There has never been a more exciting moment to work, invest, and follow what’s happening in crypto and we wanted to take time to discuss and highlight some super interesting and exciting developments in the industry. We’re seeing a tremendous amount of companies and projects being started in the space, and as we focus on investing in early stage crypto projects, we wanted to share some existing and upcoming themes we foresee becoming prominent over the next year. At a high level, we’re seeing trends in these four high-level categories:
- The Ownership Economy
- Rise of On-Chain Activity
- Governance at Scale
- Advancements in Computing
Non-Fungible Tokens (NFTs)
There has been recent excitement in creators, developers, and artists playing with non-fungible tokens. NFTs are digital tokens that have a few special properties: each minted token has a unique ID that cannot change over the course of its existence, and any arbitrary data can be attached to the token which cannot be modified in the future. These properties, standardized in a spec called ERC721, allow for a very powerful combination for storing information – it makes it possible to turn a token into a read-only file!
One of the benefits of the digital age was that it made the cost to replicate digital content zero. You could copy any image, article, audio or video, and your computer would clone each and every bit such that there’d be no way to tell the copy apart from the original. This was naturally problematic for a lot of industries as distributing this content invited a lot of piracy. Having provenance for physical and rare goods is something we’re all aware of but it hasn’t been easy to offer digitally. Blockchains enable this – they provably allow for information to exist exactly once.
This unique setup unlocks a lot of doors for interesting use cases: one can store links, paragraphs, images, gifs and even code inside a contract and mint it as a NFT. The blockchain automatically ensures each transaction (minting, buying, selling, re-selling) is openly traceable and a duplicate of that information cannot exist. Naturally, it opens up the gates for a much broader audience to experiment with what’s possible – we’ve seen digital art, video, music, game items, essays, domain names, redemption for physical goods, and even legal contracts created by artists, musicians, and developers. In the past year, over $100M of digital art pieces have been purchased, and this industry is only getting started.
What’s even more exciting is that NFTs are still smart contracts under the hood, so custom code and rules can be added to these tokens. As an example, an artist can choose to include a 20% transfer fee on a digital painting, and any future re-selling of that painting will automatically transfer 20% of the selling cost to the artist’s wallet. This not only scales infinitely and instantly, but enables value capture at a whole new layer that wasn’t possible before. You can imagine similar setups for digital tickets, royalties, discounts, etc. This, by the way, is still consistent with applications in the broader crypto ecosystem, and NFTs fit nicely with existing DeFi primitives. This means you can take out a loan against your digital art, invest in an ETF of NFTs, or tokenize the NFT itself to partially own a piece of a digital art.
We’re in the early and vanity phase of NFTs. Famous artists, athletes, influencers, and musicians are currently sharing their work directly with their fans, and as the infrastructure for case-specific NFTs matures, we’ll see a whole new wave of direct applications focused on the needs for their respective industries. This is a defining moment in the history of empowering creators, and ultimately, one thing is clear – NFTs are finally allowing creators with an alternate choice to define how they benefit off their work, on their own terms.
Social Tokens
Another theme that leverages the creative industry are social tokens. These tokens behave like normal tokens (e.g. ERC20 assets on Ethereum) but are usually minted by individuals or owners of different communities. What makes social tokens interesting is that they empower the creators behind them to design and reward their direct and biggest fans in creative ways. In the Web 2.0 world, we’ve seen influencers introduce their own social apps or invite-only experiences, but as it stands currently, the majority of those attempts divide user attention by offering them a binary choice between platforms. Web3 addresses this issue by keeping the underlying platform the same for all creators and fans and opening access to specific experiences for all token holders.
As an example, a musician can choose to mint 20M tokens and give 10 tokens each to 1M of their fans. They can have full creative freedom over how the initial distribution happens and can easily leverage any existing medium to distribute the tokens to their fanbase. They can then create a community for the token holders and add various conditions or features. They may choose to only let in people who hold at least 5 tokens in their wallet, they can choose to award 2 additional tokens for directly engaging with their community, they may allow unlocking exclusive content for 100 tokens, they may get on a call with you for 1000 tokens, etc. These rules can be arbitrary and unique to each individual, and again, the blockchain automatically enforces, verifies, authenticates, and unlocks access to any content, in turn boosting the engagement with the underlying community.
We’ve seen very creative examples of such tokens in the ecosystem. There are micro communities of musicians offering exclusive compositions, early adopters for specific crypto projects awarding users with more tokens, individuals offering a percentage of their salary to token holders, all the way up to lawyers offering an hour of their time for holding a certain amount of their tokens. Just as NFTs are tokenizing media content, we believe social tokens will monetize time and engagement with entire communities.
