The Permissionless Revolution

The explosive potential of recent developments in the cryptosphere should leave banking executives and shareholders alike quaking in their comfort zone boots.

The changes they threaten in the financial services industry could be way more profound and rapid than anything we have ever seen. If the word “disruptive” hadn't been used to death already, this would be the “rip your face off” type of disruption that really gets the juices flowing. We are talking about a disruption that could be even more dramatic than what the original internet had on industries like media, content and physical commerce. We’ve watched this space intently over the past few years and we think that the developments over the past months are quite simply earth shattering for incumbents.

Recently, the launch of a fully decentralised application called yEarn (better known by its native governance token, YFI, pronounced like “wifey”) has set itself on a path to become the ultimate manifestation of the original promises of cryptocurrencies all those years ago: a permissionless protocol on which anyone, anywhere in the world, can deposit and borrow USD stablecoins and other digital assets for a yield, purchase insurance or participate in a real-time investment strategy, whose code and infrastructure is fully transparent to all who wish to audit and study it.

For the first time, we see the permissionless nature of the digital asset space doing its thing: delivering financial services on the basis of rules and risk, rather than discretion and permission, as was the initial guiding principle of Bitcoin’s foundation all those years ago.

These views are now laid out in full in our second white paper here, which we hope you will enjoy over the weekend alongside some tea and cookies.

For those who cannot afford that luxury of time, however, here’s the quick summary.

Permission makes all the difference

Our starting point is a much more fundamental one than simply finance, blockchain or decentralisation. It concerns the idea of permission: do you need to seek permission from someone else to do what you want to do?

In many cases, we feel like we don’t: no one’s stopping us from using a piece of plastic to vouch for payment for our coffee, for example. Most of us go about our lives relatively freely, conscious that without doing anything too drastic, we’d never get into much trouble, very much like the average well-behaved kid in class.

But the reality is that we actually do receive permission to do certain things: opening a bank account, for example, requires not just that one has the money to deposit into the account, it also requires that the bank approves the account opening. Likewise, for a mortgage application or an insurance policy – most of the time things are fine but ask anyone who’s ever been refused (or tried to claim on an insurance policy) and things no longer look so pretty.

Permission implies discretion, and discretion opens itself to the risk of subversion and corruption. Whenever someone (or something) has the authority to grant or refuse permission, subjectivity enters the picture.

Contrast this with a rules-based system, where the logic is straightforward (e.g. red light = stop; green light = go). Anyone who plays by the rules can continue doing as they please, and anyone who violates the rules is removed. Of course, life is complex and cannot be perfectly codified, certainly when exceptional circumstances arise, making a rules-based system hard to implement in practice.

Add to that the issue of trust: who (or what) should enforce the rules? Between parties, none can be relied upon to uphold their end of the bargain – as a result, deference to higher authority, whether a person or an institution, becomes the only way to ensure conformance in society in most dealings. This deference ultimately confers upon that same authority the power to grant or deny permission.

For most aspects of human life, discretion is necessary, and absolute adherence to rules usually turns out to be somewhat senseless. There is one exception: in the pragmatic, zero-sum world of finance, where counterparties are just numbers on a screen, and risk and reward can be distilled into dollar profits and losses, such an environment is the ideal test bed for the manifestation of absolute rules-based systems. Hence the rise of Decentralised Finance, aka DeFi.

Until very recently, there has been no obvious solution to these problems: there was no way to have a system which would take the terms and rules of any engagement between two or more parties and render them enforceable without the involvement of a third party, be it an arbiter, the courts or some other institution.

The idea that there was no alternative solution was quickly dismantled when Bitcoin came along.

Blockchain, schlockchain

The opinions around the usefulness of “Blockchain technology” are varied, and often bifurcated.

On one hand, there are the evangelists who claim that blockchain changes everything and makes everything efficient. Taken to a ludicrous extreme, this blind obsession with the transformative power of blockchain technologies (effectively a distributed ledger of transactions) led to the crypto boom (and bust) of 2017 and 2018, when appending “blockchain” to a company name could drive massive valuation moves (see Long Blockchain Corp., formerly known as Long Island Iced Tea Corp.), much like the .com effect pre 2000.

On the other, there are the sceptics who rightly point out that everything a decentralised blockchain can do, a centralised system can do better, faster and cheaper, cleverly titling Blockchain the “amazing solution for almost nothing”. Among these are the big IT consulting firms who ironically now provide consulting services to help companies adopt private blockchains (i.e. an in-house server set up), which upon minor reflection is really an excellent marketing tactic for selling traditional IT infrastructure consulting services.

Both these views have their merits, but we think they miss the point.

A blockchain is not meant to be efficient – a centralised record is almost always more efficient than a distributed ledger. Calling 500 witnesses to an incident is necessarily much more inefficient than relying on CCTV recording from a central security post.

The promise of the blockchain was democracy, transparency, fairness and accessibility: the odds that a CCTV recording is doctored is much higher than 500 different people colluding to tell the same lie. The same can be said for personal biases, corruption and other forms of discrimination: the scope for collusion is low, especially across the wide expanse of the internet where no names (but rather cryptic – though unique and identifiable – wallet addresses) are used.

The idea was to have a system where trust was not needed, and that anyone with the requisite resources could get whatever they want done, compensating a pool of unbiased, decentralised service providers to do that work.

Why does this matter? For anyone who lives an average life in a developed economy, it doesn’t matter. Banks and credit cards are more than sufficient. But for anyone on the wrong side of his (or her) government’s books (think Belarus, Russia, China or even the US), or in the wrong country (think Iran) or simply in the wrong place in some countries (think rural India or sub-saharan Africa) – suddenly the need for permission becomes an impediment to access.

