Analyzing MetaFi: The Rise of Metaverse Finance

Written by: Outlier Ventures

Compiled by: TechFlow

Note: What kind of sparks will fly when the Metaverse meets DeFi? This is a comprehensive analysis report by Outlier Ventures on the new concept of MetaFi, organized and compiled by the volunteer community TechFlow Friends.

Since 2018, the momentum of decentralized finance (DeFi) has been growing within the cryptocurrency community. Although DeFi has garnered significant attention in the cryptocurrency space, its adoption rate remains relatively low, with less than 5% of all cryptocurrency assets being used as collateral.

This article suggests that the primary growth of DeFi in the future will not be driven by CeFi, but rather by what we call "MetaFi" to unlock value. MetaFi refers to decentralized financial tools within the Metaverse.

What exactly is the Metaverse? What value does it hold? How will DeFi combine with ongoing innovations in cryptocurrency to enable the large-scale development of MetaFi?

In summary, the Metaverse can be understood as an interface layer between the physical and virtual worlds. It encompasses a combination of hardware and software innovations, but most importantly, it is an economic system that runs parallel to the fiat financial system. In this context, we need to think about it from the perspective of financial inclusion.

1. The Metaverse Needs Crypto

As mentioned above, the Metaverse is primarily an economic system, the Meta-Economy, which can be positioned above any digital economy, virtual world, or game, all of which should be viewed as individual examples within the Metaverse, or as one of its sub-universes (Verse).

In fact, over a sufficiently long period, when the aggregate GDP of the Meta-Economy surpasses that of national GDPs, it will enjoy greater advantages compared to fiat-based economies. We believe that at least the open Metaverse is a version of an open and permissionless Meta-Economy, achievable through what we collectively refer to as Crypto. In the absence of other Meta-Economies today, our argument is: The Metaverse needs Crypto, and Crypto is the Metaverse.

In our definition of the Metaverse, people can understand it through two main concepts:

1. Interface Layer. End users can experience the Metaverse through various hardware and software technologies, such as desktop browsers, mobile applications, or extended reality (XR), virtual reality (VR), and augmented reality (AR).
2. Financial Computation Layer. This is where the computations of the Metaverse are executed, establishing a decentralized, transparent, and democratic foundation that determines how end users operate based on economic logic to exchange goods, services, and currencies, allowing developers to build the Metaverse on this foundation. Ethereum is a great example, as it is a protocol used by developers to create decentralized applications and smart contracts, as well as a ledger for recording transactions between Metaverse end users.

In the context of the first point mentioned above, the early interface layer may take various forms and shapes, and it is important to maintain an open mindset as we progress in technology and concepts. Therefore, when we refer to the beginning of the Metaverse's development, we typically mean current experiences such as games and virtual worlds, whether they are browser-based 2D or more immersive VR or AR.

The financial computation layer refers to the foundational technologies that support the Metaverse. As we described in our paper on the open Metaverse operating system, we believe the foundation (or core) of the financial computation layer will be based on technologies that can be classified as Web3.

We also believe that any digital domain within the Metaverse must be based on Web3 to provide fundamental property rights, interoperability, and permissionless value transfer across various domains (or verticals) of the Metaverse. **These technologies empower the development of a rich and diverse array of applications and instances on the Web3 foundation.

In this way, the Metaverse offers a parallel economic system composed of decentralized ledgers, characterized by globality, transparency, and being crypto-native. It provides a foundation for a new digital-first economy, which we have already observed budding through NFTs (Non-Fungible Tokens) and gaming economies (such as Play-to-Earn in Axie Infinity).

Due to its decentralized and permissionless nature, its pace of innovation is unmatched, making it difficult for traditional systems to keep up. Therefore, particularly in the context of DeFi, the Metaverse has the potential to thrive outside the jurisdiction of national regulators, or at least before national regulators begin to exert control.

Moreover, as we observed over the past 12 months in 2021, DeFi has gradually come under scrutiny and criticism from regulators in many jurisdictions. While the degree of regulation may bring some positive market effects, poorly implemented regulation often stifles innovation and favors existing financial institutions. In the case of DeFi, there are several similarities between its products and traditional financial assets.

