I interviewed industry professionals at top law firms, investment funds, exchanges, and various decentralized finance projects, in addition to attending panels and conducting independent research at UC Berkeley, to better understand the the emerging DeFi industry.

The article that follows will outline the differences between the DeFi dream and the DeFi reality, and highlights 7 of the most pertinent challenges the industry must overcome before bridging the gap. Subsequent articles will analyze the decentralized exchange of assets and decentralized lending and derivatives. These articles assume a foundational knowledge of both financial markets and blockchain technology.

The most widely used application of blockchain technology is in the creation of digital currencies, which has required the development of financial markets to support their exchange. However, these financial markets, in their current state, prevent fair and open access. Furthermore, the infrastructure that supports blockchain-based markets is vulnerable to counterparty risk, censorship, a lack of transparency, and manipulation as it remains largely centralized. Current infrastructure flaws erode trust and inhibit adoption.

Just as the internet allowed for the creation of a new information infrastructure, blockchain technology allows for the creation of a new financial infrastructure and the development of entirely new markets. The DeFi movement has emerged in an attempt to make the infrastructure that supports new and existing blockchain-based markets just as decentralized as the underlying technology.

The DeFi Dream

In a functioning decentralized financial system, internet connection would be the only prerequisite to accessing financial services, rather than geography or circumstance. A reduction in the centralization of those that control and own the infrastructure underpinning financial markets would increase transparency, decrease costs, and reduce the opportunity for censorship and / or manipulation. The global “unbanked” (both individuals and enterprises) would gain access to financial services. DeFi would not only facilitate markets for illiquid financial products that already exist but would also allow for the creation of new financial products and markets that don’t yet exist. The ability to more effectively arbitrage, borrow, hedge, and access liquidity would spur more institutions to join the movement without restricting the usage of these products and markets exclusively to them.

The DeFi Reality

While DeFi is referred to as “open finance” and is sometimes touted as a way to “bank the unbanked,” the truth of the matter is these products aren’t aimed at the mass retail investor, let alone the global “unbanked.” Technology is not usually the primary factor restricting access to financial services. More often than not, identity and/or oppressive regimes are. On the retail side, it is unreasonable to believe that the average retail investor would understand the risk profile of even the simplest DeFi products and I’ve yet to hear a compelling argument for why the average retail investor would need access to exotic financial derivatives. UX/UI challenges present further obstacles to retail adoption.

Product-market fit for most institutional investors is not any clearer. Most DeFi projects aren’t well suited for HFT (high-frequency trading) since they’re limited in terms of speed. They are not well suited to trading large positions either and traditional finance institutions won’t even consider entering into transactions in which their counterparty is unknown. At this point, institutional traders aren’t willing to make these trade-offs so long as they can trust at least one other person in the markets in which they operate.

As a result, product-market fit is currently constrained to crypto-native power users that are comfortable with the existing UX/UI challenges of crypto networks and blockchain-based assets. For user adoption to accelerate, the trade-offs required by DeFi interfaces must not outweigh the perceived benefit of ownership, access, and transparency when compared with centralized alternatives. A lack of developer education and tools is also restraining the industry. Tooling and services need to be further developed and a best-in-class stack needs to be established so that users don’t have to interact with a fragmented ecosystem marching in fragmented directions. Developers, regulators, lawyers, investors, professional traders, and retail users will have to work together to overcome existing challenges.

As a result, the transition towards a decentralized financial system is more likely to be evolutionary than revolutionary. That doesn’t diminish the potential of DeFi to reshape the way in which markets function and the way that the entire world interacts and transacts.

While the DeFi movement has the potential to provide meaningful benefits over centralized alternatives, there are many practical challenges the DeFi industry needs to overcome first. User adoption may be the biggest impediment to the development of the industry at present, new risks compounded across protocols may be the biggest threat to its sustainability. An in-depth look at the 7 most pertinent challenges follows.

