Digital Asset Fundamentals

Apr 20, 2023

Premise:

A common misconception about digital assets (‘tokens’) is that they are all currencies like Bitcoin. Many tokens grant holders access to ownership of the underlying project and collect cash flows.

One of the most innovative features of blockchain technology is the flexibility of tokens. This feature has catalyzed the virality of the industry. Projects can design tokens that function like equity, debt, currency, or other structures to incentivize users and investors in novel ways.

Token design can vary significantly between projects. Some of the most important due diligence items on an investor’s list are to understand what cash flows they are entitled to as token owners, what type of dilution they should expect, and how key governance decisions are made.

Token design is typically codified through open-source code, allowing sophisticated users and investors to audit the token without relying on third parties like regulators or auditors.

Summary:

We describe a number of different protocols that generate cash flows, and discuss their basic value accrual mechanics in order to give readers a sense of how tokens can be productive assets. We will also provide simple valuations to show that such an exercise is possible with certain crypto assets. However, these valuations should be considered illustrative and are not investment advice. They do not reflect our internal valuations, which encompass a much more nuanced view of industry dynamics and cash flow projections.

We chose to write about the selected protocols because they serve as templates for many other projects. Blockchain is open source so new projects are often derivatives of previous ones. For example, nearly every decentralized exchange imitates Uniswap to a certain degree. Therefore, consider these protocols explanatory examples instead of investments.
Data cited in this piece is as of April 2023.

Table of Contents

Uniswap – Decentralized Exchange
GMX – Decentralized Futures Exchange
Aave – Decentralized Lending

1. Uniswap – Decentralized Exchange

What is it? Uniswap is a decentralized exchange (‘DEX’) that allows users to buy and sell tokenized assets.

What is the model? When a trade occurs, the exchange takes a fee (approx. 30bps). Part of that fee is programmatically distributed to token owners (like a dividend). The rest of the fee is distributed to liquidity providers. For Uniswap, the largest decentralized exchange, all trading fees are currently going to liquidity providers and none go to token owners. However, the token owners have a right to vote on the ‘fee switch’ that will divert a portion of the liquidity provider fees to token owners.

What are liquidity providers? DEXs do not have order books. Instead, a DEX is managed through liquidity pools — a reserve of two assets that you can trade with directly. As mentioned, a user pays a small fee to make a trade, typically ~0.30%, and that fee is split between token owners and the users who supplied liquidity to the pool. So these liquidity providers contribute an asset and receive fees for making the contribution. They still own the asset and the asset is never used as collateral.

Can you provide an example? Consider the ETH-USDC pool on Uniswap. USDC is a stablecoin pegged to the US dollar and backed one-for-one by the company Circle. ETH is the Ethereum token. Say that I own ETH and I want to make some yield on my asset. I can decide to deposit 1 ETH into the ETH-USDC liquidity pool and in exchange, I receive proportional ownership of the liquidity pool. Every time someone makes a trade, I receive a portion of the ~0.30% fee paid. You can see pool fees here.

Does Uniswap make money? Uniswap generates large revenues but no profit. It uses trading fees to incentivize liquidity providers and has grown to become the largest decentralized exchange. As a result, you need to believe that token owners will vote to turn on the fee switch and assume a take rate for token owners versus liquidity providers.

Does Uniswap lose money? Uniswap does not lose money. Uniswap does not have any costs borne by the token and is simply code that exists on the internet. All revenue goes to liquidity providers to ensure the exchange is as large and efficient as possible.

Here is an illustrative valuation. Uniswap is the market-leading DEX and commands over 60% market share. The protocol generated $1.7bn of volume in 2021 and $843mm in 2022. Let’s assume a cyclically adjusted revenue number between 2021 and 2022, and assume that token owners decide to direct 10% of protocol revenues toward themselves. Further, let’s give Uniswap an earnings multiple of 25x as the leading player (68% market share) in a key category. These illustrative assumptions get us a valuation of $2.9 billion, which is lower than Uniswap’s current market cap of $6.3 billion. In this sense, the token space is just like the stock market — some tokens are overvalued, and some tokens are undervalued. We are trying to make the point that thoughtful analysis can point you in the right direction.

