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DeFi and MetaFi – Protection against the rising inflation!

DeFi-and-MetaFi---Protection-against-the-rising-inflation Press Release

We are living in the probably best time to make money. It is as simple as that, yet far more complex than one can imagine. When carefully observing the current world wearing finance glasses, it can appear as there is an infinite amount of money around us. Nevertheless, it is evident that not everyone benefits from that. Further, the unit of money – that is fiat currency – is increasingly devaluing. Another fact most do not realize is that currencies are generally prone to being replaced. These not at all stable currencies have an average life-span of 27 (!) years. What does this tell us? We need to sustain our wealth via passive income-generating assets. In the utopian, ubiquitous token economy, one will exchange and hold any form of value in the form of coins and tokens. Coins and tokens, a common misunderstanding is that both are the same which also tells us how early we still are in this industry. This tokenized value, whether it is data, real estate, skins in video games, virtual art displayed in metaverse art galleries, equity, LANDS in the Sandbox (virtual, scarce real estate) or sophisticated in game identities in the form of an NFT – when looking at the future of “value”, sky really is the limit. Therefore it is crucial to foster education on how to protect yourself from inflation via 1) DeFi and 2) MetaFi – the convergence of DeFi and the metaverse. –  Authors: Manuel Müller, Nicolas Weber

How DeFi and MetaFi protect against the rising inflation

Everyone is talking about inflation at the moment, and there is public speculation as to whether it is sustainable or possibly just temporary. The fact is that consumer prices literally exploded at the beginning of the year. Central bankers argue that these price increases are largely due to base effects from year-on-year comparisons as well as pandemic-related special effects from capacity and supply bottlenecks. Although the Federal Reserve Systems (Fed) in its June meeting loudly considered first interest rate steps for 2023 and admitted to have underestimated inflation. Should the developments continue, one can protect one’s assets from inflation by investing in assets of any kind. Collateralization structures in combination with DeFi liquidity allow value-enhancing investments whilst earning passive income (e.g. staking) and at the same time liquidity at the push of a button.

Inflation is transitory according to central banks and there are base effects. However, there are some arguments in favor of inflation in the medium to long term. You can protect your wealth by investing in tangible assets such as stocks, gold, and real estate, but you have a trade-off between liquidity, which loses purchasing power but is needed for daily needs and emergencies. This is one part where the token economy will deliver an antidote. Tokenized value is first of all very fungible. Secondly, it also instant, transparent pricing – unless we are maybe speaking about some NFTs. Though even here known market conditions are playing out and it is amazing to see how this space can also be a gateway for the mainstream to enter the crypto market. People were complaining about a lack of feasibility at times. And that can be true. NFTs however change that. You suddenly have an asset that you can create as an artist, use in a game, or wear as a character. These digital native assets seamlessly allow integration to the respective DeFi protocols. Native DeFi, not necessarily institutional DeFi per se that is required when onboarding other assets such as real estate into DeFi. Many have tried it, there were successful executions, it is however a very friction-infused and expensive process. Therefore the future of asset growth will definitely be in the intangible sphere. Also, IP will be much easier to handle once fungible and transparently leveraged on-chain. The monetization flows will be decentralized and follow a path of rewarding creators, not intermediaries. Outlier Ventures Founder and CEO tweeted as follows on the future of MetaFi: “The regulatory environment for crypto is definitely going to get much worse for crypto before it gets better. In the end, it drives the space to innovate more in a decentralized way focusing on the financialization of digital-first value. This is why MetaFi is the low-hanging fruit.”

NFT sales on OpenSea near $150m in June
Figure 1: NFT sales on OpenSea near $150m in June

Status quo of inflation

From 2007 to 2015, about USD 3.5 trillion was pumped into the market to combat the consequences of the financial crisis and to counteract possible deflation – this led to absolute low-interest rates or negative interest rates and asset-price inflation, but not to inflation. David Folkerts-Landau, Chief Economist of Deutsche Bank AG, emphasizes in the recently published research: “In short, we are witnessing the most important shift in global macro policy since the Reagan/Volcker axis 40 years ago. […] This is why this time is different for inflation.”