1.) Identity and Reputation

The first step in entering into a financial transaction often requires the identification of transacting parties. However, a core tenant of DeFi is that one’s ability to access financial services should not be dependent on most aspects of identity. This is problematic as violations of KYC / AML / OFAC regulations can not only result in large fines but could result in criminal charges. If a DeFi Relayer (an entity that hosts on order book on a DeFi protocol) facilitates an exchange between unknown parties and those parties turn out to violate any of these regulations, the consequences may be serious. Furthermore, without a way to enforce identity, most proposals for decentralized governance of these projects are quickly reduced to plutocracy.

While still far from complete solutions, projects are researching ways to allow for KYC (know your customer procedures) without introducing centralization. For example, Relayers on 0x can opt-in to implement a permissioned liquidity pool that ensures that pool is only accessible to whitelisted Ethereum addresses that meet certain requirements, such as those required by AML (anti-money laundering) and KYC policies. However, this method still doesn’t ensure identity in a way that allows one to know that a counterparty is trustworthy without excluding those outside of the traditional financial system and introducing centralization. Several parties have issued EIPs (Ethereum Improvement Proposal) to incorporate KYC/AML compliance into ERC-20 tokens. However, in many cases, these proposals would still require service providers to work together off-chain via a consortium to review each others’ KYC policies and it is still unclear whether these proposals would fully satisfy regulatory requirements.

Establishing reputation in blockchain networks is a distinct challenge. This is a strong industry focus as the range of possible products expands when there is a sense of on-chain reputation. There are currently two main ways to attempt to establish reputation in these networks:

• Allowing everyone to start on an equal playing field under the assumption that network participants are good actors. Participants that prove to be untrustworthy / uncreditworthy would subsequently be slashed (punished.) Underwriters on the Dharma network fall into this category, wherein they gradually build reputation over time via an on-chain record of their accuracy and behavior.

• Porting existing credit data to a blockchain network via an oracle. This is hardly an improvement over the traditional finance system in terms of allowing for fair access.

The lack of an on-chain reputation method that doesn’t require users to reveal too much about their personal identity means most DeFi projects require (over)collateralization in lieu of being able to establish trustworthiness.

2.) Capital Inefficiency

The overcollateralization required by DeFi projects is capital inefficient. MakerDAO requires users to deposit 1.5x the value of ETH to establish the collateralized debt position underpinning Dai (CDPs will be covered in more depth in Risk Off or On?: Decentralized Lending and Derivatives.) Even still, most people choose to keep their “loan-to-value” ratio at 300 percent in order to avoid double digit liquidation penalties.¹ Similarly, Compound requires a 2x collateralization ratio, which the company says will decrease over time.² However, some users indicated a willingness to post 4x–5x the required collateral.²

Until a decentralized reputation system is developed, there is little choice but to require users to lock up excess capital, dulling the benefit of taking out these positions to begin with. Even when/if reputation is solved, the volatility of the underlying positions could result in a persistent preference to overcollateralize.

3.) Oracles

Corruption of on-chain oracles (the mechanism that finds and submits real-world data to a smart contract) is a huge concern for these systems since liquidation occurs automatically in the event that collateral levels drop below their specified “loan-to-value” ratios. Different DeFi projects approach oracles in different ways, but many projects in the space are using MakerDAO’s oracle. MakerDAO’s oracle is currently designed to support single collateral Dai (backed entirely by ETH) but will be re-designed to support multi-collateral Dai (backed by a pool of different cryptocurrencies) in the near future. MakerDAO’s oracle pulls data from sixteen different sources for its oracle feed. These sources are comprised of Ethereum addresses voted on by MKR token holders, which are then submitted to an autonomous smart contract. The oracle chooses the median of all sixteen submitted data points. This system allows for 51% tolerance as it excludes the outliers which are more likely to be submitted by malicious actors.¹ Importantly, MakerDAO also utilizes an oracle security module in which the second layer of the protocol can activate an emergency shut down. This shut down freezes the system at its last known “safe state” if it has reason to believe the oracle may have been compromised. If an emergency shutdown occurs, users can convert their Dai to ETH at the equivalent of 1$/1 Dai, according to the state of the ledger at its last determined “safe state.¹”

Single collateral Dai oracles update every time the price of ETH fluctuates by +/-1.0% but multi-collateral Dai (MCD) oracles will update once an hour.¹ This allows the sixteen oracle inputs to be viewable for an hour before they are acted upon, increasing transparency. However, such a long lag time may not be appropriate considering the volatility of cryptoassets. The company’s argument that this delay can be compensated for by the risk model is questionable. Furthermore, liquidation of collateralized positions (essentially defaults) will be executed via auction with MCD, which means it will “six hours or more” to liquidate positions as the protocol accesses “all the arbitrageurs and liquidity across the whole marketplace and ecosystem.¹” The impact of having to wait 6 hours to unwind a single position during times of market distress, or failure, would be significant.

