Coral DeFi Market Primer — June 2021
Ethereum: The Permissionless Financial System
The global financial system is built upon trust, that’s why banking is a trillion dollar industry. Visa, Morgan Stanley, AIG all provide various financial instruments and products to clients but ultimately their entire business model is based on being a “trusted intermediary”.
But what happens if trust can be codified?
This was the grand vision of the Ethereum blockchain. A permissionless settlement layer that allows parties that traditionally could not interact with each other, the ability to do so without a trusted counterparty.
In this month’s Market Primer, we take a deep dive on the blockchain powering the DeFi (“decentralized finance”) market, Ethereum. We’ll take a look at the early days of Ethereum, the run up in 2017, the growing pains to where we are now as well as some of the key developments in the pipeline that will propel ETH to a $1 trillion asset.
DeFi Market Overview
But before we go down the rabbit hole, let’s take a look at the month of April in terms of metrics in DeFi.
Source: Defi Pulse, 90 Day DeFi TVL Growth
April was an incredible month for the DeFi ecosystem. Growing from $40 billion in Total Value Locked (“TVL”) to >$72 billion in one month the demand for DeFi products remains blistering.
The spot price of Ethereum (“ETH”) entered April floating around $2,000 and broke $3,000 for the first time on May 2nd. Even with the 50% month over month growth, ETH remains an attractive asset with a number of strong catalysts propelling the demand for spot ETH.
The growth of DeFi is no longer contained solely to the Ethereum blockchain. April saw parabolic growth across a number of Layer 1 blockchains like Binance Smart Chain (“BSC”) and Solana (“SOL”), as well as the launch of Polygon (“Matic”) an Ethereum Layer 2 solution.
Proper exposure to DeFi as an asset class requires allocation across the entire suite of blockchains, as we expect growth to continue to pick up across the major blockchains. The playbook of financial lego blocks that saw Ethereum grow to a $350bn asset is playing out on BSC & SOL at an increasingly fast pace.
Ethereum, The Early Days
After raising $18 million in 2014 via a crowdsourcing campaign off of a whitepaper initially written in 2013, the first version of Ethereum (dubbed Frontier) was released in 2015 by developer Vitalik Buterin, Ethereum leveraged blockchain technology to allow for programmable P2P transactions.
Source: Ethereum Foundation Blog, Vitalik Buterin presenting Ethereum at the North American Bitcoin Conference in Miami, Florida in 2014.
While I am overly simplifying a gargantuan computer science feat, Ethereum works as follows: Ethereum is a software application which developers can build on and users can send transactions over. The engine powering the system is an army of miners, or individuals who run GPU hardware that constantly monitors and updates the database of transactions. With enough distributed computing power and no barriers to entry to doing so Ethereum hit critical mass, similar to Bitcoin BECAUSE it lacked a single point of failure. When any participant on the network broadcast a transaction to the network, they were required to spend ETH to process the transaction (commonly referred to as gas). Thus ETH, the asset, is required for participating on Ethereum the blockchain.
Those in the industry at the time immediately took notice of the potential of a permissionless, open-source smart contract platform. Savvy trailblazers immediately flocked to the cause, dreaming up applications like Decentralized Prediction Markets (Augur) and Automated Market Makers (Bancor) which would remove established middlemen, thereby providing a quantum leap in terms of transaction types and value to the end users.
The crypto bull market that started in early 2016 brought in vast amounts of capital. From an old school loft in Brooklyn, Joseph Lubin’s Consensys housed hundreds of developers hard at work building out the early lego blocks of the Ethereum blockchain.
Something strange happened along the way though. As the bull market of 2017 minted thousands of crypto millionaires, those same investors were looking for new places to park their capital.
It became clear by mid 2017 that the key use case for the Ethereum blockchain had become a capital raising vehicle. The Initial Coin Offering (“ICO”) sparked a period of excess, whitepapers and lofty expectations from everyone in the industry.
I’m reminded of this chart below, along with headlines declaring traditional venture capital dead, showing the ICO outpacing traditional VC capital raising by ~350% in Q2 2017.
Source: Coindesk, Q2 2017 Blockchain Funding
Ethereum seemingly had reached critical mass, with projects like EOS raising billions of dollars from investors with nothing more than a landing page and a whitepaper.
