Unchained - The Most Forkable DeFi Protocols on Ethereum - Ep.166

Episode Date: April 7, 2020

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. Thank you to our sponsors!  Crypto.com: https://crypto.com/ Kraken: https://www.kraken.com Learn more about your ad choices. Visit megaphone.fm/adchoices

Hi everyone. This week I have another essay for you. This one by Kyle Samani of Multicoin Capital, titled The Most Forkable Defy Protocols on Ethereum. He looks at how easy it would be from an effort and capital standpoint to fork each of the major DeFi protocols. He 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. He also looks at the same. He also looks at the same. He also looks at the way he thinks protocols like Maker are quite defensible. He also looks at the way he thinks. He makes a the implications these defy protocols have on Ethereum's defensibility. It's a thought-provoking essay, especially considering everything Defy has been through in recent weeks. Also, it'll be interesting to see how new developments like TBTC, the new trustless version of Bitcoin coming to Defi, will play out by the metrics Kyle is weighing. I'd love to hear your thoughts on what he says. And now, here's the most forkable DeFi protocols on Ethereum. Enjoy the show. Cracken is the best exchange in the world for buying and selling digital assets. It has the tightest security, deep liquidity, and a great fee structure with no minimum or hidden fees.

Whether you're looking for a simple fiat on-ramp or futures trading, Cracken is the place for you. What's the best way to spend crypto? The MCO Visa card lets you spend anywhere visa is accepted, including your coffee shop or the Apple Store, all with up to 5% back. Download the Crypto.com app and reserve yours now. Hi, I'm Kyle Samani, and today I'm going to be talking about the defensibility of Ethereum's DFI protocols. As a suite of new Layer 1 blockchains are launching, I've been thinking about Ethereum's network effects and the defensibility of the DFI 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 Defy ecosystem on top of Ethereum has blossomed. Utilizing a couple dozen Defy 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 one effort and two, capital required to fork each of the major D-Fi protocols. Then I'll rank the relative strengths of these network effects and conclude with the discussion of Ethereum's ecosystem-level defensibility. This essay assumes working knowledge of each protocol. First, let's start with a synthetic stable coin such as Maker. About a year ago, I wrote about how layer two assets such as MKR, which is the equity of the Maker-Dow system, can capture value in a permissionless and open setting. In that essay, I specifically identified the presence of unforkable state as the key to value

capture. The best example of unforkeable state is the collateral that backs alone. In the context of Maker, the object of the object. unforkeable state is the collateral, which is primarily ETH backing the die 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 third 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 die loans, but the liquidity and the usability of die. Die must be liquid in order for Maker to be usable. If someone withdraws die debt against ETH collateral, the die is useless if there's no liquidity for the die. But usability is a super set of liquidity. Dye's usability is clear in its acceptance by merchant. It's used in other protocols like Auger,

and it's used as collateral in lending protocols like compound and lend FME. Dye is plugged into all kinds of third-party apps, services, and infrastructure, and that makes it more useful and usable. The combination of Dye's liquidity and usability is a powerful mode. A well-capitalized Alt-Maker team could try and offer a higher Dye savings rate, and they could try and pay third-parties to integrate Alt-Dye, but it's unclear if this would gain meaningful traction. Next, let's turn to Fiat collateralized stable coins such as Tether.

While Tether is not a pure DFI protocol, with an outstanding market cap of over $5 billion, I included it because it's such an integral part of the crypto ecosystem. The source of defensibility for Tether is clear. It's the most liquid asset in the crypto ecosystem alongside BTC. It is available on all major non-U.S. 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, True USD, Gemini Dollar, Dye, and others, USDT still commands more than 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 defy protocols such as stablecoin swap and shell, and centralized clearinghouses such as stablehouse. If these are successful and therefore reduce the friction associated with trading stable coins, Tether may be negatively impacted. For example, if these protocols and companies provide strong guarantees that large quantities of stable coins can be swapped with minimal slippage, derivatives exchanges may begin to accept other stable coins 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 Tether. Next, let's turn to collateralize money markets, such as Compound and LendF. Notte.Me. The unforkeable 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 in 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. An old compound team can, one, support assets that compound itself does not support. For example, Tether. Two, they could introduce more favorable collateralization ratios and liquidation penalties.