Compound takes a different approach with its oracle, aggregating and averaging price feeds from a series of exchanges and posting them on-chain consistently. The data updates every time the underlying value fluctuates by +/- 0.1%, but data is updated on-chain every 15–30 seconds, confined by the processing speed of Ethereum.² Given the importance of oracles in these systems, DeFi projects may want to more closely consider which method they use or choose to implement their own methods.

4.) Network: Platform, Liquidity, Scale

Most current DeFi solutions are built on top of Ethereum and therefore DeFi’s adoption is tied to the scalability and usability of the Ethereum network. The scalability debate is well known (and addressed below) while usability remains a challenge as mainstream users still struggle to easily interact with Web 3.0.

While the composability of protocols built on Ethereum creates even larger switching costs, it also introduces network risk. As more projects build on Ethereum, it may become harder to upgrade the base layer protocol in a way that allows for backwards compatibility.

Part of the power of DeFi is that it allows for the creation of new markets. However, decentralized markets suffer the same circular problem that all new markets do: adoption is required to generate liquidity, but liquidity is a driver of adoption. While DeFi can enable new markets and allow new participants to access them, it does not automatically create liquid markets for these products. This is a problem because assets that are illiquid tend to trade at a discount to their liquid counterparts.³ It also creates inefficient pricing as opportunities for arbitrage go uncaptured since it remains difficult to move quickly and seamlessly between crypto markets.

Alex Evans of Placeholder VC breaks down the models of current DeFi networks into three broad categories:

• Those that require users to find peers to trade with. Augur, 0x, Dharma

• Those that pool “maker” assets and offer them to “takers” for a fee. Compound, Uniswap

• Those that set parameters through governance, allowing users to trade directly with a smart contract. Ex: MakerDAO

Each model has implications for liquidity. The lack of requirement to find a specific peer with which to trade seems to be the design advantage of the top protocols. These protocols also tend to offer fewer options in terms of products / use cases, which pools demand, facilitating better liquidity. Alex Evans also believes automatic and consistent processes (MakerDAO) better facilitate liquidity than bespoke and varied ones (Augur.) This seems to have been one of the drivers behind UMA and Dharma deciding to set tighter parameters on their products (relative to a completely open system in which individual users set all parameters.)

“At least initially, the markets that have built deep pooled liquidity in a handful of important markets appear to have the adoption lead versus those that have tried to create a multi-asset infrastructure.” — Alex Evans

Assuming these markets find a way to bootstrap the necessary liquidity, blockchain infrastructure is not yet scalable enough to process volumes similar to those processed by centralized exchanges. For a sense of the limited scale of current DeFi networks, investor at Paradigm, Arjun Balaji, predicts that December 2019’s aggregate volume on 0x will lag a single day’s volume on Coinbase. While advances are being made in Layer 2 scalability and innovative solutions such as StarkDEX (currently partnering with 0x) show promise, current blockchain infrastructure has a long way to go before it can support volumes similar to those supported in traditional markets.

**Front-running, and other opportunities for manipulation, on DeFi networks will be addressed in Trade-Offs: Decentralized Exchange.**

5.) Business Models Still Undefined

While there are many options, most DeFi projects have left their monetization method “undefined” and are focused on “defining the incentives of the protocol at large.⁴” However, at some point these projects will need to generate revenue if they are to persist.

dYdX highlights three main monetization models for DeFi projects:

• Value accrual via a native token. MakerDAO (MKR)

• Monetization via fees. Potentially Compound

• Monetization via a user facing application. dYdX, Dharma, etc.

