MEV as a topic has had a decently large following in crypto since last year when it really started to come out of the dark; however, of course, MEV has been around for a lot longer than that. There is its long history in crypto, but also, as an abstracted concept, its much longer history in traditional finance. Given that history, the intellectually stimulating discussions around MEV, and the alluring monetary rewards, there have been several thoughtful research papers, posts, podcasts, and threads authored on the subject. I have found repositories like these helpful in aggregating such reading material. Now with all this out there, why should I offer a written piece as well? After all, it would be inefficient to summarize one of those arguments when the authors in this space tend to have a solid grasp of the subject and some impressive qualifications. That being said, I’d like to talk about MEV as it is seen from a supply chain analysis standpoint, hopefully offering something more unique than the average MEV piece. I believe that understanding MEV through this lens unlocks some interesting future scenarios and key questions, which as an investor in the space, can be valuable to constructing theses.

Supply Chains and Thesis Construction

At a very high level, one can construct a thesis using a bottoms-up or top-down framework. These are not mutually exclusive. In fact, it is nice when both make sense: the best company with solid idiosyncratic strengths operating in an appealing, high growth, rich TAM sector. As it pertains to this post, supply chain (or value chain) analysis would fall in the top-down thesis category.

When building theses, I’ve found that looking at the different parts of a supply chain can provide some clues as to which sectors in the chain are value saps and which are commoditized. If the value saps possess means of defensibility / moat building, then this can be a very attractive area to look for investment opportunities. One of the easiest clues is concentration among the steps of a supply chain — which regions have several providers, which only have a couple? Taking this further, it is not just the analysis of the interlinked sectors that is valuable, but it is also the analysis of how these sectors interact. Interactions alongside stand-still qualities will drive the long-term evolution of the supply chain. What are the pricing arrangements? How does information and value flow? A lot can be gleamed from answering these types of questions.

When I think about MEV, I think about a supply chain. From transaction origination to transaction inclusion in the block, there are several parties that play a role in the journey of a transaction. Thinking through each of these players and how they interact with each other can lead to some interesting observations.

The MEV Supply Chain

Using a diagram from a Flashbots MEV-boost post, let’s walk through each of the players within a supply chain:

• User — the individual or entity which does something on-chain that is represented through a transaction

• Wallet / CEX — often the first touch point of the transaction the user emits as they attempt to do something on-chain

• dApp / smart contracts — many times, the protocol the user is trying to do something with. The transaction may be interacting with an element of the protocol (i.e., liquidity or lending pool)

• Relay — the piping for transaction flow. These can deliver a transaction from a source to a builder, a searcher to a builder, a design from a builder to a proposer, etc.

• Searcher — typically a bot (developed by an individual or entity) that takes transactions it has access to and bundles them up with some of their own transactions to capture a profit (frontrun, sandwich attack, liquidation, etc.)

• Block builder — *post ETH 2.0*, this entity takes a bunch of transactions and/or bundles and, using algorithms, designs a block that is then submitted to a validator (note PBS will be introducing some pertinent changes to how this role interacts with a validator)

• Validator (or proposer) — this used to be the miner pre-ETH 2.0. An entity or user that stakes 32 ETH and runs client software which gives it a slot to add a block to the chain (economically incentivized to act accordingly via their stake)

At a high level, it might also be interesting to define what drives competitive advantages in each (excluding the user):

• Wallet / CEX — user count and integrations propagate aggregator economics, which lends to significant opportunities to add services and/or further control the user experience. In the context of MEV, large wallet providers and exchanges are capable of routing user transaction order flow through their own infrastructure, which could be monetized directly via selling the order flow to block builders / relays or less directly via coming to a sizable revenue split (of MEV profits) with a block builder / relay

• dApp — usage and control over its infrastructure configure its odds of being able to profit from MEV. To the extent it can control order routing (say via permissions through the frontend), it could, for example, route transactions through its own relays and obtain an MEV profit split with a builder or route transactions via partner infrastructure, which executes MEV operations and returns a share of the profits

• Relay — the piping benefits significantly to the extent order flow becomes exclusive. Additionally, there are network effects for relays and builders in the sense that the more transactions successfully go through a relay / builder into a block, the more other transactions are likely to be routed there. This makes the relay / builder more valuable over time and further cements its ability to build the blocks that end up being included on-chain (potential flywheel at play)

• Searcher — a competitive market, these players benefit from edge, which can arise through tools and infrastructure, access to private transaction sources, and colocation (to increase the speed of receiving transactions and getting bundles through to builders)

• Block builder — block building algorithms, hardware, and transaction sources come together to define how valuable produced blocks are. Over time, this role could lead to barriers to entry, with sophisticated hardware, evolving algorithms, and exclusive order flow agreements making it hard for new entrants to build as profitable blocks as incumbents. Differentiation in blocks aside from price are to be rendered pretty futile post PBS implementation (censorship, however, is an interesting topic in the meantime here)

• Validator — in terms of an individual validator, ETH 2.0 has changed the game and made block proposing much more accessible. With PBS (and the current MEV-boost infrastructure), the validator does not need to know much about MEV and can just select the block with the highest bid. Thus, there is little competitive advantage. However, in terms of collective validator organizations / networks, some interesting questions around competition and bargaining power emerge

Pushing and Pulling: Validators vs. Block builders

A fascinating part of this MEV supply chain to ponder about is the final link between validator networks and builders. Consolidation on both ends is possible. Barriers to entry, mutual exclusivity, and virtuous cycle mechanics drive it for block builders. Validator share, LSD liquidity / integrations / composability, brand moats, and also some virtuous cycle mechanics drive it for validators.

Thus, one will see the shifting of bargaining power between these two sectors as consolidation forces evolve over time. Stronger block builders could demand a larger share of the MEV profits from validators and validator networks, reducing staked ETH APY and the Ethereum economy’s native yield. Dominating validator networks would be able to push back and use their validator share to ensure that block builders give them a fair split of the MEV profits. Should they choose not to, they can just accept a block design from another builder (note, PBS could make things a bit different here).

Similar dynamics have played out in the past, a very relatable one being in the computer stack. Chips and computer hardware providers had certain periods of increased and decreased concentration, however, it was concentration that was more sustained on the chip side, which eventually led to a killer company in Intel and several hardware manufactures losing margin year after year as their bargaining power dwindled. Moreover, Intel even allocated capital to funding open-source hardware development, strategically forcing the commoditization and reduction in bargaining power of its supply chain neighbor.

Could the space one day see a large validator network use its treasury to support a new block building operation? This could be the case, both in terms of following Intel’s strategy with open source hardware development, but also in terms of backwards integration, which has dynamics of its own. The bottom line here is that both the block builder and validator sectors in the supply chain have some strong characteristics to their names. Operating in a chain where finite MEV can only be split so many ways will most likely lead to forms of strategic conflict and maneuvers on each end. Thus, tracking the drivers of competitive advantage, the relative concentration in each supply chain step, and strategic developments will be imperative for understanding where the value will flow.

Upstream vs. Downstream

Zooming out, I’d like to take the 2D supply chain diagram and make it 3D, with some inspiration from a stream descending downwards — this is the MEV supply chain. At its most basic level, MEV starts with user transactions (the source of the stream) and comes to fruition on the blockchain (the ocean). Just like with streams, rivers, and other waterways, diverting the valuable substance upstream carries effects on the quantity and quality of the water downstream.

Overtime, with MEV becoming better understood and the quantum of it becoming higher and higher (as more value comes on-chain), the space will see more initiatives at the user, protocol, wallet, and L2 levels to either reduce MEV (providing consumer surplus to the user) or capture MEV (as a revenue source for the protocol or serving as kickback to the user). This hasn’t predominantly been the case yet, however, several changes are becoming apparent:

• Protocols that partner with users: Over the last 1.5 years we have seen growth in the teams forming and methods being designed to help protocols (and consequently their users) retain more of the MEV profits. Especially last year (different market environment as well as state of infrastructure), so much money was ‘being left on the table’ per se, with users and their apps losing out to bots, MEV operations, and miners. This consumer or producer surplus was not being captured and thus a market opportunity emerged to help protocols capture this. Several projects arose with the goal of building infra that works with protocols to run transactions through private relays, capture some of the MEV, share it with builders, and then route back a portion of the MEV to the protocol (while keeping the remaining amount as a profit). This profit routed back could serve as protocol earnings or user kickbacks. Should this trend continue to proliferate, we would be witnessing the drying up of MEV profits downstream (searchers, relayers / builders, validators), which could lead to very interesting knock-on effects. One thing is clear, however — there is a fair argument that the user could benefit a lot more from progress with this trend

• L2s: the increasing relevance of L2s as sources of crypto transactions presents a similar shift to the prior point, with L2 networks being presented with the opportunity to retain more of the MEV profits for either the benefit of their users or their own income. This is not a novel statement — L2 teams have been open about MEV and what they could do with it. There is the FIFO / FCFS approach for decentralized sequencers. This would reduce frontrunning but could lead to spam proliferation as parties such as searchers try to be first or to increases in colocation benefits. There is the verifiable delay function (VDF), which obscures transaction data for a set amount of time, revealing it after being sequenced. And there are concepts like threshold encryption, which hide transaction details from validators. Put together, the three mentioned carry the same effect of : (-) MEV profit, (+) UX / consumer surplus. On another side, there is also the opportunity for other L2s to monetize MEV and use that for public goods funding or their own native staking yields

• App-chains: In a similar camp to L2s, app-chains represent a drain of MEV profits away from validators and builders; however, it must be specified that these would be away from Ethereum validators and other supply chain participants. An app-chain would have its own validators (and other participants) and local MEV profits would be split among those participants. The app-chain trend becomes important in the case of Ethereum MEV analysis as it represents both a loss of future MEV profits (should a powerful Ethereum app chose to move over to its own chain) as well as a loss of what could have been MEV profits (should an app that would have otherwise been on Ethereum launch on its own chain). Note, this also sparks some interesting discussions around the value of native network tokens (both in the case of ETH and in the case of the one launching the app chain)

Conclusion

There are plenty of other theses to dive into as it pertains to the MEV supply chain (i.e., cross-chain MEV), however, these are still under development (perhaps a topic for a future post). From a first principles basis, MEV is a ‘must’ as a sector to pay attention to. It is integral to the functioning of blockchains, more so fluid than static in terms of evolution, and has the potential to grow in value (in aggregate) as crypto economies scale. With this in mind, the state of its supply chain is something to be cognizant of as it can provide some worthy insights into where some great startups might evolve from.

Disclosure:* This blog series is strictly personal/ educational and is not investment advice nor a solicitation to buy or sell any assets. It does not represent any views from where the author is working — all views, opinions, and arguments are the author’s. Please always do your own research.*

So, first of all, what is cloud infrastructure? Leveraging VMware’s glossary,

Cloud computing infrastructure is the collection of hardware and software elements needed to enable cloud computing. It includes computing power, networking, and storage, as well as an interface for users to access their virtualized resources. The virtual resources mirror a physical infrastructure, with components like servers, network switches, memory and storage clusters. (Link)

Taking from this and watering it down even more, you have a bundle of computing power, networking, and storage packaged in a virtual format that replicates all these components a business would (both physically and virtually) need to run most its tech infrastructure. Sounds very similar to the watered-down version of the services we describe blockchains like Ethereum providing — trustless (financial) networking, storage, and computing (powering dApps and services). With these general purpose technologies having similar abstract bases, there could be some fascinating portability from the cloud’s evolution to the future of blockchain.

In this post, I articulate a four-legged thesis on the potential shaping of the blockchain world based off the current evolution of the cloud.

Primo

What exactly does cloud infrastructure do for business? Well, there are several facets to answering that question and I’ll only mention a couple of the more important ones. Firstly, the cloud, and accompanying SaaS tools that immensely leveraged it, reduced the barriers to starting a business. Before true compute and storage outsourcing, internet-enabled companies had to have all sorts of hardware, systems, and large IT departments to scale. Capital, time, and human resources were all needed to keep a business online. This has changed significantly; although, server crashes and IT barriers still occur with the cloud, yet not nearly to the same extent as before. Today, businesses can scale much more efficiently, rapidly, and with less CAPEX (switches costs from a BS item to an IS item).

Shifting gears, let’s look at blockchain. Ethereum and the likes allow for scaling financial primitives, in-app economies / ecosystems, and communities in a much more efficient manner. While we may be in the early days of crypto, there have been glimpses of what the power of smart contracts and trustless ledgers mean for scalability. Look no further at DeFi, which can manage billions in a streamlined way with little overhead and a small group of developers. There is also the future of gaming — an in-game economy built on blockchain technology integrated seamlessly with payments and asset interoperability. And, finally, what about the potential to take business further by enabling micro-payments, rewards systems, and portable social graphs?

Both cloud infrastructure and blockchain enable scalability. Today, when you build an application, you don’t need to know much about infrastructure, hardware, and network protocols. Tomorrow, when you build an application, you won’t need to know much about financial systems, monetization, asset flows, and more.

Secondo

Time to reintroduce the Fat Protocol thesis, which I have mentioned in a couple of prior posts. Popularized by Joel Monegro and the USV crypto team, this thesis reasoned that in a blockchain world, protocols and not applications would accrue most of the value. In the internet stack, key protocols (HTTP, SMTP, TCP / IP) generated immense amounts of value which was mostly captured and aggregated in the application layer (i.e. Facebook, Netflix, Google’s search engine). However, in the blockchain stack, the thesis argues that the protocols should accrue most of the value generated due to the benefits of a shared data layer and native token flywheel effects.

When I look at a cloud-enabled stack, I see it as an exception to the internet stack described by USV above. While I generally think their framework applies to the best internet businesses, many businesses residing on top of the cloud actually have pretty poor value accrual mechanics compared to the cloud companies below. Thus, I believe that the public cloud stack sees similar value accrual mechanics to a fat protocol world.

Prior to the SaaS era, software would be developed and physically shipped (if you are not that young, you may recall buying software in boxes at stores) with gross margins standing very high (75%+). COGS were pretty minimal and there was this fascinating J-curve associated with the fixed cost nature of software development but low-cost nature of its replication. This does still apply to many top-notch SaaS companies today, however, this fails to be the case for all the others. According to Martin Casado (GP at a16z and digital infrastructure investor), several companies out there have product lines with 0% margins “because all of the money goes back to the cloud services [they’re] hosted on” (link). He says it best: these companies are just “reselling a thin layer” on top of the cloud layer. Does ‘thin layer’ sound familiar?

Not only do cloud providers exhibit a value accruing nature, but (partially because of it) they also exhibit an oligopolistic market structure. They’re exposed to so many elements that go into building moats and virtuous cycles that it makes a lot of sense: economies of scale, cross-product subsidization, knowledge moats and knowledge compounding, brand moats, and so on.

Thinking about L1 blockchains (Bitcoin aside, looking more at Ethereum, EVMs and Alt-L1s), I’d reason that a similar market structure could evolve for serving general purpose economic needs. These blockchains benefit from network effects, knowledge / capabilities compounding, security moats, and other virtuous cycle elements which should shape a concentrated market.

Now, does that mean there will only be a couple of blockchains? No, I think there is some interesting logic to say otherwise.

Terzo

Enter the app-specific chains. In late June, dydx, a leading DeFi exchange protocol, announced that its v4 would be developed as a standalone chain in the Cosmos ecosystem. While there have been other instances of this in the past, this one really brought the app-specific chain vs. generalized blockchain discussion to light.

Why would it make sense for dydx to make this move? At a high level, it revolves around optimization and enhanced use of blocks. With its own chain secured by the DYDX token, all blocks will be for the purpose of the exchange and certain parameters and functionalities can be designed in order to significantly enhance the trading experience (vs a DEX on a generalized blockchain).

Shifting to the cloud landscape, there is a general view that all the big firms are on one of the three main cloud platforms. That is actually not the case. Bringing back Mr. Casado, he discussed this on a podcast with investor Patrick O’Shaughnessy, using Dropbox as a focal example. Dropbox, one of the leading file sharing and storage software solutions, used to use AWS S3 for its core operations. However, after some time, it transitioned several key workloads over to its own internal infrastructure. This infrastructure was directly optimized for their use case, and the benefits of the optimization along with the saved S3 costs more than covered the capital needed to invest in and maintain their internal infrastructure. Casado further elaborates on moves such as these while laying out his Vertical Cloud thesis in this blog post (suggest a read). From large, centralized clouds, Casado sees several workloads being shifted over to specialized clouds. The paragraph that captures it all is the following:

And so, in many ways, we’re entering a new and incredibly exciting era of infrastructure, in which any infrastructure service (and really any common sub-component of an application) is fair game to build a company around as a verticalized cloud. The better you are at building the infrastructure, the better the service will be. And because the market is large enough to sustain this, the large central clouds are structurally disadvantaged to compete. The primary question to startups in infrastructure has ironically shifted from “what if AWS/GCP/Azure decides to compete with you?” to “why aren’t you competing more directly with AWS/GCP/Azure?”

Does every business, SaaS company, website need its own cloud? No, and thus, the main cloud providers are not going anywhere. It just doesn’t make sense for everyone. Shifting back to crypto, I ask the same question and sense the same answer. Not every DeFi protocol, NFT tool, social dApp needs its own chain. However, for some lower-stack protocols with heavy blockchain interaction and specialized needs, it could make a lot of sense.

Quarto

Looking at the future of blockchains and crypto, I see a world somewhat mapping the evolution of cloud infrastructure. Firstly, blockchains will add significant infrastructure-driven capabilities and enable scalability improvements. Secondly, core blockchain native tokens should accrue a notable portion of the value generated relative to the ecosystems on top. Thirdly, and somewhat importantly, the future will be occupied by multiple blockchains — some large, secure, and generalized, while others will be specialized and app-specific. I struggle with maximalism making sense. The blockchain future will be much more dynamic.

Conclusion

As always, it is prudent to add a dose of skepticism and continuously stress test one’s theses. Could network effects prove too strong with L1s? What about app-specific L2s or L3s (a la fractal scaling)? Will the fat protocol thesis fall short?

I’ll end this post by saying that trends in infrastructure all have their own profiles, however, when it comes to general purpose technology infrastructure (i.e., the electrical grid, cloud, blockchain) I wonder if Mark Twain’s phrase on history rhyming carries more weight than usual.

Disclosure:* This blog series is strictly personal/ educational and is not investment advice nor a solicitation to buy or sell any assets. It does not represent any views from where the author is working — all views, opinions, and arguments are the author’s. Please always do your own research.*

What can you learn from a person who built one of the largest, most innovative, and dominant companies in American history? Frankly, way too much to cover in one written piece like this; however, after spending the afternoon reading through each and every one of Jeff Bezos’ annual shareholder letters, I could not help but share some snippets (sentences, paragraphs, events) that stood out. Below, you’ll find pieces of wisdom and advice from each of his letters spanning the years 1997 to 2020 (his last one).

I would like for the post to mainly reflect Bezos’ writing, and thus I’ll keep my commentary to a minimum. That being said, I would like to highlight one fascinating duality that stood out to me through reading all these letters back to back (which I recommend is the best way to do it). Across the letters there was an interplay between evolution and constants. By evolution, not only do I refer to the flourishing of Amazon as a business and stakeholder in the global economy, but also to Jeff as a founder and leader. The letters overall trended from being focused on business updates (with some small snippets on values) to core emphasis on key business lines and their virtuous cycle interplay (with more knowledge and best practice sharing) to the teachings of philosophy, culture, and meaning. However, alongside this evolution, there were also constants — the values that Amazon and Bezos centered on: relentless customer focus, long-term thinking, courage to take chances, and never forgetting that it is still Day 1.

Hopefully you enjoy them like I did.

1997

“We will continue to focus on hiring and retaining versatile and talented employees, and continue to weight their compensation to stock options rather than cash. We know our success will be largely affected by our ability to attract and retain a motivated employee base, each of whom must think like, and therefore must actually be, an owner.”

“To be certain, a big part of the challenge for us will lie not in finding new ways to expand our business, but in prioritizing our investments.”

1998

Cultivating a culture that does not rest on its laurels, that has relentless customer focus.

“But there is no rest for the weary. I constantly remind our employees to be afraid, to wake up every morning terrified. Not of our competition, but of our customers. Our customers have made our business what it is, they are the ones with whom we have a relationship, and they are the ones to whom we owe a great obligation.”

1999

The concept of creating the Amazon virtuous cycle is integral to their long-term strategy. The interplay between their components allows for cross-subsidization, long-term decision making, and leading customer satisfaction, among other things.

“So, as we expand our offering, we create a virtuous cycle for the whole business. The more frequently customers visit our store, the less time, energy, and marketing investment is required to get them to come back again. In sight, in mind.”

Reads a lot like blockchain to me…

“We are doubly-blessed. We have a market-size unconstrained opportunity in an area where the underlying foundational technology we employ improves every day. That is not normal.”

2000

I found this year’s letter particularly relevant to the tech market environment today. Impressive to see Bezos’ thinking in those times (the letter was written in 2001 for the year of 2000).

“Ouch. It’s been a brutal year for many in the capital markets and certainly for Amazon.com shareholders. As of this writing, our shares are down more than 80% from when I wrote you last year. Nevertheless, by almost any measure, Amazon.com the company is in a stronger position now than at any time in its past.”

Investor humility and admission of some bull market mistakes. Very pertinent to today. The “land rush” metaphor is similar to the rush experienced in 2021.

“Many of you have heard me talk about the ‘‘bold bets’’ that we as a company have made and will continue to make — these bold bets have included everything from our investment in digital and wireless technologies, to our decision to invest in smaller e-commerce companies, including living.com and Pets.com, both of which shut down operations in 2000. We were significant shareholders in both and lost a significant amount of money on both. We made these investments because we knew we wouldn’t ourselves be entering these particular categories any time soon, and we believed passionately in the ‘‘land rush’’ metaphor for the Internet. Indeed, that metaphor was an extraordinarily useful decision aid for several years starting in 1994, but we now believe its usefulness largely faded away over the last couple of years. In retrospect, we significantly underestimated how much time would be available to enter these categories and underestimated how difficult it would be for single-category e-commerce companies to achieve the scale necessary to succeed.”

Queue in Gate’s Law: “Most people overestimate what they can achieve in a year and underestimate what they can achieve in ten years.” Even the best do it…

“We still believe that some 15% of retail commerce may ultimately move online.”

2001

Alongside cashflows, shares outstanding is the second pillar of creating shareholder value.

