Mark Cuban talks about the valuation of crypto projects, as well as the wonderful wisdom of yield farming and providing liquidity

This article is sourced from Chain News, authored by Mark Cuban, the owner of the NBA's Dallas Mavericks, and translated by Perry Wang.

I will explain this issue in the simplest and clearest language possible. Yield farming through staking and providing liquidity is a core feature of most decentralized finance (DeFi) projects. The underlying principles that allow these projects to shine also apply to other crypto projects.

First, I want to state: this is not investment advice. This is merely my personal view of the market, and my opinions may be wrong on some matters when you read this, or they may change.

What business are they in?

The first question you should always ask about any DeFi project is the same question you would ask about any business you might establish a financial relationship with—"What business are they in?"

Yes, at the core of every DeFi project is a business. They may or may not know what business they are in, but they just happen to utilize blockchain and smart contracts to host and program their business processes.

Let me give an example of a DeFi and blockchain project I have personally invested in and how I view their business:

The Business Model of Polygon/Matic

Their business is very simple, but executing it is very difficult.

Their job is to provide tools that allow transactions using Ethereum/Solidity smart contracts, primarily built by external parties, to occur as quickly and cheaply as possible while still generating returns that exceed costs. To achieve this, they charge a fee for each transaction. This fee is paid in Matic tokens. Just like you buy tokens at a Dave & Buster's arcade restaurant to play games, you must purchase Matic tokens to use Polygon's network and smart contract features.

However, blockchain-based businesses quickly diverge from traditional software, and the difference lies in the intelligence of crypto businesses (like Polygon/Matic and its competitors, from BTC to ETH and even Dogecoin).

Every business or financial software service or application needs to pay for cloud computing and operational costs, and these costs often grow at a rate faster than their revenues. It’s no surprise that software companies raise large amounts of capital for this reason, to make their "software eat the world."

Businesses like Polygon have very different capital needs. Why? Because their business is not entirely built on a cloud computing platform like Amazon Web Services (AWS), but is decentralized (I won't argue here about the definitions of decentralization, security, or speed). The foundation of decentralization is built on independent parties, often referred to as "miners" in proof-of-work (PoW) networks like BTC, or "validators" (or other names) in proof-of-stake (PoS) networks like Polygon/Matic, who invest their own funds to provide computational resources to support the network platform.

Smart!

Any other business must raise large amounts of capital to host its own servers or to pay for cloud computing costs, which can be very expensive for compute-intensive applications and equally costly for applications that require scaling for high throughput. Additionally, businesses must hire all personnel, need capital expenditures to support their work, and so on.

In the decentralized crypto world, these third parties (miners, validators, etc.) provide the computational power necessary for the platform to operate effectively in exchange for token rewards from the network.

In the Polygon project, these individuals are called validators. If these third parties believe that the network platform can significantly increase the number of transactions on the network, they are willing to invest in it. If the number of transactions on the platform increases, the demand for the Polygon tokens they earn will be greatly boosted. They can earn income from selling the tokens they receive or they can hold the tokens and hope they appreciate in value when demand exceeds supply.

There can even be a more ideal outcome, as platforms like Polygon allow almost anyone to stake their Matic tokens alongside these validators and share in the validators' earnings!

There are many reasons why validators like stakers, but they are willing to share their earnings with the latter because the more staked, the more rewards validators can earn. This is a symbiotic relationship that also helps secure the network.

Why is this mechanism so smart? If Polygon or any of its competitors took the traditional, centralized business development path, controlling and owning everything, they would face the need to raise millions of dollars, if not more. Instead, they created a token with nearly zero costs and distributed tokens according to the tokenomics they defined for the community (any changes require community approval). Everyone involved benefits as a result.

The craziest part is that because these businesses are token-driven, costs are distributed, and operations are decentralized, their operational costs are far lower than traditional centralized businesses. Therefore, in a competition between crypto-based businesses and traditional businesses, crypto equity may have a significant advantage in capital and operational costs. Many financial institutions should pay attention to this phenomenon.

And how will Polygon build its transaction volume and fee revenue? By having applications that are widely used and have sufficient usage. Every platform, whether an exchange or a blockchain, is competing to achieve network effects. The more users they have, the more fee revenue they generate, and the more fee revenue they have, the more they can invest to acquire users. The more users they have, the more fees they must distribute, and the more valuable their tokens become, creating a virtuous cycle.

