Executive summary2020 so farDecentralised Finance (DeFi)Comparing ICOs and DeFi The current state of DeFi What is Yearn Finance?The journey so farRelative valuation of YFIDeFi beyond Yield farmingConclusion
Monday, 14 September, 2020
DeFi: What happens when the music stops?
In this digital investor, we examine the latest crypto market developments. We compare the 2017-2018 ICOs wave with the current DeFi wave and investigate the sustainability of the liquidity mining trend. Finally, we analyse Yearn Finance by calculating the relative valuation of Yearn Finance based on its price to earnings ratio.
2020 so far
While not yet complete, this year can already be classified as unexpected and surprising! It is unexpected because no one imagined that a novel virus would paralyse the global economy and lead to the greatest economic contraction on record. In the United States, GDP contracted by about one third (at an annualised rate) in Q2—more than in the darkest hours of the Global Financial Crisis. The US is just one example from a long list of economies that halted abruptly. This year is surprising because financial markets, particularly equity markets, have completely decoupled from the real economy. For example, it took only 5 months for the S&P 500 to recover entirely and to reach a new all-time high, while the real US economy remains oppressed and characterised by widespread unemployment and underemployment.
While the decoupling of financial markets and the economy is a topic in and of itself, this is not the one we discuss in this article. A remarkable development in the recent equity rally is the strength of the technology sector. For years, this sector has outperformed others, but this time it outstrips other sectors by a wide margin. Currently, the technology sector represents more than a quarter of the S&P 500 market capitalisation and is thus the largest sector of the index.
Thanks to the development of new services, Bitcoin, the most famous blockchain protocol and cryptocurrency, has gradually lost its dominance as measured by its current market capitalisation. Since the beginning of 2020, the bitcoin market share has declined by 9 percentage points to 57% today. This decline results from the ascendency of existing tokens and the arrival of new ones.
Decentralised Finance (DeFi)
Among the existing tokens, ether, the native currency of the Ethereum platform, on which most smart contracts are issued, has attracted international attention. The success of Decentralised Finance (DeFi) applications built on Ethereum has massively increased demand for this platform. To illustrate, the average block size doubledthis year from 20MB to about 40MB, and fees have multiplied by a factor of 10 (see Figure 1). Increasing demand has also substantially impacted ether’s price, and in June, it passed over $400 for the first time since the bull run of 2017-18.
Figure 1: ETH – Fee and block size
Source: SEBA Research
Concerning DeFi, we have observed two different adoption waves. The first wave consists of the explosion in stablecoin demand that occurred when the COVID crisis hit the financial market. The crypto dollar that benefited the most from the portfolio reallocation is the USD stablecoin Tether (USDT). USDT market capitalisation (i.e. the number of crypto dollars in circulation) increased from about $4.8bn pre-crisis to $13.7bn today (see Figure 2). Notice that USDT is issued on three platforms, but it is the Ethereum platform that has been used most frequently.
Figure 2: USDT stablecoin
Source: SEBA Research
The second wave of DeFi, more powerful than the previous, relates to yield farming, a broad group of activities that consists of borrowing and lending cryptocurrencies via dedicated Decentralised Finance applications. Therefore, we will compare ICOs and DeFi while keeping yield farming in mind.
Comparing ICOs and DeFi
Since DeFi is the catalyst for the general increase in cryptocurrency prices, it is also reminiscent of the ICO mania of 2017-18. In this section, we evaluate the similarities and differences between ICOs and DeFi.
Figure 3: Ethereum transaction fees
Source: SEBA Research
In comparison to ICOs, DeFi has an added governance feature, which can truly build community run protocols if used correctly. However, a new trend of yield farming has increased Ethereum usage and pushed gas prices higher, resulting in higher transaction costs. This prevents small investors from ‘earning’ new governance tokens. Though DeFi has improved certain practices, the current trend in DeFi is not sustainable in our view.
The current state of DeFi
Before we dive into why yield farming and its current pace are unsustainable, readers should be familiar with a few aspects.
The roots of the current environment can be traced to the emergence of Synthetix2 . Synthetix developed a way to distribute rewards to liquidity providers automatically, which became the basis for liquidity mining. Compound further championed the new form of token distribution.
