The Minimum Viable DeFi Ecosystem: An Introduction

Overview

While the recent events surrounding FTX have unquestionably presented significant challenges and headwinds for the broader crypto ecosystem, they have once again highlighted the inherent risks when centralized entities hold customer funds. As such, we wanted to spend some time going “back to basics” on DeFi, exploring what a minimum viable ecosystem looks like, and setting the table for a path forward that can realize the ideals for what this technology set out to accomplish.

“DeFi,” or “decentralized finance,” is a trendy buzzword often tossed around alongside phrases like “democratization of finance” and “immutable ledger.” While these terms all have their place in web3, they don’t do the most concrete job of outlining why DeFi is important and why an institutional approach to investing in decentralized finance makes sense over the medium- to long-term.

DeFi is an immensely complex topic in and of itself. It’s also a concept central to the value of web3 investing and asset management overall. For that reason, here at Hivemind, we’re likely to write multiple posts about it. This one serves as the most basic explanation for incorporating DeFi themes into our investment philosophy.

Getting Fundamentals Straight

Whether you’re an individual or an institution, banks take longer to process transactions than one would expect in the twenty-first century - and they charge fees along the way. Certainly, traditional finance has improved over time, relative to the 1980’s. But relative to many other sectors of the economy, financial transaction-processing functionality lags behind.

As answers to this friction, services like Venmo, Zelle, and Quickpay have sprung up and have become increasingly popular platforms for users to do everything from splitting dinner bills to receiving compensation. End users love these services. They’re quick and convenient ways to (very technical term incoming) “do money stuff” without many of the limitations on accessing or transferring funds that, while common, have become increasingly out of step with everyday modern life and its “always on” digital reality.

While these solutions improve speed and lower costs, they essentially are web2 approaches, which, at the base, reflect a more- rather than less- or de-centralized strategy for supporting markets and transactions. They ask you to trade trust for speed and reduced cost, and for the most part, consumers happily oblige.

Part of Hivemind’s future opportunity set - and the opportunity set for any web3 investor - involves understanding how crypto and decentralized finance take a fundamentally different approach to this problem.

Why Decentralize?

To oversimplify a little: there are two types of assets in the world. “Bearer assets” are things that you hold and literally “carry” value. For example, gold or cash or even a watch on your wrist are bearer assets. On the other hand, “credit assets” refer to assets sitting elsewhere with some third party holding the asset for you or acting on your behalf. Your dollars in a bank account are credit assets^, as are the stocks you’ve purchased on a trading platform. You have an “I owe you (IOU)” from an institution that you trust, and there are a whole bunch of legal frameworks that help enforce that IOU.

Crypto and decentralized finance seek to turn these credit assets into bearer assets. By holding the keys to your crypto assets, you control them. It’s the opposite of the “not your keys, not your crypto” mantra you hear so often. Your keys, your crypto. When you use hardware wallets and trade on decentralized exchanges like Uniswap, you are working with bearer assets the entire time. You don’t need a bank, a broker, a regulator, or a witness to conduct a fair trade. You also don’t need to pay the related costs associated with those parties adjacent to the transaction or wait for them to confirm the transaction. The benefits are lowered costs, more transparency and less trust, and fewer parties whose only interest in the transaction relates to fees. Access also expands as all parties are treated equally based on the information they provide. There is no waiting for accounts to be opened or required human intervention that might invite bias.

Now, there are still plenty of good reasons to want to use centralized services. They offer real humans who can help you if you get stuck and often have more intuitive front ends and workflows. People can ask themselves: “do I trust <insert institution like Coinbase> more than I trust myself to not lose these keys” and oftentimes, the answer is yes! But DeFi is important because it gives people the option to take back control.

Another vital dimension to consider is transparency. Blockchains and blockchain-based applications are about encoding information in a publicly verifiable way. (In reality, the extent of that “public-ness” is rapidly evolving in a world of zero-knowledge proofs, but that’s a whole other topic. For now, let’s just say that the people who need to verify transactions, can.) Instead of data being siloed and private within each application like Venmo, everything is public.