The Business Model of DeFi

One of the ways Polygon tries to achieve network effects is through its DeFi-based business (this link provides an excellent explanation of DeFi).

As the name suggests, DeFi is built on top of financial services.

Think of "Dave & Buster's" tokens. When you purchase their tokens, you can only use them in their arcade; you cannot use those tokens at other establishments. One of the foundational businesses of DeFi is the ability to swap a project's token for another project's token. That’s why they are called exchanges. If the exchange is decentralized, it is called a "decentralized exchange (DEX)."

An example of such a DEX I mentioned is Zapper.fi (not a true exchange, but its data tracking and token swapping features are excellent, and I am personally an investor, so I must mention it here!) as well as quickswap.exchange, bancor.network, and uniswap. They all essentially engage in the same business, which is token trading. Every time someone swaps one token for another, they earn from transaction fees. But that’s not the most exciting part.

To engage in currency exchange or even banking, sufficient capital depth is required to provide the various currencies and services needed, and the ability to hedge against pricing volatility between currencies. If you want to scale this business globally, the costs can be very high and the risks significant.

But this is not the case for DeFi exchanges. The reason operating a DeFi exchange is much better than this and any type of traditional centralized financial business is that it does not require the business owner, investors, and their creditors to provide the capital for all transactions; instead, liquidity providers (LPs) fund them. (This link explains this.)

I am personally a small LP on QuickSwap, where I provide two tokens (DAI/TITAN) to enable QuickSwap to facilitate exchanges between these two tokens.

You can learn from this link that this is just one of many trading pairs, and you can also see that QuickSwap pays LPs 0.25% of the amount exchanged for each token swap. As of the writing of this article, my initial (only from transaction fees) return is an annualized yield of about 206% (based on fees earned in the previous 24 hours). This return percentage will fluctuate during this period based on the activity level of transactions on the protocol.

But the cool thing is that I do not receive additional reward tokens for this trading pair (Titan and QuickSwap, did you two projects see my article??), but since I am currently the only LP in this liquidity pool, I take home 100% of the fee revenue. In each liquidity pool, LPs receive a share of the fees based on the percentage of liquidity they provide.

Thus, because I provided the necessary liquidity for the business of TITAN and QuickSwap, I receive 0.25% of the trading volume exchanged between these two tokens as an economic return.

As long as I continue to receive good returns, I will keep investing (volatility can cause market losses). If returns are poor, I can withdraw my funds immediately (some platforms have a lock-up period or impose certain penalties). If there are enough LPs, the capital efficiency of the exchange will far exceed that of similar traditional exchange businesses, and as an LP, I can also make some money!

Additionally, exchanges often provide LPs with extra reward tokens. I also provide liquidity on the Bancor network, where I receive rewards paid in BNT tokens. They allow LPs to provide single-sided or double-sided liquidity and offer generous rewards in the platform's BNT tokens to incentivize the use of their platform (a reference saying that this protocol essentially invented DeFi) and to mitigate token price volatility.

The returns on Bancor may not be as high as on other platforms, but they are a more user-friendly platform and do a great job of protecting LPs and retaining their liquidity.

One thing to note is that competition between exchanges is fierce. Economic returns must be high because it is indeed a laissez-faire market. The battle for LPs among exchanges is very intense. If you choose to become an LP, you must proceed with caution; unless you are very experienced in being an LP, make sure to do your homework first. You need to ensure that the platform operates a legitimate business.

Let’s take a look at another DeFi company: AAVE. AAVE, like its competitor Compound, looks like a bank. But that’s not the case. Not at all. Aave is a fully automated, permissionless platform with no bankers, no buildings, no toasters to serve customers, no vaults, no cash, no holding your assets, no forms to fill out, and no credit ratings involved.

Everything is controlled by smart contracts, it is fully automated, and you do not need anyone's approval, and you can get a loan in just a few minutes. This is called "permissionless." This approach is the future of personal banking enterprises.

What business does Aave engage in? Their job is to make it easier for people to borrow. Every time someone deposits tokens, the depositor receives a certain amount of Aave tokens, which reflect their share of the interest earned across the depositor's fund pool, and sometimes they receive Matic tokens as an incentive for users to use Aave on the Matic network instead of Ethereum or other networks.

