Is DeFi a viable business? Or just a product?

Photo by iMattSmart on Unsplash

One of the big fallacies that seems to have caught much of the crypto space off-guard is a subtle case of skeuomorphism. We’d previously touched on that idea before: where “new” technologies are built in the image of an incumbent system so that it becomes a “digital version of ______”. This logic was extended to apply to many of the later-cycle Web2 businesses which styled themselves as “the uber of ______” etc. 

So why would it apply to DeFi? After all, we too were huge enthusiasts about the revolutionary potential of DeFi, both in it is initial inception of DeFi 1.0 (which has unfortunately suffered from some degree of commoditisation and arguably lack of hype), and its subsequent renaissance in the form of DeFi 2.0 protocols which sought to build on their forebears. 

To be clear, there is nothing skeuomorphic about DeFi: yes, the concepts are similar to traditional financial markets, surplus liquidity goes in search of yield by making itself available to borrowers who require that same liquidity at a price. But the mechanics of how all of that happens, including the management of collateral, margin calls, rates pricing etc are done in a way that bears only scant resemblance to the “real world”. 

Yet DeFi seems to once again find itself in a DeFi winter, this time including the new generation of DeFi 2.0 projects. We had previously believed that this new slate of DeFi 2.0 protocols, building on the infrastructure laid down by their predecessors, would unlock a much greater spectrum of value creation and accrual. Technologically, it seems like they have. What they’ve developed is not skeuomorphic at all, and that is the problem. 

Because as businesses, they seem to have made an assumption that is, as intimated above, subtly skeuomorphic. 

They think of themselves as having the same barriers to entry as a traditional bank. 

But in a world where code is everything, and code is open for public reference, that turns out to be a very dangerous assumption. 

No barriers to bank on 

Taking a skeuomorphic view of the business environment when the fundamental nature of the business is vastly different is tricky business.  

For a traditional bank, the barriers to entry are immense, and not only in terms of preventing competitors from appearing as a result of licensing, capital requirements and regulation; the ability for their services to be decoupled and broken up is also vastly lowered by the same regulatory regime.  

As a result, while being a bank can be a rather boring business in terms of % Return on Equity (thanks to the same regulations that keep the competitors out), it is also a stable one. Limited competition means there are few other banks to which customers can move their money – custody is an expensive business to run (even if it’s just electronic money…). And where some regulated businesses (e.g. credit card issuance) can be “whitelabelled” to be provided by smaller players under the guise of “encouraging competition”, the reality is that everything falls back onto the same set of rails.  

Same banks, different wrapper. 

Within each bank, too, there is room for a proprietary edge to be developed: better technology for assessing risk, managing collateral, funding etc for example means that at the margin, one financial institution can gain a commercial edge over another in terms of profitability, lower loan losses, lower provisions etc which ultimately lead to better profits, better results and maybe better stock prices for shareholders and management. 

Things are very different in the world of DeFi: for one, the very same openness and composability of code that made it revolutionary in the first place is a double-edged sword. The lack of a regulatory framework that precludes new entrants makes competition even more intense. And to top it off, a culture (perhaps nearing the end of its life) of giving out copious amounts of monetary incentives to draw in new users has led to users being largely mercenary when it comes to seeking out “returns”. 

Of course, it doesn’t help that DeFi in itself – much like any other traditional financial service, though few would admit it – is reflexive to the price of the underlying assets itself. In a crypto bull market, DeFi goes up: the value of collateral goes up, the value of the fees denominated in said collateral goes up, the value of the tokens go up in addition to the boost from the fees. In a bear market, the reverse is also true. 

But our point here is really that building a DeFi business is actually a VERY different kettle of fish from building a traditional finance business. The very openness that allowed the pioneers of both generations (so far) of DeFi to exist is also their biggest threat. 

Community, scale, governance etc. 

A common rallying cry in favour of the more established cohort of DeFi protocols usually revolves around a few common factors: that they have an established community of users (i.e. many people use them), they are big, their governance is generally good etc. Those are all valid arguments when it comes to deciding the better one between one DeFi protocol and another. 

The problem that we’re facing however plagues ALL of DeFi, and to put it most succinctly and bluntly: a community built around making money isn’t a community at all. It’s a band of mercenaries who came for the money and will leave when the bonuses run dry. 

Sure, there are the early adopters who truly and deeply felt a compulsion to break away from the traditional financial system and supported these protocols in the beginning. But let’s be honest: that’s not the case for the vast majority of us. If it’s only about the money, that’s a great reason to get involved, but once the money stops (for whatever reason), we’re walking straight back out.  