In 2020 alone, the Fed’s balance sheet was expanded from $4.2 trillion to $7.4 trillion, by about $3.2 trillion, to deal with the aftermath of the Corona crisis – currently, the balance sheet stands at about $8 trillion, meaning that since 2020, about one out of every two dollars in existence today has been printed (Figure 1). The M1 money supply has thus been massively increased in a much shorter time compared to the financial crisis and with it the potential demand for goods (fig. 2).

fed
Figure 2: Fed balance sheet stat, source: Federal Reserve

At the same time, many countries have drastically increased their debt and adopted aid packages (fig. 3). In addition, further investments are to flow into ESG projects and infrastructure; in the U.S., for example, an infrastructure package of >$1 trillion is currently being debated. As a result of this coordinated simultaneous fiscal and monetary stimulus, significantly more money is coming into circulation than during the financial crisis of 2008/09, while at the same time strong asset price inflation has been observed on the capital markets. 

photo_2021-09-07_16-10-01
Figure 3: Fed balance sheet stat, source: St. Louis Fed

Thus, a potentially high industrial or consumer demand was created, which should lead to higher prices and thus to an increase in inflation. However, inflation did not rise initially because the global economy came to a temporary standstill and supply chains collapsed. As a result, the supply of goods became severely constrained. When the economy slowly opened in 2021, producer prices initially rose sharply because rising industrial demand met a limited supply of raw materials.

Shortly thereafter in May 2021, inflation rates (consumer prices) also suddenly shot up to new highs, 2.5% in the EU and 5% in the USA. So companies were able to partially pass on the increased purchasing costs to consumers. This process is likely to continue for some months, due to supply shortages or production delays and sluggish pricing mechanisms. Year-on-year comparisons of consumer prices (inflation), i.e. the recently published June figures, were down somewhat in Germany at 2.3%, while the USA recorded another record increase of 5.4%.

However, central banks, led by the Fed, take the view that the inflation scenario is merely temporary. At the June meeting, Fed Chairman Powell already admitted to having underestimated in particular the strength of supply and capacity bottlenecks (“bottleneck effects”) and the structural effects of deglobalization as well as environmental investments or levies (“carbon neutral economy”). At his hearing before the Senate Banking Committee on July 15, Fed Chairman Jerome Powell then had to admit that “everyone” had underestimated the inflation rate. “This is a shock going through the system associated with reopening of the economy, and it has driven inflation well above 2%. And of course we’re not comfortable with that, […]”. Essentially, however, the Fed sticks to its assessment and focuses on base, special and one-off effects due to the pandemic. Base effects by that you mean the year-on-year comparison, since prices were low in the “Corona year” and inflation is always a year-on-year comparison, the numbers must be much higher. However, if we compare today’s prices with 2019, we also see an increase,  which would indicate sustained inflation.

Special effects are, for example, the price increases resulting from supply shortages (supply and capacity bottlenecks), e.g. in the manufacturing industries. Commodity prices (except oil) had recently fallen again, but were still at a very high level and are currently on the rise again. Price increases in particularly affected industries, such as travel, are one-off effects due to pent-up demand, which according to central banks are only temporary. But even if food, rental and energy prices as well as used cars are excluded from the U.S. consumer price index, a massive increase can be seen, as the chart from Bloomberg shows. However, if the central banks are proved right, the economic data are unlikely to signal a rapid economic recovery, and unemployment rates and wages are unlikely to rise significantly abruptly. Such a rapid rise in inflation rates as we have seen in much of the world would imply a rapid economic recovery, which would be accompanied by wage increases and reductions in the unemployment rate. Corporate costs would continue to rise, resulting in further price increases (wage-price spiral). 

However, this can also be deceptive, for example, the Ifo Institute stated in June that the strong demand can only be partially served by the production bottlenecks, so that the economic data could possibly give a false (negative) impression (link).

In its June meeting, the Fed already hinted at interest rate steps for 2023 to counteract a possible sharp and sustained rise in inflation rates. In Europe, the economy has been recovering rather slowly lately, thus the likelihood of a rate hike or tapering by the ECB in the near future is decreasing, despite perceived inflation.  Especially since the ECB would dampen the economic recovery with an interest rate hike and make refinancing more difficult for indebted countries (or companies). Due to the highly disproportionate economic performance of the member states in the EU, this could be difficult to coordinate and possibly have devastating effects on individual economic locations. The central banks therefore announced a new framework for action at an early stage. Only the average inflation rate is to be used as a benchmark, so that a short-term overshooting would not give any reason to change course. Therefore, the central banks, especially the ECB, will presumably act very cautiously with interest rate steps. In summary, inflation is here to stay, some effects will only be temporary, others will probably remain for a longer period of time. The topic of inflation is currently the subject of controversial debate among economists, politicians and financial experts and is likely to be with us for the next few years – perhaps at the end of the day it is just a question of how “temporary” is defined.

Inflation in the crypto market

For traditional currencies such as USD, EUR, GBP, etc., central authorities decide on the money supply. They can both devalue money by increasing the money supply (inflationary scenario) and appreciate money by reducing the money supply (deflationary scenario) – there is no quantity limit.

