Crypto Value Investing

Introduction 1

Crypto has, for most of its history, eluded traditional valuation methods. As a currency and as a medium of exchange, it had neither a physical resource to back it nor a government to lend it de jure value. However, over the past decade, crypto currencies have become the single greatest engine for wealth creation since the advent of the internet. As the crypto space expands to include Decentralized Finance (DeFi) and companies (Decentralized Autonamous Organizations) that operate entirely within thecyberspace, traditional valuation methods are starting to become less and less applicable to protocols that collect rents, generate returns and charge fees for their services. This is the fundamental value of companies and their assets, as laid out by Warren Buffet and Benjamin Graham. While many of these projects may be deemed to be overvalued by traditional metrics in current market conditions it is important to understand how these entities create value for token holders. This allow investors to build positions in these companies based on their theses of what will happen in the crypto space, and understanding the true value of these assets can bring in a whole new kind of investor into crypto.

Risk Free Value — The Vultures of Crypto 2

Risk Free Value (RFV) is a term that analyzes the value of circulating tokens based on liquid assets- ETH, USDC, etc. RFV has also become a colloquial term for the community of investors that roam Discord servers in search of a projects with low NAV to MC correlation. While not frequently mentioned, the RFV community has broken down many DAOs, including Invictus DAO, Fei Protocol, Rome DAO, and Temple DAO. It has also partially influenced the governance of many other projects such as Redacted Cartel, Time Wonderland, and Olympus. Collectively, these protocols have Risk-Free assets in excess of $1B.

The best way to explain these kinds of RFV deals is by using an example. Fei Protocol, a California-based algorithmic stablecoin protocol. Fei was created with the intent to create a stable algorithmic stablecoin that was:

1. Composable with DeFi,
2. Competitive with rates of return and
3. Create value for stock equivalent governance token holders

The protocol started with a traditional Initial DAO offering, wherein it received the initial capital in exogenous crypto which it would then use to back its stablecoin. This Protocol Controlled Value (PCV) was at one point, during the bull market, valued at $2.5B. However, there were a series of issues with the mechanism that Fei employed to ensure that its exogenous capital could back the Fei stablecoin obligations the protocol had. In order to do this, the treasury of Fei was deposited into Balancer, which would change its ratio of stable collateral (DAI, LUSD) to risky collateral (ETH, BTC, etc) based on market prices. Esentially, this meant that the protocol would be more risk-on during good times and risk-off during bad times.

When phrased like this, this mechanism can appear to make sense- after all, in simple terms it is simply a protocol that buys high and sells low. However, problems begin to appear when the protocol begins to eliminate massive amounts of value, and failed to match benchmark BTC/ETH rewards with its $TRIBE governance during good times- and underperforming even USD during bad times. If the issue had beenpurely mechanical, and had there been a demand for the $FEI stablecoin, this problem could have been resolved. However, neither of these things were true, and a large portion of $FEI was protocol-owned. This meant that, given the limited demand for $FEI borrowing, retail investors were crowded out by the DAO, resulting inuncompetitive stablecoin returns when compared to DAI (18%), BUSD (8%), GUSD (9%) and USDC (6%). The highest rate of return for $FEI was 3%. Add to this that the fact that $FEI failed to hold its 1:1 value to the dollar (when compared to other stablecoins), and you have a recipe for disaster.In order to mitigate this, the team bought out Rari, a crypto lending platform, which briefly made $FEI competitive- until the protocol was hacked via reentrency, which proved to be the final nail in the doomed project’s coffin.

