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Multicoin Capital: DeFi protocols do not capture value, tokens that manage risk are more valuable

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The best way to prove value capture for DeFi tokens is to have some kind of risk in the system that needs to be managed.

Original title: 《 Protocols Don't Capture Value, DAOs Manage Risk 》

Original author: Spencer Applebaum, Multicoin Capital

Original translation: Kyle, DeFi Way

This article is a sequel to 《Value Capture of Layers 1 and Layer 2 ‌》. It also builds on some of the ideas in Forking DeFi Protocols ‌.

In those articles, we explored potential value capture mechanisms in both Layer 1 (e.g., BTC, ETH, and SOL) and what we then called Layer 2 tokens. In retrospect, that was a misnomer. At the time we were referring to application layer tokens — such as MKR, UNI, and AAVE — as opposed to Layer 2 tokens like Starkware, Matter, Aztec, Optimism, and Arbitrum.

Since then, we have refined our thinking about value capture in application layer tokens. As a result, we develop a new framework for the ability of DeFi tokens to capture value in this article.

Application Layer Tokens

In both Layer 1 and Layer 2 value capture, we believe the only way DeFi tokens can capture value is by managing an unforkable state.

An easy way to understand the unforkable state is to compare Uniswap and 0x.

If Alice forked Uniswap V2 tomorrow and created Multiswap, Multiswap would have $0 in liquidity while Uniswap would retain the billions that already existed. Total Value Locked (TVL) is what we call the unforkable state.

More capital in the Uniswap AMM means lower slippage for takers, providing a better experience for traders.

If Alice forks the 0x smart contract and creates the 1y protocol, there are different dynamics at play. The 1y protocol is almost as good as the 0x protocol because the 0x smart contract does not store much state (the smart contract is separate from the API, which has external integrations). After the trade is completed, the state of the 0x asset swap contract remains unchanged.

Of course, there is some off-chain state that the 0x protocol has accumulated over the years that the 1y protocol lacks. This includes integrations with other DeFi products such as DEX aggregators, wallets, relayers, etc. But the DeFi ecosystem has adapted quickly, forks have become socially acceptable, and many forks have been adopted by third-party applications.

New products — including direct copy-paste forks — can compete almost immediately. This is possible because of the rise of DEX aggregators (discussed in more depth below), vampire attacks, front-end integrations, and attractive liquidity incentives.

The general problem we raised earlier about the framework for managing unforkable state is that it is useful for evaluating “protocol defensibility”, but it does not justify the value capture of the token itself. This post attempts to answer the question: “Does this token justify the value capture and fee extraction?”

Value Capture in DeFi

There are two kinds of DeFi protocols: those that don’t manage risk, and those that do. Tokens associated with the former are always at risk of being forked. The latter are much less likely to face this risk.

Let’s take Uniswap (which stores a lot of state!) as an example. While there are some governance parameters — which AMM curves are supported, fees are split between UNI and LPs, and how the UNI treasury is allocated — the token does not manage or support any risk in the system. The UNI-LP fee switch (if enabled) taxes Uniswap takers and makers. Additionally, the UNI treasury taxes all other UNI holders (as a form of inflation). However, on a per-trade basis, the existence of the UNI token is value-destructive for users of the Uniswap protocol — makers and takers. The existence of the UNI token does not make Uniswap a better system for makers or takers.

Now let’s look at Maker again. MKR holders are the backstop of last resort if the Maker credit facility becomes insolvent. In fact, it has been used as a backstop in the past after Black Thursday in March 2020. MKR holders actually take on the risk that they will be diluted if Maker becomes insolvent. Therefore, MKR holders extract fees from the system to compensate them for the risk they take. Aave recently moved in this direction with Aave v2, where the AAVE token is backstopping risk.

Perpetual Protocol and other DeFi derivatives exchanges have to manage insurance funds to attract traders to trade there. Without a sufficiently sized insurance fund, exchanges may force a call or auto-deleverage and take funds from winning traders to cover the losses of the other side. PERP, DDX, FST, MNGO, and other native DeFi derivative tokens can be minted or staked and slashed in the event of a derivatives trader liquidation (effectively, the token acts as an insurance fund). Insurance funds are critical given experiences with BitMEX, OKEx, FTX, Binance, and other highly leveraged perp venues.

