Sushi and Bancor, the tables have turned, time to respond, quick …
Uniswap dropped a bombshell v3 Alpha Leak on March 23 2021 that flips the conversation of a once dominant, but observant, yet defensive industry player to now the industry innovator. It’s like Uniswap was the faux stalking horse, no pun intended for unicorns, waiting for all the major protocols to release their updates, before setting the new industry standard for 2021 especially with ETH 2.0 (maybe) around the corner.
In this article, we will discuss the following:
- Uni v3 Update
- Where is Sushiswap Today and What’s the Roadmap?
- Where is Bancor Today and How is it Differentiated?
- Tokenomics and Valuation
Quick primer on Decentralized Exchanges (DEXes)
- Enables P2P exchange of cryptoassets between two parties through a “liquidity pool”.
- Eliminates pain points with traditional order books in centralized exchanges chiefly: slippage cost (HFTs/Flash Boys), custody (Robinhood), geography (U.S. retail investors cannot trade FX) etc.
- Traditional order books match individual buy and sell orders
- DEX have a liquidity pool with a predetermined price expressed through a ratio between two cryptoassets. This is commonly referred to as X* Y= K.
- If this ratio is broken, arbitrageurs are incentivized to balance them. This data is realized through price oracles. Think of price oracles as an API that feeds information to the DEX, but is important to authenticating and enabling smart contracts.
- Users are incentivized to stake liquidity in these pools. Often, they will receive the native token of the decentralized exchange which promotes both 1) governance voting rights and 2) value accrual to the token through transaction fees of ~0.1 to 0.3% (depends on the protocol)
- V3 Development Leads Industry Standard.
- Capital Efficiency is the “Buzz” Word. But Should be “Customizability”
- New Staking Mechanism Unleashes ROI with Governance Upgrade.
- Mind/Market Share = Undisputed Leader.
- Conclusion: UNI is a Must Own on Any Portfolio.
Uniswap is the primary (dominant with ~60% market share) altcoins issuance and trading platform across DEXes. It has enough mind share today that enables it to perform accretive upselling/cross selling (i.e. NFTs, aggregation) if it so choose to widen its product offerings.
Uniswap has prided itself of being one of the most cost efficient platforms across DEXes. These components deliver both compelling functionality and economics to retain users (or avoid churn) despite DEGEN APY offerings from smaller competitors who are playing a Customer Acquisition Cost (negative FCF) playbook that is fueled by VC money. It’s volume and daily active users are pretty consistent across all different classes of investors from institutional (whales) and retails.
Uni V3 immediately flips the conversation from conservative, market-share “harvester” to industry innovator with the introduction of Concentrated Liquidity and Flexible Fees. It is more “like to like” with traditional order books. But, with the benefits of decentralization without sacrificing the performance of a Robinhood / Schwab / E-Trade / Coinbase. There is much greater “capital efficiency” deployed within a band of prices, enabling “take profits” and “stop losses” to minimize impermanent losses across X*Y=K.
One thing that I really like as a more traditional “boomer leaning” investor is the business license in V3 that avoids forking for 2 years. This is essentially a type of “regulatory moat”, but I liken it to intellectual property and I believe Uniswap should be rewarded with this advantage for all the capital and brainpower invested in creating a world-class exchange.
With everything developed in V3, which we will cover in more detail below, one must wonder whether Curve’s (CRV) value proposition is gone. This is no hot take. CRV might be dead if it doesn’t pivot quickly.
One immediate criticism of Uni is that it could be vulnerable to aggregators such as YFI as non-crypto-natives could rush into the market, using aggregators, and then deploy liquidity equitably across major protocols, without considering fundamental benefits such as security, privacy, or fee efficiencies. I wonder if the development of these new strategies would lead to Uniswap developing its own YFI to yield farming across all other protocols when Uniswap provides the customizability according to the investors’ risk appetite.
There are also regulatory risks around the corner as the FATF (Financial Action Task Force) could implement KYC rules on DeFi platforms despite the lack of a central authority on these platforms. This would substantially raise the operating expense and might affect the token value either economically or through headline risk.
Uniswap V3 — Quick Takes
Concentrated Liquidity and Capital Efficiency
One of the criticism of AMMs is that the X*Y = K is deployed across all price ranges above $0. This makes it inefficient because there is no targeted deployment in the strategy. For traditional order books, you can set your targets of when you want to take profit or stop loss. In other words, you have full discretion over how your capital wants to be deployed. This also helps minimize impermanent loss (not totally fixed) for more volatile strategies such as USD pairs.
V3 kind of solves this by introducing multiple LP strategies in which capital is activated across a specific band of prices. Uniswap claims this is more efficient, but that’s because they’re just reducing the width of the band ranges. But, really the efficiency comes from customizability. Uniswap also claims that this would enable higher fee generation to the native token, which is honestly great for investors who staked Uni.
A confusing part of this is that Uni claims the new LP positions are considered NFTs. I wonder if the Uniswap did this on purpose because of all the hype surrounding digital art? Or they received enough data and real-time examples especially from NFT music that justifies the use case.
