Updated: Aug 25
What is the scope for DeFi in 2021?
In Panacea Advisor’s last in a series of cryptocurrency masterclasses, “Decentralised finance – what the future looks like”, we looked at decentralised finance and what this whole area looks like for institutions and touching on high net worth clients.
We had guest speaker Dr Amber Ghaddar.
Amber is one of the founders of AllianceBlock, the blockchain startup building a framework for the world’s first globally compliant capital market by bridging centralised finance and decentralised finance.
Amber started her career in Global Investment Research at Goldman Sachs London, and moved from there to the cross asset solution team at JP Morgan, where she built the JP Morgan UK multi asset franchise.
Later she spearheaded the microsystems training strategies team at JP Morgan London.
What is DeFi, and how can people access it?
DeFi is an umbrella term that is used to describe various financial products that are built on blockchain technology.
The most famous one that’s a poster child of DeFi is Bitcoin. We’ve seen quite a big drive from institutional investors into Bitcoin this year and there’s been many reasons some people tell you why Bitcoin is a very interesting alternative asset class that adds diversification within a portfolio.
That Bitcoin is a non normally distributed asset with a very high positive kurtosis, meaning that the probability of extreme move on the upside or on the downside is much higher than let’s say the equity market.
Some people will tell you it’s because of liquidity, that finally there’s enough depth for institutions to come in.
Regulations VS Infrastructure
But the truth is Bitcoin became an alternative asset class and we’ve seen a lot of institutions coming into Bitcoin because of two reasons. One is regulations, and the second one is infrastructure.
In terms of infrastructure we’ve had leaps forward in the past two years and a half now; in terms of custody, and in terms of operational processes.
Today we have an infrastructure that smells, that tastes and that looks the same as you have in traditional finance. In terms of custody, today you can invest in Bitcoin by taking custody yourself, i.e. by opening an account at a custodian, companies like Fidelity or Copper and then having to set up the system within your infrastructure. Or you can invest in Bitcoin without having to take custody through funds and derivatives.
We see that most of the investment that is made at the private wealth level, and in the family office level is through derivatives, rather than through spots, and this is mainly for, let’s say momentum based strategies and short term strategies, where you’re just investing in the derivative entering and exiting positions on short term, medium term basis.
Bitcoin is digital gold?
Then you also have those that have Bitcoin in their portfolio under a label of digital gold and for those usually they would invest in Bitcoin and spot Bitcoin by taking custody themselves. Within DeFi, as I said Bitcoin is the poster child. But then in the past two years we’ve seen a plethora of new products coming onto the market, and these products are foremost derived from what we have in traditional finance. Products that are based on lending and borrowing, products that are based on insurance, products that are based on exchanges. But we have also seen the development of products that didn’t exist before.
Becoming a market maker
One of the most famous one is liquidity pools within decentralised exchanges.
Just to give you a little bit of background on what a decentralised exchange is. It’s matching book orders, you have buys, you have sells and you match them to find the price.
What you have in decentralised exchanges is the opportunity to say, I am holding assets or I’m holding tokens of whatever protocol, and I’m really not doing anything with them. I’m going to provide liquidity and providing liquidity entitles me to put these tokens, these assets into what we call a liquidity pool, and, in some way, I become a market maker.
In this liquidity pool you would have a lot of players, each putting their assets in there, and then you will have what we call an automatic market maker that will decide on what the price is. Of course this automatic market maker has Oracle’s in place, and is able to match or look at the various prices across the other various exchanges to determine what the correct price is.
Now the beauty of this is that you’re rewarded a fee.
It depends on the exchanges, but roughly 30 basis points every time there’s a trade that is done. Imagine that there’s five people in the pool, you have 1/5 of the pool so you will take 1/5 of 30 basis points at each when each trade occurs. This has allowed the boom of decentralised finance protocol because suddenly you did not need an exchange to be able to list your coins and you did not need all that you have in the background in terms of operation, in terms of legal, in terms of regulation to be able to create a to create a new product.
