Compiled & edited by TechFlow
Guest: Arthur Cheong, Founder of Defiance Capital
Podcast source: The DCo Podcast
Background Information
In this episode of the DCO Podcast, we are joined by Arthur Cheong, founder of Defiance Capital. We take a deep dive into the difference between liquidity investing and venture investing in crypto. As venture capitalists compete fiercely for private placement deals and drive up valuations before projects go public, less competitive liquid markets often offer smarter and more flexible investment options. Arthur shares how he seizes opportunities in these markets and talks about the unique advantages of investing in Asia.
Meet Arthur from Defiance Capital
Arthur started investing in traditional financial markets more than a decade ago, and has applied his experience in traditional financial markets to the crypto market since 2017. The host mentioned that Arthur wrote a paper on synthetic assets during the 2018 bear market, which attracted the attention of the host, and since then, the host has been following and learning from Arthur's views.
Arthur's investment journey
Arthur shared his investment experience, mentioning that at the age of 21, he was interviewed by a local media outlet and became a representative of young investors because he was very active in the investment club at university.
Arthur has been investing in the stock market since he was 19 and has always been a firm believer in the importance of financial education. Coming from a relatively modest family background, his parents often argued over finances, so he believed that learning how to manage finances was key to improving his life.
Arthur studied economics and used his small savings to learn about markets and investments. After graduation, he continued to invest and began to get involved in cryptocurrencies in 2017, gaining a deeper understanding of the field and focusing on investing in crypto assets.
The shift to crypto
Arthur talked about his transition from the traditional market to the crypto space. He mentioned that the rise of Ethereum in 2017 aroused his interest and he was attracted by the potential of building various decentralized applications on the blockchain. He believes that the global nature of the crypto market is its uniqueness. It is not restricted by geographical regions, which provides investors with broad opportunities.
Arthur pointed out that the crypto industry is still relatively young and new players are able to have a greater impact in this field. In traditional markets, it usually takes a lot of time to accumulate experience to be on par with existing players, while the crypto market provides more opportunities for risk-takers. In addition, the potential for high returns in a short period of time is also one of the important factors for him to turn to the crypto field.
The impact of low interest rates
Arthur points out that many investors first experienced zero interest rates after the financial crisis. The long period of zero interest rates after the 2008 financial crisis made illiquid investments more popular because low interest rates made people willing to take more risk to get higher returns. Since the returns on safe investments were low (for example, only 2% or 3%), investors were more inclined to pursue higher-risk investments to achieve a 70% return to meet their portfolio needs.
Arthur believes this is one reason why alternative investments, especially less liquid ones, have grown rapidly over the past 15 years. Low interest rates encourage investors to pursue riskier investment opportunities.
The host mentioned that there is a correlation between the low interest rate phenomenon and interest in cryptocurrencies. He recalled that when he was in Singapore a few years ago, crypto.com offered an interest rate of 4%, while Singapore's interest rate was zero at the time, which attracted a large number of people to the crypto market. Arthur also agreed with this view, believing that getting a 0% interest rate in the bank has made people more interested in any investment return higher than this, prompting them to explore emerging investment opportunities such as cryptocurrencies.
Cynicism in Cryptocurrency
Arthur mentioned that the maturity of market participants may lead to more cynicism over time. He believes that this phenomenon is not just due to the collapse of FTX or Three Arrows Capital, but the experience and growth of investors in the crypto market. While in traditional markets, the competitive environment prompts investors to experience this maturity earlier, participants in the crypto market usually join because of the pursuit of ideals such as decentralization and anti-censorship.
Over time, Arthur said, investors will realize that many theoretical concepts face challenges in practical applications, causing them to become more skeptical. He pointed out that the low threshold of the crypto market attracts a variety of people, including extremely intelligent innovators and some opportunists, and this extreme difference makes the market full of uncertainty.
Arthur further emphasized that despite the cynicism, it is very important to maintain "cynical optimism". He believes that investors should not easily believe everything, but should not completely deny the potential of new technologies. This balance is not easy to grasp, and many people tend to tend to one extreme.
When talking about how to better manage risk through cynicism, Arthur believes that this mindset helps investors focus more on potential downside risks. He pointed out that identifying potential bad investments is the key to successful investing, especially in markets with low liquidity.
