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Traditional asset managers and firm ex-pats have been showing a growing interest in decentralized finance, or DeFi.

DeversiFi, a data layer trading solution, this week closed a $5 million funding round led by ParaFi Capital, a Connecticut-based asset manager that focuses exclusively on DeFi. Last week publicly-traded Brooker Group, an asset manager based in Bangkok, said it would move $48 million, half its assets, into a portfolio of DeFi projects and decentralized autonomous organizations, or DAOs.

A DAO, pronounced like the first part of Dow Jones, is a group of people using code, or smart contracts, stored on a blockchain to manage the treasury and governance functions of an organization. Because many DAO members never meet or even learn one another’s legal names, the structure has been described as a company made up entirely of freelancers. 

It’s not totally inaccurate, but it belies the rate at which they and the rest of the DeFi space are growing.

There’s currently $78.07 billion of total value locked (TVL) in DeFi projects, up from $14.37 billion, or 443%, compared to just six months ago, according to DeFi Pulse. In the same six months MakerDAO, the org behind USD-pegged stablecoin DAI and one of the most well-known DeFi projects, has seen its dominance slip to 16.5% of that TVL.

The TVLs that appear in this story were retrieved on May 17 and May 18. 

DeFi Pulse calculates TVL by pulling data on the ether (ETH) and ERC-20 tokens held by a smart contract. That balance is then multiplied by the current price in USD. DeFi Pulse's calculation does not take the value of outstanding loan balances into account, which is the main reason it differs from – and is usually lower than – the calculations done by DeFi Llama, the data provider for the TVL values that appear on CoinMarketCap.

Trading assets under management and fund prospectus for total value locked and white paper

TVL is to DeFi what assets under management are to hedge funds. But TVL tracks funds being managed by smart contracts running on the Ethereum blockchain. Humans get involved to maintain the smart contract’s underlying code, but usually only after DAO participants have put the matter to a governance vote.

Not all DeFi projects are DAOs. But there are a lot of parallels between them and traditional financial products, which has made them an appealing point of entry for large-scale investors.

To continue the hedge fund analogy, a DAO’s white paper serves many of the same purposes as a fund prospectus. It lays out the theory and technical rules that govern how a smart contract manages funds.

The MakerDAO white paper, in particular, has been at the center of an ongoing class-action lawsuit. The suit, filed in April, alleges MakerDAO knowingly deceived investors by claiming in its white paper that DAI was a safer investment than other coins because it’s over-collateralized.

Plaintiff Peter Johnson has said he and others endured six-figure losses when DAI’s primary collateral, ether (ETH), dropped sharply during the March 12 “Black Thursday” crash and triggered the MakerDAO smart contract to liquidate thousands of collateralized debt positions held by investors – something the over-collateralization policy was meant to safeguard against.

In its defense, Maker has said that by filing the lawsuit Johnson violated an arbitration clause in the terms of service he signed in 2018. As a result, legal proceedings for the $28 million lawsuit have been halted since September.

What responsible, intentional DAO participation looks like, according to an attorney

Gabriel Shapiro, managing counsel at Atrium and co-founder and head of legal at ZeroLaw, said there are a few ways potential DAO investors and participants can protect themselves from potential liability in something like the MakerDAO class-action lawsuit.

He recommends only participating in DAOs “wrapped” in a legal business entity that provides strong limited liability protection for its members, shareholders and management. If that’s not the case, he said, consider incorporating your own legal entity and having it participate in a DAO, rather than personally becoming a member.

“In my opinion, liability is never destroyed, only distributed,” Shapiro said. “By structuring an organization as a general partnership, generally speaking, you just increase the number of people who are liable for the underlying issue.”

In either case, he recommends potential members be intentional about how they interact with a DAO. 

That’s not woo-woo mindfulness advice. 

Shapiro said he sees lots of participants misunderstand the tax withholding and reporting obligations of a DAO when it unintentionally meets the definition of a legal partnership.

“Many DAOs may, unwittingly, be legal partnerships,” Shapiro said. “Accordingly, it is possible that all of the income of the DAO is 'passed through' to its members and the DAOs should be providing all members with Form K-1s so they can report their respective portions of the DAO's profits and losses as their own income and loss each year.”

Liability and tax obligations mean bookkeeping is vital. While the smart contract itself can take the place of more traditional record-keeping, that’s only a viable option if the participant or their accountant knows their way around a block explorer, like Etherscan

Failing that, Shapiro said to look for DAOs that have good front-end and middleware specific to their smart contract configuration.

