The DeFi asset management track is gaining popularity. What are the potential and constraints of the improved Melon?

By Jack Purdy, Messari Research Analyst

As one of the first projects to raise funds through token sales, Melon appeared in the cryptocurrency world dictionary several years earlier than decentralized finance DeFi, and its goal was to re-architect the core part of the financial system. Although Melon developed a viable product and led the trend of decentralized governance, its native token MLN evaporated 99% of its value after a brutal bear market.

Now that DeFi is booming, the bull case for asset management platforms has become clearer, with Melon growing by 1,600% over the past year. Even so, its market cap is currently $60 million, which is still much smaller than many other top DeFi projects. One of the main reasons for the low valuation is that in its current state, its economic design does not allow MLN to generate significant value accumulation. This situation did not change until several community members proposed an improvement proposal, MIP7, which outlined a way to better link platform growth with MLN value accumulation.

Melon’s Current Economic Design

Before discussing MIP7, it is helpful to understand how Melon currently works. Melon allows potential fund managers to launch an investment vehicle according to a specific set of parameters without having to go through the many hurdles of traditional fund launches, such as heavy administrative costs, legal hurdles, and operational burdens.

Traditional Fund Management (fund size $10 million), source: Melon

On the other hand, investors can evaluate funds based on transparent on-chain reports and allocate funds to any fund that meets their preferences. Managers set up funds, investors request investments, and third parties approve investment requests, all of which require burning network tokens MLN to execute. These can be regarded as cash flows of the system, meaning that MLN holders will be compensated based on the number of funds created and the amount of investment, with the former accounting for the vast majority of expenses. There are currently 375 funds, generating about $23,000.

Source: Dune Analytics

At the current price of 1.75 MLN per fund (about $87, after the recent price increase, the fee for creating each fund has been reduced from 8.75 MLN to 1.75 MLN), even if it is expanded to create tens of thousands of funds per year, it is difficult to support a market value much larger than the current level. MLN's current token economics also make it difficult to predict the MLN burn rate, because the speed of fund creation varies greatly at different cap times.

Entering the MIP7 Era

The MIP7 proposal proposed by Melon community members is intended to alleviate these problems. It introduces a new fee structure. Instead of charging a fee for the creation of each fund, an annual fee of 20 basis points is charged on the total assets under management (AUM) of the Melon fund. Therefore, if some funds are successful and receive significant investment, the protocol can monetize them more effectively.

Likewise, since AUM is easier to model than fund creation, MLN holders can better predict MLN burn rates. MIP7 also proposed withdrawal fees and fee discounts for MLN staking, but has been resisted by the community and is unlikely to be implemented.

Focusing on AUM fees allows us to evaluate potential returns through various assumptions regarding the scale of DeFi growth and the percentage of Melon funds held. I use the market capitalization of DeFi to speculate, rather than the market capitalization of cryptocurrencies as a whole, because the growth of Bitcoin or other Layer 1 assets has not greatly expanded Melon's investable universe.

This is a conservative assumption since there are already wrapped versions of BTC and ETH that make up the largest holdings. However, I believe Melon’s success depends on the growth of other investable assets since most BTC investments will continue to remain off-chain while the unique opportunities we see in DeFi will remain on-chain.

The total market value of DeFi assets is currently around $6 billion, and Melon’s share is only $2.2 million. However, I expect the overall market size to increase significantly in the future, and the demand for asset management will naturally increase with it. Let’s take a look at how changes in these two variables affect Melon’s potential profitability.

Melon’s annualized protocol profitability sensitivity: As the total market value of DeFi grows, if Melon can occupy a small proportion, it may see considerable gains

Based on the actual growth of DeFi, we use the proposed 20 basis points annual fee as a factor, which can result in profitability ranging from less than $1 million to $25 million. By estimating the returns and applying multiples of other asset management protocols, we can derive the total network value of Melon.

For the composite coefficient, I used the coefficient of yearn.finance, whose Vault product offers a variety of yield-generating strategies, and the coefficient of Balancer, which offers an ETF-like auto-balancing product through an automated market maker AMM pool. Using a range of yield numbers between $1 and $10 million, and the P/E ratios of YFI and BAL (20x and 56x), we can come up with a number of different results, ranging from a market cap below Melon's current $65 million level to an appreciation of more than 750%.

Predicting future returns is wishful thinking at best at this stage, but providing scenario analysis helps assess the value of the network under various scenarios. In order to assess the likelihood of any one scenario, it is necessary to study the favorable factors that may drive returns. As mentioned in their latest community meeting, the team is pushing for a Q4 release covering multiple improvements, including the addition of a decentralized exchange DEX aggregator, OTC over-the-counter trading, simplified fund creation, and fund migration.

More importantly, however, Melon v2 will support integration with other DeFi protocols. This means that fund managers can not only buy and sell assets, but also lend out native governance tokens and farm for yield. Most of the funds in DeFi projects are currently used for yield farming, so this additional functionality will attract investors seeking to increase their returns. In addition, the range of assets will be further expanded, so fund managers can invest in DeFi assets that have emerged in recent months, which will further attract investors interested in these high-growth assets.

However, even with all these new improvements, whether Melon can grow to such a level of returns will largely depend on the demand for active management in this space. Although Melon allows for automated strategies, it has not gained much traction. This niche market is served by automated strategies, such as Yearn's Vault and Set protocols, which are both orders of magnitude larger than Melon. These strategies use on-chain data to optimize certain parameters and automatically execute them, so users don't have to actively trade all the time, while saving on gas fees.

Actively managed funds, such as those we see on Melon, differ in that they do not follow a set of rules, but rather allow fund managers to trade at their discretion. Ultimately, success will depend on the ability of these managers to generate alpha. Using the traditional fund market as a reference, fund managers manage $4.3 trillion.