Unfortunately none of this was sustainable. And with the market turnover in 2018, a vast majority of the Ethereum based projects boasted miniscule user numbers, broken functionality and investors holding assets down 90%+ from their peak.
Darkest Before Dawn
By 2019, even many “crypto lifers” declared Ethereum dead. However, in the background world-class entrepreneurs like Robert Leshner of Compound Labs and Hayden Adams of Uniswap were hard at work building the decacorns of today.
One of the major pain points to participating in the ethereum ecosystem has always been the wallet interface. The development and continued iteration behind Metamask, the industry leading solution for Ethereum “hot wallets” has been a pivotal factor in new users jumping in to ETH-native apps.
Almost 5 years after the initial announcement of Ethereum, many of the pie in the sky ideas for native financial applications had been launched and were being actively used by thousands of users per day, trading billions of dollars. By mid-2020 it became clear that Ethereum had found a new product market fit, which brings us to….
The market turmoil also sparked the popularization of the small but burgeoning new sector called Decentralized Finance (“DeFi”). On March 12th, 2020, the entire DeFi sector had just under $1 billion in TVL. TVL represents the total assets staked as supply in the protocols, which add to the liquidity of the underlying protocols. As previously noted, that number sits at ~$72 billion today.
Source: Defi Pulse, All Time DeFi TVL Growth
The tremendous growth can be partially attributed to the beginning of the popularization of the concept of “Yield Farming.” Yield Farming refers to the idea of a protocol that pays out incentives to users for actively participating in the functions of the underlying protocols. For example, if someone decides to lend out money to a borrow/lend-based protocol, the person lending money would receive an additional yield in the form of the protocol’s native token while also receiving their in-kind yield. This native token could then participate in the token governance proposals and capture the protocols’ specific cash flow generation.
Synthetix (“SNX”) protocol was the first decentralized finance application in 2019 to bring yield farming to the market but Compound (“COMP”) was the one that brought it to prevalence. Given its position in the market as one of the first usable and mature DeFi platforms, participants flocked to Compound to partake in the phenomena, chasing abnormally large yields. Compound launched their yield farming incentives on June 15th,
2020 and within three months, their TVL went from under $100M to over $600M. Over the same period, the entire DeFi sector went from $1.17B to $10B, with dozens of new projects being launched per week.
New projects encompassing derivatives, asset management, payments, and decentralized exchanges (DEXs) were popping up exponentially, and the summer of 2020 was dubbed “DeFi Summer.” During this period of massive growth, SushiSwap (SUSHI) and Yearn (YFI) gained the most notoriety. Yearn had a 7-day yield farming incentive campaign to bootstrap their community-based protocol. What started as a pet project turned into a ~$2 billion protocol, and those that participated in purchasing and farming upon release received a 158,457% return in under one year.
Sushiswap competed with Uniswap’s dominance as the leading decentralized exchange. At the time, Uniswap had no token and the only incentives one would receive for participating in Uniswap’s platform was for being a liquidity provider, which, depending on the pairs you provided liquidity to, could be a good way to generate yield on idle holdings. Sushiswap launched its own yield farming campaign as an incentive to port liquidity over from Uniswap to its native DEX. This move sparked contention in the ecosystem, given that much of the project was a fork of the Uniswap code. While controversial, Sushiswap developed its own ecosystem and has taken a different approach to attract users to its platform. Sushiswap provides a more horizontal integration and multi-platform plugin, versus Uniswap’s vertical integration and constant improvements to its Automated Market Making (“AMM”) operations. For those unfamiliar with the meaning of an AMM, an automated market maker (AMM) is a type of decentralized exchange (“DEX”) protocol that relies on a mathematical formula to price assets. Instead of using an order book like a traditional exchange, assets are priced according to a pricing algorithm.
Uniswap announced plans to roll our Uniswap v3 in early May 2021. Rather than supplying liquidity across the entire bonding curve of trading pairs, v3 will allow liquidity providers the ability to choose the parameters along the curve by which they supply liquidity. What does this mean for the end user? Deeper order books, with lower slippage for traders and a myriad of revenue opportunities for liquidity providers. This is iteration at its finest, a wholescale
upgrade to a protocol transacting billions of dollars per day that will roll out from start to finish in under one year.