Originally each LP token in V2 is fungible and identical to each other. Within new LP strategies across customized price bands, these LP tokens are no longer the same as each other, so therefore by definition they are no longer ERC-20 tokens.
The concern is composability and this unfortunately makes Uniswap a more closed-loop system. You wouldn’t be able to necessarily execute Aave flash-loan arbitrage as easily as you would in V2 (please correct me if this is not the case). On the other hand, if Uniswap wants to upsell/cross-sell and introduce features that its competitors have, then it might make sense for this strategy.
Flexible Fees and Structure
There are 3 different fee tiers per pool: 0.05%, 0.30% and 1.00% which depends on the volatility of the pair. The most aggressive and illiquid ones are prone to higher volatility and earn transaction fees of 1%. This is perhaps to compensate for impermanent losses.
There is also new developments on the optional 0.05% fee allocated to the governance treasury. Before it was set across all tokens. Now it is set on a per-pool basis between 10% and 25% of LP fees. This makes it more confusing to calculate the value accrual to Uni token because now we need to take into account all the pools available according to the governance fee set. However, this is definitely a more equitable fee mechanism that rewards higher volatility strategies with greater fee generation (I assume).
Optimism and Gas Fees: Sometime later in the year, Optimism, a Layer 2 scaling solution, will be rolled out on Uniswap. This is interesting because there’s this constant divergence of opinions between Optimism and ZK Roll Ups. I wonder whether Uni will set the standard here. Ideally, these development should lead to lower gas fees… But not too sure here since 1) I’m not sure if creating more LP strategies with customized price ranges would actually incur more gas fees and 2) gas fees are already industry low for Uniswap.
Oracles: Time Weighted Avg Price (TWAP) oracle improvements. This improves functionality.
License: Business Source License 1.1 which doesn’t allow V3 to be forked for up to two years. I view this as an optimistic development akin to intellectual property protection.
- No Longer Viewed as Just the “Vampire Attack” for Nefarious Uses.
- Yearn + SBF = Diversified Financial.
- Management Change Often a Huge Catalyst for Investments.
- Leader in Product Innovation in 4Q20/1Q21.
- Must Continue Development Path or will be “Lyft to Uber”.
Sushi is considered the #2 DEX platform with ~15% market share that peaked at 25% in early January 2021. Compared to Uniswap, Sushi’s volume and trading profile is more concentrated with large bag holders (whales). One might misconstrue this and say that this just diamond hands from VC investors, but view this more as investors diversifying their bets across DEXes.
Sushi had a checkered past. It’s infamous for its controversial fork of Uniswap utilizing a “vampire attack” to suck out Uniswap’s liquidity ($1B in less than a week) by introducing a native token Sushi. This was when Uni didn’t have its own token and retailers simply rushed to DEGEN during DeFi summer.
Afterwards, Sushi was acquired by Yearn, which was game changing (face lifting). It really reinvested itself to becoming a community-driven alternative in DEXes. A lot of its developers are community based and anonymous, but passionate about building out product developments on Sushi. I view this as a Reddit community building out the next generation tools in finance. This fervor is enabling it to roll out features including: Deriswap, Miso, Mirin, Bentobox etc.
These features have attracted liquidity around Sushi’s ecosystem. The driving force really is the active community hyping up these new product innovations. Still, this is diametrically opposite of Uniswap’s development path. For example, Uni is focusing primarily on ETH compatibility whereas Sushi wants to be ubiquitous: Polkadot, THOR, BSC, Solana etc. This also naturally creates the iOS vs. Android, Apple vs. Samsung, Uber vs. Lyft — Rule of Two, technology narrative, but applied in DeFi.
Many investors over the past year have completely missed out on Sushi because of its controversial launch. Despite the involvement from Yearn, there was still significant doubt behind the legitimacy of this project. If Sushi were a stock, it would probably not get a second chance at life. This is what makes the cryptoasset space so unique! That said, Sushi is legitimizing itself and price/valuation is often the best sentiment. In addition to Yearn, I think SBF’s involvement as a multisignature member and one of the largest investors of Sushi also helps with its trajectory such as integrating the project with Solana.
In fact, I believe there is a path to which Sushi could overtake Uniswap. I think YFI would need to play an important role marketing itself as the first go-to touchpoint to retail investors as has Coinbase/Binance done for on-ramping individuals to cryptocurrency trading. This could develop into some form of preferential volume funneling down to Sushi’s liquidity pools.
A few highlights on product developments:
MISO — Or “Minimal Initial Sushi Offering” is a token launchpad similar to Coinlist. Listing fees will be split 70% to go directly to Sushi holders, 20% as UI incentive for launchpads to use MISO / integrate with other projects, and 10% as developer fee.
Bentobox — Is a lending platform in which anyone can create a pair and others can borrow or lend against that pair. Each pair is isolated vs. against a variety of collateral assets such as Aave or Compound. It is similar to Bancor’s Vortex in that it enables margin trading strategies so DEGEN’s can lever up on LPs.
Deriswap (Sushi V2) — New platform launched in Nov 2020 introduced by Andre Cronje that has trading, lending, futures and options in a single platform.