The results were a PR nightmare. The $TRIBE token, which had gone for $2.5 at its height, traded at $.13-$.14 at its end. The team initially refused to pay out the hack victims, creating massive division within the community and leading the team to go radio silent for months. Various investors, (notably DCF God Capital), realized that the Fei issue could largely be broken down into various stakeholders. These were original investors who were suing Fei Labs, the Fei Team, hack victims, and current token holders. The team wanted to shut down the project, but couldn’t do so simply by saying they wanted to, as this would look bad and hurt their reputation. Hack victims wanted their money back, investors wanted out, and original investors wanted the Fei team to have cash in the bank to pay for any kind of settlement. Various

then drew up a proposal that fit these criteria, and ended up passing after a month. It created an average 30% profit, largely due to some execution issues and lack of capital at the start of the project. So far, this has been how most RFV shutdowns have worked, and legal has largely not been consulted or used- although this is likely to change.

The parallels to Traditional Finance (TradFi) are fascinating. The best investor in recent American history, Warren Buffet, began his career as the modern day equivalent of a distressed asset vulture. His company, Berkshire Hathaway, was originally a textile company, which Mr. Buffet was attempting to take over in order to then reorganize and profitably sell. When management fought him on it he simply took over the company and made it his own. Later, as he got more and more assets, he began to invest directly into stocks- and into large companies which were either on the edge of declaring bankruptcy or in desperate need of reorganization. We believe that currently the industry is in a phase where mostly RFV investments are being pursued. However, these investments dry up. After this, the crypto native investors will largely shift their attention into investing into projects based on their fundamentals and the ability to agitate for change and restructuring. With that said, let us look at a series of crypto projects that are likely to benefit, or play a role in, this new era of crypto value investing.

Uniswap and Sushi: Owning Liquidity. 3

Uniswap is ubiquitous in DeFi. Even in other chains where Uniswap is not used, the vast majority of DEXes use Uniswap’s core code, simply forking it.. Most ERC20 and the vast majority of other tokens are traded on Uniswap or Uniswap forks. Between V2 and V3, Uniswap has $3B in TVL. While Uni has a smaller TVL than its relatively lesser-known rivals, like Curve (which currently has $6.12B) it had far more trading pairs, was far more permissionless, and had achieved this massive amount of TVL without the typical ongoing crypto rewards that Curve, Compound, RBN and others had used to receive higher TVL.

During the bull market, Uniswap achieved a TVL of $26B. Over the course of its history, it has allowed LPs to make billions in fees. LPs in Uniswap, even during the first half of this year, made half a billion dollars from fees. Yet despite these massive flows, Uni has never touched the profits that LPs have made, in spite of its V3 code having a built-in function allowing for the enacting of fees, with the smallest increment being 10%. Uniswap’s hesitance can be explained from various perspectives.

From a technological perspective, Uniswap does not necessarily have network effects. While one could argue that the Uniswap router shows that Uni has the ability to have network effects by using Uniswap’s massive liquidity pairing to match prices, this is misleading. With increasing frequency, retail and institutional investors in the space are turning towards aggregators such as 1Inch, Paraswap and Coincidence of Wants (CoW) to process their transactions efficiently, and there is no kind of “consumer loyalty” towards one type of AMM- whether it’s Uni, Curve, Sushi or any other AMM. This lack of network effects means that when fees are levied against LP providers, it is highly likely that the code base will simply be forked, and most mercenary capital will be deployed to these pools which will outcompete Uni’s own.

From a regulatory perspective, this kind of rent taking would make Uniswap more vulnerable under securities laws. As crypto has cooled, the SEC and CFTC have pursued aggressive enforcement against crypto protocols, filing suits and investigations against anyone from Yuga Labs to Kim Kardashian, whom was fined $1.2M for failing to disclose the payment she received for rug pull EthereumMax-all steps the SEC failed to take during the bull market. There is a general sense of unease in the crypto space (especially in the DAO space) as the CFTC currently attemptsto sue a DAO in federal court. Most DAOs are stepping back and avoiding doing any drastic changes to their business model until the dust settles and there are some clear guidelines, and this appears to be the approach Uniswap is following at the moment.

