Original article posted on Alexandria on 23 October 2020
Decentralised finance (DeFi) is an ecosystem of finance applications on Ethereum that enables traditional financial services such as lending, borrowing, trading, and asset management, but in a fully self-custodial environment, so that no one entity (like a bank) controls your assets.
There is now over $12 billion in assets locked in DeFi protocols. A 2,300% rise in the last 12 months.
“Last name Ever, first name Greatest.” Drake, “Forever.”
Defensibility is what creates the most value for companies and protocols. It’s what enables them to become the greatest. If you can’t protect the value you create, it is clear that you will not be able to capture any of that value for your own investors and stakeholders.
While 70 percent of the value in tech today may be driven by network effects, network effects by themselves are not a sufficient moat when it comes to decentralized finance (DeFi) applications and the 24/7 liquid capital markets they enable (excluding Ethereum as the underlying platform).
“What is, for example, the defensibility or the long-term value of a marketplace which cannot rely on users’ lock-in, and therefore has lower/no network effects? What if because users own their own transaction history and reputation data they could switch to another platform seamlessly?”
In other words, the permissionless, open-nature of DeFi protocols means they cannot rely on stakeholder lock-in on the supply or demand side. Therefore, network effects, the moat du jour for all modern tech companies, are much more limited.
But if not network effects, then what? This article isn’t concerned with what causes token prices to rise and fall. Instead, we seek to build a framework for thinking about the strengths and weaknesses of a protocol’s defensibility. How to build a platform defensible enough to become the Greatest Ever?
“Thinking of a master plan cause ain’t nothing but sweat inside my hand.” Eric B & Rakim, “Paid in Full.”
Competitive advantages (capital, relationships, team, timing, unique insight, etc.) can give a protocol an early lead ahead of the competition, but it’s not enough to stay ahead.
An excellent example of this is Bancor, an on-chain liquidity protocol that enables the automated, decentralized exchange of crypto assets on Ethereum. Bancor had “a first-mover advantage” as the first crypto AMM when it launched in 2017, and “a capital advantage” (capital is never a moat, other than as a corollary of “economies of scale”) following its $153M token sale.
However, new AMM DEXes came to market afterwards, such as:
They have since overtaken Bancor ($75M market cap, $2M 24h volume) by orders of magnitude in terms of token market cap, value locked, trading volume and any other KPI that you wish to use.
You should leverage all the competitive advantages you can to kickstart your protocol’s flywheel, but you will need to craft your defensibility master plan to take advantage of such early success.
The various ways of deterring competition are called, in different contexts: barriers to entry, sustainable competitive advantages, defensibility, or, colloquially, moats.
While it is exceptionally early in the development of DeFi, there are two moats that are early contenders for being the most important: brand (trust) and skin in the game (ecosystem strength). We believe these elements to constitute a protocol’s true “unforkable state”.
Let’s dig in.
Brands are consensus systems through which reputation and narratives emerge from users sharing their impressions. One of the fundamental functions of a brand, therefore, is to signal quality, by getting the relevant player (the protocol’s founding team, key stakeholders, etc) to play an iterated game instead of a single move game. In this sense, brands are the cumulative reputation of a platform’s interactions with its stakeholders and broader community.
Consequently, trusted brands are earned over time, not bought off the shelf. When it comes to DeFi, as ironic as it may sound and at least until a protocol matures past its progressive decentralisation stage, a protocol’s brand is about its trustworthiness: do you trust this platform and the key people behind it?
Building a trusted DeFi brand has two core components: social and technical.
Why should I trust the people building this protocol? Does this platform align with my ethos and values? A lot of this comes down to signalling.
Take Compound, the open money markets protocol, for example. Robert Leshner, the founder, is a very active member of the broader DeFi community, making angel investments into other platforms, and publicly discussing governance proposals and industry trends. Several Silicon Valley establishment VC funds like a16z back Compound too. Its brand is “Silicon-Valley elite,” which you can interpret however you wish, but for many, it will mean that the founder isn’t going to run away any time soon. Can the same be said for clones without similar sweat equity or reputation on the line — as per anon founders like SushiSwap?
Synthetix, the open synthetic asset issuance protocol built on Ethereum, is another interesting example. Havven (its original name) was called a scam by many in the Ethereum community. Synthetix is now seen as part of the DeFi establishment and received investment from the quintessential crypto-establishment fund, a16z.
