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Crypto winters have a way of shining a light on the projects that are here to stay. It’s an important time because we think some of the winning protocols across critical infrastructure are already in the market. Power laws are strengthening on public blockchains. Moore’s Law is playing out on L2. Lindy effects are taking hold. And Metcalf’s Law points to the leaders continuing to lead.
In this two-part series, we revisit the Ethereum DeFi ecosystem to uncover the signal.
Disclaimer: Views expressed are the author's personal views and should not be taken as investment or legal advice.
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The DeFi Report is a data-driven exploration of the web3 tech stack from first principles & on-chain data — and an ongoing analysis of where value could accrue.
Let’s go.
A useful analogy/mental model for DeFi today is a comparison to the early days of music streaming. In the late ’90s, Napster & Limewire burst onto the scene as peer-to-peer music-sharing networks — allowing users to download MP3 files directly from another user’s hard drive. This was extremely disruptive. It turned the music industry on its head seemingly overnight. It was also an ideologically driven movement around the idea that “music should be free on the Internet!” Naturally, the music industry pushed back. The term “pirating” was used to stigmatize the industry. Lawsuits ensued. Napster and Limewire were shut down. Hundreds of smaller, spammy “pirate” sites emerged in a game of whack a mole. The innovation was out of the box.
Yet it still took another 10 years for Spotify to emerge with a proper business model.
When we look back at this, we can observe some clear parallels to DeFi:
The emergence of a disruptive, peer-to-peer model. For music, it was initiated by the emergence of the internet + broadband. For DeFi it’s the introduction of public blockchains and smart contracts.
Compression of costs. At the time Napster was introduced, HP charged $995 for CD burners. DeFi can lower costs by removing intermediaries such as transfer agents, custodians, and onerous reconciliation of bi-furcated accounting systems.
Power structures and existing business model moats are seemingly dismantled overnight via new technology.
It starts with a “wild west” market, unclear business models, and pushback from incumbents. Napster and Limewire were adopted first on college campuses. There was really no business model. Monetization came via spammy banner ads. They were labeled as shady “pirates” by incumbents.
It’s all eerily similar to what we see in DeFi today.
The big difference?
The DeFi protocols with network effects are likely here to stay. We don’t see an incumbent launching new solutions and knocking off the blue chips. Why? The open-source nature of the tech, lindy effects, brand, shared standards, and the fact that liquidity begets liquidity. We think it’s more likely that TradFi will merge with DeFi — rather than DeFi protocols being displaced with something new.
As such, when we study DeFi protocols, we ask the following questions:
What is the step-change innovation?
What is the business model today?
How is the project integrating within the tech stack — and evolving the business model as a result?
What will it look like in a regulated environment/merger with TradFi?
How does value accrue to the token and is it likely to outperform ETH?
Let’s dive in.
Uniswap dominates the market in terms of users, revenues, liquidity, and trading volume. Despite the fact that Uniswap is open-source code that can be copied at will, its market dominance has persisted since its inception.
Data: Token Terminal
Furthermore, Uniswap drives more value to Ethereum than any other protocol within the network today:
Data: Token Terminal
Currently, traders are paying liquidity providers directly on Uniswap. The protocol isn’t capturing any of the fees just yet — 100% of the value is being pushed out to service providers on the edges (LPs as well as Ethereum validators & L2s).
With that said, the market consensus is that trading fees will ultimately compress toward zero (as in traditional finance). If that’s the case, we need to forecast how liquidity providers will be compensated in the future. We think it will be through MEV & gas fees — given the value currently being driven to Ethereum & L2s.
Uniswap’s lead investor is a16z — one of the most powerful VC firms in the world. This is a company that has invested in and guided 71 start-ups to unicorn status over the years. They understand how to integrate horizontally and vertically to capture value.
And this is exactly what we’re observing with Uniswap.
Here’s the progression of the protocol to date:
November 2018: Launch v1 on Ethereum and iterate the protocol over time (currently on v4)
July 2021: Began deploying to L2s and alternative L1s: Arbitrum, Optimism, Polygon, Avalanche, Celo, BSC, & Base. This grows market share while enhancing the user experience via lower fees for traders.
June 2022: Purchase an NFT Aggregator to capture an adjacent business (this has been a flop thus far).
April 2023: Launch their own wallet. The wallet is strategic as it allows Uniswap to control more of the user experience.
June 2023: Launch UniswapX — which aggregates liquidity across chains, introduces gas-free trades, and enables gas-free cross-chain swaps.
It seems the next logical progression is for Uniswap to launch its own app chain within an Ethereum L2. We think this could occur within the OP stack and possibly on Coinbase’s L2, Base. Launching their own app chain within Ethereum will allow Uniswap to ultimately capture the golden goose: tx fees + MEV.
In a regulated environment, traditional finance firms will be able to leverage permissioned pools within Uniswap to trade all kinds of financial products and assets with each other.
If/when this occurs, Uniswap could become quite profitable — allowing the protocol to kick out value to UNI token holders.
Takeaways
Uniwap is well-funded (raised $165m in Oct. ‘22) and doesn’t have to worry about profitability or returning value to token holders right now. Instead, they have the luxury to focus on the following:
Growing liquidity — and the ensuing network effect
Creating a superior user experience — and a sticky relationship with users
Establishing trust and building the brand (lindy effects)
Integrating within the tech stack
We view Uniswap as a step-change innovation similar to how we think about Bitcoin and Ethereum. In addition to fundamental enhancements to trading and market making (anyone can be a market maker, avoid slippage, hedge positions by providing liquidity, and reduce costs due to the removal of intermediaries) — the key breakthrough pertains to the ability to bootstrap liquidity for illiquid assets — a massive addressable market. Of course, it’s also possible that traditional stock and FX markets converge on the AMM model in the long run.
