When we’re making the case for Melon we’re often asked about how we intend to disrupt asset management.
The answer may surprise you. We aren’t trying to disrupt asset management. What we are focused on is automating the way existing asset management protocols are enforced. The techies among you might already be raising an eyebrow here: “Existing asset management protocols? Off-chain? Who has off-chain protocols?”
Yet protocols predate computers. Protocols are simply standardized operating procedures to get tasks done quickly and efficiently. There are protocols for getting married (where to register, how to ensure it is legally recognized), for driving on the road (left side or right?), for finding a table at a restaurant (show up or book in advance) etc etc. And there are protocols in the asset management industry.
These protocols involve countless financial intermediaries which, together, play a crucial part in ensuring that investors in funds and fund managers can trust one another. As we will see below, the enforcement of such protocols involves considerable administration costs which impose significant barriers to entry in the industry. Since each intermediary is a potential point of failure, the current asset management industry is also clunky, inefficient and vulnerable to the behaviour of bad actors (think Bernard Madoff)
But the technology now exists to improve this infrastructure. Automation of asset management protocols = the Melon solution. In this blog, we’ll take a look at what asset management protocols are and how blockchain technology can automate them. We’ll then examine how other financial protocols are fast becoming automated and how Melon has the potential to become the platform that DeFi will operate on in the asset management 3.0 era.
What are asset management protocols and why are they important?
Imagine it’s 2003 and you wanted to invest with Bernie in his US equity fund. You don’t know him personally, but his sales team tell you that he’s been posting continuously good returns. How do you know that his returns are real? How do you know Bernie will use the money you send him to buy only US equities, rather than Bolivian bonds, Iraqi real estate, or worse, a new car for his wife? What measures are in place to give you (the investor) security? And even if you decide that Bernie is legit, and isn’t going to go off piste with your money, how do you establish a fair valuation price to buy your first share in Bernie’s portfolio? Who provides you with that information? How do you know that Bernie’s fund really owns the underlying assets he says it does?
The answer is that you rely on certain industry protocols. The list of doubts you may have is endless and without these asset management protocols, there is no easy way to keep tabs on any of these things. So over the many years that asset management has been around, protocols have been developed and fine-tuned to spit out a pretty robust set of standardized procedural rules to establish trust between investors and asset managers to interact with one another without necessarily having to know or directly interact with one another.
So before you send your money to invest in Bernie’s fund, you will probably want to check the fund’s assets and liabilities. The fund manager knows that investors want this information to guide their own decision making and so one financial industry protocol is for funds to publish financial statements at regular intervals so that fair values can be determined. Of course, investors want to know that the financial statements are accurate. They are suspicious if the audits are not done by an independent entity. Hence, another asset management protocol is that funds are audited by an auditor which is fully independent of the fund manager.
If you do decide to buy shares in Bernie’s fund, you will want to know that the price that you’re buying into the fund is correct at the time that you’re making the investment (there’s no point in investing today in a fund which was valued at $100 a year ago, since the underlying value of the fund may have changed significantly over the last twelve months). Again, protocols exist between the fund administrators, the auditors and the fund managers to ensure that the investors know that the price they pay when they make the investment is accurate.
So this is how ‘protocols’ were implemented before modern technology — using a complicated web of service providers to assure things like payment on delivery, good price execution, reliable settlement, accurate accounting, safe custody, no fund embezzlement, etc. This imbroglio of bilateral protocol implementation is mostly invisible to the average person who nevertheless typically bears its costs.
Enter blockchain technology and Melon
Blockchains enable secure and reliable transactions between two parties (despite them not being known to each other) without the need for an independent third party being necessary to establish trust. We can also assign conditionality to transactions, written in code, enforced in a smart contract, again, doing away with those third party intermediaries. This is exactly what the Melon Protocol does. It is simply automating existing asset management protocols with code. The basic rules of the game still apply (safe custody, fraud prevention, accurate accounting, fee calculation, transparent and provable fund positions, etc) but how these rules are enforced is different.
