DeFi has become the focus of people’s attention with the frenzy set off in the summer. It is no longer a secret that the DeFi protocol is creating real economic value. These agreements now lock up billions of dollars in assets, facilitate billions of dollars in financial activities every day, and provide users with open, borderless, and censorship-free financial services.
What is less known is that although many DeFi protocols have their own unique cryptoeconomic design, most of them share a common business model. The core of this business model is the agreed balance sheet, which can be defined as the total amount of assets under management, also known as the total lock-up value TVL. Understanding this can provide insight into how these agreements work and how they protect themselves from competition and capture value.
Agreement as the coordinator of financial activities
The DeFi protocol is a coordination mechanism that defines rules and provides incentives to promote financial activities. Most DeFi agreements raise assets in the community through crowdsourcing and use these assets for productive finance such as market making (Uniswap and Curve), lending (Compound and Aave), or synthetic asset creation (MakerDAO and Synthetix) Active. Users provide their capital to the protocol to exchange value streams, whether they are inherent to the system, such as governance tokens for liquid mining, or from outside the system, such as payment in stablecoins and other encrypted assets (ETH, BTC, etc.) cost of. How much value the agreement creates for its stakeholders depends on how effectively the agreement uses its balance sheet to make profits.
Balance sheet profitability as a business model is not new. This is how banks and other financial institutions have generated cash flow for thousands of years. In the simplest model, a bank absorbs capital in the form of debt (such as deposits) and equity at one end, and then uses the capital to make a profit through financial services such as loans at the other end.
The DeFi agreement is similar to this, except that there is no trusted third party to guide these financial activities, and a geographically based legal system to specifically supervise and implement agreements between stakeholders. The DeFi protocol uses smart contract enforcement on the public chain to facilitate mutual financial activities and resolve disputes.
The key stakeholders in the DeFi protocol include liquidity provider LP, coin holders, developers and users. Although these groups are described separately, they are not mutually exclusive. The most successful DeFi protocol is the one that best aligns the incentives between these groups.
The liquidity provider provides funds to the agreement, and the funds are used to promote financial activities for production
The token holder governance agreement to obtain value from the operation of the agreement
Developers construct agreements, design rules and incentives to coordinate expected financial activities
Users use the protocol to meet their financial needs
The DeFi protocol accumulates funds by selling tokens, retaining protocol proceeds, and crowdsourcing liquidity. The latter was mistaken for the total value of the locked position. In fact, when users provide liquidity to the protocol, nothing is locked. The capital provided by the user to the agreement functions more like a demand deposit, rather than any form of permanent capital. The user essentially lends funds to an unsecured agreement, because they know that the agreement distributes benefits according to a set of rules, and can request the return of funds anytime, anywhere.
The agreement will retain the privilege of managing user funds only if it can continue to provide persuasive reasons for users to provide funds. When these reasons are not valid, capital may flee in an instant, rushing to more attractive pastures at the speed of the Internet.
The user keeps the funds in the agreement in the agreement for various reasons, mainly economic reasons. The main reasons include access to transaction fees, token rewards and security. Users can not exclude each other and consider these reasons according to their own preferences. The conclusion is that as long as users believe that the agreement has the ability to adjust capital according to risk preferences to create value, the agreement can retain user capital.
That is, the DeFi agreement creates rules and incentive mechanisms for the community to build a balance sheet and facilitate financial services, thereby creating value for all stakeholders in the agreement.
The following are some case studies to illustrate this model of the DeFi protocol. Please note that the templates for each paragraph are the same to emphasize the similarities between these agreements.
case study
Uniswap
Uniswap encourages users to provide their capital for asset market making on Ethereum by providing rules and incentive mechanisms to coordinate decentralized transactions. Users provide their capital to Uniswap in exchange for the exchange fee that Uniswap generates by investing capital in productive market making. However, unlike the capital raised by traditional organizations through equity or debt, the capital raised by Uniswap from users is not permanent. Users can retrieve their funds anytime and anywhere, and as long as they believe the agreement can use the funds to generate transaction fees, they can keep them in Uniswap. Uniswap will incur a certain amount of fees to provide the best service for users who want to conduct peer-to-peer P2P asset transactions without a trusted third party.