Imagine a whole system built upon these verifiable transactions. Users can track the origins of assets, provide easy proof of payment, and access their funds from anywhere. Developers can freely explore this treasure trove of data and build platforms focused on everything from trading history to tax calculations. Platforms can prove that they are solvent and liquid, or not even ask users to give them custody of funds in the first place. DeFi has the power to unleash both users and builders.

From an institutional investment perspective, consistent with our overall philosophy about crypto, Hivemind believes in this opportunity set because we expect DeFi activity to grow inevitably over time. DeFi will not always be the best choice for every user or for every use case, but it’s undeniably a different option than the status quo today with very real benefits. Companies that play in the DeFi space constructively, and other digital assets and blockchain applications that help expand use cases for and credibility of the DeFi area, are therefore of sustained interest to us - with a variety of caveats.

^Let’s ignore FDIC insurance for a minute; the point is: you have a claim on your cash and are not literally holding it.

The Minimum Viable DeFi Ecosystem

As we evaluate DeFi ecosystems and potential investments, we consider the concept of a “minimum viable” DeFi ecosystem. Specifically, we look for ecosystems that contain or applications that contribute to the core building blocks we believe are necessary for an ecosystem to reach scale and credibility. These key criteria are:

1. Enable Something CeFi Doesn’t: DeFi allows the cheap, quick, and final exchange of value. Within those principles, programmable money and smart contracts potentially allow users to do many exciting things, and those activities in turn can be the basis for a thriving ecosystem, which in turn spurs useful and inventive new applications, creating a self-sustaining value flywheel. However, that flywheel needs to begin with DeFi offering something that users cannot easily get some other way, especially within CeFi.
2. Constructive Application of Leverage: In the past eighteen months, leverage has had more negative implications for crypto than positive ones. But the reality is that within finance, the ability to lend and borrow against an asset is fundamental to sustainable value creation and efficient markets. Compared to traditional centralized finance models, DeFi leverage can be, broadly, faster, cheaper, and more accessible than its traditional counterparts for consumers. There’s significant value embedded in companies and assets that enable the constructive use of DeFi leverage.
3. Tethering^ to Stablecoins: Stablecoins, in our view, are a critical pillar of scaled DeFi. While not all stablecoins are created equal – and the asset class itself needs to continue to mature – we believe that tying the value of crypto to another currency, commodity, or financial instrument, such as the USD, reduces volatility in an ecosystem and is an important bedrock for building a flourishing DeFi ecosystem.
4. Platform to Exchange: A means for exchanging value is critical. When people join an ecosystem, they need to be able to acquire or trade for something new as opposed to hanging on to the assets they came in with. This can be done through AMM or order book model decentralized exchanges (“DEXs”). Different AMMs can be optimized for big or small transactions, a concentrated set of assets vs. the long tail, and stablecoins vs. other types of crypto. These platforms help assets get exposure to the community and give participants access to assets which may be unavailable at other venues.
5. Enable Sticky Community Activity: There needs to be a way for people to get value into an ecosystem and then hold it there. Bridges, exchange support, custodian support, and the presence of complementary  tax and compliance software are all necessary for a given token and ecosystem to thrive. A credible DeFi system needs all of these “table stakes.” Furthermore, there needs to be a reason for people to want to enter and stay, which primarily comes from having interesting assets in addition to useful tooling.

^Pun intended, sadly.

Now, these aren’t the only factors that make DeFi ecosystems successful. Nor are they the only times of applications that add value to ecosystems and users. As an example, a DeFi ecosystem can be tremendously enhanced by liquid staking, derivatives, and asset management platforms. Liquid staking can help users generate passive yield without the capital and time requirements normally required by staking; option & futures trading platforms allow members of an ecosystem to make investments in preferential vehicles, and asset management platforms can help aggregate yield opportunities. These entities work in tandem to improve the utility of an ecosystem - and so all of the above are areas that Hivemind is either evaluating or planning to support.

The bottom line: over the past few years, tremendous amounts of money have been poured into various DeFi ecosystems, sometimes without much of a strategy for or understanding of the fundamental basis for the value of DeFi vs. CeFi or how to compare DeFi ecosystems. We hope this initial primer outlines the kind of informed, institutional-grade approach that the space deserves. In future posts, we’ll explore additional aspects of DeFi. In the meantime, even with the continuation of the crypto winter and its fallout, we’re optimistic about what lies ahead.