So, to emphasize the point again, the Melon Protocol doesn’t claim to disrupt asset management. Rather, it improves the way that current asset management protocols are enforced in a web3 tokenised world. Asset management has been around for centuries and the dos and don’ts are pretty clear. Melon simply automates these rules using smart contracts to carry out functions which until now have had to be done by intermediaries. This smart-contract powered asset management infrastructure is exciting because it drastically speeds up processes, lowers barriers to entry, provides far greater transparency, gives greater control to investors and removes any single point of failure.
This is a good thing
All of the above can be summarised as: Melon doesn’t change the ‘what’, but the ‘how’ of asset management. Some of the biggest disruptive trends of all time also impacted the ‘how’ and not the ‘what’. Uber didn’t change the act of taking a taxi, but it significantly changed the ‘how’. Amazon didn’t change the ‘what’ of retail, but it certainly changed ‘how’ we buy stuff. Netflix didn’t change the ‘what’ of home TV entertainment, but it did change the ‘how’.
Moreover, this is why many of the ‘new’ solutions provided by DeFi aren’t really that ‘new’. Uniswap, 0x, Compound and Melon are not trying to rewrite financial protocols. They are simply automating them. The new and novel part of these projects is again in the how — they are much more efficient and can achieve the same goals, without the need for financial intermediaries to act as ‘safeguards’ or ‘enforcers’.
Other DeFi protocols follow this same thinking
We feel no shame in acknowledging that we aren’t reinventing the ‘what’ of trade and finance. Financial ‘protocols’ haven’t evolved much over the millennia. Let’s not forget that there were deposit-taking intermediaries (i.e. banks) at least as early as the time of the ancient Egyptians and futures contracts date back to at least the time of Hammurabi in 18th Century BC Babylon — a cuneiform tablet in London’s British Museum from that time specifies a quantity of a commodity (slaves), at a certain price, to be delivered at a certain date. We don’t know for sure when options contracts first came into existence but we know that they were being traded in London at the time of the South Sea Bubble of 1720. These contracts, all intended to transfer property from one peer to another, and all forming market transactions of the day were completed using the standard protocols of the day. Those protocols would not have been so functionally different to those used today. It’s just that today’s protocols are executed using more sophisticated technology (e.g. computer drives vs tablets; internet or cellular messaging vs. carrier pigeon). How might blockchain technology change what tomorrow’s financial industry protocols look like?
This is what the typical value chain of a Visa credit card payment looks like. In other words, these are the financial intermediaries that were required to establish trust between payment customers and merchants of goods and services before blockchain technology came along.
Again, and importantly, blockchains did not reinvent the ‘what’ (payments and accounting) of transfer payments. The novelty is simply in the ‘how’, i.e. in the implementation of the protocol. The bitcoin blockchain, for example, has provided an entirely alternative P2P payment infrastructure without needing any of the participants listed above to establish trust between merchants and customers.
This is what the typical value chain for order-matching on the London Stock Exchange might look like This complicated web of players is what is required to establish trust between buyers and sellers of tradable assets.
0x-type exchange protocols facilitate P2P order book matching for limit orders on-chain. Buyers and sellers can place limit orders and are assured that if they trade, they always trade at the price they want to trade. The risk they take is that they don’t trade because they can’t find the other side at their price before the market moves away from them.The idea behind order-book matching (the ‘what’) is nothing new or innovative, however, the implementation of it using smart-contracts (the ‘how’) is. For starters, it enables faster exchange and settlement. Second, it is non custodial and therefore provides better ‘guarantees’ than off-chain approaches dependent on financial intermediaries which introduce single points of failure.
In other words, with 0x-type protocols we no longer need to rely on central counterparties, settlement houses, custodians and exchangesto trust that trades are recorded and settled promptly (typically 2–3 days in the traditional world). This process (the ‘how’) is completely dis-intermediated and replaced with code rendering it trustless. It also ensures almost immediate settlement.
When you are buying (typically) financial instruments, (e.g. securities, currency, derivatives) there are two types of trade orders you can place. The first is order book matching where you can make or take a ‘limit order’. Here, you set a limit on the price you will buy or sell at, and specify how much you will buy or sell at that price. The trade will be executed when you find another participant who will take the other side at that price (i.e. sell the amount you want to buy, or buy the amount you want to sell). Order-book trading guarantees that you trade at the price you want to trade, which means that there is no risk of e.g. overpaying. But there is a risk that the market moves away from you and you don’t get to transact.
