Bankless - Building a $500M DeFi Fund - Arthur0x

Jul 15, 2021

Primer: Arthur Cheong (Arthur0x), founder of Asia's largest DeFi focused funds DeFiance Capital, shares the secret of how he turned a 6 figure portfolio into 9 figures in just 3 years. He explains the fundamentals of what he is looking out in a protocol and exactly which metrics he used to valuate. He also shares which token is currently undervalued. Which, among the Ethereum killers, will Arthur bet on?

Who is Arthur0x?

Founder and fund manager of DeFiance Capital, one of the largest DeFi focused funds in Asia
DeFiance Capital is based on fundamentals, not narratives or sentiments
Started in spring 2018 - wanted to run a crypto research startup but no product-market fit
Hence decided to focus on investing instead during the bear market in 2018
Bought a lot of tokens that nobody wanted at that time
One of the most successful DeFi investors in the entire crypto space - turned 6 figures to 9 figures in 3 years
Currently 29 years old, based in Singapore

The secret ingredient in Arthur0x's success

Do homework and research with a focus not on the now but the ongoing trend
Persistence, especially during a bear market where people just drop out
The belief that we are building something bigger - not just speculation

"I think this really brings to the fact that crypto is a major level playing field. And for everyone from different backgrounds, because I didn't come from a very wealthy family. I came to Singapore only 10 years ago. So I think crypto just really give everyone the opportunity, who is willing to put in the effort and willing to make it happen."
- Arthur Cheong

It is possible to come into crypto, look around, formulate an opinion of what is going on, then turn that into a fund or something else
Spend time in the community, communicate with the protocol's team, give support - this will give you influence in the future on how the protocol is run

Token value accrual

During a bear market, tokens will just drop 90% and still drop another 80%, so there must be a base floor to the price because there are still people using the product
Since there are users, there must be some value accrued to the token, hence it should not drop to zero
This should give the token holders a lot more confidence during bad times

Things to take note

Does the token have a good design and is it well integrated into the platform?
Does the token have strong value accrual?
Is the token used as a growth catalyst for the protocol?
How are they going to distribute the token?

Example: Synthetix

Huge fan of Synthetix token economics right from the beginning
They pioneered using token inflation to incentivize the community and early adopters
Inflation starts at a very high level and gradually tapers down to reward early users who believe in the protocol and took the initial risk
By taking the risk of staking with the Synthetix protocol, the token holders are rewarded by the fees generated by the protocol, both in the native token and also in the extra fee income generated by people trading in the protocol

Example: Bancor

Went through a lot of iteration, finally arrived at a token economic model that makes sense
Bancor captures the most value for the token holders - 40 to 60% of the fee goes to the Bancor token holder, not in the form of income but in the form of burning
There is also support for a new liquidity pool as well
Still very complicated, not a lot of people understood this, hence not valued highly

Example: Aave and Compound

Value accrual is quite similar between the two
Takes a small percentage of interest owned that accrue to the depositor to the Treasury
In the future, token holders can vote on how the Treasury's accumulated reserve is going to be used - either returned to the token holder or further investment into the protocol

How to have confidence and conviction?

When you keep doing something, and you keep getting validation from your action, your confidence will increase

"Confidence is the memory of winning. And I believe that it should be the same for everyone. Like when you're doing something and you keep getting certain form of validation from your action, and then your confidence will just increase."
- Arthur Cheong

His first major bet was in Synthetix during the bear market
Spent 1.5 months writing a very comprehensive report, put it out there and was received very positively
After a few months, the market started reacting to that, so confidence was built from there
As he keeps repeating this method, he managed to outperform Bitcoin despite the dominance of Bitcoin, and this gave him the confidence and the signal to start DeFiance Capital.

The Edge of DeFiance Capital

One of the top crypto native funds that can invest in DAO directly
Been in the space for a long time and is comfortable with the structure
DAO structure gives some protection to the investor as well because the majority can influence decisions

Fundamentals

Team quality, like the track record of what the team had built
Valuation of the protocol
Technical architecture
Community involvement
Token value accrual
Near term catalyst

On Diversification

Diversification only protects against protocol hacks, where you can lose 100% of your investments
Does not help to prevent correlation risk, because when everything goes down at the same time
However, in a bull market, some protocols will do better than others, based on their fundamentals

On Meme investing drowning out Fundamental investing

Draws parallels to the traditional stock investing world - before Benjamin Graham published his book on Security Analysis, nobody had a way of valuing a stock properly
Similarly, we are in a similar phase in crypto, so retailers need to be educated over each market cycle

On the Metrics to valuate Decentralized Exchanges (DEX)

Trading volume
Fee value capture against the market cap for the protocol - for non-stablecoin protocol, take 0.05% of trading volume as a fee, while for stablecoin protocols, will be slightly lower (e.g. Curve is 0.04%)
- similar to the Price to earnings ratio in Tradfi
Total Value Locked (TVL) - which represents how much capital this protocol is securing
Capital efficiency - depends, case by case basis
Users and user growth - e.g. Uniswap has no cash flow because there is no value capture at the moment, but has a tremendous user base and the best user growth in the industry, hence it is valued very highly

Buyback and burn

Arthur0x thinks that buyback and burn is not the most optimal solution especially if a protocol still has a lot of growth potential
In early-stage startups in the TradFi world, nobody will be doing share buybacks or giving out a consistent dividend
If it still has a lot of growth potential, the capital should be reinvested rather than burning capital directly
Areas of re-investment could be: more education, more outreach effort, more translation so those in non-English speaking communities can join in the fight
Understands there might be tax implications for giving dividends to the token holder, but there should still be a better way to design this.