Exhibit A: Decentralized Exchange Market Share (% of Total Volume)

Source: Theia Research, Token Terminal, Ethereum blockchain

2. GMX – Decentralized Futures Exchange

What is it? GMX is a decentralized futures exchange. Consumers can go on GMX to initiate a long or short position on ETH, for example. GMX uses a dual-token model: GLP is the token given to liquidity providers and GMX is the token that controls governance and cash flow from fees. Platform fees are split 70-30 between GLP owners (liquidity providers) and GMX owners. GMX token owners received $33mm in dividends in 2022 and are projected to receive more than double that amount in 2023.

How does it work? GMX is essentially a pool of assets that traders can trade against — if someone wants to go long 5x ETH with 1 ETH of collateral, then the GLP pool (liquidity providers) will set aside 5 ETH (the most the trader could win), and if someone wants to go short 5x ETH with 1 ETH of collateral, then the pool would set aside the USDC equivalent of 5 ETH (the most the trader could win). GMX has taken market share from centralized exchanges like Binance and FTX, which provide similar leveraged trading products.

This seems like a thoughtful risk model. What is the downside? The protocol cannot support net open interest beyond the assets available in the liquidity pool. Therefore, size and scale are limited by the size of the liquidity pool. This gives large players like GMX (which currently has a $680 million liquidity pool) an advantage over new entrants but a disadvantage versus large centralized exchanges like Binance.

What is the revenue model? The liquidity pool synthetically takes the opposite position of the trader, such that any profit made by the trader is a loss for the liquidity pool and vice versa. Traders pay 0.1% fees on their notional size when opening or closing a position. Additionally, they pay a borrow fee every hour.

Who gets the revenue? Liquidity providers receive 70% of revenue and token owners receive 30%. The fees get paid out in ETH. Currently, liquidity providers earn a 25% APR and token owners earn an 8% APR. Remember the GLP owners exclusively bear the risk that traders could earn profits against the house, while the GMX owners only benefit from fee-based cash flows regardless of trader performance.

Is this a durable business model? Decentralized derivatives exchanges are likely to be winner-take-all or winner-take-most, similar to decentralized spot exchanges, as more trader activity attracts higher liquidity and more liquidity leads to better price efficiency. Decentralized derivatives exchanges are still quite small relative to the overall crypto derivatives market, and they are set to benefit from the collapse in trust at centralized exchanges.

Here is an illustrative valuation. GMX is one of the market-leading derivatives exchanges with 20% of the market share. GMX owners went from receiving a $4 million dividend in 2021 to receiving a $33 million dividend in 2022, and the business is on track to deliver $62 million in 2023 assuming no additional growth. Let’s assume 20% additional growth in 2023, which doesn’t seem unreasonable, and a 25x multiple for best-in-class protocol in a growing segment of the market. This would result in a valuation of $1.9 billion, which is substantially higher than GMX’s current valuation of $1.2 billion. This is an illustrative valuation and does not fully explore all of the nuances around investing in GMX, but hopefully, it makes the point that there are assets with strong fundamentals in the Ethereum ecosystem.

Exhibit B: Decentralized Futures Market Share (% of Total Volume)

Source: Theia Research, Token Terminal, Ethereum blockchain

3. Aave – Decentralized Lending

What is it? Aave is a decentralized protocol that enables the deposit and borrowing of tokenized assets. It aims to create a decentralized alternative to collateralized lending institutions.

How does it work for depositors? When a depositor places ETH into an ETH pool on Aave, they receive an interest-bearing token (called “aETH”) in return. This token accrues interest over time and can be transferred within the Aave ecosystem. To withdraw their original ETH plus the accumulated interest, the depositor must return their aETH token. All this is done using smart contracts.