In most cases, a native token monetization model introduces another layer of friction to user adoption. For other projects it might not make sense. For example, a token monetization model doesn’t make much sense in networks where ownership / voting percentage can be determined by participation, which is recorded on-chain.² Nadav Hollander of Dharma points out that a fee model implemented at the protocol level, in addition to being somewhat anathema to blockchain ideology, could easily be forked away.⁴ However, Compound is not against keeping a small amount of the interest flowing through the system in a model akin to the AUM model in traditional finance.²

The latter appears to be the prevailing model. Dharma, dYdX, and others found that they needed to build out full stack products (Expo on dYdX, for example) because they found that developers weren’t willing to invest the time necessary to build on these new protocols. While the 0x model is often touted as the exemplary model, 0x’s success was enabled, in part, because there was already an existing market for DEXs (decentralized exchanges.) 0x’s protocol opened into an existing market, whereas these new DeFi protocols have to create new markets from scratch.

In an effort to bypass many of the challenges of creating a two-sided marketplace from scratch, it’s likely that new DeFi protocols will continue to build out full stack services and monetize those, at least over the near term.

It is important to remember that creating a marketplace is a service business and that is unlikely to change. Whatever entity enables a marketplace also has to offer services to both the demand and supply sides. Marketplaces can’t be created out of thin air, even by the smartest protocols. They will always require a team / company to support the ecosystem with the services that allow marketplaces to live and grow.

As a result, designing businesses with “minimal viable decentralization” may be a more efficient way of launching of products and approaching early governance⁶ although its likely to be viewed less favorably by those that prioritize decentralization above all else.

DeFi business models are not constrained to the above mentioned models. For example, Arwen is planning to monetize via a revenue sharing agreement with centralized exchanges for the trades referred by Arwen⁵ (further details will be provided in Trade-Offs: Decentralized Exchange.)

6.) New Risks Compounding Across Protocols

Cryptocurrencies and blockchain-based markets have fundamentally different characteristics than their traditional counterparts. DeFi protocols benefit from composibility which leads to faster innovation, but also results in higher levels of interdependancy. Therefore, it’s fair to assume that the risk profile of these products, especially in combination, is not yet fully understood. While each project claims to have developed its own robust risk models, the complexity of analyzing these new risks across interdependent protocols is non-trivial. It’s also worth noting that most risk models weren’t very useful in 2008. In some cases, these models failed because just one assumption was flawed.

Many of these projects utilize concepts that contributed to the 2008 financial crisis, but more importantly, they utilize them in new and untested ways. For example, the rehypothecation of collateral, fractional ownership of structured products, and pooling of risk were all elements of the 2008 financial crisis. DeFi takes these concepts and applies them to highly volatile and hard to value assets in relatively illiquid markets with insufficient safeguards. The combination of all of these factors, combined with the complexity of creating a cohesive view of collateral rehypothecated across protocols, creates an entirely new risk profile for which there is little precedent. Superfluid collateral? Let’s not do this.

In this context, it’s worth considering what a market failure would look like. MakerDAO is an experimental network upon which the success of many other projects depends. It is important to remember that in the case of market failure, CDPs and other DeFi products are not insured and a third-party is not likely to step in to recapitalize small cap crypto start-ups (moral hazard debate aside.) Investors, users, and token holders will be responsible for recapitalizing this highly interdependent DeFi system.

The systemic impact would likely be jarring. Dai is commonly traded on 0x Relayers as a pair with ETH. It is often deposited on Compound and then lent out again to hedge funds to be used for risk-on trades. dYdX is also dependent upon MakerDAO since its short ETH token is long Dai. dYdX further depends on Dharma (which lends in Dai) and the 0x protocol (which facilitates the trading of Dai) to access liquidity. The cascading effect of a failure of any one of these protocols would likely cause a systemic unwind that is rapid (due to volatility of underlying, rehypothecation, and automated execution of smart contracts), jarring (these markets are not as liquid as traditional markets), and significant. The rewards may be high, but the risk is at least commensurate.

Cryptoeconomics don’t defy the principals of regular economics and cryptofinance (DeFi) can’t escape the classic risk/reward constraint of regular finance.

