Kyle Samani of Multicoin Capital reads from his essay on how defensible each of the major DeFi protocols on Ethereum are, and what that says about Ethereum’s defensibility. He evaluates how easy it would be from an effort and capital standpoint to fork each of the major DeFi protocols, and makes a strong case for how and why he thinks protocols like Maker are quite defensible, and why he believes certain dexes are less so.
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As a suite of new layer 1 blockchains are launching, I’ve been thinking about Ethereum’s network effects, and the defensibility of the DeFi protocols built on top of Ethereum.
A couple of years ago, I wrote about the network effects of non-sovereign layer 1 monies like Bitcoin and Ethereum. Since then, the DeFi ecosystem on top of Ethereum has blossomed: utilizing a couple dozen DeFi protocols, users have withdrawn a few hundred million dollars of debt that’s fully collateralized against an even larger pool of capital.
Now that these protocols are collectively facilitating a few hundred million dollars of economic activity, it’s possible to begin to reason about defensibility. One way to do this is to quantify and compare network effects. However, it’s very difficult to quantify network effects with precision since the underlying dynamics of each protocol are unique, therefore making it challenging to compare each protocol on an apples-to-apples basis.
In this essay I’ll consider the 1) effort, and 2) capital required to fork each of the major DeFi protocols. Then I’ll rank the relative strengths of these network effects, and conclude with a discussion of Ethereum’s ecosystem level defensibility.
This essay assumes working knowledge of each protocol.
Synthetic Stablecoin – Maker
About a year ago, I wrote about how Layer 2 assets such as MKR (which is the “equity” of the MakerDAO system) can capture value in a permissionless, open setting. In that essay, I specifically identified the presence of unforkable state as the key to value capture (the best example of unforkable state is the collateral that backs a loan). In the context of Maker, the obvious unforkable state is the collateral (which is primarily ETH) backing the DAI loans.
However, it’s now clear that this framing is incomplete. To understand why, let’s assume that the only source of network effect for Maker is the collateral. A wealthy 3rd party could fork all of Maker’s contracts, and create an alt-Maker ecosystem, they could deposit tens of millions of dollars of collateral to bootstrap liquidity in that alternative ecosystem. But what then? The alt-Maker ecosystem is useless if no one wants to buy or interact with alt-DAI.
Maker’s most potent source of defensibility is not MKR, or the collateral backing the DAI loans, but the liquidity and the usability of DAI. DAI must be liquid in order for Maker to be usable. If someone withdraws DAI debt against ETH collateral, the DAI is useless if there’s no liquidity for the dai. But usability is a superset of liquidity. DAI’s usability is clear in its acceptance by merchants, its use in other protocols like Augur, and its use as collateral in lending protocols like Compound and Lendf.me. DAI is plugged into all kinds of 3rd party apps, services, and infrastructure, and that makes it more useful and usable.
The combination of DAI’s liquidity and usability is a powerful moat. A well capitalized alt-Maker team could try to offer a higher Dai Savings Rate (DSR), and they could try to pay 3rd parties to integrate alt-DAI, but it’s unclear if this would gain meaningful traction.
Fiat Collateralized Stablecoins – USDT
While Tether is not a pure DeFi protocol, with an outstanding market cap of over $5B, I included it because it’s such an integral part of the crypto ecosystem.
The source of the defensibility for Tether is clear: it’s the most liquid asset in the crypto ecosystem alongside BTC. It is available on all major non-US exchanges, serves as collateral for many derivatives exchanges, and is used to settle a huge percentage of OTC trades.
Despite fierce competition from USDC, PAX, TUSD, GUSD, DAI, and others, USDT still commands >80% of the stablecoin market (when measured using market cap). This is the ultimate testament to the defensibility of USDT.
There are a few teams that are working on stablecoin clearinghouses, including DeFi protocols such as StableCoinSwap, and Shell; and centralized clearing houses such as Stablehouse. If these are successful – and therefore reduce the friction associated with trading stablecoins – USDT may be negatively impacted.
For example, if these protocols and companies provide strong guarantees that large quantities of stablecoins can be swapped with minimal slippage, derivatives exchanges may begin to accept other stablecoins as collateral. Today, cryptocurrency derivatives exchange FTX offers this service natively; however, the presence of liquid stablecoin clearinghouses may accelerate this trend for other exchanges, which is likely bad for USDT.