Finally, Arthur shared some experiences to avoid investment pitfalls, including paying attention to whether the project team is willing to accept feedback and make improvements. He believes that if the team is deaf to external feedback, this is usually a red flag that there may be problems with the project.
Bridging the East and West in Crypto
Arthur pointed out that cryptocurrency is a global industry, but there are significant differences in the thinking and mentality between the East and the West. He believes that assets that can create consensus between East and West will generally perform better. For example, Ethereum gained widespread recognition from the Eastern community in its first few years, especially in its promotion in China, which laid the foundation for its subsequent development.
Arthur further explained how geography affects how people form investment theories. He mentioned that Western communities tend to focus more on the technology itself, while Eastern communities focus more on factors such as the background of the project, its backers, and the distribution of the market. Eastern investors realize that in addition to technology, there are many other factors that can have a significant impact on the success of a project.
The host added that the West has the technology, while the East has the users. Eastern markets tend to be more receptive to new technologies because the regulatory environment there is relatively ambiguous, allowing innovation to occur. In addition, Eastern entrepreneurs are usually more focused on product distribution, while Western entrepreneurs are more obsessed with the technology itself.
When asked how they bridge the gap between the East and the West specifically, Arthur said that as investors, they are able to understand the different perspectives of the East and the West. Living in Singapore, a global city, they are able to communicate with founders and investors from China to gain balanced market insights.
Finally, Arthur also mentioned that the early days of the Internet also experienced similar asymmetry, especially in terms of infrastructure and user behavior as countries such as China and India caught up with the United States. He believes that similar phenomena currently exist in the field of cryptocurrency, especially in terms of investment opportunities and market reactions.
Liquidity and venture capital
Arthur pointed out that there is currently a surplus of private equity capital and a shortage of professional capital in the public market. He believes that this capital imbalance creates more opportunities for investors. Although venture capital is still supported by a large amount of funds, the number of high-quality projects is relatively small, which allows excellent projects to obtain higher valuations.
Arthur further explained that the capital structure of the traditional market is dominated by ordinary investors, while in the crypto market, the situation is just the opposite. In the crypto market, the scale of venture capital is much larger than that of hedge funds, which leads to an unusual situation: in the absence of ordinary investors, it is difficult for venture investors to find exit opportunities. Therefore, Arthur believes that the return potential of liquid investments is higher because the competition in the public market is relatively small.
He also emphasized that liquid investors are better able to manage risks, especially in a rapidly changing industry, where investors need to have the ability to flexibly adjust their portfolios. In the past two years, the NFT field has experienced dramatic fluctuations, and many investors have failed to adjust their investment strategies in a timely manner, resulting in losses.
Arthur mentioned that although venture capital usually relies on the "power law" - that is, a few successful investments can cover the losses of the overall portfolio, in the crypto market, exit opportunities have become more difficult and valuations are constantly compressed. Therefore, he prefers liquid investment because it allows him to manage risks more effectively.
When it comes to project valuation, Arthur suggests that teams should consider appropriate valuations when listing on the public market. He believes that too low a valuation may convey a signal of low project quality, while too high a valuation may lead to difficulties in the price discovery process. Therefore, it is recommended that teams determine a reasonable valuation by comparing benchmarks in order to provide investors with some upside in the public market.
Arthur also mentioned that although many projects were listed at valuations much higher than what he suggested, this does not mean that the market will correct this phenomenon. He believes that the current high valuation problem in the market still needs to be solved, and both investors and project teams need to be more cautious in the process.
Market downturn and exchange impact
The host mentioned that in the context of the current market downturn, for many liquidity investors, the problem is not just waiting for valuations to decline before looking for opportunities, but the need to recognize that the market needs participants who can provide liquidity at appropriate valuations. Exchanges should not be the only institutions that determine listing valuations, and as the market matures, a liquidity fund ecosystem may gradually develop, which will help prevent tokens from experiencing a 90% plunge after listing.