Additionally, we believe the Metaverse represents an informal economy, where its products are often commodities of the digital marketplace, which may or may not appear in traditional markets. Just as it is impossible to regulate every aspect of global economic activity, the same applies to the Metaverse. Given the potential for exponential growth of economies in VR, AR, and XR environments, the scope for potential regulation becomes more challenging, not to mention the enforcement of such regulations over time within the Metaverse.

We firmly believe that the DeFi components that promote the growth of the Metaverse will achieve unprecedented financial inclusion on a global scale. Furthermore, we believe that economic activities within the Metaverse will facilitate intergenerational wealth transfer, benefiting future generations and being inclusive of digital natives, digital creators, digital workers, gamers, and musicians—individuals with digital value that is not recognized by traditional financial systems.

2. The Current State of the Digital Economy

Today, billions of dollars in value are trapped within proprietary network platforms, such as social media (Facebook, Instagram, or TikTok) or games (Fortnite and Roblox).

What we refer to as Web2 actively builds "moats" to capture these funds and users for as long as possible, in order to extract as much "lifetime value" as possible for shareholders.

Generally speaking, the operating principle of Web2 companies is shareholder supremacy, often at the expense of user interests. **In social media or free games, this value is primarily monetized through advertising, and profits are generally not shared directly with users themselves. Even for Roblox, a company that operates on the premise that "creators can monetize UGC (user-generated content)," the estimated percentage of revenue that users receive is only 25%. The same applies to music streaming models and shows on YouTube.

It is estimated that the total value of the global digital economy is $11.5 trillion, accounting for 15.5% of global GDP. Over the past 15 years, its growth rate has been 2.5 times that of global GDP, nearly doubling in size (since 2000), with an increasing population relying on the internet for their livelihoods.

If we focus on a subset of the digital economy—the digital creator economy—it currently represents only a small part of the mainstream digital economy, but its core areas are growing. It includes publishing, gaming (skin creation), digital art, streaming, music, film, and more.

On the supply side, there are currently up to 50 million content creators in this field, primarily consisting of hobbyists (46.7 million) and about 2 million professionals. In the digital creator economy, professionals can easily earn $100,000 per month. However, most people's earnings are much lower, income is still unstable, and compensation for work done through the system may take months to receive. We believe that most of today's digital creator economy will not be considered part of the Metaverse because value cannot be freely traded across platforms, and most is locked into the value of individual platform equity.

We further break down the limitations of Web2 digital platforms:

Limited Inclusivity: Taking the digital creator economy as an example, most traditional creators are economically excluded because the value they create is ignored, outside the control of Web2 platforms, and their income is unstable. In short, unlike those working for centralized companies and receiving fiat salaries, the existing financial system cannot assess the relevant risks of providing loans to wealth creators in the digital economy.

Dynamic Terms and Conditions: Participants in the traditional digital creator economy cannot trust that highly centralized services possess credible neutrality, which poses risks of de-monetization and de-platforming for two types of content creators. For example, when OnlyFans suddenly bans adult content creators, platforms like Facebook and Twitter also regularly revoke developers and their APIs. In reality, the rules for participating in these platforms are not clear, cannot be consistently applied, are not auditable, and may be changed at any time (unlike the code of smart contracts).

Isolated Design: As mentioned earlier, platforms make it difficult or even impossible for people to transfer value directly or through cashing out to outside the platform, thus exiting its closed digital economy. This leads to monopolies, meaning that over time, even if users can exit, they have no other options.

3. Web 3, NFTs, and the Metaverse

In contrast, in the Web3 world composed of cryptocurrencies, DeFi, and NFTs, the entire paradigm revolves around users and their sovereignty: their identity, data, and wealth.

In Web3, even data itself can be a form of digital wealth and income. This means that while there are still platforms to help create, discover, or curate management processes, users can have complete control over their outputs and freely transfer value between platforms, allowing for permissionless resale, borrowing, and lending. In short, transferability is a fundamental form of "property rights."

It is no surprise that we find from the early successes of Web3 that when moats are removed and transferability becomes possible, people will spend more time and money on platforms they prefer, such as the blockchain game Axie Infinity. We have elaborated on this in our previous papers. In the long term, the Metaverse and its platforms (including most of Web2) will adopt the technologies and principles of Web3, not necessarily because it is the right thing to do philosophically, but because it is a good business.