Tokens = Securities
In the end, there is one thing that regulators are absolutely correct in is that a lot of these tokens are initially securities. Most of these tokens are issued as a way to raise funds to the future protocol. The protocol doesn’t exist, you issue tokens and you raise the funds to be able to build this protocol.
What we have seen in the field is that people now, instead of doing what we call “initial exchange offering” IEO instead of ICO because if you do an IEO and you’re in the US you really fall under the SEC rules and you are a security. What people now do is they create initial fundraise from crypto VCs, from a crypto high net worth individuals in what they they call seed rounds at private sales, which allow them to develop a minimum viable product, an MVP.
Once this minimum viable product is on the market, they go and ask some legal opinions on which country they’re based that say, “oh you know what, the token that I’m issuing is a utility token” and that allows them to go onto a decentralised exchange and publicly issue their tokens.
Becoming a central bank
One of the interesting things that I find in there is that each protocol becomes its own central bank. You can imagine that each protocol is a country and the riskier the country is, normally the higher the credit spread on this country is.
When you’re a very young protocol, you will need to pay people to basically buy your coins and put them in this liquidity pool. How do you pay them? By offering them a yield.
Let’s say I’m a new protocol, and I want to build a lending and borrowing protocol. I issue my coins and then I open a liquidity pool on a decentralised exchange. Because I’m very new, what I would say is I am very high risk. Because I’m very high risk, I’m going to pay you 50% per annum for you to buy my tokens, put them in the liquidity pool and provide liquidity. If you want to compare it to what we have in credit market, it is not very contrarian to what we have in credit market. It’s a very emerging country risk.
In emerging countries you have risk.
You have political risk, you have economical risk you have tonnes of risk in there but you never get a 50% spread. In the end it offers you very high return products with, I would say also high risk. This is why it is interesting to have a small allocation to these type of products.
How can you invest in DeFi?
How can you invest in these products because everything that I described now sits in the decentralised space.
If you’re a crypto investor, it’s very easy for you to do that. You just go and try to find the pools that are the highest yielding pool, then you do some due diligence to understand if it’s a real pool or it’s a fake pool and if there’s a real product behind it and if there is not a real product behind it. Then you go and you invest. On some of the pools that I invested, we were making 300% per annum.
What is the risk?
The risk is that what if the protocol would fail?
The second risk is what we call impermanent loss and impermanent loss is a very idiosyncratic feature of liquidity pools. What it says is, when you enter into liquidity pool, you need to put in a pair. Imagine you have USD EUR, you need to put USD and EUR in the pool, you cannot put just one leg.
What does that mean?
It means that if you have one asset in the pair that is much more volatile than the other asset, you will end up with more of the “more’ volatile assets and less of the “less” volatile assets. Let’s say you have a BTC so Bitcoin and let’s take my coin AllianceBlock coin. You have a Bitcoin/AllianceBlock pool, you put in Bitcoin and you put in Alliance Block. Let’s say Alliance Block rallies 50%.
What happened? The pool will need to rebalance because technically the amount that you have put in is equivalent in dollars term. Well, usually the pool thinks in ETH term, but let’s simplify things in dollar terms. Let’s say you only put $10,000, you put $5,000 equivalent of Alliance Block at $5,000 equivalent of Bitcoin. Alliance block rallies 50% what would happen? Suddenly you have, $12,500, but this amount needs to be rebalanced.
Now imagine in a very volatile market which is the case of most of these protocols, you will suffer from what is called impermanent loss.
This impermanent loss is a type of market of your assets within the pool. One way to bypass that for protocols for young protocols is to offer very high yields in order to cover you in case markets become very volatile. I would say it is quite beneficiary. Let’s say you have pools that are yielding 200% 300% per annum, even if you lose 100% you’re still making more than 100% per annum and doubling the amount that you initially put in.
How can you access this if you are an institutional investor?
Rules and regulations
First issue is compliance and regulations of course.
