paradigm becomes seemingly limitless. Collecting bad debts may still ultimately lean on the legal system, and anyone engaging in lending is going to be in a constant battle against fraud; welcome to finance! I hope that companies like Spring Labs can bridge legacy ratings systems and crypto finance markets.
It is important to note that an opt-in ratings system that gives debtors access to unsecured credit does not preclude a privacy oriented crypto finance market where all relationships are secured and trust-minimized. Both will exist hand-in-hand and will tap the same wholesale financing markets.
Guarantor networks and developing markets
You might be thinking ‘this credit rating malarkey sounds all well and good for those with on-chain assets and a solid transaction history, but what about Usman from Nigeria?’ While I haven’t noticed anything in this area to date, I see a decent opportunity for experimentation around a capital-efficient guarantor network built on crypto finance protocols.
Guaranteeing someone else's debt by placing the entire value of the debt into a smart contract doesn’t solve a lot of problems, as in this case the debt effectively becomes fully secured, which is not capital efficient. I’m hoping someone smarter than me will try and build a kind of margined guarantor network where I can guarantee 20 of my trusted friends, and they reciprocate, and we each place 20% of the total guaranteed value in a smart contract as collateral. That way the system can survive a default rate of up to 20% before it becomes insolvent — you could easily introduce a sort of margin call when defaults reach 15%, where the network of guarantors must post more collateral or have their guarantees rescinded and future access to financing cut off. If people value access to financing, they will value their on-chain reputation and good standing.
If someone can make this work, the incremental cost of serving new customers in developing markets could be drastically reduced (lower bad debts and recovery cost, lower customer DD costs), meaning even low-value consumers could be profitable for interface/application layer businesses that tap commoditized wholesale financing and have highly automated compliance functions.
Crypto finance has lower UX hurdles vs incumbents
Back in November, when talking to Zach and Jackson who host the Tokenomics podcast, we discussed how crypto projects targeting financial use cases have a lower competitive hurdle when it comes to UX. I said that we are already seeing some crypto applications deliver financial services with a better UX than incumbent offerings, despite the fact that the crypto product in question was built in 6 months by 4 hackers. Another 4 months have passed and we are seeing big leaps forward from Dharma, dYdX, Bloqboard and others. Many customer interactions with a bank are slow, multi-day processes that involve ugly user interfaces. Would you rather that as your competition, or Uber, Twitter, Youtube or any of the other tech incumbents that will supposedly be challenged by Web 3?
The next bull market will drastically lower capital costs
When the next crypto bull market comes, the amount of latent capital in the crypto finance economy will increase by an order of magnitude. This could allow entrepreneurs to tap capital markets that are offering better prices and rates than legacy competitors.
The niche of crypto finance that excites me the most
Fully synthetic crypto derivatives really excite me. When I say synthetic I mean a derivative contract that delivers price exposure without ever transacting in the reference asset. This is what distinguishes Market Protocol and UMA from dYdX. dYdX allows you to lever up when trading ERC20 tokens, however Market and UMA essentially create swaps settled by an oracle (similar to Augur markets). The benefit of the fully synthetic design is that you can create a token that represents any stock, commodity, index, fiat currency or any other asset. All you need is a price feed; there is no requirement to create a security token representing a legal interest in the underlying asset. In a way, MakerDAO also fits into this definition, and they have built and are proving out the most important and needed synthetic asset for crypto finance: Dai.
The holy grail with respect to synthetic crypto derivatives is building a settlement system that does not rely on an oracle, but instead utilizes a properly incentivized crowd to source settlement values. I’m excited to say that Market Protocol is working on just that.
These products have a proven market that can be used to bootstrap liquidity in the near term; Bitmex swap products are the most liquid instruments in crypto, and thus offering a similar solution with no counterparty risk (as they are non-custodial) and lower funding costs could be the first breakout product for DEXs. There’s also a massive opportunity to bring these products to emerging markets to offer individuals with the unprecedented capability to invest in global asset markets, regardless of their geographic location.
What does this mean for ETH?
As this space grows, it’s hard to not be a little bulled up on ETH. The cross dependencies growing in crypto finance are significant; every protocol or application uses Dai and the ease of borrowing/lending/trading assets that live on a single base layer adds materially to the user experience. ETH is being gobbled up as collateral in a variety of applications, reducing its free-float:
However, in the sharded world of ETH 2.0, things are going to get a lot more complicated for developers. Cross-shard communication is going to present a challenge to highly interdependent or ‘composable’ smart contracts.
Get in contact with Wyre Capital
At Wyre Capital Management we already see several companies and assets in the crypto finance space that we believe are capable of generating outsized returns over the long term, and are always looking to invest in new projects and companies that are seeking to build key infrastructure and applications for this ecosystem. When managing money for our LPs, we are searching for teams targeting realistic and achievable commercial outcomes that address genuine pain points for real consumers and businesses. As part of the Wyre family, Wyre Capital Management is uniquely placed to drive your company or project forward; Wyre is an important strategic partner to a large number of crypto companies and has a growing footprint in the crypto finance space, both in terms of investment and commercial integrations. We can integrate seamless fiat on-ramps and new user on-boarding (KYC) natively into the UI of your application. Should you receive investment from us, we will happily provide our input and support whenever you need it!
If you are working on something cool, have a commercial mindset, are execution oriented and have a long term vision, reach out to us at email@example.com
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