DeFi — Alpaca Finance: My Analysis and DCF Valuation
Disclaimer: The information contained herein is for informational purposes only. Nothing herein shall be construed as financial advice and is solely the opinions of the author who is not a licensed financial advisor or registered investment advisor. Trading cryptocurrencies poses considerable risk of loss. The author does not guarantee any particular outcome.
DeFi is only going to grow bigger
In recent months, the cryptocurrency market suffered multiple blows to the gut. Back in May, we had Elon Musk reversing his stance in receiving Bitcoin as payment for Tesla over environmental concerns. Also, we had China declaring their stance against cryptocurrencies and taking action to bring down mining farms.
And most recently, we have the fear of the Fed increasing interest rates, Evergrande defaulting on their loans and again China affirming their stance against cryptocurrencies.
Despite all bearish pressures, the DeFi ecosystem continues to push towards new all time highs. As of 27 Sep 2021, the TVL of DeFi, across all networks, is estimated to be US$179.29 billion, with Ethereum taking pole position and Binance Smart Chain (BSC) as runner-up. In merely a year, the space grew by ~22 times!
When we look at other on-chain metrics, we see good signs of traction too. According to on-chain data explorer, BscScan, the BSC network achieved close to 2 million daily active users, measured by unique addresses, and over 8.6 million BEP-20 daily token transfers within a year.
We are seeing real traction and activity under the hood. I strongly believe that DeFi is here to stay and innovation in this space is going to blow everyone out of the water.
The first wave of DeFi innovations
In the first wave of DeFi innovations, we saw the rise of decentralised exchanges (DEXes) powered by automated market makers (AMMs), such as Uniswap and Pancakeswap, and lending/borrowing platforms, such as AAVE and Venus. With their strong appeal towards strong believers of “Not your keys, not your coins” and yield farmers seeking for sky-high APYs, these platforms gained massive adoption and traction, making themselves worthy competitors of centralised exchanges such as Binance, Huobi and FTX.
However, as they grew, I am of the opinion that they are facing a set of problems likely to hinder the continued growth of DeFi.
- Slippage is not insignificant as there is insufficient liquidity to meet trading demands.
- Capital efficiency is less than ideal for yield farming as only over-collaterised loans are available.
With the mentioned limitations, I could argue that centralised exchanges is at the advantage.
Alpaca Finance — The next wave of DeFi innovations
But with the next wave of DeFi innovations, centralised exchanges may soon have to take a backseat. In this wave of DeFi innovations, I like to put my focus on Alpaca Finance, which I believe is a strong candidate that can leverage DeFi to the next level.
Alpaca Finance is a fair-launch leveraged yield farming protocol on Binance Smart Chain (BSC). Launched in March 2021.
As a leveraged yield farming protocol, at their core they are the solution to the limitations mentioned above. They match lenders with borrowers seeking to leverage their LP positions on decentralised exchanges such as Pancakeswap. On Alpaca Finance, borrowers can take leverage positions of up to 6x to boost their yield farming returns. This in turn helps to reduce slippage on decentralised exchanges that the borrowers choose to stake on. As a lender, they get to enjoy higher returns as well due to the higher utilisation rate. This is pretty much a win-win situation for all parties involved.
In addition, ALPACA, Alpaca Finance’s native BEP-20 token, also has a synthetic interest-bearing token, ibALPACA. This opens up opportunities for them to be part of the future-yield tokenisation ecosystem, which is set to disrupt the interest-rate derivatives of the traditional finance market. In 2020, the global interest-rate derivatives (IRD) notional outstanding amount is estimated to be US$466.5 trillion. Yes! Trillion not billion.
Alpaca Finance — Competitive Advantage
Naturally, Alpaca Finance is not the only protocol providing leveraged yield farming, and they are not the first to do so either. However, below are some key points that I believe set themselves apart from their competitors.
As TVL in DeFi dapps grew exponentially, the ecosystem was not spared from the sneaky hands of hackers. In Feb 2021, an attacker successfully drained US$37 million from Alpha Homora, a pioneer in leveraged yield farming. In order to avoid the same fate as Alpha Homora as much as possible and to give assurance to users, Alpaca Finance put in place effective measures to mitigate the likelihood and impact of such an event.
- Flash loans are prohibited on Alpaca Finance.
- Since launch, Alpaca Finance has undergone a total of 11 audits by Certik, Peckshield, SlowMist and Inpex. This is by far one of the protocols with the most audits performed in such a short span of time.