Traditional Financial Instruments
The DeFi ecosystem is growing at an exponential rate. We’ve seen decentralized versions of almost all existing financial instruments, and these exchange, lending, borrowing, options, derivatives, and swap protocols are quickly gaining traction. For decentralized exchange protocols like Uniswap, the average daily transaction volume has been at or even more than that of Coinbase, topping $1B. Although there are some constraints on exactly how closely some of these protocols can work compared to their traditional counterparts, we’re slowly seeing signs of near feature parity with numerous options and derivatives protocols and foresee a larger wave of users and traders preferring the decentralized version over centralized ones.
There has been a growing distrust in how certain centralized platforms operate and how often certain decisions favor the company’s interest over their users. These public events usually invite and convert more users to try the decentralized implementations, and with the amount of liquidity flowing into the ecosystem, having 24×7 real time markets, and users maintaining full control over their assets, we’re likely going to see a big shift in user preferences, and are heavily investing in this sector to gain exposure to the best protocols.
Stablecoins
There has been a massive increase in experimentation of new stablecoin concepts. Over the past few years, we’ve seen the rise of DAI (MakerDAO), USDT (Tether), and USDC (Coinbase), as they’ve dominated the DeFi ecosystem and have been a base for protocols to build on top of. These existing stablecoins have largely been 1:1 backed by verifiable USD reserves, or in the case of DAI, minted through overcollateralization of ETH deposits. While both these methods have worked really well and have scaled to over $1B in circulation, there has been a new wave of stablecoin designs and implementations that are trying to move away from the previous model. There are now attempts to create a few new types of stablecoin protocols: ones that drastically reduce the collateral requirements compared to their predecessors, ones that add new features in addition to guaranteeing stability, and finally, algorithmic stablecoins that increase and decrease their supply automatically based on demand and are not directly tied to a USD reserve.
The first two leverage the work done by existing protocols and aim to improve some aspects of their design and bring in efficiencies. As an example, Liquity (portfolio company) has been able to design a stablecoin which reduces the collateral requirement down to 110% compared to 150% for Maker. This offers a massive incentive for existing Maker users to move their assets over to Liquity and free up that additional capital that was originally locked. Similarly, we’re seeing attempts at stablecoins being tailored to different communities and rewarding users in various ways for actively using the coin. Some examples of this include receiving 2-4% interest for simply being a coin holder, and giving users a smart contract-based protection policy for the underlying holdings similar to FDIC insurance.
On the algorithmic side, there has been an extreme amount of innovation in the past few months. We’ve seen over 20 experiments in various models of stablecoins that do not peg to USD and aim to automatically scale their supply based on demand. This has been a topic of economic and game theory research for quite some time in this ecosystem and we are seeing some early signs of viable models that may prove to keep an algorithmic system functioning at scale. The opportunity for this model is massive – this would allow an entirely new currency to exist which can scale infinitely, is only tied to its own usage, and would be analogous to setting up a new global federal reserve.
Yield Optimization
As new DeFi primitives are being introduced, we are seeing protocols and infrastructure focused on diversifying a user’s holdings and optimizing their earnings. Similar to robo advisors, we’re finally seeing protocols that are in a position to automatically move and trade funds between different protocols to get the best and most stable interest rate for the user. This is a very exciting opportunity as we believe there are massive network effects for the winning product in this space, and the emergence of newer optimization tools is also accelerating the development of decentralized structured product offerings. With the current imbalance of supply and demand for various lending protocols, there are massive fluctuations in the APY, and the interest often varies by day. As we see more yield optimization protocols emerge, we will see more stability in the current DeFi ecosystem and move towards seeing fixed rate lending contracts.
Composability
What’s unique about this ecosystem is that most interactions come with an on-chain proof. That proof not only confirms that a certain trade occurred, but in certain cases also represents the claim on the given underlying asset. For example, when I deposit 10 ETH into a lending protocol like Compound, the protocol in return sends me 10 cETH tokens which represent my claim to redeem the original deposit. If in the future I want my ETH back (full or partial amount), I just have to trade my cETH tokens and I immediately get my original deposit, plus interest, back into my account. Because these tokens behave like bearer tokens and represent the claim on the underlying asset, any future receiver of cETH tokens can simply go back to the Compound protocol and redeem the underlying asset.
The benefit of this setup is that it unlocks a massive ecosystem for applications and protocols to work together without needing permission or a formal partnership. From the example above, I can now use my cETH tokens in any other app willing to accept cETH instead of ETH. I can choose to trade options, buy insurance, borrow/lever-up against that same collateral, or trade it at a different price based on the use case. For interactions with yield bearing protocols, we’re seeing more and more examples of applications that let you re-use your positions and interest without always having to make a withdrawal. This is a key piece in enabling new and more exotic financial instruments that usually have not been offered to retail investors in the traditional financial markets. Some examples of this include being able to combine and hedge options issued by two or more separate protocols, and creating an ETF of just interest rates for all lending protocols.