Automatic distribution is important because governance tokens represent ownership of the protocol. Those who hold tokens can theoretically be stewards of the protocol.
After Compound began distributing COMP tokens in mid-July, many protocols began mimicking liquidity mining to distribute tokens.
Figure 4: How Liquidity Providers hop from one protocol to another
Source: SEBA Research
Whenever a protocol begins token distribution, early LPs (Liquidity Providers) often gain more rewards in APY (Annualised Percent Yield) terms, and the rewards decrease as more tokens enter circulation. LPs frequently sell their tokens on Uniswap, and when the rewards begin to fall, LPs move their liquidity to a newly launched protocol.
Gas fees have been pushed higher due to the increased usage of the Ethereum blockchain. A typical Ethereum transaction cost USD 8 at the market peak, and complex transactions involving un-staking or staking tokens to different liquidity pools cost more than USD 100. High Ethereum gas fees prevented small investors from rotating liquidity to maximise their yield. Instead, small investors bought new protocol tokens from Uniswap expecting that they would be able to sell much higher. Lower supply and liquidity pushed the prices higher. Some of the tokens jumped hundreds of percentages in one day, further incentivising farming these tokens. As old tokens appreciated in price, yield farmers sold old tokens for massive gains and began to farm new tokens that offered higher APYs.
Yield farmers made money by hopping from one protocol to another. As long as there are buyers for new protocol tokens, yield farmers can continue jumping among protocols. When buyers stop accepting the other side of the trade, this deranged activity will be arrested. Clearly, this trend is not sustainable3. A significant correction in markets will stop buyers from buying tokens from new forks that are not distinct from their predecessors and thus have no defensibility.
Does this mean that all the yield farming is manic and lacks merit? Absolutely not. One example we want to stress in this article is Yearn Finance. Yearn Finance distributes its token, YFI, through liquidity mining. Yearn is not a direct fork of any other protocol and has a distinct value proposition.
What is Yearn Finance?
In the simplest form, Yearn Finance automates yields for protocol users. One can think of it as a smart savings account. For traditional investors, it helps to think of the following analogy: Yearn Finance is a protocol that rests on top of a banking layer and switches deposits to the bank that offers the highest deposit rates.
Yearn was built by Andre Cronje as iEarn. While managing stablecoins for friends and family, Andre decided to automate it using on-chain oracles and smart contracts.
Though Yearn Finance offers a wide range of products, the most relevant for our discussion are vaults. Vaults implement strategies that fetch the best yield. There are two types of vaults: yVaults and Delegated yVaults. yVaults are simply yToken4 containers. Delegated vaults allow users to maintain exposure to an asset and use vault strategies to earn a yield. For example, the delegated Link vault allows users to lock LINK on Aave and authorise it to be used as collateral. Yearn borrows stablecoins against LINK collateral based on health factors, and stablecoins earned beyond the loan value are used to purchase LINK, which is then added to the vault, thereby increasing the yield.
Anyone can propose a strategy for the vault, and if approved by the governance, the proposer receives 5% of the profits generated from the strategy.
All system-generated rewards are directed into a multisig treasury5. The treasury always maintains a buffer of USD 500,000 for operational expenses, and the remaining funds are distributed to YFI staked in the governance pool. The multisig treasury activity can be monitored hereherelink1.
The journey so far
The governance token of Yearn Finance (YFI) was launched in mid-July, and the founder did not allocate any tokens to himself. After he announced the token, the founder began yield farming. This strategy makes the YFI launch the fairest launch since bitcoin. At the beginning, only 30,000 YFI were minted. The community approved Proposal 0Proposal 0link1, which argued to allow more YFI minting to create ongoing incentives for the LPs. However, at the moment, the community does not agree that there is dire need to mint more YFI.
With limited supply and high usage, YFI price skyrocketed from USD 32 to a high of approximately USD 39,000, despite Andre’s assertion that it has zero value. However, we believe that YFI must have significant value for the platform to function the way it is intended.
