DeFi Market Neutral Strategies

This week I’ve been writing some content for a DeFi fund, and digging into two topics specifically:

1. Describing for investors the broad set of opportunities created by decentralized finance - starting with global macro trends and drilling down to specific strategies.
2. In particular, I’m looking at market neutral strategies in DeFi - methods of benefitting from growth in the digital asset market, while avoiding the volatility that is so typical of crypto coins and tokens.

The Big Opportunity
From a macro perspective, the global growth of blockchain and crypto technologies during the past decade has been tremendous, outperforming any other asset class. Most recently, during the past two years we have seen 10X growth of assets in DeFi protocols: from under $10 billion at the beginning of 2020, to over $100 billion today. Still, decentralized finance is in its early stages. 

DeFi has loads of room to gain market share, considering over $400 trillion is held within the global financial system.
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Look for disruption to happen most quickly in the realm of lending and borrowing, as DeFi builds on inherent advantages:

• peer-to-peer transactions
• lower friction for transactions and greater efficiency
• faster pace of innovation across the ecosystem
• greater transparency
• lower cost and greater ease of cross-border payments
• on-chain tokenization, which provides means for protocol functionality and development
• smart contract integration  
• elimination of intermediaries
• streamlined verification processes, leading to improved accessibility and faster transaction settlement

Decentralized Finance is composed of protocols functioning in a financial system utilizing smart contracts, and operating without intermediaries such as banks, brokers, and clearinghouses.  

DeFi applications provide traditional financial services using processes that are permissionless, global, and transparent. Result: traditional finance is set for disruption across multiple verticals, including consumer banking and credit, capital markets, insurance, mortgage products, collective investment, consumer payments,  and financing for business purposes. 

Looking at the macro picture, in this interview Dan Tapiero and Dan Morehead  talk with Michael Ippolito about the macro-level future for digital assets and the legacy fiat economy. Key points:

• The legacy fiat system is, and will continue to be, heavily manipulated as central banks and governments pursue interventionist policies, with rates suppressed to historically low levels.
• Bonds are in a long-term bear market following a historic bull run. ​

• ​Mr Tapiero expects an exodus of capital (leading to devaluation) from the manipulated legacy fiat world into the digital asset ecosystem. ​

Yield-searching capital will increasingly look to crypto because a) yield in the fiat economy is stuck at historically low levels, and b) investors can achieve outsized yield in DeFi right now.

Why are yields so attractive in the digital economy?

• DeFi first gains advantage by utilizing smart contracts and blockchain technology to achieve efficiencies for stakeholders, including the elimination of intermediaries. Fees generated by the protocol are often directed toward those who own and stake protocol tokens, or provide liquidity.
• Crypto allows decentralized participation in the functionality of financial transactions. You as an investor can be a banker, or a market maker, or a lender, or likely in the future an insurer. Participation = more yield.
• This user-investor-stakeholder dynamic is fundamental to Web3, manifesting also in the use of incentives in DeFi as protocols reward specific activities to build user base and functional capacity.

Market Neutral Strategies

Market neutral DeFi investments offer income investors a way to participate in the growth of DeFi and other crypto protocols, without taking directional risk with respect to the underlying digital assets.

Utilizing USD-pegged stable coins and other asset-pegged currencies (for example, wrapped Bitcoin or wrapped Ethereum), investors can achieve preservation of principal while generating income via fees and incentives. Dollar coins provide a particular opportunity, considering the outsized role USD plays in the global economy. As the broader crypto market grows, the result is massive demand for dollar-denominated stable coins, delivering compelling yield opportunities.

Similarly, tokens pegged to crypto assets (e.g., wrapped tokens) exist to solve specific problems for protocols. These tokens open capacity for an ever-expanding array of transactions across blockchains, along with related investment opportunities.

​All of this means you can utilize USD stable coins or other pegged assets to develop a market neutral approach - benefitting from capital inflows and overall ecosystem growth, while avoiding the stomach-churning volatility of asset speculation.

​For example, Anchor Protocol is one of the most popular stable coin investments currently, offering around 19% APR. Deposited funds are used in the protocol to provide loans that are collateralized through bonded assets. The investor/lender receives interest on the loans, plus subsidies generated via the collateral assets.

​Investors can also get excellent stable coin returns via single-side staking within a protocol, or by providing liquidity to trading pairs. From here, the options grow in complexity, as protocols incentivize via different rewards tokens, autocompounding, and other automated DeFi functions arising out of generated rewards/yield.

While stable coins offer market neutral opportunities, and are increasingly seen as safe haven investments, they are prone to systemic risk, particularly with respect to their asset peg. This post is meant for educational purposes. Please do your own research!