Mark Cuban on crypto valuation and the beautiful wisdom of yield farming and providing liquidity

The billionaire owner of the NBA's Dallas Mavericks uses clear and concise language to educate the public on the basic operating principles of blockchain networks and DeFi protocols, and why they are businesses that will change the world.

Written by: Mark Cuban, owner of NBA Dallas Mavericks Translated by: Perry Wang

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

Let me start by saying this: This is not investment advice. This is just my personal opinion on the market, and I may be wrong about some things, or those opinions may change by the time you read this.

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 have 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 use blockchain and smart contracts to host and program their business processes.

Let me give you an example of DeFi and blockchain projects that I have personally invested in and how I view their businesses:

Polygon/Matic Business Model

Their business is very simple, but very difficult to execute.

Their job is to provide tools so that transactions using Ethereum/Solidity smart contracts, which are primarily built by external parties, can be conducted as quickly and cheaply as possible while still delivering more benefit than the cost. To do this, they charge a fee on each transaction. This fee is paid in Matic tokens. Just like you go to a Dave & Buster's and buy tokens to play games, you must buy Matic tokens to use Polygon's network and smart contract features.

However, blockchain-based businesses are quickly taking a different path from traditional software, and that difference is precisely the wisdom of crypto businesses like Polygon/Matic and its competitors, from BTC to ETH and even Dogecoin.

Every enterprise or financial software service or application has cloud computing and operating costs that are growing wildly, often faster than its revenue. It’s no surprise that software companies are raising massive amounts of money for exactly this reason, so that “software eats the world.”

A business like Polygon has very different funding needs. Why? Because their business is not built entirely on a cloud computing platform like Amazon Web Services (AWS), but rather decentralized (I won’t argue about the definition of decentralization, or security, or speed here). The foundation of decentralization is built on independent parties, usually called “miners” in proof-of-work (PoW) networks like BTC, or “validators” in proof-of-stake (PoS) networks like Polygon/Matic (or other names), who invest their own funds to provide computing resources to support the network platform.

clever!

Any other business would have to raise a lot of money to host their own servers, or to pay for cloud computing costs, which can be very expensive for compute-intensive applications, and equally expensive for applications that require scalability and throughput, plus they would have to hire full staff, capital expenditures to support their efforts, and so on.

In the decentralized crypto world, these third parties (miners, validators, etc.) provide the computing power to effectively run the platform in exchange for rewards in tokens within that network.

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

Even more ideally, platforms like Polygon would allow almost anyone to stake their Matic tokens alongside these validators and share in the validators’ profits!

There are many reasons why validators like stakers, but they are willing to share their profits with the latter because the more the latter stakes, the more rewards the validator can get. This is a symbiotic relationship that also helps to protect the security of the network.

Why is this smart? If Polygon or any of its competitors had taken the traditional, centralized corporate path, they would have controlled and owned everything and would have had to raise millions of dollars, and possibly more. Instead, they created a token at near zero cost and distributed it according to the token economics they defined for the community (and any changes required community approval). Everyone involved benefited from this.

The craziest part is that because these businesses are token-driven, costs are distributed, and operations are decentralized, their operating costs are much lower than traditional centralized businesses. Therefore, in the case of crypto-based businesses competing with traditional businesses, crypto equity may have a clear capital cost and operating cost advantage. Many financial institutions should pay attention to this phenomenon.

How will Polygon build its transaction volume and fee revenue? By having an application that is widely used and has high enough usage. Every platform, whether it is an exchange or a blockchain, is racing to achieve network effects. The more users they have, the more fee revenue they have, and the more fee revenue they have, the more money they can invest in acquiring users. The more users it has, the more fees it has to distribute, and the more valuable its token becomes, and so on.

DeFi Business Model

One of the ways Polygon is trying to achieve network effects is through DeFi-based businesses (here’s a link to an excellent explanation of DeFi).

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

Think of Dave & Busters tokens. When you buy their tokens, you can only use them in their mall, you can't use them in other places of business. And one of the basic businesses of DeFi is the ability to exchange the tokens of one project for the tokens of another project. That's why they are called exchanges. If the exchange is decentralized, it is called a "decentralized exchange (DEX)".

Examples of this type of DEX I give are Zapper.fi (not really an exchange, but the data tracking and token swapping features are amazing, I’m an investor so I had to mention it!) as well as quickswap.exhange, bancor.network, uniswap. They are all basically in the same business, token exchanges. Every time someone exchanges one token for another, they make money from the transaction fees. But that’s not even the best part.

To be in the currency exchange business, or even in the banking business, you have to have enough financial depth to be able to offer the various currencies and services you need, and you need to be able to hedge against the risk of pricing fluctuations between currencies. If you want to do this business on a large scale around the world, it can be very expensive and risky.

This is not the case with DeFi exchanges. The reason why running a DeFi exchange is so much better than this and any type of traditional centralized finance business is that it is not the business owners, investors and their creditors who need to fund all the transactions to happen, but rather liquidity providers (LPs) who fund them. (This link is an explanation of this).

I am a small LP on QuickSwap and I provide two tokens (DAI/TITAN) to enable QuikSwap to provide exchange between the 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 each token swap amount, and as of this writing, my initial return (from trading fees alone) is an annualized rate of return of approximately 206% (based on fees earned in the previous 24 hours. This return percentage will fluctuate during this period depending on the activity of trading on the protocol.)

But the cool thing is that I didn’t get any additional bonus 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 fund pool, I took 100% of the fee income. In each fund pool, LPs get a certain percentage of the fee share based on the percentage of liquidity they provide.

