Mirroring traditional asset management success in the DeFi ecosystem

The importance of asset management firms is increasingly recognized in the world financial system. Despite the last few years of difficult markets and changing regulations, the asset management business is the most profitable with the highest returns on capital. Their profit margins are consistently higher than in most other sectors. As per the US SEC government report, in 2016, the total value of global assets under management (AUM) stood at $69.1 trillion. 

Factors which drove investors towards these asset management firms are –

1. Their professional relationships with the chief executives of most of the leading companies give them access to high-value choices. 
2. Asset management firms are at the epicenter of global events; from politics to extreme weather, anything that affects markets. Given their expertise, they are able to channel the investor’s funds to better prospects. 
3. They are also in a better position to assess risk and accordingly diversify investor’s money and are able to quickly adapt to liquidation strategies proactively as the market place evolves.

Can the DeFi ecosystem benefit from such a system while keeping its core value intact i.e. trustless and permissionless?

Though the asset management industry has grown significantly, it has fundamental problems:

1. Asset management businesses or companies take custody of investor capital. Clients usually have to put their faith in the expertise of asset managers.
2. Many asset management companies offer their services to high net worth individuals because it can be difficult to offer services to smaller investors at an affordable price.

DeFi comparison with traditional financial system:

DeFi, however, proposes an entirely new financial system that is independent of the traditional financial infrastructure or instruments. DeFi applications do not need any intermediaries or arbitrators. The smart contract specifies the conditions of settlement between individuals, and transactions are recorded in distributed-ledger to avoid any single point of failure.

Individuals in the DeFi ecosystem can participate openly without need for permission. Another significant advantage of DeFi is interoperability that helps DeFi companies scale products by leveraging other innovations in the industry. When combined, powerful financial products are possible. For example, integration of stable coins in Compound, creating lending protocols.

This has led to the commitment of many developers in developing a DeFi ecosystem. With over 50 active DeFi projects, and $9 Billion crypto tokens locked in DeFi smart contracts, DeFi is now one of the fastest-growing sectors in the blockchain. Source: DeFiPulse.

The key reason is complexity which makes the onboarding process too long or difficult to understand, thereby discouraging most crypto traders to participate in DeFi financial primitives.

In a survey by ARPA in July 2020 found that only 1% of crypto traders have used decentralized finance protocols. Even for experienced DeFi liquidity providers, the rise in competing DeFi products has become too difficult to check and properly manage their portfolio.

The presence of asset management services in DeFi could be good for attracting a wide range of users from Crypto novice to institutional investors. 

In traditional asset management firms, clients usually have to put their faith in the firm and their services are available only to wealthy businesses and individuals. DeFi asset management protocol should not compromise the core values of decentralized finance, which are – trustless (no central party), and permissionless (open for all). Additionally, the DeFi developer should take into account the dynamic nature of cryptocurrency and technology. Here things change quickly putting greater pressure on the firms to respond to users evolving needs and safeguard users’ funds. For e.g., increasing gas fees, rise in competing DeFi financial primitives, price volatility.

What DeFi asset management protocols should look like:

(a) Tracking ‘Robo-advisor’: In traditional financial systems, third-party financial service providers get secure access to financial data through APIs. This enables firms like asset management to study financial data and accordingly allocate client capital. Today the firms have built algorithms to execute actions automatically. We know it as ‘Robo-advisor’.

In the DeFi ecosystem, developers can reference price/ interest rates for several DeFi protocols off-chain by using oracles from ChainLink. Now for automating, developers can use Ethereum bots (relay networks) as used by the Maker system – “Keepers” to automate liquidation of debts. 

Instead of setting up their own relay infrastructure, developers can use Gelato Network’s relay infrastructure built on the Ethereum service-layer. Using Gelato, developers can specify conditions (If-this-then-do-this) to automate transaction execution. This way developers can create robo-advisors to refinance (rebalance) users’ capital to best performing yields without need to have custody of users’ capital. This would streamline users’ experience as it removes the complexity of manual monitoring and placing each transaction themselves.

(b) DeFi transactions impact on Ethereum network, and how to decrease gas fee: Today Ethereum network is reaching the limits of its throughput and we need a more efficient way to handle these increasingly complex DeFi transactions. With the lowest Gewi setting, users end up paying upward of $2-3 for each transaction.

Now, remember, the interest rates in DeFi protocols keep changing at the block-by-block rate i.e. every 15 secs due to changing supply and demand in liquidity pools. For yield farmers to tap on best rates, they could move funds between protocols and could end up paying more than $50 -100 in a week. This cuts down profit and may even result in a net loss, making DeFi space inaccessible for investors with $100-1000 crypto.

To solve this challenge, developers could think of pooling together user liquidity and then batching the funds to DeFi financial primitives. This not only creates large gas savings but also reduces the number of transactions going out on the network. This reduces gas fees for everyone on Ethereum, not just users of the platform. 

But, this pooling mechanism has a problem – Who controls the key for the pool wallet? Can we trust that person? To avoid a single point of failure, we can do the following:

• I-OWE-YOU tokens: This approach is like traditional mutual funds. When users put their funds in DeFi protocols (e.g. lending), they receive interest-bearing tokens in exchange. These tokens add interest every Ethereum block (~15 seconds) and are transferable to anyone. Whoever holds these interest-bearing tokens can redeem them for the principal plus interest by interacting with the platform’s smart contract. Smart contracts enforce these conditions and reduce the risk for users. Example of interest-bearing token: Compound’s cTokens (e.g. cDAI, cETH).
• No single person owns the encryption keys: To make sure no single person has access to capital in the pool, the pool wallet can be multi-signature- no single ownership or burn encryption key so as no one has access and the smart contract manages the interactions. 

(c) Risk decreasing: A good process on their own does not make sure good outcomes. Another vital factor for asset management is risk mitigation. Traditional asset management firms are in the epicenter of global events and are able to better assess market risk for each instrument. Accordingly based on each client’s risk tolerance level, the funds are diversified.

For DeFi, instead of relying on the judgment of one or project team, the protocol can use the collective decision of the community to decide on the risk score for each yield farming strategy in the platform’s library. Using vote (governance token) the community agrees on the score. As traditional asset managers ask investors for their risk tolerance, similarly DeFi users can set their tolerance level on the platform. Once defined, the robo-advisor matches the strategy risk score with the user tolerance level and accordingly diversifies user capital.

These propositions can help to create set-and-forget framework for DeFi asset management protocols, thereby allowing broader participation, including crypto novice and institutional investors.