- Partnerships with Nexus Mutual and InsurAce to provide protocol insurance for users.
- Every order from the admin(the group of core developers) has to pass through the Timelock contract and is delayed for 24 hours before taking effect. In the event of any undesirable code manipulation, this gives the community ample time to react.
- Implementation of safety feature, Alpaca Guard — An auto-activated mechanism to protect users from potential price manipulation, flash liquidation, and market failure.
According to Alpaca Finance’s review of Alpaca Guard, during the market crash on 22 Jun 2021, despite having more than US$1.3 billion in TVL, it effectively reduced the total position liquidated to ~US$ 900k and only amounted a total of US$ 57,020 in bad debt.
Personally, I can attest to the effectiveness of Alpaca Guard too. On 7 Sep 2021, the market suffered another flash crash which caused my position to fall below the expected liquidation threshold in a matter of minutes, but because of Alpaca Guard my position was protected and I was not liquidated.
Alpaca Finance — Key Performance Metrics
Within 6 months, Alpaca Finance amassed US$1.4 billion in TVL and was able to hit peak TVL of US$1.8 billion in Aug 2021. Currently, they are ranked first among all leveraged yield farming protocols., in terms of TVL.
Alpaca Finance — Token Distribution
According to on-chain data analysis by Moonlight, it is evident that the tokens are fairly distributed among token holders with little to no connections between each other. This is a good sign as this lowers the probability of a rug-pull event.
Alpaca Finance —Token Value Accrual
With all the defining qualities that has been mentioned about Alpaca Finance, as a token holder, it is important to be able to capture the economic benefits gained by the platform.
At the moment, token holders get to benefit from the platforms revenue streams in the following manner:
- 10% of the 19% performance fees for yield farming positions on the single-asset CAKE vault is distributed as Protocol APR to ALPACA lending depositors.
- 4% of the 5% of every liquidation bounty that any liquidation bot receives as a fee, goes towards buybacks and burns of the ALPACA token.
- 10% of 19% of the lending interest that lenders earn goes towards buybacks and burns of the ALPACA token.
As part of the buyback and burn mechanism, a total of 4,169,976 ALPACA has been burned. In today’s price, that is equivalent to ~US$4 million.
Because of the several mechanism in place, ALPACA is deflationary in nature with a fixed supply of 188 million tokens.
Alpaca Finance — DCF Valuation
Based on the token value accrual mechanism that Alpaca Finance employ, I find it appropriate to treat the fees collected from the borrowers as cash flow and the economic benefit is indirectly distributed to the token holders via buyback and burn. In this format, using DCF model to discover the fair token price of today seems justifiable.
Due to various systemic factors which I believe may limit the growth of the platform to some extent in the near-term, I chose to value the token with a set of assumptions that are more conservative as compared to the recent historical growth rate experienced in the DeFi ecosystem.
Following are the key assumptions that I have made in my DCF model.
Assumption 1: In the past year, TVL may have experienced an exponential growth but there might be potential downside risk as we approach the final phase of the bullish super-cycle. I believe it will be safe to assume that TVL of the DeFi ecosystem is to grow at 50% Y-o-Y over the next 5 years.
Assumption 2: Based on my evaluation, Alpaca Finance is considered one of the pioneers in the leveraged yield farming space with strengths that are not easily replicable by competitors and they hold the lead position in terms of TVL. I believe their market share in the DeFI ecosystem can continue to grow at 5% Y-o-Y over the next 5 years.
Assumption 3: As Alpaca Finance is considered an early-stage startup with about 6 months of operation, it is still considered as a high-risk investment. I believe assuming the discount rate at 40% is fair.
Assumption 4: Going inline with mature company estimates and developed countries’ GDP estimates, upon achieving terminal value after 5 years, I assume that Alpaca Finance can continue to grow at a sustained growth rate of 2%.
With the above assumptions, I deduced that ALPACA token should be valued at US$6.17 per token at current circulating supply (MC/TVL: ~0.81) and US$3.22 per token at total supply (FDV/TVL: ~0.42). Comparing with the current token price, based on a conservative outlook, there is good potential for significant upside of at least 300%.
For a full breakdown of my assumptions, feel free to review my spreadsheet here.
Summary
As a platform that can provide a safe environment to earn high APY, I find that to be very appealing for yield farmers and institutions looking for a predictable passive source of income. In the coming years, I expect to find more competition in this space. I am excited to see the progress of Alpaca Finance and how they can continue to innovate to stay ahead of the curve and maintain their lead.
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