Risk is not strictly meant to act as a backstop. It is broader than that. Risk must be managed. The need for risk management is most evident in borrow/lending protocols such as Compound and Aave. If these protocols allowed any form of collateral, malicious actors would deposit bad collateral, withdraw good collateral (such as stablecoins or ETH), and then use this bad asset as collateral. This would result in huge losses for lenders. So, it is natural that both AAVE and COMP holders manage the type of collateral and other risk parameters, and backstop risk in the event that they incorrectly parameterize the system and incur losses.

As a general rule of thumb, any protocol that offers leverage must have some kind of risk management. Leverage is inherently risky and must be managed. Governance tokens are necessary to manage this risk. However, without leverage (like UNI), there is not much to manage.

Returns to Scale

The result of this "backstopping framework" is that larger protocols with native tokens that have 1) higher market caps and 2) more liquidity have returns to scale.

As an example, let’s assume a team forks Aave and creates a new borrow/lending protocol called Suaave. Let’s also assume that the creators of Suaave are well capitalized and are funding the system with $10 billion in TVL. Naturally, the creators of Suaave launch a new token called SUAVE.

If both AAVE and SUAVE manage risk in their respective ecosystems, then the Aave protocol may be a better venue for lenders. Why? Because the AAVE token has already achieved a level of market cap and liquidity that is difficult for SUAVE and other new tokens to replicate. Therefore, AAVE provides better support for the entire system. Additionally, because AAVE’s token distribution is somewhat decentralized and the system has been through multiple public votes and upgrades, it provides a stronger social safety net that cartel groups of bad actors cannot abuse governance in a malicious way.

This creates a powerful flywheel where the largest platform — the one with the most liquidity and largest market cap token — is able to attract users because it’s the most secure. These new users bring in capital, revenue, and TVL, which drives up the platform’s native token price, further strengthening this flywheel.

The same flywheel doesn’t work for tokens that don’t manage risk or back the system, because there’s no concept of “platform security.”

Unnecessary Fee Extraction with Zero Risk Management

In the long run, any token that doesn’t manage some kind of risk in the system can be forked off. This naturally begs the question: do DeFi users really care about fee extraction, and if not, why does it matter?

Today, it’s clear that DeFi users are fee insensitive. This won’t last indefinitely, though. As Jeff Bezos famously said, “Your profit is my opportunity.” The larger the unnecessary fee extraction, the greater the incentive for third parties to undercut/fork/take other actions to circumvent fees. In particular, we want wallets and other frontends to do this and position themselves as acting on behalf of their customers.

If Alice forks Sushi and creates Tempura, why would LPs stay with SushiSwap (where they can only earn 25 bps instead of Tempura’s 30 bps)? The answer, of course, is that SushiSwap has differentiated taker traffic because it has a brand. $10B ADV at 25bps is a better deal for LPs than $0 ADV at 30bps.

But if all LPs move their funds to Tempura, then taker flow will naturally follow, since most traders are using, either explicitly or implicitly (e.g., check out 1inch, then go directly to the protocol), DEX aggregators and frontends!

Over time, as more retail participants enter the space, we think they will connect directly to hyperlocal frontends that aggregate prices across many venues. The result of this will be less brand value, since the primitives themselves don’t own the customer relationships. On top of that, sophisticated market participants do care about paying unnecessary fees. When this happens, we expect the dominant frontends to fork out pure fee-collecting tokens.

Conclusion

The best way to prove value capture for DeFi tokens is to have some kind of risk in the system that needs to be managed.

Logically, this framework proposes that some DeFi tokens - most notably UNI, SUSHI, and YFI - should consider building new features and functions so that their respective ecosystems have a certain amount of risk to manage. As the total amount of risk in these ecosystems increases, they become increasingly difficult to fork.