Collateralized Money Market – Compound / Lendf.me
The unforkable state in the crypto lending protocol Compound is the collateral in the system.
Therefore, the defensibility of Compound can be understood as follows: as the value of the collateral pool increases, borrowers can borrow more capital, at lower rates, which then draws more lenders. That cycle is virtuous.
So, how difficult is it for someone to fork Compound and therefore bootstrap liquidity into an alt-Compound?
Well there are a few ways to do this. The alt-Compound team can:
- Support assets that Compound does not itself support (e.g. USDT).
- Introduce more favorable collateralization ratios and liquidation penalties.
- Lend their own assets in the alt-Compound pool at a competitive or even discounted rate.
- Subsidize 3rd party lenders to undercut Compound’s rates.
Today, Compound has less than $100M of collateral backing the system. If the creators of an alt-Compound undercut Compound’s rates by subsidizing users – for example on the order of 100 basis points per year – the annualized opportunity cost of bootstrapping liquidity would be less than $1M. This level of scale is easily venture fundable.
However, in addition to Compound’s internal liquidity (in the form of lending and borrowing rates), Compound is also subject to a couple of unique forms of external liquidity that may provide additional defensibility.
First, there are 3rd party aggregators such as Instadapp, Zerion, RAY, idle.finance, Aave, etc. These systems route deposits to Compound, which in turn lowers borrowing rates, which then attracts more borrowers. While organic capital flow is certainly good, it’s not clear that it matters on the margin (because an alt-Compound team can subsidize rates to bootstrap liquidity anyways).
Interestingly, the presence of aggregators can actually backfire because the aggregators are incentivized to send user assets to the highest-yielding lending pools. Assuming similarly trusted contracts, governance and oracle mechanics, aggregators may not be loyal to Compound at the expense of their users, and so an alt-Compound team can actually win over aggregators with subsidies. Moreover, a sufficiently large aggregator can siphon liquidity away from Compound into its own pool or an alt-Compound fork. While this hasn’t happened yet, I expect it will in the coming years.
Overall, it’s unclear if 3rd party aggregators will act as a substantial source of defensibility for Compound.
Second, let’s consider cTokens, which represent your balance in Compound and accrue interest over time. cTokens are somewhat-analogous to DAI. If third party apps integrate cTokens (for example, for use as collateral in other lending protocols), that makes cTokens more usable outside of the core Compound protocol. That makes it difficult for lenders (in this case, the cToken holders) to move from Compound to an alt-Compound.
While the Maker/DAI – Compound/cToken analogy is good, it’s not perfect: the only reason to create DAI is to sell it for something else (e.g. more ETH). Therefore alt-Maker is useless unless there is a market for alt-DAI. However, this is not true for Compound. Compound is still useful even if 3rd party apps do not utilize cTokens.
Empirically, this is all playing out as the theory would predict. The China-based dForce community forked the Compound codebase and launched a collateralized money market protocol called lendf.me, they’ve already bootstrapped ~$20M of collateral into the system in just a few months. They accomplished this by
- Offering protocols that Compound does not support (notably USDT, imBTC, and HBTC)
- Localizing the service with 3rd party integrations for Chinese users.
It does not appear that the dForce community had to subsidize rates on lendf.me to accomplish this. This was able to happen all organically.
It’s clear then, that Maker is more defensible than Compound. With a subsidy budget, anyone can fork Compound and bootstrap liquidity internal to its lending/borrowing market. But successfully forking Maker requires more than a subsidy budget: it requires liquidity and usability for DAI external to the protocol itself.
Generalized Synthetic Asset Protocol – Synthetix
Synthetix is a specific type of exchange focused on trading synthetic assets. The defensibility of an exchange is generally understood to be a function of liquidity. However, Synthetix is not a traditional exchange because it does not offer a central limit order book (CLOB) like virtually all major exchanges across both traditional markets and crypto. All exchanges such as the NYSE, CME, Coinbase, and Binance offer central limit order books.
One of the defining features of Synthetix is that takers do not incur any slippage when trading synths (synthetic assets) against the collateral pool; however, liquidity is limited in this model based on the amount of collateral in the system. This means that liquidity – and therefore defensibility – is primarily a function of available collateral.
