New Episode on NaluFM: How to invest in Decentralised Finance?
vestr’s Head of Business Development, Stefan Wagner, and Head of Investment Solutions at Belvoir Capital, Adrian Marcu, discuss the topic of Decentralised Finance (DeFi) and how to evaluate investment opportunities.
Besides DeFi, the two also discuss the following in the episode:
- The Importance of Decentralised Finance
- Investment Opportunities in DeFi and its Risks
- Cryptocurrency and Stable Coins
Read the full interview Stefan hosted with Adrian:
What actually is Decentralised Finance, or DeFI, and why should it matter to anybody?
DeFi should matter. And it will matter to everybody because it’s totally revolutionary. It is a new way of organising markets. Anybody will be able to and can participate. Simply by connecting their wallet to a decentralised, smart contract, or as we call it, a decentralised market.
The true revolution lies in its simplicity and speed. Once you find a suitable price, you can do an instant settlement. As soon as you have traded an asset, you can settle it in your wallet, disconnect and take it away with you.
In the old world of centralised markets, we needed institutions to verify a trade, we needed institutions to settle in between, and you needed to wait usually t+2 in most asset classes.
There are other arguments as well, like no counterparty risk, etc. But this is the main advantage of DeFi.
And how can people benefit from the use of DeFi?
In order to trade something, you need liquidity. Which means, you need to attract people who will add liquidity into those new smart contracts. And those people get rewarded. We also do this at Belvoir with one of our products. By simply adding Bitcoin, Ethereum, or, in our case, stable coins to a smart contract. Then, we simply wait until people want to trade and add this liquidity.
So, whenever they trade, you get a reward usually in the form of a fee. And this is similar to a market making in the traditional markets. With the exception that anybody can participate in DeFi. You don’t need high tech, you just need to add your assets to those protocols.
You mentioned already that you launched a product on Decentralised Finance. What are the different sources of alpha that you mine? Where do you generate the return from?
There is a need in the market to exchange stable coins against other stable coins. So maybe you are aware there is Tether or USDC or Binance USDB, USD. They are all stable coins and they are there for their own reasons.
What we do is we provide liquidity for stable coin versus stable coin for people who need to switch from one into the other. We have no exposure to the crypto market per se in this case. We leave our capital or the clients’ capital in the stable coins and they don’t really fluctuate a lot but we get rewarded and it is very similar to being a market maker in the traditional markets.
The technique of how price is fixed or traded every second is a bit different. How the book is being built. But the principle is very similar.
You have very little exposure to the broad crypto pricing market. But how do you then look at your risk as an investment? How do you measure your risk, if traditional factors like volatility or Sharpe Ratio don’t work?
They would work. It depends in the traditional world if you would say I’m a market maker for US dollars versus Hong Kong dollars. You could also argue there is no risk because the currencies are pegged. They are barely moving, but you can still earn a buck because you’re a market maker if you are a bank.
So you could say we have some specific risks in our product. First, they are typically the stable coins themselves: are they really as stable? Is the peg going to hold for a long time? This is a specific risk, which we look very deeply into.
The second one is the liquidity risk itself. In the particular smart contract, you should be able to get out at all times. But there are exceptions.
The third typical risk of DeFi and smart contracts, which is non existent in the traditional world, is hacking risk. So those protocols need to be programmed in a way that they do not get hacked. And there are ways to check this, there are IT audits. The codes are open source, so you can look into them. It is important that we respect this hacking risk.
Other than that, we would also apply Sharpe Ratios or volatility risk as well or market risk if we would have it in this sense. But in our very special case, this is not the case.
You mentioned that you try to generate a steady return and you try not to be exposed to the big swings of the crypto market. So, how do you achieve that there is no price risk to the broad crypto market?
Especially in the DeFi space, there is a natural need from market participants to switch from one stable coin to the other. For example, USDT to USDC or Binance to BUSD. Whatever their reasons. We are covering this niche and this need. We provide liquidity within the smart contracts or DeFi in this space.
Therefore, we look at where there is the need for liquidity. In which blockchain on different blockchains. We are invested in different smart contract protocols and we allocate only stable coins to all those protocols.
This is the reason why we barely have price exposure at all of the crypto market. We earn fees and basically generate the returns this way.
What exactly is a stable coin?
That’s a very good question. A stable coin is a coin or a token that is pegged to a fiat currency, usually the US dollar. Now, many people ask why on earth do you need this?
When people sold bitcoins when they traded it off-exchange on-exchange a few years ago, they would book a transaction at their local bank. The banks were very suspicious because they have the rules with KYC and anti-money laundering and they were blocking those transactions. Which caused a lot of trouble. So people could not easily de-risk and up-risk their positions by just selling their cryptos against dollars.