7.) Regulation

The primary concern regarding regulation of the industry doesn’t seem to be that current regulations are too restrictive, but rather the concern is related to the ambiguity as to how existing regulations will be applied in regards to blockchain-based networks and cryptocurrencies. Many of the startups in the space don’t know how to determine whether they should launch or not because the regulatory environment they are operating in is so unclear. The cost of all this uncertainty is high.

In fact, the regulatory burden is so high that some start- ups have determined that they don’t have enough capital to launch in a fully compliant manner, made all the more difficult by the recent crypto winter fundraising environment.

From Dream to Reality

Projects in the space are acutely aware of the above cited problems and are actively working to overcome them. For example, Dharma now pays gas fees for users to make the user experience easier while MakerDAO is planning to abstract the process of converting Dai to MKR upon redemption for MCD. Networks across the board are increasingly removing the requirement to hold native tokens, choosing to replace them with more widely used cryptocurrencies such as Dai or ETH. This is an important step since it removes what has historically been a hurdle to DeFi adoption.

New innovations and projects also enter the space frequently and could provide solutions to many of the weaknesses of current projects. For example, the Arwen protocol is ideally suited to HFT since only the opening and closing of escrow gets posted on-chain, while the rest of the protocol operates like a Layer 2 channel, allowing trading to happen much more quickly.⁵ The trade is also only visible to the trading party and the exchange. Since there is no on-chain execution of individual trades, miners do not see the transactions ahead of time, eliminating most of the front running issues that DEXs face.⁵ The protocol could also solve other critical painpoints, such as allowing for fractionally collateralized options (which dYdX is actively working towards), trustless fiat conversion (via integration with banks) and quicker movement of tokens across exchanges, allowing for effective arbitrage.⁵

In 2017–2018, the main focus in the DeFi industry was on building DEX scalability and liquidity. Solutions for each are quickly evolving. The focus in 2018–2019 has shifted to lending. The composability of DeFi products should allow the whole ecosystem to move forward at a faster pace and may allow for more mainstream adoption throughout 2019, as users are lured into the ecosystem via multiple protocols (trading, lending, derivatives) that all require users to transact with cryptocurrency.

Many of these dynamics could spur more usage and adoption in the next eighteen months, creating the flywheel effect common in two-sided markets. The key point is to acknowledge that while the challenges are persistent and numerous, the industry is far from stagnant, and real and rapid progress is being made. However, risks need to be seriously assessed and considered so that this progress can be sustained.

References

All interviews personally conducted are unattributed

1. https://unchainedpodcast.com/rune-christensen-of-makerdao-part-1-how-to-keep-a-crypto-collateralized-stablecoin-afloat/

2. https://unchainedpodcast.com/how-youll-earn-interest-on-your-crypto-with-compound-ep-82/

3. http://people.stern.nyu.edu/adamodar/pdfiles/country/illiquidity.pdf).

4. https://unchainedpodcast.com/nadav-hollander-on-how-dharma-could-create-new-forms-of-debt-ep-80/

5. https://unchainedpodcast.com/how-to-trade-on-crypto-exchanges-without-fear-of-hacks/

6. Idea credited to Brendan Forster as articulated in a panel at New York Blockchain Week

https://twitter.com/benschecter/status/1499588950599610372

through the (currently painful) process of daoing, i’ve identified several inherent properties common across functional daos. by designing daos with these common properties in mind, we can not only improve the experience of daoing but also design systems that accomplish more than traditional corporations ever have (one example here).

these properties are: Autonomy, Emergence, Complexity, Agency, Transparency

Autonomy

• what it means: the ability to make your own decisions without being controlled by anyone else; the right of an organization, country, or region to be independent and govern itself (Cambridge)

• what it means in the context of daos: in contrast to traditional corporations, daos cannot be controlled or captured