Where Synthetix succeeded in building its brand was through the founder Kain, and the broader team who engaged the Synthetix community directly and acted as transparently as possible at all times. Although the tokenomics (the ultimate DeFi OG pumpanomics contract) certainly helped bootstrap interest in the platform, really it was the founding team’s consistent and transparent communications strategy that helped Synthetix build a trusted relationship between the protocol and its community.
If we are to learn anything from the incredible rise of Yearn (the DeFi yield aggregator built on Ethereum) it is that community alignment, in particular, the idea of a “fair launch,” is an incredibly powerful tool for quickly building a trusted brand that people want to get behind.
In the case of Yearn, we actually saw a form of network effect in play. As each new user publicly asserted their support for Yearn and its ethos, belief in the protocol compounded, resulting in more and more value accruing to each of the YFI stakeholders (holders of its token, $YFI, through value locked in the protocol as well as price appreciation, and to Yearn users through more efficient pools as they increased in scale).
Social network effects, like those seen in Yearn, can be very powerful. At the same time, there is a time component to a trusted brand. Staying “on brand” comes from consistency over time.
Just as quickly as Yearn rose in acclaim as the ultimate community built (and owned) DeFi platform, its untainted reputation is starting to lose its veneer. Social network effects are like “sand”: “In small quantities, sand dissipates in a breeze. But if you layer enough sand down on top of itself, it becomes hard as stone.” Yearn’s brand hasn’t yet blown away in the breeze, but it is clear that more work is required for it to become a truly trusted brand. A DeFi platform’s brand can only truly become rock solid when it is no longer affected by single points of failure such as the actions of the founding team. Until then, founding teams must put in the work to keep adding layers of credibility to reap the rewards a trusted brand can later. And distribute the responsibility. Every action counts.
Building up a trusted brand in a technical sense is not easy. Focusing on protecting your users’ assets is a good start. Liquid investors tend to classify the riskiness of a protocol (outside of whether it is audited or not) based on the length of time the protocol has gone without a hack. In a similar way that the social elements of a brand build up over time (“to become hard as stone”), there is a Lindy Effect at play when considering a brand’s technical trustworthiness; the longer a protocol has gone without any kind of technical breach, the longer it is likely for that to continue. Trust compounds over time.
Just because there is a flaw in your code, it doesn’t mean that you shouldn’t be trusted. Similarly, if you have just launched, it doesn’t mean you start with a zero balance in your “trust” account. Builders can develop greater trust in their approach quicker by open-sourcing the code, creating incredible developer documentation, engaging the community in bug bounties, running incentivised testnets and generally being as open and as communicative as possible whenever problems arise.
Plotting the current relative social and technical brand strengths of the leading DeFi platforms we get something like this:
“Community is about ownership — feeling not just that I am part of something bigger than myself, but that I have some skin in the game. It doesn’t matter so much whether that stake is economic or not — in fact, I think non-economic stake (e.g. reputation) can be a much bigger motivator.” Lane Rettig, former Ethereum Core, currently part of Spacemesh.
When we have real skin in the game — when we have upsides and downsides — we care about outcomes in a way that we wouldn’t otherwise. We act differently. Taleb says that skin in the game is all about symmetry: “the balancing of incentives and disincentives…” This idea of balancing incentives and disincentives is powerful when considering the open and permissionless financial services enabled by DeFi.
DeFi systems contain direct and indirect stakeholders, each of whom will have different motivations, and therefore diverse incentives. In both cases, symmetry is essential, and contribution is the critical frame: how can a protocol be designed that incentivizes the most value to be exchanged between a protocol and its stakeholders? Close alignment between stakeholders and protocols is a recipe for a powerful moat.
Direct stakeholders include liquidity providers (LPs), the demand side, developers, token holders, etc. You can think about direct stakeholders in terms of the classical definition of community. They have primary exposure to the ups and downs of the protocol’s success.
Assessing skin in the game for direct stakeholders is not a precise science, and we are yet to develop effective metrics with long-term predictive value. Taking the lead from the adage that “You can’t improve what you don’t measure,” we can start by thinking about what we can measure.
Relevant data points include diversity and frequency of community-led contributions on GitHub, the number of community-built tools, the number of “quality” community interactions on Discord, the levels of community engagement in governance (comments on forums, number of proposals), and the proportion of the network staked (2-sided liquidity network effects are considered separately). Such activity can be used as data points to build up a reputation for the relevant contributors, which can then be rewarded in economic and non-economic terms by the protocol and the initial stakeholders.