Compound
By providing rules and incentives, Compound allows users to provide their capital to build a currency market for assets on Ethereum. Compound can coordinate decentralized lending. Users provide their capital to Compound in exchange for the interest that Compound generates by investing its capital in productive loans. Like Uniswap, the capital raised by Compound from users is not permanent. As long as they believe that the agreement can maintain solvency and earn interest from it, their capital will remain in Compound, otherwise users can withdraw their capital anytime and anywhere. Compound will incur a certain amount of fees to continue to provide the best service for users who want to perform peer-to-peer asset lending without a trusted third party.
Svnthetix
Synthetix coordinates the creation and trading of decentralized synthetic assets by providing rules and incentive mechanisms, enabling users to provide their capital to cast synthetic assets (debt denominated in any asset supported by Synthetix). Users provide their capital to Synthetix in exchange for the transaction fees that Synthetix incurs when users reprice synthetic assets through contracts (Synthetix users trade synthetic assets in a peer-to-peer contract rather than a peer-to-peer way). Like Uniswap, the funds Synthetix raises from users are not permanent. Users can withdraw funds anytime and anywhere, and only if they believe that the agreement can maintain solvency and generate transaction fees, will they keep the funds in Synthetix. Synthetix will incur a certain amount of fees to continue to provide the best service to users who wish to exchange synthetic assets in an unlicensed manner and point-to-point without the need for a trusted third party.
Defensive strategies in the free-flowing Internet capital world
If the DeFi industry has some new understanding of the defensive nature of the protocol in August, it is: It is very difficult to build a moat in DeFi.
When the code is open source and capital can move freely on the Internet, traditional competitive advantage resources (such as economies of scale, switching costs, patents and regulatory licenses) will be meaningless. Just as we witnessed in September that SushiSwap SushiSwap used a fork to attract more than 75% of Uniswap’s liquidity, even if it is an “obvious” source of competitive advantage such as liquidity, it is indisputable in this world. In the Internet age, competitive advantage resources (such as aggregation) have little effect, because the aggregator neither owns any data of its users, nor has an underlying license-free agreement running on an open database that anyone can access.
If the DeFi protocol seems indefensible, how can you capture value?
The defensive nature of the agreement stems from the following points:
Community, including developers, token holders, liquidity providers and users
Integration with real-world institutions and other agreements
Brand and user experience. When the agreement first succeeds in its market, the brand and user experience are particularly powerful, which can help it build brand equity and set user expectations
Agreement resources, such as agreement treasury and insurance funds
Security is particularly important for the main application of the blockchain
community
Community is one of the most important value drivers of the DeFi protocol, especially when there is a strong common value narrative between communities that needs to be merged. After all, under all restrictions, all decentralized agreements will be guided by their communities, making the agreement the ultimate source of value creation and sustainability. Building a decentralized protocol is a game of system building, not just writing code. The agreement needs a broad, decentralized, and responsible stakeholder group who believe in the vision of the agreement and are willing to make all efforts to make the agreement successful. Stakeholders need not only efficient agreements, but also agreements that can be trusted for a long time.
For financial agreements, in addition to simply creating and distributing value over the long term, many factors that build trust are effective risk management. Anyone can fork some code and provide similar functions, but forked code does not guarantee strong risk management. The agreement requires world-class developers dedicated to perfecting the agreement, as well as thoughtful and diversified currency holders to manage the agreement in the long term.
Careful management of the agreement is the only way that the agreement will attract, store and manage most of the world’s wealth. The combination of shared value narratives, world-class developers, and thoughtful and diversified currency holders can create effective interaction and high loyalty communities who believe in and benefit from the value created by the agreement. A community of missionaries lays the foundation for long-term value creation.
integrated
Just forking a protocol does not mean that anyone will use it. Integration with real-world institutions and other agreements will benefit the agreement significantly. At the real-world level, integration with exchanges, custodians, wallets, aggregators, payment gateways, and various financial service providers has brought about the need to be difficult to fork. Terra’s Chai Payments application is a good example. Chai serves more than 2 million users and only relies on the Terra blockchain to provide convenient and cheap payments for its infrastructure. All subsequent Terra products, such as the upcoming Anchor money market protocol, can cover Chai’s large and growing user base at the time of launch, thereby providing a strong demand that will not be forked.
At the protocol level, privileged integration with other protocols can create unforkable utilities.
Yearn’s Vaults and Earn products are a good example. Yearn’s Vault has been whitelisted by some Maker oracles, which allows them to facilitate asset rebalancing and unbinding more effectively than other agreements that run similar strategies but are not whitelisted. Similarly, when a stable currency is used to provide liquidity to Year’s Curve yPool, it is actually to deposit the stable currency into the year to get yToken, and then inject yToken into the Curve’s liquidity pool to earn transaction fees. This also helps to improve the liquidity of yToken, so that it is easier and more effective to obtain and sell Earn revenue-optimized stablecoins.