• design principle: design for the highest degree of autonomy (weakly linked, autonomous sub-daos) while providing checks and balances on distributed power

the biggest difference between corporations and daos is that daos can be capture-resistant, meaning they incorporate mechanisms to prevent the capture of shared resources by bad actors (more here). in traditional corporate structures, capture resistance is weakly ensured via trust and reputation, since both matter in the repeated game of public business. internal capture is prevented via regulations enforced by higher-level, external agencies. daos require different assurances against capture since trust, reputation, and regulation are mostly absent in large, somewhat anonymous, digitally native networks. daos can be designed to be capture-resistant, but most aren’t. there are three main ways a dao can be captured:

1.) control over decision making

the 2020 wave of daos pioneered “progressive decentralization,” or turning control over to a community once a protocol built by a centralized core team achieved product-market-fit. this approach prevents the core team from being distracted by building a community and a product at the same time, and avoids design by committee, which isn’t usually conducive to shipping products. this method builds community around collective ownership, launching a token once operations are “sufficiently decentralized” and suddenly turning decision making over to a group of new token holders, usually via token-weighted governance. all decision making has been centralized up to this point and a large portion of product-related decisions often remain centralized. since decision making has been centralized from the start, decentralizing it can feel like giving up control, which core teams are often reluctant to do.

community members are drawn in by a token launch, not by co-building or participating in the network over time, which can create communities that are more speculative in nature. given a lack of other criteria, like previous contributions to the dao, tokens are generally distributed based on retroactive usage, which has proven to be a weak contributor acquisition method. contributors quickly become frustrated by a low degree of involvement in decision making. these dynamics can result in lower voter participation, making any decentralized decision making less capture-resistant as less voices are represented.

regardless of the path towards decentralization, token-weighted governance increases the possibility of capture in the decision making process, the risks of which are well outlined here. Optimism’s two house governance system is a positive first step towards more capture-resistant governance (more here.)

for daos to be capture-resistant, we must decouple power (decision making rights) from wealth (token holdings)

2.) control over resources

to avoid some of these challenges, we experimented with a different decentralization method at RabbitHole. our hope was to build a community around collective decision making, by inviting contributors to co-create with us much earlier in the decentralization process (pre-token) rather than building a community around collective ownership of an already finished product and token. We involved our community gradually in non-core business operations, spinning up a series of community-led working groups. however, since there was no mechanism for decentralized decision making, working groups were still reliant on external stakeholders for access to critical resources (in this case a centralized company, without a governance mechanism). as a result, our working groups were vulnerable to capture and we made the decision to pause this experiment until we could empower working groups with more autonomy.

even when decentralized decision making does exist, the party controlling the resources (ie. parent dao) still has lower context as to the value a working group provides. while working groups may be equipped with their own budgets, they are still subject to a budget allocation process that is outside their control. even with a token to align incentives between a parent dao and a working group, the value a working group adds may not be reflected in the token value of the parent (ie. metagovernance, the value of which is hard to tie back to a core business value.)

when one group controls access to resources for another, the relationship becomes adversarial

while working groups help to control and separate scope within a monolithic organization, the higher autonomy design choice is to replace them with multiple sub-daos. autonomous sub-daos allow communities to organize around specific goals with complete autonomy over how to achieve them, to maintain direct ownership over their own resources, and to share directly in any upside generated from their efforts.

these sub-daos can focus on building either the supply side (to increase the scale/scope of product offerings) or the demand side (to explore new use cases or aggregate users). they may also take the form of a subsidiary, providing services across the ecosystem (ie. metagovernance.) all sub-daos should have economically sustainable business models, so they are not dependent on external parties for resources, but a native token quickly becomes an important means of creating “weak strategic alignment” between daos via token swaps (more on this method here; see MetricsDAO and Goblin Sax).

3.) control over execution

the greatest opportunity for capture occurs at the execution phase. governance generally works as follows (see more here):

• a proposal is put forward

• the community votes on a proposal

• the outcome of the proposal is either autonomously executed on-chain or an off-chain action is executed by a select party

• execution is verified and / or analyzed by the community

execution is the phase most vulnerable to capture since nothing prevents those with execution power (ie. multi-sig signers) from ignoring the will of voters and executing whatever actions they choose. this doesn’t mean we should eliminate all positions of trust within daos. there is a common misconception that in order to avoid capture, decentralized organizations must be flat. but daos are leaderful, not leaderless. daos can still have hierarchy, it’s just that it’s fluid.

