Introduction

The true promise of decentralized financial rails is to empower underserved communities and increase economic freedom by lowering the barriers of entry to access capital and compound wealth. Although permissionless DeFi protocols can achieve this purpose, the knowledge required to capitalize on market inefficiencies, produce passive income, and compound wealth still puts certain markets and communities at a disadvantage. Luckily, those without the knowledge can leverage experts in financial markets who help put their capital to work through various strategies that attempt to optimize risk-adjusted returns.

In DeFi, the ability to identify the best yield opportunities are abstracted away in vaults managed by strategists, most notably in protocols like Yearn Finance, as well as dynamic liquidity provisioning protocols like Arrakis Finance. While Yearn and Arrakis have been the go-to platforms for yield and dynamic LPing, there are inherent limitations, like gas requirements and solidity flexibility, that prevent strategists from taking advantage of all opportunities the crypto market has to offer. This limitation is Sommelier’s opportunity. Sommelier is an automated liquidity management app-chain built on the Cosmos SDK that has the potential to become the leading multichain yield marketplace in the space.

Sommelier Overview

Founded by well-known leaders in the Cosmos ecosystem, Zaki Manion and Jack Zampolin, the team raised a $3.5M seed round in March 2021 from funds like Standard Crypto and Multicoin Capital, and an additional $23M Series A in October 2021 led by Polychain Capital. Although its mainnet went live in the Cosmos ecosystem, Sommelier leverages a proprietary version of the Gravity Bridge, a bi-directional Ethereum bridge, for deposited assets to be utilized in Ethereum-based DeFi today. Due to the lack of a native stablecoin, as well as a dominant lending facility in Cosmos today, yield opportunities in Cosmos are sparse outside of LPing on a DEX like Osmosis. This influenced the Sommelier team’s decision to first focus on Ethereum, as the dominant liquidity network, but there are plans to have multi-chain strategies in 2023 across Ethereum Layer 2s, Cosmos, Avalanche, and more.

Sommelier can be seen as a custom-built data processing environment that offers all the tools needed for capital allocators to build 100% automated strategies in a non-custodial way. Sommelier allows strategists to pull Ethereum data off-chain, utilize live data feeds to calculate and monitor parameters like volatility, volume, and performance metrics, to create dynamic mid-frequency strategies that change with on-chain market conditions. Additionally, Sommelier can aggregate and batch transactions, which can make it more gas efficient than other yield protocols on Ethereum.

Architecture

Because of its app-chain architecture, Sommelier has additional stakeholders that may increase its level of decentralization when compared to most Ethereum-based dApps. Unlike protocols like Yearn that have vaults controlled by multi-sigs, all Sommelier vaults today, called ‘Cellars’, are Ethereum smart contracts with privileged functions that can only be called by the Sommelier validator set. Unfortunately, with only 34 active validators and a Nakamoto Coefficient (NC) of 3, and when compared to other Cosmos chains like Osmosis, which has 150 active validators and a NC of 7, the Sommelier community should focus on distributing its voting power in order to reduce potential attack vectors in the future.

Outside of the validators that secure the network and control the Ethereum-based cellars, the remaining stakeholders of the Sommelier platform are:

• Cellar Strategists (Quant teams/Traders)

• Cellar Creators (Developer teams) - typically same team as the Strategists

• Users (Cellar Liquidity Providers)

• Stakers (SOMM token holders delegating to validators)

After a Cellar Strategist and Creator deploys their smart contract on Ethereum (or another chain in the future), they must go through Sommelier governance to have SOMM validators and stakers vote on accepting their strategy to the platform. Once accepted, the Strategist/Creator teams are rewarded with a bounty for contributing to the network, and users are able to start depositing funds into the Cellar to put the strategy to work. As mentioned above, validators ultimately control the smart contract after acceptance via governance, but strategists still own the responsibility of making strategy recommendations as new market data comes in, with each recommendation requiring a two-thirds majority vote by the validators to reach consensus. After each recommendation is approved, validators pass the new instructions along to the Ethereum smart contract via the Gravity Bridge for execution.

Comparing Product Offerings

Although upcoming Yearn v3 and Arrakis v2 updates will provide additional tooling to strategists to build more complex and automated strategies, Yearn lacks the ability to take off-chain strategies and turn them into 100% automated on-chain execution, and Arrakis is more focused on infrastructure and strategies specific to AMMs, with a majority of its usage centered around like-for-like asset pools.

Since capital is a finite resource, professional strategists are in a constant battle over capital accumulation from potential investors. To maintain their edge against their competitors, they need to keep their alpha proprietary. As DeFi becomes more institutionalized, this will ultimately require their strategies to be moved off-chain, while still giving capital depositors self-custody control over their assets. Below is a high-level comparison of strategies made possible with Yearn, Arrakis, and Sommelier.