Brand and user experience
Brand and user experience can be a powerful source for DeFi agreements to maintain a competitive advantage and capture users. This is especially true when a DeFi agreement is the first successful agreement created in the market, allowing it to set expectations around user experience and work with users to build brand equity. The simplest example is Uniswap.
According to most measures, Uniswap is the first successful automated market maker AMM. In the past few months, even though many more advanced and flexible AMMs have entered the market and provided users with better services, Uniswap still maintains a leading position in the competition. If the conversion cost only requires users to connect to the new exchange with MetaMask, why is it so? The reason is because users are used to the experience of using Uniswap and trust the Uniswap brand. Blockchain is a confrontational environment, and a wrong move will cost users a heavy price. Having confidence in the smooth operation of Uniswap, and knowing how to use it safely, allows users to have no distractions and will not switch between protocols quickly. This is a general trend in many of the most successful agreements to date.
Agreement resources
Whether it is to raise funds through the operating mechanism of the agreement or retain part of the proceeds, some agreements have a large number of financial resources, which may be a competitive advantage that cannot be forked. Reserve valuable assets can create a moat for the agreement.
Insurance funds can make users more confident in the security of the use agreement. Large-scale insurance funds provide users with a stronger guarantee that they will not lose their funds when depositing assets into the agreement for certain financial activities. Aave is a good example. Its newly issued Aave tokens will support the Aave protocol and provide insurance for any losses borne by depositors.
Similarly, large treasuries can grow both endogenously (through activities such as pledges) and exogenous growth (through retained earnings or capital raising). They provide a large amount of asset value that can eventually be returned to stakeholders. The treasury not only allows the agreement to return value to the token holders (dividends and token repurchase), but also allows the agreement to participate in various institutionalized construction activities (ecosystem expenditure). This may mean everything from paying developers to write code to incentivizing liquidity providers to fund the agreement. The idea is that the vault provides opportunities to reward the contributions of a broad and diverse group of stakeholders. For example, as of the end of July this year, the value of Synthetix’s vault assets was approximately US$150 million, including various endogenous and exogenous assets such as SNX and ETH. There are only a dozen of global cryptocurrency funds that have larger assets than Synthetix vaults.
safety
For the DeFi protocol running on its own blockchain, security is particularly relevant. It is an important advantage for attracting funds from competitors and an important source of competitive advantage. More secure protocols provide users with more confidence and are therefore more attractive for high-value transactions. Delphi recently adopted the cross-chain liquidity protocol THORChain, which contributed an excellent example. THORChain’s token economics ensures that its security is directly proportional to the liquidity added to the network. Specifically, it ensures that the total value of the RUNE pledged (in the fund pool) and bound (by the validator) is at least 3 times that of all external assets in the liquidity pool. Once the ratio deviates from its 3:1 goal, THORChain achieves this goal by adjusting the system’s revenue from or flowing to validators or liquidity providers. The result is that forking liquidity from THORChain does not fork its utility because it does not fork its security.
The more DeFi protocols have in the above five defense dimensions, the better the effect. These five functions magnify factors such as liquidity to a position where network effects can actually begin to occur.
The future trend of the business model of making profits on the balance sheet
The community balance sheet is the basic primitive of DeFi. However, the current DeFi protocol attempts to use this pooled liquidity to do something, but it is only Xiaohe who has a sharp corner.
Short-term vs. long-term liquidity
Currently, the agreement does not distinguish between short-term and long-term liquidity providers. This system benefits more speculative liquidity providers, who jump from one agreement to the next in search of the highest possible return. In fact, long-term liquidity providers provide more value to the agreement.
In traditional finance, illiquid liquidity is more valuable than liquid liquidity: If a customer deposits currency into a longer time deposit, it will earn more interest than demand savings. For traditional banks, this is a key point, because if people can withdraw all their funds at any time, as an institution that relies on liquidity, banks can go bankrupt quickly.
Martin Krung, Swiss cryptocurrency analyst
If the agreement contains measures such as lock-in funds, token reward installment withdrawal mechanism, strong encouragement of long-term liquidity and suppression of short-term liquidity, it may help solve these problems. It is important not to completely eliminate short-term liquidity providers, because they also provide value, but more importantly to ensure that the agreement can effectively attract more sticky capital.