Three, they could lend their own assets in the alt compound pool at a competitive or even discounted rate. And four, they could subsidize third-party lenders to undercut compound rates. Today, compound is less than $100 million 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 $1 million. 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 third-party aggregators, such as Instadap, Zirion, Ray, Idle Finance, AVE, and others, 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 could 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. So overall, it's unclear if third-party aggregators will act as a substantial source of defensibility for compound. Second, let's consider C-tokens, which represent your balance in compound and accrue interest over time.

C-tokens are somewhat analogous to die. If third-party apps integrate C-tokens, for example, for use as collateral in other lending protocols, that makes C-tokens more usable outside of the core compound protocol. That makes it difficult for lenders, in this case the C-token holders, to move. move from compound to an alt compound. While the maker slash die and compound slash she token analogy is good, it's not perfect. The only reason to create die is to sell it for something else, for example, more ETH. Therefore, Alt maker is useless unless there is a market for Alt die.

However, this is not true for compound. Compound is still useful, even if third-party apps do not utilize seat tokens. Empirically, this is all playing out as the theory would predict. the China-based DeForce community forked the compound code base and launched a collateralized money market protocol called Lendef.mee. They've already bootstrapped more than about $20 million of collateral into the system in just a few months. They accomplished this by one, offering protocols the compound does not support, notably Tether, IMBT, and HBTC, and two, localizing the service with third-party integrations for Chinese users. It does not appear that the DeForce community had to subsidize rates on LendMe 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 and borrowing market. But successfully forking Maker requires more than a subsidy budget. It requires liquidity and usability for dye external to the protocol itself. Next, let's consider a generalized synthetic asset protocol. such as synthetics. Synthetics 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, synthetics is not a traditional exchange because it does not offer a central limit order book like virtually all other major exchanges across both traditional markets and crypto. All exchanges such as the New York Stock Exchange, Chicago Mercantile Exchange,

Coinbase and Binance offer central limit order books. One of the different defining features of synthics is that takers do not incur any slippage when trading synth synthetic assets against the collateral rule. 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 synthetics exchange is actually hampered by the need for takers to onboard into the synthetics ecosystem

by training real assets such as eth for synthetic assets, such as SE. For synthetic assets, such as SE. Today, most users onboard into the synthetics ecosystem via the decentralized exchange called Uniswap. The largest liquidity pool on Uniswap is actually S-Eath to Eth. So while the need for a liquidity bridge is a constraint to growth, it's also conversely a moat. If someone forks the synthetic ecosystem to create alt-synthetics, she will need to bootstrap an analogous liquidity bridge. So how do the network effects of synthetics compare to that of maker and compound? First, let's consider the collateral in the protocol.

Like in the cases of Alt-Maker and Alt-compounds, anyone who forked synthetics 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. Die in the case of Maker, C-tokens in the case of compounds, and synthetic assets in the case of synthetics. Unlike makers die,

synthetic assets do not require liquidity extra to the protocol. by design. Instead, synths are more comparable to compound C tokens. Like C tokens, 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. And the last major form of defensibility for synthetics is the real asset synthetic asset bridge. While synthetics leverages UniSwap for this today, and all synthetics team could easily provide their own real asset alternative synthetic asset bridge using Unitsetka, company swap, Khyber, or other freely available DFI protocols.

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CBC News. With the RBC Avion Visa, you can book any airline, any flight, any flight, any news. anytime. So start taking off your travel list. Grand Canyon? Grand. Great Barrier Reef? Great. Galapagos? Galapagos? Switch and get up to 55,000 Avion points that never expire. Your idea of never missing out happens here. Conditions apply. Visit rbc.com slash avion. Next, let's consider automated market makers such as uniswap, steel coin swap, shell, bandcore, future. Swap and Khyber. Compound is an automated market maker, albate for borrowing and lending instead of for trading. As such, the defensibility of most of these trading-focused automated market makers

can be understood to be comparable to that of compound, excluding the notion of C-tokens. Empirically, this seems to be the case. While not all of these automated market makers are directly competitive because of different product focuses, such as focusing on stable coins versus futures, the defensibility of each protocol is primarily a function of the same. size of each protocol's liquidity pool. Whereas larger liquidity pools and compound allow for tighter lending and borrow rates, larger liquidity pools in trading focus automated market makers offer lower slippage for takers. On-chain liquidity protocol, Khyber has become the most liquid automated market maker over the last 12 months, largely by tapping into other automated market maker

