How To Value a DeFi Protocol.
There is no doubt that 2020 is the year that DeFi shined
The Total value locked in defi has pulled a 20x in just a short period of time.
In this article I will be sharing with you the important valuation tactics and indicators that you have to use when evaluating which project is the next protocol you will part your hard-earned money with. All to help you snag the opportunities in the market and help you pick the right gems.
The big question is, How do you value a DeFi-protocol?
Market Cap
You might think it is as simple as heading down to Coingecko to look up the market cap of that particular Defi protocols token.
Why market cap alone is a poor indicator of value.
Market cap is one of the most floored evaluation metrics to evaluate the value of a particular Defi token.
Lets take UNISWAP as an example
This is the current market cap of Uniswap , but before Uniswap could even reaches this valuation, in the times the DEX was airdropping to participants, did uniswap have no value? I think not.
DYDX could also be used as another example the DeFi protocol does not have a token and are simply listed on crypto price aggregators as an exchange. Does these also mean that DYDX has no value as a DeFi project.
TVL
Another common metric used to evaluate value is TVL.
Total Value locked (TVL) is the geeky way to explain the total number of ETH and ERC20 tokens locked in the smart contracts in any given time for a Defi- protocol and expressing that value in US dollars.
This TVL figure does matter to a certain degree as an unsused protocol with the TVL of 0 is probably not going to be worth much, no matter how you slice or dice it
Essentially, TVL is the balance sheet of any Defi-protocol, however, most people often over value TVL as a Defi metric because that’s the step most commonly used to rank Defi projects, the problem with it is that it gives the impression to people like me and you that this value is well actually locked. TVL can be cannibalized by forked protocols very quickly and by no means is a static measure of value.
All that is not truly surprising to those who understand what defi protocols are. Which merely provides the rules logic and incentives to encourage economic activity. Most of the time it is by crowd sourcing crypto assets from you and I and using them to do things like crypto lending (Aave), market making (Uniswap) or creating synthetic asses like (Synthetics).
The true value comes from how these DeFi projects use the TVL, what they do with the liquidity provided to them.
So why would anyone want to provide their assets to things like Defi protocols?
Simply because we are incentivized to do so, with huge things like interest or the ability to earn a percentage of the fees generated by the protocol or a vote in the governence of the protocol and all that jazz. Essentially what is really happening in DeFi protocols is that users are putting up their crypto for any of these returned values.
What that simply means is that value creation is contingent on how well a Defi-protocol monetizes that balance sheet or TVL.
Balance sheet monetization is the backbone of central finance as we know it.
Balance sheet monetization is exactly what central banks do with their balance sheet, when you lock your value with a bank that value does not simply sit in a gold vault to give the Italians a job.
They monetize that balance sheet from loan investments or using it to provide capital towards other financial services.
Defi-protocols often work in a similar way, except the pesky banker middle man is replaced with smart contracts on public block chains, it is immutable, and transparent.
Which brings us to a very serious question.
How is value actually created and captured by defi protocols?
To understand Defi value creation we have to first understand who the main stakeholders in these protocols are. There are 4 main particpants in a Defi proocol.
Liquidity providers are the group of people who get economic incentives and the value proposition offered by a specific Defi protocol.
Which often includes trading fees interest rates but also token incentives.
If they truly believe in the project’s use cases as well as for t he future and not decide to dump those tokens on the market, this will make this group of people token holders as well, HODLers.
Developers who build and maintain and add features to the protocol.
Defi protocols which create value can make themselves unique by offering superior value propositions to liquidity providers.
Another value that they add is to also offer and allow users access to the services that they want, which then attracts more token holders who want governance rights to the protocol and to gain a cut of that fees incentives.
This above creates a serious value creation loop.
But value creation is one thing and value capture is another.
Sustained value capture has been evidentially the most difficult for Defi protocols to achieve. The main reason why this is hat value prepositions need to remain attractive compared to competitors otherwise it is highly likely and highly evidentially there will be capital flight, to the next better incentive providing protocol.
It might mean you are getting some decent economic incentives by lending out your crypto on a certain Defi protocol. However, there is nothing stopping another project from offering a slightly different tweaked economic model that provides better incentives,
That is not all they must do to grow and retain the liquidity supplied to them
shake that confidence of your LPs, whether it be with security or inactivity and it will result in a migration of liquidity providers in heartbeat.
When it comes down to token holders it essentially is very straight forward if the token price out performs the wider crypto market and other Defi protocols then these stakeholders are going to be happy.
Balancing value creation, value capture.
Strong fundamentals and pump-amentals.
We can see the development of Defi protocols, adopting different tactics within both marketing and tokenomics. Greater incentivizing, longer periods of time where they park their assets, as well as higher penalties of of early withdrawals, all of which are techniques to retain their projects value. We have seen some successful projects that have already implement this as well as many upcoming projects worth looking at providing value in every form towards the future of finance.
But as usual, these are your bags and ultimately you decide where and what protocols are of the most value to you. None of this is financial advice do you own research!
-Francis