By the Numbers

If Uniswap had enacted its lowest fee rate of 10% of LP’s profits, then Uniswap would have made $50m over the first half of 2022. This would have given Uniswap $100m in revenues a year at the same return. This would effectively have given the token, which trades at a FDMC of $6.5B, a PE of 65. This would put it in line with several other clear trailblazers in the industry, but it is far from a value investment. This is also accounting for crypto’s “better half” of the year-before prices broke previous ATHs, Terra imploded, 3AC went bust and Celsius declared bankruptcy. This means that although there may be some fundamental value in Uniswap, the vast majority of investors will also have to have a high level of confidence that Uniswap can continue to develop high quality code and start to create natural monopolies and market effects to leverage its liquidity and position. Without these steps, Uniswap cannot be considered a value token.

Sushi

Sushi, unlike Uniswap, already has some fees for LP providers- but these remain limited at around .25%. With a TVL of $560M and a FDMC of $362M, Sushi appears to be more highly valued, as it has already established its willingness to charge fees to LPs. However, the team for Sushi is not as well known, not known for developing much of their own tech (although they are working on this), and in general is not the luminary that Uniswap is. So, while from a numbers perspective, it is potentially more attractive, Sushi investors are at risk of forever playing catchup to other competitors, not ever becoming truly able to develop their own natural monopolies. DEXs will need to look into the creation of lending protocols and options creation systems that can lean on native liquidity to allow for long-tail lending. This kind of product could create a definitive comparative advantage. Additionally, the optimization of liquidity will be crucial. Leveraged liquidity, such as ETH in contracts being staked ETH rather than a normal ETH or extra USDC circulating in lending protocols being lent to liquid HFT firms, can help to increase yields and efficiency of capital. This seemingly minute detail will greatly increase yields compared to competitors and allow whoever masters these types of systems to gain a massive portion of the total TVL.

RBN — Success Fees for Algorithmic Options Vaults 4

A few years ago, decentralized crypto options were in their infancy. Via OPYN, options were beginning to appear, but there was not a large amount of liquidity for certain options. The options that did trade were concentrated on CEXes with counterparties that were often not secured or properly hedged. Into this space came Ribbon, with an elegant but seemingly all-solving solution. Focusing on creating a more uniform volume, Ribbon targeted token holders with a product that is familiar in crypto: “vaults”. Ribbon’s options vaults, which algorithmically would select OTM strike prices, would earn a steady return for investors while exposing them to the risk that their principle and gains could be destroyed if the strike price is ITM. However, over time, the vaults should yield massive profits. This is because most options bought are bought by market makers and others who are buying the options as downside or upside protection for their otherwise non-directional strategies. Additionally, in order to encourage Ribbon’s success, Ribbon would receive a performance fee for profits earned and receive no fees if it failed.

This has allowed RBN to earn roughly $1m in profit from these fees, with a current TVL of $92m, which is one third of its previous high of $308m in TVL. While miniscule compared to their FDMC of $370M, it is important to note that Ribbon is noticeably one of the few protocols which has continued to ship new products and has retained a relatively high % of its previous TVL compared to other protocols (Uni V2 is at 1/8th ATH TVL). Recently dabbling in exotic options, Ribbon launched R-Earn, which earns in USDC terms and has $13.89M deposited. In the same vein of USDC-centric returns, Ribbon has launched Ribbon Lend. Ribbon Lend exposes depositors to counterparty risk as the funds are used by HFTs Wintermute and Folkvang. Collectively, they have $46.5M in deposits, equivalent to half of the TVL of Ribbon’s legacy options vaults, and the yields are incredibly competitive, yielding 12% (7% real 5% RBN emissions). As a result, at the time of writing, RBN is planning on increasing the counterparties available on Ribbon lend by four, introducing Auros, Amber Group, Nibbio, and Parallel Capital, two of which will be selected via a vote which will likely see high levels of bribes. All these MMs have A level credit ratings, and thus Ribbon continues to avoid taking on significant amounts of counterparty risk for its depositors while increasing the effective amount of liquidity. 7% returns in USDC are relatively low for market makers, and it will be interesting to see if in the future some will raise rates in order to get more of a share of the capital.