Interestingly, the growth of the Synthetix exchange is actually hampered by the need for takers to onboard into the Synthetix ecosystem by trading real assets (non-Synths such as ETH) for synthetic assets (such as sETH). Today, most users onboard into the Synthetix ecosystem via the decentralized exchange called Uniswap, the largest liquidity pool on Uniswap is actually sETH-ETH. So while the need for a liquidity bridge is a constraint to growth, it’s also conversely a moat: if someone forks the Synthetix ecosystem to create alt-Synthetix, she will need to bootstrap an analogous liquidity bridge.
So, how do the network effects of Synthetix compare to Maker and Compound?
First, let’s consider the collateral in the protocol. Like in the cases of alt-Maker and alt-Compound, anyone who forks Synthetix can capitalize the collateral pool themselves, or subsidize others for doing so. Therefore, the collateral base is unlikely to provide meaningful defensibility.
Next let’s consider exogenous assets: DAI (in the case of Maker), cTokens (in the case of Compound), and synthetic assets (in the case of Synthetix). Unlike Maker’s DAI, synthetic assets do not require liquidity external to the protocol… by design! Instead, Synths are more comparable to Compound’s cTokens: like cTokens, synthetic assets can be used as collateral in third-party apps, but they don’t need to in order for the protocol to function. While this could become a source of defensibility in the future, it has not yet.
The last major form of defensibility for Synthetix is the real asset <–> Synth bridge. While Synthetix leverages Uniswap for this today, an alt-Synthetix team could easily provide their own real asset <–> alt-Synth bridge using Uniswap, Kyber, or other freely available DeFi protocols.
Automated Market Makers – Uniswap, StableCoinSwap, Shell, Bancor, FutureSwap, Kyber
Compound is an automated market maker (AMM), albeit for borrowing/lending instead of for trading. As such, the defensibility of most of these trading-focused AMMs can be understood to be comparable to that of Compound, excluding the notion of cTokens.
Empirically, this seems to be the case. While not all of these AMMs are directly competitive because of different product focuses (e.g. focusing on stablecoins vs futures), the defensibility of each protocol is primarily a function of the size of each protocol’s liquidity pool. Whereas larger liquidity pools in Compound allow for tighter lending/borrow rates, larger liquidity pools in trading-focused AMMs offer lower slippage for takers.
On-chain liquidity protocol Kyber has become the most liquid AMM over the last 12 months largely by 1) tapping into other AMM liquidity pools such as Uniswap, and 2) by leveraging third-party integrations that route taker order flow. It’s clear that all the AMMs are going to tap into one another’s liquidity pools as they continue to improve over time. For example, 0x just enabled this in their most recent v3 upgrade.
Paradoxically, once all the AMMs within a given vertical (e.g. stablecoin swaps) tap into one another’s liquidity pools, all of those AMMs become perfect substitutes. None of the AMMs will be able to compete on distribution. The ultimate winner from this end-state of perfect competition will be takers, who will therefore always receive best execution.
Non-Custodial Central Limit Order Book Exchanges – dYdX, IDEX, Nuo, 0x
The defensibility of these protocols are comparable to those of centralized exchanges, albeit with a few disadvantages.
First, all of these protocols are subject to the constraints of the underlying blockchain which ultimately settles trades, these limitations include non-deterministic order execution, high latency, and miner front running. All of these constraints deter liquidity providers, and therefore increase slippage for takers.
Second, these decentralized exchanges generally do not support cross-margining and position netting. While I hope to eventually see this develop in the DeFi ecosystem, it’s clear that this is years away. Meanwhile, centralized exchanges like FTX and Binance offer cross-margining today, and are rapidly expanding their product offerings to maximize capital efficiency for traders.
Mixer – Tornado.cash
Tornado Cash is unique among the other DeFi protocols above. While the others are focused on borrowing/lending and trading, Tornado is focused on mixing funds to maximize user privacy.
Today, Tornado Cash does not support private payments in a pool. Rather, it can just be used to anonymize funds. The source of defensibility in Tornado is the size of the anonymity pool. Since funds cycle through the pool relatively quickly (eg. the entire asset base seems to turns over every 1-2 weeks), the network effects are, by definition, fleeting. Moreover, beyond a certain point, a marginally larger anonymity set doesn’t really matter. For example, as the anonymity set grows from 500 to 1,000 addresses, it’s not clear that the next marginal user cares. Who is the marginal user who believes 1/500 is not good enough, but that 1/1,000 is? Thus, in its current form, Tornado Cash is not that defensible.