Arthur added that while venture capital (VC) may drive valuations too high to some extent, he believes that the role of exchanges cannot be ignored. Many major industry events in the past decade have been related to exchanges, and the current market still cannot completely get rid of the influence of exchanges. He pointed out that exchanges often have an incentive to list projects at high valuations because this is usually accompanied by incentives to launch pools. Project parties may pay 5% to 10% of the supply to exchanges as listing fees, and high valuations make these incentives more valuable.
Arthur also mentioned that when the market starts to decline, these incentives have been paid to users, and users may quickly sell these tokens, causing the price to fall further. Therefore, exchanges play an important role in the pricing process and their influence cannot be underestimated.
The role of narrative in market dynamics
The host mentioned that this was a good time to discuss an article he wrote last year (Narrative Advantage). The core idea of Narrative Advantage is that all markets operate based on narrative. Products or projects need to be supported by some basic core ideas so that people can classify them into broader categories, and this classification drives the formation of inequality. He observed that attention and capital are like a river, and investors can choose to go downstream or upstream, or think of it as the relationship between sails and wind. If you can think smartly about positioning and narrative, you can find the right position in the flow of capital and attention.
He further pointed out that attention and capital are highly correlated. Without attention, even if there is a large influx of capital, it will not make much sense; conversely, without capital, the acquired attention cannot be effectively utilized. Therefore, understanding and applying narratives is particularly important in market dynamics.
The power of this narrative not only influences investor decisions, but also shapes the overall trend and sentiment of the market. Through effective narratives, projects can attract more attention and funding, thereby standing out from the competition.
The impact of AI and other trends
AI is a great example right now, with a lot of consumer attention focused on this area, so companies focused on AI tend to be able to raise a lot of capital and convert that money into more users. Obviously, this trend should eventually translate into a meaningful user base and returns. However, if this all collapses, there will be problems in the market. The host mentioned that similar situations have occurred in areas such as gaming and NFTs, and may now occur with HDI. Overall, he emphasized the importance of narrative, noting that businesses cannot be completely divorced from narrative, nor can they build companies based solely on narrative.
Arthur agrees, saying the article perfectly encapsulates certain beliefs that drive the market. He points out that many people subconsciously understand these, but few can clearly express them in writing. This phenomenon is particularly evident in the cryptocurrency field because there is a lack of valuation framework. People invest in this industry to find those potential breakthrough projects. As long as a project shows the potential to change the world or paradigm shift, it will usually receive more attention, capital and resources, even though these projects may not have been verified yet.
He cited the example of data availability (DA), mentioning the launch of Celestia. Celestia's price in the public market once approached a 10x increase, although it has since pulled back. People are increasingly skeptical about how much value the DA layer can accumulate in the long term, and whether it will fall into a zero-sum competition in terms of fees. As a result, Celestia's valuation has also undergone adjustments. However, if you can deeply understand the DA technology and believe that it will occupy a core position in modular architectures, it makes sense to invest heavily in Celestia or other DA solutions early on.
The host went on to discuss Celestia’s price action, mentioning that Celestia was trading at $2 at one point, and when DA became the narrative, the price shot up to $17 or $18, and even over $20. He thought this was a great example of how an asset could be undervalued for a period of time, but then quickly rise in price as the narrative became a driving force.
The parasitic nature of L2 on Ethereum
The host pointed out that before version 1.5, L2 paid a certain fee to Ethereum, and part of these fees came from users' MEV (miner extractable value) and transaction fees. However, since the introduction of blobs, L2 has reduced the fees paid to Ethereum by 90% or even 98% or 99%. He used the example of cloud service providers (such as Amazon) reducing storage fees to illustrate this point, arguing that although fees have fallen, the increase in demand can make up for this decline.
He then raised the question: if L2 fees are reduced by 98%, will this be compensated by an increase in demand for L2? He expressed uncertainty as to whether this demand will be met. At the same time, he pointed out that L2 has the flexibility to choose when to submit data to Ethereum, thereby "game" gas fees to a certain extent. Therefore, unless L2 can introduce MEV to L1, he believes that L2 is indeed parasitic so far.
Arthur agrees with this view, arguing that L2 is indeed parasitic to L1 at the current moment because all fees are falling. He points out that L2 is actually capturing existing users and not really attracting new users to use L1 as an asset. Although the technology has improved and scalability has increased, this has not translated into more demand for Ethereum as an asset. He believes that L2 can only not be considered parasitic if it expands the market size.