Whenever a borrower takes out a loan, they pay an algorithmically set interest rate. What’s really different is that sometimes borrowers also get rewarded. Because Aave and similar platforms want you to use the platform early and often, especially when it is still a startup trying to attract depositors, they reward their users.

Of course, Aave charges a very small fee for each transaction, and they also earn through the interest rate spread on loans not allocated to depositors. I should add that the underlying blockchain network, whether Ethereum, Polygon/Matic, or any other network, also charges fees for each transaction. (That’s why they often fund rewards for users.)

Now let’s discuss in specific scenarios.

These DeFi protocols act as automated businesses that provide deposits and loans, matching services without buildings, large departments, branches, written documents, approvals, or confirmation calls. For Aave and its competitors, the most important thing is transaction volume. They can create wealth for depositors and token holders because their management fees are negligible compared to their revenues. Compared to similar traditional companies, automated financial market makers have much higher capital and operational efficiency. Banking enterprises should be fearful.

Let’s recap.

Basically, traditional centralized businesses first need to raise funds. Start up, and then hope to earn enough revenue to return sufficient capital to their investors and/or founders to keep them happy.

In the crypto/DeFi world, businesses do not need as much capital to start and operate, and they do not need to raise funds in the traditional sense; these businesses can raise funds by selling tokens, can reward LPs instead of having to raise liquidity for financial transactions, can reward stakers who support validators, and these protocols can operate on the blockchain, where most capital expenditures/infrastructure and most key security are provided by miners or validators. These projects can build communities to replace the many layers of bureaucracy.

What I want to discuss is: what makes the cryptocurrency world so different, and why it is a model for future tech companies and all businesses?

Profits are useless. None of the companies I mentioned earlier think that they must earn profits to distribute to owners' pockets. There is no need for financial engineers, and no reason to manipulate earnings per share (EPS) data. This is not to say that these DeFi projects do not need to cover their costs. They do need to, but their mission is not profit maximization because in almost every crypto-based business, they are decentralized.

Every token represents an equal stake. No matter who owns it, every token holder can participate in the community. Yes, owners with larger stakes will get more votes, but there are no multiple tiers of tokens. Venture capitalists (VCs) or founders' tokens do not receive preferential treatment like stocks. (At least as far as I understand), decentralization and automation completely change the rules of the game.

This is not to say that every crypto blockchain or DeFi project will succeed. Far from it. These facts are not a secret in the cryptocurrency world. Competition is fierce. In fact, many, or most, will fail. They will not gain enough users or generate enough fees to ensure success.

You might want to check out this website, which is a good site for tracking the fees generated by different projects. The competition in the crypto space is intense, but compared to traditional centralized businesses under the same conditions, I would choose to bet on crypto businesses.

Valuing Blockchain or DeFi Projects

So how do you value blockchain or DeFi projects? First, look at the revenue.

It’s not much different from evaluating software companies; I would observe current revenue, growth rates, defensiveness, and the strength of the community. If I believe the platform can continue to grow as quickly or faster than the entire crypto industry, it will catch my attention.

If they are all talk, boasting about what they are going to do but have done nothing for years and have no revenue, I would be very concerned.

When I invest in ETH, BTC, and other tokens mentioned above, I know the prices will fluctuate, but just like the early growth of the internet, sales cure all. With happy customers willing to pay for the goods and services provided by the application, and a community destined to grow and support it, I will be a long-term holder of your tokens, and I will also stake those tokens and possibly invest in LP with them.

Another Topic

One area where these DeFi companies are very different is that they are not based in the U.S. and are not limited liability companies. Their governance is decentralized, and no one has majority control (though founders certainly have significant influence). This is not only due to the spirit of decentralized autonomous organizations (DAOs) but also because of the absolute stupidity of our regulators, forcing some of the most influential and innovative entrepreneurs of this generation to operate their businesses abroad.

During the global pandemic, I did one Zoom talk after another, and when we look back at the pandemic 10-20 years from now, we will see that the businesses created in 2020 and 2021 will change the world. Among these businesses, DeFi and other crypto institutions are already firmly positioned at or near the top of the rankings.

Unlike the early development stage of the internet, where we nurtured and supported innovation and entrepreneurs, we have seen American politicians spewing nonsense about the innovations that crypto is fostering. Hopefully, this situation will change quickly, or we will lose the next great engine of growth that this country needs.