DeFi — an ecosystem made for “whales”?!
Decentralized Finance (#DeFi) dominates the blockchain news these days. A huge amount of capital is flowing into these systems. We speak about billions of dollars.
The DeFi promise: High interest rates, rising evaluations of DeFi tokens and new forms of ecosystem governance create a new inclusive permission-less financial ecosystem.
It’s about time to ask important questions, like:
- Is DeFi as revolutionary, decentralized and democratic as it is aspiring to be?
- Who profits the most from this development?
- What can we learn from this phenomenon for the future of blockchain ecosystems and their governance?
But, let’s take one step at a time and see, what actually happened since January 2020:
A short history of DeFi success factors
Stage 1: Staking native tokens
First, “traditional” DeFi projects like 0x project launched their staking portals to push token holders into more action and create more “utility” for their native tokens. The promise: If you stake your ZRX tokens (the native token behind 0x project) and regularly participate in governance votings of the project, you get the chance to earn some reward. Well-known DeFi projects like MakerDAO did that before, others like Kyber followed suite. It roughly works like this:
- Stake your tokens for a certain time-frame (usually called an epoch).
- Engage in governance — either by regularly voting yourself or by delegating your voting power to a delegation pool.
- Claim your rewards.
All this happens on-chain. In general, you “hand over” your tokens to a smart contract that is part of the staking ecosystem of that platform. You can gain control back over your tokens by simply “unstaking” — usually with some time delay.
Remark: This all works similar to Ethereum v2 when its proof of stake system (beacon chain) is introduced later this year. So, we get a first feeling of Ethereum’s mainnet future.
Stage 2: Yield Farming governance tokens
Later in June, projects like Compound, Aave, Synthetix, Curve or Balancer started to use advanced mechanisms like yield farming to attract large amounts of crypto assets onto their platforms. By depositing and “locking” your assets into their platforms’ liquidity pools (instead of just staking or hodling it). These platforms use your tokens actively in their systems — and generate higher returns. You not only get back considerable interest rates. Additionally, you now also receive native platform tokens, that are set-up to enable the community to govern the future of these platforms. This goes so far that you can earn tokens on 4 different dimensions like in this sBTC example when you provide e.g. Wrapped Bitcoin for Synthetix’ sBTC pool on Curve. Offerings like this currently push the valuation of these projects to 8 billion dollars . The immense value of tokens locked into these systems doubled every few weeks! DEFI Pulse gives a nice overview about the most popular projects — most of them are tightly integrated with each other.
Governance Token Issuance — similar to ICOs, yet different
If you will, issuing governance tokens turns the ICO (Initial Coin Offering) wave of 2017 upside down: While ICOs offered project tokens for sale very early in their development (mostly just based on rough ideas and a project roadmap written down in a whitepaper), these projects now issue tokens once their platform is already working and has proven some product-market-fit. We could name these GTIs — Governance Token Issuances. GTIs address many issues of ICOs, because
a) the tokens have utility (namely governance) from the very start and
b) they push decentralized ownership — at least at the first glimpse.
Everybody who engages with the platform is entitled to earn some of those tokens. In many cases, the companies who launched the platform quickly set up DAOs (decentralized autonomous organizations) and hand over the governance and ultimate control of the platform to the token holders.
So, that’s progress for sure — especially towards demands of regulators like the US Securities and Exchange Commission (SEC) who made these aspects central to their judgments of several token issuers. The SEC saw many ICOs very critical and denied their launch in the US because some projects never fulfilled the promises of their whitepaper to create a functional platform that made use of the token and/or kept control over the platform.
By issuing tokens with built-in utility on a running platform these new DeFi projects solve two critical problems — very smart!
So, all is fine, isn’t it?
I’m afraid: It’s not.
The risks in DeFi
As you might imagine, this trend bears significant risks, because there’s no free lunch — as we all know.
Some of these risks are obvious technical risks, like fresh, mostly unproven smart contracts managing assets worth hundreds of millions of dollars — you can imagine how big the motivation will be for fraudsters and hackers to attack these systems.
But there are also market risks, like the volatility of certain cryptocurrencies involved in these systems. A sudden crash in the price of one asset might lead to chain reactions and enforce liquidation of your position if your collateral falls beyond the critical threshold. You see, asset prices are critical in these systems — and so are the market prices fed into these systems: the oracle problem. Oracles are the interfaces between smart contracts on blockchains and external data — like prices from centralized exchanges. If these oracles have a bug, get hacked or manipulated through false data from the outside world — then chaos might follow.
Often, it is a combination of technical and market risk, maybe combined with low liquidity of certain assets that cause opportunity for fraudster like in the bZx hack.
And then there are other, more subtle risks and problems for holders of smaller amounts of tokens that impose interesting questions on a broader scale. I would like to dig into these in the rest of this article.
The subtle problems…
Let’s start again with staking. Isn’t it cool if the users of the platform use their tokens as described in the whitepaper to govern the platform? In theory: yes. That sounds very decentralized and democratic, doesn’t it? Well in practice there are some drawbacks, like:
You need a considerable amount of tokens to make staking economically reasonable for you.