Lend is a product that most would not associate with Ribbon’s core product, but it speaks to the thinking process of Ribbon. USDC-based products had long been the least successful products they had and, as a result, Ribbon decided to try something different to deliver returns to depositors whowere looking for USDC-denominated returns. With their announcement that they were going to start a decentralized options exchange called Aevo, which would be on Ribbon’s own L2 in DyDx style, it is likely Ribbon will continue to grow steadily throughout the year, and be incredibly well prepared for the next bull market where we will go from crypto being established and idea that it will not go, to the realization that DeFi in general is here to stay.

Numbers and Value

Ribbon’s performance fees are normally 10% in performance and 2% in management, with performance fees only being charged when the weekly strategy is profitable. When Ribbon had a TVL in the hundreds of millions and returns in the tens of millions, it recieved millions in fees. Although liquidity for Ribbon is incredibly limited compared to the market cap ($1m on chain liquidity versus $1B MC, ratio of $1 backing every theoretical $1000) the fact that this liquidity is so miniscule does represent an opportunity to buy RBN OTC at a significant discount if a given party wants to sell.

The above graph assumes a 10% return average on TVL to calculate fees.

Looking at this chart, which in our opinion is quite conservative, there is a very strong value potential for Ribbon as it continues to build products from which it takes fees and from which said fees can be taken without much fear of vampire attacks, Ribbon could see billions in TVL in the next cycle. If this is the case, then the DAO could make far more money from fees alone than the entire currency FDMC. Additionally, Ribbon’s DAO is increasingly looking at ways to earn interest on the assets in the DAO, and it is likely that Ribbon could become a powerful force in angel investing, taking advantage of being on the cutting edge of DeFi to identify partner protocols and interesting projects, seed invest in them and create more value. While this is more a projection of our belief in Ribbon’s growth, the fact remains that Ribbon remains undervalued compared to its potential fees in the future from a value perspective.

LDO — Staking Network Effects 5

Staking and Lido fit together like Soda and Coke. Lido is by far the largest liquid staking and stacking entity by size, with its closest competitor, Coinbase, having only half its percentage hold over the industry, and other decentralized options like Rocket Pool trailing by several orders of magnitude. Lido’s stETH asset is also heavily used in DeFi, with most Ribbon Finance eth-based collateral being in stETH and being accepted as collateral on Compound and AAVE.

Lido functions as a decentralized staking provider for “liquid staking”. Staking in crypto is a process that inherently eliminates liquidity, as tokens are locked away for set periods of time. Lido allows investors to tokenize these positions, effectively being able to trade the underlying illiquid assets with other users. Lido facilitates this process, as well as the creation of nodes for the actual staking. A defining aspect of why Lido has become so ingrained in the crypto world is ironically due partially to the collapse of 3AC and Celsius, both of which were heavy holders of stETH. Since most stETH liquidity is in Curve, where it effectively has incredibly concentrated liquidity attempting to maintain near 1:1 with underlying, it is quite highly correlated. However, with such a large portion of stETH being sold, prices plummeted. As a result, there was now incredibly deep liquidity for buys of stETH at below “real” value. This meant that it was far more competitive to buy stETH than to create new tokens with RocketPool and other alternatives. This helped Lido to cement its position.

A Natural Monopoly

In a space known for its decentralization and forks, which renders traditional code-centric monopolies useless, Lido is the rare example of a new kind of natural monopoly. Because of its network effects within the staking system, which allows it to maintain the high rates of return and mitigate any one point of failure alongside its incredibly deep liquidity, there is no real reason to use other liquid staking options. Add to this the fact that stETH’s main competing product, cbETH, is centralized and US-based, introducing regulatory and jurisdictional risk, and the reason for stETH’s domination becomes obvious.