“Limiting share count means more cash flow per share and more long-term value for owners. Our current objective is to target net dilution from employee stock options (grants net of cancellations) to an average of 3% per year over the next five years, although in any given year it might be higher or lower.”

2002

Relentless customer focus.

“In this year’s American Customer Satisfaction Index, the most authoritative study of customer satisfaction, Amazon.com scored an 88, the highest score ever recorded — not just online, not just in retailing — but the highest score ever recorded in any service industry.”

2003

The ownership mentality.

“Long-term thinking is both a requirement and an outcome of true ownership. Owners are different from tenants.”

“Our pricing strategy does not attempt to maximize margin percentages, but instead seeks to drive maximum value for customers and thereby create a much larger bottom line — in the long term.”

2004

“Our ultimate financial measure, and the one we most want to drive over the long-term, is free cash flow per share.”

2005

Sometimes you won’t have all the information, but you need to make a decision. Judgement can be the secret sauce to some of the best CEOs.

“As you would expect, however, not all of our important decisions can be made in this enviable, math-based way. Sometimes we have little or no historical data to guide us and proactive experimentation is impossible, impractical, or tantamount to a decision to proceed. Though data, analysis, and math play a role, the prime ingredient in these decisions is judgment.”

Sometimes calls go against numbers, which can be short-term focused.

“We’ve made similar judgments around Free Super Saver Shipping and Amazon Prime, both of which are expensive in the short term and — we believe — important and valuable in the long term.”

Controversial decisions can be the instigators of true innovation and thus value creation.

“Math-based decisions command wide agreement, whereas judgment-based decisions are rightly debated and often controversial, at least until put into practice and demonstrated. Any institution unwilling to endure controversy must limit itself to decisions of the first type. In our view, doing so would not only limit controversy — it would also significantly limit innovation and long-term value creation.”

2006

First mention of AWS.

“Amazon Web Services is another example. With AWS, we’re building a new business focused on a new customer set … software developers. We currently offer ten different web services and have built a community of over 240,000 registered developers. We’re targeting broad needs universally faced by developers, such as storage and compute capacity — areas in which developers have asked for help, and in which we have deep expertise from scaling Amazon.com over the last twelve years. We’re well positioned to do it, it’s highly differentiated, and it can be a significant, financially attractive business over time.”

“In some large companies, it might be difficult to grow new businesses from tiny seeds because of the patience and nurturing required. In my view, Amazon’s culture is unusually supportive of small businesses with big potential, and I believe that’s a source of competitive advantage.”

Real long-term vision shines through in this very matter-of-fact description of business line growth.

“In our experience, if a new business enjoys runaway success, it can only begin to be meaningful to the overall company economics in something like three to seven years. We’ve seen those time frames with our international businesses, our earlier non-media businesses, and our third party seller businesses.”

2007

First mention of Kindle. This year’s letter shares some thoughtful content on Kindle, its product design process, and its significance to Amazon and its corporate identity.

“November 19, 2007, was a special day. After three years of work, we introduced Amazon Kindle to our customers.”

2008

Maintain the long-term thinking, even in the darkest of times.

“In this turbulent global economy, our fundamental approach remains the same. Stay heads down, focused on the long term and obsessed over customers. Long-term thinking levers our existing abilities and lets us do new things we couldn’t otherwise contemplate. It supports the failure and iteration required for invention, and it frees us to pioneer in unexplored spaces.”

Energized by finding opportunities to improve and become more effective.

“The good news for shareowners is that we see much opportunity for improvement in that regard. Everywhere we look (and we all look), we find what experienced Japanese manufacturers would call “muda” or waste. I find this incredibly energizing.”

2009

The Amazon senior leadership mentality.

“Senior leaders that are new to Amazon are often surprised by how little time we spend discussing actual financial results or debating projected financial outputs. To be clear, we take these financial outputs seriously, but we believe that focusing our energy on the controllable inputs to our business is the most effective way to maximize financial outputs over time. Our annual goal setting process begins in the fall, and concludes early in the new year after we’ve completed our peak holiday quarter.”

2010

Amazon, a federated system of services, exhibiting modularity as well as interdependence.

“Our technologies are almost exclusively implemented as services: bits of logic that encapsulate the data they operate on and provide hardened interfaces as the only way to access their functionality. This approach reduces side effects and allows services to evolve at their own pace without impacting the other components of the overall system. Service-oriented architecture — or SOA — is the fundamental building abstraction for Amazon technologies.”

Technological innovation is fundamental to Amazon’s DNA and existence.

“All the effort we put into technology might not matter that much if we kept technology off to the side in some sort of R&D department, but we don’t take that approach. Technology infuses all of our teams, all of our processes, our decision-making, and our approach to innovation in each of our businesses. It is deeply integrated into everything we do.”

2011

Illustration of Amazon as infrastructure which enables other micro economies to evolve on top of it. Fat protocol thesis, perhaps?

“Invention comes in many forms and at many scales. The most radical and transformative of inventions are often those that empower others to unleash their creativity — to pursue their dreams. That’s a big part of what’s going on with Amazon Web Services, Fulfillment by Amazon, and Kindle Direct Publishing. With AWS, FBA, and KDP, we are creating powerful self-service platforms that allow thousands of people to boldly experiment and accomplish things that would otherwise be impossible or impractical.”

Enabling others to innovate and create value.

“I am emphasizing the self-service nature of these platforms because it’s important for a reason I think is somewhat non-obvious: even well-meaning gatekeepers slow innovation. When a platform is self-service, even the improbable ideas can get tried, because there’s no expert gatekeeper ready to say “that will never work!” And guess what — many of those improbable ideas do work, and society is the beneficiary of that diversity.”

2012

Showing some affinity to Ben Graham.

““In the short run, the market is a voting machine but in the long run, it is a weighing machine.” We don’t celebrate a 10% increase in the stock price like we celebrate excellent customer experience. We aren’t 10% smarter when that happens and conversely aren’t 10% dumber when the stock goes the other way. We want to be weighed, and we’re always working to build a heavier company.”

2013

Empowering employees and decentralizing the ability to innovate.

“This decentralized distribution of invention throughout the company — not limited to the company’s senior leaders — is the only way to get robust, high-throughput innovation. What we’re doing is challenging and fun — we get to work in the future.”

Many business leaders fail to innovate because the risks are too high. Failure must be tolerated if one is to go for the fences.

“Failure comes part and parcel with invention. It’s not optional. We understand that and believe in failing early and iterating until we get it right. When this process works, it means our failures are relatively small in size (most experiments can start small), and when we hit on something that is really working for customers, we double-down on it with hopes to turn it into an even bigger success. However, it’s not always as clean as that. Inventing is messy, and over time, it’s certain that we’ll fail at some big bets too.”

2014

What defines a great business opportunity.

“A dreamy business offering has at least four characteristics. Customers love it, it can grow to very large size, it has strong returns on capital, and it’s durable in time — with the potential to endure for decades. When you find one of these, don’t just swipe right, get married.”

“I believe AWS is one of those dreamy business offerings that can be serving customers and earning financial returns for many years into the future. Why am I optimistic? For one thing, the size of the opportunity is big, ultimately encompassing global spend on servers, networking, datacenters, infrastructure software, databases, data warehouses, and more. Similar to the way I think about Amazon retail, for all practical purposes, I believe AWS is market-size unconstrained.”

2015

The importance of corporate culture and how it comes to evolve.

“A word about corporate cultures: for better or for worse, they are enduring, stable, hard to change. They can be a source of advantage or disadvantage. You can write down your corporate culture, but when you do so, you’re discovering it, uncovering it — not creating it. It is created slowly over time by the people and by events — by the stories of past success and failure that become a deep part of the company lore. If it’s a distinctive culture, it will fit certain people like a custom-made glove. The reason cultures are so stable in time is because people self-select.”

Understanding asymmetry and experimentation. This is the math behind innovation.

“The difference between baseball and business, however, is that baseball has a truncated outcome distribution. When you swing, no matter how well you connect with the ball, the most runs you can get is four. In business, every once in a while, when you step up to the plate, you can score 1,000 runs. This long-tailed distribution of returns is why it’s important to be bold. Big winners pay for so many experiments.”

The methodology of decision making (more on this in 2016).

“Some decisions are consequential and irreversible or nearly irreversible — one-way doors — and these decisions must be made methodically, carefully, slowly, with great deliberation and consultation. If you walk through and don’t like what you see on the other side, you can’t get back to where you were before. We can call these Type 1 decisions. But most decisions aren’t like that — they are changeable, reversible — they’re two-way doors. If you’ve made a suboptimal Type 2 decision, you don’t have to live with the consequences for that long. You can reopen the door and go back through. Type 2 decisions can and should be made quickly by high judgment individuals or small groups.”

“As organizations get larger, there seems to be a tendency to use the heavy-weight Type 1 decision-making process on most decisions, including many Type 2 decisions. The end result of this is slowness, unthoughtful risk aversion, failure to experiment sufficiently, and consequently diminished invention. We’ll have to figure out how to fight that tendency.”

2016

Day 1 vs. Day 2. This runs deep in Amazon’s core operating logic and corporate culture.

“Day 2 is stasis. Followed by irrelevance. Followed by excruciating, painful decline. Followed by death. And that is why it is always Day 1. […] Here’s a starter pack of essentials for Day 1 defense: customer obsession, a skeptical view of proxies, the eager adoption of external trends, and high-velocity decision making.”

The psychology of customers.

“There are many advantages to a customer-centric approach, but here’s the big one: customers are always beautifully, wonderfully dissatisfied, even when they report being happy and business is great. Even when they don’t yet know it, customers want something better, and your desire to delight customers will drive you to invent on their behalf. No customer ever asked Amazon to create the Prime membership program, but it sure turns out they wanted it, and I could give you many such examples.”

The science of decision making. One cannot wait to have all the information for the world moves fast. Bad decision outcomes can be improved by having the flexibility to course correct.

“Second, most decisions should probably be made with somewhere around 70% of the information you wish you had. If you wait for 90%, in most cases, you’re probably being slow. Plus, either way, you need to be good at quickly recognizing and correcting bad decisions. If you’re good at course correcting, being wrong may be less costly than you think, whereas being slow is going to be expensive for sure.”

“Fourth, recognize true misalignment issues early and escalate them immediately. Sometimes teams have different objectives and fundamentally different views. They are not aligned. No amount of discussion, no number of meetings will resolve that deep misalignment. Without escalation, the default dispute resolution mechanism for this scenario is exhaustion.”

2017

High standards, a core component of the Amazon fabric.

“What do you need to achieve high standards in a particular domain area? First, you have to be able to recognize what good looks like in that domain. Second, you must have realistic expectations for how hard it should be (how much work it will take) to achieve that result — the scope.”

“Perhaps a little less obvious: people are drawn to high standards — they help with recruiting and retention. More subtle: a culture of high standards is protective of all the “invisible” but crucial work that goes on in every company. I’m talking about the work that no one sees. The work that gets done when no one is watching. In a high standards culture, doing that work well is its own reward — it’s part of what it means to be a professional.”

2018

A builder’s mentality.

“From very early on in Amazon’s life, we knew we wanted to create a culture of builders — people who are curious, explorers. They like to invent. Even when they’re experts, they are “fresh” with a beginner’s mind. They see the way we do things as just the way we do things now. A builder’s mentality helps us approach big, hard-to-solve opportunities with a humble conviction that success can come through iteration: invent, launch, reinvent, relaunch, start over, rinse, repeat, again and again. They know the path to success is anything but straight.”

The magnitude of failures must expand with the size of the company. Normally, management teams feel the inverse — the bigger they get, the less failures they feel pressured to have.

“As a company grows, everything needs to scale, including the size of your failed experiments. If the size of your failures isn’t growing, you’re not going to be inventing at a size that can actually move the needle. Amazon will be experimenting at the right scale for a company of our size if we occasionally have multibillion-dollar failures.”

2019

On sustainability.

“We’ve also committed to reaching 80% renewable energy by 2024 and 100% renewable energy by 2030. (The team is actually pushing to get to 100% by 2025 and has a challenging but credible plan to pull that off.) Globally, Amazon has 86 solar and wind projects that have the capacity to generate over 2,300 MW and deliver more than 6.3 million MWh of energy annually — enough to power more than 580,000 U.S. homes.”

Job creation and global responsibility.

“Over the last decade, no company has created more jobs than Amazon. Amazon directly employs 840,000 workers worldwide, including over 590,000 in the U.S., 115,000 in Europe, and 95,000 in Asia.”

2020

The philosophy of success.

“If you want to be successful in business (in life, actually), you have to create more than you consume. Your goal should be to create value for everyone you interact with. Any business that doesn’t create value for those it touches, even if it appears successful on the surface, isn’t long for this world. It’s on the way out.”

Combatting the social gravity of similarity. Be unique.

“We all know that distinctiveness — originality — is valuable. We are all taught to “be yourself.” What I’m really asking you to do is to embrace and be realistic about how much energy it takes to maintain that distinctiveness. The world wants you to be typical — in a thousand ways, it pulls at you. Don’t let it happen.”

There is plenty more in the letters themselves. Please find a repository below.

Repository of Annual Letters:

https://venturebeat.com/wp-content/uploads/2010/09/amzn_shareholder-letter-20072.pdf

http://media.corporate-ir.net/media_files/irol/97/97664/reports/Shareholderletter98.pdf

https://s2.q4cdn.com/299287126/files/doc_financials/annual/Shareholderletter99.pdf

https://s2.q4cdn.com/299287126/files/doc_financials/annual/00ar_letter.pdf

https://s2.q4cdn.com/299287126/files/doc_financials/annual/2001_shareholderLetter.pdf

https://s2.q4cdn.com/299287126/files/doc_financials/annual/2002_shareholderLetter.pdf

https://amazonir.gcs-web.com/static-files/5383e42d-62c9-4daa-aefb-2887fe5437be

https://amazonir.gcs-web.com/static-files/2b0b9eb6-0e9d-40f9-8708-f9f73d1ed485

https://amazonir.gcs-web.com/static-files/2eb4e2f3-fcaa-4bbe-8347-9900c904ab4f

https://amazonir.gcs-web.com/static-files/6aeb7e92-c03e-4397-8185-bac1090b4897

https://amazonir.gcs-web.com/static-files/e1eca4aa-7e81-4f6c-bafe-f10fc8202316

https://amazonir.gcs-web.com/static-files/8ae4440b-2b22-43fb-90ed-f6fb72b294e1

https://amazonir.gcs-web.com/static-files/54e35115-6b28-4227-aec1-6d31373cbd16

https://amazonir.gcs-web.com/static-files/09ce64e0-bae0-4d4f-916d-32cf971254ce

https://amazonir.gcs-web.com/static-files/7fb2d8d7-0296-44c3-a9e7-6de5dbec5537

https://amazonir.gcs-web.com/static-files/c262ba80-84d1-4fa5-a1bd-fde2f7d706d5

https://amazonir.gcs-web.com/static-files/92a6a617-a7f3-49b0-9b32-c1966c6e5369

https://amazonir.gcs-web.com/static-files/a9bd5c6a-c11c-4b38-9532-ae2f73d8bd10

https://amazonir.gcs-web.com/static-files/f124548c-5d0b-41a6-a670-d85bb191fcec

https://amazonir.gcs-web.com/static-files/e01cc6e7-73df-4860-bd3d-95d366f29e57

https://amazonir.gcs-web.com/static-files/1bfd8929-81a0-46d7-a378-6aff9a203093

https://amazonir.gcs-web.com/static-files/4f64d0cd-12f2-4d6c-952e-bbed15ab1082

https://www.aboutamazon.com/news/company-news/2019-letter-to-shareholders

https://www.aboutamazon.com/news/company-news/2020-letter-to-shareholders

Disclosure:* This blog series is strictly personal/ educational and is not investment advice nor a solicitation to buy or sell any assets. It does not represent any views from where the author is working — all views, opinions, and arguments are the author’s. Please always do your own research.*

When looking back at 2021, North America’s crypto equity markets representation (asides from Coinbase’s blockbuster direct listing) was dominated by Bitcoin (and other cryptoasset) mining companies. Raising capital through SPACs, these firms tapped into equity markets in order to finance their capital-intensive mining equipment purchases (i.e. from Bitmain) as well as operationally heavy process set-ups (warehouse selection, layout design, electricity / water systems, etc.). While this requires a lot of capital up front, the idea is that once the Bitcoin starts flowing (especially at prices between $40–60k) high margins bring large profits in (*cash profits assuming some of the mining rewards are sold).

Capital markets have changed quite significantly from 2021, and SPACs (yet alone a crypto one) would be hard to successfully carry out in today’s environment. Bonds or other debt facilities (such as private placements) would be equally as tough. So, how should an aspiring Bitcoin or PoW cryptoasset mining company get from point A (multiple capital needs up front) to B (profitably mining BTC) as touched on above?

While I do not spend much time focused on cryptoasset mining, I find it an intellectually stimulating activity to study components of non-crypto sectors and see if any knowledge / practices can be ported over. In comes gold mining. Now, gold mining is a whole other ball game vs. Bitcoin mining; however, certain parallels can be drawn on the financing side, and that is the topic of this post.

Creativity with Gold Financing

Similar to the simplified illustration above of Bitcoin miners needing to get from point A to point B, gold mining companies need to realize a similar objective. Upon zoning in on an exploration site, they need to expend significant capital before getting an ounce of gold. The biggest and best companies may be able to internalize this capital sourcing; however, even they along with the rest might seek out the capital markets to raise capital for the specific project. Just like with other companies, they could pursue traditional capital market routes (common or pref equity, tradable bonds) or they could pursue something more specialized:

1: Gold Trusts

These financing vehicles tend to offer a synergistic relationship between the buyer of the trust and the miner. Basically, a miner can set up a structured vehicle whereby they receive funds up front and in exchange pay out a certain predetermined percentage of the mining output on an annual basis. The miner gets low cost of capital funding up front and shares in the output success with the investors.

This version of the gold trust can be amplified by creating certain mechanisms which enhance the appeal for investors. One of the most well-known examples is the Barrick-Cullaton Gold Trust, which Barrick used in 1984 to raise $17m. This trust paid investors 3% of the mine’s output when the price of gold was <=$399/oz, with the percentage rising to 10% of production when gold was at a price of $1,000/oz. Barrick wins by avoiding equity dilution and interest costs, and only has to pay out more of the mining production when prices rise, assuring a certain level of profitability.

2: Bullion Loans

Structured in a bespoke nature, these loans are, as the name implies, issued in bullion and not fiat / cash. A bank will lend a mining company gold, and over the course of a predetermined period, the miner will pay back the loan in the product of their mining operations (along with interest). Collateral generally tends to be the mines themselves.

One more recent example is that of the bullion loans taken by the Tanzanian Royalty Exploration Company. The loans were structured for one year, subject to renewal, carried an 8% interest rate, and could be paid back in gold (the valuation date for such bullion was the date of the loan agreements). Interestingly, there was the option for the company to repay the loans in cash or stock as well.

3: Gold-indexed Bond Offerings

Taking the debt avenue one step further, these bond offerings are like typical bonds, yet can be redeemed for cash or gold bullion equal to a certain amount determined by the bond offering. Over time, the later an investor chooses to redeem, the more value in ounces of gold they receive. These instruments may have interest coupons like normal bonds.

An illustrative example here is the 3.5% gold-indexed bonds offered by U.S. company Refinement International. Each bond was worth 10oz of gold with the coupon worth 0.35oz of gold. A more fitting example is the 2% gold-indexed bonds issued by Barrick in 1987. Held to maturity, the investor would have received 3.38oz of gold.

Gold -> BTC

Given some of the examples above, it becomes quite an interesting exercise to apply this to Bitcoin mining companies. Again, while the two industries are very different, some of the deeper principles may be relevant and one could look to these gold miner financing avenues for inspiration.

But before even processing the inspiration component, it may be helpful to ask why is this all necessary? Well, given the state of both the capital markets and the Bitcoin mining industry itself, capital will be much harder to come by, yet definitely still in demand. Leveraging some of Arcane’s research, miners appear to have modest cash flows (most likely lower now than represented below), face large incoming machine payment bills, and harbor potential liquidity concerns.

One of the worst things a company could do is offload large quantities of its balance sheet BTC in a bearish price environment to meet short term cash needs. Thus, in order to pursue an optimal future path that does result in survival, access to financing is crucial. Perhaps some new financial innovation can emerge in this sector to create vehicles or instruments that offer Bitcoin and PoW asset miners a cheaper (and available) source of capital, while also providing investors with appealing risk / return exposures.

Utilizing some of the frameworks above, one could see BTC mining trusts, BTC loans (it would very interesting to see this come from DeFi infrastructure) and BTC-indexed bonds. The foreseeable resistance, in my opinion, would originate from potential regulatory concerns (the industry is still navigating a spot BTC ETF, which has been very tough so far) and BTC appetite. On the latter, BTC’s shift in narrative from an inflation hedge asset to a risk-on one makes this market environment a very hard one for its appetite. However, if that narrative were to shift again, or if an appealing risk / return opportunity is created, a BTC miner specialized debt instrument could garner interest.

Conclusion

Drawing this to a close, there are a couple points I wish to re-emphasize. (1) Gold miners != Bitcoin miners. I can’t say this enough… this is not the argument here. However, there are notable similarities that lend to cross-knowledge utilization, which could prove valuable. (2) BTC as a SoV asset has a long way to go before even getting close to the level gold was at in the 1900s, but all innovation starts small. (3) There is white space for innovation in Bitcoin miner financing and I’m excited to see what evolves.

Disclosure:* This blog series is strictly personal/ educational and is not investment advice nor a solicitation to buy or sell any assets. It does not represent any views from where the author is working — all views, opinions, and arguments are the author’s. Please always do your own research.*

Emerging from a deep read of Ray Dalio’s Principles for Dealing with the Changing World Order (specifically Part I), I couldn’t help but draw connections to what might be one of the timeliest combinations of long-term trends: the ending stretch of the long-term U.S. debt cycle and the rise of programmable store of value assets (namely Bitcoin and Ethereum *to date*). The rise of BTC / ETH in the coming years / decades has a strong probability of coinciding with the accelerating devaluation of U.S. currency and debt, tremendously increasing its appeal as the backbone of the next monetary system.

