Investing in DeFi: Part 1

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Bitcoin and Ethereum on the Run.

Investing in DeFi: Part 1

The Opportunity

The internet made information cheap and accessible; it created a platform where individuals could tap into one of the largest information distribution networks in the world. With just a website, you can interact with anyone, anywhere in the world. To us, the internet has been about connection and reach; websites are simply the storefronts of the digital world, an access point to a global user/client/reader base.

The internet was about sharing information; the internet of value is about trust. Blockchains are an accounting innovation that strengthens redundancies and the tamper-resistant features of ledgers. The legacy system relies on recourse deterring guarantees when performing value transfer. Blockchains, on the other hand, rely solely on game-theoretic guarantees enforced by mathematics. To put it simply, the legacy system relies on brand-based trust, whereas blockchains rely on math-based trust.

Brand based trust has its limitations due to the high costs associated with manufacturing this trust. Legacy financial services manufacture trust through the fixed costs of financial infrastructure, legal expenses, labour costs and ongoing regulatory compliance costs. These costs make certain transactions cost-prohibitive. This isn't just limiting for the service provider, but more importantly, it's limiting for the user. There are entire business models that cannot feasibly exist today because brand-based trust is too expensive.

Certain transactions, due to their simplicity and locality, are cheap to perform using brand-based trust. These are not the type of transactions that open blockchains will be replacing, at least not yet. More complex financial business logic such as asset issuance, asset exchange, derivatives, asset management, lending and borrowing are where open public blockchains can and will compete.

We are witnessing the birth of new financial protocols. Think about the internet protocol, a standardised means through which information can be disseminated globally. The internet of value will be a suite of protocols through which value and financial services can be disseminated globally.

The article this weekend will focus on the infrastructure behind these new financial protocols, and next weekend we will cover the financial protocols themselves in more detail.

The Infrastructure Required for the Internet of Value

The first layer of the open finance technology stack is units of value. There are multiple variants to units of value, whether it be DAI (an algorithmically pegged stablecoin backed by ETH), USDC (stablecoin backed by dollars in a bank account) or even ETH and BTC. Every DeFi transaction begins and ends with a unit of value, whether the end-user is making a deposit into a lending facility, swapping one digital asset for another or making an investment into the index.

Each unit of value has its own unique risks. For example, DAI has collateral risk as it is backed by ETH, a volatile cryptoasset, as well as the potential for smart contract bugs in the MakerDAO code to be exploited. Users will deal with the unit of value they are most comfortable with. When Etherbridge interacts with DeFi, we use Ethereum as our unit of value because, in our own capacity, we can afford short-term volatility around ETH's price. The point is, there are many options depending on your preferences and risk tolerance.

The second layer is the smart contract transactional layer. All of these new financial primitives require a settlement engine to process, execute, and settle users' requests on the network. Ethereum is the leader of this layer at the moment. Other public blockchains such as Binance Smart Chain, Polkadot, and Solana also are experiencing growth in network effects and activity.

The final piece of infrastructure necessary is an oracle system. Chainlink is our oracle of choice; you can read our most recent Chainlink review here. There are a variety of ways we can solve the oracle problem; we can use an off-chain, brand-based trusted source of data such as Bloomberg. Alternatively, we can use decentralised oracles such as Chainlink that leverage cryptoeconomic incentives and mathematics to ensure data reliability and accuracy. Both have their trade-offs and benefits, depending on the use case you are applying them to.

Layer Zero: Human Beings

Mike and I were fortunate to receive more advice from experienced individuals than we knew what to do with when we started Etherbridge. When it comes to investing in open public blockchains, the two pieces of advice that stand out today are "don't fall in love with any of your investments" and "it's about the product, no one cares about the technology".

Investing in transactional layers such as Ethereum, Binance Smart Chain, Polkadot or Solana provide different sets of ideals that you can support and capitalise. These base networks, like nation-states, have their own constitutions and their own set principles. They are, after all, "truth engines"; how they go about determining truth is of utmost importance to their community. This brings us back to the blockchain trilemma that illustrates the trade-offs design teams and communities need to make around scalability, security, and decentralisation.

Over the course of the last year, we noticed a significant trend when it came to these base layer blockchains. It has become blatantly obvious to us that every new marginal user of blockchain inadvertently holds diminishing ideals around the idea of decentralisation. In essence, each new user cares less about decentralisation than those who came before them.

At the end of the day, human beings decide. Blockchains are human manifestations of social contracts, but most users are unaware or couldn't care about the underlying social contract. They want fast, low-cost and expressive global financial services. It's no longer good enough to cite Ethereums moat as "decentralisation"; it needs to compete where users place importance, transaction fees and transaction time.

Our view still remains the same; the future is decentralised. However, there are opportunities that are less idealistic in this investable universe. Factoring layer zero into your analysis of public blockchains might just help you better navigate the opportunities available in the space. 

Whether human beings value the tenet of decentralisation or not, only time will tell.

Notable Articles and News Stories This Week:

European Investment Bank Issues $121M Digital Notes Using Ethereum

The lending arm of the European Union, the European Investment Bank (EIB), has used the Ethereum blockchain to issue two-year digital notes for the first time. The notes were issued on the 28th of April are jointly managed by Goldman Sachs, Banco Santander SA and Societe Generale AG. Investors will be able to purchase the notes using traditional fiat. According to the EIB, they made the decision because they believe "the digitalisation of capital markets may bring benefits to market participants in the coming years, including a reduction of intermediaries and fixed costs, better market transparency through an increased capacity to see trading flows and identity asset owners, as well as a much faster settlement speed.

Read about it here or view their official statement here

Federal Reserve Keeps Rates Near Zero, Maintains Asset Purchases, Sees Inflation as ‘Transitory’

Following the Fed's two-day meeting on Wednesday, Jerome Powell has signalled that the central bank is not looking at raising interest rates anytime soon. He also stated that they would continue with their $120 billion a month bond-buying program and when asked as to when the time was to start talking about tapering its asset purchases, replied, "No, it's not time yet". With a loose monetary policy, we can usually expect risk assets like stocks and crypto to continue to appreciate in value. Powell also stated that the central bank is not worried about inflation, and any uptick during the reopening of the economy will probably be temporary or 'transitory'.

Read more here

Inflation Worry Spreads Beyond Bitcoiners to Wall Street Stock Analysts

Concerns about inflation have spread beyond the crypto and bond market on Wall Street. The Bank of America has recently published a report in which they disclose that mentions of the word "inflation" in S&P500 company earnings calls has more than tripled year-on-year, the biggest jump in 17 years. The biggest drivers of inflation were cited as being raw materials, transportation and labour. Historically the number of mentions of inflation in earnings calls has led CPI by a quarter (with 52% correlation). It will be interesting to see what happens over the next few months.

Read about it here

Whilst we all have the option to look, to seek to understand, it’s often easier not to. Bitcoin, Ethereum, and distributed ledger technology are complex systems that require significant due diligence. At Etherbridge, we aim to lower the barriers to understanding this fast-growing digital economy.

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This is not financial advice. All opinions expressed here are our own. We encourage investors to do their own research before making any investments.