New Financial Instruments
A breakthrough technology enables new applications that were inefficient or just not possible before. We are currently seeing versions of existing financial instruments get decentralized along with variations in features compared to traditional finance. The DeFi landscape currently has great lending, borrowing, options, perpetuals, and ETF protocols and we’re just seeing a new wave of how these existing protocols are being uniquely combined to create newer instruments.
An example of an emerging new primitive is Flash Loan: a flash loan lets you borrow nearly unlimited amounts of money from a pool, risk free, for a period of ~15 seconds. This window roughly represents the time it takes for a transaction to confirm on the Ethereum blockchain and a user can write the code to execute any complex transaction by chaining actions using the initial borrowed capital. If the trade goes through, the protocol takes a small cut of the profit but if it fails, the blockchain, by design, restores the state of the system and reverts the entire transaction as if nothing happened at all. As a simplified example, if there was a $0.02 arbitrage opportunity between DAI ($0.98) and USDC ($1), I can choose to flash borrow 6k ETH => convert it to $10M USDC => sell that for $10.2M DAI => convert back to 6120 ETH => return 6k ETH back to the protocol and pocket 120 ETH in a single 15s transaction. If the arbitrage in this scenario disappears by the time the transaction finishes, it would just fail and the system automatically returns 6k ETH back to itself.
This is a very powerful primitive as we’ve seen users borrow millions to take advantage of arbitrage opportunities, and even borrowing tokens to vote on certain open proposals as an activist. We’re just seeing some professional tools being created to let everyone use flash loans easily and we are excited to see how this primitive gets used in DeFi.
Decentralized Autonomous Organizations (DAOs)
What if creating a company meant deploying a piece of code and automatically getting payroll, accounting, board of directors, charter, and treasury management setup? What we’re seeing now is a new wave of companies existing only on the software layer. Everything from coding the logic of a simple escrow contract to facilitating an entirely functional bank (with lending, borrowing, savings, etc.) can now be represented with only a few hundred lines of code. The notion of having code embody a definition of an organization sounds ridiculous at first, but it is a representation of rules that a group of people mutually agree on with the added ability to modify them should social consensus change. DAOs enable such organizations to exist. You can write specific rules that trigger various actions in a system and ensure that the goals of a project are separated from the politics or hierarchy of an organization. This includes writing conditions that manage everything from voter rights, to cap table, to dividend disbursements, to auditing; all these layers that have lived on top of existing organizations can now be merged directly into the lowermost layer that defines that very same organization.
We’re seeing a rise in decentralized projects converting their treasury into a DAO, allowing the company to optimize for longevity of their protocol. These DAOs can be case specific and embed custom rules that work just for them. For example, a DAO can have a rule requiring 3 out of 5 votes in favor to move forward with any decision. They can in addition also add a rule that checks if the last voted decision is related to payments and automatically disperse the amount upon approval. You can imagine hundreds of unique use cases spanning anywhere from automatic board decisions to real-time vesting. Not only is this exciting because of all the newer workflow possibilities of working in an organization, this model also uniquely enables companies to exist beyond geographic jurisdictions and for the first time allows pseudonymous individuals to participate. We believe that spinning up DAOs will become very common in the future and it would be not strange to invest directly in a DAO via crypto instead of a legal entity.
Active Participation
Projects in this ecosystem are behaving more like communities. Protocols are intentionally being designed to allow as many users as possible to voice their opinions on the direction of product development. This sounds messy at first but this approach has been proven to be extremely scalable and vital to the success of a few popular protocols. Users have been able to vote on product direction, how money should be spent by the team, and have even collectively validated insurance claims after an exchange hack lost users’ assets.
We’re seeing cooperatives operate at scale and protocols that are being designed to embrace and award individuals who are active users. There have been a handful of retroactive “airdrops” where all users of a platform have received protocol tokens for simply using the product. Teams operating in this space are able to financially reward early adopters, and offer them an avenue to directly get involved in the governance process. A lot of current active participation is tied to treasury management of existing protocols, and users in the community are able to propose changes to the product, request funds and grants to expand the platform, propose sponsoring events for marketing, etc. These proposals are published in the open and discussed by active participants of the community, and then go through a voting process where meeting quorum triggers the change. There has been an incredible show of self organization and collaboration among individuals, and a lot of these changes also integrate with DAOs. It is often the case that a committee decision to tweak protocol parameters or fulfill grants automatically happens at a software level as soon as voting thresholds are met.
