DeFi - DWeb - The Metaverse - Privacy

What do we mean when we talk about cryptocurrencies or crypto assets? And how do the definitions we use affect our investment strategies?

Bitcoin, the network and the crypto asset, are both fairly easy to define: a permissionless non-censorable decentralized peer-to-peer immutable record of digital transaction: Bitcoin, the network, is the decentralized ledger (DLT) recording transactions in Bitcoin, the asset.

We believe that the wider crypto markets actually suffer from their long-term association with the original and still-dominant cryptoasset, Bitcoin: Originally a means of payment and evolving into a store of value. Though Satoshi’s double-spend solution is perhaps the most ground-breaking innovation in the history of money, crypto has the potential to be so much more.

Crypto’s reputation as a disrupter of the centralized status quo has been damaged by its association with “meme coins'' such as Dogecoin or, worse, Safemoon and Shiba Inu. Boom and bust markets attract gamblers, fakes, manipulators and false prophets. Though huge gains are available to early-adopters (and early sellers), those left holding assets after the pump risk catastrophic losses. The failures hit the headlines bigger and faster than crypto’s successes.

Source: Coingecko. https://ogounaya.medium.com/. Newsweek.

Yet underneath the hype and the memes we find hard-working and often-obsessive builders of entirely new ecosystems. Code is decentralizing and democratizing finance, gaming, commerce, governance, the internet itself and more.

The results of such building are evident in the growth of new decentralized financial infrastructure. Decentralized exchanges have grown in total liquidity available (known as TVL or total value locked) from under $1 billion a year ago to $20 billion today. Similar results have been achieved by lending and borrowing protocols.

Web 2.0, finance and gaming/collecting are dominated by massive monopolists. Finance is dominated by multi-trillion dollar asset managers, banks that are protected by the government as they are too big to fail and have powerful lobbyists, and “free” brokerages that sell your data to billionaire hedge fund managers. In gaming, it’s the Epic Games’ (Fortnite) and Microsoft’s (Minecraft) who control access, your data, and any extras (e.g. skins) you purchase in-game. Auction houses Christie’s and Sotheby’s dominate fine art markets.

What doesn’t Facebook know about you?

Youtube and other platforms use and control viewer data while offering content creators a small fraction of total advertising revenues.

Panics, pump & dumps and crashes undermine the key crypto narrative that traditional markets of all kinds are broken and that crypto “fixes this”.

While crypto networks seek to disrupt nearly every industry known to man, Hartmann Capital sees significant product market fit, traction, and demand in four thematic sub-sectors. As a result, these four categories make up our investment focus for 2021::

1. Decentralized finance (DeFi) – Using crypto protocols to engage in TradFi in a permissionless manner: trading (tokens, futures, options, other derivatives and synthetic assets), lending/borrowing, payments and investment management.

2. Decentralized web (DWeb or Web3) – Permissionless analogues to the tightly controlled “big tech” web 2.0 platforms: storage, search, streaming, email, news, indexing, naming and social media.

3. The Metaverse – Permissionless applications and infrastructure for gaming, virtual realities, collecting, digital organizations (DAOs)and art markets. As digital worlds gain in value, so do the items and avatars in it. Instead of game developers or Facebook owned Oculus owning these worlds, decentralized infrastructures enable user owned content and user driven decision making via digital organizations like DAOs. Creators and customers both win by bypassing platforms that monopolize client information and take the majority of the income.

4. Privacy solutions – Anonymity is lost in the current web 2.0, sacrificed for free or for low-cost access. Crypto asset transfers are highly transparent. All on-chain activity is public. Nevertheless, there are cryptographic privacy solutions for any of the three applications above (e.g. payments in DeFi, social media in DWeb, or in game in the Metaverse).

DeFi

Crypto began to mirror “real word” traditional finance (TradFi) with the founding of Bitcoin, based on Satoshi’s 2008 paper entitled “A Peer-to-Peer Electronic Cash System”. Bitcoin turned out not to be the most efficient payment system, so early crypto adopters pivoted to BTC as “digital gold”, and began to seek new payments solutions (e.g. Lightning network).