The recent launch of NFTs by TikTok has proven the correctness of this prediction. But the better news is that this could happen even before Web3 receives explicit permission or adoption from closed platforms. Instead, NFT derivatives can, in principle, be represented and freely traded in the permissionless market of Web3 through innovations in decentralized commercial infrastructures like Boson Protocol.

4. Definition of MetaFi

For us, MetaFi is an all-encompassing term that refers to the protocols, products, and/or services that enable complex financial interactions of non-fungible and fungible tokens (and their derivatives). For example, through MetaFi, individuals can now use fractional parts of NFTs as collateral on DeFi lending platforms.

To understand MetaFi, we must first emphasize two core principles that enable DeFi: 1) Unstoppable, 2) Composability; these two principles serve as a "currency Lego" for developers, combining to form a highly innovative parallel financial system.

Developers around the world can openly participate and compete to offer the highest yields, decisively eliminating inefficiencies. Equally important, regulators can only limit the interaction of fiat-based systems they regulate with DeFi, but they cannot necessarily restrict what happens within DeFi itself (as long as the projects and their teams are sufficiently decentralized).

MetaFi brings these DeFi principles to a broader Metaverse through a mix of non-fungible and fungible tokens, combined with novel forms of community governance, such as decentralized autonomous organizations (DAOs). The combination of these different cryptocurrency primitives makes a mature parallel economy possible, potentially bringing hundreds of millions or even billions of users to the cryptocurrency ecosystem over the next decade. We believe that four key trends in MetaFi will accelerate this process:

1. Development of Financial Tools: Previously, the DeFi storage stack was only mastered by a small portion of the cryptocurrency developer community due to its technical complexity. However, through NFT platforms, creators and communities can more easily set economic terms for creative exchanges with users, from perpetual royalties to issuing their own community tokens. Fans and communities can also directly share in the economic success of the products and cultural projects they love.
2. Financialization of Everything: Many people disdain the speculative nature of cryptocurrencies, unaware that this is a feature rather than a flaw. Through MetaFi technology, the value and flow of everything can be captured through digital assets, allowing open free markets to form long-tail value, and real-time price discovery can unlock potential value that has yet to be realized on the internet.
3. Improvement of DAO Service Stacks: A mature DAO stack allows for collective governance of purely on-chain digital and financial services without the need for companies and centralized intermediaries (like banks). The main characteristic of DAO members is the ability to join and exit smoothly based on clear terms.
4. Interaction of Risks: History shows that existing financial institutions often fail to assess the risks of emerging markets; whether basic banking services or insurance. This has led to the mutualization of risks within communities, from agricultural communities to shipping industries. Traditionally, this has been done through cooperatives. DeFi has already provided users with community-based insurance supply tools, especially when combined with DAO service stacks.
5. Gamification of Finance: Generation Z is more interested in becoming financially literate than previous generations. As a result, many new banks offer new and engaging ways to help individuals manage their finances, providing educational platforms that make it easier to learn financial courses. This makes young people more willing and likely to engage with financial products than their parents and grandparents. Moreover, we find that the boundaries between memes and financial tools are becoming increasingly blurred, such as cryptocurrencies like Dogecoin or various "meme stocks" offered through Robinhood, allowing people to invest and trade more freely within internet culture.

5. Understanding NFTs as Collateral

To truly understand whether digital representations can serve as actual financial assets for loans, it is important to understand the guarantees of NFTs as a form of collateral in DeFi. As we emphasized at the end of 2020, NFTs generally have worse liquidity than fungible tokens, but they can increasingly be used in DeFi protocols.

However, it is important to note that this was before the explosion of NFT art in early 2021, before the emergence of blue-chip NFTs like Crypto Punks and Bored Apes, and before the breakthrough success of the Play-to-Earn blockchain gaming category led by Axie Infinity. This prediction of the combination of DeFi and NFTs has now begun to play a role in everyday MetaFi.
Total loans of wETH on NFTfi as of December 13, 2021

Total loans of DAI on NFTfi as of December 13, 2021

Moreover, it is increasingly interesting that the interaction of fungible and non-fungible social tokens, created for and by the creator class, has significantly reduced their reliance on intermediaries, allowing people to gain shares in the creator or community franchises and the future value they create. The total value of social tokens is now approximately $1.1 billion and continues to grow.