At the time of writing, Yearn Finance has USD 1.18 billionUSD 1.18 billionlink1 of value locked, of which approximately 32% is locked in the vaults. As stated previously, vault strategies can be proposed by anyone. The fate of USD 432 million is decided by YFI holders. If the price of YFI is low, an attacker could acquire significant supply and then propose and approve a strategy that is detrimental to vaults. Therefore, the barrier to vault entry should be high, and the only way to maintain this barrier is through high YFI price.
Relative valuation of YFI
Figure 5: Annualised earnings of protocols
Source: SEBA Research
In less than two months, Yearn Finance has generated approximately USD 1 million in profits. Given the pace at which Yearn is developing new products, it is not unreasonable to expect that it will at least maintain the current run-rate.
DeFi beyond Yield farming
Finally, in addition to the rise of DeFi applications that have benefited existing cryptocurrencies, new projects have been launched. Among the most notable launches, we find new platforms, such as Polkadot and Cosmos, that may offer more flexibility than the incumbent Ethereum platform because they create the basis for the interoperability of blockchains (i.e. they allow different blockchains to speak to each other).
In addition to interoperability, oracle projects also complement the digital ecosystem. Oracles gather and verify information available on the internet of information and the internet of things so that the internet of value can use it. For example, a smart contract that consists of a bet on whether team A or B will win the next game must read the final score somewhere on a website (internet of information). There is a risk that the website in question has been hacked or mistakenly reports the wrong winning team. To mitigate this risk, oracle solutions aggregate information from multiple information providers and give a single and consistent piece of information to the smart contract.
Although the example above does not fully represent the significance of oracles, imagine how many insurance products and investment solutions depend on simple and observable triggers. Many of these projects could be fully digitised in smart contracts if the trigger could be reliably observed.
DeFi has been yet another interesting experiment in token design and governance of open source protocols. DeFi has also provided impetus to other sectors such as oracles and insurance.
The liquidity mining trend is not sustainable and may end with a bust that will decimate most of the newly forked protocols. However, just as a few ICOs survived the test of time, we think that DeFi protocols that add genuine value, such as Yearn Finance, will continue to thrive.
1We are not suggesting that all the yield farming tokens have a moat and their use is warranted. We are simply stating the fact that these tokens immediately find their use somewhere. ↵
2Synthetix is a platform that enables the creation of on-chain synthetic assets such as commodities, equities, etc. ↵
3An example of this is Sushiswap and its derivatives. Sushiswap is a fork of Uniswap with one significant improvement. Uniswap does not have a token and the fees do not go to users. Sushiswap added a token, SUSHI, and decided to distribute the fees to token holders. Sushiswap was further forked into Y U No, Kimchi, Hotdog, etc. (these are real fork names). When markets took a bad turn, all except SUSHI corrected by more than 99% and became almost worthless. ↵
4yToken is similar to c-Token of Compound and a-Token of Aave. It can be thought of as a receipt that contains information about the user’s deposits and then tracks the user’s share of the growing pool. ↵
5A multisig (multi-signature) treasury is controlled by multiple holders. Typical implementation of multi-sig is m of n signatures. For example, 3 of 5 signatures are needed to execute a transaction. ↵
Subscribe to the research newsletter and get weekly updates about the latest articles of SEBAresearch
Subscribe to newsletter↓
This document has been prepared by SEBA Bank AG (“SEBA”) in Switzerland. SEBA is a Swiss bank and securities dealer with its head office and legal domicile in Switzerland. It is authorized and regulated by the Swiss Financial Market Supervisory Authority (FINMA). This document is published solely for information purposes; it is not an advertisement nor is it a solicitation or an offer to buy or sell any financial investment or to participate in any particular investment strategy. This document is for distribution only under such circumstances as may be permitted by applicable law. It is not directed to, or intended for distribution to or use by, any person or entity who is a citizen or resident of or located in any locality, state, country or other jurisdiction where such distribution, publication, availability or use would be contrary to law or regulation or would subject SEBA to any registration or licensing requirement within such jurisdiction.