With the launch of smart contracts on Ethereum in 2015, new iterations of legacy finance arrived, slowly at first. The DAO was intended to be a decentralized on-chain investment management before it was hacked in 2016.

Holders of crypto assets wanted to borrow against them, either to access some wealth without selling and losing exposure to their tokens and likely incurreing a tax liability, or to leverage their positions to profit from the significant gains available in the earliest days of Ethereum. MakerDAO was first, and is now joined by other lending protocols such as Aave and Compound. Since the “DeFi summer” of 2020, decentralized applications mirroring all aspects of finance have exploded.

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Defi aims to be (1) trustless, (2) transparent, (3) decentralized (granted, not always, but ideally so), (4) permissionless (accessible to all) and (5) less expensive than the traditional financial system.

Rather than shares, crypto assets are tokens that trade on blockchains, with widely different rights to governance and cash flow. Hartmann Capital focuses on several token key metri

1. How does a DeFi token accrue value? Or if it doesn’t currently, how will it?

Decentralized exchange (DEX) Uniswap does not pay fees to tokenholders, while Sushiswap DEX’s SUSHI token is entitled to 0.05% of all trading volume, paid in SUSHI tokens. However, UNI might accrue fees in the future.

2. How inflationary are token rewards?

Tokens, especially those issued by new protocols, tend to be inflationary in the medium term, as the goal is usually to incentivize users. Paying customer acquisition costs in protocol tokens can backfire, however, if the earned tokens are immediately liquidated by users, or if there are other motivated sellers (e.g. vesting venture capital). The promise of high returns can disappear if the reward token collapses in value.

3. How are teams incentivized?

Hartmann Capital prefers that teams are incentivized by tokens that vest over many years, and are not earning anything elsewhere. Thus the interests of the devs and the holders are aligned.

4. Was the token “fair launched”?

In a fair launch, users get the lion’s share of tokens, and the use of tokens for up-front fundraising is kept to a minimum. If investors got in before the users, not only are their interests not aligned (having bought at a very low price), but they are incentivized to sell once a target profit is made. A new protocol does not need large sellers at the same time they are issuing tokens to users to acquire customers during the launch phase.

5. What are the ancillary rewards to holding the token?

As users are earning tokens, or devs’ and investors’ tokens become vested, the token could come under selling pressure unless the token has uses beyond pure value accrual (see “fees” in 1 above). Tokens can be staked in decentralized exchanges to earn fees and perhaps other incentives, or lent out on Aave or Compound. Hartmann Capital often creates private pools on the Balancer DEX for example that can earn trading fees of 0.5 to 0.6%, and this could amount to 100% extra income per year.

Hartmann Capital takes a crypto-native approach to DeFi analysis, but also uses TradFi metrics, such as fees paid to tokenholders (similar to dividends), tokens burned (similar to a stock buyback), or gains to the decentralized treasury (building bookvalue) that may in the future be paid to tokenholders or used to enhance token value.

As the Defiant showed last month, DeFi protocols are out-earning many TradFi businesses, and with better efficiency. Yield protocol Yearn Finance is on track to earn more than similar TradFi competitors, with lower costs.

One of the next phases to watch out for is the institutionalization of DeFi, effectively attracting TradFi users with protocols that possess TradFi UXs (e.g. KYC). Compound Treasury and Aave Pro both are releasing whitelisted liquidity pools where TradFi institutions can lend and borrow while meeting legal, reg and admin responsibilities.

DWeb

The internet is highly centralized and dominated by “Big Tech”. The mostly advertising-driven model of social media and the “winner take all” characteristic of many services (e.g. Spotify, Amazon Web Services) leads to extreme monopolization and a loss of privacy. Apps end up knowing almost everything about you, and they use this information to keep you on their service and, worse, to manipulate your other behaviors.