The Lido DAO

Lido is managed by a DAO which uses the Aragon decentralized software to allow investors to vote and choose on proposals. The Lido token was mostly given to very early adopters and there are relatively limited rewards for current stakers, with a FDMC of $1.6B. Accounting for the book value, which is $65m in liquid and $200m in LDO tokens, the value is somewhat better but still incredibly high. It is our opinion that as withdrawals become allowed for stETH, total TVL will increase. We also believe that there are potential avenues where Lido can create value by allowing for LUSD-style lending against stETH, or allow for ETH lending against stETH, creation of leveraged products with different risk / liquidity / time profiles. In short, although in our opinion over valued, Lido could increase the products it has available and, if it increases market share with other staking networks, could be a force to be reckoned with.

LQTY and FraxShares — Algorithmic Stablecoins 6

LQTY is the governance token for Liquity, an algorithmic debt-based stablecoin backed by ETH. The stablecoin uses a keeper liquidation mechanism, which means some of the profits from it go towards LQTY token holders. Unlike other tokens, LQTY is unique in the sense that it is NOT a DAO and the LQTY effectively does what it wants when it comes to governance. LQTY is held by the team, so in theory, value creation would suggest LQTY and team interest aligned- but this is not necessarily a given. Thus, this has an element of team risk, but at the same time can be looked at more as investing into distressed crypto assets, with high risk and high potential reward. LUSD itself is unique in that it trades above peg, meaning in exchange for minting and maintaining an 80% Loan To Value (LTV) ratio, you receive functionally more than 80% (roughly 84) in USD terms. This is partially because it forces you to lock up only ETH, effectively making you have an opportunity cost for not staking said ETH. However, ETH is far more liquid than stETH, so depending on an individual’s risk appetite, this could be more desirable to get better USD exposure and to arbitrage the price difference. Recently, LQTY has also introduced what it has come to call “Chicken Bonds”. This is as a response to the over pricing of LUSD compared to the dollar, and effectively allows LUSD holders to lock their LUSD in exchange for receiving more, slowly allowing the price to approach $1. While questionable financial engineering, there is a fundamental reason for it and while the price imbalance continues the high yield of the LUSD bond makes sense.

FraxShares is the governance token for Frax, an undercollateralized algorithmic stablecoin. Frax is backed partially by stables but also partially algorithmically, as users can use 1 dollar worth of a stable asset to mint one dollar worth of Frax (subject to liquidation etc). This allows for arbitrage to maintain the 1:1 parity of Frax to USD. Frax Shareholders receive fees from the process. However, this system is subject to potential liquidity cascades and events like Black Thursday, where high gas fees lead to liquidations becoming impossible and assets crashing in value.

DG from Decentral Games — Metaverse/Crypto Native Businesses 7

Decentral Games is a metaverse- and, more specifically, a Decentraland based Casino company. Hiring people in the metaverse to work these jobs and host these events, DG takes in profits from these compliant casinos. The company is governed by the DG governance token, and has assets of $18M, while their FDMC is $44M. Taking in $700k in revenues last week, DG shows how new metaverse and DeFi-native apps and companies may be governed. While not necessarily a value play, it is interesting to see these kinds of companies and how they are developing. It is perhaps the only example of a non-finance focused DAO and shows ways of giving value back to investors and pursuing policies like dividends, bonds and other incentives when having to also worry about operating expenses.

Conclusion

As the crypto winter intensifies, there will be less so-called “exit liquidity” and more general profitability from speculative investments that fail to create value- and there already has been an increase in demand for “real yield” and returns for investors. The way returns are rendered to investors are numerous, and will be covered in my next segment “BitDAO and Crypto Buybacks”. As a result, we are starting to see, with various DAOs, the formations of the first truly self-sustaining and operational crypto companies that have their own lines of business and operate as international entities, something that will have incredible implications if allowed to continue moving forward as more and more money flows into crypto, DeFi and DAOs.