No representation or warranty, either express or implied, is provided in relation to the accuracy, completeness or reliability of the information contained in this document, except with respect to information concerning SEBA. The information is not intended to be a complete statement or summary of the financial investments, markets or developments referred to in the document. SEBA does not undertake to update or keep current the information. Any statements contained in this document attributed to a third party represent SEBA's interpretation of the data, information and/or opinions provided by that third party either publicly or through a subscription service, and such use and interpretation have not been reviewed by the third party.
Any prices stated in this document are for information purposes only and do not represent valuations for individual investments. There is no representation that any transaction can or could have been effected at those prices, and any prices do not necessarily reflect SEBA’s internal books and records or theoretical model-based valuations and may be based on certain assumptions. Different assumptions by SEBA or any other source may yield substantially different results.
Nothing in this document constitutes a representation that any investment strategy or investment is suitable or appropriate to an investor’s individual circumstances or otherwise constitutes a personal recommendation. Investments involve risks, and investors should exercise prudence and their own judgment in making their investment decisions. Financial investments described in the document may not be eligible for sale in all jurisdictions or to certain categories of investors. Certain services and products are subject to legal restrictions and cannot be offered on an unrestricted basis to certain investors. Recipients are therefore asked to consult the restrictions relating to investments, products or services for further information. Furthermore, recipients may consult their legal/tax advisors should they require any clarifications. SEBA and any of its directors or employees may be entitled at any time to hold long or short positions in investments, carry out transactions involving relevant investments in the capacity of principal or agent, or provide any other services or have officers, who serve as directors, either to/for the issuer, the investment itself or to/for any company commercially or financially affiliated to such investment.
At any time, investment decisions (including whether to buy, sell or hold investments) made by SEBA and its employees may differ from or be contrary to the opinions expressed in SEBA research publications.
Some investments may not be readily realizable since the market is illiquid and therefore valuing the investment and identifying the risk to which you are exposed may be difficult to quantify. Investing in digital assets including cryptocurrencies as well as in futures and options is not suitable for every investor as there is a substantial risk of loss, and losses in excess of an initial investment may under certain circumstances occur. The value of any investment or income may go down as well as up, and investors may not get back the full amount invested. Past performance of an investment is no guarantee for its future performance. Additional information will be made available upon request. Some investments may be subject to sudden and large falls in value and on realization you may receive back less than you invested or may be required to pay more. Changes in foreign exchange rates may have an adverse effect on the price, value or income of an investment. Tax treatment depends on the individual circumstances and may be subject to change in the future.
SEBA does not provide legal or tax advice and makes no representations as to the tax treatment of assets or the investment returns thereon both in general or with reference to specific investor’s circumstances and needs. We are of necessity unable to take into account the particular investment objectives, financial situation and needs of individual investors and we would recommend that you take financial and/or tax advice as to the implications (including tax) prior to investing. Neither SEBA nor any of its directors, employees or agents accepts any liability for any loss (including investment loss) or damage arising out of the use of all or any of the Information provided in the document.
This document may not be reproduced or copies circulated without prior authority of SEBA. Unless otherwise agreed in writing SEBA expressly prohibits the distribution and transfer of this document to third parties for any reason. SEBA accepts no liability whatsoever for any claims or lawsuits from any third parties arising from the use or distribution of this document.
Research will initiate, update and cease coverage solely at the discretion of SEBA. The information contained in this document is based on numerous assumptions. Different assumptions could result in materially different results. SEBA may use research input provided by analysts employed by its affiliate B&B Analytics Private Limited, Mumbai. The analyst(s) responsible for the preparation of this document may interact with trading desk personnel, sales personnel and other parties for the purpose of gathering, applying and interpreting market information The compensation of the analyst who prepared this document is determined exclusively by SEBA.