Governments can also pressure Big Tech to restrict access, as happened this week with China’s ban of Didi. This is not a one-off. Geofencing is already common in certain regimes. Or governments can actually ban certain sources of information, and when they do, we want that information preserved so that history can not be rewritten by autocrats.

The solution is the decentralized web. DWeb is to Web 2.0 as DeFi is to TradFi: Decentralized, transparent, permissionless and immutable.

Every Web 2.0 use had a decentralized analogue before the rise of the platforms. In the 1990s, the world wide web was decentralized. But email became gmail, and blogs were overcome by Facebook.

Similarly, every Web 2.0 has at least one DWeb decentralized analogue. Audius is a decentralized Spotify. Handshake is a new alternative to existing DNS Certificate Authorities and naming systems run by ICANN. Filecoin/IPFS, Arweave, Sia and Storj are striving to be the decentralized equivalent of AWS, Azure and Dropbox, combined.

The challenge for Web3 protocols is we are still in the earliest days and, without the ability to sell users’ privacy to advertisers, few workable business models have emerged to date But this was true of Web 2.0 in the previous century, and immense profitability and market dominance followed.

True profitable use cases are rare, but we hold out great hope, trusting in the skills of devs to evolve great products such as Arweave (permanent uncensored storage) and Handshake (decentralized internet addresses).

the Metaverse

We spend much of our time online, with our virtual habits further molded by COVID lockdowns. Not coincidentally, online gaming, collecting and simply living have been dominated by metaverse platforms in the same way as DeFi and Web 3.0.

Microsoft, a dominant Web 2.0 bigtech, is the ultimate judge of what is allowed in-game in Minecraft, and this centralized control is a bug in almost all online games. In fact, it is urban myth that Vitalik Buterin was spurred to create Ethereum after losing access to centralized, in-game tools that, it turns out, he had no right to, even after paying for them.

The Metaverse is the digital analog to our physical lives and world. Digital goods and collectibles, digital real estate, digital avatars and identities are easiest understood when thinking of the gaming industry. And as millennials and zoomers already now spend half their day in the digital world, it makes sense to protect these digital goods and services from centralized monopolies. Hence we need a decentralized ecosystem where the rights to digital goods and digital identities belong to the users, beyond the control of centralized platforms.

As gaming grows in stature and can even support professionals, it becomes more important to place control over key elements in the hands of the users, rather than the platforms.

The leader in this space is Axie Infinity. Though there are many other decentralized games and collectibles, Axie covers all the bases, and so serves as a great example of what can be achieved, and in a short time, with crypto.

Axie Infinity is an online game sharing many similarities to Pokemon. Due to the limitations of Ethereum, Axie lives on its own layer 1 chain, Ronin, but is further decentralized in that the Axies and land in the Axie metaverse are non-fungible tokens, owned on the blockchain, and easily transferable. The game is extremely popular, and some gamers have been able to earn a living playing it. This is because the game rewards, a (fungible token) called Smooth Love Potion (SLP) is liquid on many exchanges, and can therefore be monetized into local real world currency. As top Axies are effectively dollar-earning assets, the best can command very high prices: In June the high trade was $127,778. Land on which to play new Axie games traded this week for over $650,000.

Revenues are exploding (currently over $2 million per day), making Axie the number one metaverse protocol by almost every measure, and a price to sales ratio that any growth company would envy.

The protocol has over 350,000 daily users, and generated over $170 million in trading volume last month. The governance token, AXS, has outperformed pretty much every other seasoned crypto asset recently:

Other games and collectibles, such as Gods Unchained, and virtual worlds such as Decentraland (a sort of Second Life) are only now coming to their own on layer 2s in order to avoid the high gas costs of Ethereum layer 1 (as Axie has done with its own chain). Hartmann Capital is paying close attention to this space, eager to find the next Axie.

Collecting and creating are worse than gaming in some ways. For the trading of major works of art, two auction houses dominate. Fees are huge: Sotheby’s charges both a buyer’s premium (25% for the first $200,000) and a selling commission (negotiated). And the antiquated system for proving lineage is subject to manipulation and even criminality.