Finally, there is a solution. And efficiency doesn’t even feature in it – no point being efficient if it’s inaccessible.

More than words

Promises are easy to verbalise – but they’re a different story when realised.

yEarn (aka YFI) is possibly the first project that has successfully demonstrated how the diaspora of tools in the DeFi space have come together to create a profitable, infinitely scalable system.

We say system because it is exactly that: pure code sitting on the Ethereum network, auditable by anyone, written by an enigmatic developer named Andre Cronje, the economic interest of which flows entirely back to the users of the network. Most interestingly, Cronje owns none of the 30,000 YFI governance tokens – he has publicly disavowed making a profit from his creation, and that ironically has led to the popularity of the system multiplying exponentially.

What does yEarn do? Well, at its most basic, it’s the equivalent of a smart savings account. Users deposit tokens, mostly in the form of USD stablecoins (which maintain a stable value of US$1 each) into the smart contract which is itself programmed to seek out the best deposit rate available in the DeFi world, make deposits en masse (saving on fees) and reallocate whenever better rates are available.

Deposit rates range from 3% to 5% p.a. for USD deposits, and as we write this summary, around 80-90% p.a. for deposits of Ether (paid in Ether) – in any case, way better than what is on offer at any high street bank, especially in this low-yield environment, but certainly with its risks.

YFI is fascinating for many reasons. For one, the speed at which new products are created, coded, distributed and scaled up is unmatched by any other private entity in existence. There is no company, no shareholders, no office, no staff, no overheads – just code that picks up very tangible fees (whether denominated in USD stablecoins or other digital assets) while providing significant economies of scale for users.

Moreover, the nature of smart contracts, their track record of absolute enforceability and their transparent auditability gives depositors the confidence that yEarn can’t “run away with their money”. Because the code can only be changed with consensus from a majority of tokenholders who are also the users, the alignment of interest is absolute – there isn’t a profit interest for equity holders interfering with optimisation, something we wrote about in our other paper on The Theory of Nachas.

And it turns out that users are very happy to pay fees if they are reasonable: yEarn (and its other sister protocols) charges a fee of 0.5% per withdrawal and 5% of any “harvesting” event where a deposit is returned from a smart contract. Most of it is profit, but users still don’t mind, perhaps because of the transparency of the entire system.

The DeFi world (and anything to do with “crypto”) is often made out to be opaque, confusing and dodgy. The reality is that it is as transparent as can be, and certainly more so than any traditional financial institution. The contents of each of YFI’s vaults, including links to the underlying code, are available for public scrutiny, nicely compiled onto sites like Feel The Yearn. Other analytics sites like Dune Analytics go further, logging every single harvesting event onto a dashboard for yEarn.

The result is that we can calculate accrued and incoming earnings on the YFI protocol in real time. For example, with north of US$1.4bn of deposits in the protocol, withdrawal of all of these assets would result in fee income (at 0.5%) of US$7m.

Add on the “carry” from successful harvesting events over time and we have the world’s first fully automated money market fund manager. Except that all its “staff” are volunteers, many of their shareholders are also their users, and all of this was built with $0 funding raised. Just a creative mind, a great community and code.

Annualised full year income according to Ryan Watkins, analyst at research house Messari lands at around US$20m, of which about US$7m is guaranteed from any withdrawals of these smart contracts. With the YFI token trading at just under US$30k each, it actually has a P/E ratio, of about 50x trailing earnings.

In case you’re wondering how long it took for YFI to amass these deposits, the answer is “around two months” – yEarn only got released to the public at the end of July 2020. Imagine what the forward earnings could be. The prospects for the “earnings” are mind boggling. The real “forward PE” is hard to compute but the margin of safety so to speak is high. The only things scaling faster than the price of its token (nearly 1000 times already) is its earnings.

Don’t forget Ether

With all the excitement around DeFi, it is easy to forget that unlike the internet (which no one owns, although many have tried!), the underlying infrastructure of DeFi is the Ethereum network itself, and owning a part of that computing capacity is simply a matter of owning its native token, Ether, without which no transaction on Ethereum can take place.

Of course, there will always be challengers to Ethereum as a protocol, but even within the land of the permissionless, it is the ecosystem that has the largest critical mass that continues to attract new development, users and ultimately growth. Just as we argued against the idea of a permissioned blockchain, the issue here isn’t efficiency: there isn’t much point having an efficient protocol when there are no applications for it to run.

In the case of Ethereum, the ecosystem is, to say the least, diverse, with many of these projects, in their absolute ingenuity, forming the decentralised versions of things we have traditionally relied on centralisation to achieve – lending, borrowing, insurance, trading, broking, pricing:

The best is yet to be

To be clear, all of this promise and potential in the DeFi space is not mutually exclusive to the volatility that characterises the digital asset space.

As we’ve argued before, the opportunities on offer in the DeFi space offer investors the potential for Venture Capital style exponential returns coupled with the liquidity of a listed instrument (if not better, trading 24/7). Let us not understate the risks – they are big, as with any early stage opportunity but controlling that balance of risk versus reward is key to having a shot at these returns in the long run.

We continue to do our work and watch the space intently, having identified it as one of the greatest emerging opportunities that one may invest in that we have seen in our lifetimes. We believe that it would be irresponsible as managers to ignore the potential developments in this space and pass over them until they are “real” – because they already are.

The implications on the future profitability (or lack thereof) for incumbents in the financial services space are becoming ever more real by the day.

As always, we do not claim to have a crystal ball that tells us with absolute certainty what the future brings. We do have some ideas for the paths things may take, and depending on the evidence presented to us by the market, we adapt accordingly.

Edward PlayfairSeptember 4, 2020