What about for borrowers? During the loan period, borrowers can deposit collateral in any asset to borrow ETH or other tokenized assets from a pool. The collateral value must be greater than the borrowed amount (over-collateralized) and borrowers can keep the borrowed asset as long as the collateral's value stays above the liquidation level.

What happens if collateral declines in value? If the value falls below the liquidation level, the protocol automatically and immediately liquidates the collateral to bring the loan back above the liquidation threshold.

How did it do in 2022 with the massive volatility? This feature allowed AAVE and similar lenders to perform smoothly through the large negative price shocks throughout the past year. Because loans are over-collateralized and liquidated so efficiently, there was no contagion or asset runs caused by the lending protocol.

What is the revenue model? Aave charges a variable fee (of at least 10%) on interest that the protocol generates for lenders. This fee is collected by the AAVE DAO, where it is used to support and grow the protocol. Token owners can vote at any time to distribute fees directly to token owners.

Here is an illustrative valuation. For the sake of this valuation, let’s imagine you believe that decentralized finance has a real future in global capital markets. Aave is the market-leading collateralized lending protocol with 55% market share, and the protocol has good prospects after demonstrating its resiliency during the 2022 crash. Most large investors wouldn’t think of putting large amounts of capital at any untried protocols. The company earned $37 million in 2021 and $21 million in 2022, so you pick a midway earnings figure of $29 million for 2023. However, your belief in the growth of decentralized finance markets means you are willing to pay 35x earnings. This would give Aave a valuation of $1 billion, which is still below its current market capitalization of $1.3 billion.

Exhibit C: Decentralized Collateralized Lending Market Share (% of Total Volume)

Source: Theia Research, Token Terminal, Ethereum blockchain

4. Concluding Remarks

We wanted to walk you through a few of the most well-known protocols in decentralized finance in order to dispel the common misunderstanding that there are no fundamentals in blockchain investing. However, valuing and forecasting blockchain asset performance has unusual exchange rate exposure. If the value of ETH fluctuates, the USD value of the cash flows will also change dramatically. For this reason, we believe that considering assets relative to the native currency (in this case, relative to ETH) is the best framework for fundamental investors.

Unlike the stock market, many of the most valuable blockchain protocols are not stable or safe investments. We have found that large, well-known protocols tend to be fairly valued or overvalued. In our opinion, the most undervalued opportunities live within the small caps, frontier markets, and investments that require a fair amount of technological expertise.

Disclosures:

This presentation (“Presentation”) has been prepared for informational purposes only.

At the time of this writing, Theia Blockchain LLC (“Theia”) holds a position in GMX. While Theia does not hold positions in Uniswap or Aave, Theia frequently uses both applications to trade, borrow, and lend, among other activities.

While the information provided herein is believed to be accurate and reliable, none of Theia, or any of their respective affiliates or representatives or any other person makes any representations or warranties, express or implied, as to the accuracy or completeness of such information. No representation or warranty is made as to the continued accuracy of this information after the date of this Presentation. This Presentation does not purport to contain all of the information that may be required to evaluate a potential investment with Theia described herein and any recipient hereof should conduct its own independent analysis of the data contained or referred to herein. Only those representations and warranties contained in a definitive documentation under which an investor will invest in an investment vehicle, if any, shall have any legal effect. These materials are not intended to be and do not constitute a recommendation to any person or entity as to whether to acquire or dispose of any securities of a fund managed by Theia or any other person. In furnishing this Presentation, Theia does not undertake any obligation to update the Presentation or to provide the recipient access to any additional information.

This Presentation is not an offer to sell or a solicitation of an offer to buy any security of a fund managed by Theia, or any person. An offering of the security described herein, if any, will be made pursuant to a definitive offering documents and the information contained therein together with a subscription agreement and related documentation will supersede the information herein in its entirety.