Decentralised Finance (DeFi): Crypto-backed Financial Services with Recurring Cash Flows and Measurable Value
It's time to debunk the myth that crypto has no fundamentals.
Decentralised Finance (DeFi) is a class of applications built on top of the blockchain that extends the concept of cryptocurrencies (i.e. decentralised money) to the rest of the financial services stack, providing an open-source, decentralised alternative to conventional financial services.
DeFi protocols are two-sided markets—parties on one side of the market provide liquidity, while parties on the other side of the market consume liquidity (e.g. borrow funds, exchange assets). The exchange of services happens without intervention from a centralised intermediary.
DeFi applications are built on smart contract-based platforms, with the most popular being Ethereum. However, there are other competing ecosystems being developed concurrently.
The sector has grown at an unprecedented rate, particularly since 2020. The total value of assets locked in Ethereum-based DeFi protocols alone has increased to USD 80 billion in 2021.
The technical limitations imposed by build on blockchain have brought about a number of unique and interesting financial innovations in the DeFi space—including Automated Market Makers (AMMs), flash loans, amongst others.
DeFi protocols can be studied with conventional valuation metrics because they generate consistent, positive cash flows.
The implied P/E multiples of the most popular DeFi protocols today are broadly in line with those of blue-chip FinTech companies. The estimated PEG ratios of these protocols is signicantly lower than those of the wider market.
I’ve been speaking to a lot of people about crypto lately, and in my observation, those who do not fully understand the technology nonetheless associate it far more with its negative aspects than its positives.
In this article, I examine an emerging vertical within crypto known as Decentralised Finance (or DeFi) to de-bunk some common myths about the asset class. In particular, I hope to show that:
cryptocurrencies have broad utility beyond their role as digital money
there are blockchain-based applications being deployed today by real market participants committing substantial pools of capital. These protocols provide utility and generating positive, recurring cash flows for their users.
contrary to popular belief, it is possible to apply traditional financial metrics to assess the fundamental value of decentralised applications built on top of the blockchain.
So, what is DeFi?
The traditional financial system is comprised of a network of banks and other financial service providers that store money, underwrite loans, provide insurance and other services for customers. Customers wishing to access these services must go through one (or often more) intermediaries, incurring fees and adding incremental complexity and inefficiency at each step.
DeFi is a class of applications built on top of the blockchain that extends the concept of cryptocurrencies (i.e. decentralised money) to the rest of the financial services stack. It presents a open-source alternative to conventional financial services in which the middle-man is removed and the same services are provided in a trustless1, and often lower-cost manner.
Imagine you are taking out a mortgage from the bank. A typical underwriting process could last several weeks, maybe more. The lender first needs to appraise the value of the property you are pledging as security. It then needs to assess your personal income and wealth, in addition to other background checks and due diligence. To obtain the best rates, you might engage a broker to source the cheapest possible rates, who will charge a broker fee. Legal contracts will need to be drawn up, perhaps with assistance from a conveyancing solicitor, before details are authenticated and the loan is (finally) disbursed.
Taking out a secured loan on a DeFi lending protocol is a far simpler process. After connecting your digital wallet to the online interface and depositing funds, the loan proceeds are automatically disbursed to your wallet. The assets you provide as security are automatically locked into a smart contract and returned when you repay the principal (with interest). This all occurs without intervention from a bank or any other centralised intermediary.
So who provides the loan principal if no banks are involved? Well, the same protocol allows users to deposit assets and earn interest. In other words, DeFi lending protocols are a two-sided market—they facilitate borrowing by parties on one side of the transaction and provide yield on the other. In some cases, the protocol charges zero fees: all interest paid by borrowers is disbursed to lenders, returning full value to platform users.
Of course, this is only one example of what DeFi can do. There are other protocols that provide asset management services, facilitate decentralised asset exchange, amongst many other applications. Before reviewing these, I briefly describe the underlying suite of technologies that enable DeFi.
Technology stacks used by DeFi applications
Although describing the underlying tech is not the purpose of this article, I think a brief explanation is helpful for:
placing DeFi in context of the wider cryptocurrency space; and
understanding the different blockchain ecosystems that DeFi protocols can be deployed upon.