For example, suppose you put a limit order to buy ten shares at a price of $100 p/sh, but just as you enter the order, the market drifts higher. First to $100.10. Then to $100.20. Then to $100.30. Tomorrow it trades at $101, the day after at $102, and next week at $110. Since your limit order was $100, you’ve missed the boat, for now.
To prevent this risk, you could have placed a ‘market order’. This would guarantee that you got your ten shares, but it won’t guarantee you a price. Suppose there was only one share offered at $100. Another offered at $101. Another at $102 etc all the way up to $109. A market order to buy ten shares would mean you bought each of those as they were offered, giving you an average buy price of $104.5.You take the risk that you may not be able to fill your order if the price moves away from you.
In other words, when you’re buying assets you can guarantee either the price or the volume, but not both. This is the fundamental ‘what’ of trading on exchanges.
Market makers are traders who offer their clients a way out. Thus, if you are a large holder of a company’s stock which you wish to sell (e.g. you are a large pension fund) you might go to the trader and ask them to give you a firm price for your holding. The trader will make a firm price to the pension fund committing to buy the large amount of stock betting that they will be able to unload it in the market at a profit net of commission. The client therefore guarantees the volume they can trade at but gets no say on price. Meanwhile, the trader charges a spread for taking the risk and hopes that he or she can unwind the position safely without a loss.
Uniswap-type protocols automate this market-making process. Up to a certain size, buyers and sellers can always trade the volume they want on demand, but the tradeoff is that they have no choice on the price they trade at. Note again, there is nothing new or particularly innovative about automated market-making itself (the ‘what’). In the end, traders are still ultimately forced to choose between price risk or volume risk. The new and exciting part is in the ‘how’. These protocols don’t take custody of the assets before the trade, they reliably handle settlement and they are not controlled by any single party.
In other words, with Uniswap-type protocols we no longer need to rely on the complex web of intermediaries listed above to provide risk prices, liquidity, settlement, central counterparty services etc. These processes (the ‘how’) are rendered trustless with code.
This is what the typical lending value chain looks like in banking. This network of players is what is required to establish trust between borrowers and lenders. In other words, it is the trust value chain for the credit market.
Maker and Compound-like protocols enable borrowing and lending on-chain. Lenders and borrowers can agree on terms through a transparent marketplace. The underlying code will automate and ensure that collateral requirements are within limits, interest payments are made on time and the duration of the loan is as promised amongst other things. In the case of lending, there are some parts of the trust value chain which are not disrupted. For example, lending protocols have some limitations because they don’t (yet) provide any information on the borrower, identity, credit history etc. This means that at all times the loan has to be over-collateralized which limits the value proposition to an extent.
But blockchains haven’t re-invented lending (the ‘what’). The fundamental role of channelling money from lender to borrower is identical to that performed in ancient times. Instead, they have made the ‘how’ in lending much more efficient by disintermediating many of the players required to establish trust, rendering it largely trustless. Whilst the system is still not able to handle one of the most significant parts of the value chain; this is likely to come with time and a huge part of the trust value chain has already been addressed.
The intersection of DeFi and Asset management 3.0
So to conclude, the Melon Protocol is the conscious and ambitious intersection between all DeFi protocols. It has the potential to be the platform that DeFi operates on for asset management. It brings together all the components of asset management and integrates them natively through the modular design and composability of contracts. Through Melon, investors can use blockchain technology to manage an account, set up a fund, make a trade, lend or borrow, account for trades, account for P&L, risk-manage, audit portfolios, distribute fees and much more. Moreover, this can be entirely automated without the endless intermediaries listed above. So for those of you who wondered whether we were disrupting asset management. The answer is , we are disrupting how it is done and we think that’s much more exciting.
This blog was co-authored by Mona El Isa & Jenna Zenk
A big thanks is also due to Dylan Grice and Julie Simon for helping us articulate our views.