To apply this logic to cryptocurrencies, one can draw the following analogy: Bitcoin would thus initially be an inflationary currency because the supply is continuously increased and bitcoin devalues, i.e. prices decrease while demand remains constant. However, the rate of supply expansion decreases about every 4 years (210k blocks), which again tends to be deflationary. This mechanism works until 21 million bitcoin is reached and supply is constant. Since the total supply (“total supply”) is limited, many speak of a deflationary character, provided that the user numbers continue to increase. The system is thus fundamentally inflationary with increasing deflationary tendencies, i.e. Bitcoin systematically tends to appreciate, which fundamentally drives up prices.

The Corona pandemic prompted central banks and governments to provide massive monetary aid, which primarily led to asset-price inflation. The flood of liquidity needed to be invested and investors ultimately seek yield. With the bond market not an adequate alternative to riskier asset classes due to low interest rates, much capital flowed into stocks and cryptocurrencies. Bitcoin has put in a fabulous performance (Fig. 4).

Fed balance sheet stat, source St. Louis Fed .
Figure 4: Fed balance sheet stat, source: St. Louis Fed

Therefore crypto based assets are well positioned as a hedge against the current inflationary scenario, deriving its value from both speculative interest as a hedge, cause investors are usually seeking returns in times of high liquidity. Cryptocurrencies like Bitcoin are built around those same principles as well. However, Bitcoin has not yet provided definitive proof of its function as an inflation hedge, now inflation has increased significantly for the first time and time will tell how adoption will continue. When it comes to utility and value within an ecosystem, critics argue that there could be more utilized and sophisticated projects.

Consequently, there is another exciting development in the crypto market, namely decentral finance (DeFi). Currently, you can generate between 1%-25% realistically with such DeFi products, but significantly higher returns have also been possible. Now adding the metaverse layer on top of it will further accelerate the growth within this space.

Real world assets as a hedge?

In principle, financial experts have always recommended investing in real assets such as gold, real estate, shares, etc. as a hedge against inflation. These are largely dependent on real interest rates, i.e. the nominal interest rate of a 10Y US government bond minus the inflation rate. For 38 years, the real interest rate has been falling because bond interest rates are falling, and now inflation is rising rapidly.

Treasury Inflation Indexed Security vs PCE, source
Figure 5: Treasury Inflation-Indexed Security vs PCE, source: St Louis Fed

The clear losers in this development are all types of fixed-income investment products as well as demand deposits in checking or savings accounts and, of course, cash. Whereas winners are tangible assets (“real assets”), such as gold, real estate, (dividend) stocks, classic cars, works of art, Bitcoin and more because they generate returns and are relatively stable in value when compared to inflationary fiat. In addition, real estate is valuable because you have a high utility and create dependency, thus there is usually good pricing power. Rents and real estate prices are expected to continue to rise. Stocks and real estate both have a strong dependence on interest rates. Essentially, the valuation of future profits or cash flows changes via the discount rate and the debt burden via the refinancing rate. Rising interest rates would therefore generally justify a lower valuation.

Currently, many market participants continue to assume rising real estate prices as well as rising rental yields, because rents are of course also a part of inflation and rise accordingly. Of course, these assumptions also entail risks. Real estate traditionally involves high transaction costs and is rather illiquid with little price transparency, so a connection with blockchain could open up exciting prospects. Further, it is possible to leverage the same concept within the metaverse with virtual LANDS,  at times a more straightforward approach. Especially when it comes to DeFi.

The problem with investments as a hedge against inflation is basically that you can only invest part of your assets, e.g. in real estate – it’s a constant trade-off between liquidity, which is constantly devaluing investments. What if you need short-term liquidity? To understand the impact of the loss of purchasing power and possible benefits of tokens, we have prepared a fictional thought experiment. Let’s imagine hyperinflation, i.e. for one unit of account I get 1 loaf of bread today and ¾ loaf next week and only ½ loaf the month after. Accordingly, the value of goods and substitute currencies (gold, bitcoin) as a medium of exchange increases. For goods with a high momentary utility, like bread or other food but also toilet paper, I get proportionally more than for my money. Perhaps counter-intuitively, however, rare and valuable items, such as luxury watches or real estate, inherit very poor means of exchange during a hyperinflation. This is due to the fact that when it is mainly daily consumer goods that are in demand, you often get only relatively few of these goods in exchange for your watch, which after such a hyperinflation in a stable system is then worth much more again. But what if I had only fractions of a watch or a property and could transfer them immediately? This would probably be a gamechanger for the owners in such times.