Which DeFi protocols are undervalued and why?

Sushiswap

Given the volume they are doing, should not be trading at such a price

There are others who argue that Uniswap V3 is going to kill Sushiswap because it is like an older version like the V2 design
But did not play out at all
Uniswap V3 is more for the active liquidity provider (LP), which means the professional market makers - hard for retail to be a passive LP for V3
Some tests (small sample size though) show that V3 did not necessarily perform better than V2
At the current price, sushiswap is being priced at zero growth, which is unlikely to happen

Aave and Compound

Lending and borrowing is among the most defensible in DeFi
No new lending and borrowing protocol using a similar design on Ethereum can disrupt them within a year
Why? It takes a long time to build trust and both had been operating for more than a year with no security incidents
Also takes a long time to build a network effect since you need to have sufficient deposits in the platform for people to borrow
Lastly, since the token is worth a lot more, the liquidity incentive they give out is more effective as well

Will there be just one Automated Market Market (AMM) in the future?

Arthur0x don't believe that there is a power law where only one AMM will dominate the market
Why? Liquidity is very fungible and has no loyalty
If there is a new AMM with a superior design, liquidity will flow over and it will dominate for a while
When in equilibrium, there could be a few dominant AMMs where their market share will not change much
Also, once your order is of a certain size, people will start using aggregators too

Eth Killers

Most of them will not be able to chip away at Ethereum's dominance - perhaps less than 5 such ETH killers can chip away the dominance but will not be able to kill it
Currently, over 95% of DeFi and NFT are on Ethereum, and over the next 2 years, might see it coming down to 80%

Reasons

Other protocols are starting ground zero, hence their growth rate will be faster than Ethereum
Some of the ETH killers are using a blue ocean strategy to target new users that are not on board right now
The network effect of Ethereum is so entrenched
Scaling solutions that are EVM compatible further help to entrench Ethereum network effect
Ethereum itself is constantly improving
Ethereum has a clear road map on how they plan to be decentralised further

More about the network effect of Ethereum

Binance tried to build their own DEX before but failed - it's only after they latch on to Ethereum network effect that they quickly became the crypto company with the largest user base
Switching a base layer is not an easy thing to do, unlike switching a Dapp

"I think the best analogy will be the App Store analogy. Like right now, the two most dominant App Store is Google and Apple. So a very big tech company, Microsoft tried to compete in this, they tried to have their own app store as well. But even a company of this size, couldn't do it."
- Arthur Cheong

A good analogy is like how Google and Apple have their own app store but when a big tech company like Microsoft tries to compete in this, they failed

Which ETH killer will Arthur0x bet on?

Solana is the best bet to compete with Ethereum
Cannot compete with what Ethereum is best at, have to adopt a totally new approach
Solana accepted that they will not be as decentralized as Ethereum, and will have much fewer nodes because of the higher hardware requirements needed
Rather bet on something totally different than another protocol where they are making marginal improvements to Ethereum.

How does the East view crypto differently from the West?

Asia can be divided into 2 different parts: the English speaking region and the non-English speaking region
Historical and cultural factors will dictate the pace of adoption.

English speaking region

E.g. India and most of South-East Asia
Adoption is pretty common
Understand DeFi and uses it in a significant way
Have a decent DeFi community
Needs to see more built-in checks and balances in the protocol

Chinese speaking region

E.g. China, Hong Kong and Taiwan
Initially sceptical back then in 2018 but in 2020 after the DeFi summer, there are more users as a result of that
Slightly less focused on the ethos
More focused on the self custody of assets because they have seen the troubles of OKEx where nobody can withdraw any balances for 2 months
Trust a lot more on the team behind the protocol

Japan and Korea

Due to the language barrier, have not been using DeFi a lot compared to other regions.
Currently, over 95% of DeFi and NFT are on Ethereum, and over the next 2 years, might see it coming down to 80%
Language barriers can be crossed by using translation and building a strong community in a foreign language
Cites the example of Vitalik going to China to evangelise Ethereum, so now China has a big committee with very good mindshare

Views on Chinese Government FUD on crypto?

They just want to have a lot more control over the financial market, which they view crypto as being a part of
The exodus of Chinese miners is real - going overseas
The concentration of hash rates in China will become history, will never come back because of the uncertainty
Fiat on-ramp in China is being curtailed further so it will be harder to convert local currency to crypto and back, in order to curb OTC trading
The growth of crypto users in China will slow down

Views of Singapore Government on crypto

The regulator at the top really tries to understand crypto, and their level of understanding is probably one of the top with regards to the global regulatory purview
They know the benefits of DeFi, but whether they buy into it 100% remains to be seen
They want to wait and see if the benefits of DeFi can translate to real-world activities
Follows the FATF guidance drafted by major countries like the US and EU
A lot less prosecutorial and less aggressive

Thoughts on the crypto industry in the 2nd half of 2021

More scaling solutions following the success of Polygon and Binance smart chain
More users will come in, crossed 1 million users now, but could go up to 5 to 10 million by end of the year
Predicts TVL will hit 200 billion by end of the year
Predicts ETH price will be around 5k to 10k by end of the year

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