However, in a future version of the service, Tornado Cash aims to support privacy-enabled asset transfers inside the privacy pool (rather than just anonymizing funds, which is what’s available today). In this model, capital will be a lot stickier as it won’t leave the system so quickly. This will allow the anonymity pool to grow much larger, making it more useful for larger amounts of capital.
The notion that large amounts of capital will only enter a large privacy pool is unique relative to the other DeFi protocols discussed earlier. For example, if the entire privacy pool is just 1,000 ETH, that pool may not be useful for someone wishing to anonymize 9,000 ETH, and in fact that can be harmful for first 1,000 ETH owners in the pool, as the owners of the first 1,000 ETH may not want a 90% probability of being associated with the other 9,000 ETH.
For a user who wants to anonymize 10,000 ETH, they may require a pool of 90,000 ETH. This model, while not yet available, is clearly more defensible than the status quo because it enables the wealthiest people to use the service, and the wealthiest people, by definition, have the most capital and have the largest incentive to hide their wealth.
After considering the hypothetical difficulty of forking these protocols and the empirical evidence we have in the limited number of cases, I’ve ranked the defensibility of these protocols from strongest to weakest. Note that this ranking is necessarily conjecture, as it’s impossible to quantify and therefore rank on a purely objective basis:
- Fiat collateralized stablecoin – USDT
- Synthetic stablecoin – Maker
- Mixers – Tornado.cash
- Generalized synthetic asset protocol – Synthetix
- Collateralized money market – Compound / Lendf.me
- Automated Market Makers – Uniswap, StableCoinSwap, Shell, Bancor, Futureswap
- Non-Custodial Central Limit Order Book Exchanges – dYdX, IDEX, Nuo, 0x
I ranked USDT at the top because it faces the most competition, and is still 5 – 10x larger than its largest competitor, which is USDC. While USDT is controversial, it’s extremely defensible. Coinbase is one of the best capitalized companies in the space, and its been unable to meaningfully displace USDT after 18 months. While it’s possible that stablecoin clearinghouses may change these dynamics in the future, it’s too early to know.
Based on the commentary above, it should be clear why Maker is next. The Maker protocol does not function if DAI is not liquid and not usable external to the core protocol. Both of these traits are not easily forkable and are not subsidize-able.
I ranked Tornado third, above the lending and trading protocols, because wealthy users – who are going to provide the vast majority of capital in these protocols – require the presence of other wealthy users in order to make these systems work. And because wealth is not evenly distributed, I expect that the market may only support 1 – 2 privacy pools, rather than the 10+ that are available for trading and lending.
Next is Synthetix, while I noted above that Synthetix and Compound are similar in terms of their network effects, I ultimately chose to rank Synthetix above Compound because of the real asset – Synth bridge that acts as an additional form of defensibility.
Below that, the common traits among the protocols in the bottom half of the list is heightened competition. This is clear empirically: entrepreneurs and venture investors are betting that these markets are not that defensible. Furthermore, as discussed above, competitors can easily bootstrap liquidity in most of these markets fairly easily by subsidizing liquidity.
Ecosystem-Level Network Effects
I’ll conclude this essay by considering the implications of everything discussed above on Ethereum’s defensibility, at the ecosystem level.
In short, Ethereum’s defensibility – at least as it pertains to DeFi protocols – is materially stronger than that of any individual DeFi protocol. The primary source of Ethereum’s defensibility is not capital, or liquidity, but it’s the composability and interoperability of these protocols as a whole.
It’s truly amazing that someone can use ETH as collateral, withdraw DAI against it, lend out that DAI on Compound or Lendf.me, and use that DAI as collateral to borrow ZRX, and then sell the ZRX for ETH…. all in a single transaction, in a single moment in time.
The ultimate testament to the power of the Ethereum-level network effects around DeFi was the recent bZx attack which took place on Valentine’s Day. The attacker’s transaction was likely the single most complex transaction ever processed by the Ethereum network, chaining together five sophisticated protocols. Recreating this level of interoperable infrastructure in any ecosystem is going to take years (just as it took Ethereum years to build to where it is today). As such, I recommend that most new layer 1 teams focus on other use cases beyond DeFi, at least until they bootstrap their respective ecosystems.
Bravo to the Ethereum community for pioneering DeFi!