positions of trust (like those with execution power) should be elected or legitimized by the broader community with clear mechanisms for removal if/when the responsibilities of those positions are abused or neglected. Yearn’s gov 2.0 proposes such a model, wherein highly autonomous yTeams are empowered by YFI holders to act independently in the best interest of yearn, within a constrained domain of action and discrete decision-making powers, subject to monitoring by YFI holders which have the power to remove contributors if roles are abused (more here).

being a leader in a dao is the most humbling thing I’ve ever done because you cannot rely on static positional authority. you must constantly earn respect with the community. on the good days, it’s meritocracy; on the bad days, trial by jury.

positions of trust don’t need to be open to the entire dao. while power should be distributed, it shouldn’t be permissionless. unauthorized participation can actually threaten a DAO’s resistance to capture as it creates more attack vectors (more here). while participation by as many community members as possible should be encouraged as an input into decision making, the ability to put forward certain proposals, make decisions, and hold positions of trust should be subject to qualifying criteria.

daos (the human layer) do not need to be as decentralized as the protocols they are built around (the tech layer)

Emergence

• what it means: the fact of something becoming known or starting to exist (Cambridge)

• what it means in the context of daos: in corporations, ideas are dictated from the top down. in daos, initiatives surface organically from the community

• design principle: emergent daos don’t have to be amorphous. a strong mission and culture can guide collective decision making without being overly prescriptive

emergence is vital to maintaining an active community. daos that don’t support emergence become little more than shell communities over time as contributors get frustrated having little ability to influence the dao. the most emergent daos are “day-one daos,” which form organically when groups of people rally around a mission, idea, belief, or event. they’re decentralized from the beginning and decide what to do or build collectively. these daos usually launch tokens immediately as a way to raise funding, which also immediately decentralizes decision making. this provides contributors with full autonomy to shape the dao emergently but day-one daos can struggle to guide decision making given the lack of structure.

let’s define culture as a set of shared beliefs about how decisions should be made (mission) and which behaviors will be rewarded (values). culture is mostly an afterthought in traditional corporations. decision makers are determined via hierarchy and decisions are implemented by force, so there is little need to define a framework around how decisions get made. In contrast, culture is a critical tool for guiding decisions made by a collective.

why are mission statements so important for daos? because they provide a north star for decision making and set a general direction for the dao. directionless daos tend to lose momentum, and i’ve never seen a dao that lost momentum get it back. a strong mission can also create a moat. people think community is a moat but it can’t be since community members are constantly changing. your mission, however, can consistently draw in value-aligned contributors and keep them there when the dream of the dao inevitably fades into the reality of the dao (twoirtter.eth).

contributors can only meaningfully contribute to 3–4 daos, so they need a compelling reason to contribute to one over another. RabbitHole contributors have said they work with us specifically because they understand our mission and share our beliefs. this is important because it creates a sense of belonging, which is among the top things contributors crave.

https://twitter.com/Flynnjamm/status/1499773066448146440

clear values are the second component of building a strong dao culture. more emergent daos tend to develop around icons, “mimetic filters,” lore, or specific events, which serve as a natural filter to draw in value-aligned contributors. they must then work together to collectively define their mission and values (see Yearn Blue Pill). the best values make clear which behaviors will be rewarded and which actions should be prioritized over others within the dao (see example).

mission statements and values can be suggested by a core team (see CCS, Mirror 1, 2, and 3, and ENS) or collectively created by contributors (see OADAO). regardless of the process for defining them, establishing a clear mission and values provides emergent daos with just enough guidance about how to make decisions without being overly prescriptive.