Arthur further explained that many of the current L2 fees come from priority fees and a small amount of MEV, so there is no reason for L2 to pass these feedbacks to L1. He emphasized that L2 needs to attract new users to continue the demand for Ethereum as collateral, thereby maintaining Ethereum's position in the entire L2 ecosystem.
The moderator then asked whether L2’s fuel assets would change as wallet account abstraction and chain abstraction evolve, and whether other assets would be used as fuel.
Arthur believes that this will not have a significant impact on Ethereum's position, because the current demand for Ethereum mainly comes from its properties as a programmable currency, rather than fuel demand.
Arthur believes that this may not be a good thing in the long run, as it is generally desirable to be closer to users to capture value. He noted that while Ethereum’s brand remains strong in the short term, this distance may start to have an impact in the five to ten year time frame.
The moderator added that many DNS and router companies experienced significant declines after going public in the early days. He compared the discussion of gas fees to bandwidth, arguing that L2 can be infinitely expanded, but whether this will increase the value of Ethereum over time is still unclear?
Arthur further pointed out that Ethereum’s success as a technology platform may not be consistent with Ethereum’s relationship as a valuable asset, which is a dangerous relationship. He emphasized that while Ethereum’s brand remains strong in the short term, how to capture value will become increasingly important in the future market.
Revisiting Game Theory
An extensive paper on games written by Arthur's team a few years ago identified three parameters or frameworks for evaluating excellent games: team background, product and distribution, and economic sustainability. Arthur said that they revisited this framework and believed that these qualities are still the key to the success of Web3 games. Recently, he has been playing (Black Desert) and mentioned that it is the first AAA game in China, which has brought him many inspirations.
He pointed out that the excessive financialization of many consumer products makes it difficult to distinguish whether the product-market fit has been truly found. If a lot of resources are invested without finding a real market fit, it is very dangerous for entrepreneurs and teams. He believes that the initial success of many games often relies on incentive mechanisms, and there is no game that can be self-sufficient and show sustainability.
Arthur went on to say that although they have seen some limited success, these successes are not enough to excite crypto investors. For example, the number of daily active users of the Pixelmon game is stable at 2 million, but its valuation is not high compared to other Layer 1s. He believes that crypto investors as a whole hold a discount attitude towards the gaming industry, and the current crypto gaming industry has not launched big enough works to change the market's perception.
He mentioned that in the past two years, the Web3 gaming industry has attracted a lot of capital, with at least 15 billion to 20 billion in funding. Therefore, funding is no longer an excuse, and the next one to two years will be a critical period to test the results of these investments. If results cannot be proven during this period, venture capital and investors may not inject funds into the Web3 gaming industry again.
The host also shared his views, mentioning that he recently played (Red Dead Redemption) and thought it was a beautiful game. He emphasized that he would not participate in Web3 games unless similar games could be developed. He pointed out that many Web3 game studios may not focus on the game itself, but on the data availability layer, or package the same content in different ways.
He mentioned that in the future, time may be used as an excuse, arguing that many good teams take several years to build. Speaker 1 then quipped that when applications are not successful, they turn to infrastructure.
Arthur agreed with this view, mentioning that in the crypto space, more and more people seem to be building "applications that serve other developers," a trend that is also becoming more common in game development.
The future of DeFi and the potential of Aave
The host mentioned a recent paper by Arthur's team on Aave. He began to think that DeFi primitives (such as lending, etc.) should eventually be close to the valuations in traditional finance. He asked Arthur what he thought about this and if he could elaborate on their views on Aave.
Arthur responded that regarding the first part of valuation, since the DeFi industry is still small, valuation multiples do not have to converge because DeFi still has a lot of room to grow. For example, JPMorgan Chase is already the largest bank in the world and cannot expect its size to double without economic growth. And DeFi still has a lot of exponential growth potential as long as the rest of the world remains the same. Therefore, he believes that DeFi's valuation multiples should not be the same as traditional finance because it still has a lot of growth potential.