DeFi protocols, like all other blockchain-based decentralised applications, run on smart contracts enabled by supporting Layer 1 blockchains such as Ethereum, Polkadot and Cardano. Not all Layer 1 blockchains are smart contract-based. For example, you cannot run a DeFi protocol on Bitcoin because it does not support smart contracts. In particular, whereas Bitcoin runs on the unspent transaction output (UTXO) model, smart contract blockchains such as Ethereum are far more complex and support the embedding of pieces of self-executing code into its blocks. This provides a level of interactivity and composability that forms the basis of decentralised applications such as those in the DeFi space today.
While most DeFi protocols today run on Ethereum, there are a number of emerging competitors to that ecosystem. For example:
Binance Side Chain (BSC) is an independent blockchain developed by Binance that is compatible with Ethereum’s smart contract functionality, but is able to execute transactions at far lower cost and higher speed due to its use of Binance Chain. DeFi protocols built on BSC have exploded in popularity recently due to the high gas fees charged by Ethereum.
Other blockchains such as Polkadot and Avalanche boast the same backward compatibility with Ethereum applications, and are built with financial applications in mind (for instance because they allow for much higher throughput). This makes them better suited to DeFi, however as second movers they have yet to gain the same traction and adoption that Ethereum has benefited from.
The current state of play
The DeFi ecosystem did not even exist three years ago, yet the sector has grow at an unprecendented rate (particularly since 2020). The total market capitalisation of DeFi protocols stands today at around USD 100 billion.2 According to Defi Pulse, the total value of assets locked on Ethereum-based DeFi protocols alone has increased from only c. USD 600 million in 2019, to USD 15 billion 2020, to a peak of over USD 80 billion in May 2021.3 The upward trend is apparent (albeit to a lesser extent) even after adjusting for the price appreciation of crypto assets in USD terms over the intervening period (see the second chart below).
Just as in the traditional economy, most of the current activity on DeFi focuses on the lending and borrowing of assets. There are, however, a wider class of applications supporting other financial activities, as summarised in the table below. I compare these to traditional finance service / fintech companies to better place them into context.
To highlight a few examples:
Compound is a decentralised lending protocol that facilitates lending and borrowing of crypto assets (as already described above). Deposited assets are converted into ‘cTokens’ that automatically accrue interest and can be redeemed at any time. The interest rate earned on each asset is floating, and is calculated as a function of the supply and demand for loaned funds.
Uniswap is a decentralised, non-custodial4 asset exchange protocol that enables trading of assets via liquidity pools (also known as Automated Market Makers, as described further below). Users can either trade assets via the protocol or participate as a market maker and supply assets to the protocol to earn transaction fees.
Nexus Mutual is a decentralised insurance provider that allows users to purchase insurance cover as well as participate in claims assessment. Currently, users are allowed to purchase insurance against technical failure and custody risks (e.g. wallet hacks).
Set Protocol is a decentralised asset management protocol that allows for the create or invest in sets, which are a portfolio of basket of underlying assets, including other cryptocurrencies and tokenised equities (e.g. FAANG stocks), with more to come.
Automated Market Makers (AMMs) and other DeFi innovations
The limitations imposed by building on blockchain have brought about a number of unique financial innovations in the DeFi space.
One example of these is Automated Market Makers (AMMs). In the early days of Ethereum-based decentralised exchanges, developers trying to replicate the conventional order book-based system of exchange quickly realised that this was not a workable solution. Whereas web-based applications are fast, low-cost and support high throughput, decentralised applications can be slow and computationally expensive—every interaction with a smart contract (i.e. the process that enables interactive blockchain-based web applications) incurs gas fees and can take several minutes (and often more) to confirm.
AMMs replace the traditional order book system of exchange with liquidity pools. A liquidity pool holds a stock of two assets, say Bitcoin and Ethereum, which users can trade between. Liquidity pools determine price algorithmically with formulas that vary in complexity. For example, Uniswap uses the formula:
x * y = k
where x and y are the value of the stock of two assets held on in the pool, and k is a constant.
