Is DeFi a Bubble?
My Defi Forecast
Introduction
DeFi (Decentralized Finance) tokens have under gone what many describe as a mania. Tokens like SNX and LEND at their peaks were up over 100x. The fabled 100x most retail investors chase and very few ever realize. Despite being early in the macro bull cycle, many market participants and observers believe we are witnessing the formation of a bubble. Some notable figures in the space expect the DeFi bubble to deflate and capital to flow back into legacy alts.
I’ll concede we may be witnessing the formation of a micro bubble. However, on the macro side I believe this is just the beginning. I expect to see the general crypto market and DeFi token trend higher for another year. However, given the inherent volatility we should expect sizable pull backs along the way. The purpose of this write-up isn’t to convince investors to buy, rather, I would like to share my investment outlook in hopes of providing an alternative perspective.
Scarred Investors
Many investors who experienced or witnessed the 2017 mania are understandably reluctant to get involved. Some have been badly burned and others have seen their peers get “rekkt”. Also, investor psychology make it difficult for individuals to invest in any asset which has appreciated significantly over a short period of time. Instead investors are looking for the next big opportunity. This mentality has encouraged many to seek out hot DeFi plays. As a result, we’ve seen seen the much anticipated “alt season” resurface.
In the previous cycle, the catalyst was the ICO (Initial Coin Offering) mania. In 2017, I often referred to ETH as the ICO ETF because it was the main use case for the cryptocurrency. In an effort to follow in ETH’s success, many layer 1 smart contract competitors emerged. As ETH hit new highs, “ETH Killers” became the hot play. Consequently we observed the following gains:
- EOS: 4000%
- NEO: 136900%
- ADA: 6400%
- TRON: 10500%
This time around liquidity mining and DeFi coins have taken the center stage. I suspect all those scarred investors will eventually reengage the market. Due to the cyclical nature of markets, this will inevitably generate another mania.
Cyclical Nature of Markets
Speaking of cycles, this brings me to my next point. The euphoria mentioned above took many months to play out. I believe cycles are inevitable and more often they tend to rhyme. I view cycles as the collective sentiment of market participants over a period of time. Fear, greed, joy, excitement, despair, and other emotional states are all captured by the charts. In part, this might explain why they tend to look very similar.
Both bull markets and bear markets are needed for different reasons. Bull markets play a salient role in attracting capital and engaging investors. In contrast, bear markets are required for reconciling the excess and misallocation of the bull market. In other words, these cycles are essential in attracting capital and allocating it into productive investments. This could be the invisible hand that many esteemed economist refer to. In sum, we’ll see some froth in the DeFi space but this doesn’t mean DeFi as a whole is a bubble. In fact, I believe DeFi will continue to lead the markets in gains produced.
Scaling Ethereum
Many crypto investors believe ETH 2.0 will not be able to scale. I hold a more optimistic outlook. Some of the brightest minds are working on Ethereum 2.0 and the foundation has deep pockets. Moreover, ETH has produced a vast network effect. Teams building on Ethereum have a vested interested in its success and are likely to expend resources to help Ethereum scale successfully. Also, many who’ve leveraged composability are essentially locked in.
Currently there are a few projects building side chains to remove bloat and increase the speed of the network like Xdai, OMG, and LRC. More notably, DOT has made big waves in the scaling conversation. It’s technically a layer 1 blockchain, however in my view it’s likely to end up being complimentary to Ethereum. For this reason, I often refer to DOT as a layer-2 scaling solution for Ethereum. The bridges being built by DOT to ETH will enable two-way flow of tokens and smart contracts. This will accomplish two objectives:
- Alleviate or dilute congestion on Ethereum
- Developers will be able to build on DOT and leverage Ethereum’s composability and other superior features
For these reasons, I foresee Ethereum and Polkadot creating a symbiotic partnership. I’m sure many will find this view contentious but I believe Polkadot will essentially serve as a massive side chain for Ethereum. Regardless of how development proceeds, I firmly believe Ethereum will eventually scale and reduce fees. In this setting the users will have very few constraints and limitations. As a result, we’ll see more money flood into the defi space from retail investors. Expect to see the total value locked to go parabolic once Ethereum reconciles its scaling issues.
Critics
With any innovation or new trend you’ll naturally find critics. Generally speaking I believe criticism is healthy. I believe engaging in dialogue, thought exercises, and rigorous debate are prudent means of approximating the truth. Today with social media we can quickly gauge the sentiment to determine people’s general predisposition towards an idea, product, or a technology. For instance, it’s abundantly clear that Bitcoin maximalist don’t want anything to do with defi.
For all of us defi believers this resistance reveals how early we are. Before any technology is broadly adopted there tends to be a lot of push back. As defi protocols iterate and Ethereum scales, many reasonable people will admit they were wrong. Once the protocols become more ubiquitous in finance the luddites will be forced to capitulate. At some point it’ll become a huge disadvantage to not get involved. Until we begin to see a broader consensus, I don’t think you can call defi a bubble.
Venture Capital
Venture capital (VC) interest is just beginning to see an uptick. It’s no where near its 2018 peak. Many VC firms have begun exploring opportunities in the defi space. Unlike the previous cycle, we’re seeing real utility for tokens. Tokens confer holders voting rights, ability to share revenue, and monetize node deployment. In many ways, it’s like purchasing security but better. Buying the token is akin to buying a share of the protocol. For this reason, VC firms have started to buy defi tokens in the secondary markets. For instance, Parafi invested $4.5 million into Aave by purchasing LEND tokens. These firms are also participating in private rounds.
These private sales tend to get oversubscribed multiple times over. Also, the public rounds are selling out fast. Riochain’s public round sold out in less than 4 hours. It’s only a matter of time before VC activity matches and exceeds its 2018 peak. I’m sure VC firms will exit and take a profit. This will lead to heavy market volatility. However, I believe we’ll have some insulation due to tokenomics. Most defi tokens can be staked to generate passive income and extract value from their respective protocols. Once profits are extracted, I believe many VC firms will just let their remaining tokens ride to generate passive income. As more tokens get removed from the circulating supply and get staked, a strong price floor will form. These thinly traded assets will be primed as the giant herd of retail traders make their foray into the defi market place.
Conclusion
In sum, don’t let your biases prevent you from participating in the big trend. The parabolic price movements can be a little misleading. This is particularly an issue for new market participants who’ve only traded in the legacy markets prior to crypto. We’ve never had an accessible secondary market for early stage projects. Moreover, many of these defi tokens which produce the best gains belong to projects who’ve been hard at work in the bear market. They are now releasing high quality products. Many of these new financial products are still in their early testing stages. They have yet to begin marketing and building their bridges to the legacy system. This clearly demonstrates how early we are in this new trend.
Due to this outlook, I started shifting my portfolio in Q1 and went heavy into defi. I believe new capital will flow into Bitcoin and legacy alts. As people become more educated about defi I expect this new capital to then flow into defi tokens. Also, many existing holders who are reluctant to invest in defi tokens will become more open-minded once their legacy alts begin appreciating. Given the robust yields and feature richness of defi, I believe it will become a blackhole for all digital assets. If you want to position yourself ahead of this unstoppable movement you should consider allocating some time to research. I’m not advocating for people to allocate heavily as I have. Although, getting 5–10% exposure could be worthwhile if my views are validated in the coming year. In crypto, the retail investor has a better shot at participating in trends early. I plan to capitalize on the opportunity.