The Long-term Debt Cycle

It must be said that most of the thoughts / analyses discussed in this section are based on Dalio’s work and historical analysis, thus all attribution goes to him. Dalio’s analysis of history (both general and financial) revealed the existence of several types of cycles, each with different durations. Focusing specifically on credit, there appeared to be two types: short-term credit cycles (the boom / bust archetypes) and long-term debt cycles. The latter last 50–75 years and comprise the entirety of a monetary system cycle, which describes the birth, rise, and fall of a monetary system. The former occur several times during a long-term debt cycle and are formative in creating booming times as well as eventually driving credit crunches and recessions.

Homing in on long-term debt cycles, Dalio paints its evolution through several different frameworks. I’ll bring up a couple here. Firstly, illustrated by the image below, there is the evolution of the debt cycle, with the horizontal axis denoting time and the vertical axis denoting real economic value. You see, debt and credit can get a bad rap (especially when we are at the end of a credit / debt cycle), but they are instrumental in financing economic growth, real productivity gains, and the rise of a nation. There are periods where credit can be directed appropriately and the use of it matches the economic needs; however, these periods always move into periods of excess and/or periods of constraint where the cost of capital shifts away from the optimal point. Additionally, over time, Dalio argues that the quality and impact of expanding credit decrease. Eventually, the quantum of debt in the system is too far ahead of the claimable hard assets… and the time for readjustment arrives (more on this later).

The second framework worth mentioning is the evolution of the monetary system. Throughout this long-term debt cycle (and most likely longer than the cycle itself), is the evolution of the monetary system across three phases: 1) Hard money, 2) Paper money (claims on hard money), 3) Fiat money. At first, there is the use of hard money. Gold, silver and other materials form the core representation of currency. They require the least amount of trust (maximal credibility as a store of value, “SoV”), yet have the least flexibility in terms of credit creation. As the ecosystem evolves, the allure and growth potential of credit creation becomes too attractive. Thus, private and public institutions foster the creation of paper money. Backed by claims on assets such as gold, paper money allows for the creation of some credit, while still retaining some credibility. Full on money printing is not possible given the constraints of pegging or the potential for redemption. However, mass financing of wars, social programs, infrastructure building, and economic growth ends up taking an ecosystem to the third phase: fiat money. Currency thus becomes backed by the full force and power of Government XYZ. The currency, and more specifically the debt securities denominated in that currency, have value because of the trust in the government institution, not because of any hard assets in the background. This phase witnesses the maximum creation of credit as flexibility is the highest; however, governments and central banks will eventually run themselves into a tough spot: how does one find a way to pay off all this debt? They can 1) undergo austerity measures (too painful and too costly from a political angle), 2) default on their debt and restructure (too costly from a trust and reputation standpoint + immensely value destructive for the holders of the debt (for every liability there is an asset) ), 3) redistribute money and credit (i.e., taxes, which are ok in some circumstances but face a limit on the political front), 4) print money and monetize the debt (least painful and can be done without much notice). Well, which one would you put your money on governments choosing in the long run?

“All currencies devalue or die” — Dalio

Enter Crypto: BTC / ETH

With the frameworks in mind, it becomes pretty hard to argue that the U.S., the world’s leading power and reserve currency provider, is not somewhere in the late part of the long-term debt cycle. A high-level recap: the U.S. has been in the third monetary phase since 1971; inflation has been creeping up over the decades with sporadic spurts (early 1970s, 2021–2022); the government is in clear need of more and more financing (infrastructure, social issues, global conflict); the same story plays out every time the government ‘shuts down’; and, the level of debt is ever-so high and getting higher.

Thus, at some point, perhaps in the next couple of decades, the monetary system as it stands today could meet its end. A restructuring and regeneration of a new system will come about and humanity will keep going (hopefully and thankfully). BUT, the new monetary system must now move back to Phase 1: hard money. And what will be the hard money? Well, gold has its strong chances, but we now live in a highly digitized age with an emerging, tech savvy Millennial and Gen Z populace. Why can’t digital SoV assets, like BTC and ETH, be regarded as the backbone of the next monetary era?

I think the probabilities are still overall in favor of that not occurring, however, there is enough plausibility and time left until the cycle is complete for a fair argument to be made in its favor. BTC / ETH (or another crypto asset) formulate a great choice for the new monetary system. Firstly, they are superior to metals / hard assets when it comes to utility, speed, storage, and digital nativeness. Are we seriously going to conduct eCommerce, digital trading, international transfers, etc. in gold? Secondly, there is applicable value to these assets having strong qualities of decentralization. Where is all the gold stored? Where is all the BTC / ETH stored? Two very different answers. In Phase 1, the monetary system built optimizes for the highest credibility — decentralization can formulate a key deciding factor here. Thirdly, it is accessible and increasingly more logical to younger generations. Gold is tough to acquire and trade, but fungible and divisible ETH or BTC can be accessed (nearly entirely) where there is an internet connection. With the increase of internet penetration and digitization, this should carry some weight. Needless to say, younger generations are learning about economics and transactions on Roblox, Fortnite, Steam and other digital economy games / platforms. A digital SoV makes sense to them.

Bringing those arguments together, I think it is fair to say there is a shot for a digital SoV to emerge as the backbone of the new monetary system. This adds another layer of excitement to the whole crypto industry.

Conclusion

I would like to end by saying that there is a theoretical / speculative approach to some of the argument’s development in this post. As an admirer of Nassim Taleb’s work, I cannot help but apply a fair dose of skepticism and rigor with regards to the speculation here, especially as it pertains to timing. The end of the long-term debt cycle is coming, but when precisely, I do not know. Additionally, what will the emergence of a new cycle look like? Will it go to China / Renminbi? Will the U.S. somehow find a way to restructure and retain the USD (tough according to Dalio’s logic)? Could it be global or self-sovereign system? Absence of proof is not proof of absence, so hard to say. That all being said, the timeliness of the end of the long-term debt cycle and the rise of crypto and the digital economy could be quite optimal…

Disclosure:* This blog series is strictly personal/ educational and is not investment advice nor a solicitation to buy or sell any assets. It does not represent any views from where the author is working — all views, opinions, and arguments are the author’s. Please always do your own research.*

As one can see above, the network flywheel runs off the interaction of contribution from multiple parties. First, the founders create the protocol with a powerful vision, which they communicate to the world. This vision should be compelling enough that some community starts to form around the vision— these are the first dev contributors, advocates, and users. This should create some investor interest as early momentum makes it accretive to generate monetary value. Now, there is a token that has value, which presents a profitable opportunity for miners or validators. These start to mobilize equipment / stakes to secure the network. With this, somewhat of a functional platform arises. A functional platform then means opportunity for developers and other founders to build on top — a true ecosystem is starting to evolve! However, their projects cannot exist in isolation… they need to be useful and present some form of value. With this, end users come in and they bolster the community around the founding team. The cycle is complete and positive reinforcement can create momentum to power this flywheel over time. So much momentum can be created that the founding team can move on, and the flywheel still runs. A decentralized ecosystem has been nurtured.

While Yayha’s framework was used to shed light on blockchain networks, I am of the opinion that one can apply it, or at least parts of it, to tokenized protocols that exist on top of these blockchains. Zooming in on the ‘useful applications’ part of the network flywheel, we have another inner flywheel that exists.

Networks and Flywheels, vProtocol

Applying that same model to protocols atop blockchains, we see similar components. In certain protocol economies, you have the founders and their vision, the investors / speculators that help catalyze some value, the stakers / security providers that can empower platform functionality, the devs / contributors that build out the protocol or build on top of it, and the users that find value in using it and help build the community. Where can one see this in DeFi, for example? Say you have a lending or options protocol — founders come in with the vision and beta version, token is dropped and investors create some price action, in addition to holding it some token holders stake it in a security module, this lowers the cost of capital on the network / makes it more viable so contributors keep building it out along with more users finding it useful, and community starts to strengthen. There are some slight creases in the analogy, but it still makes sense. Now, the analogy does not apply to every tokenized protocol. However, this analogy could definitely be informative as a guide for long-term protocol success. Currently, the craziness of the market may obfuscate lacking components of the network flywheel. The token price or community hype provides illusions of success when in the current form the flywheel may not ever kickstart. So, what are the most common pitfalls out there?

No real token value

It may be that the token has no real value. At first, things seem great at launch, however, if the token is just used as a medium of transaction in the protocol or some type of pure reward mechanism, etc. then its long-term value proposition is weak, and over time more selling than buying will lead to a negative spiral caused by price decline. This can be seen in secondary P2E gaming tokens or pure marketplace currency tokens. A defensible ecosystem should have a token that has real utility, some value accrual, or provides value to the ecosystem’s functioning. This is why tokenomics is so important. As I have stated in the past, brainstorming tokenomics and constantly revising / testing them is crucial in the process of launching a protocol and managing it. A failed token design could explode in one’s face directly, however, most of the times it actually boils up over time and then suddenly fails as certain variables trigger a negative spiral. Thus, designing a token with value is key. Whether it is a staking security model, a utility model enhancing platform usage, or a model that drives liquidity in the protocol, a worthy token model can make a big difference in the success of the network flywheel.

Where is the platform functionality?

Sometimes there can be a great vision, the investors are there, and there is an interesting token model… but there is no real functionality. This one is obvious, but it can be missed by so many in the moment of excitement, promises, and bubbly markets. Making sure that there is real functionality in the network is key — a working, secure protocol makes it worthy for real contributors to come and build. Some drivers of functionality are the following: great integrations, logical platform security systems, controllable parameters / processes, among others. The good talent won’t come to build on a protocol that lacks the ability to actually function. Now, do there always need to be stakers, per the diagram? No, governance comes into this component nicely. Systems for controlling parameters (i.e. lending protocols) or an expensive governance token for security purposes (i.e. oracles) are applicable here.

Useful applications…

Ah, the hot topic in many facets of crypto — is this protocol actually useful? Why will end users come to use the protocol? Why will they increase their usage and expand to using other features? These are important questions. While they could be answered easily, their performance in reality can be dismal. Perhaps a protocol has an interesting idea, but the use case is too early or is not really there. Perhaps it is a good idea, but there is a competitor that just does it better for cheaper and with more features. I don’t believe that founders fail to answer this, it is rather just that it can be hard to achieve the answers in reality. Driving useful applications comes down to a great vision, a deep understanding of the space and the target market, being knowledgeable on competitors and their performance / their gaps, and, best of all, understanding the user. This last one can be the toughest at times — am I going after the DeFi degen? The institution? The new web3 user? I am a firm believer that creating useful applications is derived from maintaining a ‘customer first’ mentality. Now, it is totally fair for your customer to change over time; in fact, recalibrating your network flywheel to a more suitable customer can be a great action that enhances the longevity and strength of the flywheel. Bottom line: make sure there is real use for the protocol.

It all comes together under the big picture

There is a lot going on in the network flywheel. While Yayha did a phenomenal job at creating an understandable framework, it did have the byproduct of obscuring the tough details behind both making all the key components work themselves and making them work interdependently. At the end of the day, a protocol could have all the components in the short-term, but if they are not operating well together, then the flywheel won’t get to the point of acceleration it needs and decay may settle in. The truth of the matter is that the network flywheel can sometimes be more like a Swiss watch — there are several gears turning concurrently and for a founding team and community to manage that can be tough. This is where the softer qualities can be very important — proper communication, openness and community, inspiration, and thoughtfulness can be the oil to getting the gears turning.

As a founder, community contributor, or investor, knowing your flywheel, how to monitor each part of it, and where the opportunities lie for improvement are crucial in determining the long-term success of the protocol. Another point to note is that flywheels can change over time, and this is totally okay, in fact sometimes really needed. Network flywheels build defensibility and generate value for an ecosystem… understand your flywheel closely.

Disclosure:* This blog series is strictly personal/ educational and is not investment advice nor a solicitation to buy or sell any assets. It does not represent any views from where the author is working — all views, opinions, and arguments are the author’s. Please always do your own research.*

The figure above captivated me while reading The Dao of Capital, a poignant name for a reader in the crypto space (and no, it is not about DAOs). The image is inspired by one shown in the book, which is subsequently devised from the original ideas of Eugen von Böhm-Bawerk, a notable Austrian economist and later Minister of Finance. It is used to illustrate his metaphor of a tree’s growth as representative of an economy. A crosscut analysis of a large tree trunk reveals several rings in a pattern of concentric circles. Every ring represents a year of the tree’s growth and resource allocation. The key concept here is that the tree in Figure 2 above will be weaker than the tree in Figure 1.

Why does this matter? Well, the image boils down to the concept of investing. There are two types of trees above, which are argued to be economies. Both have several layers of annual rings, representing invested capital. The outer most layer becomes finished goods, bark, as it sheds off to consumption. The difference, as one can see, is that Figure 1 has more rings than Figure 2, and Figure 2 has a big outer layer compared to Figure 1. As an economy, Figure 1 chose to invest capital throughout different maturity classes in a patient and less-direct manner. Every year a ring is added, but not everything is put into that ring as energy and resources must be saved for future rings. Figure 2, on the other hand, chose to put a lot into more short-term rings. Ring 1 in Figure 2 had the most invested in it and it will get much faster to becoming a fruit of investment than any other ring in both trees. However, the size of Figure 2’s trunk will be smaller than Figure 1 over the long term.

Confused or bored? I could understand that, but there is actually something very valuable behind all this.

Trees and Crypto Projects

So, why is Figure 2’s trunk smaller over time? Well, investments, capital, resources, all things needed to grow a ring of wood, have tradeoffs. A tree, just like a founding team, can allocate capital and resources to get results (bark) in the short, medium, and long term. To get more immediate results, they can deploy a lot into shorter-term objectives. To get longer term results, they need to be more thoughtful, work longer and harder for less in the short-term, and suffer the loss of certain benefits. This is a very tough tradeoff, especially in an environment where people playing on different time horizons are making a lot of money and getting a lot of attention right now. Some protocol or project is reaping the chunky layers of bark now, raising big funding, having high token inflation, speaking large on Twitter, etc. It is psychologically and strategically hard to operate in that environment. Add the fact that these markets are emerging and changing fast, and it kind of seems to make sense that one should spend and attract as much attention now to take advantage as a first mover.

However, note which trunk is larger… that of Figure 1. Additionally, it is the sturdier one as well. Intermediate rings act to reinforce each other, and this is an important point to note as it conveys that these rings have value, even though they are not the bark to be consumed yet. If you believe that your project truly can change the world, why would you try and direct resources to getting immediate results? Why kill the golden goose in the short to medium term, when with patience and hard work (and less benefits now), you can have a stream of golden eggs in the future? I would like to note that the question is a lot harder in the real world than it seems and I am understanding of objections to it in this volatile space and environment. That being said, the trunk in Figure 1 is larger though.

Let’s bring in a Web2 analogy. In my opinion, examples of Figure 1 are companies like Amazon. Bezos and his team were playing a different game — invest all profits in business lines (to the disdain of Wall Street quarterly earnings fans), lose money on experiments to make money in the future, take big bets and try new things, think about investments now yielding fruit in 5 years. These are snippets of the thinking style that was fomented there, and I believe it played a huge part in the company’s success.

Bolstering the tree analogy is the concept of compounding. Böhm-Bawerk also stated that capital structures are cumulative. Investments / capital allocation before leads to what comes after. Play the long-term game and the work and small wins will reinforce over time to become something much stronger and greater. Compounding is an easy word to throw around, but one much harder to achieve as it requires discipline and focus.

Going back to crypto, the projects that will really go about changing the world, the projects that have staying power and will generate tremendous value, are those that invest and allocate resources with long-term goals in mind. These days, nearly any project can launch a token, throw out a bunch of emissions for APY, have a couple of quick v1s, and achieve some form of market cap. When this ring becomes bark, however, what happens then? Other teams will build some things and create some value in the space, but then the vesting is up and it is time to go somewhere else. Rings 4 and 5 were the fattest and became bark. And then there will be those teams, contributors, and communities that will build for Rings 17, 23, 37… these projects will become protocols, which will become crucial infrastructure, which will touch our lives in many ways. These are the trees to watch, and ironically, will sometimes be trees that are ignored, disregarded, or objected against because lack of immediate results.

I’ll end by saying that it takes a lot of courage to grow a 5, 10, 30-year tree, even more so in an environment like crypto. A handful (relative to the eventual sample size) will do it though, and while time ticks on, their trunk will get larger and sturdier, outgrowing the forrest.

Disclosure: This blog series is strictly personal/ educational and is not investment advice nor a solicitation to buy or sell any assets. Please always do your own research.Disclosure: This blog series is strictly personal/ educational and is not investment advice nor a solicitation to buy or sell any assets. It does not represent any views from where the author is working — all views, opinions, and arguments are the author’s. Please always do your own research.

The lego stack / tower has been a captivating framework amongst those in DeFi. The basic notion is that several DeFi protocols can be combined in the form of a stack to provide different financial services. At the center of these combinations is the principle of composability, which dictates that protocols’ interoperable nature allows them to combine seamlessly. With the ease of protocol composability, product innovation can materialize via the combination of lego blocks.

Where does one see this today? Derivative protocols can build on top of Uniswap. In order to tap into deep liquidity for the underlying assets of the derivative instruments, these protocols may find it useful to plug into the well-known DeFi 1.0 AMMs. There are also fixed rate protocols working off of core money market functions delivered by Compound and Aave. A great example of this is Notional Finance, which makes use of Compound’s cTokens in order to build its yield flows. As these blocks combine, they create the potential for more combinations, inherently growing the stack. In some ways, going back to middle school math, adding one more object to the group leads to several new potential relationship subsets.

However, this piece does not go into the innovation catalyzed by combinatorics-based properties. Nor, and it is important to mention this, does this piece cover the risk characteristics exhibited by the lego stack. A pertinent question here revolves around how risks stack up / compound. My thoughts for this post revolve more around switching costs and their profile in the DeFi lego stack.

Switching Costs in TradFi / Web2

Switching costs have been a formative moat in financials and tech businesses. If one has ever gone over the core Morningstar moats, switching costs are right up there with brand value and economies of scale. What does one mean by switching costs? A high level interpretation is a set of financial, operational, economic, or other costs which arise when a business or consumer attempts to switch to a competitor. The switching cost could be considered negative to the end-consumer, but it is good for the business that is providing the service or product. Why? Because the stronger the switching costs, the harder it is for customers to leave… meaning more stickiness, retention, and opportunity to generate value.

Some great examples can be seen in Visa, Mastercard, and Salesforce. In the case of Visa and Mastercard, what drives the strong ROIC and compounding earnings growth of these two companies is the importance of their business to those that use it: banks and merchants. Becoming part of this network requires significant capital undertaking and commitment — banks can’t just change from Mastercard to a competitor in a couple of days. Visa and Mastercard run the piping infrastructure for financial transactions, and trying to remove one’s bank from that infrastructure is more than just rebranding, it is the alteration of a mission critical system. Thus, with switching costs, these two entities can count on strong retention and possess significant pricing power. In fact, both have consistently raised take rates over the past 10 years at a 3.5–5% CAGR.

The same can be argued for Salesforce. This company is a phenomenal SaaS business, especially as for the customer it is an easy entry (meaning it is not hard to start using and getting used to it), but a very hard exit. Moving off Salesforce after using it for a couple of years would constitute a major CRM headache — transferring data, profiles, logs, and more, in addition to changing key firm operations from sales to strategy to finance. Thus, the costs in terms of time / money as well as potential exposure to risks of data loss or business disruption make it hard for businesses to stop using Salesforce.

Overall, switching costs constitute a valuable moat which helps guarantee the reliability of revenue streams and customer retention, while also facilitating the opportunities for cross-selling and price increases.

DeFi and Web3 Switching costs

Looping back to the intro, if composability provides the means for these lego blocks to seamlessly build off and combine with each other, then would that not lead to the flexibility to switch blocks? I think this can be the case in the short-term, however, in the long-term I am of the opinion that switching costs will strengthen, and consolidation will increase among the lower levels of the stack.

Two questions emerge from that opinion. Firstly, why, in the short-term, is flexibility possible and switching costs not too significant? Well, right now DeFi is still quite nascent. There have been several lego blocks created and introduced, and given that it is still early, the costs of switching are not too high. For example, a derivatives exchange that plugs into Uniswap could move to Balancer. Would it take some developer resources, audits, and testing? Yes, but it is feasible.

Why, then, as time goes by do switching costs strengthen? This is the more fascinating question to think about. A couple of points support switching costs strengthening:

1. Time. The nature of time strengthens a relationship as long as the blocks on top are happy with the lower blocks. In a way related to the Lindy effect, the longer lego towers stand on the blocks of Uniswap and Aave, per se, the harder it would be to change those blocks out. Hundreds of millions of dollars of liquidity would be in there, more code and technical debt would be tied to it, and psychologically, for the core contributors it just becomes something they are used to. If there is no terrible reason to switch, why undertake the effort and potential risks (especially smart contract-related) of moving over?

2. Lego-stack network effects. What happens when several of the mid-level blocks all interact on the same lower level blocks? Composability and functionality are at their prime. These protocols can work together in such an efficient and synergistic way that more value is generated being on those lower blocks than moving to others. In the case of Notional — what if a whole suite of financial services used cTokens? The ease of building a sub-ecosystem of products that allows for seamlessly moving from fixed rate lending / borrowing to other financial products is appealing to both the developers and users. As these lego blocks build and cross-combine, the lower blocks become more important as enablers of product combination.

3. Liquidity & virtuous cycles. If one pairs points 1 and 2 together, one gets this evolution whereby a couple of key protocols at the bottom comprise the foundations of most lego stacks. As more stacks are built on core DeFi 1.0 protocols, these have increasingly more liquidity. As these have more liquidity, it makes sense from an efficiency standpoint to build on them, hence increasing liquidity. As liquidity, and thus revenues, increase, so do: protocol resources, developer funding, community contribution, and product iteration. Thus, the protocol gets better (theoretically, of course). All of this makes it harder to switch. If one is managing a derivatives protocol that is plugged into Uniswap, which has the best liquidity and a solid developer team that is constantly making the product better, it becomes much harder to propose a switch to {other AMM}. The rationale for moving deteriorates. Simultaneously, the lower lego blocks consolidate into a few key protocols via the quest for efficiency / liquidity.

Thus, over time, switching costs should emerge in the DeFi stack. Mainly, they will be comprised of: decreased efficiency and liquidity, increased smart contract risk, and operational integration costs pertaining to sub-ecosystems.