There was always the promise that DeFi should “bank the unbanked” and help to build open financial systems for developing countries. So, shouldn’t token holders with “small pockets” also be able to take part profit from these platforms and their incentive mechanisms? Or even better: Shouldn’t these systems designed for these users in the first place?
DeFi staking — made for whales?!
Well, let’s assume this won’t happen in the first instance — let’s take someone from the mid class in the US: Joe. Let’s say Joe has savings of 50.000$. Despite all the warnings to use at most 1-2% of his savings for crypto, Joe is an enthusiast and convinced of DeFi. He is as crazy and invests 20% of his savings into crypto — that’s 10.000$. But Joe isn’t stupid, he knows that most valuations deeply depend on Bitcoin and Ethereum. So 90% of his portfolio goes into major assets like BTC and ETH. That leaves 1000$ for DeFi experiments.
Joe is a big fan of 0x project. Yet, he knows that diversification of his portfolio is important. So, he puts 1/10th of his DeFi portfolio into 0x project — that’s 100$. The rest goes into other cool stuff. Now he wants to stake. He takes a glimpse into 0x’s staking pools. He can choose one of just 11(!) staking pools, sees their historical data — and the amount of reward sharing from the past. Yet, when Joe wants to dedicate his ZRX balance to one of the pools he sees that the transaction costs about 2$ at the current gas cost for transactions on Ethereum — remember: satking happens on-chain. 2$ — that’s quite an amount — 2% of his ZRX holdings. But Joe is such a big fan of the project and wants to be part of it — living the DeFi aspiration. The problem: The generated earnings won’t cover his initial transaction cost for a considerable amount of time.
In theory, Joe can switch the delegation pool and give his voting power to someone else. In practice, he won’t do that, because it’s simply crazy expensive for a small to medium token holder to do that.
Here’s the math (data from August 8th, 2020):
Prominent 0x staking pools like DUST pool earned 197 ETH over the last 6 months. It shared 30.5 ETH of that amount (15%) to its stakers. That’s ~11.895$ (ETH=390$). There are 3,7m ZRX staked in that pool. That means each staked ZRX token roughly earns 0,0032$ over a period of 6 months if it was staked in that pool.
ZRX is currently valuated by 0,42$. So, Joe has ~238 ZRX tokens to stake if he invested 100$. If he had staked his tokens he would have earned ~0,76$ in 6 months! The cost of staking, unstaking, maybe switching between staking pools is easily 10 times higher!
My conclusion: If you don’t own at least 1000$ in ZRX staking doesn’t make any sense for you from an economic perspective. But most projects aren’t open about this important aspect.
Because it puts a big question mark behind the “De” in DeFi!
The recent developments in DeFi let me assume that DeFi staking is primarily made for whales or venture capitalists entering the market. It is very attractive for big amounts of money. Even delegation is rather uninteresting for small holders.
So let’s have a look into yield farming if we see similar patterns there.
Yield farming — made for whales?!
If the staking scenario created some doubts in me — yield farming is even worse. Remember: you get incentives in governance token of the platform in correlation to the amount of collateral you put into the platform. Doesn’t that already ring bells?
Well it gets better: Some of these projects like Compound are mainly venture financed. Remember: They didn’t do an ICO. The capital build such a platform had to come from somewhere in the first place. Compounds’s website is very open about their tight link to well-known ventures:
So, let’s ask the question: who will profit most from a newly launched DeFi token with a 500 million $ market cap out of nowhere? You guess it. The project still holds 40% of their tokens (worth 200 million $). So governance can be used to show the way. And the big players are already leading the votes. Token Daily’s newsletter #43 also points into that direction — coining the term “ReFi,” or Re-centralized Finance.
The discussions around token distribution of these projects are just about to start — like this one on Cointelegraph. It is referring to an interesting tweet by Simone Conti who recently did an eye-opening analysis about DeFi projects and the distribution of tokens among the community (remember blockchain data is publicly available on platforms like etherscan).
But let’s be cautious. If you take a closer look into the comments on Twitter you’ll see: it’s not that easy to analyse token distribution when delegation pools are in play and many token holders delegate their tokens. I’m certainly not in the position to confirm or question these numbers. But I’m sure we’ll see lively discussions in this regard!
I don’t want to speculate how these developments in DeFi will determine the future path of blockchain ecosystems. But I’m sure we are now at an interesting point of its overall development. Big companies and institutional investors get attracted. Even bigger money will find its way into crypto networks — and it will influence important decisions — for better or worse.
It’s obviously not enough to simply push governance to a blockchain and hope for the best. “One token one vote” simply won’t work. History will repeat, power will be centralized. We certainly need new ways of governing systems by the masses. New methods like quadratic voting have to be tried out to balance the power at play.
But for now even small steps would help to improve the systems:
- DeFi projects should be more open about the token distribution and influence of venture capitalists or other large stakeholders.
- DeFi projects should explicitly give a statement how much tokens you have to stake at minimum for which amount of time to cover your staking cost.
- DeFi projects should create more transparency about their delegation pools — not only how much profit they share, but also how they actually influenced the voting in the past.
Founders of DeFi projects bear a lot of responsibility. They will determine how much “De” will be in DeFi — and maybe how the value systems beneath these blockchain ecosystems develop further!