Minding tax obligations on the yield farm

Red, who goes only by his username, is a community manager at Harvest Finance, yield farming aggregator DAO. He said he’s gotten into the habit of timestamping airdrops so he can relay the information to his accountant during tax season

Airdrops are the equivalent of free samples at Costco. They’re meant to make people more likely to want to pay for the product because they suggest the issuer is so confident in it, they’re certain the recipients will come back for more.

One of the most famous airdrops occurred in 2017 when Bitcoin Cash did a hard fork of Bitcoin and unexpectedly gave bitcoin holders an equivalent amount of its new BCH tokens. 

“If you get an airdrop, like I did the other day that was worth something like $3,000, I had to make sure I recorded that I just got $3,000 for free,” Red said. “Just because I never withdrew that, it doesn’t matter. That was one popular theory in DeFi for while, that you only realize gains when you withdraw.”

Red said he got into DeFi, and eventually DAOs, when his brother-in-law started telling him about smart contracts and blockchain in 2017. The biggest difference between the initial coin offer, or ICO, heyday of 2017 and now is that there are actual products, said Red.

“Back then it was like, you know, white papers and theoretical [promises] only and, ‘Hey, we’re gonna build this, so give me a billion dollars,” he said. “And then there’s literally like a 95% failure rate. But that 5%, the people who learned lessons along the way from people who were pioneering, they’ve actually built things that are sustainable and scalable.”

That eventually led him to Harvest Finance, which launched in September.

Harvest Finance’s yield farming aggregator gives holders of its FARM token exposure to over 100 different strategies and, in return, distributes 30% of the profits to token holders. The DAO saw its TVL briefly surpass $1 billion in October, right after it launched, but it has since fallen and been relatively flat in 2021. Harvest’s TVL was $275.4 million when this story was being written. 

The concept of yield farming has gotten a lot of traction and comes up often in conversations about liquidity. Having no central institution that allows people to cash out whenever they want – remember, this is DeFi – has given rise to liquidity pools, groups of people who make their cryptocurrency available for exchanges or lending. In return, they receive rewards. 

The value proposition of Harvest Finance is that buying their FARM token gets you exposure to many liquidity pools without having to look for the most lucrative ones on your own.

But having been launched in the aftermath of the MakerDAO lawsuit has left a mark. Harvest Finance has gone out of its way to list its auditors –  Least Authority, Haechi, Peckshield and CertiK – on its website and make their reports publicly available through GitHub.

Earning member’s trust with automated code pushes, voting and delegates

One of the other security measures touted by DAOs has been that decisions to add new features or make changes to the smart contract need to be proposed and voted on by members, usually limited to token holders. But there have been instances of developers, the ones with access to the source code, not making the changes that a DAO’s members have voted for. 

That’s brought on the advent of some new security measures, said George Harrap, head of DeFi at YAP Global and co-founder of Step Finance. Step, currently in alpha testing, has set out to become the one-stop-shop for yield farming on Solana, a proof-of-stake (PoS) blockchain launched by the Switzerland-based Solana Foundation in 2020.

“Some of them make it so that when you’re submitting a proposal, you’re actually submitting code for the change you want, and the smart contract will automatically integrate that into the codebase if enough votes have been cast when the voting period elapses,” he said. 

He also said that voting among DAO members has been plagued by the same pitfalls of voting in general: Apathy and low turnout. Some DAOs have allowed the election of delegates so that members who don’t want to actively participate can allow someone else to cast a vote for them. 

And because everything in DeFi happens and is visible on the blockchain, there’s also the potential for developers to fork, or copy, the open-source code of one project and start their own.

The catalyst that led to the launch of Sushiswap was growing dissatisfaction among members with Uniswap’s high cost for submitting proposals. 

“It made people ask, well are they really serious about this,” Harrap said, “like they don’t actually want proposals. You needed something like 10 million UNIs or something to make a proposal. And each point cost the equivalent of $40.”

Rather than rally to pay the nearly $65 million it would have cost to propose a change, a handful of members forked Uniswaps code and started their own DAO. Sushiswap, which currently has a TVL of $4.48 billion, has been hot on the heels of Uniswap, which currently has a TVL of $6.66 billion

Traditional asset managers and firm ex-pats have been showing a growing interest in decentralized finance, or DeFi.

DeversiFi, a data layer trading solution, this week closed a $5 million funding round led by ParaFi Capital, a Connecticut-based asset manager that focuses exclusively on DeFi. Last week publicly-traded Brooker Group, an asset manager based in Bangkok, said it would move $48 million, half its assets, into a portfolio of DeFi projects and decentralized autonomous organizations, or DAOs.

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