Destiner's Notes

DeFi shareholders

27 January 2021

Owning a piece of a company is good. But what’s really cool is owning a piece of the unstoppable decentralized protocol.

DeFi is a really exciting experiment. What started unconsciously as a set of tools and dapps not connected to each other, later morphed into a network of diverse yet interdependent protocols.

“Lego” meme took over some of the best Crypto Twitter minds, and for a good reason. Working with each other in tandem, protocols enhance each other via network effect. On top of that, applications with various levels of trustlessness (from open-source UIs hosted on IPFS to centralized exchanges) offer those services in a way that’s familiar to end-user. Developers can build on top of primitives, or mix them to synthesize something new.

But that’s only the beginning. Many of those protocols have launched a token. Usually, the immediate utility is governance, with the expectation that someday token holders will be rewarded.

In some ways, these protocols differ from “traditional” tech startups. Sure, the equity is liquid instantly, the small holders have arguably more power in the governance process. The process is overall more transparent and inclusive.

But many aspects are similar. There’s lots of uncertainty, and the path to success is not clear. This implies a huge risk for everyone involved, but also offers a big upside.

But most important similarity is that the road to hashflow must be found. The token’s single function can’t be governance. At some point, a protocol has to figure out how to reward holders. Otherwise, a rational holder would just dump it for a profit.

There are many ways to monetize a protocol, and designing a reasonable token value accrual model is an active research field. Buyback-and-burn/make/build/stake, you name it. But the general idea is simple: the protocol charges some kind of fee proportional to the value of the transaction, and later distributes it to token holders in some way.

This makes it simple for prospective holders to evaluate an investment: in a rational market, the value of the protocol token is proportional to the transactional value of that protocol.

Protocol activity → token value

Of course, there are a few caveats. First, the crypto market is far from efficient. At the time of writing, Bitcoin Cash has a market cap of 7.8 billion dollars, which is 7.8 billion more than it should be. Second, current activity doesn’t transfer to future activity easily. Space is evolving unpredictably at this stage. A year ago, Curve didn’t exist. Yesterday, it did $221.9 million in volume.

But eventually, the market will settle. The current players are likely to share the majority of the market. The exact future contribution of each protocol is hard to measure, but deep fundamental analysis might reward with some hints.

The point is, owning those tokens should eventually transfer into a regular, predictable stream of dividends. As with investing in general, it’s important not to bet everything on a single project, and diversify accordingly. For passive investors, DeFi index funds can provide good coverage. For others, it might be more exciting (and rewarding) to create a more personal portfolio. It likely doesn’t really matter: DeFi will either make 100x or not.