He further pointed out that DeFi is much more scalable than other financial services. Compared with traditional finance and fintech, DeFi has very low marginal costs. For example, as long as the market size expands and the number of users increases, Aave does not need to do much to achieve growth. In contrast, fintech often just provides a better front-end interface for traditional finance and does not fundamentally change anything. Therefore, as the scale expands, fintech will still inherit the cost structure of traditional finance.
Arthur believes that DeFi will not face this problem because its marginal cost is low and it can scale quickly as long as the product is correct. He mentioned that DeFi's rapid growth in 2021 is due to this.
Regarding the potential of Aave, Arthur expressed his confidence in the future of DeFi. He believes that decentralized currencies such as Bitcoin and stablecoins and finance-related use cases such as speculation and fundraising have found product-market fit in the market. For DeFi, he is very confident that it will continue to exist in the next five years, but he is concerned about whether it can grow tenfold in the next five years. He emphasized that when investing in DeFi, he is not concerned about whether it will exist, but whether it can exceed the current level.
Arthur also mentioned that DeFi is going through a classic Gartner boom cycle, with 2025 being the peak of excitement, followed by hacking incidents and various problems. He believes that DeFi is currently emerging from the trough of loss, and may gradually enter the enlightenment stage in the next few years, when everyone will return to basics and admit that blockchain is still the best choice for financial use cases.
He concluded that finance is currently the largest use case in crypto, and that other use cases, while interesting, are nowhere near the scale of finance. He expects that when people realize this, some of the leaders in the DeFi space will be repriced.
Finally, Arthur pointed out that many infrastructure projects are valued at up to 10 billion or 20 billion, while Aave’s valuation is only 1.5 billion. As one of the most important primitives in this field, he believes that Aave still has a lot of room for valuation improvement.
Challenges and opportunities in DeFi
The host mentioned that Arthur has been observing DeFi for six or seven years. He asked what changes have taken place during this time that make Arthur optimistic about the industry and believe that it will continue to exist and grow.
Arthur responded that first, more and more wealth is stored on-chain in the form of digital assets such as Bitcoin, Ethereum, and stablecoins, so financial services are needed to manage these assets. He said that if DeFi's product-market fit is not high and it does not accelerate, he may be pessimistic. However, as long as the total amount of assets on the chain continues to increase, he will continue to be optimistic about the growth of DeFi because the two are related.
The moderator further asked whether there were any changes within DeFi besides the above external factors, such as changes in basic primitives or improvements in user experience.
Arthur believes that security practices and ways to prevent vulnerabilities have improved in the past two years because everyone is aware of the seriousness of the problem. He mentioned that a cybersecurity company called Hyper Native recently raised a large amount of funds to conduct technical detection before vulnerabilities occur. He believes that security will improve in the next few years, and the user interface and user experience of on-chain interactions will become more friendly, similar to the secure login methods of Web2 (such as email and password). He believes that the technology is mature and will be widely adopted in the future.
Arthur also mentioned that those who have experienced the past two years know what unsustainable practices are, so he does not think that the same mistakes will be repeated in the short term. He does not think that similar unsustainable policies will appear in the market again.
The host made the opposite point, arguing that the unsustainable phenomenon still exists. He mentioned the situation of Pump Fund, pointing out that out of the 2 million tokens launched, only about 92 tokens have a market value of more than $1 million. He believes that some older people in the crypto field may not realize this.
Arthur agreed that Pump Fund was indeed a bubble, not a simple Ponzi scheme. He believes that people who participate in Ponzi projects usually know that they may lose money in 99% of cases. He pointed out that the problem with DeFi is that many projects have given false promises, such as Luna, which was promoted as sustainable, but in fact it was not.
Arthur stressed that while the participants of the Pump Fund knew what they were doing, many projects in DeFi made unrealistic promises. He believed that although the Pump Fund might be a value extraction project, the way it operated was transparent.
Regarding Friend.tech, Arthur said that the project could become bigger, but its current structure is still not decentralized enough. Speaker 3 added that Friend.tech's success lies in the participation of certain large funds, but its degree of decentralization is questionable because key control rights have not been returned to the community.
Finally, Arthur believes that the future of DeFi is still full of opportunities. Although it faces challenges, DeFi will continue to develop with the advancement of technology and the maturity of the market.