Uniswap has made a lot of its early users very happy by way of allocating 60% of its tokens to the community. Another way of thinking about skin in the game for direct stakeholders is in terms of how Cialdini discusses the powerful rule of reciprocity in his book Influence.
The reciprocation rule essentially states that if someone gives something to us, we feel obligated to repay that debt. The buying power of each of Uniswap’s unexpected winners may be small on an individual basis but extremely powerful on an aggregated basis. Time will tell. At the same time, Uniswap’s supply-siders, the LP community, are a financially-motivated bunch that may not be so susceptible to the psychological burdens implied by the reciprocity’s allure, meaning that they cannot be guaranteed to stay around forever, particularly if the incentives are more attractive elsewhere.
We saw an example of the relatively weak skin in the game of the Uniswap supply-siders (albeit prior to the launch of $UNI) by virtue of the Sushiswap saga. The Coinbase blog documents the rise and fall of SushiSwap in great detail, and includes this excellent diagram:
What we can learn from SushiSwap is that incentives can have impressive short-term effects, in terms of drawing in both supply and demand. However, without sufficient skin in the game for the key direct stakeholders, these effects can be fleeting.
Interestingly, what “saved” SushiSwap from complete annihilation was the impact of FTX founder, Sam Bankman-Fried, stepping in to support the protocol after news of SushiSwap founder, Chef Nomi’s less than graceful exit became public. Sam had material skin in the game due to Alameda’s capital locked in the network. Moving control of the protocol to a multisig that included public figures like Larry Cermak, the director of research at The Block Crypto, also added some credibility, as such public figures were staking their reputation publicly by agreeing to be involved, giving them skin in the game in the success of the governance proposals to be taken.
Despite the success of SBF and the multisig holders in overseeing the Sushi liquidity migration away from Uniswap, the launch of $UNI shortly thereafter removed much of the incentives for those not connected to Alameda to continue supporting the project. Clearly, community contribution must go beyond simple liquidity provision or demand for the service on the platform, to equate to real skin in the game. As a result, protocol incentives must be more precisely calibrated than just rewarding governance tokens to early supporters.
Chef Nomi’s exit illustrates the detrimental impact of key stakeholders not showing symmetry in their commitment to the protocol. Long-term commitment to anything has to go both ways if it is to work. Food for thought (excuse the pun) is how well Sushi might have done if Chef Nomi averted his worst instincts sooner by distributing control of the protocol to key stakeholders. This could have given Sushi a chance to evolve more organically. After all, governance is not only about defining control, but about enabling systemic evolution.
Switching gears, Chainlink is an example of a protocol with a highly engaged group of direct stakeholders. While we can all see that Chainlink’s token price is what largely incentivises its “marines,” it’s important not to roll our eyes too much at this incentive; Chainlink’s highly engaged community has encouraged other protocols to integrate with Chainlink and take advantage of the Chainlink marines. It has become a self-fulfilling cycle, whereby more integrations increases the price of $LINK, which incentivi`es its marines further, and so on until the sweet nectar can be extracted no more. This seems to be an extension of the rule of reciprocity, such that those who get rich from the success of a protocol’s token feel like that they must repay such a gift.
We are fervent supporters of the burgeoning ownership economy where instead of “... a platform’s inner circle of founders and investors taking home the value, users are able to earn the majority of value generated from their collective contributions.” This is a modern interpretation of “The Bill Gates Line,” which sets out what a platform is, and why Facebook isn’t one.
Ensuring that direct stakeholder groups have skin in the game when it comes to the success of your protocol is arguably the most powerful moat a protocol can build. While not the core subject of this article, it is becoming more apparent by the day that a protocol’s biggest barrier to a fork is to maximise the Voice of its stakeholders. Maximizing stakeholders’ voice makes them more likely to believe that they can suggest changes that would increase their benefit of the platform. This increases their skin in the game as they would have more to lose by leaving. The best way to maximize voice is through effective governance.
Consequently, we want to see more examples of successful community incentivization, governance and participation. Designing incentives that reward long-term skin in the game and deeper participation are ways to avert some of the mercenary effects of industrialized liquidity mining that we currently see on the market. Time-weighted rewards are a good recent development, and rewards based on dynamic reputations that take into account many disparate contributions is a development I’m particularly looking forward to.
Indirect stakeholders are B2B relationships, or more precisely protocol to protocol (P2P), i.e. the other protocols that the protocol in question integrates with. These relationships are distinct from direct stakeholders as indirect stakeholders typically only have secondary exposure to the ups and downs of the protocol’s success.