Conclusion

These high level thoughts point to a pertinent conclusion: pay attention to the development of those lower level blocks. What is being built on top of them? Why are protocols integrating with them? How are integrations tracking? How are liquidity / AUM / listings changing? These blocks will have immense importance to the stacks of tomorrow. Understanding their progression towards building switching costs can be important to determining their viability as a crucial protocol of the future.

Disclosure:* This blog series is strictly personal/ educational and is not investment advice nor a solicitation to buy or sell any assets. It does not represent any views from where the author is working — all views, opinions, and arguments are the author’s. Please always do your own research.*

In late 2008, an anonymous figure by the alias of Satoshi Nakamoto published the first Bitcoin whitepaper.[i] While it would take some years for this paper, and its subject Bitcoin, to become mainstream, the seeds of a workable digital currency were sown. In Bitcoin, the world finally had a trustless, P2P, digital currency that worked. However, as the years passed by and activity on the Bitcoin blockchain grew, the thesis of Bitcoin fulfilling its intended destiny as a global online currency began to crack. Simply put, Bitcoin could not handle high transaction throughput and it was too volatile to serve as a medium of exchange. In 2014, a superior form of digital currency emerged from the Bitcoin community: the stablecoin, a digital token that is representative of a real-life currency unit. From 2014 up to today, the use of stablecoins has increased exponentially and parties ranging from financial regulators to banks to consumers are beginning to feel the effects of an innovative technology that most have yet to fully understand. While stablecoin technology can be frightening, and does come with a new set of risks, its potential for impact is significant, especially in the case of the global economy and society at large. This brings me to the purpose of this post, which is twofold. Firstly, this post will detail an argument for the utility of stablecoins, their benefits, and how those benefits stand to be greater than the drawbacks. Secondly, this post introduces a discussion around potential regulatory approaches to centrally issued stablecoins and proposes a high-level regulatory framework that addresses stablecoins in a thoughtful and innovation-friendly way.

Introduction

Definition

According to Coinbase, one of the leading financial institutions in the crypto space, a stablecoin is defined as “a digital currency that is pegged to a ‘stable’ reserve asset like the U.S. dollar”.[ii] Stablecoins can be obtained through an exchange (i.e. Coinbase) as well as through a minting process carried out on the issuer’s website (or through a partner’s website). As referenced above, the main motivation behind the creation of stablecoins was to launch a scalable and stable digital currency, avoiding the pitfalls of Bitcoin as it pertains to price volatility and low throughput. Effectively serving as an online dollar, the stablecoin manifests several characteristics of today’s currency, but with improvements in speed, cost, and efficiency driven by its digital nature.

Stablecoin Types

While the stablecoin market started with a single token from Tether, an institution somewhat notorious for its USDT stablecoin, the sector blossomed across the years to include several other stablecoins and new modes of stablecoin operation. Overall, stablecoins can be categorized as one of the following: fiat collateralized, crypto collateralized, and algorithmic.[iii]Starting with fiat collateralized, this is a stablecoin that is tied to a fiat currency (i.e. the U.S. dollar) and has 1:1 redeemability to that fiat unit. It is generally assumed that the reserves for this type of stablecoin are denominated in that same fiat currency. Examples include Tether’s USDT and Circle’s USDC. Then, there are crypto collateralized stablecoins, which are backed by cryptoassets (i.e. Ethereum) as means for reserves and redeemability. The best example is MakerDAO’s DAI, a decentralized stablecoin backed by Ethereum reserves. Lastly, there are algorithmic stablecoins, which have no collateral and rather work through a set of burning and minting mechanisms to keep the stablecoin in line with a target price. Fei Protocol’s FEI and Frax Protocol’s FRAX are two examples of this. Overlaying these three types of stablecoins is the secondary categorization of whether their issuance is centralized or decentralized. Centrally issued stablecoins originate from an entity that has a physical presence (i.e. Circle in the United States). One thing to point out is that centrally issued stablecoins are nearly always fiat collateralized. On the other hand, decentralized stablecoins are subject to governance by a decentralized autonomous organization (“DAO”). These stablecoins do not have a physical entity backing and governing them. Rather, DAOs are composed of contributors and community members from all over the world.

While the stablecoin market is very diverse and newer products like decentralized algorithmic stablecoins are intriguing, this post will focus solely on discussing centrally issued stablecoins (albeit, the post’s second and third sections do also apply to other classes of stablecoins). The reason why the post will exclusively focus on centrally issued stablecoins is because it is currently the most widely adopted category, and thus holds the highest probability of being the mainstream stablecoin of choice. If one compares the outstanding market value of the top three centrally issued stablecoins to the top three decentralized stablecoins, the adoption divergence becomes clear: centrally issued stablecoins total ~$131b and decentralized stablecoins ~$21b, respectively. By breakdown, they would be USDT ($76.59b), USDC ($40.79b), and BUSD ($13.61b) versus DAI ($8.98), UST ($8.19b), and MIM ($3.75b).[iv] With a significant first mover advantage, centrally issued, fiat-collateralized stablecoins have been leading the way as the most adopted stablecoin version, attracting significant regulatory attention, which is another reason for it being the subject of the post’s focus.

Use cases

Today

The use cases today for stablecoins are nearly entirely related to the crypto economy. The first main use case is as a medium of exchange, particularly for the Decentralized Finance (“DeFi”) ecosystem as well as the NFT ecosystem.[v] [vi]Stablecoins like USDC are used to move value from one smart contract to another, used as an intermediate holding asset between two investment operations, and used for asset exchange. The main attraction of stablecoins as a medium of exchange stems from their near zero price volatility. In the crypto economy, where prices are tremendously volatile, stablecoins serve as a great medium of exchange and intermediary store of value. Furthermore, it is not that stablecoins are used just by investors and users in the crypto economy as a medium of exchange, but they are also used in an automated way by DeFi protocols as means of payouts (i.e. in the case of decentralized option markets) and liquidity pools (i.e. in the case of savings protocols).[vii] [viii] A significant share of stablecoin market value is locked (deposited) in DeFi protocols, amounting to a big chunk of the $100b+ DeFi total value locked.[ix]

The second main use case for stablecoins is as a medium of payment. Within the crypto economy, there are an estimated 1.7m DAO members.[x] Several of these members are active and paid contributors, with stablecoins being a key form of payment. In addition to DAOs, several crypto-focused and crypto-native organizations have chosen to pay their employees directly in crypto, again with a popular form of payment being stablecoins.[xi] Adjacent to this is the use of stablecoins within the charity realm. Crypto contributions to charity have skyrocketed the last few years. For example, Fidelity Charitable, the U.S.’s largest grant maker, has received over $274m in crypto contributions YTD.[xii] While most donations are still denominated in Bitcoin and Ethereum, the use of stablecoins for donation is becoming more accepted as well as demanded given that it is much less volatile than the aforementioned cryptoassets.[xiii] Products like Coinbase Commerce enable merchants and charities to accept USDC as a form of payment.

The third main use case today for stablecoins, which is interlinked with the first two yet trails them in usage, is that of remittances. As will be discussed in the next section, the current infrastructure for remittances is clunky, slow, and very expensive; thus, stablecoins present a more efficient means to send money cross-border. Several notable entities are attempting to address and promote this use case. Facebook’s Novi has kicked off a pilot which will allow users to send the Pax Dollar stablecoin from the U.S. to Guatemala, a sizeable remittance corridor.[xiv] Blockchain entity Celo has created a mobile-first blockchain angled towards developing nations to establish a remittance market where fees average around $0.01.[xv] Partners to Celo include, but are not limited to, the World Economic Forum, the United Nations World Food Programme, the World Bank, and the Digital Euro Association. While still nascent, the stablecoin-driven remittance industry is starting to scale.

Tomorrow and Beyond

While the use cases above are valuable and illustrative of stablecoin utility, they represent a drop in the bucket of the future use cases, assuming adoption ensues. Looking to a global payments total addressable market (“TAM”) of $35t and an M2 money supply TAM of $130t, the stablecoin market opportunity is tremendous.[xvi] A plausible future of digitized finance and society could see stablecoins form the most common medium of exchange and choice for payments. Stablecoins would be crucial as an intermediary and currency in financial markets, a main avenue for corporate and retail payment flow, and the backbone of cross-border payments for the purposes of remittances, foreign aid, foreign exchange, and more. It is this potential that has driven some of the world’s most valuable companies (Visa, Mastercard, Facebook) and most powerful governments (U.S., E.U., China) to get up to speed with stablecoin technology.[xvii] [xviii]

Benefits and Drawbacks

While the interest in stablecoins is certainly unarguable, the debate on the benefits and drawbacks pertaining to the technology is still in progress, with some of the top companies, institutions, governments, and individuals in the world contributing their views. While there are plausible risks, which I will concede, to stablecoin adoption, I argue that the benefits far outweigh them and, with the introduction of fair and innovative regulation, the path to stablecoin adoption should become smoother and more viable.

Benefits

The main benefits pertaining to stablecoins can be summarized across the vectors of speed, cost, and inclusivity. First and foremost, stablecoins offer a faster means to move money than the current financial infrastructure. Given their ability to be settled on blockchains, stablecoins can transfer value in under minutes, which blows ACH settlement of ~1–3 days out of the water. According to a 2020 report from the Office of the Comptroller of the Currency (“OCC”), stablecoins based on decentralized technologies can supply faster and more efficient payment mechanisms than the current financial infrastructure, which is well suited to the changing financial needs of the nation.[xix] A report by Deutsche Bank argued that stablecoins, specifically CBDCs, would dramatically increase the efficiency of settlements as it pertains to currency and securities, which currently faces a multi-day lag.[xx] By increasing the speed and reducing the time for transfer and settlement, stablecoins unlock a whole set of economic advantages. At a high level, minimal settlement times will spur greater market efficiency as it enhances the flow of money in the economy: people would receive their salary in minutes (enabling them to spend faster), businesses would receive their revenue in minutes (allowing them to reinvest faster), and governments could engage in more direct monetary policy in order to avoid some of the negative effects of currency drain on the money multiplier.[xxi] The displacement of the check by stablecoins would create immense value for low-income households, which have traditionally been left out of the FinTech wave.[xxii] By just not having to go to gregarious check cashing operators, low-income families would save a significant portion of yearly wealth. Note, that a reasonable counter is that this vision will take time to come together. And, while I agree with that, stablecoins are not a technology that only works at scale — the benefits of speed can be reaped in an incremental fashion as adoption grows.

Secondly, there is the benefit of being a lower cost medium of exchange. Going back to the use case of remittances and cross-border payments, blockchain-based stablecoins enable international transaction at a minimal fraction of current methods. For context, the World Bank estimates that the average cost of global remittances was 6.30% of the amount sent.[xxiii] Additionally, concerning the U.S. alone, it is estimated that the average cost in 2020 to send money out of the country was 5.14%, respectively.[xxiv] According to the World Bank, if remittance prices could be cut by 5 percentage points, the world would save up to $16b per year.[xxv] At the current level, stablecoins can more than do this, with most transactions priced at less than a penny.[xxvi] A potential counter to that is that current digital payment offerings are most likely already doing this, so why add additional risk through stablecoins? Well, sadly, this is not the case at all. Not only have the unit costs of finance not gone down over the past century, but even with the advent of FinTech, a large share of the globe’s population is not benefiting, especially those in the low-income bracket.[xxvii] Low-income households still operate on checks, prepaid debit cards, and debit cards. These forms of personal finance expose them to significant overdraft fees as well as make them disproportionately bear the brunt of credit card costs embedded in prices.[xxviii] Stablecoins and digital wallets would change the check and debit businesses drastically, whether through innovation-propelled efficiency or outright disintermediation, alleviating low-income groups from several fees and economic costs. It is important to note the argument for the stablecoins’ low-cost advantage is not just echoed by groups in the private sphere, but also by government officials and policymakers, who have agreed that the markups and transaction costs of the financial system need to be reduced (i.e. Fed Governor Waller’s speech on CBDCs).[xxix]

Thirdly, there is the benefit of inclusivity, which was partially touched on above. According to the Federal Deposit Insurance Corporation (“FDIC”), 25% of American households are unbanked or underbanked.[xxx] While I do concede Fed Governor Waller’s argument that a subsect of these people has no interest in joining the banking system (estimated by him as ~4% of the population), it does not necessitate that the other ~21% should be ignored.[xxxi] By creating a low barrier form of digital cash that has immediate access to digital financial services, this large group of American society can now be fully included in the financial sector. The economic consequences would be tremendous: more consumers, more capital, more services, etc. On top of this, if one expands this argument to the global economy, the economic effects would be titanic, with the World Bank estimating that a whopping 31% of global adults are unbanked.[xxxii] Combine this with the fact that ~78% of the world’s population has a mobile phone, and it becomes clear that a digital, mobile-based stablecoin could encompass a significantly higher percentage of the global population than the current financial system.[xxxiii] It is important to highlight that this is not a farfetched argument as entities like Celo already have the technology in place to make this a reality. It is the cooperation among governments and financial institutions that is being waited on. One final point to mention is that stablecoin technology could greatly increase the effectiveness of government financial aid and monetary response to lower-income groups. While the COVID-19 Fed-Treasury response was astonishing in many ways, the relative effectiveness compared to a theoretical scenario under stablecoins is poor: Congress passed the COVID-19 relief bill on March 27, yet by May 1, only 64% of the eligible people had been sent their first round of pandemic payments.[xxxiv] In the words of a Brookings Economic Study, eligible lower income households largely suffered because “Uncle Sam did not know how to send money to its citizens”.[xxxv] Thus, stablecoin technology can be accretive to government policy as well.

In addition to these main benefits, there are a couple of other ones to mention. Firstly, according to the OCC, stablecoin technology on decentralized blockchains offers more security and resilience than current financial institutions in some circumstances.[xxxvi] Secondly, the digital nature of stablecoins strongly aligns with the younger generations (Millennials and Gen Z) as these tended to grow up in a more digital-friendly era.[xxxvii]

Drawbacks

In terms of the cons pertaining to stablecoins, there are four main ones. Firstly, and this is the most important one I argue, stablecoins are a new technology, and new technologies entail significant known and unknown risks. The technology behind stablecoins can be hard for financial institutions to adopt, thus leading to increased cybersecurity risk, new fraud vulnerabilities, certification issues, and more.[xxxviii] As financial institutions and businesses plug into stablecoin rails, their insufficient knowledge of blockchain technology, or an unforeseen tech stack risk, makes them susceptible to attack. Additionally, the reliance on underlying blockchain technology could lead to further exposure to risk. For example, if an accepted stablecoin is produced on a blockchain A, which becomes the target of a successful overriding 51% attack, then the ledger becomes compromised and the stablecoin balances and transaction history may be altered.[xxxix] One last thing to mention is that stablecoins are innately connected to the nascent crypto economy. The cryptoasset space faces a confluence of high leverage and significant volatility. When certain loan liquidations coincide with periods of low liquidity, a cascade of falling asset prices and liquidations ensues, threatening to de-peg stablecoins (more on this below).[xl]

AML / CFT compliance presents another big risk for institutions dealing with stablecoins. Regulators as well as financial institutions fear that the current pseudonymous nature of cryptoassets can expose those that interact with stablecoins to money that has been laundered or that is / will be used for terrorist financing. Doing so would be in breach of the AML / CFT standards developed by the Financial Action Task Force (“FAFT”), a G7 intergovernmental agency whose prime purpose is to combat money laundering.[xli] Without being able to regulate stablecoin money flow at certain choke points, government departments such as the Treasury are very concerned. Moreover, it is not an issue that can really be dealt with by one country alone: as long as there is a breach in the system somewhere around the world, then the whole stablecoin network would technically be compromised.

Thirdly, there is the inherent issue with what is called last mile delivery. According to the OECD, stablecoins overall are very promising, especially for the developing world, however the crux of the matter doesn’t lie within their use, but rather within the fiat on-ramps and off-ramps.[xlii] Once USDC has been sent to a user in Western Africa, how easy is it for them to turn it into their local currency, say the Naira? There are no stablecoin ATMs, neither many crypto off-ramps. Even in nations with wide scale use of digital / mobile money, there lacks a network for cashing out stablecoins or cryptoassets in general. The benefits behind stablecoins are potentially challenged by the inability for the stablecoin to work full circle.

Fourth and finally, there is the inherent liquidity risk within stablecoins and the consequences that may bear on the wider financial system. This risk is represented in a couple of different ways. Liquidity risk may arise from the misalignment of the settlement timing and processes between other financial systems and the stablecoins. The President’s Working Group on Financial Markets, in collaboration with the FDIC and OCC, detailed an example whereby the stablecoins would be operating 24/7, but the payment rails for minting / redeeming would only work during regular busines hours. This would lead to periods of temporary shortages and mismatches between supply and demand.[xliii] Liquidity risk also manifests itself in the minting / redeeming processes as well as the maintenance of the peg. In certain market situations, significant redemptions could lead to breaking the $1 peg (as was seen with money market mutual funds in 2008), which would catalyze a whole series of negative consequences as well as sow distrust in stablecoins.[xliv] If this is the case, stablecoins could become reminiscent of 1830s Wildcat banking.

Before moving on, the reader may be surprised not to see the threat to U.S. monetary policy as a drawback for stablecoins. This was not addressed because stablecoins, even private ones, actually strengthen the government’s ability to conduct monetary policy. As Fed Governor Waller stated, “private stablecoins pegged to the dollar broaden the reach of U.S. monetary policy rather than diminish it”.[xlv] Now, whether it is a threat to countries that will lack stablecoins denominated in their own currency is a fair question, but the onus there falls more on those governments than on stablecoin technology itself.

Are stablecoins worth it?

Both the pros and cons bring up several fair points, and it is the soundness of both sides that makes the overall discussion on stablecoins somewhat challenging to conclude. That being said, I argue that the aforementioned benefits are very compelling, and their potential is too significant to ignore. On top of this, I reason that certain risks can be mitigated via sound and innovative regulation. Thus, with this regulatory assistance, the benefits are well worth underwriting the risks left over.

Recapping the benefits of stablecoins as compared to the current financial system, their performance across speed, cost, and inclusiveness, at least as it stands at today’s scale, is significantly better. It is interesting to note that there are several proponents for dealing with the current financial system’s shortcomings in more traditional ways. The Fed is working on FedNow, which aims to provide a real-time payment service[xlvi]; however, this is only scheduled to launch in 2023 and government deadlines tend to be overly optimistic. There are also FinTech solutions, which manifest great progress in the likes of PayPal’s merchant network, Tencent’s WeChat, and Wall Street’s Zelle. Yet, as was argued above, these systems drastically underserve certain echelons of the population and still are slowed down by choke points created by the current financial system (i.e. taking money out of Venmo still takes a matter of days). Some even say that they exacerbate inequality, brining into question the societal costs of FinTech.[xlvii] If there is a solution like stablecoins that does offer a nuanced approach to tackling the problems associated with speed, cost, and inclusivity, why not be supportive of at least giving it a try?

A counterargument to the above emanates from the risks that stablecoins bring. I concede that technology risk, security risk, and issues pertaining to last mile delivery are problems that will have to be faced head on. It would be erroneous to present stablecoins as a unicorn-like solution with no problems. These are risks that involved parties will have to work together to tackle, but the magnitude of the benefits makes this worth it. Through better education and security practices, some of the technology risk can be assuaged: as the space evolves, there will be several consulting and cybersecurity firms filling in to assist, just as there was with the internet. Through funding innovation and building government-private sector partnerships, the last mile delivery problem and other similar constraints can be alleviated. Additionally, these issues should begin to fade with greater stablecoin adoption, which by default provides more avenues for usage.

Will there still be technology risk and unknown unknowns? Could certain problems, like increased network fees, arise as stablecoin systems scale? These are fair questions, and yes, risks and problems like those will be present; however, so was the case with other momentous technologies like the internet. Additionally, it is also not as if financial institutions aren’t exposed to serious technology risks now: cyber breaches, hacks, and system failures have plagued them for years (i.e. Reserve Bank of New Zealand, Equifax, JP Morgan Chase, and more).[xlviii] Therefore, it is not wise to reject stablecoins based on the technology risk alone.

When it comes to the drawbacks as they pertain to AML and liquidity issues, this is where legislators and regulators can play a crucial role. If regulation is designed which balances security with sensibility and cognition of this being a new technology, then these drawbacks can be reasonably addressed. This brings me to the next section, which aims to discuss stablecoins in the eyes of regulatory regimes.

Stablecoin Regulation

Assuming that Congress, the Treasury, and the Fed were to let centrally issued stablecoins continue to scale by bringing them into the regulatory framework, what would this look like? Before answering that, it makes sense to first ask if they can be regulated, or is a completely new legal regime needed? I believe the former is correct, and there are two key pieces of financial legislation that give the government the ability to regulate stablecoins. The first is a clause within the Dodd Frank Wall Street Reform, whereby under Title VIII, the Financial Stability and Oversight Council (“FSOC”) can require the regulation of “payment activity” that it determines “is, or is likely to become, systemically important”.[xlix] It can be argued that the $150b and growing stablecoin market value should characterize stablecoins as systemically important, or at least likely to become so. The second is a surviving provision from the repealed Glass-Steagall Act, Section 21(a)(2), whereby deposits, or deposit-like products, that are marketed as retaining a constant value (i.e. price stability) could be considered regulatable.[l] If this is proved to be the case, then stablecoin issuers would require federal or local supervisory oversight. Given the definition of stablecoins, it can be reasoned that they fit this description.

Going back to the central question of this section, regulating a new technology can be quite complex; however, the underlying principles of stablecoins relate to two types of financial products existing today: deposits and securities, such as of a money market mutual fund (“MMMF”). The relationship to these products can provide some insight into certain regulatory frameworks to learn from. Looking at stablecoins as deposits would most likely make regulation of stablecoin issuers akin to that of commercial banks. To address the potential risks pertaining to stablecoin runs and liquidity risk, legislation could require stablecoin issuers to be insured depository institutions, subjecting them to appropriate supervision by the FDIC.[li] [lii]This would help dissolve the contagious and inherent bank run problem, which could easily plague stablecoins. Regulating them this way would also bring stablecoins into compliance with the Section 21(a)(2) provision, which if not in compliance with can result in criminal punishment. Some members of Congress have taken this path even further, arguing that it is only banks that should be able to issue stablecoins (proposed Stablecoin Classification and Regulation Act of 2020, an amendment to the Federal Deposit Insurance Act).[liii] While this is a clearer and, frankly, easier way to incorporate stablecoins into the regulatory framework, it begs the question of whether this would cause regulatory overburden for stablecoin issuers. It is tough to confidently argue that they should be fully regulated as commercial banks when they are very similar to FinTech companies that largely operate as shadow financial institutions. What would be the effect on the competitiveness of stablecoins and would this taint some of its benefits?