6. Framework of MetaFi

To understand MetaFi within the Metaverse, we first visualize the main components of the Metaverse (represented in a chart). We use the previous framework of the open Metaverse operating system, which focuses on the layers of the Web 3 stack applied in the Metaverse.

The Metaverse (as shown below). This diagram consists mainly of three parts: 1) Layer 0, Layer 1, and Layer 2 as the foundation; 2) DeFi; and 3) Universe (Applications) (Verse).

1) Foundation

This part consists of core frameworks (or protocols) labeled as Layer 0, Layer 1, and Layer 2, such as Polkadot, Ethereum, and Polygon.

These core frameworks allow applications to be built on top of them due to shared application logic and security; they also have a unified communication layer (obtained through execution and consensus, but also including bridges and similar cross-chain technologies), enabling horizontal value transfer. The horizontal axis labeled as the open Metaverse and its related components should be included in applications aimed at providing experiences within the Metaverse. If an application does not integrate with this core layer, it will become isolated, and the economic and creative value within that application will stagnate and gradually disappear, ultimately leading to a lack of financial inclusivity for that application.

We can see similar situations in the traditional world, where services that have not integrated into a broader ecosystem gradually disappear due to a lack of competitiveness for end users.

2) DeFi

This part consists of small financial applications that can be used within the aforementioned core protocols, which can be referred to as "currency Legos," considered unstoppable applications that achieve complex financial dynamics through smart contracts.

3) Universe

This part consists of a set of domains or parallel universes that make up the whole of the Metaverse. Vertical domains such as virtual worlds must connect to the foundational layers based on compatibility and free value transfer.

DeFi in the Metaverse (MetaFi) appears at the intersection of vertical and horizontal components. This is where specific domain assets (primarily NFTs) interact with fungible components (foundational and financial). The vertical domains within the Metaverse are diverse and numerous; the definition of each vertical domain may be very subjective, thus requiring justification for the definitions of vertical domains, but essentially, MetaFi is a phenomenon that occurs at the intersection of fungible and non-fungible.

7. Foundations Supporting Horizontal Growth

As described above, the foundational components include core frameworks (or protocols) labeled as Layer 0, Layer 1, and Layer 2 (such as Polkadot, Ethereum, and Polygon). Here, protocols can typically facilitate modularity, meaning each component (L0, L1, and L2) serves each other to some extent.

A direct and well-known example is Ethereum, a Layer 1 framework that provides smart contract functionality. This means that the framework offers custom logic that can be used to create a range of different computer programs and run them in a decentralized manner. Similar to Bitcoin's decentralized approach, but in addition to decentralization, Ethereum also provides what we call smart money or programmable money through smart contracts.

To simplify the concept, we focus only on Layer 1. Since Ethereum provides a unified layer for developing various applications through smart contracts and smart money, it has proven to be a framework capable of providing revolutionary services to the financial sector (as DeFi has also been proven).

This concept of unification means that any smart contract on the Ethereum network can interact with each other, catalyzing interoperability between services and games based on Ethereum.

The horizontal axis in the diagram remains the horizontal growth factors of the broader Metaverse. This means that Layer 0, Layer 1, and Layer 2 will continue to serve as the foundation for all vertical domains (or parallel universes) that constitute the Metaverse. Applications classified as DeFi primarily support complex financial applications around this horizontal layer, enabling individuals to lend, borrow, and trade within the cryptocurrency ecosystem.

8. Collection of MetaFi Activities

Regarding the situation illustrated above, the number of vertical domains and their respective definitions will continue to evolve as the Metaverse develops. However, we attempt to define some emerging core activity collections as follows.

Virtual Worlds: Virtual worlds are digital spaces designed for social, commercial, or gaming purposes, which may or may not mimic the real world and its physical phenomena. When they do mimic, they typically include rare elements represented by NFTs, which can be freely bought, traded, and built upon. Notable examples include Sandbox and Decentraland.