AMMs set prices based on the relative supply and demand for each asset held in the pool. They do so programatically and without the computational burden of a live order book, making them much better suited for deployment on the blockchain.
Like DeFi lending, AMMs are a two-sided market. The liquidity (i.e. stock of assets) held in the pool is contributed to by other users, who earn a return from transation fees charged on the exchange of assets. As discussed above, some protocols (such as Uniswap) pay out all transaction fees to liquidity suppliers, returning full value to market participants.
Valuation analysis of DeFi protocols
It may be surprising to some, but DeFi protocols can be studied with conventional valuation metrics because they:
are cash flow positive and generate consistent, maintainable earnings today, and
have transparent and publicly auditable “accounts”. Unlike the financial accounts of a company, DeFi protocols are hosted on the blockchain and publicly accessible by anyone.
To put this to the test, I have considered nine of the most popular DeFi protocols built on the Ethereum blockchain, and compiled data on their market capitalisation, cash earnings and earnings growth (in the case of the latter, applying subjective assumptions about future growth prospects).
To promote open source contribution and encourage public discourse, I have hosted the underlying analysis on Github. Please feel free to audit my findings or overlay it with your own analysis. My work is meant as a conversation starter and any constructive feedback and suggestions are welcome.
The table above shows that DeFi protocols have a wide range of P/E multiples, from 18x to 197x, with a median of 57x. This is higher than the multiples of the broader market and large financial services organisations, but broadly in line with the multiples of blue chip Fintechs.
P/E multiples express a company’s value as a multiple of current earnings. All else equal, companies that are expected to grow faster will have a higher P/E multiple (to reflect that a higher proportion of a company’s earnings potential being realised in the future). A PEG ratio re-bases P/E by the expected earnings growth of a company to adjust for this difference.
The PEG ratios in the table above are calculated on necessarily subjective assumptions about the growth prospects of DeFi. These assumptions embed significant uncertainty, and this limitation should be borne in mind when interpreting the results.
The estimated PEG ratios of the DeFi protocols are significantly lower than those of traditional financial service providers and the wider market. That is, the protocols are significantly cheaper on a per-unit earnings and growth-adjusted basis than traditional financial services companies. This could reflect a couple of things:
the protocols are inherently more risky—i.e. they are not bound by the same risk management and governance functions of traditional companies. Further, liquidity flows freely between protocols, and any combination of operational or technical risk factors could trigger an outflow of capital overnight.
investors are expressing different views about the earnings growth prospects of these protocols. The uncertainty in growth prospects itself embeds modelling risk.
investors are not well-informed about DeFi protocols and the cash flows they are generating today. Given the value of DeFi protocols is contingent on their wider adoption by both investors and users alike, this could be depressing their values relative to the wider market.
The crypto space is maturing rapidly, and market participants should seek to continuously evolve their perception and understanding of the asset class, revisit the facts and stay abreast of latest market developments.
DeFi is only one example of the multiple classes of applications being built on top of the blockchain today—it is providing financial services in an open and decentralised way, democratising access and reducing fees. As this diverse ecosystem grows, it will be incredibly exciting to see what other use cases emerge next.
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Hi, I’m Park!
Open Source Finance is a blog to document my journey into the complex and fast-moving world of fintech. In this blog, I share ideas, insights and key learnings about companies, technology, entrepreneurship, innovation and more.
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Trustless—meaning you are not required to believe that your service provider is acting in your best interests. When depositing money at a bank, customers are implicitly placing their faith in the bank to make best use of that money and retain sufficient reserves to allow the customer to withdraw their money freely. Decentralised finance removes that need because, firstly, there is no intermediary to deal with, and secondly, the behaviour of the application is expressed explicitly in code and publicly auditable by all involved parties.
https://coinmarketcap.com/view/defi/ (accessed 26 May 2021). This excludes some protocols that do not issue publicly traded utility tokens.
User’s assets are not held on the protocol itself. Rather, they are locked into a smart contract in accordance with the function of the exchange.