Why not? When there are many more projects out there dishing out generous incentives to get involved? It wouldn’t take more than a couple of minutes on Twitter to pick up a couple of success stories of individuals who made small transactions on a myriad of random protocols and managed to pick up “airdrops” of free tokens as a result, and who went on to immediately sell them off.  

It also doesn’t help that most DeFi protocols build on other DeFi protocols, creating linkages that almost ensure correlation – even if users don’t realise it. The ease of copying/pasting code and creating forks creates ever more operationally (and financially) leveraged dependencies that are correlated to an underlying zeitgeist, and the more naïve users are fooled into thinking that they’re “still early” when it comes to discovering a new fork, little knowing that they are being set up as exit liquidity. 

And when it all comes down, even the best long-term incentives may not stem the tide of selling. 

We’ll say it again: a community built around monetary incentives isn’t a community, it’s a band of mercenaries. Mercenary marketing tactics draw mercenary capital. 

DeFi first, or DeFi last? 

The fact that DeFi was the first commercially viable application of crypto doesn’t mean that everything has to start with DeFi as a business model.  

In fact, we would question if DeFi is a viable business model to start with.  

To be clear, this does not mean that DeFi isn’t a viable technological model – it is, and it has proven to be a very good one. But being technologically viable and commercially viable are two different things. 

The hypothesis that we are considering is that DeFi is something that should maybe come as an offering, AFTER a defined business has already been established. 

Here’s an analogy: Consider a café whose business is selling cheap, affordable coffee that is served quickly and without frills. The model is simple: paper cups, instant coffee mix and some milk, set up near a busy office street by the train station. Cheap coffee, undercutting Starbucks, giving office workers their daily caffeine hit without fuss. 

To extend the analogy: DeFi 1.0 = freeze dried instant coffee; DeFi 2.0 = 2-in-1 instant coffee; DeFi 3.0… Yes, freeze-drying creamer is an equally brilliant technological development.  

Sounds great? Kind of. Until another instant coffee stand pops up, offering free chocolate sprinkles. And another offering collectible generative art paper cups. And another, and another… Soon the hype around the initial idea (which wasn’t a bad one) dies down, competition is abundant, and notwithstanding the brilliance of the underlying technology (freeze dried coffee must still be one of the world’s greatest inventions), it’s a terrible business. 

Consider the alternative: A museum of contemporary art, hosting exhibitions of great artists and drawing live music performances to massive crowds. There’s a café at the back of the museum, and it sells instant coffee, with milk, in paper cups. Replace the scene with beer at festivals, wine at concerts etc. and you get the idea: same instant coffee, doesn’t need to be sold cheap either. Instead, it can be sold for huge margins, with little competition and people will buy it. Same technology, same model, completely different outcomes. 

This is starting to become the case when it comes to DeFi as well: the tools and technology that power DeFi – AMMs, liquidity pools, staking pools, collateral management, pricing oracles etc. are like instant coffee. They’re great inventions, but in a commercial setting they’re indefensible: the code is available for all to see, and nothing stops new competition.  

And Starbucks? Decent coffee, they write your name on the cup, they’re mostly polite and nice to you and they have well-decorated spaces. That’s your high street bank right there. 

But the communities are a different story: Axie Infinity launching Katana on its own chain, for example is but the tip of the iceberg in a growing trend within gaming communities especially. People are there for the game, but sure, they’ll stop by the marketplace for some DeFi services. 

DeFi Kingdoms tried to build a game around DeFi, attempting to abstract away the complexity of DeFi into simple concepts like gardening for normal users. The problem was it was DeFi first, then game. The greater success is perhaps TreasureDAO’s Bridgeworld, which is game first, then DeFi, offering a rich collection of lore texts for users to get immersed in, including storyline events, a plethora of affiliated projects in the same ecosystem and a highly engaged community that has more to look forward to than simply optimising for APR/APY rates.  

Would it be hard for DeFi services to be subsequently added? It turns out that forking Uniswap v2’s AMM code takes a matter of hours to redeploy the code, and auditing it takes a couple of weeks after. Once the community is in place, liquidity and engagement come as a natural consequence. 

In a world where there are no barriers to entry and no impediments to user movement, the old theories of how to run a business scarcely apply. 

We wrote this years ago when we articulated our Theory of Nachas, and we will articulate it again: alignment of interest is everything in a world with no barriers to competition. Customers must be turned into users and partners. Exploiting customer surplus for profit has to be replaced with co-opting customer satisfaction for value. 

So perhaps the answer is neither DeFi first or DeFi last. DeFi is just another tool, a product to be offered to users. It can be innovative and technologically superior, but DeFi doesn’t make a business. 

Community does.