As components of NFTs, virtual land is closely related to in-game currencies and/or governance tokens of virtual worlds, meaning users can use tokens to purchase assets in the virtual world and vote on improvement proposals.

Adoption of virtual worlds has made significant progress, with only a few dozen people interacting with them at the beginning of 2021. In the past 30 days, there have been 65,000 unique addresses interacting with the smart contracts of Somnium Space, Decentraland, Sandbox, and Crypto Voxels, a fourfold increase since early November. Among them, Sandbox has made the largest contribution, both in terms of monthly active users (4,100) and total land sales value to date (112,000 ETH or $450 million).

Gaming: We can define gaming as digital activities primarily used for entertainment. What distinguishes gaming in the Metaverse is that they often include play-to-earn elements, where users or players earn token rewards for their contributions to the game. This creates an entire in-game economy, linking capital and labor to generate value.

Axie Infinity may be the most famous Metaverse game and one of the pioneers of this genre, both in terms of users (nearly 2 million monthly active users) and protocol revenue (annualized $2.5 billion). Blockchain gaming has also gained widespread acceptance since the beginning of this year. Nearly half of active blockchain wallets are now connected to games, with the top 10 blockchain games collectively having 4 million monthly active users.

Avatars: Avatars are designed to create unique digital identities for users, including 3D avatars that can be interoperable across various Metaverse spaces and are often produced in large quantities as generative PFP (Profile Picture Projects).

PFPs can be understood as famous social clubs that enhance NFTs with fungible tokens based on their projects, often including governance rights or other benefits. Popular projects like CyberKongz and SupDucks distribute native tokens to their NFTs (certain rare categories). In the CyberKongz project, holding a genesis kong allows users to earn 10 banana tokens every 24 hours. These tokens can be sold on Sushiswap or used in the "banana store" for upgrades, renaming, purchasing equipment, etc., and can also be used for breeding (breeding a new kong requires spending 600 banana tokens).

Equipment: Equipment refers to digital items that can be showcased in the Metaverse, which are currently most valuable in games but will soon expand to other Metaverse categories. An increasing number of designer brands are using NFTs to tap into the market of 2.7 billion gamers worldwide. Players can now own unique skins designed by top fashion brands and showcase their taste to millions online. For example, Balenciaga collaborated with Fortnite to design four sets of virtual clothing, and Burberry partnered with Mythical Games to launch fashion items represented by NFTs.

Markets: Markets are digital places that match supply and demand, allowing us to discover more NFTs and facilitate better price discovery. Markets like OpenSea, Superrare, and Rarible allow users to trade freely and directly issue NFTs. This way, these NFTs can be used as financial assets. Fractionalization allows high-value NFTs to gain liquidity by being divided into fungible tokens and owned proportionally. The combination of fractionalization and binding functionality is particularly popular, effectively forming index fund solutions for specific categories of NFTs, such as the platform NFTX and Beeple's B20 index. The booming NFT market has led to a surge in trading volume. OpenSea's trading volume was only $1 million in January 2021, while it exceeded $2 billion in November 2021.

Yield-Generating NFTs: NFTs can generate income in two ways: indirectly or directly. Indirect income generation includes using NFTs as collateral for loans and then reinvesting the loaned funds at higher interest rates; NFTfi allows the use of NFTs as collateral for loans.

Additionally, a persistent trend in recent months is that NFT-first projects will add a native token, adding another yield-generating element to their NFTs. Ether Cards is launching its Dust token, distributed to each existing Ether Card based on its rarity. Dust tokens can be used to participate in lotteries to win blue-chip NFTs. This overlaps with avatars, as CyberKongz and SupDucks can also be seen as yield-generating NFTs.

Access Tokens: These can be either fungible or non-fungible tokens that grant holders various forms of value, through proximity to a community, specific individuals, or future minted tokens. A good example is The Bored Ape Yacht Club, a collective of 10,000 ape NFTs, where ownership not only grants access to the Discord community but also allows speculation on the future value of The Bored Ape Yacht Club.