Again, in terms of skin in the game, it is the contribution of the relevant B2B/P2P relationships to each other is what matters, in other words, how much does each protocol benefit the other? These kinds of situations are the rare occasions where 1+1>2.
Uniswap is a leading example in this category. You can think about the importance of Uniswap’s sUSD pool for Synthetix, and the role that Uniswap has played in providing liquidity for many other upstart protocols. Such other protocols benefit from Uniswap’s liquidity and are therefore incentivised to see Uniswap succeed in turn, and send more value (through volume, or brand kudos) its way. A good example being Zapper enabling UNI farming natively through its dashboard.
Other examples include Ren’s integration with Curve. Ren has brought hundreds of millions of dollars of Bitcoin onto the Curve platform. Both Curve and Ren are incentivized for each other's platform to succeed and do well. As a result, their respective communities are incentivized to support each other with bug catching, governance proposals and so on.
Although Compound’s direct stakeholders (outside of its VCs) do not have the strongest skin in the game (virtually no protocol currently does), Compound has strong defensibility in terms of the symbiotic nature of its many integrations with the likes of Binance, Coinbase Wallet, Dharma, Instadapp, Multis, Argent, Coinbase Custody, Bitgo and Fireblocks. We also see this in terms of the Dharma team actively participating in the Compound governance through submitting, developing and testing a new interest rate model. Another example being Instadapp’s one step CDP to Compound integration. There is symmetry involved in these integrations as the better Compound becomes, the better it is for the end-users serviced by the integrators like Instadapp, Dharma, et al.
Skin in the game via protocol relationships, symbiotic composability, in other words, is one of the most powerful moats we’ve seen to date in DeFi.
Plotting the current relative strength of the direct and indirect stakeholders of the leading DeFi platforms we get something like this:
As set out at the start of this article, network effects in DeFi are weaker than in traditional tech. There are two types of relevant network effects at play in DeFi; 2-sided liquidity network effects (more supply-sider capital means lower slippage for the demand side which incentivizes more supply-siders and vice-versa and so on, etc etc) and bandwagon network effects in terms of a belief in something, e.g. Yearn’s approach to governance and its fair launch.
As we’ve seen over the last few months, 2-sided liquidity network effects don’t create defensibility in crypto. When suppliers and users can move freely, marketplaces such as exchanges lose defensibility. Bandwagon network effects can be powerful when harnessed well, but ultimately can be considered as part of a protocol’s trusted brand effects.
Economies of scale effects are a measure of how well costs can be saved at scale. Economies of scale will undoubtedly be a powerful moat for the leading DeFi platforms in the future as scale makes gas optimization and transaction batching (amongst many other things) more efficient. Yearn is one of the few examples in this regard as its pooled capital scales in gas efficiency. It is still a weak moat, however, given how freely such capital can leave the platform.
As a reminder, builders should consider the following when planning their DeFi moats:
Skin in the Game (Direct Stakeholders)
Skin in the Game (Indirect Stakeholders)
The aim of the game is to get into the top right quadrant below, and to do so you must maximize your stakeholder base’s skin in the game and build a trusted brand.
A parting caveat is that a moat is only good for so long as a competitor is competing for the same job to be done. Christensen’s “jobs to be done” theory is a mindset exercise for how to step into your customer’s shoes and understand what elements of performance they actually care about in a product, versus which elements they don’t. For example, Uniswap is doing an excellent job right now at facilitating token swaps in an incredibly low-friction manner.
However, given how nascent the DeFi industry is, a protocol’s job to be done will evolve over time due to changing customer demands. DeFi protocols must also take care to support all their stakeholders, such as supply-siders. We understand that the underlying DeFi protocols, as well as the interfaces that interact with them, will need to adapt in the coming months and years; that’s a given.
Moats, therefore, are never static or said another way, moats are not a sufficient ingredient for success, but they are necessary. For now, building and maintaining a trusted brand and ensuring that your key direct and indirect stakeholders have sufficient skin in the game appears to be the best framework we have.
Dermot O’Riordan (@Dermot_ORiordan)
Thanks to the valuable contributions of Batu from Binance, Freddie Farmer of DeFi farming fame, Ross Middleton from Deversifi, Jack Laing and Michael O’Rourke of Pocket Network, and my teammates and partners at Eden Block for their many discussions and feedback on this article.