** Notice how quickly Sushi pushed new product developments against Uniswap. The energy behind the development community is one of the distinct advantages of Sushi protocol
Mirin (Sushi V3) — This is a proposed upgrade that includes customizable LPs where CEXes are interlinked, providing liquidity to Sushi and becoming liquidity providers. These are called “SubPools”. There is also a Uni V3/CRV type model being proposed that enables it to customize price ranges. There will also be features that address impermanent loss protection which are being developed by the Yearn team.
- Earliest DEX, but Lost First Mover Advantage.
- But, v2.1 Addresses Major Pain Points.
- More Incentives with BNT. AMM + NXM (Insurance) + Loyalty.
Bancor was first launched in 2017 as one of the largest ICOs. It was the FIRST AMM built on Ethereum. It is the Grandfather of DEXes.
Currently, it hold single digit market share, but is still a Top 5 DEX. V2.1 rejuvenated interest on the platform. When looking at the TVL, there’s no coincidence that the features of V2.1 enabled Bancor to carve out its own differentiated advantages. V2.1 was innovative in that it tackled major pain points in DeFi including token pair requirements (i.e. need both ETH and DAI) and impermanent loss.
Bancor struggled with adoption at first. It required a BNT token to provide liquidity to every liquidity pool, making it extremely capital inefficient, burdening users with economic friction. In V2.1, that is no longer a requirement. Instead, each time a LP contributes a single trading pair in a liqudity pool, Bancor would mint new BNT to match it as a form of “co-investment”. This is quite unique as it builds “skin in the game” for BNT holders. At the same time, this is perhaps why BNT TVL shot up in the first place…
Its latest functionalities address impermanent loss by implement a Nexus Mutual type of issuance mechanism that protests against losses. Essentially LPs are insured by the # of days they stay invested up to 100 days (100%). However, this insurance mechanism is only activated after 30 days.
Bancor also released a product called Vortex which allows LPs to double dip. Essentially, when LPs deposit BNT, they receive vBNT (Vortex BNT) which could be used to purchase another asset. When unwinding that trade, users need to buyback in vBNT to withdraw the deposited BNT. To make the trade work, investors need the following to happen:
Tokenomics does remain a concern after implementing these features. There is no theoretically limit to the supply of BNT as it is dynamic. Co-investments are capped as a result of this supply model. But, I could potentially see a scenario in which the reverse could be voted on to boost adoption.
Also LPs are exposed to the fluctuations of BNT, which could be problematic in impermanent loss scenarios. If we are in a draconian market condition, LPs could be left holding large amount of BNT that might be worth a lot less due to the minting process.
Below is a really solid short video from @DeFiFrog explaining Bancor V2.1.
Tokenomics and Valuation
- It is important to show both circulating and diluted because of inflation mechanisms. Each protocol has their only emission schedule which is provided in their websites. We need to know the inflation rate or management has full discretion to increase the total supply which causes dilution to existing token holders.
- Total Value Locked or TVL, is the ability of the protocol to extract value from token holders. It is useful when tracked over time because capital essentially has no loyalty. Uni has a distinct advantage because of its mindshare whereas Sushi used to have a ratio above 1, but is losing TVL recently relative to its market capitalization. I like to track TVL on a Week over Week basis as a trade strategy. I found it useful as a lagging indicator to price action.
- Volume enables us to get a sense of how revenues are generated on the platform. There are better way to extract volume and I prefer to do it on a month over month basis. However, it is extremely difficult to predict volume going forward. Typically, I would try and sensitize this over a growth metric when I “fit” a valuation.
- This can translate to a more traditional Enterprise Value / Sales metric used in TradFi valuations. Coincidentally, the TradFi exchanges’ comp to DeFi matches up quite nicely. UNI is like ICE in terms of market share and recognition. Sushi/Nasdaq sometimes play second fiddle, but are nonetheless still important. Bancor/CME have differentiated offering versus their peers. These are loose anecdotes, but providing some context here is helpful to explain these valuation discrepancies.
Note that this is not an exhaustive list of metrics available when analyzing DeFi projects, but serves as a solid basis translating the operating metrics into a simple valuation framework.
I thought Eloise article on P/E metrics for DEXes (this model is more similar to P/Sales) is very helpful. The author has a spreadsheet, which I thought was fantastic. I really like how this person used Google Sheets and built their own functions to actively refresh the queries.
I believe crypto markets are becoming more efficient than before as great projects will always trade at a premium relative to its competitors. As we see in the valuation analysis, I think its no surprise that the project’s features are properly reflected in how the market is valuing them.
I think with Coinbase IPO coming around the corner on April 14th 2021, it will be a huge catalyst in terms of unveiling what public markets (traditional investors) are valuing cryptoasset exchanges. Given how things are trading relative to traditional players, I think valuation is appropriately reflected.
That said, I am very excited to see how Sushi will respond to Uni’s V3. I think each of these projects have key differentiating factors that will correspond to each investor’s profile and appetite for risk. I also think that the community aspect is something I underestimated and underappreciated throughout this process — as yours truly was also one who totally missed out on Sushi.
Disclaimer: The following is designed for informational purposes only. This is not investment advice.