14 Defi -Decentralized Finance

Zhao

At the last peak in Jan 2018 the total market cap of crypto – i.e. all the crypto money in circulation – stood at $770 million. Today that number is $2.6 trillion! The most significant driver of this growth has been institutional onboarding. To highlight a few OG crypto-native market makers: Alameda Research now trades >$5B in cryptos daily, GSR trades >$4B daily, Genesis Trading’s institutional lending desk processed $36B loans in Q3 2021, etc… Their success caught the attention of “traditional” big market makers: Jump Trading, Tower, HRT, Susquehanna, Jane Street, and the latest addition as of Jan 11, 2022… Cita-last-straw-del.

“But why do we want institutions in DeFi?” you may wonder. “Isn’t the whole point to decentralize and give power to the people?”

Yes. Of course. But 1) markets need liquidity and 2) what does it actually mean to give power to the people? It was never the existence of hedge funds and banks in traditional markets that was the problem. It was that traditional markets rigged the game, giving hedge funds and banks hidden privileges and special access totally unknown to retail traders.

Like the fact that non-accredited investors <$1M net worth can’t invest in startups or buy secondaries in private deals. (Whereas, anyone can buy any crypto project’s token in DeFi.)

Like the fact that if retail traders wanted to buy options or oil futures, the minimum trade size is 100 shares’ worth and 1,000 barrels’ worth, respectively. (Whereas, assets trade in infinitely fractionable increments in DeFi.)

Like the fact that retail traders can’t directly market-make on the traditional exchanges: CME, NYSE, NASDAQ, etc. (Whereas, on crypto exchanges like FTX, Binance, Coinbase, etc. retail traders can quote and execute trades programmatically using the exact same APIs as professional firms.)

If DeFi is our second chance to build a new financial system free of structural biases and bureaucracy, then we need to massively accelerate institutional adoption to get there.

Three ways that institutional activity directly lifts crypto markets:

  1. It increases liquidity, which means tighter spreads, lower slippage, and huge executional improvements.

  2. Each new initiate injects huge chunks of capital into the system, many billions in lifetime value (e.g. when Microstrategy bought 125,000 BTC, now worth >$5B).

  3. It creates memes and marketing (e.g. when SBF rekt Coinmamba over $SOL at $3; when Su Zhu pumped/pumps $AVAX).

Three ways that institutional activity indirectly lifts crypto markets:

  1. Wild returns from market inefficiencies continue to lure the biggest IQs from TradFi to crypto (e.g. Jane Street = “HR department at FTX”?)

  2. Market makers continue to be the biggest bootstrappers of new DeFi projects (e.g. Alameda is the biggest liquidity provider for Serum, QCP is the biggest liquidity provider for Ribbon Finance)

  3. Funds trading market-neutral strategies (e.g. basis trade) must constantly borrow assets, pushing up lending rates which trickle down to retail in the form of “juicy yields.”

Since March 2020, Fed Chairman JPow has injected $5.4 trillion dollars of stimulus checks into circulation, ballooning M2 supply by 34%! That’s one-third of all US dollars in existence! Printed in the last 22 months! 🤯 🤯 🤯 The result?

Yield on stock market: 100%

Yield on Bitcoin: 400%

Yield on DeFi: 69420%

Ok fine JK on that DeFi number. But the point is: during COVID 2020, every DeFi project alive suddenly realized “Hey, I too can pull a JPow! I too can print magic Internet monies, call them ‘reward tokens’ in lieu of ‘stimmie checks,’ then give them out to users based on how much they use my product!!”

Yield as CAC (customer acquisition cost). What could go wrong?

Lending platform Compound Finance was one such pioneer in “liquidity mining,” i.e. rewarding liquidity providers/lenders and liquidity takers/borrowers with a new magic internet coin called $COMP. As the value of $COMP appreciated, the return on lending and borrowing (i.e. “yield”) rose dramatically. And differently for each underlier (e.g. ETH, DAI, WBTC, USDT, USDC) based on supply and demand so that users were incentivized to keep switching between borrowing and lending different tokens to optimize yield.

This was such a successful customer acquisition hack that suddenly every AMM and every lender started doing it.