Capital efficiency and use case expansion
Uniswap may only use about 25% of its balance sheet assets to facilitate transactions a day. The remaining 75% is idle and used only when large transactions cause asset prices to rise or fall significantly according to Uniswap’s pricing curve. This is in sharp contrast with traditional market makers, who trade assets on a daily basis much higher than those on their balance sheets, and often use leverage to further improve their capital efficiency and increase returns. Other agreements are also processed with similar logic, such as Maker, which only idles the $1.8 billion collateral on its balance sheet in a smart contract that generates zero returns; or Nexus Mutual, which only uses its $70 million in ETH capital Idleness generates zero income in the fund pool. This list is very long, but it highlights that the DeFi agreement has not yet released the full potential of its balance sheet.
The agreement can unlock this potential in many ways. On the one hand, the agreement can further improve risk management, which may lead to a lower mortgage rate and therefore more effective capital use. Although, a more imaginative way is that the agreement can use the assets on the balance sheet for adjacent use cases other than the main purpose. For example, if the use of asset pools can facilitate lending and transactions, why can’t the agreement use the same liquidity pool to serve two use cases?
A few months ago, Dan Elitzer, an investor in IDEO CoLab and founder of the MIT Bitcoin Club and a member of the founding team of Yam Finance, speculated on this possibility, saying that certain agreements may gradually do this to make liquidity pools. The assets in can be used for various opportunities at the same time to generate the highest risk-adjusted rate of return.
If I am willing to store a fixed percentage of assets in my wallet and hope that they will passively generate the highest return, why don’t I put them all into a dedicated Balancer liquidity pool to earn transaction fees? And, if the pool contains ETH, DAI, REP and ZRX, why should I not lend any of these assets if the loan is over-collateralized by other assets in my pool?
Of course, can the assets in the pool also provide lightning loans with a small fee? Maybe I am willing to take more risks, hoping to provide loans to traders who fund 20 times leveraged perpetual contracts (such as Futureswap)? It can be regarded as the ultimate development of passive investment and personalized investment.
Dan Elitzer, one of the founding team members of Yam Finance
If this is a vision that is almost close to the right (I think so), in the future, super agreements that facilitate various financial services may rule the world instead of today’s professional application agreements. This distinction is similar to the difference between a professional bank that only focuses on consumer banking and a diversified financial institution like JP Morgan, which covers consumer banking, commercial banking, and investment banking. And asset management, providing a wide range of financial services. The idea here is that by making the liquidity in the liquidity pool available for multiple use cases at the same time, a symbiotic relationship can be created between these use cases.
The DeFi protocol may continue to focus on its initial use cases for the foreseeable future, but in the long run, many protocols may find themselves in competition with each other.
Fund allocation
Capital allocation is the process of arranging the company’s financial resources to maximize shareholder returns. Essentially, the company has five main funding options, including reinvesting operations, issuing dividends, repurchasing stocks, repaying debt, and acquiring other companies. In most cases today, the DeFi protocol only discusses the following two options: issuing dividends and repurchasing shares (tokens). However, considering the maturity stage of these DeFi protocols, neither of these two options are suitable.
Companies rarely use their financial resources to repurchase stocks or pay dividends to shareholders in the early stages. the reason is simple. Why should we reward shareholders now when capital can earn higher returns and reinvest in the company? This is especially true for start-ups in high-growth industries. If the company succeeds in the market, its potential return on capital will be huge.
Investors in early-stage startups do not want dividends and stock buybacks. They want growth and future profits. However, the current DeFi protocol is just the opposite.
The DeFi protocol is not to buy back tokens, but to burn or distribute these tokens to token holders and distribute fee income to token holders. These agreements could have adopted a more thoughtful method for capital allocation. Joel Monegro, a partner at Placeholder, talked about this idea in a recent article. He suggested that the agreement should buy back and reissue tokens to incentivize growth, rather than buy back and burn the tokens to return value to the holders. In the more common case, it is better for agreements to allow any income they generate to accumulate in the treasury, and then take a more proactive attitude towards how to distribute them. There are many ways an agreement can use its retained earnings to incentivize growth and reward stakeholders for creating value. From paying developers to rewarding liquidity providers, rewarding agreement managers and even subsidizing users, you can get results.
DeFi protocols have proven that they can create value for coin holders, which is a good thing, but now that they have proven themselves, it’s time to think carefully about the allocation of funds.
