With more than $50 trillion in assets under management, the active investing industry affects us directly through savings or capital allocation across geographies, industries, or asset classes.
Due to its openness and transparency, DeFi can potentially render the current active investment industry obsolete, resulting in superior strategies and capital allocation. This will increase competition, options, and yield (interest/returns) for savers and investors.
This article describes the current state of active investing in DeFi and explains why DeFi represents the future of active investing. Please also refer to our earlier article titled Why DeFi is the future of passive investing.
How Active Investing is Currently Conducted
A fund manager (such as Fidelity or Bridgewater) engages in active investing when they establish a fund, which is a capital pool. The public and other financial institutions have access to the fund’s shares for purchase (such as pension funds).
The fund’s objective is to outperform the market over time by investing its capital in a diversified portfolio of assets according to a predetermined strategy. The fund manager achieves this objective by investing in assets, such as stocks, bonds, commodities, real estate, and derivatives, that it believes are undervalued and will provide a disproportionately high return on their level of risk. The value of the fund fluctuates alongside its underlying portfolio.
For the fund to outperform the broader market, the fund manager conducts research, verifies and reports on its strategy, and rebalances its portfolio by trading assets where it sees investment opportunities. Brokers, exchanges, clearinghouses, and custodians, who all charge a fee, execute these trades.
Active funds charge their investors significantly more than passive funds, typically 1 percent of the fund’s value per year, or 2 percent of the total value and 20 percent of returns in the case of some active specialised managers such as hedge funds.
How Investing Actively in DeFi Operates
Active managers in conventional finance can be replicated in DeFi by a decentralised application (dApp) known as a yield optimizer, such as Yearn Finance (although asset manager and yield farmer are also used interchangeably).
The objective of these decentralised applications is identical to that of active investment funds in conventional finance: to outperform the market. However, they are governed and execute their respective strategies in vastly distinct ways.
How a Straightforward Yield Optimisation dApp Works on the DeFi Blockchain
A token, such as USDC, is deposited by an investor into a decentralised application in exchange for a fund token, which represents a claim on a portion of the fund. The investor deposits are then used to acquire an underlying asset portfolio. Over time, the fund rebalances its portfolio by exchanging assets for better opportunities. As the value of the underlying assets rises, so does the value of the fund token, which the investor may redeem at any time.
Who Determines the Investment Strategy and Transactions of the Fund?
DeFi dApps are configured with automated, continuous investment strategies in lieu of a fund manager making investment decisions. In DeFi, this is only possible if a smart contract on a shared platform has direct access to assets and other financial products and services.
Frequently, a decentralised autonomous organisation (DAO) governs the selection and configuration of investment strategies. A DAO is a method for coordinating a group of individuals with a common goal using trustless and transparent tokens and smart contracts. Votes that are weighted in various ways are used to make decisions collectively.
Yearn Finance is one of the most prominent examples of DAO-based decision making, as its community votes on each fund’s investment strategy and allocation. To maximise yield, new investment opportunities are regularly discussed. Depending on the risk tolerance of the fund, these opportunities can consistently yield between 5 and 30 percent annually.
Numerai, a decentralised application for yield optimization, is another example. Instead of directly voting on which assets to acquire, members of this community vote on artificial intelligence algorithms and data sources to optimise trading and capital allocation. Fully decentralised, Numerai can recruit some of the world’s best data scientists, rewarding them for the best algorithms and data. Since 2021, the best Numerai funds have generated returns in excess of 800%.
Where does the Yield Originate?
Today, yield in DeFi typically derives from one of the following three sources:
If the portfolio of tokens underlying the security appreciates in value, price fluctuations may result in a yield (which can include derivative tokens that rise as other tokens lose value).
When a protocol or decentralised application mints new tokens as a reward for a specific action, these tokens are newly minted. A decentralised exchange may mint governance tokens to compensate liquidity providers. Similar to dYdX, dApps may offer retroactive airdrops of governance tokens to encourage the use of their dApp. To encourage token holders to stake their tokens in a proof-of-stake security system, Layer 1 protocols mint new tokens. Even though it may appear as though money is being created out of thin air, these tokens have real utility and are valued by the market.
Those who use a particular product or service may incur fees and interest. For instance, the Curve DEX levies fees on CRV governance token holders. Moreover, holders of liquidity provider tokens directly collect fees from users who trade with automated market makers. Those who lend assets through decentralised applications such as Aave and Compound receive interest payments from borrowers.
Why DeFi is Beneficial to Active Investing
Active investing in traditional finance and yield optimization in DeFi share three components: an investor, a fund manager, and a trading and settlement procedure.
All three components of a DeFi ecosystem reside on the same public, decentralised ledger, as opposed to the closed and opaque ledgers of numerous financial institutions. This results in:
A financially open and transparent system in which anyone can participate and construct; and
Automated transaction processing increases efficiency, decreases costs, and reduces entry barriers for new projects.
Openness leads to better strategies.
In DeFi, fund managers are replaced by decentralised, self-executing applications. Through the governance and incentive mechanisms of a DAO, anyone can create their own fund or contribute to the strategy of an existing fund. Because anyone with internet access can contribute, DeFi yield optimizers have access to a much larger knowledge base than traditional fund managers! The Annual Millennium Prize is an illustration.
Moreover, instead of data being siloed and hidden within the ledgers of individual financial institutions, the transparent nature of decentralised public ledgers provides a rich and reliable dataset upon which investment strategies can be developed. Due to the availability of all information, “cooking the books” will no longer exist. Everyone is required to be competitive because everything is visible.
Composability Induces the Multiplication of Innovation
In conventional finance, active investment products and services are coordinated by a series of siloed institutions. Because each institution owns its own systems and data, it is difficult to build on top of one another, resulting in a great deal of waste as the same products and services are replicated a hundred times.
As all dApps in a DeFi ecosystem exist on the same distributed ledger, products and services can be seamlessly combined. If a DeFi project develops an optimal algorithm for switching capital between various liquidity pools, that algorithm may be utilised or improved by anyone.
This enables the layering of an infinite number of products and services, forming a chain of tokens and decentralised applications to which anyone can contribute. How can conventional finance’s closed and compartmentalised products and services compete with the innovative capabilities of a self-evolving, open yield optimization machine?
Automation and Compositional Capability Provide Instant Liquidity
There is no need to wait two days for a multitude of intermediaries to settle the trade behind the scenes because everything is recorded on the same ledger in DeFi. This allows DeFi yield optimizers to allocate capital instantly to the location with the highest yield, resulting in drastically reduced fees, increased participation and access for all, and capital that is automatically programmed to seek the highest returns.
What Does the Future Hold?
The vast majority of DeFi’s yield is currently derived from the closed loop of cryptocurrencies, which is still heavily driven by speculation. The yield is not derived from tangible assets, such as rental income or company dividends.
DeFi has thus far demonstrated a more efficient and optimal asset allocation paradigm, although it is still early. Assuming capital seeks the greatest risk-adjusted returns, it is only a matter of time before $400Tn of real-world assets are represented by tokens and managed by DeFi.
Hire a reputable Defi development services provider today and start earning profits.