It’s All a DeFi Thesis

DeFi has been in the doldrums for the better part of the last year. As liquidity mining has faded from focus, investors and retail have shifted their attention elsewhere. DeFi winter started months before the broader market sell off and most DeFi tokens are down 90%+ from all time highs.

Investors should ignore DeFi at their own peril. The growth of other crypto sectors will provide catalysts for DeFi as more assets move on-chain. In the short term, the 2020/2021 bull market has helped pile billions into crypto project treasuries, which will inevitably find its way into DeFi. In the medium term, emerging Web3 categories like DAO’s, NFT’s, gaming, and physical networks will exponentially expand on-chain economic activity. These assets will expand DeFi’s addressable market by an order-of-magnitude. Betting against DeFi is betting against crypto succeeding.

The DeFi of the future will look very different from the DeFi of summer 2020. Patient fiduciaries will replace risk-on degens. Low-risk 10% yields will replace shitcoin-denominated four digit APY’s. DeFi investors of the future will care about earning yield on stablecoins, L1 tokens like ETH, and their native token. This will provide a catalyst for structured products. Crypto-native companies will have a need for working capital, which will drive demand for credit.

The DeFi Bear Market

Crypto tends to be an industry of extremes and the shifting market sentiment towards DeFi is certainly no exception. Summer 2020 — commonly called DeFi Summer — saw liquidity mining blow onto the scene and introduce novel token mechanisms and massive price run ups in every token that had a mention of reflexivity in their white paper. Things have obviously changed. DeFi summer has given away to an Alaskan winter.

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What’s driven this shift in sentiment? While DeFi fundamentals explain some of it, I believe the answer is narrative driven:

• The initial hype wave that drove this market — liquidity mining — has faded
• There are shinier things elsewhere

A detailed analysis of liquidity mining’s shortcomings is outside the scope of this article, but needless to say it is now quite clear that liquidity mining in and of itself does not lead to sustainable growth. A few of the largest issues:

• Subsidized liquidity is highly mercenary and will leave pools as soon as incentives end
• Yields are largely generated through token rewards — if those token prices fall, rewards fall. Hence, any broad decline in DeFi prices make liquidity mining campaigns less attractive, which creates a negative flywheel
• Like most things in crypto, very few projects had actual product market fit and retail participants eventually lost interest after a number of rug pulls and hacks

The other factor that has provided headwinds for DeFi has been the emergence of shinier objects. Interest in NFT’s has exploded, driven by high end collections and the adoption of NFT’s by celebrities. Blockchain gaming also saw a huge surge in 2021/2022 and drew retail attention away from DeFi.

Crypto treasuries: the catalyst hiding in plain sight

While the industry has wasted more than a few brain cells debating about when the proverbial institutions will enter DeFi, little attention has been paid to the billions of assets already on-chain. As an increasing number of projects like Uniswap launched governance tokens over the past two years, on-chain treasuries have swelled in value. Despite severely depressed markets, a large number of projects have treasuries worth more than $100M. There are also an increasing number of on-chain investment vehicles. BitDAO, which has more than $1B in assets, is the largest.

Crypto treasuries are generally dominated by a project’s native asset, but will also often hold stablecoins and ETH (or whatever L1 token the project favors).

Despite raising record breaking amounts of capital over the last two years, crypto projects have deployed surprisingly little of this capital into DeFi. Part of this is (rationally) due to risk management — DeFi is risky and the last month has seen large blow ups in the form of Terra and 3AC. Private startups with small treasuries should certainly be highly conservative with their assets.

However, established protocols with on-chain treasuries are dynamic economies that should optimize the (risk-adjusted) performance of their treasuries. DeFi is the obvious way in which they will do this. Protocols will rationally seek to compound their treasuries 3–5% a year by deploying a portion into a diversified basket of established DeFi protocols. Given that an impending bear market always brings burn rates to the forefront, these treasuries may start to focus on yield sooner rather than later.

