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Crypto Categories: Defining DeFi

December 22, 2021

In Sorting Out the Crypto World, we identified the need for a classification system for crypto coins and introduced the categorization scheme developed by MV Index Solutions (MVIS), a VanEck subsidiary. This crypto categorization series will offer a closer look at several of these digital assets categories: smart contract platforms, media and entertainment (metaverse), DeFi and infrastructure applications. Here we explore DeFi.

Understanding DeFi

Decentralized finance (DeFi) protocols are software programs that run on top of another cryptocurrency and that use a combination of that other protocol's asset (as well as their own and maybe others) as a means to automate a financial service. DeFi protocols connect lenders and borrowers, buyers and sellers, without requiring a centralized institution. In aggregate, DeFi protocols comprise an overlapping ecosystem of decentralized applications and smart contracts that mostly operate on Ethereum, the largest open-source blockchain smart contract platform. More specifically, the DeFi protocols can be divided into several sub-categories that further refine their use case:

  • Decentralized exchanges, or DEXs (Uniswap, 0x): Allows users to exchange crypto assets peer-to-peer. DEXs provide access to trading pairs even when the volume of the underlying asset may be too small to warrant attention from larger exchanges. Transactions can occur either via a decentralized order book or by matching orders and setting prices algorithmically.
  • Lending/borrowing platforms (Compound, Aave): Involves the creation of time-limited interest-bearing instruments, which must be repaid at maturity, and the matching of lending and borrowers to issue those instruments.
  • Derivatives (Synthetix): Users can trade real world assets such as stocks, FX and commodities in the form of crypto-denominated tokens; or, in the case of prediction markets, manufacture "shares" representing a portion of the value of outcomes such as elections, sports or market events.
  • Asset management (Mirror, Numeraire): Allows users to create and maximize the value of an asset portfolio based on risk references, time horizons, diversification or other conditions.
  • Insurance (Nexus): Provides protection against risks by trading the payment of a premium for the possibility of collecting a payout in the event of a covered scenario.
  • Aggregators (Yearn.Finance): protocols that offer diversified products and services.
  • Asset-backed reserves (Olumpus Dao): protocols that aim to provide protocol-owned liquidity through a mix of rebases, bonding mechanisms, and the accumulation of other stablecoins or digital assets.

Importantly, most DeFi apps don't demand personal information to register. Anyone can use DeFi products by visiting an application's website and connecting via a MetaMask wallet or similar protocol. Thus, while DeFi is a fast-growing area, it remains immature, with a variety of unresolved economic, technical, operational, and public policy issues that are important to address.

How DeFi Compares to Traditional Finance

  Traditional Finance DeFi
Custody of Assets Held by regulated service provider or custodian. Held directly by users in non-custodial wallet or via smart contract-based escrow.
Units of Account Fiat. Denominated in digital assets or stablecoins.
Execution Intermediaries process transactions between parties. Via smart contracts operating on the users' assets.
Clearing & Settlement Processed by service providers or clearinghouses, typically after a period of time. Writing transactions to the underlying blockchain completes the settlement process.
Governance Specified by the rules of the service provider, marketplace, regulator and/or self-regulatory organization. Managed by protocol developers or determined by users holding tokens granting voting rights.
Auditability Authorized third-party audits of proprietary code or potential for open-source code that is publicly verified. Open-source code and public ledger allow auditors to verify protocols and activity.
Collateral Requirements Transactions may involve no collateral, or collateral less than or equal to the funds provided. Overcollateralization generally required, due to digital asset volatility and absence of credit scoring.

Source: UPenn "DeFi Beyond the Hype" May 2021; VanEck.

Valuing DeFi projects

DeFi protocols, similar to smart contract platforms, generally earn money by collecting transaction fees. The fees are distributed to token holders in the form of payouts or through "burns"1 that reduce the supply of tokens. Payouts generate a direct return to market participants, while burning tokens increases each users' relative share of the network similar to a share buyback. By comparing the market cap of the DeFi protocol with the fees earned by the protocol, investors can observe an effective "price to sales" and "price to earnings" ratios for these projects.

That said, different DeFi tokens have different earnings models that make this PE exercise more complicated. For example, revenue is split between interest payments from borrowers and trading fees from traders, the latter which may be more relevant to protocol sustainability. Still, in aggregate, the constituents of the MVIS CryptoCompare Decentralized Finance Leaders Index are producing total revenue at an annual rate of $4.9B2 vs their combined market cap of $29B, putting the universe on ~6x price-to-sales, a steep discount to smart contract platforms (~20x), which reflects uncertainty around the barriers to entry and the regulatory environment.

MVIS DeFi Leaders Index as of 11/23/2021

  Annualized total revenues
(last 30 days)
Price-to-sales
Uniswap $2.6B 8.21x
Aave $638M 5.9x
Maker $104M 25x
Curve DAO $135M 14x
Compound Governance Token $415M 7x
yearn.finance $313M 3.7x
Sushi $571M 2.85x
Perpetual $27M 32x
Synthetix $18M 83x
Serum* $67M 11x

Source: TokenTerminal, VanEck calculations, as of 11/23/2021. *Serum data based on last one week fees annualized as of 11/16/21.

DeFi Leaders Total Value Locked by Protocol

DeFi Leaders Total Value Locked by Protocol

Source: DefiLlama, as of 12/10/21. UNI: Uniswap; CRV: Curve DAO; AAVE: Aave; MKR: Maker; COMP: Compound Governance Token; YFI: yearn.finance; SUSHI: Sushi; PERP: Perpetual; SNX: Synthetix; SRM: Serum.

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