We believe this is not only the way forward to organize decentralized global communities, but will also help us test and improve economic theories and change how we believe economies with multiple actors behave. We are currently in super early days of testing governance at scale and are excited about platforms that will help manage decision making for these communities.
Scalability
Part of what makes blockchains slow is the premise that every action in the system must be independently variable by any actor in the system. This is a great property to have in designing resilient decentralized systems but in reality implies that you can only be as fast as the slowest step in your process. Ethereum currently handles around 20 transactions per second, which in comparison to google searches, visa transactions, or tweets per second is insignificant. For blockchains to be able to support more day-to-day use-cases, we need to do better. When we talk about scalability in blockchains, it usually aims to increase the throughput as its outcome, but there are multiple ways to accomplish this. What we’re seeing now are experiments and implementations of recent advancements in distributed systems and cryptography to help increase the throughput of current blockchains (and specifically ethereum) by 2-3 orders of magnitude.
These innovations are being applied in two places: Layer 1 and Layer 2 of a blockchain stack. Layer 1 (L1) refers to the base layer (the blockchain itself) and there have been newer consensus algorithms and networking protocols that are enabling higher number of transactions per second and lower confirmation times in the system. These types of innovations have enabled newer smart contract platforms to emerge as they’ve seen the bottlenecks of the ethereum architecture and have been able to address some of those challenges and offer 100x faster solutions. We’ll continue to see more experimentation in new Layer 1 blockchains as technologies like libp2p, hotstuff, verifiable delay functions (VDFs), sharding, and proof of stake implementations mature.
Layer 2 (L2) protocols sit on top of existing L1 blockchains and offload transactions to occur outside of the system, offering a boost in performance of the underlying L1. Similar to how we scale servers in web 2.0, we can design systems that become the first touchpoint with a user. They maintain a history of all actions on their own and batch submit those transactions to the underlying blockchain every few minutes. This allows you to scale the throughput exponentially without exceeding the limits of the main chain. While this sounds great and easy in theory, implementing a mathematically safe way to do this is not as simple. In order to maintain a trustless version of the system, there needs to be some game theoretic assumptions about how users will interact with the protocol. Since L2s maintain their own version of transactions until they are ready to settle on the main chain, there are multiple opportunities to fraud the system either before or during settlement and change account balances. As a result, the security assumptions of these systems are still being tested because the outcomes change as the system holds more assets. There are currently two promising approaches to solving this for Ethereum: Optimistic Rollup and ZK Rollup – both allow you to batch transactions while maintaining feature parity with Ethereum.
Multiple companies are building their flavor of Optimistic and ZK rollups and we will be seeing a surge in a mass transition towards Layer 2 protocols for DeFi and NFT projects over the coming months. This category is extremely exciting for the future of blockchains as the core innovations here enable all consumer-ready, high-throughput applications to exist. We expect multiple unicorns in this category as this space matures.
Dark Contracts
It’s well understood that the information that lives on most blockchains exists on a public ledger. This allows anyone to inspect and verify the transactions and ensure that everyone always has access to the exact same information. While this unique property is beneficial in allowing for a more fair and easily auditable infrastructure, it’s not too difficult to see the downsides of having everything public as a default. You wouldn’t want everyone to know how much money you have in your wallet or which proposal you’ve voted in favor or against for a given protocol. The need for some privacy is a must in any financial system and this is currently one of the factors preventing bigger institutions from actively engaging in the ecosystem.
With recent advancements in cryptography, we’ve seen a big emergence of applications using Zero Knowledge Proofs (ZKPs). A ZKP is a method through which you can prove having access to a piece of information without disclosing the information. This proof is a custom “circuit” that you write for your specific use case, and the mathematics of the circuit guarantees the anonymity of the computation. More concretely, a user can prove they own some tokens. or they’ve taken an action with said tokens, without publicizing the exact amounts of that transaction. If the circuit evaluates to true, the receiving party can be sure that the provided information is correct.
You can now design custom circuits to trade openly without hinting your positions to anyone monitoring the blockchain, you can prove you voted on protocol governance decisions without disclosing your vote, you can even prevent the company from knowing what action you’re taking on their product, you can prevent front-running of trades, etc. ZKPs unlock a whole new era of private computation. We’ve seen encrypted chat messages, token trades, emails, etc but we finally have the ability to write private smart contracts. This has massive benefits and new use cases as for the first time this introduces the ability to have a piece of software that itself cannot know what is happening as it executes the code, works on encrypted inputs and outputs, and always executes correctly. We’re just beginning to unlock what a world with private computation would look like and we foresee this sector to have an enormous impact on blockchain application design over the next few years.
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These are just some of the topics and themes that we believe will be prominent over the next few years, and what we’re focused on as a fund. We currently have multiple investments in most of these categories, and will continue to invest in the best founders and technologies in this ecosystem.
