Most DeFi protocols are not set up to win because they have no sustainable moat.
This thought has been at the back of my mind for months.
Here’s a thread on why most things in DeFi probably won't last and 5 examples of moats that do exist even in an open source world.
First off, what is the #1 thing a DeFi protocol needs to grow?
Your money, either in the form of transactions or as deposits (Total Value Locked – hate the term but lets use it for now).
People deposit money in DeFi because they expect a protocol will help them earn a return.
That return could be via yield farming, trading fees, lending and borrowing, etc.
Typically the DeFi protocol will charge some fee for their service.
More TVL = more money being used to generate a return = more fees for the service provider.
You'd think high and growing TVL = successful, right?
Not the case.
Most TVL isn’t "locked." It’s a deposit, not much different from a savings account.
In most cases, TVL is growing or deposited because depositors (you) are paid tokens as a reward.
DeFi protocols are paying users at the expense of investors in the token who are getting diluted and dumped on when rewards are paid.
(To be fair, this part is not too dif from tech startups receiving VC funding to build products and onboard users.)
Here’s the real issue: DeFi protocols are not being built to last beyond the death of token incentives.
They're not being built with the most important thing for long-term success – a competitive advantage aka economic moat.
A moat is quite simple in concept – it’s what makes one protocol superior to others for users, allowing for the protocol to maintain value capture (fees) and dominate market share.
You have a lot more room to tinker with parameters like fees if you establish and maintain moats.
The challenge DeFi faces is that many of the best traditional moats don’t exist in an open source, globally accessible world.
Things like:
•Proprietary tech, patents, etc.
•Product differentiation (see: forks)
•Barriers to entry
•Lower cost of production
•Geography
Forking of open source code eliminates many traditional advantages.
The best way to think about moats in crypto is “unforkability” - the aspects of a protocol that can't be forked comprise its moat.
Here are 5 examples of unforkability.1234
When I say community, I’m not referring to Twitter shill mobs. A good community consists of
- High quality, long-term aligned devs and investors
- Scale of users and tokenholders
- Shared belief in the product and/or team
The strongest communities are the BTC and ETH communities - you know even if all goes to shit there’s someone out there willing to sell their house in exchange for Bitcoin.
Note: community is important but it’s usually not enough by itself. The product still has to make sense!
A stand-alone protocol is highly susceptible to being forked and restarted. A protocol w/ actual utility for DAOs & 3rd party services has an advantage over forked competitors who would have to rebuild partnerships or integrations built on top (e.g. CRV-CVX).
I like to think of DeFi as having “capital effects” – a network effect induced by having more capital in the system.
You’re going to have a hard time successfully forking Aave or Curve who each have $20+ billion in capital in their networks.
More capital in your network means better supply side transactions, which creates more demand which then incentivizes more suppliers, and so on.
While powerful, it can be hard to see early on what has capital effects vs. what is mercenary liquidity.
To me brand is about trust and recognition.
As an example, Uniswap dominates the DEX market in large part due to their brand recognition and trust in the protocol. You know when you LP or swap on Uni, you're probably not going to get rugged for your capital.
Blockchains are lawless lands and lost funds aren't coming back. With 8-9 fig hacks on the regular, a protocol prioritizing security and not getting hacked is an important feature.
Better perceived security = more whale users = stickier capital at scale
We can apply these to something like Ethereum to see what max success looks like:
Some examples of DeFi protocols that have these competitive moats:
•Chainlink (all 5)
•MakerDAO's Dai (2-5)
•Curve Finance (2, 3, 5)
I wrote this thread because it's important to recognize that most things are not being built sustainably and manage your investment time horizon accordingly.
Unsustainable = short-term trade
Moat = long-term potential
(note: moat does not automatically mean successful token)
Haven't been much of a threadooor historically but it was fun to write in a new medium outside of Substack.
If you found it valuable give it a like/rt and I'll do more threads in the future.