You don’t know who are the people that are in this pool. From a KYC AML perspective, it is very hard to justify an investment there because you’re putting your money in a black hole. You don’t know if there’s terrorism money, you don’t know if there’s money laundering money that is in this pool.
One of the solutions that we are working on at AllianceBlock is what we call a “trustless KYC AML” that will KYC AML everyone in the pool and people that don’t want to be KYC AML, then they don’t need to be in in this pool. You can already imagine that the fact that you have put in a KYC AML system would already bring the yields down because you have less risk. But it will still be very sustainable yields compared to what we have in markets today. I’m still happy to make 50% per annum in a KYC AML greenlit pools. As I said first is the compliance and regulations point of view, i.e. you need to KYC AML everyone within the pool, that is doable.
How do you access this?
Do you really need to go on an exchange and take custody and have a wallet and buy this product on the left and this product on the right? As you can already see it’s quite complicated.
What you have is opportunities to have these products wrapped into certificates. Instead of doing all of the work yourself in terms of choosing the protocol. All you do is have a sort of actively managed certificate, and you will have a list of these protocols, and you can pick and choose what are the protocols that you want to invest in. Our view is that there’s a huge opportunity in USD stable coin pools. I mean what are fed rates now, 5 basis points? What are deposit rates now, 60 basis points per annum in USD?
Imagine that I am giving you a USD product that is paying you more than a high yield bond, much more than junk bond. Junk bonds are, I would say around 500 basis points spread. That’s like 5% and I’m giving you a product that is paying you between 12% and 16%. That is regulatory compliant. All you need to do is buy this certificate, and then allocate. This is where we see the real opportunity. Not on the more I would say exotic product, at the 200% 300% level, but more on these USD stable coin products that are paying you much more than junk bonds without the risk.
I mean there’s always risk and the risks are a little bit different but compared to the risk that you have in junk bonds. I would say the reward that you get is very enticing.
What happens in terms of due diligence that’s done for the protocols and what are the risks that you need to be looking out for?
If you go through the certificate route, you still have a security risk.
Remember all of these protocols are open source and one of the issues that I’ve noticed in the field is that a lot of people are very quick to go to market. Which in a way is good because it is an open source product and it is supposed to be improved continuously. But what happens is there is no real failsafe in these protocols and you see a lot of these protocols getting hacked. In my opinion, too much for me sometimes to be comfortable.
This is why it is important to in a way to wait until the protocol matures enough because everyone tries to attack. If you’re a hacker, you’re going to try to find whatever opening there is and if there is an opening, you’re going to attack. The good thing about hacking is that, once it’s hacked once it’s not going to get hacked twice because the community is going to come and strengthen the system. But it is a real risk.
Cyber security is a real risk.
A way to hedge this risk is to have what we call insurance on these protocols. Of course, it’s going to decrease the yield, but it still remains a high yield compared to what you have in traditional markets. That is to be honest the real risk. Of course there’s the regulation compliance risk, especially in terms of AML, KYC AML. But as I said, this is something that also can be solved by creating pools that are KYC AML compliance, and where all the participating actors have been checked the previous way.
What sort of products might they be coming across that it would be good for the advisor to be aware?
Right now, even JP Morgan is not offering Bitcoin, per say i.e. taking custody of Bitcoin. As I said, from an operational perspective and an infrastructure perspective it requires you to onboard a new custodian, a digital custodian, there there’s a lot of work in the background.
What JP Morgan and other banks are doing is giving access through funds.
You have the GBTC form, that’s the grayscale fund. You have a few funds and few in Europe Exchange Traded products that gives you access indirectly without you having to take custody to Bitcoins. I would say, some banks are already offering derivatives. There are two derivative markets. You have the CME derivatives, trading futures on the CME and the CME has its own rules and sometimes you will see that the CME derivative varies from the decentralised finance derivatives in terms of pricing and you always have arbitrage opportunity there. Most of the derivative markets, most of the future markets sits on exchanges such as STX and Binance and some others.