On the other hand, stablecoins could be regulated as securities. MMMFs, funds which take in capital to invest in highly liquid, near-term instruments, tend to report NAV at $1 and seek to maintain that peg. This carries a very similar proposition to stablecoins, and thus some have argued that stablecoin issuers should be regulated like MMMFs. The issue with this, however, is that stablecoins would then be treated as securities, and this carries a higher level of burden than basic currency.[liv] Additionally, a stablecoin violates the principal-interest component of a capital markets investment, which calls into question how it could even be a security.[lv] Finally, how would merchants, businesses, and consumers use stablecoins on an ongoing basis if they were securities? This would drastically reduce the trust and ease of use behind stablecoins.

Regulating stablecoins, I argue, will require coming up with new amalgamation of several provisions already well understood and passed under other legislation. A high-level detailing of a sound approach would look like the following. Firstly, stablecoin issuers could be defined as lite depository institutions, whereby they take in fiat as deposits, which are covered by a new scheme under the jurisdiction of the FDIC. This would alleviate general issues pertaining to liquidity risk, trust, and some systemic risk. Secondly, stablecoin issuers would be given certain leeway to invest a portion of deposits in highly liquid, near-term instruments like MMMFs do, without receiving the same securities classification. This would allow them to fairly earn interest to cover operational costs and potentially make a profit. It must be stated, however, that capital buffers should be required as to cushion any issues that may occur within the markets the stablecoin issuer invests in. These capital buffers could be determined similarly to the Basel II method of calculation for capital requirements. Although MMMFs have broken the buck before, the FDIC component should guard against this as well as the following. Thirdly, stablecoin issuers should be eligible for a master account at the Fed, which would allow them to park reserves there safely and earn some interest.[lvi] Stablecoin issuers should also be able to access some type of discount loan window during times of immense financial stress. Having the Fed as a lender during emergency times should compound the benefits of being FDIC insured as it pertains to liquidity risk. Fourthly, the Treasury and Department of Justice should take a measured approach to AML / CFT compliance. Full AML / CFT compliance cannot be paired with the current state of blockchain-based stablecoins and forcing that matter risks reducing some of their benefits, especially as it pertains to the lower-income bracket. For example, having identity data on every stablecoin wallet (assuming it is even possible) significantly raises the costs of operation and leads to issuance policies that will most likely block unbanked users as that is easier than dealing with them from a compliance perspective. Looking into a blockchain-based system of red flag raising and tracking (i.e. contracting firms like Chainalysis), blended with KYC checkpoints for transactions above a certain nominal value, is an advised path to take and would bring stablecoins somewhat in line with the general principles of FAFT guidance. Just as every transaction on the internet is not fully regulated, not every stablecoin transaction needs oversight. Finally, the Consumer Financial Protection Bureau should be consulted on the disclosure of information to customers, standards of data protection, and rights of recourse.[lvii]

The proposals detailed above shouldn’t be taken as rigid solutions. Rather, they serve as discussion points and key principles off which to construct a comprehensive regulatory package. With these principles as focal points, I am confident that regulation would be able to mostly mitigate the two key risks mentioned above. By doing this, those cons can be assuaged with the benefits side not being too affected, thus strengthening the argument for stablecoins.

Concluding Remarks

Stablecoins have the potential to reshape the financial system, engineering better standards for speed, cost, and inclusiveness; however, they also introduce some noteworthy risks. That being said, just because there are risks present, it doesn’t mean stablecoins should be feared and outright banned. America’s success was defined by the risks it took, and, in most cases, it took those risks in a thoughtful way. With prudent regulation, as suggested above, that focuses on shoring up stablecoin issuers against liquidity risks and AML / CFT compliance risks, in addition to innovation attempting to solve some technological issues and the last mile delivery problem, stablecoins have a serious shot at fulfilling their grand potential. Regulation may as well be the lynchpin to this success, however, and that is why regulators must approach stablecoins in a thoughtful, innovation-friendly, and forward-looking way.

Sources

[i] Nakamoto, Satoshi. “Bitcoin: A Peer-to-Peer Electronic Cash System,” October 31, 2008. https://bitcoin.org/bitcoin.pdf.

[ii] “What Is a Stablecoin?” Coinbase. Accessed December 12, 2021. https://www.coinbase.com/learn/crypto-basics/what-is-a-stablecoin.

[iii] Gogel, David, Sumedha Deshmukh, André Geest, Daniel Resas, Christian Sillaber, and Kevin Werbach. Rep. DeFi Beyond the Hype: The Emerging World of Decentralized Finance. Philadelphia, PA: Wharton Blockchain and Digital Asset Project & World Economic Forum, 2021.

[iv] “Cryptocurrency Prices, Charts, and Market Cap.” CoinGecko. Accessed December 12, 2021. https://www.coingecko.com/en.

[v] Gogel, David, Sumedha Deshmukh, André Geest, Daniel Resas, Christian Sillaber, and Kevin Werbach. Rep. DeFi Beyond the Hype: The Emerging World of Decentralized Finance. Philadelphia, PA: Wharton Blockchain and Digital Asset Project & World Economic Forum, 2021.

[vi] President’s Working Group on Financial Markets, the Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency. Report on Stablecoins (pp. 8–9). Washington D.C. 2021.

[vii] “DeFi & USDC: A Guide to Global Stablecoins and Decentralized Finance.” Circle. Accessed December 12, 2021. https://www.circle.com/en/digital-dollar-stablecoin-solutions-for-defi.

[viii] President’s Working Group on Financial Markets, the Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency. Report on Stablecoins (pp. 8–9). Washington D.C. 2021.

[ix] “Total Value Locked (USD) in DeFi.” DeFi Pulse — The Decentralized Finance Leaderboard. Accessed December 12, 2021. https://defipulse.com/.

[x] “DAO Ecosystem Overview.” Deep DAO — Insights for a Decentralized World. Accessed December 12, 2021. https://deepdao.io/#/deepdao/dashboard.

[xi] Chester, Jonathan. “How USDC Is Enabling International Payments with Bitwage.” Circle, October 1, 2021. https://www.circle.com/blog/how-the-usdc-stablecoin-is-enabling-businesses-to-get-paid-better-with-bitwage.

[xii] Hadero, Haleluya. “Charities See More Crypto Donations. Who Is Benefiting?” Los Angeles Times, November 20, 2021. https://www.latimes.com/business/story/2021-11-20/charities-see-more-crypto-donations-who-is-benefiting.

[xiii] “How to Donate Crypto.” Coinbase. Accessed December 12, 2021. https://www.coinbase.com/learn/crypto-basics/how-to-donate-crypto.

[xiv] Webber, Daniel. “Facebook’s Novi Poses Fresh Challenges for Remittances.” Forbes. Forbes Magazine, October 29, 2021. https://www.forbes.com/sites/danielwebber/2021/10/28/facebooks-novi-poses-fresh-challenges-for-remittances/?sh=1e7fb9a578f0.

[xv] “Celo: Crypto Made for Mobile.” Celo Alliance. Accessed December 12, 2021. https://celo.org.

[xvi] “DeFi & USDC: A Guide to Global Stablecoins and Decentralized Finance.” Circle. Accessed December 12, 2021. https://www.circle.com/en/digital-dollar-stablecoin-solutions-for-defi.

[xvii] “Digital Currency Comes to Visa’s Settlement Platform.” Visa, March 29, 2021. https://usa.visa.com/visa-everywhere/blog/bdp/2021/03/26/digital-currency-comes-1616782388876.html.

[xviii] Gkritsi, Eliza. “Shanghai to Test Offshore Yuan Stablecoin on the Conflux Blockchain.” CoinDesk, September 17, 2021. https://www.coindesk.com/business/2021/09/17/shanghai-to-pilot-offshore-use-of-digital-yuan-on-conflux-blockchain/.

[xix] Office of the Comptroller of the Currency. Interpretive Letter 1174. OCC Chief Counsel’s Interpretation on National Bank and Federal Savings Association Authority to Use Independent Node Verification Networks and Stablecoins for Payment Activities (pp. 3). Washington D.C. 2021.

[xx] Deutsche Bank Data Innovation Group. “The Future of Payments Part III. Digital Currencies: The Ultimate Hard Power Tool.” Deutsche Bank, January 2020 (pp. 11). https://www.dbresearch.com/PROD/RPS_EN-PROD/PROD0000000000504508/The_Future_of_Payments_-_Part_II__Moving_to_Digita.pdf?undefined&realload=lqrOA51wXo2dq2pIEUVF7Fe2PNRlMllf5miWouvSJfZGkr2X0Io3YHzxQ6GP\~DThNttVtYSeuHy8/qSn0E1Jpg.

[xxi] Deutsche Bank Data Innovation Group. “The Future of Payments Part III. Digital Currencies: The Ultimate Hard Power Tool.” Deutsche Bank, January 2020 (pp. 10–12). https://www.dbresearch.com/PROD/RPS_EN-PROD/PROD0000000000504508/The_Future_of_Payments_-_Part_II__Moving_to_Digita.pdf?undefined&realload=lqrOA51wXo2dq2pIEUVF7Fe2PNRlMllf5miWouvSJfZGkr2X0Io3YHzxQ6GP\~DThNttVtYSeuHy8/qSn0E1Jpg.

[xxii] Klein, Aaron. “Can Fintech Improve Health?” Brookings Institution, September 2021. https://www.brookings.edu/wp-content/uploads/2021/09/20210922_Klein_Can_fintech_improve_health.pdf.

[xxiii] “Remittance Prices Worldwide Quarterly.” The World Bank, June 2021. http://remittanceprices.worldbank.org/sites/default/files/RPW_Report_Mar2014.pdf.

[xxiv] “Average Cost of Sending Remittances from the U.S. 2020.” Statista, May 17, 2021. https://www.statista.com/statistics/962747/average-cost-of-sending-remittances-from-usa/.

[xxv] “Remittance Prices Worldwide.” The World Bank. Accessed December 13, 2021. https://remittanceprices.worldbank.org/en.

[xxvi] Sudaric, Slobodan. “Save Money, Transact Faster: Stablecoins as an Alternative to Traditional Banking.” Nasdaq, September 7, 2021. https://www.nasdaq.com/articles/save-money-transact-faster%3A-stablecoins-as-an-alternative-to-traditional-banking-2021-09.

[xxvii] Financial institution unit economics over time, Georgetown Lecture.

[xxviii] Massad, Timothy G. “Regulating stablecoins isn’t just about avoiding systemic risk.” Brookings Institution, October 5, 2021. https://www.brookings.edu/research/regulating-stablecoins-isnt-just-about-avoiding-systemic-risk/.

[xxix] Waller, Christopher J. “Reflections on Stablecoins and Payments Innovations.” Board of Governors of the Federal Reserve System. Federal Reserve, November 17, 2021. https://www.federalreserve.gov/newsevents/speech/waller20211117a.htm.

[xxx] Massad, Timothy G. “Regulating stablecoins isn’t just about avoiding systemic risk.” Brookings Institution, October 5, 2021. https://www.brookings.edu/research/regulating-stablecoins-isnt-just-about-avoiding-systemic-risk/.

[xxxi] Waller, Christopher J. “Reflections on Stablecoins and Payments Innovations.” Board of Governors of the Federal Reserve System. Federal Reserve, November 17, 2021. https://www.federalreserve.gov/newsevents/speech/waller20211117a.htm.

[xxxii] “2. The Unbanked.” The World Bank. Accessed December 13, 2021. https://globalfindex.worldbank.org/sites/globalfindex/files/chapters/2017 Findex full report_chapter2.pdf.

[xxxiii] “Smartphone Penetration Worldwide.” Statista, June 2, 2021. https://www.statista.com/statistics/203734/global-smartphone-penetration-per-capita-since-2005/.

[xxxiv] Klein, Aaron. “Can Fintech Improve Health?” Brookings Institution, September 2021 (pp. 24). https://www.brookings.edu/wp-content/uploads/2021/09/20210922_Klein_Can_fintech_improve_health.pdf.

[xxxv] Klein, Aaron. “Can Fintech Improve Health?” Brookings Institution, September 2021 (pp. 24). https://www.brookings.edu/wp-content/uploads/2021/09/20210922_Klein_Can_fintech_improve_health.pdf.

[xxxvi] Office of the Comptroller of the Currency. Interpretive Letter 1174. OCC Chief Counsel’s Interpretation on National Bank and Federal Savings Association Authority to Use Independent Node Verification Networks and Stablecoins for Payment Activities (pp. 8). Washington D.C. 2021.

[xxxvii] Deutsche Bank Data Innovation Group. “The Future of Payments Part III. Digital Currencies: The Ultimate Hard Power Tool.” Deutsche Bank, January 2020 (pp. 7). https://www.dbresearch.com/PROD/RPS_EN-PROD/PROD0000000000504508/The_Future_of_Payments_-_Part_II__Moving_to_Digita.pdf?undefined&realload=lqrOA51wXo2dq2pIEUVF7Fe2PNRlMllf5miWouvSJfZGkr2X0Io3YHzxQ6GP\~DThNttVtYSeuHy8/qSn0E1Jpg.

[xxxviii] Office of the Comptroller of the Currency. Interpretive Letter 1174. OCC Chief Counsel’s Interpretation on National Bank and Federal Savings Association Authority to Use Independent Node Verification Networks and Stablecoins for Payment Activities (pp. 9). Washington D.C. 2021.

[xxxix] President’s Working Group on Financial Markets, the Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency. Report on Stablecoins (pp. 13). Washington D.C. 2021.

[xl] Klages-Mundt, Ariah, and Andreea Minca. “(In)Stability for the Blockchain: Deleveraging Spirals and Stablecoin Attacks.” Cornell University, March 2, 2021. https://arxiv.org/pdf/1906.02152.pdf.

[xli] President’s Working Group on Financial Markets, the Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency. Report on Stablecoins (pp. 19). Washington D.C. 2021.

[xlii] Rühmann, F., et al., “Can blockchain technology reduce the cost of remittances?” OECD Development Co-operation Working Papers, №73 (2020): 23. https://doi.org/10.1787/d4d6ac8f-en.23

[xliii] President’s Working Group on Financial Markets, the Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency. Report on Stablecoins (pp. 13). Washington D.C. 2021.

[xliv] Massad, Timothy G. “Regulating stablecoins isn’t just about avoiding systemic risk.” Brookings Institution, October 5, 2021. https://www.brookings.edu/research/regulating-stablecoins-isnt-just-about-avoiding-systemic-risk/.

[xlv] Waller, Christopher J. “Reflections on Stablecoins and Payments Innovations.” Board of Governors of the Federal Reserve System. Federal Reserve, November 17, 2021. https://www.federalreserve.gov/newsevents/speech/waller20211117a.htm.

[xlvi] Waller, Christopher J. “Reflections on Stablecoins and Payments Innovations.” Board of Governors of the Federal Reserve System. Federal Reserve, November 17, 2021. https://www.federalreserve.gov/newsevents/speech/waller20211117a.htm.

[xlvii] Klein, Aaron. “Can Fintech Improve Health?” Brookings Institution, September 2021. https://www.brookings.edu/wp-content/uploads/2021/09/20210922_Klein_Can_fintech_improve_health.pdf.

[xlviii] “Timeline of Cyber Incidents Involving Financial Institutions.” Carnegie Endowment for International Peace. Accessed December 13, 2021. https://carnegieendowment.org/specialprojects/protectingfinancialstability/timeline.

[xlix] “Title VIII of the Dodd-Frank Act.” Board of governors of the Federal Reserve System. Accessed December 12, 2021. https://www.federalreserve.gov/paymentsystems/title-viii-dfa.htm.

[l] Jackson, Howell, and Morgan Ricks. “Locating Stablecoins within the Regulatory Perimeter.” The Harvard Law School Forum on Corporate Governance, August 5, 2021. https://corpgov.law.harvard.edu/2021/08/05/locating-stablecoins-within-the-regulatory-perimeter/.

[li] President’s Working Group on Financial Markets, the Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency. Report on Stablecoins (pp. 2). Washington D.C. 2021.

[lii] Catalini, Christian, and Jai Massari. “Stablecoins and the Future of Money.” Harvard Business Review, August 10, 2021. https://hbr.org/2021/08/stablecoins-and-the-future-of-money.

[liii] Stablecoin Classification and Regulation Act of 2020. Bill (2020).

[liv] Michel, Norbert, and Jennifer J Schulp. “A Simple Proposal for Regulating Stablecoins.” Cato Institute, November 5, 2021. https://www.cato.org/briefing-paper/simple-proposal-regulating-stablecoins#biden-administrations-proposals.

[lv] Michel, Norbert, and Jennifer J Schulp. “A Simple Proposal for Regulating Stablecoins.” Cato Institute, November 5, 2021. https://www.cato.org/briefing-paper/simple-proposal-regulating-stablecoins#biden-administrations-proposals.

[lvi] Massad, Timothy G. “Regulating stablecoins isn’t just about avoiding systemic risk.” Brookings Institution, October 5, 2021. https://www.brookings.edu/research/regulating-stablecoins-isnt-just-about-avoiding-systemic-risk/.

[lvii] Massad, Timothy G. “Regulating stablecoins isn’t just about avoiding systemic risk.” Brookings Institution, October 5, 2021. https://www.brookings.edu/research/regulating-stablecoins-isnt-just-about-avoiding-systemic-risk/.

A couple of developments that set up some context for this post:

• The FeiRari merger was successfully passed by both DAO voting processes — on to the new path of building value and unlocking synergies

• Polygon, Optimism, Arbitrum, and StarkWare have all been making solid progress in terms of L2 improvements, deployments, and functionality

• Uniswap’s successful governance proposal to commence Polygon deployment and likely conduct a liquidity mining campaign is the latest vote of L2 confidence

Bottom line is that we are beginning to ramp towards an L2-based DeFi ecosystem and Fei Protocol has a very interesting opportunity to capture growth and create value. While I understand that Fei v2 is currently the main focus amongst the team and core contributors, I believe that their ‘L2 playbook’ should become a close second.

The Stablecoin Product

First and foremost, L2s are a huge market opportunity for $FEI. Assuming that Ethereum becomes the settlement layer, and a multi-layer, hyper scalable ecosystem is stacked on top of it, stablecoin provision will be crucial in the upper layers as transaction frequency (i.e. the money multiplier) will be higher and consumer interaction will be significantly larger. This is not to say that stablecoins won’t be valuable on the settlement layer.

Currently, competitors like $DAI and $MIM are eating up heavy market share on L2s. While L2s themselves are nowhere near Ethereum in terms of market size, the progression to a multi-layered ecosystem will catalyze significant growth for L2s, meaning that these stablecoins could benefit from a first mover advantage in an ecosystem on the brink of exponential adoption.

By getting $FEI up on the L2s (into exchanges, lending pools, option markets, and more), Fei Protocol could strategically position itself to be able to capture the transition to a multi-layered ecosystem and combat the effects of first mover advantage possessed by competitors before it might be too late.

LaaS

Assuming that Fei Protocol deploys contracts onto L2s in a safe and effective manner, the second key strategic opportunity lies in its LaaS product. The first thing I thought of when engaging with the Uniswap proposal to launch on Polygon, in which liquidity mining was suggested, was why liquidity mining? Why is the Uniswap community thinking in a DeFi 1.0 way? And then it hit me — the DeFi 2.0 liquidity methodologies are somewhat missing on L2s.

If this multi-layered world plays out, then we will see numerous projects moving contracts to L2s (we have already seen a glimpse of this). In order for their products to work well and have the same service level / UX as on Ethereum, they will need a good amount of liquidity.

Enter LaaS. If Fei Protocol (as well as Ondo Finance, which makes the coordination of this a bit more difficult) is well positioned on L2s, then it can be the leading partner to several DeFi DAOs in facilitating short-term liquidity boosts as they get their products going on the new layers. Part of the current problem with L2 UX is that liquidity is very low (i.e. try SushiSwap or Balancer, two amazing projects, on some L2s and you will not get the same performance as on Ethereum, gas costs aside).

Projects need liquidity on L2s. Let’s not make the mistake of going down the DeFi 1.0 liquidity mining path. Therefore, DeFi 2.0 methods need to be available on L2. Hence, LaaS opportunity. QED :)

Capital Bridges

In this multi-layered world, capital bridges stand to be one of the most crucial infrastructure components. In order to move between L2 ecosystems and chains, we need efficient, secure, and cost-effective bridges. Connext, Hop Protocol, Synapse and others have emerged to be players in this market. Of course, there are also native bridges like those of Optimism and Arbitrum (but these are costly and slow) and entire blockchains that facilitate capital movement like THORChain and Cosmos. The issue is that a look into platforms like Connext and Hop Protocol reveals stables like $USDC, $USDT, and $DAI (no $FEI).

As L2s grow in use, transaction volume in the bridges will grow at a similar pace, if not even faster. As these bridge volumes grow, the demand for stables used within them grows. Thus, there is value in getting $FEI onto these bridges as it can lead to another source of demand. It also will help combat the first mover advantage (pertaining to competitors) described two sections above as users will come into the L2s starting with $FEI.

Conclusion

Bringing it all together, an L2 strategy would focus on the following: deployment on L2s to rival competition in a market that could soon scale exponentially, strategic positioning of LaaS to facilitate the exponential growth of the L2 market, and demand capture of the chokepoints of capital flow to and from this L2 market, which is also growing exponentially. All these are self-reinforcing as well: owning a part of the bridge flow aids L2 market share capture, LaaS creates L2 liquidity depth for $FEI, and $FEI dominance in L2s strengthens the case for trading into it via a bridge.

This post serves more as a high-level perspective of what the L2 playbook for Fei Protocol could look like. Note, these strategic priorities carry a lot of depth and discussion behind them that was not covered. Once Fei v2 is on solid footing, L2 deployment and related product growth should be the main strategic focus.

