Institutional participation in Decentralized Finance (DeFi) has dramatically scaled up over the past few months. As the total value locked (TVL) in DeFi tracks towards $50 billion (and with 40 of that 50 entering since early November of last year), it’s evident that the market has evolved beyond hobbyists and early adopters.
Decentralized finance (DeFi) leverages smart contracts automatically executing code residing on blockchains, primarily Ethereum. Most often this code replicates common traditional finance market actions such as lending or trading but without facing off with a traditional financial market intermediary. This disintermediation is meant to reduce financial drag by middlemen, and while there’s a great debate as to where DeFi stands in such cost optimization, adoption is increasingly undeniable.
Participation in these protocols is often marketed as riskless “yield farming” which, given the nascency of the systems in play, the difficulty of maintaining low-bug code, and the community’s cultural aversion to heavy use of Ethereum’s testnets, is far from riskless. There are many flavors of losing all of one’s money invested in these yield farms and it’s the market expectation to occasionally lose a significant percentage of one’s stake in a platform — getting “rugged”.
Be that as it may, the rewards (the yields) have, thus far, been ample compensation for wearing the risk. With the substantial price appreciation of cryptocurrencies has come a similar appreciation in the captured tokens in these yield farms, driving returns to the high double digits.
Savvy players have meaningfully improved their technical capabilities; most serious players can review new contracts swiftly with commensurate automation and monitoring for abnormalities.
The scale has changed
While individual wallet metrics continue to improve across the board and new money continues to enter the DeFi mark globally, increasingly it is funds, trading firms, and centralized yield platforms providing the bulk of the liquidity.
In recent months, a few whale institutional wallets like those that belong to Alameda, Three Arrows, 0XB1 and Celsius are now dominating the capital pools of many of these platforms. Big Data Protocol, a fringe, extremely low-risk farm, attracted over $7 billion within 24 hours of launch. It’s becoming the expectation that, when the code can be easily vetted, a popular project will attract north of a billion — see Float, FEI, Ellipsis, etc.
This notion of low-risk farms is largely driven by the repeated copy-paste of well known smart contracts such as Sushi’s MasterChef or the Synthetix Rewards contracts. Often the code changes from these reference “safe” implementations are minor (although that does not mean riskless) and it can be quick to get to a high degree of confidence that one’s money isn’t in for a great deal of risk.
Safe or “low risk” in this context should be taken with a relatively large fistful of salt grains. Many times have assets become trapped due to incorrect, minor changes to the reference implementations. Many of the old guard or blue-chip DeFi platforms have had critical vulnerabilities, which while not exploited, certainly could have been. That said, with strong risk controls, diversification (to the degree it’s possible), and improving smart contract code review competencies, institutions are well-positioned to participate.
Gas fees are largely a red herring for institutions
Despite the repeated narrative of how expensive transactions have become on Ethereum — with the fees soaring to hundreds of dollars for complex transactions in February — the impact is mainly on individual users looking to transact on scales of below $100,000. At institutional sizing, where most participants are moving large sizes, the fees are an annoying, but minor drag on performance.
Ethereum fees are, after all, fixed and don’t scale with transaction size. A $50 million swap on Curve incurs the same fees as $200. Ultimately, the perceived value of settlement on Ethereum right now is high and much of that premium is the perception that there’s a lot of value to capture.
The returns in the space vary wildly. To some extent, it’s relative to risk pricing; new platforms with unaudited, complex code often generate the highest returns but the risk of total loss is significant. Various institutions size and price risk differently. Many funds achieve returns north of 100%, but there’s many also with more conservative risk books where the focus is on yield generation on established, well-vetted platforms — those returns have still been north of 20%.
With traditional market yields in the 0-2%, a small amount of capital working in DeFi at DeFi return archetypes can achieve significant outperformance.
What lies ahead?
Ethereum as a master settlement layer is starting to feel a little bit inevitable. As various layer 2 solutions roll out, there’s a great deal up for grabs and a lot of market share to be carved. It’s starting to feel like much of finance will move wholesale to Ethereum.
Joshua Greenwald runs Digital Asset Alpha LP, a fund being managed by Uphold Asset Management Ltd. Josh heads up Asset Management on the Uphold platform, a digital money platform serving over 6 million customers in more than 150 countries.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
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