Hello readers,
Welcome back to the latest edition of The DeFi Report. This week we’re digging deep into the billion-dollar question: where will the most value accrue within the web3 tech stack?
Disclaimer: Views expressed are the author's personal views and should not be taken as investment advice. The author is not an investment advisor.
The DeFi Report is an exploration of the emerging web3 tech stack and an ongoing analysis of where value could accrue. We provide easy-to-follow mental models, frameworks, and data-driven analyses of DeFi and web3 business models.
Let’s go.
To properly forecast value accrual within the web3 tech stack, we need to zoom out a bit. Aggregation theory was first proposed by Ben Thompson back in 2015. The core idea is that the value chain for any given consumer market is divided into three parts: suppliers, distributors, and consumers/users. Pre-internet, powerful business models made outsize profits in various markets by integrating two of the parts while creating a competitive advantage in delivering a vertical solution.
The internet turned this on its head by collapsing the cost of distribution — which neutralizes the advantage of pre-internet business models that could bundle supply, trust, and distribution.
With the internet, suppliers can easily become commoditized via aggregation — leaving consumers and users as the first-order priority.
Printed newspapers are a powerful example of this concept. Pre-internet, newspapers owned printing presses and delivery services that they could bundle with editorial content and advertising. They controlled supply and distribution via geographic physical constraints. Google broke this down by aggregating trusted digital content via search rankings — which enabled a more effective advertising business model. The impact on both printed and digital newspapers was very real:
To visualize this further, let’s look at a few examples. We’ll start with Uber. Pre-internet, taxi companies had local monopolies on transportation. This was accomplished by bundling medallions, dispatchers, and cars (supply, distribution, and trust). To get a ride, the consumer would have to wave their hand and track down a car. Uber broke this down by aggregating cars/drivers and creating a much better user experience for the consumer with a nifty app. Users can trust the service due to driver reviews.
We’ve seen the same concept play out with hotels. Pre-internet, hotels bundled rooms, brand, and trust. Consumers never considered staying in someone else’s home since there was no trust in a service like that. Then came Airbnb. They turned the model on its head by aggregating supply and combining it with a slick application that users could trust via host rankings & reviews.
Key Takeaway: The internet is an incredible distribution mechanism for companies that can create a sticky relationship with users, aggregate supply, and establish trust.
One of the (many) interesting things about public blockchains is that they collapse the cost of trust. Let us not forget that Bitcoin was a free market solution to a trust crisis in 2008. So, naturally, the industry that looks like it could benefit the most would be finance. Banks, brokers, exchanges, etc. These organizations spend a lot of $ to maintain trust — inefficiencies that can be stripped away with superior technology. For example, transfer agents become smart contracts. Messaging, accounting, settlement assurances, and custody become bundled services on public blockchains.
Remember, printed newspapers were disrupted when they lost their distribution advantage — as the cost of physical delivery was removed from the equation. Google captured its ad business by stripping away the cost of distribution — enabling a better advertising model. We see a setup for similar dynamics playing out between DeFi and traditional finance with regard to the trust advantage held by TradFi today.
As lindy effects are reinforced with time, we think that public blockchains and smart contracts will gain the trust of users. Forthcoming regulations will certainly play a role.
Applications that are able to gain sticky users with a superior UX, establish trust, and aggregate liquidity (supply) are likely to win.
Let’s explore how this formula fits into the tech stack.
Wallets & Aggregators: wallets and aggregators monetize by providing user access to applications sitting underneath them. They skim transaction fees but do not control the liquidity. The liquidity is controlled by the smart contracts run by the applications.
A key area we track is whether users are transacting at the wallet & aggregator level or directly on the interface that runs the smart contract. We can analyze this by looking at the revenues of MetaMask vs an application such as Uniswap.
The above data is from 1/1/21 - 2/9/23. We can see that Uniswap is driving more revenue than MetaMask at a 5x clip.
We can also look at trading volumes vs aggregators. Below we have Uniswap vs 1inch.
The data is telling us that most users are going straight to Uniswaps interface. Meanwhile, Uniswap has consistently controlled about 70% of dex trading volume.
Let’s move further down the tech stack and examine the anatomy of a user trade.
L2s & Ethereum: every transaction processed through Uniswap ultimately settles on Ethereum. As L2s scale with lower transaction costs, we believe most transactions will also flow through the L2s. This means Uniswap users (and any application on Ethereum) has to pay the L2, as well as a gas fee to Ethereum validators. A final tax on users comes from MEV, which is also paid to Ethereum validators. Therefore, it is reasonable to assume that Ethereum could ultimately capture the most value within the tech stack if it can maintain its network effect. It’s worth noting that early studies are showing that up to 80% of the value created by L2s (cheaper fees) is accruing to Ethereum at the base layer. This indicates that the middle layer within the infrastructure stack may not see much value accrual.
Ethereum has a large lead today in terms of its network effect when compared to alternative smart contract platforms. They dominate in terms of users, developers, revenues, total value locked, etc.
Network effects beget network effects. Developer tooling, programming languages, EVM & smart contract standards, liquidity, and composability throughout the tech stack drive these network effects.