Therefore, since I provide the required liquidity for the TITAN and Quickswap businesses, 0.25% of the exchange volume between the two tokens will be distributed to me as a financial reward. As long as I continue to get good returns, I will continue to invest (volatility will cause market losses). If the returns are poor, I can withdraw my funds immediately (some platforms have a shelf period or impose certain penalties). With enough LPs, the capital efficiency of the exchange will be much higher than similar traditional exchange businesses, and as an LP, I can also make some money personally!

Additionally, exchanges often offer additional reward tokens to LPs. I also provide liquidity on the Bancor network and get rewarded in BNT tokens. They allow LPs to provide one-sided or two-sided liquidity and give generous returns in the platform's BNT tokens to incentivize the use of their platform (a reference statement, it is basically the protocol that invented DeFi) and prevent token price volatility.

Bancor’s returns may not be as high as other platforms, but they are a much easier platform to use and do a good job of protecting LPs and retaining their liquidity.

One thing to note is that the competition between exchanges is brutal. The economic rewards have to be high because it is really a hands-off market. The competition for LPs is fierce. If you choose to be an LP, you must proceed with caution, unless you are very experienced in being an LP, make sure you do your homework first. You want to make sure that the platform is running a legitimate business.

Let's look at another DeFi company: AAVE. AAVE, like its competitor Compound, looks like a bank. But it's not. 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 holdings for your assets, no forms to fill out, and no credit ratings involved. Everything is controlled by smart contracts, it's fully automated, you don't need to get approval from anyone, and it takes only minutes to get a loan. This is called "permissionless." This approach is the future of personal banking companies.

What is Aave in business? They make it easier for people to borrow and lend. Every time someone deposits tokens, the depositor is awarded a certain number of Aave tokens that reflect their share of the interest earned on the entire pool of depositors, and sometimes Matic tokens as a means of incentivizing users to use Aave on the Matic network, rather than Ethereum or other networks.

Every time a borrower borrows, they pay the interest rate set by the algorithm. What’s really different is that sometimes the borrower gets paid, too. Because Aave and similar platforms want you to use the platform early and often, especially when it’s still a startup and trying to attract depositors, they reward their users.

Of course, Aave charges a very small fee on each transaction, and they also make money on the spread of loan interest that is not distributed to depositors. I should add that the underlying blockchain network, whether it is Ethereum, Polygon/Matic or any other network, also charges fees on each transaction. (This is why they often fund rewards for users).

Now let’s talk about this in a specific context. These DeFi protocols act as businesses that automatically provide deposits and borrowing, matching services, with no buildings, no huge departments, no branches, no paperwork, no approvals, no confirmation calls. What matters most to Aave and its competitors is the volume of transactions. They can create wealth for depositors and token holders because their overhead is tiny compared to their revenue. Automated financial market makers are much more capital and operationally efficient than similar traditional companies. Banks should be afraid.

Come, let's review.

Basically, traditional centralized businesses first need to raise money, start a business, and then hope to make enough revenue to return enough capital to their investors and/or founders to keep them happy.

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

What I want to discuss is: What makes the cryptocurrency world so unique and why it is a model for the future of technology companies and all companies?

Profits are useless. None of the companies I mentioned earlier think that they have to earn profits to distribute to the owners. There is no need for financial engineers and no reason to manipulate EPS figures. This is not to say that these DeFis do not need to cover costs. They do, but their mission is not to maximize profits, because in almost every crypto-based business, they are decentralized. Every token represents an equal stake. Every token owner can participate in the community regardless of who owns it. Yes, owners with a higher percentage will get more votes, but there are no multiple tiers of tokens. Venture capitalists VC or founders' tokens will not receive preferential treatment like stocks. (At least that's what 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 no 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.

Try this site, it’s a great site to track the fees incurred by different projects. Competition in the crypto space is fierce, but crypto companies are better than traditional centralized companies, all other things being equal, I would choose to bet on crypto companies.

Valuing blockchain or DeFi projects

So how do you value a blockchain or DeFi project? First of all, you have to look at revenue.

Not too different from evaluating a software business, I look at current revenue, growth rates, defensibility, strength of the community, and if I think the platform can continue to grow as fast or faster than the crypto industry as a whole, it gets my attention.

If they are talking big and talking about what they are going to do but still haven't done anything for years and have no revenue, I would be worried.

When I bought ETH, BTC, and the other tokens mentioned above as investments, I knew that there would be price fluctuations, but just like the early growth of the Internet, sales healed everything. With happy customers willing to pay for the goods and services provided by the application, and a community that is destined to grow and support, I will become a long-term holder of your tokens, and I will also stake these tokens and possibly make LP investments with these tokens.

Another topic

One thing that’s very different about these DeFi businesses is that they’re not based in the U.S., and they’re not limited companies. Their governance is decentralized, and no one person has majority control (although the founders certainly have significant influence). This is not only because of the spirit of decentralized autonomous organizations (DAOs), but also because of the sheer stupidity of our regulators, which has forced some of this generation’s most influential and innovative entrepreneurs to run their businesses abroad.

I have given Zoom talk after Zoom talk during the global pandemic, and when we look back on the pandemic 10-20 years from now, we will see that businesses that will change the world have been created in 2020 and 2021. Among these businesses, DeFi and other crypto institutions are already and will be at or near the top of the list.

Unlike the early days of the Internet, where we fostered and supported innovation and entrepreneurs, we have seen American politicians speak out against the innovation that crypto is fostering. Hopefully, this changes quickly, or we will lose the next great growth engine that this country needs.