Stand-alone digital works fare no better for creators. Even if entitled, creators rarely get any royalty on the trading of works after the initial sale, and are many steps removed from their eventual customers.

Just like in Web 2.0, digital and analog rights to music, art and photos, for example, are generally controlled by centralized entities, such as record labels, galleries and visual media companies. A recording artist might have several layers of dominant platforms between them and their fans: Spotify in Web 2.0 and the record label.

Crypto solves this. Artists such as Justin 3Lau are able to interact directly with fans through the use of non-fungible tokens as evidence of ownership. 3Lau knows who his fans are (or at least their Ethereum addresses) and vice versa. Price discrimination (charging different customers different prices for slightly different services/products) is possible: 3Lau can auction off special packages such as limited edition mixes, backstage passes and even customized compositons. There are no platform commissions or restrictions on marketing. As a result Justin gets a much larger piece of the selling price.

In general, control, and revenue, passes to the creator rather than platforms.

Crypto offers a future of augmented reality in digital galleries and gaming as in the film Ready Player One. Do we want platforms like Microsoft and Facebook controlling this, charging intermediation fees and selling our data to advertisers?

Privacy

Speaking of selling our data, we believe that privacy is the fourth key element of the crypto universe. We’ve been living so long IRL without privacy that we forget that it should be an inalienable right.

Facebook has probably been the most egregious violator of privacy, yet it still has almost 2 billion active daily users, and growing. DWeb is intended to allow users to take back their data, yet there is another kind of privacy that is often absent from crypto.

The average person probably believes that crypto is anonymous. Tales of Bitcoin’s use for paying off hackers, buying drugs on Silk Road, a defunct “darknet”, and to avoid exchange controls are fixed in the minds of the public and governments alike.

Yet crypto assets are not anonymous but pseudonymous. As all transactions are fully transparent, once an owner is matched, there is zero confidentiality. Everybody knows which (main) address is billionaire Mark Cuban’s. Do you really want it broadcast where and when you go for a coffee and pay with crypto?

Careful planning can mitigate the problem of being tracked, but can not completely solve it. Governments and regulators, especially, can obtain KYC information from the centralized exchanges and match it to on-chain transactions to “follow the money”. So, too, can less well-intentioned folk.

Solutions to complete privacy are few, but are gaining in popularity. There are privacy coins, such as ZCash and Monero, as well as smart contract “mixers” that make matching inbound and outbound transactions difficult (e.g. Tornado Cash), and therefore difficult to trace.

Secret Network, a stand-alone chain built with Cosmos SDK, enables privacy for all DApps within its ecosystem. The blockchain supports encrypted inputs, outputs and smart contract states for end-to-end privacy.

Privacy use cases on Secret are quickly multiplying. Private NFTs can be used in Pokemon-style games, such as Secret Heroes, where the game play details of each “hero” and skin owned on-chain is hidden from other players. Sienna DEX keeps all aspects of each transaction private.

Hartmann Capital believes that privacy will be an important element of DeFi and DWeb, and is actively monitoring the space for innovators.

Final Thoughts

In TradFi, asset allocation is at least as important as security selection, and often dominates idiosyncratic returns. Strategies such as yield enhancement, activism and catalyst investing need to be applied to the best crypto asset classes. Hartmann Capital views the four subgroups of DeFi, DWeb, the Metaverse and privacy to be the most investable sectors within the crypto universe for the foreseeable future.

Though currently the fund is biased to DeFi, the Metaverse as a whole is on the verge of multiple breakthroughs, and is experiencing tailwinds from new layer 2 scaling solutions such as ZKRollups (Gods Unchained), Polygon (Aavegotchi and Decentraland wearables) as well as layer 1s such as Flow (NBA Topshots) and Ronin (Axie Infinity). Axie is showing the space what can be achieved when a great gaming product combines with flawless decentralized execution.

DWeb and privacy applications have yet to take off, but we are positioning ourselves today for a thematic rally in the coming years.

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2021 Investment Themes