Disclosure:* This blog series is strictly personal/ educational and is not investment advice nor a solicitation to buy or sell any assets. It does not represent any views from where the author is working — all views, opinions, and arguments are the author’s. Please always do your own research.*

Background

Liquity is a decentralized borrowing protocol that offers interest-free loans (in the form of LUSD) against ETH. While it is architected similar to MakerDAO, some key differences exist: 0% interest rates, immutable and decentralized protocol management, higher capital efficiency, and a robust peg mechanism for a simple user experience. Some comments on its functionality:

• Users deposit ETH into a vault (called trove) and take out a loan for any time horizon they wish, as long as the ETH is above the 110% collateral ratio. Unlike other debt protocols, liquidation is completely algorithmic, thus being more efficient and simpler. A minimum debt of 2,000 LUSD must be taken out

• Due to having no supply-side on the protocol level, Liquity can support 0% interest rates. MakerDAO cannot do so since it needs the interest revenue to control DAI price

A great test of Liquity’s mechanisms occurred on the May 19th market crash, where Liquity efficiently managed liquidations of under-collateralized debt positions. Out of all the stablecoins during this crash, Liquity’s LUSD was one of the best at maintaining as close to the peg as possible.

One last thing to mention — the core team had a dual focus when setting up Liquity: creating a robust, efficient debt protocol and offering best-in-class decentralization. Liquity doesn’t have a central frontend, instead setting up paid partnerships with other frontends (i.e. Zerion) to prevent a central point of failure. Driving this strategy is a comprehensible and trustless SDK that makes it easy for frontends to plug into Liquity’s functionality.

Liquity’s BD: Frontend acquisition

Currently, LQTY is used for frontend user cost of acquisition (“CAC”). Liquity protocol gives LQTY rewards to the frontend operators proportional to their respective TVL versus the entire network. The operators are entitled to distribute as much of these rewards as they want to their users as kickbacks.

While this in great in theory, it reflects a DeFi 1.0 approach to BD. The problem with this is that using the LQTY to fund CAC increases dilution and creates sell pressure for the token. This would be acceptable if the value driven from the frontend acquisition more than paid for this; however, I think that this is not the case. Liquity has been distributing significant LQTY tokens without getting much TVL growth at all:

• Since May 2021, circulating supply has grown quite strongly from 2.79m to 13.8m. On the other hand, TVL has gone from ~$3b up to $4.5b (mid-May) down to $2.47b

• This is effectively destructive to LQTY value. Ideally, there should be a better BD strategy more suitable to LQTY interests and accretive to the tokenomics behind LQTY

Potential Proposal

While the problem is evident, coming up with a solution is definitely tougher, and I am very open to community discussion on how to achieve this. That being said, one (very) theoretical way would be to finance some of the frontend acquisition through LUSD. How could this be done?

1. The Liquity community and team would need to work with lending protocols to allow for LQTY to be used as collateral. Given the LUSD proposal on Aave as well as the great track record with Fei-Rari, the Liquity community has some relationships it can flex to start conversations

2. This is where the strategy gets innovative (or riskier, frankly). Assuming one can get these lending markets accepting of LQTY, I propose that the Liquity treasury take out a loan using LQTY as collateral (interesting connection to my prior post on levering DAOs). The terms would be ultra conservative with a high collateralization ratio

3. Using the loan (denominated in ETH ideally), Liquity would proceed to take out loans on its own protocol to obtain LUSD, which it then uses to finance a percentage of the CAC. Over time, the treasury can pay back the loan / manage its debt load through its accrued fees from other staked LQTY in the treasury (or, and we are getting very theoretical here, a staked version of its original LQTY collateral)

What does an idea like this do? Drives greater use of Liquity + avoids LQTY dilution and sell pressure.

Risks & Friction

The idea above is not perfect at all… Firstly, there is significant friction to getting LQTY up as collateral. It would be hard to navigate the governance process for collateral acceptance just given the history of other protocols doing so as well as potential concerns with LQTY’s past volatility. The best option is probably some type of pool on Fuse.

Secondly, this idea assumes that Liquity is financing very profitable CAC. What happens if that LUSD is just pummeled into wasteful frontends that lack longevity? The Liquity treasury would accumulate a lot of debt with lower probabilities of paying it off without eating up treasury value. The success of the idea hinges on good BD that yields revenues to then pay off the debt.

Thirdly, would this be able to be conducted in an automated manner? Even after assuming the team wanted to include something like this in a v2, it would have to be smart contract code (unless they do move to a DAO model). Making this executable in an invulnerable way is very (and possibly too complex). The lack of a DAO also makes the whole treasury concept semi-void.

Conclusion

There definitely is a flaw in how frontend acquisition and growth is funded assuming that the goal is to make LQTY a valuable and well structured token. The proposal I gave is just a high level series of thoughts and has its risks/complications — this is just one of many ways to approach the issue and there are definitely other interesting approaches out there. However, all of this is effectively just an enjoyable brainstorm session if the team and community are not behind creating a better v2. If they are, then the frontend acquisition strategy is definitely something to work on.

Disclosure:* This blog series is strictly personal/ educational and is not investment advice nor a solicitation to buy or sell any assets. It does not represent any views from where the author is working — all views, opinions, and arguments are the author’s. Please always do your own research.*

Ever heard of the Modigliani-Miller Theorem (M&M)? As I was walking to grab dinner today, M&M suddenly popped into my head. A theory that every Finance major has heard of, but one probably not really remembered (given its lack of real life applicability), the M&M theory broadly states that “the market value of a company is correctly calculated as the present value of its future earnings and its underlying assets, and is independent of its capital structure”. Why do companies take on debt then? Well, this theory is only applicable under four key assumptions: there are no taxes, no bankruptcy nor transaction costs, no information asymmetry, and investors have the same cost of borrowing as companies. Realistic? No… BUT, the theory does have value as one can build propositions off of it by changing an assumption at a time. Add in taxes, and borrowing becomes very valuable as it lowers the cost of capital and enhances firm value. Add in transaction and bankruptcy costs, and now the level of leverage becomes a tradeoff between the tax benefits and the potential bankruptcy and transaction costs. You get the point.

Anyways, thinking about this theory, and how theoretically one can calculate the optimal leverage ratio for a company under certain conditions, I realized that nearly all DAOs lack debt. Quite weird, right? We have a set of financial theories, as well as a lot of practical research, which argue for the levering of firms. At least a little leverage can be value enhancing. So, why don’t DAOs have debt? Well, I think there is some rationale supporting the fact that all DAOs are too young in their lifecycle to lever up. For example, check out this graphic (taken from one of Aswath Damodaran’s presentations):

If we were to reasonably assume that all DAOs fit under Stages 1–3 (and 3 is pushing it), then debt is not practical. Why? Because high growth is high risk, and the cost of debt for DAOs would be too high as to not be value enhancing for a DAO. This is fair and I concede it; however, I have two scenarios in which it does make sense to think deeper about a DAO’s capital structure and its use of debt.

Firstly, the space might not be there yet, but it will get there sooner than later, especially for some of the bluechip DAOs (i.e. MakerDAO). Starting to think and speak (as a community) about DAO leverage makes sense. Even if we could begin to take small, baby steps with regards to levering DAOs, we would benefit from it. Secondly, why should that graphic apply to DAOs? It is a tough question, but in some sense a fair one. DAOs are in many ways different structures and treating them as full fledged companies could be dangerous. By dangerous, I mean both for saying that they are too early for debt as well as that they should be taking on debt. Frank conversations and experiments is what we need to be focused on. Maybe it is the case that DAOs shouldn’t take on much debt for a number of reasons that we develop. But maybe, and I think theoretically, they should. And that is what we need to start figuring out.

Pros and Cons of Debt

What are the pros and cons of debt, at least in the way that we understand it to be for companies?

Pros

• Tax benefits. The tax code (in general) is tilted in favor of debt, with interest payments being tax deductible in most parts of the world. Yes, DAOs do have to and should have to pay taxes

• Discipline. Debt creates a disciplinary force for managers (in the case of DAOs, core contributors and community). Borrowing money makes capital allocation more thoughtful and adds another set of parties who are involved in the success of the business

Cons

• Bankruptcy costs. Borrowing money increases the probability and possibility of bankruptcy. It increases insurance premiums, affects valuation, presents increased costs to certain services, etc.

• Agency costs. What is good for lenders might not always be good for the equity holders. This is a bit trickier for DAOs given the automation and anon P2P nature of DeFi lending (but this will most likely begin to change and, even without change, lenders do have expectations and there are implicit restrictions on actions)

• Loss of future flexibility. This is a big one and a notable concern in the crypto space. If a DAO levers up, it is losing flexibility to react to certain events and is absorbing debt capacity now at the cost of not doing it in the future

While these were rationalized for the corporate / equity world, they all apply to DAOs and would form considerations that each DAO would have to digest as they think about leverage.

Finding the Optimal Amount

This will be by far the trickiest subject of thought. Even in the TradFi world, all one really has at their disposal is some tools and theories; however, in reality none of that can truly spit out what is the right leverage ratio. These theories and assessments change with time, and perhaps we need a new way to do so in crypto. That being said, just understanding the relationships between debt and no debt can point to general directions for a DAO to go with regards to levering. I learned of five ways to determine the optimal capital structure:

1. Lifecycle approach (refers to the graphic discussed above)

2. Cost of capital approach — the optimal debt ratio is the one that minimizes the firm’s cost of capital

3. Enhanced cost of capital approach — the optimal debt  ratio is the one that generates the best combination of low  cost of capital and high operating income

4. The APV (adjusted present value) approach — the optimal debt  ratio is the one that maximizes the overall value of the firm

5. Sector approach — the optimal debt ratio is the one that  brings the firm closes to its peer group in terms of financing  mix (less applicable until DAO debt is much more established)

Using components of these tools / theories, DAOs could get a sense of what direction to go in with regards to leverage. Each one has its pros and cons, and thus a wholistic approach would be advised. Perhaps, with a steadier revenue and some profitable capital allocation opportunities, knowing to lever up a bit calls for the use of these tools to understand around what leverage range to aim for.

Types of Leverage

After understanding what move to make (i.e. lever up a turn or two), the choice of debt instruments is another big consideration. Should it be fixed or variable? In USDC, DAI, or even Euro stables? 5 year or 30 day maturity? These considerations are important, and factors like the intended use of capital, profit stability, strength of DAO treasury, macro outlook, etc. all play into this. The one known as it pertains to DAOs here is that DAOs are currently limited in their choices. DeFi innovation has been tremendous, but we still have a long way to go. With protocols like Element Finance and Notional Finance leading the way with fixed rate lending, there are some inroads forming on the fixed vs. variable front. However, when it comes to denominations and tenures for debt, the choices are limited. It will take time for debt markets to professionalize, yet, if DAOs start engaging with the debt protocols, then progress on both fronts would be reinforcing and symbiotic.

Conclusion

This post is just the tip of the iceberg for corporate debt; however, these are some high level buckets that should at least kick off a conversation or two. The real elephant in the room is whether DAOs are even ready for this or not… and that is tough to answer. Also, what opportunities are out there for deploying capital that require a big chunk of debt? Perhaps mergers will be the first one. Yes, protocols like Tribe have big treasuries and can spend tokens, but why not add in some leverage into the mix, assuming taking a loan from Notional or Maple would be possible? All just considerations to think about.

Debt is very valuable in the corporate world. Used correctly, it can enhance firm value, be used in strategic situations, and facilitate operations. Used incorrectly… it is BAD. I have faith in correct use, but we need to figure a lot out first. I look forward to talking about this subject more with fellow DAOs and peers in the space.

Disclosure:* This blog series is strictly personal/ educational and is not investment advice nor a solicitation to buy or sell any assets. It does not represent any views from where the author is working — all views, opinions, and arguments are the author’s. Please always do your own research.*

Current State of Governance

A run through Tally’s dashboard highlights low engagement across the board. There are two stats to look at while on Tally’s site: the “engagement ratio” and the actual number of votes. The former measures the number of delegated tokens / total tokens. This essentially represents how many tokens have consciously been transferred to some person or entity with the impression that they will be knowledgeable and active in the voting process. The latter is the actual number of votes (1 token = 1 vote). Taking this number and comparing it to the circulating supply (maybe some adjustments needed for certain holders) gives one a rough picture of the level of governance engagement. A couple of examples are highlighted below (note-  circulating supply displayed as a range given input from multiple sources like Messari & CoinGecko):

Uniswap (520m — 628m circulating supply) — 19.96% Engagement Ratio

Compound (6m circulating supply) — 40.71% Engagement Ratio

Rari Capital (11.3m circulating supply) — 21.67% Engagement Ratio

Fei Protocol (453m — 455m circulating supply) — 18.36% Engagement Ratio

As one can see across both metrics, voting engagement needs improvement.

What is ISS?

Institutional Shareholder Services Inc. (“ISS”) is a proxy advisory firm. What this means is that institutions (i.e. pension funds, mutual funds, hedge funds, etc.), which own multiple shares of multiple companies, pay ISS to advise and (nearly always) vote on their behalf in shareholder votes. Many times, at an AGM, you will see these whales allocate their voting blocks to the measures being voted on. Proxy advisory firms such as ISS have become very valuable entities over the past decades as the nature of equity ownership and equity governance has changed. Firstly, institutional ownership of equity has increased with time, and these days institutions dominate shareholder voting. Secondly, as the nature of governance has changed, shareholder voting has become very costly, as seen across the categories of time, expertise, and personnel. Massive institutions like BlackRock can insource proxy voting research; however, the long tail-end of large, medium, and small equity holding institutions cannot afford to do this. As a Harvard research paper poignantly put it: “third-party proxy advisory firms satisfy a market demand by centralizing these costs so they do not need to be duplicated across multiple investment firms”. This makes it feasible for a small wealth management firm or medium sized mutual fund to participate in governance. Thirdly, regulation has intensified around investment managers needing to be involved in the proxy voting events of their portfolio holdings as well as acting to the best of their ability to guide governance to the benefit of their clients. Basically, these institutions cannot just ignore or loosely pay attention to governance, they need to be thoughtful and active. This motivation, paired with the costliness, leads to the economic value presented by proxy advisory firms.

In crypto, we have this governance problem, which could be caused by a myriad of things from complexity associated with understanding proposals, low attention bandwidth (i.e. being a holder of so many tokens, each with its own proposals, is tough), and maybe even a lack of knowing that one’s token entitles one to voting power. Paired with this is an overall lack of traditional institutional involvement, no real pressure for funds to participate in governance, and several coordination deficiencies.

This is all going to change. I foresee a future where more institutions accumulate DeFi (and Web 3.0) governance tokens as part of their portfolio strategies. If anything, governance in crypto is even more valuable than governance in equities. As institutions do this, the need to understand not only how the protocols work, but what is going on with all these numerous proposals, will be immense. If the current users now aren’t doing well with participating in governance, how will these TradFi institutions do it? We have a significant opportunity… there needs to be a service that guides them through this process, and this leads me to crypto’s ISS.

There are many ways of tackling this, one of which would be to create a new DAO dedicated to this very mission; however, this would entail a lot of upfront costs — getting smart researchers, being well connected to the DAOs which have active proposals, and building knowledge stock over time. A new DAO is possible, but maybe we can use some of what already exists in the space to get this service going.

Proposal

The initial structure that I envision starts with a team like the one at Llama. This entity produces solid research on several projects that have governance components. While mainly conducting treasury-focused analysis, the team members and community contributors know a lot about these projects through their work and have the ability to retrieve data and information in a very efficient way. It wouldn’t be as much of a startup cost to begin gathering information around key proposals and releasing research. This is actually well aligned with what is going on in the treasury, and the work across both buckets can be symbiotic.

However, research alone won’t be the cure to the aforementioned governance engagement issue. We want voting to be guided by this research. Thus, I propose a partnership between the Llama team and Tally. Llama provides the key ingredients to produce successful governance research and advisory. Tally provides the infrastructure for voting to be delegated to Llama’s proxy advisory services.

Initially, the combined partnership would look like this. For every project that Llama covers, members of the team and community would begin to gather intel on the key governance voting proposals. Setting up a one-pager template, the members would detail the proposal (an overview), list the pros and cons, perhaps a paragraph on parties involved, and then conclude with their advice on what way to vote. This research would be accessible to the public for the time being. Moving on to Tally, the platform would show a special box pertaining to the ‘delegate’ functionality that lists the Llama Advisory group (a very nice addition to this would be a preview of the one-pagers on that project). This box would basically delegate people’s or institution’s vote to the Llama Advisory group, which would direct voting based on its research.

As this service begins to gain traction, and as the space develops to having more institutional involvement over time, Llama can offer this as a product to institutions. The research on voting would become proprietary and would be sold for an annual fee to these firms. The fee could be collected by some form of payment mechanism, or via Tally (i.e. in order to delegate to Llama Advisory, you would let some of your governance tokens be transferred as a tax, a.k.a. the fee — this is similar to how the Graph protocol does delegation). In fact, finding a potential way to monetize the delegation mechanism to the Llama Advisory group could be most successful in charging institutions.

If approached in the right way, this partnership will be a win-win for everyone involved. Llama gets a significant boost in the users / institutions consuming its content. Moreover, it gets to build relationships with key ecosystem players and diversifies its current treasury-focused business model. Needless to say, look at how successful ISS has been as a company in the TradFi world — this is a big revenue opportunity as the space matures. Tally benefits as its platform use increases significantly, given that the proxy vote, and possibly payment, will be realized through it. Projects and the community benefit from increased involvement, more public thoughtfulness on the proposals, and (hopefully) more efficient governance processes.

Now, there are some risks to consider here, but, with the ability to speak with the respective teams / communities, I think we could mitigate them in certain ways:

• Llama becomes influenced by a large party to push a vote one way. This has been a certain regulatory concern in the equity world with proxy advisors. We need to ensure that unbiased and objective analyses are run on proposals. Checks and balances / transparency needs to be instituted. The general risk of losing community trust should also motivate the team to behave accordingly. Incentives can be discussed as well

• Institutional payment for services could be interpreted as partial. I.e. would Llama contributors be pressured to favorably conclude on investor-introduced proposals if that investor paid for their services? Would just the potential of this happening reduce trust? This is a tough one to tackle, and we would need to devise a very strict proposal for customers, outlining impartiality

• Insider trading can interfere with research and voting. Assuming this partnership were to really scale, Llama’s team / core contributors could take token positions in protocols before releasing its research / voting. We would need to find incentive mechanisms to prohibit this (perhaps some form of auditing?)

The Future

The basic details mentioned above are just the start… in the not too distant future, the ownership of governance tokens will be spread out across more and more institutions. Wealth managers, pension funds, endowments, the very same entities that use ISS, will need a similar service for DeFi (and DAOs overall) governance. It makes complete sense for them to use the same model with their crypto exposure. In fact, it makes even more sense just given that crypto is very complex and harder to understand for the traditional manager. Given this knowledge gap, these firms would pay for the research and voting advisory, especially with pressure from clients on understanding the developments of their holdings and influencing them to participate in a way that benefits the long-term success of the clients. Token advisory services is very much a part of the future — and it’s time for us to get a head start on building it now.

Conclusion

This idea is in its early innings, however, its potential to tackle a deep problem within crypto is very exciting. A lot of it is still malleable, and I am very open to feedback from the community at large as well as to in-depth discussions with projects and especially involved parties (i.e. Llama and Tally). I look forward to presenting an updated proposal upon further research and significant input from others.

Disclosure:* This blog series is strictly personal/ educational and is not investment advice nor a solicitation to buy or sell any assets. It does not represent any views from where the author is working — all views, opinions, and arguments are the author’s. Please always do your own research.*

Overview

• Connext presents the opportunity to bet on a multi-chain, multi-layer world through a capital infrastructure play

• At its core, Connext is an L2<>L2 / L1 bridging solution, allowing users to move capital between chains / layers in a trustless and efficient manner

• With a strong team and a very competitive product, Connext will be able to capitalize on winner-take-all economics and, through its SDK-based business model, will become the backbone to dApp cross-chain operations. Overall, Connext’s value lies in its future abstraction — it is ‘behind the scenes’ financial plumbing

• Finally, Connext presents great opportunities for value add as well as multiple avenues to exit

Protocol

Connext is an interoperability protocol for interacting between L1s and L2s. Without introducing any new trust assumptions or external validators, Connext’s NXTP (the protocol technology) lets users swap assets across L1s and L2s in an efficient and timely manner.