DeFi, ETH & Beyond
The massive interest in the DeFi space brought excitement and intrigue, but also triggered externalities that weren’t foreseen. The price of gas on the Ethereum network skyrocketed. Prior to Compound’s yield farming campaign, the average gas cost on Ethereum for a transaction was 12.30 GWEI, and today, it sits at 137.76 GWEI.
Source: Statista, Historical Gas Prices in GWEI from Inception
The upward trend in the spot price of ETH further exacerbated this issue, as the increased cost made it difficult for many smaller participants to realize a positive gain from yield farming activities, as the cost of a simple transaction skyrocketed from a few dollars to $150+. Some projects were unable to continue with operations as the gas costs made it prohibitive for them to build and ship out functionalities.
In true crypto fashion, the pain experienced by its participants led to continued technological advancements. Many layer one protocols, which are new base layer chains in which people can build applications on top of (think ETH and BTC) and layer two solutions, second layer solutions that are meant to improve the functions of the existing base layer chain, think a layer on top of ETH & BTC, raced to capture as many projects and ultimately, TVL to their protocols with enhancements.
Entrants like Polkadot (“DOT”), Kusama (“KSM”), Near (“NEAR”), Avalanche (“AVAX”) , Solana (“SOL”), Binance Smart Chain (“BSC”), have experienced astronomical growth with the hopes they can capture projects with lower fee structures. The yields on these other chains have been desirable, occasionally breaking 100%+ APY, which has led projects to try to port activity to a new chain — with AAVE being one of them. During this time, copycat projects on new chains are taking market share due to the inflated gas fees on Ethereum. While these yields are great, incentives often wane over time, and it will be interesting to see how fickle the capital really is. Are people adopting new chains because they are better? Or are folks just trying to capture the inflated incentive structure? In our view, it is the latter.
Source: Coin 98 Analytics, Comparison of Top Tier Layer 1 Blockchain Platforms
Layer 2 solutions, like DyDx launching on Starkware, and Aave (“AAVE”) projects on Polygon (formerly known as Matic), have gained initial traction with over $400 million TVL. Arbitrum is around the corner, and Optimism, one of the most anticipated Layer 2 solutions, is set to launch in July. While not a layer two solution, Flashbots have been making waves on reducing malicious actions on these protocols, which has already caused a reduction in gas across the board and has been making miners more money.
ETH, Still The Layer 1 King
While there are a number of other blockchains that are also experiencing parabolic growth like BSC & Solana, the developer community of Ethereum has a 3–4 year head start on other Layer 1 blockchains, as solidity has become the coding language of choice for a majority of the world-class blockchain developers.
Through this lens, it makes sense why a majority of the innovation in the space begins on ETH before being replicated elsewhere. In no way am I knocking other platforms for copying ideas that work on ETH, rather it’s more a point that having the best developers in the world trained in solidity has tangible value that is difficult to replicate.
Source: The Block, “Ethereum’s Developer Ecosystem”
One of the bear cases for ETH as an asset has always been the lack of understanding surrounding its inflationary policy. With the acceptance of EIP-1559, a proposal to burn a portion of every gas fee paid, there is a very realistic chance that ETH goes from being an inflationary asset to a deflationary asset overnight. This switch has already stirred up strong demand for ETH, as all network participants will not only continue to require ETH to conduct their activities on the blockchain but a mental shift with many now viewing ETH as a store of value similar to hard assets like Bitcoin, Gold and hard assets.
Disrupting the traditional finance world wasn’t going to come without fireworks and controversy, but it is clear that the DeFi space is here to stay, and the eyeballs are here. The St.Louis Fed has written a report about the sector, and Brian Brooks, Head of the OCC, believes DeFi is the killer app of crypto.
The hefty yields offered are a stark comparison to the idle, negative-yielding cash of the traditional finance world, so it’s inevitable some of that cash will migrate over to this world. In the meantime, the TVL will continue to grow from its current standpoint of ~$72 billion TVL and the blitzscaling pace of innovation in DeFi will not stop.
PROPERTY OF CORAL CAPITAL LLC. NOT AN OFFER TO BUY OR SELL SECURITIES, OR A SOLICITATION OF AN OFFER TO BUY OR SELL SECURITIES. THIS PRESENTATION IS INTENDED FOR INFORMATIONAL PURPOSES ONLY.