Disclaimer: Your capital is at risk. This is not investment advice.
Part 1: Ethereum's Hidden Card - The Investor's DeFi Primer
Few would disagree that Bitcoin has played the most significant role in the digital asset ecosystem, contributing to over 60% of the market’s $1Trn valuation. However, Bitcoin is not the only digital asset worth watching. Ethereum (ETH) sits in second place with 15% of the total market, 14% ahead of its next closest competitor Polkadot (DOT). This piece will introduce readers to the Ethereum Network and examine the plethora of decentralised financial applications it supports. We will then go on to conclude that Ethereum’s distinctive applications make it a prime asset for diversification when investing into digital assets.
Readers should treat this article as a primer for the start of their journey through Ethereum’s financial technology stack. While future additions to this series will look in more detail at the ‘sub-sectors’ of Ethereum, this piece will focus on Ethereum’s most promising sector; Decentralised Finance, colloquially known as “DeFi”.
From Bitcoin to ICOs: The Fundraising Boom That Changed the Course of Crypto
It all began with Bitcoin’s decentralised network of validators. These entities have the crucial role of securing blockchain networks and making sure they are protected from external manipulation. Multi-sig contracts came after validators; enabling added security to on-chain settlement through requiring multiple cryptographic keys be used to authorise a transaction. Advances in blockchain security were side-lined by initial coin offerings, also known as ICO, in 2017.
More than 800 token sales were conducted in the ICO boom, raising around $20bn. Few imagined that so much value could be generated by ‘altcoins’ fundraisers, leading to this headline piece written in The Wall Street Journal in 2017, headlined:
“Initial Coin Offerings Surge Past $4 Billion—and Regulators Are Worried”
To give an idea of the size of these offerings, EOS, Telegram, Bitfinex and Huobi token alone had a combined value of $7.1bn raised through ICOs, according to CryptoVantage.
While ICOs raised a significant amount of capital, they also played an important role in engaging “users” within these alternative blockchains – much in the same way that crowdfunding platforms work. When users directly own a stake in the platform that they use, they become more loyal, refer friends and contribute to the positive development of the tokens’ ecosystem. In other words, aligning incentives between users and investors give the greatest potential for network effects. A concept that has been proven time and again in social media companies like Facebook, Snap, and Tencent.
Looking back at the 2017 ICO boom today, the numbers now appear modest in the context of Decentralised Finance. According to Dune Analytics, the past 30-day trading volume for decentralised exchanges was $43.79b, highlighting the exponential growth that the digital asset ecosystem has exposed. One notable example of this is AAVE, which carried out over $450m in “flash loans” in December 2020. Flash loans are uncollateralised loans which create and settle debt in a single transaction block. If the debt is not settled, the transaction is rolled back, which acts as a safeguard for the creditor. Flash loans are typically used for arbitrage and fast-paced transactions like collateral swaps.
Bitcoin and Tokens Seeded the Ecosystem’s Value
While Bitcoin undoubtedly carries the gauntlet for the digital asset space, it is important for investors to be aware of the vast amount of digital assets that are now available. Bitcoin, in our view, should make up the lion’s share of any investment allocation to the space. However, that does not mean it is the only asset worth buying.
Bitcoin has partners in this ecosystem, notably the Ethereum Network. Not only is Ethereum the second-largest digital asset with a market cap of $143bn according to CoinMarketCap, but it has the gold standard for token creation, the most popular beingERC-20. Chainlink, AAVE, and UniSwap are all in the top 20 digital assets by market cap, totalling around $10bn. What they have in common is that they all are ERC-20 tokens, built on top of Ethereum.
Etherscan, a block explorer from Ethereum, records more than 355,000 individual ERC-20 token contracts, overshadowing the 6,000 coins and blockchains that CoinGecko records. These numbers are likely to grow and therefore investors should avidly follow the market to avoid being left behind.
Smart Contracts Are a Platform for Innovation
Although scalability issuesare often mentioned, Ethereum consistently accommodates over 7mn weekly transactions, which, as we can see from our Terminal, is magnitudes larger than Bitcoin’s 2mn weekly transactions. Ethereum’s smart contracts are on-chain contractual agreements between several parties which enable users to engage in trustless deals; a feature that is responsible for much of this unparalleled throughput.
The potential that comes with harnessing these smart contracts is unfathomable, but as Sergey Nazarov pointed out on CoinDesk’s ‘Breakdown’ podcast;
“Understanding the evolution of a space really begins with how evolved the infrastructure is” [paraphrased].
Market participants have seen Ethereum’s scalabilitycontinuously pale in the face of decentralised application (dApp) growth, which shows a distinct lack of capable infrastructure. However, this does not indicate a lack of potential. There are over 3,000 dApps, which have an aggregate daily volume of $140mn deployed on the Ethereum Network, according to Stateofthedapps. This is comparable to the weekly on-chain transaction value of Dash over a 12-week average, found on our Terminal.
Decentralised Finance is Here to Stay (on Ethereum)
DApps drive value to Ethereum through several different protocols. However, readers should question whether this growth will be exclusive to Ethereum in future. Platforms like Flow’s, CryptoKitties, and the wider gaming sector will likely leave Ethereum in the future. Nonetheless, we believe that DeFi and financial innovation will continue to thrive on Ethereum.
Currently (as of January 21st), DeFi’s total locked value has exceeded the $24bn market cap of Tether, which would set the aggregate value of DeFi as the third-largest digital asset. Not too bad considering that, as a sector, it was broadly irrelevant until last summer.
DeFi will continue to excel as it enables two very positive factors. Firstly, the tools made available to developers and financial experts by Ethereum have enabled fast-paced creation of superior open-source finance products, and at a fraction of the cost of old-world counterparts. Secondly, and perhaps most importantly, investors do not have to rely on ‘Too-big-to-fail’ middlemen or brand-backed contracts, but instead mathematical smart contracts that run on a network of decentralised global computers. This provides both certainty and transparency of a transaction being settled when required, (unlike Lehman Brothers).
Ethereum smart contracts enable participants to engage in trustless contractual agreements. These contracts are recorded and traceable, with zero discretion, providing investors with the chance to use the most open-source and reliable financial products that we have ever seen.
This Does not Make DeFi Riskless
Ethereum’s DeFi has a long way to go with de-risking its systematic issues. In 2020, 17 major DeFi exploits and ‘hacks’ took place, totalling to $150m in losses, according to CoinGeek. Readers should be aware that the vast majority of these exploits were aimed at lending and borrowing protocols and happened at the start of the DeFi Summer. We describe most events as ‘exploits’ because users tend to lose money from entities that exploit protocol mechanisms in insecure infrastructure; in contrast to stolen funds from a nefarious ‘rug-pull’*.
(*Rug-pull: These occur when the protocol creator has direct access to funds left in a liquidity pool, and this ownership enables them to siphon funds away from users to their personal wallet)
As Sergey Nazarov stated on CoinDesk Breakdown;
we should look at the promises that an industry intends to carry out, rather than focus on its current situation. [paraphrased]
In conclusion, Ethereum’s ecosystem should not be underestimated. It provides value for investors through its smart contracts, tokens, throughput, and DeFi. All these attributes should be considered when choosing the next digital asset to include in portfolios.