It is worth noting that the above categories do not operate in isolation and often overlap in many cases. For example, a successful mechanism is emerging that allows play-to-earn 2.0 projects like Axie Infinity to hold yield-generating NFTs while also transferring to other NFT use cases. Similarly, some already established crypto protocols (centered around fungible tokens) have launched NFTs as an additional interactive means, such as Gitcoin selling NFTs to fund digital public goods. We expect to see more peculiar combinations of the above categories in the near future, as well as the creation of entirely new MetaFi categories.

9. Current Limitations

There is still much work to be done before MetaFi can realize its true potential. More specifically, the current state of MetaFi faces several limitations that need to be overcome to achieve widespread acceptance:

1. NFT Valuation. To buy, sell, or use NFTs as collateral for loans, holders need to know the value of their NFTs. NFTfi addresses this issue, allowing users to list their NFTs as collateral on the NFTfi website, where lenders provide loans based on their perceived value of these NFTs. Valuation is essentially done by lenders, rather than by an unbiased third party.
2. Legal and Regulatory Issues Related to Fragmentation. If you divide an NFT into 100 parts and distribute them to different people, especially when the NFT carries rights such as voting or revenue rights, it is still unclear who can do what, when they can do it, and how to manage these rights.
3. Cross-Blockchain Standards. The current Metaverse is no longer solely built on Ethereum; it is also built on different Layer 1 or Layer 0 blockchains, which still do not achieve 100% interoperability. This means that the inability to transfer value is unavoidable in the short term.

To fully unlock the value of DeFi for the Metaverse, NFTs need to be easily integrated into DeFi protocols, such as being able to be traded, borrowed, lent, and re-borrowed. While today's DeFi currently only applies to fungible tokens, we expect new methods to connect NFTs and DeFi.

1. Fragmentation of NFTs. This means dividing non-fungible tokens into many fungible tokens. People can view the fragmented parts as a share of ownership in the NFT. For example, meme creators can use asset creation platforms to create memes, fragment them into highly fungible tokens, and trade them on DeFi DEXs like Uniswap. Notable NFT fragmentation projects include Fractional and DAOfi.

2. NFT-ification of DeFi. This means upgrading DeFi protocols to accept NFTs as a form of collateral. For example, creators can create assets in virtual worlds and use them as collateral to borrow on platforms like Centrifuge or Pragmafy.

3. NFTs as Derivatives. Creating a series of liquid digital assets whose value will depend on off-chain assets, in-game items, social capital, etc.; these digital assets are represented in the form of NFTs and may be connected to data instructions to determine their form. For example, digital artists can create art, create an NFT derivative, and use it as collateral to mint synthetic assets on Synthetix, such as stablecoins, synthetic gold, or stocks.

10. Outlook for MetaFi in 2022

In summary, MetaFi, or Metaverse finance, is an all-encompassing term that refers to the protocols, products, and/or services that enable complex financial interactions of non-fungible and fungible tokens (and their derivatives). It includes the foundational components of the blockchain space (such as Layer 0, Layer 1, and Layer 2), the DeFi stack, and various universes.

MetaFi inherits two core features of DeFi protocols: Unstoppable and Composable. Its development is driven by several key trends, such as the mutualization of risks, gamification of finance, development of financial tools, and improvement of DAO service stacks.

We hope we have clarified that the current form of MetaFi is still in its infancy. While some of its functionalities are hard to imagine, we are only just beginning to understand the capabilities it may exhibit in the medium to long term. However, based on what we see in the market and after detailed research on the catalytic factors, we anticipate the following developments in the short to medium term:

1. Combinations of different MetaFi categories and the creation of entirely new categories, such as users creating games in virtual worlds, owning their economies, or generating non-fungible assets like equipment or avatars.
2. Improvements in user experience/user interface for financial MetaFi projects, potentially incorporating VR elements. For MetaFi to truly succeed, it needs to achieve broader understanding and a more seamless experience for the general public.
3. Further innovations in DeFi 2.0 will shift to MetaFi, similar to the innovations we see in Olympus DAO and Alchemix, as we need better solutions to address the fragmentation of NFTs, particularly regarding legal and governance issues, as well as the NFT-ification of DeFi.
4. Improvements in foundational technologies (like Layer 1) that will lower transaction costs, increase user numbers, achieve scalability, and overall make it easier to access applications on blockchain protocols.