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Finding Alpha in DeFi

source-logo  coindesk.com 29 July 2021 15:18, UTC

Alpha is the mythical metric constantly chased by participants in capital markets. Conceptually, alpha is used to quantify the excess returns of an investment strategy relative to the standard market benchmarks. Given the relative efficiency of capital markets, alpha is scarce and very hard to replicate systematically. 

The opposite happens in inefficient markets such as decentralized finance (DeFi) where the availability of alpha is more prevalent, although not easy to discover and capture. 

Jesus Rodriguez is the CEO of IntoTheBlock, a market intelligence platform for crypto assets. He has held leadership roles at major technology companies and hedge funds. He is an active investor, speaker, author and guest lecturer at Columbia University in New York.

DeFi has challenged many aspects of traditional capital markets including the creation and discovery of alpha. The sources and mechanisms for producing alpha in DeFi are diverse, unorthodox and challenging from a technological standpoint but they also lead to great opportunities.  

What are the sources of alpha in DeFi and how can we take advantage of them? Let’s start with a simple question.

What is alpha?

Alpha is an overloaded term in capital markets that typically refers to the ability of an investment strategy to outperform the market. By market, we often refer to benchmark indices such as the S&P 500, Nikkei 225 or Russell 2000 which capture the performance of a specific financial sector. In semi-efficient markets, it is inconceivable that strategies that invest in passive index benchmarks or portfolios can systematically outperform the markets. One of the most emblematic and simple to understand papers about alpha discovery in traditional capital markets was published in 2019 by BlueMountain Capital. In that research, BlueMountain attributes most alpha produced in financial markets with four fundamental sources:

  • Behavioral: A behavioral-type alpha exists when an investor, or more likely a group of investors, behave in a way that causes price and value to diverge.
  • Informational: An information-based alpha arises when some market participants have different information than others and can trade profitably on that asymmetry.
  • Analytical: An analytical-type alpha takes place when all participants have the same, or very similar, information and one investor can analyze it better than the others can.
  • Technical: Alpha can also be based on technical market inefficiencies. This is common when some market participants have to buy or sell securities for reasons that are unrelated to fundamental value such as laws, regulations or internal policies that can produce a divergence between price and value.

These four categories capture the source of most alpha produced in traditional capital markets. While many of these categories certainly apply to the world of DeFi, the new market certainly adds its unique touch to it.

Is DeFi alpha different?

In one word, yes! Comparing alpha in traditional capital markets versus DeFi is the analogous of comparing Newtonian and Einstein physics. Some of the principles of Newton’s laws apply in the universe of relativity but most laws are completely different.  

Read more: When DeFi Becomes Intelligent | Jesus Rodriguez

The programmability and decentralization of DeFi protocols together with the native inefficiencies of this nascent market, makes alpha in DeFi different from other asset classes and even crypto in centralized markets. In general, the unique characteristics of alpha in DeFi markets can be attributed to two fundamental elements: 

  • The ability of benchmarking the DeFi market
  • The native sources of alpha in DeFi

The DeFi index benchmark dilemma

Indexes are the default mechanisms to evaluate the performance of a specific asset class and they are essential to quantify the degrees of alpha in a given market. However, the idea of benchmarking the DeFi market through an index mechanism is not that trivial as the behavior of the market is dictated not only by asset prices but also by the behavior of protocols. 

In traditional capital markets, the units that compose a given index are a direct representation of the performance of a given segment of the market. The Russell 2000 is based on a representation of the small cap equities while the Nasdaq Composite is based on a selection of technology equities. Outperforming those market indexes is a direct measure of alpha but that methodology does not quite apply in the case of DeFi. 

The equivalent of a traditional market index in Defi would be to model an index of the governance tokes of different DeFi protocols. We have examples of this already in the market such as the DeFi Pulse Index or the Bitwise Index. Could we say that a strategy that outperforms those indexes is effectively producing alpha? 

Read more: 10 Reasons Quant Strategies for Crypto Fail | Jesus Rodriguez

The answer is not quite simple because the governance tokens are not a direct representation of the performance of the DeFi market. Other metrics such as total value locked (TVL) in specific protocols or liquidity mining fees are a clearer reflection of DeFi alpha and are not directly related to the price of governance tokens. 

DeFi poses a challenge to traditional index methodologies because quantifying the performance of the market can’t simply be reduced to modeling a weighted average with the prices of the governance tokens. The behavior and activity of the underlying protocols is equally if not a more important vector to benchmark the performance of the DeFi space. The lack of a clear index methodology makes quantifying alpha in DeFi drastically more challenging than in other asset classes.

The sources of alpha in DeFi

The lack of a clear quantification method are not the only characteristics that make alpha unique in the DeFi space. Arguably, the strongest differentiator of DeFi alpha is related to its singular provenance and formation. Alpha takes many shapes and forms in DeFi but, most of the time, can be associated with one of the following sources:

Infrastructure Alpha

DeFi’s market infrastructure layer can be, by itself, a source of alpha. Validator or staking nodes in DeFi runtimes are able to produce returns that can be considered alpha by standard market definitions. By hosting validators or staking nodes, DeFi infrastructure providers can earn alpha returns in the form of rewards without having to execute a specific market trading strategy. This type of dynamic has no analogies in traditional markets but is part of what makes DeFi alpha unique.

Protocol alpha

Financial primitives in the form of protocols are the cornerstone of the DeFi ecosystem and, without a doubt, its most important source of alpha. Part of the beauty of DeFi is that the infrastructure itself is growing. The launch of new protocols such as Uniswap v3 or Curve v2 creates new forms of alpha that are not present in a previous iteration of the market. This source of alpha is likely to remain relevant while the DeFi space continues to evolve.

Governance alpha

Changing the rules of establishing DeFi protocol is another vector that leads to the systematic creation of alpha. In protocols like Curve, Compound or Aave, governance proposals regularly alter aspects such as liquidity incentives which can immediately translate into alpha type returns. Monitoring and taking advantage of governance proposals is one of the most lucrative trading strategies in the current state of the DeFi space.

Information alpha

In an unregulated, inefficient, early stage market such as DeFi, the asymmetry of information can lead to incredible returns. Parties close to new protocols have access to information, such as a token’s distribution model, launch of integration schedules, governance proposals that can translate into major sources of alpha. As the DeFi market becomes more efficient, this asymmetry is likely to be corrected, allowing a more level playing field between investors in-the-know from the beginning and everyone else.

Analytic alpha

An analytic edge is a source of alpha in any market and DeFi is no different. DeFi is an incredibly>

A different but exciting type of alpha

DeFi is reimagining many of the core concepts related to the creation of alpha traditional capital markets. The unique characteristics of DeFi translate into sources of alpha that we haven’t seen before. While the traditional methods to quantify alpha don’t directly apply in the DeFi space, the new market offers completely asymmetric forms of alpha across all layers of the stack. 

coindesk.com