A number of crypto treasuries have already explored moving into DeFi. Some examples of early adopters and discussions

• The Synthetix treasury deployed 5M USDC into Maple in November 2021
• In February PoolTogether began exploring using Notional to earn yield on its stables
• This March Notional proposed that Angle should utilize Notional to earn yield on its treasury

The Index Coop has one of the most sophisticated treasury management strategies and has been earning yield on its stable since August 2021. The Index Coop’s finance nest leverages its treasury both to support its own products and to extend its runway. Index Coop has deployed nearly $3M to support liquidity across its product line. On the treasury side, Index Coop has more than $5M in stables earning yield across Balancer, Aave, and Uniswap. Given the success of the Index Coop in using DeFi to extend its runway, I expect many other treasuries to follow.

The emergence of DAO treasury management tools may help catalyze this adoption by making it easier for DAO’s to deploy funds on-chain and manage risk. On the software side, Coinbooks (Lattice portfolio company) and Coinshift are making it easier for DAO’s to track their finances. Llama has also built a crypto-native accountancy that advises DAO’s on treasury management.

Web3 Drives DeFi

Attention in emerging Web3 categories like gaming and DAO’s has exploded over the past year. As Axie Infinity became one of the most discussed games on earth, money flooded the space and at least 100 blockchain games have raised money in the last year. Similarly, Constitution DAO brought mainstream attention to DAO’s and has helped catalyze tens of millions of dollars being poured into on-chain crowdfunding campaigns. In my view these categories are obvious catalysts for DeFi. Both bring an increasing number of assets on-chain thereby expanding the addressable market for DeFi.

If blockchain gaming is successful in any form, it will inevitably drive more assets and users into DeFi. Blockchain games will expand the install base of crypto wallets and familiarize users with on-chain assets like stablecoins. Blockchain games will also create virtual economies that grow the universe of on-chain assets through in-game assets and grow demand for economic primitives like credit.

The rise of DAO’s will also expand DeFi’s addressable market. Crowdfunding campaigns like ConstitutionDAO will onboard more users into Web3. They’ll also increase on-chain economic activity by moving corporate financial activity like payroll and treasury management onto public blockchains.

DeFi 2.0: Sustainable Yields

The leading DeFi protocols of the future will be ones that serve the needs of patient and more conservative capital allocators. These allocators will want to compound their treasuries by earning sustainable yields on stablecoins, L1 tokens like ETH, and their native tokens. Project treasuries and DAO’s will want to access working capital without having to continuously sell off their treasuries. This provides tailwinds for structured products and credit.

Structured products are pre-packaged investments that leverage derivatives to make it easy for investors to achieve a specific risk-return objective like enhancing yields. In a DeFi context, structured products generally come in the form of single asset vaults built to earn yield. Leading structured products platforms include Ribbon and Friktion. Ribbon’s most popular product is its Theta Vault, which earns yield by running an automated options selling strategy.

Structured products will grow as DeFi matures because they can offer sustainable yield on a variety of assets. Structured products generate sustainable (though generally not risk free) yield through the natural market forces of volatility and participants wanting to transfer risk. They can also support yield generation on most liquid tokens, making them attractive for projects that want to compound the native token in their treasuries. For example, Ribbon supports vaults for longer-tail assets like $APE and $AAVE.

Decentralized credit markets will also grow by an order of magnitude as the universe of Web3 entities needing working capital expands. Crypto projects wanting to fund their operations without selling off their treasuries will leverage on-chain bond markets. Just this month, Ribbon raised $3M by leveraging Porter’s bond platform. Maple (Lattice portfolio company) has serviced $1B+ in credit to crypto-native institutions. While their customer base today largely consists of trading funds, I expect it to include crypto projects in the future.

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Credit will also grow as it will offer one of the only sustainable competitive yields in DeFi. Today, Aave offers <1% yields on USDC. It seems likely that Aave’s yields will become the ‘risk-free’ DeFi interest rate and hover in the low single digits. For those who want to earn 5–15% APY on stablecoins, going further out on the risk curve and funding true credit protocols like Maple will be a natural choice. Fixed-rate lending platforms like Notional (Lattice portfolio company) also stand to benefit from people seeking higher yield.

Moving Past the DeFi Doldrums

As we enter what seems to be a sustained bear market, the industry inevitably seeks the next narrative to save us: DeSci, NFT Financialization, ETH L2’s. I think the answer is sitting right in front of us — decentralized financial products that process billions of dollars in transactions daily and have successfully weathered incredibly volatile markets. Nearly all crypto theses involve financial activity moving on-chain, which by definition grows DeFi’s addressable market. It’s all a DeFi thesis.

This is not investment advice.