Eventually some smart guys came up with the idea: okay, we collect all the dollars and issue a stable coin. This allowed people to stay within the crypto universe at anytime with zero risk. As a result, we have several stable coins today.
These days we even have a couple of stable coins which are called algorithmic stable coins. These are not covered one-to-one by fiat but they are collateralised. There are different models.
This is good for us because there is competition in the market for stable coins. And we are providing liquidity in different stable coins. And this is one reason, one good reason why we earn fees and returns.
There are different methodologies. I guess that goes into your research before you invest in Decentralised Finance?
It does not and I would not even say that one is better than the other. There is a big discussion around Tether because they become systemically relevant. Even the Fed has a reason to talk about it, which is pretty unique I say.
The assets behind Tether are north of 60 billion, I think they are at 70 billion now. The big question is, what are they holding behind and they have commercial papers, cash treasuries. And this way, the Fed is a bit worried because if there would be a run on Tether, then the Fed is not sure if they could liquidate all the assets behind it.
And others are more regulated USDCs, closely connected to Coinbase, so they are more regulated.
What was the reason to launch your product as an AMC, as an actively managed certificate, not as a fund?
The basic reason is it is easily accessible for anybody. You can buy from 1000 euros up. You can buy it through the exchange. In short, it is just very easy.
Usually, you could not structure such a product in a highly regulated fund. Hence, you would only be left with offshore structures, which are okay in principle. But usually only available and really good for more sophisticated investors. And they are usually much more expensive. And we decided to make it really easily accessible to all. Even retail clients if they want through the exchange. And we found this a very good solution for the time being.
How long has it been running now? And how has the performance been?
So the last price was up only 2%. It’s interesting to know that our overall expectancy of the performances is 8 to 12% per year. So, highly conservative. Totally untypical for people in the crypto world where everybody is looking for crazy moves up and down with 20% a day.
With this specific product, we have the intention to deliver a very, very boring, but steady return, month by month. So we’re up 2%, and we only went live three months ago.
Are you expecting certain things to affect how much yield you can earn there? What’s going to happen in the future? And what do you expect to open up maybe as new opportunities?
This is a race or an equilibrium, I would say between demand and supply. On the one hand, the more capital flows into DeFi, the lower the years will be because more people will provide liquidity. On the other hand, if the growth stays as it used to be until about November last year, then we should face another 2, 3, 4 years of very, very attractive risk adjusted returns here. I am not worried at all about this, so I think we’re well positioned there.
I am not so optimistic about the current crypto market in general. It is totally normal to have clear retracements in crypto markets as well. We’ve seen this since the emergence of Bitcoin four or five times already on the mega cycle basis. And I have the feeling that we are on the down move at the moment, which may take another three to six months.
This should be quite favourable for our niche product in this case. Because people who want to stay on the sidelines have a good alternative to park and earn on top. Especially in times where fiat money is at zero or even negative interest rates.
I mean, a lot of people talk about crypto right now and some of the opinions are polarised, but is there something you would like to debunk about crypto?
Well, you have to be careful. There’s so many different crypto projects out there. And it is relatively easy. That is why it is important to filter out the nonsense stuff.
So I have to be open there with 15,000 different coins or even more, there is lots of nonsense on the market. So try to look at the promising…
But nothing changes: sentiment more than price, so the minute it moves, everybody gets excited about it, even if we know it’s nonsense.
Very true, very true. But the parallels to the internet and dotcom bubble are not quite there. While in 1998/ 1999, many people knew that many stocks would be worthless, but everybody was happy to pay the premiums at high prices. Because it was clear that a few companies or projects will be the long term winners. Some people shared the opinion: “Let’s buy a whole portfolio; if I have to write off 80%, I’m still fine”.
Same thinking applies today. You can try to apply stock-picking or coin-picking methodologies, they are sensible approaches as well. We refrain from this at the moment, in this case. But it is a very, very similar pattern here.
And the main point is that the technology is definitely revolutionary. In my opinion, it will change our world. We will have a totally new concept of exchanging our own assets, owning our own assets in our own wallets. The custody of coins will be totally different, and much more fluid. This will, in the long term, increase economic efficiency.
What are your top 3 favourite finance movies?
Well, I’m maybe not the youngest anymore. So it must be Wall Street. And I have to admit Wall Street is probably one of the reasons why I landed in the financial industry in the first place. I used to work for banks for over 20 years as a market maker, a trader, derivative trader, foreign exchange equities. So this was very, very exciting to me. And I’m sure this was one of the reasons.
But a newer movie was of course, The Big Short. It was fantastic. The movie was really describing the situation of the subprime crisis in an interesting way. And probably pretty true, I would say.
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