Bottom Line
The team is executing its roadmap. The protocol has clear network effects, a sticky brand, lindy, and what appears to be a runaway lead on its competition. Of course, we don’t need 50 AMMs. We only need one or two.
The question an investor needs to be asking is whether Uniswap’s risks outweigh its potential — and whether UNI will outperform ETH in the next adoption cycle.
The business model and market structure is creating a massive network effect, pointing to a “winner take most” market in our opinion. We’re observing this play out as we speak. We think this is due to lindy effects (trust) and the utility of the collateral/receipt token produced by liquid staking protocols. If users can access any DeFi protocol or re-staking service they want with an asset like Lido’s stETH, what is the incentive to use another staking provider that may not have the same integrations?
This concept highlights a key distinction between yield-generating assets in traditional finance vs crypto: crypto assets are multi-function. This points to the products that create the most liquidity/functionality/utility first becoming widespread across the market.
In TradFi, every bank can offer money market accounts to their customers. They are all essentially the same product, but every firm can offer its own version since there is no interoperability or utility to a money market account besides the yield. This is not true for a tokenized yield-generating asset. The same product/asset earning a yield could also be used to provide liquidity on an exchange, be packaged into another yield-generating product, or provide economic security elsewhere within the tech stack. Therefore, we expect to see network effects accrue to these products in ways that were not possible with traditional financial products.
We’ll explore this concept further in part two — we think it applies to stablecoins and tokenized bonds as well.
Lido offers the lowest take rate (10%) of any liquid staking protocol on Ethereum. They have the strongest lindy effects (trust) and the most recognizable brand.
Being first to market and integrating with the DeFi ecosystem has allowed Lido to capture 31.8% of all staked ETH. This gives Lido a 2.4x lead on its #2 competitor Coinbase — which takes 25% of the user yield today.
Below is a quick view of the top 10 staking providers on Ethereum.
Users can deposit stETH (the receipt token for staking ETH with Lido) within all of the blue-chip DeFi protocols, providing additional services and earning additional yield (with additional smart contract risk). This is creating a moat for Lido. Furthermore, the emerging re-staking protocol Eigen Layer now accepts stETH — allowing holders to deposit their stETH into additional layers of the tech stack (L2s, data oracles, etc), providing economic security and validation services — in return for additional yield.
The next logical step could be to integrate with traditional financial service providers. For example, consider a large financial service provider offering access to ETH trading and custody. At some point, customers will want to earn a yield by staking their ETH. To retain assets under management, these firms will need to offer staking.
So here’s the question: will traditional finance firms with broad distribution build their own liquid staking protocols (as Coinbase did)? This requires building out integrations with all the necessary ancillary services within the tech stack. Or will they integrate with a protocol like Lido? And take a small fee for providing the distribution?
Lido takes 10% (split 50/50 between the DAO and node operators) of the yield paid out to validators/stakers. There are currently 8.34m ETH staked within Lido.
Back of the napkin projections: let’s say Lido grows to 20m ETH staked in the next few years and ETH price goes to $5k. That’s $100b in TVL. At a 5% yield, the protocol does $5b in total revenue/year. 10% capture = $500 million. That’s a pretty solid business. Keep in mind that Lido is lean (34 employees per LinkedIn) and super scalable.
One of the biggest concerns with Lido is that it’s become so dominant that the protocol has become a centralization concern for the Ethereum Network. As such, there is pressure for Lido to decentralize its validator network (similar to Marinade Finance, the leader on Solana) — proving to the market that it cannot control the network and censor transactions. We’re now seeing this via Distributed Validator Technology. We think it’s possible their smaller competitors will end up as node operators within Lido’s decentralized node operation in the future.
Lido has tried to establish market share on other networks such as Solana, failing to do so thus far. If you’re interested, we covered Marinade Finance, the leader on Solana in a prior report.
Remember, it took 10 years for the proper business model to emerge within music streaming after the innovation was out of the box (largely due to the incumbent industry stalling progress). We’re about 5 years into DeFi and see many parallels. The big difference is that we think Uniswap and Lido may have already won their respective markets — similar to how we think Bitcoin and Ethereum have already won theirs. In the near term, the big unknown is whether or not new laws & regulations will make it difficult for the winning protocols to go mainstream.
But in the long run, we expect to see traditional finance leverage DeFi protocols to offer new products and services via their broad distribution. New rules and regulations will have to come first.
One catalyst in this regard will be the formation of a yield curve in DeFi — which starts with the Ethereum stake rate. Staking yields are currently variable and depend on the volume of activity on-chain + the number of validators on the network.
CoinFund, a crypto investment firm, is seeking to standardize Ethereum’s yield with its new Composite Ethereum Staking Rate (‘CESR’). This could introduce a transparent version of the “LIBOR” rate for DeFi.
A yield curve for DeFi. Fixed rates via interest rate swaps. Permissioned peer-to-peer trading pools. Global markets where anyone can be a market maker. New financial products and services. Lower costs. And broad distribution via early mover traditional financial enabling the merger of TradFi + DeFi.
That’s how we see it playing out in the long run.
Thanks for reading.
In Part 2 we cover the lend/borrow space and stablecoins. It will hit your inbox next Monday.
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Disclaimer: 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.