That was when Yearn Finance created a smart aggregator of all other yielding platforms to take care of the fund routing optimization headache.

Once again it got too easy to make money.

DeFi degens started dumping out of staking and dumping into swap pools (why stake your $ETH for 7% APY when you could be making 50% on Yearn??). There was just no way to compete for users’ wallet share. And that’s when Lido Finance realized, “Why ask people to choose between staking and lending when you can tell them to do both! Let them have their cake and eat it too!” Lido then invented “liquid staking,” i.e. rewarding stakers with 1 stETH for every 1 ETH staked, such that users can then chuck their stETH as collateral for more borrowing and more lending.

What could possibly go wrong? As long as new stimmie-checks and institutional capital continue pouring into crypto, as long as inflation narratives keep driving the next marginal buyer into crypto, as long as markets remain greedy, nothing could go wrong. Just like, as long as the US dollar stays a reserve currency, nothing could go wrong. Keep printin’!

So after all that, where is DeFi headed now? What other unsolved problems–what other untapped growth hacks–remain on the yellow brick road to financial Emerald City?

  1. TradFi Distribution Channels:

The next 1 Billion users on DeFi will look nothing like the first 10 million early adopters. Crossing the chasm to onboard the “early majority” will require deeper integrations into traditional finance distribution channels: credit unions, traditional brokerages (e.g. Paxos-IBKR, Robinhood), 401-K and IRA plans (e.g. AltoIRA), modern wealth managers / robo advisors (e.g. Wealthfront and Betterment), expansion into non crypto-specific indices (e.g. ARKK), deeper inclusion into enterprise treasuries (beyond Microstrategy, Square, Tesla), etc.

  1. Prime Brokerage and Cross-Chain Margining for Retail:

DeFi today is notoriously capital-inefficient. If Alice buys 1 BTC long on Uniswap, and sells 1 BTCPERP short on FTX, the two platforms each don’t know about her positions on the other. So FTX will ask her to post much higher collateral than the correlation between BTC and BTCPERP necessitates. This sucks for Alice (and all retail traders who don’t have access to prime brokerage services) because she could otherwise use the excess collateral to earn yield elsewhere.

  1. Options Market:

Trading volumes for BTC and ETH options grew 443% in 2021, yet 95% of that volume remains on Deribit. Why? Until Pyth, Dexs could not auto-update margin requirements at a fast enough frequency to prevent systemic nonlinear liquidation events. Plus, protocol-level computational ceilings limited the ability to price-update across the full options chain (dozens of strikes and dozens of tenors per token). Furthermore, the crypto-degen appetite for 100x leverage had already found satiation in trading perps while up-only markets blinded even conservative traders from any region below Yreturn = 0. So the use case of options as hedging instruments and portfolio insurance largely fell on deaf ears. All of this should change in 2022.

  1. Crypto Exchanges Acquiring TradFi Brokers:

In traditional finance, broker-dealers are separate entities from exchanges. Operationally, they are the sales & marketing and customer acquisition arms of the exchanges. But in crypto, the trading stack is vertically integrated. (Imagine if Robinhood, Citadel, and BOX had a massive merger into one single behemoth… that’s basically FTX today.) It makes tons of strategic sense for the large crypto exchanges to go on massive shopping sprees and buy out TradFi broker dealers for (i) their retail customer base and (ii) their deep embeddings with corporate HR systems to deliver employee equity compensation (e.g. Schwab, Fidelity).

In the end, all arrows point to a DeFi <> TradFi convergence as we build upward and onward, standing on the scaffolds of old fiat market structure. “So we beat on, boats against the current, borne back ceaselessly into the past.”

Comment by Micheal M: I’ve read your articles but I still genuinely don’t understand what problem all this is meant to be solving. Integration into ‘TradFi’ just sounds like a way for the early adopters to keep the bottom from falling out of assets that will run out of buyers by entangling them so heavily in the regulated financial system that the government will be forced to buy digital currencies to protect regular citizens who have made ill-advised purchases. The ‘anarchy’ seems absolutely horrible for everyone except early adopters.

Zhao (2021) A DeFi crash course for normies: Crypto markets since 2017