If you’re a developer looking to launch a web3 app, you are likely to pick Ethereum for these reasons.
Meanwhile, every single transaction at the top layer of the tech stack must flow through each layer below, ultimately funneling down to Ethereum at the base layer. None of this is free.
The “Fat Protocol” thesis observes this and assumes that Ethereum will accrue the most value. In this case, Ethereum becomes the web3 version of Google, Amazon, Facebook, and the banks — extracting rent (captured by the distributed validator set & ETH holders) from every user at the application layer. But does Ethereum actually have a moat?
As mentioned, if you’re a developer looking to launch an app, you’re probably going to pick Ethereum today. Ethereum makes it easy to bootstrap your project by providing standards around programming languages, tooling, a robust dev community, liquidity, users, wallet integrations, etc. This makes it easier to build a project and attract users quickly.
But what happens if your project blows up? Let’s say you solve a big problem and create the best user experience in the ecosystem. Your smart contracts aggregate the most liquidity. You attract a sticky and loyal cohort of users — who visit your interface every day. They trust you. These users don’t care that you’re on Ethereum. They just like using your app. Meanwhile, you have to charge your users for execution (L2), and settlement (L1) at a minimum. This is in addition to what you charge users directly for your service.
At what point do you start to wonder if you’re driving more value to Ethereum than you are receiving in return??
For example, Uniswap did $3.6 million in fees yesterday. In addition to those fees paid by traders, they also paid gas fees and the hidden MEV tax to Ethereum validators.
For this reason, we think it’s possible that the largest and most successful applications could look to build their own “app chains.”
In this case, Uniswap would take its trusted brand, sticky user relationships, and aggregated liquidity elsewhere. They would then integrate backward with infrastructure that they can control. This would be possible on Cosmos, Avalanche, or Polkadot — alternative Layer 1 chains that seek to make it easy for applications to build their own blockchains and vertically control more of the value stack.
Looking back at recent history via Aggregation Theory, this would look similar to Amazon, Google, or Microsoft integrating backward with infrastructure — via web hosting (AWS), operating systems (Windows/Android), etc. — after first establishing a lock-in relationship with users. In each case, owning the relationship with the user was the thing that mattered.
Large applications will only make the move if they believe the pros outweigh the cons.
Control the application, the wallet, the oracles, and the block space. Full vertical integration and value capture.
Sovereignty. Change things about Ethereum that you do not like. For example, Uniswap does not have a say in what the next Ethereum Improvement Proposal will do. What if it negatively impacts their user experience?
Mitigate the negative externalities of MEV via more control of your validator set.
More control of fees. Uniswap could reduce or remove trader fees and instead monetize for its liquidity providers at the validator level.
Unique control of the user experience. For example, Uniswap could provide discounts or incentives for users that hold a particular NFT — as one example.
Focus on building the best product and user experience.
Lose access to the immense amount of liquidity on Ethereum.
Bootstrap a validator set/security.
Lose composability with the ecosystem on Ethereum.
Potential friction bridging Ethereum assets to another blockchain.
Added complexity and developer friction.
Loss of standardization with programming languages, tooling, EVM, etc.
dydx, the largest derivatives platform on Ethereum is making the jump to Cosmos. You better believe that Uniswap and others with sticky users are watching this closely. If dydx can execute a proper implementation without sacrificing liquidity, security, users, etc. it should make their derivatives platform *much* more valuable. Why? They’ll be able to vertically integrate, create a better UX, and capture a larger share of the value chain.
*a16z is an investor in both dydx and Uniswap. It’s possible they advised dydx on this move with the intention of taking the learnings and applying them to Uniswap later on.
Aggregation Theory provides a useful guide when analyzing where value could accrue within the web3 tech stack. Our current thinking is that applications *and* infrastructure should accrue the most value. That said, this is clearly a moving target. We’re still in the early innings of web3 development. As such, the infrastructure (Layer 1s) has captured the most value thus far. Ethereum’s network effects make it a very effective ecosystem for any developer to initially build on. We expect this to persist for some time. However, as we look into the future, the value could move up the tech stack. Applications that gain a sticky relationship with users could look to port them over to their own app chains, thereby vertically integrating while capturing more of the value chain. dydx is our Guinea Pig today. If their implementation is successful, this would be a clear sign that the “Fat Protocol” thesis could be in jeopardy over a longer time horizon.
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Individuals have unique circumstances, goals, and risk tolerances, so you should consult a certified investment professional and/or do your own diligence before making investment decisions. The author is not an investment professional and may hold positions in the assets covered. Certified professionals can provide individualized investment advice tailored to your unique situation. This research report is for general educational purposes only, is not individualized, and as such should not be construed as investment advice. The content contained in the report is derived from both publicly available information as well as proprietary data sources. All information presented and sources are believed to be reliable as of the date first published. Any opinions expressed in the report are based on the information cited herein as of the date of the publication. Although The DeFi Report and the author believe the information presented is substantially accurate in all material respects and does not omit to state material facts necessary to make the statements herein not misleading, all information and materials in the report are provided on an “as is” and “as available” basis, without warranty or condition of any kind either expressed or implied.