Austria: SEBA is not licensed to conduct banking and financial activities in Austria nor is SEBA supervised by the Austrian Financial Market Authority (Finanzmarktaufsicht), to which this document has not been submitted for approval. France: SEBA is not licensed to conduct banking and financial activities in France nor is SEBA supervised by French banking and financial authorities. Italy: SEBA is not licensed to conduct banking and financial activities in Italy nor is SEBA supervised by the Bank of Italy (Banca d’Italia) and the Italian Financial Markets Supervisory Authority (CONSOB - Commissione Nazionale per le Società e la Borsa), to which this document has not been submitted for approval. Germany: SEBA is not licensed to conduct banking and financial activities in Germany nor is SEBA supervised by the German Federal Financial Services Supervisory Authority (Bundesanstalt für Finanzdienstleistungsaufsicht), to which this document has not been submitted for approval. Hong-Kong: SEBA is not licensed to conduct banking and financial activities in Hong-Kong nor is SEBA supervised by banking and financial authorities in Hong-Kong, to which this document has not been submitted for approval. This document is not directed to, or intended for distribution to or use by, any person or entity who is a citizen or resident of or located in Hong-Kong where such distribution, publication, availability or use would be contrary to law or regulation or would subject SEBA to any registration or licensing requirement within such jurisdiction. This document is under no circumstances directed to, or intended for distribution, publication to or use by, persons who are not “professional investors” within the meaning of the Securities and Futures Ordinance (Chapter 571 of the Laws of Hong Kong) and any rules made thereunder (the “SFO”). Netherlands: This publication has been produced by SEBA, which is not authorised to provide regulated services in the Netherlands. Portugal: SEBA is not licensed to conduct banking and financial activities in Portugal nor is SEBA supervised by the Portuguese regulators Bank of Portugal “Banco de Portugal” and Portuguese Securities Exchange Commission “Comissao do Mercado de Valores Mobiliarios”. Singapore: SEBA is not licensed to conduct banking and financial activities in SIngapore nor is SEBA supervised by banking and financial authorities in Singapore, to which this document has not been submitted for approval. This document was provided to you as a result of a request received by SEBA from you and/or persons entitled to make the request on your behalf. Should you have received the document erroneously, SEBA asks that you kindly destroy/delete it and inform SEBA immediately. This document is not directed to, or intended for distribution to or use by, any person or entity who is a citizen or resident of or located in Singapore where such distribution, publication, availability or use would be contrary to law or regulation or would subject SEBA to any registration or licensing requirement within such jurisdiction. This document is under no circumstances directed to, or intended for distribution, publication to or use by, persons who are not accredited investors, expert investors or institutional investors as defined in section 4A of the Securities and Futures Act (Cap. 289 of Singapore) (“SFA”). UK: This document has been prepared by SEBA Bank AG (“SEBA”) in Switzerland. SEBA is a Swiss bank and securities dealer with its head office and legal domicile in Switzerland. It is authorized and regulated by the Swiss Financial Market Supervisory Authority (FINMA). This document is for your information only and is not intended as an offer, or a solicitation of an offer, to buy or sell any investment or other specific product.
SEBA is not an authorised person for purposes of the Financial Services and Markets Act (FSMA), and accordingly, any information if deemed a financial promotion is provided only to persons in the UK reasonably believed to be of a kind to whom promotions may be communicated by an unauthorised person pursuant to an exemption under the FSMA (Financial Promotion) Order 2005 (the “FPO”). Such persons include: (a) persons having professional experience in matters relating to investments (“Investment Professionals”) and (b) high net worth bodies corporate, partnerships, unincorporated associations, trusts, etc. falling within Article 49 of the FPO (“High Net Worth Businesses”). High Net Worth Businesses include: (i) a corporation which has called-up share capital or net assets of at least £5 million or is a member of a group in which includes a company with called-up share capital or net assets of at least £5 million (but where the corporation has more than 20 shareholders or it is a subsidiary of a company with more than 20 shareholders, the £5 million share capital / net assets requirement is reduced to £500,000); (ii) a partnership or unincorporated association with net assets of at least £5 million and (iii) a trustee of a trust which has had gross assets (i.e. total assets held before deduction of any liabilities) of at least £10 million at any time within the year preceding the promotion. Any financial promotion information is available only to such persons, and persons of any other description in the UK may not rely on the information in it. Most of the protections provided by the UK regulatory system, and compensation under the UK Financial Services Compensation Scheme, will not be available.
© SEBA / Kolinplatz 15, 6300 Zug, Switzerland
Join us as we