• Note that the emphasis is on the word ‘swap’ and not ‘port’ or ‘migrate’. The current version of Connext cannot be used to pass arbitrary event data between chains; therefore, one cannot use the protocol to migrate a token from Chain A to B

• Albeit, users will not become frustrated at this inability, as swapping USDC on BSC to USDC on Optimism is basically the same as migrating, except that it is cheaper and faster than using migrating-based bridges

• NXTP is a lightweight, simple contract that uses a locking pattern, a network of off-chain routers that participate in pricing auctions and pass ‘calldata’ between chains, and a user-side SDK that finds routes and prompts on-chain transactions

Ecosystem Players:

Users

• Interact with a front end that is powered by NXTP. Best example right now is xPollinate

• Undergo the transaction process (discussed below) to fulfill the need of swapping one asset from one chain for it on another chain / rollup

Routers

• These are the liquidity providers, which set up a pool of assets on two chains / rollups and link up with NXTP to provide liquidity for swaps

dApps

• Integrate with NXTP by using the SDK. They then can manage front ends that channel assets to the NXTP contract for swapping to occur

Transaction Process:

The process can be broken down into three phases:

• Route action: the user broadcasts a message signaling their desired use of a specific bridging route. Routers respond with sealed bids containing commitments to fulfilling the transaction within a certain time and price range

• Preparation of transaction: once a bidder is selected, the user submits a transaction containing the router’s signed bid to the contract on the user’s side. This consequently locks up their funds on the user chain. The router detects an event (sealed chosen bid message) and the contract locks up the assets on their side. This lock up is incorporative of their fees

• Fulfillment: the user’s side will then receive a confirmation message of funds locked and it will send a signed message for a relayer to claim. This relayer (typically another router) will submit the transaction and receive a submission fee

• Note that transactions can be cancelled unilaterally by the person owed funds on that chain (router for sending chain, user for receiving chain) prior to expiry

Adoption Metrics

Daily Volume

Daily Transaction Count

Implied Average Transaction Value

Team

https://twitter.com/arjunbhuptani

• Connext, Co-founder & Project Lead (May 2017 — today)

• Moloch DAO, Co-founder (Oct 2018 — today)

• Colgate University, B.S. in Physics and B.A. in Philosophy

Notes:

• In the space since 2017, great experience and recognition

• Known for a strong grasp of state channel mechanics and inter-chain flow of value and information

• Previously, Connext used to focus on payments infrastructure within crypto and consequently solving for scalability became key

https://twitter.com/LayneHaber

• Connext, Co-founder & Protocol Lead (Jun 2017 — today)

• Arctica Health, Founder & CEO (May 2016 — Jun 2017)

• UCLA, B.S. in Chemistry and Materials Science

https://twitter.com/RHLSTHRM

• Connext, Co-founder & CTO (Jun 2017 — today)

• Lone Wolf Partners, Partner (Jan 2016 — today)

• ColorTokens, Core Engineer (Jun 2015 — Apr 2017)

• Tip’d Off, Co-founder (May 2014 — Jun 2015)

• Tesla, Senior Test Engineer (Sep 2010 — May 2014)

• Element Energy, Engineering Manager (Jun 2010 — Sep 2010)

• UC Santa Cruz, B.S. Electrical Engineering

Notes:

• Deep skillset suitable for technical side of Connext. Full-stack developer (NodeJS, React, React Native, RDS, NoSQL, Cloud Infrastructure, DevOps, Serverless) + Ethereum developer (Solidity, Truffle)

• Longer history as a developer in crypto relative to others

https://twitter.com/sanchay_mittal

• Connext, Project Manager (Nov 2020 — today)

• Other: Gitcoin, ConsenSys, HyperLedger

Jake Kidd

• Connext, Full-stack Developer (Feb 2021 — today)

• Other: Neato Robotics, Akruta

Cap Table

• First raise when company was an Ethereum payments solution (2017): ~$1m

• Bridge round (2019): $0.5m from ConsenSys Ventures

• Seed (03/22/21): Raised $2.2m from Polychain, 1kx, Huobi Capital

• Ecosystem round (07/13/21): Raised $12m from 1kx, ConsenSys Mesh, Coinbase Ventures, MetaCartel Ventures, Scalar, and others. Also included investments from staking service providers (i.e. Blockdaemon, Figment, Stakefish) and ecosystem players (i.e. Edge and Node, Loopring, Arbitrum founders)

Competitive Analysis

There are three ways to approach interoperability between chains:

Narrow Competition

Hop Protocol

• A locally verified mechanism for sending tokens across rollups. Hop leverages existing arbitrary messaging bridges (“AMBs”) to send funds between chains, with a bonder (liquidity provider) fronting the capital to make the process fast. To incentivize rebalancing, the protocol also utilizes AMMs on both sides to swap between the “canonical” asset for a chain and hTokens, a representative asset used by the bonder

• Since the proof of transfer is passed between chains using an AMB, Hop doesn’t need users to run off-chain code like Connext

Presents the following tradeoffs:

• Hop is less economically secure than Connext. It depends on AMBs, which means that if chains don’t have them, they need to be created. This introduces new security risks. Hop’s design also cuts corners like optimistic rollups’ seven day exit periods for settlement

• Hop is less capital efficient. It requires both entry and exit liquidity given its AMM model on both sender and receiver chains. In contrast, Connext LPs only need exit liquidity and incur no liquidity lockup, “achieving 10x+ better capital usage”

• Limitations to bonding. Bonders must pay gas costs based on Ethereum mainnet. Connext can have transactions go directly from L2 to L2 without touching the base layer

• Bonders are exposed to MEV and transaction submission races, according to the Connext team. Transactions cannot be front run on Connext as the users negotiate route and pricing off-chain

Synapse

• Synapse conducts integral blockchain activities such as asset transfers, swaps, and generalized messaging with cross-chain functionality. The Synapse network is secured by cross-chain multi-party computation (“MPC”) validators operating with threshold signature schemes (“TSS”). The network is leaderless and maintains security by each validator running the same process upon receiving on-chain events. Once two-thirds of all validators have collectively signed the same transaction using their own individual key, the network achieves consensus and issues a transaction to the destination chain

• Currently, validators are selected based on community governance and consensus. Upon reaching a certain project milestone, validators on the Synapse Network will have to stake $SYN to secure the network

Presents the following tradeoffs:

• While it can enable fast and efficient swaps, it introduces significant new trust primitives that can lead to increased security risk. With a whole new group of validators (currently selected by the community, which can be worrying) and game theory, Synapse adds complexity, whereas Connext bypasses it. Both can do the same thing when it comes to swaps, except that right now, Synapse can use its protocol ($SYN) to increase yields for pool deposits, creating increased liquidity in the short term

• When compared to Connext, certain swapping routes are relatively complicated and involve several more swaps than needed. This may introduce issues pertaining to higher fees in the long run, as well as increased risks along the way

Wide Competition

Ren

• Not necessarily trustless

• Lacks scalable way to integrate with other chains / layers given its security configurations

• Great for porting over assets, not necessarily moving value fast

Cosmos

• Works when all chains run on Tendermint / are a parachain

• Expensive in terms of time and fees. Like Ren, the focus isn’t on moving value fast and efficiently

THORChain

• Positioned more as an L1<>L1 exchange that seeks to establish permissionless swapping between L1 native assets, using RUNE as a medium of exchange as well as for security collateral. There is a future where THORChain releases pools for rollup swaps, however, this is not within the project’s current core focus

• Leads to increased security risk, whereas Connext inherits the security of the base chains it works on top off

• If THORChain’s decentralized swapping capabilities prove successful and scalable, this could be a threat to Connext’s offerings pertaining to L1<>L1 swaps

Bridges

• Examples: Optimistic bridge, Near Rainbow bridge, Avalanche bridge

• These lack the time and cost benefits that Connext offers, and in many ways, are the worst choices presented to users. They are crucial in the infrastructure they provide, but their use should be minimized to significant capital movements (in order to set up swapping pools and liquidity on the other side) as well as batch-settlement capital flows

Potential Investment Theses

#1 If one underwrites the thesis of a multi-chain, multi-layer world, Connext offers a ‘project-neutral’ way to bet on it. At its essence, it is an infrastructure play and wins no matter which L1s and L2s prevail.

• Competition in the L1 and L2 space can intensify, developing commodity-like market traits

• The cross-chain bridging space, on the other hand, is indicative of winner-take-all economics. With L1s or L2s, it makes sense for a user / dApp to use multiple ones (as they have different offerings); however, for a bridge aggregator technology, it makes more sense to use the best one that covers all ecosystems, rather than multiple ones

• Location within the value chain can emerge as a value sap: Connext is a group of capital superhighways and generates revenue through tolls

#2 Value lies in the SDK. Connext is a B2B protocol that will behave like abstracted infrastructure within the logic of dApps. It strategically makes sense for dApps to have inter-chain functionality built into their ops as dApps will want to maintain users on their site for the whole cross-chain process, otherwise they risk losing the user to another competing dApp. Therefore, Connext’s capital plumbing will be of value.

This is not a long-term prediction; rather, dApp integration with cross-chain liquidity infrastructure is becoming a priority. Several takeaways from ETH Lisbon have discussed dApp teams needing to focus on solving for cross-chain capabilities.

#3 Sizable TAM. The value of transactions going through bridges will be in the billions, and eventually trillions, assuming the multi-chain, multi-layer world develops. With some tweak-able conservative assumptions, Fee TAM is in the low billion single digits:

#4 Great team with deep sub-sector expertise

• Known amongst the right circles for their leadership in cross-chain bridging

• Rich dev experience suitable for the complexity of the team’s goal

• Past track record highlights ability to execute. Specifically, recent releases have been well received, and in circumstances of bugs, they were corrected and updated in a timely manner

#5 Opportunities for value add combined with multiple exit strategies

• Leverage network as integration opportunities for the Connext team

• Assist with team hiring and community growth. Currently, the community is somewhat small as evidenced by experience on Discord. Achieving a community like Index Coop, where several BD strategies can be led by members, could formulate part of the go-to-market

• Offer expertise on token economics design

Value add is complemented by multiple paths to exit:

• M&A: Can be acquired by another bridging solution, wallet provider (i.e. Metamask), or infrastructure company

• Token (much more likely): Can go liquid via a token drop, with lockup expiry probably lying between 1–4 years

Catalysts

#1 Growth of L2 ecosystems

• Once more dApps onboard and bring transaction-intensive ops to L2s, ecosystem growth will really hit full tilt

• Progress with development at Arbitrum, Optimism, and other chains / rollups point to the imminence of this catalyst

#2 High gas environment on Ethereum

• Drives capital to other ‘cheap’ chains: Avalanche, Binance, and Fantom

#3 Connext’s integrations with other frontends and applications

• This will drive transaction flow to Connext and will lead to recognition of its cheap and fast cross-chain swapping mechanism. Progress with integrations is going well according to the team

#4 Progress with liquidity expansion

• Team recently selected the first cohort of routers

Risks

#1 Smart contract risk

• Cross-chain swapping attracts smart contract and game theory risks across the board. Part of the allure of being able to pull this infrastructure design off is matched by the higher burden of risk. Given that state channel-based bridging at scale hasn’t been done before, several unknown unknowns are present. Additionally, it is still early, and while the Connext team has made respectable progress to date, scalability and growth can introduce several issues that may not exist at this point in time

#2 Execution risk

• While the team has great experience, significant execution risk exists. It has yet to be seen whether this team can adequately scale a platform and turn it into an infrastructure layer provider like Chainlink or the Graph. Team hires and community growth will be key, a possible area of value add

#3 PMF risk

• Assuming PoS / MPC-based cross-chain swapping applications work at scale (in light of the aforementioned security tradeoffs), and dApps desire the ability to do more than swap cross-chain (i.e. general information delivery), then Connext will be at a disadvantage to protocols like Synapse and THORChain. These protocols would be able to bundle swapping with cross-chain data delivery in one offering

#4 Aggregators win out over protocols

• Several great minds in the space see value accrual power moving over to app-based aggregators. These will plug in and provide multiple services to users. If fee compression were to start hitting DeFi (some signs of this already), then aggregators would sit on top and find different revenue opportunities while bridge protocols could be commoditized

Potential Model

Drivers:

• Transaction Count

• Average Transaction Value

Assumptions:

Projections:

Valuation:

Disclosure: This blog series is strictly personal/ educational and is not investment advice nor a solicitation to buy or sell any assets. Please always do your own research.Disclosure: This blog series is strictly personal/ educational and is not investment advice nor a solicitation to buy or sell any assets. It does not represent any views from where the author is working — all views, opinions, and arguments are the author’s. Please always do your own research.

The Backdrop

Why do we have finance anyways? Well, as society developed, the role of capital, and the ability to make the most of it, increased in importance. In a series of waves, society came to incorporate trade, investment, and currency / credit (refer to The Ascent of Money as to why I have these grouped together). And thus, we had the creation of the financial system, which has one overarching goal: to connect savers / lenders with borrowers / spenders. At the crux of finance is this connection, with every transaction being represented by a flow in one direction or the other. Today, there are currently two ways to accomplish this:

• Direct finance: savers coordinate directly with spenders (i.e. stocks, angel investments, loans to friends)

• Indirect finance: financial intermediaries manage the flow of capital between savers and users (banks, hedge funds, insurance firms)

While both useful depending on the circumstance, indirect finance has become the predominant mechanism. Today, finance is run by intermediaries. To the DeFi user, this is not new news, but maybe the reason why this is the case can be of intrigue.

Why Financial Institutions?

Overall, the ‘Why’ can be boiled down to two reasons:

• Transaction costs. This refers to the actual costs (time & money) of realizing the transfer of capital. Transaction costs manifest in the form of legal agreements / lawyer fees, surmounting barriers to entry, higher risk, and more. Financial institutions can minimize transaction costs as economies of scale allow them to amortize these costs over their customer base. For example, a bank has its own legal team to overlook thousands of loans — this fixed legal cost is spread across all the depositors, making it much more feasible for the average person to effectively loan money.

• Information asymmetry. If markets evolve to be extremely asymmetric, then they eventually fail. A great paper on this, dubbing it the “Lemons” problem, details the logic with which the increase in information asymmetry raises the cost of transferring capital and lowers the quality of opportunities for capital. Think about credit markets in less developed countries. Since banks don’t have access to or cannot correctly ascertain information concerning the financial viability of capital demanders, they choose to raise interest rates across the board, accommodating for invisible risk. This then leads to the lack of funded good ideas and the increased existence of high risk (potentially bad) ideas that can meet the interest hurdle rate. Basically, credit markets fail. It is argued that financial intermediaries are better suited to deal with information asymmetry — their experience in credit assessment, risk pricing, and access to market information gives them an edge when it comes to managing capital. Accompanying this “Lemons” problem is that of moral hazard. When a person has information asymmetry, they can possess a moral hazard, meaning that they don’t bear all the costs associated with taking on risk (i.e. think insurance). Financial intermediaries can mitigate this hazard by shaping behavior of those receiving and giving capital (covenants, payment terms, legal provisions). These mitigation methods are typically not available to average individuals.

So, that is the boiled down version of why financial institutions exist. How does this fit in with DeFi?

What about DeFi?

The primitives of DeFi are fascinating and in many ways fulfill the key competencies of financial intermediaries, but in a decentralized way. DeFi applications do leverage economies of scale to deal with transaction costs — they make access to capital cheaper (I concede that in some cases not), the choice of investment paths more broad, and the barriers to building and using financial blocks lower. For example, Ethereum has lowered the transaction costs of doing complex and customized financial transactions by providing standards, a market for capital, and security to developers.

DeFi also manages to deal with information asymmetry. This is where the fundamentals of crypto game theory are so valuable. Incentive models (i.e. slashing), network security and design, and the use of a token all exist to fundamentally reduce the odds of market failure. Loans can be made in a trustless way because these parameters exist — crypto has been able to deal with moral hazard and the “Lemons” problem.

Now, while this is working on a small level (relatively), the question is can it scale? That is the trillion dollar question, and I can only give opinions as to why it can and where it is limited. In terms of transaction costs, the more DeFi scales, the better it will actually be — more liquidity means less financial costs associated with transactions. As the system scales, legal frameworks will emerge to grow with it, spreading legal costs across usage. Finally, the technology in itself is a reduction of transaction costs overall. With information asymmetry, it is slightly less clear, but I have hope. Currently, DeFi economic designs are doing a reasonably good job in dealing with this; however, the scalability is a grey area. Can we get to under collateralized loans / credit in a trustless way? This is a big question, and while many projects are attempting to deliver credit to crypto, they still behave in a similar way to financial intermediaries. This is where I see DeFi 2.0 being extremely innovative, and possible answers to scalability can emerge from projects like Alchemix, Tokemak, and Liquity.

DeFi has the potential to replace financial intermediaries, and is already demonstrating significant early progress to reaching that goal, but it has a way to go. Learning about financial intermediaries, what they offer, and how they came to the scene can be very valuable for DeFi contributors. It is helpful to blend the appreciation of history with looking forward.

Credit to one of my college finance courses for providing some of the structures used above :)

Disclosure:* This blog series is strictly personal/ educational and is not investment advice nor a solicitation to buy or sell any assets. It does not represent any views from where the author is working — all views, opinions, and arguments are the author’s. Please always do your own research.*

I spent a nice chunk of the Sunday morning reading through Why Nations Fail — a good break from crypto and finance, at least so I thought. Running through Chapter 7, “The Turning Point”, I couldn’t help but think about crypto in the context of the Industrial Revolution. Specifically, the legislative changes undergone by Parliament during the early innings of the Industrial Revolution.

The chapter starts with an account of William Lee, a soon to be local priest who invented a ‘stocking frame’ knitting machine, which would free people from endless hand-knitting. Proud and excited of his invention, he went to Elizabeth I to show the machine and be granted a patent; a machine, that by all objective measures, would benefit society and the economy. What happened? Well, contrary to so-called common sense, Queen Elizabeth I declined it — “It would assuredly bring to [my subjects] ruin by depriving them of employment, thus making them beggars”. No patent and no more development of the machine. Why? The mechanization of machined production was just too risky from a political standpoint as it could destabilize society. Acemoglu and Robinson, authors of Why Nations Fail, draw from this and other strands of evidence a key point: “the elite, especially when their political power is threatened, form a more formidable barrier to innovation”.

Quite a frustrating point to swallow, but as history shows, time (and of course LUCK) can come to the aid. As the years went by, both changes in the legislative powers of Great Britain (the Parliament gaining more power over the monarchy) and changes in the composition of the political body drove the creation of a favorable set up for the Industrial Revolution to prosper.

Firstly, the reshuffling of those in power began to occur starting in 1832, when the First Reform Act was passed, enfranchising Birmingham, Leeds, Manchester, and Sheffield. What do all these cities have in common? They were clusters of factories and innovation centers. The inclusion of these boroughs in the legislative mix started to tilt the scale towards supporting manufacturing and away from supporting an entrenched land-based aristocracy.

Secondly, the rise in wealth of the manufacturer and entrepreneurship interest groups led to the ability to incentivize change in their favor. Added to this was the decrease in the relative wealth of the aristocratic land owners and (quite importantly) West Indies plantation owners. Result: more members of the House of Commons and Lords either were manufacturers / entrepreneurs or were investors in those businesses.

Third and finally, the passage of acts that enforced property rights (Sir Timothy Baldwyn’s case), voting expansion, and patent protection built the rails to scale the innovation provided by the entrepreneurs.

So, how does this all relate to crypto? Well, the industry finds itself in a similar position to William Lee — the technology and potential is amazing, but the political elite are scared. What does this mean for the banks? What does this mean for the Fed? What does this mean for the wealth of key donors? What does this mean for the ability to tax? The list goes on and on. Crypto is innovation and innovation is creative destruction — things will become obsolete and other things will be completely remolded. This is a scary time for the political elite, even if the potential of the innovation is amazing.

However, one can be optimistic as history has shown (of course we might need some time and luck, which I concede are drawbacks to my reasoning). With time, the current political elite will begin to shuffle out. New senators and reps will see the promise in crypto money to (sadly as this sounds) finance their campaigns and (what they should actually be thinking about) its ability to help their constituents. Old senators and reps will also see the same benefits and switch over (we already saw this in August with the Infrastructure bill voting patterns). Key people in society will begin to invest in the space, which translates to influence: all these accredited investor funds in BTC and ETH lead to the slow shift in wealth and protection incentives. The successful crypto players like SBF, Coinbase, a16z will aid in the education and the establishment of the new political elite. And, overall, the generational shift from boomer to millennial will create a significant change in societal behavior and desires… making way to influences everywhere in the system for crypto to be valued. These are the catalysts that stand to shift the US legislative and executive bodies.

Conclusion

What does all this mean? Does it mean that we have a rosy road ahead where everything will be rock solid awesome? No, sadly not. A lot of negative barriers can be set up and progress may take a lot longer in the US. BUT, should we be negative and doubt the future of American crypto? According to history, no. Contrary to what the average history class teaches, the Industrial Revolution wasn’t a straight a-ha moment for the British, a “this makes sense, let’s do it” process. History tremendously simplifies success. There were several barriers, it required time and toil, but in the end the revolutionary innovation prevailed. Crypto will go through the same, but in 100 years, kids will be told all the good things and how obvious it seemed from the start. That’s history I guess.

Disclosure:* This blog series is strictly personal/ educational and is not investment advice nor a solicitation to buy or sell any assets. It does not represent any views from where the author is working — all views, opinions, and arguments are the author’s. Please always do your own research.*

One of the big calls of DeFi is that it stands to eventually topple CeFi, and what place better to start at than with exchanges? The rise of the DEX has been a feat in the making for years, but we only really started to see the logos of DEXes last year, when platforms such as Uniswap, Curve, Balancer, and Sushiswap came to the scene and managed to amass billions in liquidity. Billions is a cool number to throw around, but when compared against centralized platforms such as Coinbase, Binance, Huobi, and Kraken… it is not that big at all. To paraphrase DeFi investor Santiago R Santos (Partner @ ParaFi), DeFi can be conceived as a rounding error of CeFi’s volume… but all things do start small. eCommerce used to be a blimp in the sea of big retailers, fintech wasn’t known 20 years ago, and what happened to taxis again? Massive transformations begin at small scales, and there is a formidable argument for why DeFi is the next big transformation.

To convince one of that transformation, the best place to start at is looking into the rise of DEXes. A DEX, for those of you that are not familiar, is a ‘decentralized exchange’, and it describes an exchange platform that is not run by any entity, but rather the community (let’s hold the Almeda — SushiSwap counter back :) ). Liquidity is incentivized through coded economic incentives, and transactions are carried out using blockchain technology and smart contracts. While DEXes may sound scary, they aren’t bad at all, especially once you have crossed the hurdle of setting up a browser wallet and gaining some familiarity with the Ethereum ecosystem. DEX’s are truly democratic and accessible for anyone with an internet connection and some crypto — quite revolutionary one may say! The DEX is the ultimate progression in financial exclusion: in the 80s we needed a stock broker, in the 2000s we needed to pay fees on this and that and go through paperwork, and now we have a permissionless and global system that doesn’t rest on a corruptible entity. This post will first focus on why the DEX is a more favorable platform than the CEX (centralized exchange). Then, it will proceed to add some quantitative color to where we stand in the adoption curve, giving an insight into the impressive market opportunity that lays ahead.

Why use a DEX?

1. Less friction: After gaining some familiarity with Ethereum and crypto in general, the ability to trade nearly any crypto asset on a DEX is totally frictionless. You find the asset you want, you enter the asset you want to exchange it for, you pay some gas (possible financial friction here, especially at the moment), and you get your asset. This definitely beats any centralized exchange, which presents the following barriers:

• KYC. While I do understand the necessary KYC procedures concerning AML, I believe that many people are left out the financial system because of this, and, therefore, miss out on wealth creation and management opportunities available to the rest

• Fiat-to-crypto. Exchange some WETH for some ALPHA? That is a hard feat to accomplish on any CEX. Most offer USD/EURO/GBP based trades. It would be a pain to have to convert into those currencies, just to buy another asset when you can pierce straight through all of that on a DEX

• ACH. This is definitely an issue in the U.S. (Coinbase, Kraken, Gemini). Why do you have to wait 7 days to send an asset off to a browser wallet if you want to, say yield farm? I understand why Coinbase has to do it (not really their fault that the financial plumbing is old here), but why should consumers endure it? Uniswap takes seconds…

2. Fees. Well, let’s be honest, we all care about our transaction fees. Now, before I begin here, I do want to concede the point on gas — it is pricey at the moment with Gwei to the moon, but taking a step back, I am a believer in ETH 2.0, Layer 2 development, and chain interoperability; therefore, massive gas fees will be a thing of the past (think of dial-in internet… ). With proper scaling solutions implemented, transaction fees will be pennies on the dollar compared to the ‘network’ fees CEXs are skimming off every transaction. Even currently with gas, larger transactions still enjoy smaller fees on DEXes than on CEXes. **Fair point against this here is Binance’s incredible 0.1% fee… (conceded and highlighted below)

3. Asset availability. A CEX can’t really match up to a DEX - maybe Binance comes the closest to doing so as they are moving fast in addressing asset availability and ICO hosting (kudos to them). But still, for most seasoned participants, you will always look on Uniswap or Balancer first for that asset you heard on Twitter before you look on a CEX. While this point is more of a crypto-native one, it is still important nonetheless. In the future, other ecosystems such as NFTs will blossom, making the need for vast and diverse asset availability key. What better platform to have that on than one that lets users create liquidity around demanded assets?