liquidity pools, such as Unuswap, and two, by leveraging third-party integrations that route take or order flow. It's clear that all of the automated market makers are going to tap into one another's liquidity pools as they continue to improve over time. For example, zero X just enabled this in their most recent V3 upgrade. Paradoxically, once all of the automated market makers within a given vertical, for example, stable coin swaps, tap into one another's liquidity pools, all of those automated market makers become perfect substitutes.

None of the automated market makers 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. Next, let's consider non-custodial limit order book exchanges. This would include DydX, IDX, NUO, and ZeroX. 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 settled trades. These limitations include non-deterministic order execution, high latency, and minor for earning. 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 finance offer cross-margining today and are rapidly expanding their product offerings to maximize capital efficiency for traders. And lastly, let's consider a mixer called Tornado Cash. Tornado Cash is unique among the other DFI protocols above. While 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, for example, the entire acid base seems to turn over every one to two 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 that 1 out of 500 is not good enough, but that 1 out of

1,000 is? Thus, in its current form, Ternando Cash is not that defensible. However, in a future version of the service, Tornado Cash aims to support privacy-enabled asset transfers inside of 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 ecosystem 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 DFI 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-Eath. And in fact, that could be harmful for the first 1,000-Eth owners in the pool, as the owners of that 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 stateless. 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. Okay, now let's get to the rankings. After considering the hypothetical difficulty of forking these protocols and the empirical evidence we have in a limited number of cases, I've ranked the defensibility of these protocols from strongest to weakest. Note that this ranking isn't necessarily conjecture, as it's impossible to quantify and therefore rank on a purely objective basis. First, tether and other fiatur collateralized stable coins. Second, synthetic stable coins such as maker. Third, mixers such as tornado cash.

Fourth, generalized synthetic asset protocols such as synthetics. Fifth, cloudolized money markets such as compound and lend-dath.mee. Sixth, automated market makers such as uniswap. And lastly, non-custodial exchanges such as D-YDX, Idex, and Nuo. I ranked USDT at the top because it faces the market. most competition and is still five to ten times larger than its largest competitor, which is USDC. While Tether is controversial, it's extremely defensible.

Coinbase is one of the best capitalized companies in the space, and it's been unable to meaningfully displaced USDT after 18 months. While it's possible that stable coin clearinghouses may change to these dynamics in the future, it's true or later to know. Based on the commentary above, it should be clear why Makers next. The Maker Protocol does not function if dye is not liquid and not usable external to the core protocol. Both of these traits are not easily forcable and are not easy to subsidize. 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 one to two privacy pools, rather than the 10 plus that are available for trading and lending. Next is synthetics. While I noted that synthetics compound or similar in terms of their network effects, I ultimately chose to rank synthetics above compound because of the real asset synthetic asset bridge that access 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 easy by subsidizing liquidity. Okay, and with that, we can now turn to 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 DFI protocols, is materially stronger than that of any individual DFI 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, die against it, lend out that die on compound or lendf.m.A, and use that die 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 Ethereum-level network effects around DFI was the recent BZX attack that took place on Valentine's Day. The attacker's transaction was likely the single most complex transaction, ever processed by the Ethereum Network, training 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 one teams focus on other use cases beyond DFI, at least until they bootstrap their respective ecosystems. Bravo to the Ethereum community for pioneering DFI. Thanks to Haseeb Qureshi, Alex Prudin, Ali Yaha, and Michael Anderson for providing feedback

on this essay. This is Kyle Samani from Multi-Coin Capital. Thanks so much for joining us today. To learn more about Kyle and to read his essay at Unchainedpodcast.com, check out the show notes inside your podcast player. All crypto, no hype, sum merch. Shop Unchained T-shirts, hats, mugs, and stickers at shop.com. Again, that's shop.com. Unchained is produced by me, Laura Shin, with help from fashion. recording Anthony Youde, Daniel Nuss, Josh Durham, and the team at CLK transcription. Thanks for listening.