From the rise of agreements to agreement cooperation
Agreement parties and meta-governance
The two main problems of the current agreement governance are the indifference of voters and the huge whales. When a small holder only holds 0.01% of the token supply, how can it compete with five VCs that jointly own 51% of the tokens and hold opposite opinions? Many protocol governance votes usually only get a single-digit percentage of token holders to vote-far less than the majority of votes like the US presidential election and corporate shareholder voting. Many agreements now have a delegation mechanism that can solve this problem, but even so, the content of the agreement governance is only a shallow exploration. If in addition to delegating voting rights to well-known agreement politicians, can voting rights be delegated to inter-agreement voting institutions? Projects such as PowerPool and PieDAO are solving this problem.
The first product of PowerPool is the DeFi Index for Liquid Mining, which builds and establishes weights based on community votes to realize the meta-governance of composite protocols. The index will be implemented in the form of a Balancer liquidity pool, consisting of eight governance tokens, including PowerPool’s own token CVP. It is proposed that the initial share of each token is 1/8 or 12.5%, and all management tokens merged in the liquidity pool will be voted in the corresponding agreement based on the decision of CVP token holders. The main idea is to hope that this agreement can become a governance aggregator and coordinate governance decisions in all its constituent agreements.
Similar ideas range from coordinated incentive liquidity pools to privileged integration that is not open to other protocols. It is conceivable that PowerPool or its competitors may become a huge political party, a force in agreement governance, and a clear synergy between agreements.
Decentralized dispute resolution and subjective contracts
One of the most ambitious projects in the crypto space is Aragon, which ultimately aims to become a sovereign digital nation running on Ethereum. A potentially powerful layer of the Aragon protocol stack is its decentralized dispute resolution system, called the Aragon Court. The Aragon Court is composed of financially motivated jurors to participate in dispute arbitration between community participants.
Tools such as the Aragon Court not only allow agreements to create subjective contracts within themselves, but also allow them to establish subjective contracts between agreements. Imagine cross-agreement financial transactions between agreements without over-collateralization and a high degree of partnership that cannot be expressed in code. The decentralized court system greatly expands the possibilities of collaboration. This system pushes the blockchain-based economic system to get rid of the pure “code is law” dispute resolution system.
Coordinate the expansion plan
One thing that has become apparent in the past few months is that DeFi is currently not scalable. Just a wave of small-scale hype will cause the use of Ethereum to reach its limit. Block space is blocked, transaction time increases, gas prices soar, and Ethereum sometimes feels paralyzed. To make matters worse, it will take several years for the underlying expansion in ETH 2.0 to become a reality, and it will not be realized until the last stage of the ETH 2.0 upgrade. As Ethereum founder Vitalik explained, the result is that “the Ethereum ecosystem is likely to bet on all kinds of rollup schemes (plus plasma and state channels) as a near- and mid-term future expansion strategy.”
However, this does not mean that expansion will not happen soon. In fact, the situation is quite the opposite. With the help of Layer 2 expansion solutions (such as rollup), Ethereum can achieve several orders of magnitude expansion in the near future, even once ETH 2.0 Phase 1 starts and rollup moves to the shard chain for data storage, it can reach the theoretical maximum of 100,000 TPS. .
In the foreseeable future, these rollups will become island centers of composable activities, while cross-rollup activities can only occur asynchronously. The result of this, coupled with the fact that many rollup solutions have just come out, means that the first protocol to migrate to rollup may have a clear competitive advantage over the protocol that does not migrate. In addition, in a sense, agreements that shift to the same rollup scheme are effectively establishing partnerships. Maintaining composability in this more scalable environment may result in synergy between such collaboration agreements.
to sum up
In the third quarter of 2020, the risk paid off. During this period of time, there will be a feeling that everything is important and everything is not important at the same time. When DeFi asset prices soar across the board, the long-term issues of sustainability and competitive advantage seem to have little effect. However, since the market has cooled down now, investors are becoming more interested in positioning for the next stage of DeFi.
The world of open source financial agreements is the new frontier of economic activity. Most of DeFi’s features have been around for less than two years, and it is only in the last few months that we have a glimpse of how these agreements perform and compete in the long run.
It was impossible to predict how this fast-growing industry would work even months ago, let alone a few years ago. But this does not mean that investors cannot think deeply about which factors are really important and which factors are not important at all. For long-term DeFi investors, what is important is not the flood of food-named tokens, worthless forks and Ponzi economics, but the legitimate source of its sustainable competitive advantage. How can DeFi be made? The agreement creates and captures value now and in the future.
The DeFi world is full of opportunities. They are waiting for thoughtful investors to take full advantage.