4. ICOs. For those teams out there launching a protocol, it must be said that issuance fees and transparency are much better on a DEX. This is a bit similar to the Direct Listing vs. IPO battle going on now. On a DEX, the issuing entity is comparably more in control of the process

5. Hacking and vulnerability points. CEXs have your data, custody your assets, and are controlled by team of people at a company. This can lead to certain vulnerability points (bring in the calls to Mt. Gox) that could lead to risk of asset loss. Now, the main CEXs have been doing a great job with security measures (2FA, Vaults, etc.), but, if a user knows how to properly safeguard their assets, a DEX is a better choice. Note, to concede another point, that is a big if — for some people, Coinbase vaults and CEX custody services are a better solution

Given those 5 core points, it is also fair to list some of the disadvantages:

• Lack of fiat onramps: this is a tough pill to swallow, and something that the crypto world really needs to figure out. CEXs are the main and nearly sole way to bring on wealth to crypto ecosystems from the non-crypto world

• BTC and non-ETH denominated trades: this can also be a key point for certain crypto users who don’t want to be or are not part of the Ethereum ecosystem, where basically most of the DEX volume lies

• Cold storage: some CEXs offer cold storage solutions as part of your account. This is great for those that wish to have more security and don’t want to go the Ledger route

DEX vs CEX: the transformation so far

Looking at the 2020 progress of TVL and volume in DeFi is pretty amazing. The growth has been phenomenal, but the space is still in its infancy — this propagates both tremendous opportunity as well as risk.

So, where are we right now on the CEX vs. DEX battle? Let’s begin by going through a couple numbers.

Daily Trading Volume (stats from CoinMarketCap)

DEXes:

• Uniswap: $866m

• Sushiswap: $295m

• 1inch: $165m

CEXes:

• Binance: $22,471m

• Huobi: $6,983m

• Coinbase Pro: $3,135m

Average multiple on volume (CEX/ DEX): $10,863m / $442m = 24.6x. So, the positive surrounding this figure for DEXes is that it points to them controlling around 3–4% of the market — this signifies a massive TAM runway, and that is assuming no growth at all in crypto volume at all. The negative is that volume can be a driver of efficiency and a builder of moats… could this volume discrepancy be building a wall around a subset of crypto users? Given the pros of DEXs described above, I think not, especially in the long run. Needless to say, it still must be mentioned as a current disadvantage

Assets Listed (stats from CoinMarketCap)

DEXes:

• Uniswap: 1,246

• Sushiswap: 139

• 1inch: 718

CEXes:

• Binance: 331

• Huobi: 311

• Coinbase Pro: 46

Here, the script is flipped a bit. The average multiple on assets listed from DEX/CEX is 701 / 229 = 3.1x. If you are really trying to get involved in crypto beyond some blue chips and the ETH/BTC… then DEXs are the place to go.

Fees (stats from DApps and exchanges themselves)

DEXes:

• Uniswap: 0.3%

• Sushiswap: 0.3%

• 1inch: variable and based on DEXes it aggregates off of (can be considered sub 1%)

CEXes:

• Binance: 0.1%

• Huobi: 0.2%

• Coinbase Pro: 1.49% — 3.99%

Here, we are in a tough spot. Asian CEXs are doing better than DEXs! American CEXs are lagging behind both. I will have to concede to Binance on this one… but wonder about the sustainability of it all. And, of course, gas costs were not incorporated here… this would definitely tilt the scale towards CEXes, but I am trying to take a long-term view, and for that I assume we will solve the scalability issues residing currently with Ethereum.

Conclusion

Overall, I attempted to use some whitespace here to highlight where I see DEXes outperforming CEXes (note, I have some U.S. CEX exchange bias, which may have shaped some of these arguments, especially the fee one). Additionally, I provided some color around 3 key quantitative parameters, which tell us an interesting story — DEXes are a drop in the bucket market-wise, but offer more availability and lower/ constant fees (except against Binance (especially!)). I find the space truly fascinating and can see a future where DEXes flourish as they better address what crypto participants are and will be looking for. Yet, as mentioned before, there is risk in all of this; however, so was there in the internet. I look forward to following DEXes closely as I interact with and monitor them.

Disclosure:* This blog series is strictly personal/ educational and is not investment advice nor a solicitation to buy or sell any assets. It does not represent any views from where the author is working — all views, opinions, and arguments are the author’s. Please always do your own research.*

NFTs have been fascinating me for quite a while. Clearly, crypto has been having a crazy month, leading to a flurry of thoughts, emotions, and reading. While my main focus remains on DeFi, I do sometimes find myself treading into NFT articles and posts. As a small child, I was an avid collector of many things. Some were pretty random: bottle caps, Yogurt toys, and these little disks called Tazos. Others were more mainstream and had real value: stamps and currency bills. My fascination and excitement at collecting these items was strong, and as I recall these collections, I identify a similar feeling I get when researching investment opportunities. In both ways, it is a hunt with an objective — there is a journey, uncertainty, and thrill when you have realized that certain objective. The bridging of these two feelings led me to an important question: can we consider NFTs an investment, or even better, an investable asset class? And in addition to this, I will add a personal question: should I be investing and running diligence on NFTs? While some posts have been formal, this one will follow a more informal structure as I attempt to “think out loud”.

Question 1: can we consider NFTs an investable asset class?

This is a hotly debated topic among some in the crypto community. One side points to NFTs as objects to own, but they aren’t really investible. While one does spend money on them and own them, they lack the profile of a legitimate investment (*Aside: technically every purchase can be understood as an investment, but the context here is around an actual financial investment where you expect to generate wealth). This would fall into the category of objects we can own multiple of for the purpose of ownership: fashion items, sports items, etc. The other side points to NFTs as valuable collectibles, which do have the profile of a legitimate investment, albeit one that is typically very illiquid. Here, we can think of art, baseball cards, and cars. In fact, there is already some solid evidence for this side, namely the scaling crypto art sector (a recent NFT art collection ran up an auction bid of $2.2m). An objection to this point in general stems from the fact that some don’t consider art or cars a legitimate investment. This is a fair objection — 90% of art actually devalues as soon as you leave the gallery and there are only a handful of classic models among a sea of cars that have hit the value J-curve experienced in collectible cars. But, as assets, some of these have performed very well: between 1985 and 2018 the art market’s return has been relatively in line with that of fixed income, according to a new report from Citi based on data from Masterworks.io. Value may be volatile and pretty murky, but it is there, which begs the question of it being an asset that can be structured as a financial investment.

So, how do I as a young investor categorize NFTs? Well, given the existence of fairly structured opinions for and against it being an investable asset, I can only conclude that the term is too broad — it is rather an umbrella category. The best non crypto parallel would be deciding whether personal ownership objects can be investable or not.

Now that I have established that, let’s zoom into our identifiable section of the NFT universe that consists of investable assets: crypto art and collectibles (again pretty broad here). And, given that they do share some important similarities, we can group them into an asset class. These investible NFTs share the following key characteristics:

• They are non-fungible, unique tokens

• They communicate ownership of a specific piece of data

• They are defined by their characteristics, especially visible and emotional

• Their value is derived from perception as well as supply/demand forces

So, bottom line is yes, they are theoretically an investible asset class.

Given this, what are the avenues to investing in NFTs? Well, there are currently two ways to do so: invest via acquiring NFTs yourself or invest in a fund of NFTs, managed by active and experienced people in the space. The former one is the most intuitive — this is how we do things in the non-crypto world. We buy art and cars and form our own collections. Maybe we do go in on a partner or two, but you rarely see a fund or tradable stake related to one of these collections. The latter one may come as a big surprise, and it is in fact, one of the most interesting developments in the NFT space. Today, you can invest in a fund that owns multiple NFTs. The first that comes to mind is NFTX, a platform that mints NFTX tokens that are backed by actual NFT collectibles. The goal here for an NFT investor would be to possess or own a stake in a pool of selected assets that given their characteristics will rise in perceptive value over the long term, with the ability to liquidate by selling to a future buyer.

Question 2: should I be allocating capital to NFTs?

Now this is a more difficult question to answer. On one hand, I am intrigued by the space and like the value proposition. Here we are in what might be the tiny beginning of a whole new collectible/ art era— owning a fund of certain NFTs today could be worth a whole lot more in the future when the space becomes mainstream. However, on the other hand, I face questions with value and use cases:

1. I find it extremely hard to pick the right one (i.e. imagine picking the right Monet among thousands of other paintings when impressionism was just getting started). Yes, NFTX and the likes exist, but still there is severe execution risk here

2. Investing in an asset that is valued just by desirability and taste is scary. There is no cashflow or utility in many cases… buying and relying on someone else to buy later at a higher price due to perception is a tough pill to swallow

3. It is harder to have mental models/ frameworks for the thesis. What is a competitive moat in NFTs? Bottom line is that wrapping my head around an investment here becomes hard to do

Given all the above, I cannot be certain enough to enter as an investor. This may change, and I can say that for now I do enjoy the space as an onlooker and future consumer. Times change, and so will I, so we will see where this goes.

Future

With that said, I want to end this post by offering my personal vision for the future. I do certainly believe that the underlying technology is phenomenal for the use case of collectibles and, therefore, see a future where:

• Video games have virtual economies based on in-game NFT ownership. Skins, cards, tags, etc. are tradable and unique

• Sports franchises capitalize on the digital youth generation and produce NFTs for fans and sports fantasy games. Franchises can partner with games and vendors to create NFTs that fulfill all kinds of tastes (for a preview of this, check out Dapper Labs)

• Digital art, photography, and other media really takes off. With the components of blockchain, NFTs can cut out fraud and piracy, enabling a value unlock for several creators that was not available before

Disclosure:* This blog series is strictly personal/ educational and is not investment advice nor a solicitation to buy or sell any assets. It does not represent any views from where the author is working — all views, opinions, and arguments are the author’s. Please always do your own research.*

Why Africa? The question I hear either directly or indirectly when I present my vision for the future of crypto. “It cannot be Africa”, most people snap back — too many conflicts, not wealthy enough, lacks the technology and financial infrastructure, it’s not Silicon Valley… the list goes on. However, if you take a step back and digest all of these factors, while there may seem to be some merit on the face of it, the reality is they are actually in favor of crypto. Given its unique environment and current charted path, Africa has the potential to be a cradle for mass crypto usage and innovation, here is why:

Demographics, Geography, and Technology

Many comment that Africa doesn’t have the solid technology infrastructure or knowledgeable human capital, but that argument is a generalization and not a fair one. The current generation of Africans is actually really tech savvy as well as really young. In fact, “60% of the nearly 1.3 billion-strong population is under the age of 25” (Business Daily). According to the Financial Times:

“18-to-24-year-olds across the continent are entrepreneurial, optimistic and tech savvy. Nearly four in five of 4,200 young people interviewed in 14 sub-Saharan countries by PSB Research, a US-based polling firm, believe that WiFi is a human right, while two-thirds say they are witnessing the start of the ‘African Century’.”

Furthermore, according to PwC:

“From the demographic dividend of a young and rapidly expanding population to an increasingly affluent and aspirational middle class, Africa has the potential to become a new powerhouse of production and consumption in the 21st century, just as Asia was able to do in the late 20th .”

It is clear that the dynamite combination of tech savviness and youth can propel Africa forward through the adoption of innovative strategies and technologies.

Additionally, the friction between African countries is beginning to be reduced, which could lead to easier access to knowledge, cross-border value creation, and the reduction in transaction barriers. It is crucial to note that within Africa, several inequalities persist between nations and, therefore, lower barriers to knowledge and value transfer can drive further equality. Given the impact of the 2019 African Continental Free Trade agreement going into effect, “a free-trade zone could help in collaborative initiatives, such as the benchmarking described here, to close the gaps and transfer knowledge across countries to enable the delayed promise of growth in Africa and helping make the growth inclusive — thereby accomplishing that rare phenomenon of getting lions to leapfrog” (HBR).

Technology-wise, Africans have operated off mobile technology and mobile payments to a greater extent than Americans and Europeans. They were the first ones really experimenting with mobile money, as we saw in Kenya with M-Pesa. Moreover, the evidence piles up when looking at the most popular majors at African universities, the pace of development, and the national initiatives to boost African tech (seen especially in Nigeria and Uganda). Africans aren’t lagging completely behind, rather, they are dealing with a different set of circumstances in their own way, which gives their tech profile a unique spin that complements crypto: African tech is young (meaning flexible and not routed in the old VC paradigms of Silicon Valley), mobile, and financial (fintech is second nature to the African youth at this point).

The last point I will make is that Africa does have tech infrastructure, but again, it is different to the west. The pillars of African tech infrastructure are in mobile (skipped landlines all together) and eCommerce (think Jumia and DTC through social media). If you look at the rates of mobile adoption, they have been growing the fastest in the last decade or so. While African nations are not up to the same penetration rates as Western countries, they are building a trajectory and path to get there.

Economic and Financial Issues

There are several consequences of Africa’s lesser developed financial infrastructure and mounting economic issues, but one positive consequence is the drive to push Africans to look for innovative solutions. It must be stated that African entrepreneurs and citizens face non-Western problems. PayPal cannot really help with cross border payments when dealing with issues like hyperinflation, FOREX controls, massive ACH and trans-border fees — these simply aren’t Western problems. Thus, Africans cannot just adopt PayPal, Visa, and JP Morgan Chase and be good to go, they require a different solution, and crypto is emerging as the possible winning horse. Going back to the above, African financial infrastructure/ currency problems can be summarized as inflationary issues, government mistrust, trans-border barriers, lack of financial transparency, lack of hardware besides phones, and an economy that necessitates a fast-moving substitute to cash (checks won’t do). What does crypto offer? It offers several deflationary or stable assets/ currencies; is based on P2P networks and code, not third parties and leaders who can rig the system to their financial benefit; it fixes several of the FOREX and border transaction issues (dramatically reducing the fees and barriers); it can be interoperable with phone wallets and networks; and, it moves just as fast as cash! The juxtaposition of the African issues with the characteristics of crypto makes a very compelling case. Now, I don’t want to generalize and over assume here, but even taking it all with a grain of salt, one has to admit that there is a chance for crypto to be a solution.

Security

Currently, several African nations face problems related to security; specifically, these problems can be grouped into financial and physical. How can crypto help both of these? Well, concerning the former, crypto is very applicable here. Blockchain ledger technologies stand as a great tool to increase transparency and scare off potential criminals from fraud or robbery. Stealing cash is one thing, however, stealing certain crypto currencies where a public ledger allows traceability is another. Imagine organizations and governments operating off of crypto — the barrier to corruption, syphoning off state resources, and criminal actions is much higher. I understand that this argument is a lot more futuristic than others, but it definitely deserves to be mentioned. Now, going to the latter security issue, crypto can also ameliorate certain physical security problems such as carrying wads of cash and having to keep your money in potentially fragile or hazardous institutions (e.g. VSB Bank in South Africa).

Significance of Improvement

So, we have a proposed solution, but is it good enough? Well let’s look at the golden investor rule in venture: does it make something 10x better? Yes, it does:

• Is it faster? ACH in the US is 3–5 days; moving money between African countries and bank accounts takes longer in many cases and leaves you exposed to inflation. How long does crypto take? Well seconds to minutes at best, and a little longer if there is some centralization at play.

• Is it cheaper?

Note numbers from 2018, but still very pertinent. Versus bases points using crypto, we have more than 10x here for sure.

• Is it safer? This one is hard to measure quantitatively, but if you look at issues ranging from security, government manipulation and mishandling of the treasury, and available monetary storage and investing opportunities, it is fair to say there is a significant improvement.

Conclusion

So, we can conclude that crypto is good enough to fit the missing puzzle piece for African financial infrastructure — it is cheaper, faster, and safer by a combined 10x+. The question then is where do we go from here? Well, first things first, it is important to internalize African potential and withhold yourself from judging the book by its cover. Second, take some time to look into projects such as Celo and Bundle. Third, and most importantly, we need to assess what are the barriers to crypto as a solution, and right now I can come up with four:

• Fiat onramp: this proves to be the trickiest barrier as regulation and fraudulent sites restrict the ability for Africans to get their fiat into crypto. We need better onramps, looser regulation, and a clampdown on fake crypto schemes to build a better gateway to crypto. One very interesting solution — national digital currencies or the Libra project.

• Merchant adoption: having all the youngsters on it is one thing but moving a whole economy to crypto is very hard. A big barrier is the adoption by merchants of crypto. If startups can come up with clean fintech and hardware solutions to onboarding merchants that don’t really understand crypto, then we can really get the full circle of the economy on crypto.

• Breaking down the stigma: crypto is still very small and most people still see it as a scheme, a way to launder money, or a construct that can only work on paper. Blockchain and crypto education is paramount to growing acceptance and trust in the system that can take Africa to the next level.

• One size doesn’t fit all: Africa has a wealth of diversity with regards to culture, customs, law, politics, economies among other factors. Generalizing one set of solutions for all countries is not the way to go about this; however, the intention of this piece was to highlight that the general issues faced across the continent piece together well with crypto. All things considered, I do see a future where cryptocurrencies and assets flow freely between African countries forming somewhat of a tech ramped up version of the Euro Zone.

I still have a long way to go before I can really begin to add value to this thesis — I look forward to keeping you updated on my journey!

Disclosure:* This blog series is strictly personal/ educational and is not investment advice nor a solicitation to buy or sell any assets. It does not represent any views from where the author is working — all views, opinions, and arguments are the author’s. Please always do your own research.*

Going off of the theme of decentralization, presented two blog posts ago, I have decided to create a short post concerning the valuation of Uniswap, a decentralized crypto exchange (DEX) that resides on the Ethereum blockchain. Personally, I have been interacting with Uniswap for about a year and consider it to be the best decentralized exchange out there in terms of UI and UX. Moreover, I even find it better than a centralized exchange. The trust issues with KYC have begun to really seep deeper within me the more I navigate the crypto world. Do we really need to give all this information to conduct a token swap? Uniswap, among other protocols, has answered “no”!

Uniswap, founded and brainstormed by Hayden Adams, went the traditional VC route before becoming decentralized. It received funding from major firms such as Andreessen Horowitz and upcoming firms such as Variant. Then, in September, Uniswap decentralized, providing ownership of the exchange to the public, most of which went to its users (talk about community ownership…). If one was a Uniswap user prior to September 2020, one received 400 UNI (worth around $1,200 at the time). Overtime, preprogrammed inflation will hand out more UNI tokens to both investors as well as the treasury, creating the supply curve below:

Holders of UNI act as part of the governance mechanism, that is they get to vote on proposals relating to the platform and direct its course. More importantly, and something overlooked by the mainstream media coverage, is the protocol fee switch, which, if turned on by governance holders, would allow for a 0.05% fee charged per trade. Upon learning this back in September, my eyes lightened up as I saw a viable channel to monetization. In order to really understand the potential of this, I sought to build a BoE valuation model (couldn’t go more complex as this is still such a young and new opportunity). My model sought to value UNI through two different ways: one was on a P/E basis per every year forecasted, and the other, which is the one I focus on more, was a basic DCF based on fee earnings. One thing to note is that I did assume the 0.05% fee switch to be turned on next year (this can be debated).

First Basic Model:

Second Basic Model:

Reflecting on this valuation, there are pros and cons that need to be discussed.

Pros

• Trading volume is too conservative. Attending a talk given by Scott Kupor (a16z) the other day, the biggest lesson the firm had from the last decade was how they consistently underestimated TAM. I think this is the case for Uniswap, and if we really are to move to a crypto-centered world, massive volume growth should be seen in 2023 and beyond. Now, there are some big assumptions here, namely that we do move to this crypto world and that Uniswap is chosen as a DEX of choice. While the former is always up for debate, I am quite bullish on the latter. There are three reasons that support my stance. 1) The UI/UX is phenomenal and should drive an advantage. 2) Uniswap targets the tail-end of tradable assets. The tech isn’t the best suited for trading large amounts of money into the largest tokens, however, it is great for the what would be the OTC equivalents in stock markets. Pink sheet stock exchanges are valuable, and I see Uniswap as fitting that mold. 3) Uniswap has a bustling community around it and is backed by some very strong investors, leading to the building of a solid network foundation

• Took into account dilution through a SBC expense-like manner

• P/E is inline, if not lower, than competitors. A 30x is a very fair multiple, especially given that it will still be in growth phase by 2025. Moreover, if one looks at these graphics from Messari, one can better understand how Uniswap warrants being traded above competitors:

Cons

• In come my traditional finance tendencies: way too much value is coming from TV (however, this can be justified given the youth and future prospects of the company)

• WACC, even at 30%, might be a bit too low. There is a lot of potential volatility and risks here. We should, therefore, measure it against a higher hurdle rate

In conclusion, I am happy to reflect on my first attempt to understand the value of UNI. Clearly, the drivers are volume and the fee switch. Volume will be propelled by both crypto and the exchange’s future adoption. The fee switch is more binary and up to the governance body. As a believer and investor in this token, I really feel that this has the potential to be a phenomenal business, while I also understand the immense amount of risk at bay here. If it just manages to scrape the surface of OTC markets today, well, then we are really in for a phenomenal ride.

Disclosure:* This blog series is strictly personal/ educational and is not investment advice nor a solicitation to buy or sell any assets. It does not represent any views from where the author is working — all views, opinions, and arguments are the author’s. Please always do your own research.*