In a period of high inflation (3%-7%), these fractions of real estate can also serve as inflation protection, especially in combination with moderate interest rate increases. How does it work? You have the possibility of collateralization, i.e. the real estate fractions are issued as equity tokens to the investors and can subsequently be used as collateral for a loan. Thus, the investor can protect her money from the loss of purchasing power and invest in tangible assets (real estate), which continue to increase in value, and at the same time release liquid funds as needed. It is particularly interesting that one participates fully in the performance at any time, since the tokens are deposited only as collateral, and are liquid when needed. Especially since you still profit from inflation with a credit / loan, since you later have to pay back “less” than you initially got because the money devalues.

Total Value Locked in Defi (USD
Figure 6: Total Value Locked in Defi (USD), (source: defipulse.com)

Generally, as seen above the value locked in DeFi is significantly increasing. Real world assets however only play a minimal portion in this equation, Most of it stems from the major DeFi protocols out there. WBTC, ETH, USDC, MAKER, OCEAN. Not house A, painting B, IP C. Therefore it becomes obvious that at least in the contemporary stage, the more feasible approach is MetaFi…  

Leveraging MetaFi

All the above finally leads us to MetaFi – one of the latest trends within the crypto space and mainly pushed by players such as Outlier Ventures. Indirectly it is basically all encompassing the metaverse as well as DeFi ecosystems with its reach. The possibility to seamlessly switch from metaverse to metaverse while respectively collecting assets while playing alone will be able to support someone’s life needs. Take for example a recent Bloomberg article titled: “This Video Game Is Turning the Pandemic Jobless Into Crypto Traders”. The reference goes to Axie Infinity. It for instance describes an IT specialist from Manila who got laid off, yet made 3 times his income via the recently skyrocketing game. Axie is currently valued at over 4 billion Dollars. While industry experts had been expecting players like Decentraland or The Sandbox taking the limelight, it truly thus far has been the most expensive NFT collection. This also emphasizes how early we still are in the industry.

Now when it comes to applying DeFi, leveraging MetaFi within DAOs and respective treasuries as well as generally pursuing this avenue, it becomes evident that much less friction is involved when it comes to the DeFi integration as e.g. collateral. A must have pre-condition for this however is a transparent pricing tool or sophisticated algorithm which can determine the correct pricing of the NFTs. Oracles manage the off-chain-on-chain data flow. There are various projects out there developing products for the NFT – DeFi merge. DAOs like PleasrDAO utilized a portfolio of high valuable NFTs for a $3.5 million loan at Cream Finance. With one or various wallets connected to the metaverse as well as NFT-DeFi protocols such as MGH DAO. This allows a seamless collection and transfer of value across different verticals. Let’s imagine you have a monthly income of USD 10,000, but now liquid assets. Furthermore, you need a loan for an apartment purchase and a new car. Luckily you own 3 Cryptopunks and 2 BAYC (Bored Ape Yacht Club is one of the most known NFT collections out there) members. Now you use some of it as collateral and suddenly you have your money. Sure it is an overcollaterization in most cases. But this is solely temporary as it is very possible that once decentralized ID, contribution and trust management evolve, even this “pain point” for user (depending from which perspective you look as it is also safer to have these loan structures in place) could be jettisoned.

One of the most overlooked aspects within blockchain amongst especially the so-called “experts” is interoperability. We should rather care about which bridges between chains we can build than arguing about which chain or layer 2 is the right one. The same applies to the metaverse: There will be various open and decentralized metaverses emerging. Here too it will be crucial that interoperability is fostered. As seen in the figure below, this consequently allows a smooth ecosystem management and most importantly: an intuitive one. 

Managing the metaverse interoperability
Figure 7: Managing the metaverse interoperability

Conclusion

Inflation is a topic that affects us all. Nevertheless, there are various solutions to this. The innovative approach is definitely MetaFi. Not yet fully evolved and intuitive, but does promise far greater benefits and diversification. The goal now is to on the one hand foster education and on the other hand more user friendly experiences when interacting with the different ecosystems. When headlines are about JPGs selling for millions of dollars one can quickly forget the vast array of applications in store the project rollout. Therefore raising awareness on the topic of MetaFi is and will be a substantial driver in Web 3.0 adoption.

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Authors

Manuel Müller and Nicolas Weber have co-written this article to foster education on the topic of MetaFi.

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A Computer Engineering graduate who writes news focuses on cryptocurrency-related and blockchain technology. He is enjoying using his skills to contribute to informing people of the exciting technological advances that happen every day.