These I would say are a little bit more maybe uncomfortable to access because you still need to have wallets. You don’t want to leave all of your funds sitting on the exchange because the insurance process that you have there is not as stringent as in regulated markets. Usually most people, or most asset managers, most private wealth managers would invest in CME futures.
If I’m correct, Goldman has opened a crypto trading desk and I am sure that they are offering futures like one delta one certificates on BTC. That’s very simple. With Goldman is like long the futures and just selling you wrapping it into a certificate and you can offer this to your clients with no issues.
But one point to highlight correctly, I think in the UK you really need to be a sophisticated client to access these products. I believe the FCA came in and said, no derivatives and no ETPs and no ETNs and the rest for for retail customers. But again, I would say the less complicated and the cleanest way is to access funds that already hold Bitcoins.
What I would ask the people on the call is to be careful in what is this fund investing in. Is the fund holding Bitcoin? Do they have custody of Bitcoin? Or are they invested in futures?
If they are invested in futures, are they invested in CME futures, or are they invested in non CME futures? Keeping in mind that you do have a big risk on the non CME futures in terms of operation because you never know when these exchanges are going to be shut off. You heard what happened to Binance recently. There’s some operational risks that they need to consider when they’re invested in funds, investing in futures that are not CME futures.
The future of DeFi
The revolution we’re going through in the investment space is very similar to what we’ve seen, I would say maybe 10 years 5,6 7 years ago in retail banking.
When we started having FinTech coming and disrupt retail banking, creating new payment system, creating even digital banks, and this has forced incumbents players to actually start modernising their infrastructure as well.
I remember when I came to England, which was 10 years ago. I’m a customer of Barclays, I didn’t really have a really good Barclays app. My Barclays app could do nothing at all. And now today because Barclays has been buying the technology of fintechs, developing fintechs in house, they have an app that is, I would say quite valid and quite good. I’m not promoting Barclays by the way. I mean quite good when you compare it to Revolut. This has pushed banks to disrupt themselves, because we know big incumbents, making IT changes in bank is never the priority, the priority is making money. Being front office and making money through clients or through investments.
Now what DeFi is doing in my view is similar to what fintechs have done to retail bank and DeFi is going to do it to the investment banks and the asset management space. I would say, because it’s an industry that is in its infancy. There is a lot of trial and error going on. I think it’s healthy. Things are still are still evolving. But I do think in the future and we’re already seeing it in banks like every bank has a blockchain team. Every bank.
Actually a lot of banks are working on improving their infrastructure and making their infrastructure much more flexible and adaptable and less costly. What people don’t realise is that infrastructure in investment bank is, I mean the legacy systems that you have in there are oh my god disgusting.
I was at a bank that has bought a lot of banks. You end up with legacy systems sitting one on top of the other. If you’re a developer, it’s just gross. But the issue is banks have never put in money in IT. They’ve never felt the need to put money into IT. But now when they see these asset managers coming out, very flexible asset managers and very achieved asset managers. For them, they need to start thinking and start investing in their own infrastructure. And a good example is the ETF revolution in some way. Beta funds, everyone talked about active management and suddenly we have exchange traded funds that just track the S&P, and suddenly, all of the banks have a suite of products that track, Smart beta or whatever it is.
You can see that the banks are getting there. If the banks are getting there, it means things are changing and things will keep moving forward. I would say that right now, you will see banks adopting some parts of DeFi and DeFi adopting some parts of what we have in traditional finance. And I would hope that I would say in 20 years time, even less I would say 15 years time, we would move away from the intermediation framework that we have in investment because not just blockchain, but AI as well.
How AllianceBlock is helping to shape the future
We are building a bridge between decentralised finance and traditional finance and we offer various product for asset managers, private wealth managers, family offices that give them access to decentralise finance. Similar to what I was talking about, a product that are wrapped in certificate, yield products that are wrapped in certificates and very systematic strategies as well in the crypto space.