While both Yearn and Arrakis may expand their offerings in the future through additional tooling and optimizations, they are predominantly known for the specific use cases mentioned above. In comparison, Sommelier is a generalized yield marketplace that has no limitations on the strategies it can implement, even though all strategy types listed above are not yet live today.

Today, Sommelier offers the three strategies shown below with a combined $1M TVL on the platform. For a protocol that launched a year ago, adoption has been slow due to its first strategy only launching in July this year, the lack of liquidity mining enabled, and the fact that it is a Cosmos-based chain that solely interacts with Ethereum DeFi today.

Unlike most DeFi protocols that only show current returns, the Sommelier UI shows its users key financial performance metrics for each strategy that you’d expect from an institutional financial product.

Over the coming quarters, as more strategists are onboarded to the Sommelier platform, and as decentralized derivative markets grow in liquidity, the expectation is to see some of the most complex on-chain DeFi strategies deployed on Sommelier.

Tokenomics and Valuation Modeling

Like other Proof of Stake chains, the native SOMM token has multiple functions:

• Validators and Stakers bond SOMM to secure the chain

• Voting power towards governance proposals

• Pay for gas fees for on-chain transactions

• Value accrual through platform and performance fees

With a max supply of 500M tokens, SOMM was distributed to multiple stakeholders at inception, with a majority of the supply given to the Sommelier Foundation, as well as the DAO for future on-chain governance purposes like liquidity mining and grants to onboard new strategists.

Unlike most Cosmos ecosystem chains that either utilize inflationary rewards through unlocking uncirculated supply, or continually minting new supply per block to incentivize their stakeholders, Sommelier has no inflation today. Although this has led to a low stake rate, with <5% of the entire SOMM supply currently staked, the plan is to offer sustainable rewards back to their token holders over time as more strategies are deployed.

Like a TradFi fund, deposited capital and profits are distributed across the various stakeholders. Instead of the typical “2 and 20” model where 2% of total deposited capital and 20% of profits are paid out to the fund for management and performance fees, respectively, individual cellars will have different payout functions.

As an example, below is the breakdown for Sommelier’s ETH-BTC Trend strategy, which aims to provide a better risk-reward tradeoff than buying and holding ETH and/or BTC.

This particular cellar has the Strategy Provider and the Sommelier protocol splitting management fees 1.5% and 0.5% of TVL, respectively. Additionally, profits are split 90%, 7.5%, and 2.5% between the LPs, strategists, and the Sommelier protocol.

Below is a diagram that outlines the flow of funds and information between all stakeholders in one example strategy. For simplicity, this diagram shows a linear flow of info and funds, and does not represent the potential for users, stakers, and strategists to compound returns back into strategies.

Sommelier’s value capture is a mix between YFI’s buyback model and MakerDAO’s liquidation auction model. Whenever a strategy profits, the portion meant for the protocol is sent back to Sommelier’s chain from Ethereum in the form of the underlying token the strategy is focused on, and is then auctioned off to market participants bidding in the native SOMM token. After each auction, the SOMM tokens accrued are redistributed back to SOMM validators and stakers. While the original documentation mentioned burning a portion of SOMM to make the token deflationary, those plans have been put on hold at this time.

Based on the management and performance fee splits mentioned above, we attempt to perform a valuation scenario analysis based on different levels of TVL and average strategy return. For this analysis, we assume a 1% platform fee, 5% performance fee, a 50 P/E ratio, and a baseline annual strategy return of 10%.

Although the crypto industry is nascent with illogical valuations compared to traditional companies, it is reasonable to expect that as more multi-chain strategies are deployed on Sommelier, and as Cosmos-based DeFi grows with the introduction of native USDC and multiple large lending protocols launching in 2023, the Sommelier platform should be able to reach $1B TVL in a future bull market. Additionally, with Yearn currently valued at a 40 P/E ratio, according to TokenTerminal, a 50 P/E ratio for Sommelier in a bull market should be relatively conservative, considering its future growth potential.

Overall, with a $750M future valuation based on the assumptions laid out above, Sommelier currently sitting at $66M FDV could be a project to watch out for in the next cycle.

Conclusion

Despite hitting over $200B in TVL at peak, DeFi has yet to scratch the surface of its potential. As institutional capital allocators enter the space in size, they will look for products like Sommelier that can extend their on-chain influence and cash flow by helping them raise crypto-native capital. Additionally, Sommelier’s ability to transparently compare off-chain strategy performance of institutions will optimize capital utilization and give retail participants a more even playing field on-chain. While leveraging an app-chain to optimize the Ethereum DeFi experience is a relatively new concept pioneered by the Sommelier team, it could be a pattern we see in upcoming cycles as crypto markets mature and become more efficient. Ultimately, the ability of the Sommelier community to onboard quality strategists with high alpha will determine its success.