Complexity

• what it means: a complex system emerges organically as a result of the behaviors of the components within it, rather than according to a predetermined plan (Bristol)

• what it means in the context of daos: most corporations are complicated systems, with any complexity tightly controlled by bureaucracy. daos are complex systems, meaning it’s hard to determine the impact actions in advance (more here)

• design principle: communities should co-create seasonal charters to guide efforts in a way that accounts for uncertainty while preventing chaos

since well designed daos empower contributors to make decisions that can meaningfully change the trajectory of the organization, outcomes are hard to anticipate. that doesn’t mean that daos have to be chaotic. just because we don’t know the exact destination, doesn’t mean we can’t steer at all.

strategy can exist in daos, the difference relative to corporate strategy is that dao strategy is co-created by contributors rather than set from the top-down. the simplest way to do this is via collectively authored charters (see here) that serve as a mutable guide outlining high-level goals, suggested processes, and guiding principles to inform decision making over a season. these charters maximize contributor scope within a “container,” providing a collectively agreed upon roadmap that defines what needs to be accomplished while allowing contributors to determine how they arrive at the intended destination. allowing for re-evaluation and updates to charters at regular intervals is important since much of how a dao operates is discovered through day-to-day experience (twoirrtter.eth)

while dao visions are collectively discovered over time, dao strategy should be collectively set at regular intervals

while contributors want the ability to shape strategy, i’ve found that they also don’t want to be handed a completely blank slate. at RabbitHole, we found the optimal balance in providing an initial charter outlining ~70% of what a working group will drive towards and empowering the community to provide feedback and fill in the rest.

Agency

autonomy is present at the organizational/dao level while agency is present at the individual contributor level

• what it means: the ability to take action or to choose what action to take (Cambridge)

• what it means in the context of daos: in traditional corporations, top level management holds most of the agency. in daos, all network participants maximize agency

• design principle: daos need to be designed with the understanding that individual contributors will optimize for agency via voice and exit

1.) Voice (change the system from within)

governance gives contributors the option to have a voice in decision making. while most governance conversations focus on how to increase voter participation, having the option to vote is actually more important than constantly voting. if contributors have the option to effectuate change, but don’t choose it, they have nobody to blame. if they do exercise the option, they feel empowered by the agency to influence their own destiny. since the option is more important than the action, the expectation should not be that every tokenholder votes on every vote. most everyday users don’t want to participate in democracy for the products they use each day. even if they wanted to, it’s a full time job to keep up with all proposals and so quorum is usually only met on the most controversial proposals. once we accept that option to vote is more important than the action of voting, we can stop applying a one-size-fits-all decision making model to governance. this will allow us to make more effective decisions, which is one of the two primary purposes of daos (along with collective ownership.)

https://twitter.com/chaserchapman/status/1488584926903607300

what effective decision making comes down to is empowering high context people to make localized decisions while granting everyone else the option to protest when/if needed. if we design for agency, we can start experimenting more with consent-based governance (see Mirror 0004), optimistic governance (see Aragon and Tribe), and lazy consensus (see Colony) and we can start to think about differing voting rights based on identity, reputation, and contribution (See Element).

2.) Exit (leave to create start a new system or join a competitor)

part of the beauty of daos is the fluidity of participation and the ability to work, on a part-time basis, for multiple daos at once. it also means that exit is an easier option for contributors than it is at a traditional corporation. core teams should be prepared to fill in any gaps created by a primarily part-time contributor base that may frequently choose exit. maintaining continuity of work when turnover is high increases the need for thorough and transparent process documentation and clearly outlined strategies. you probably don’t want to evaluate your dao on retention. instead, focus on ratifying co-created policies and processes that allow any contributor to plug into well defined, yet flexible, and well documented workflows, reducing dependency on any one contributor without adding top-down bureaucracy.

Transparency

• what it means: the quality of being done in an open way without secrets (Cambridge)

• what it means in the context of daos: daos redefine the meaning of “radical transparency” in a way that would severely rattle private corporations

• design principle: design for nearly complete transparency and higher levels of accountability relative to traditional organizations

while public corporations make some data transparent, they do so in a highly edited format, released at infrequent intervals. in contrast, all the raw data pertaining to on-chain actions of a dao is publicly viewable, in its entirety, in real time. contributors expect a similar level of transparency for all off-chain data and decision making. providing this level of transparency into off-chain actions is where many daos fall short and run into conflict.

the purpose of transparency in corporations and daos is also different. the purpose of corporate transparency is to inform shareholders about decisions that have already been made. the purpose of dao transparency is to enable contributors to make decisions. this makes transparency all the more important in daos as information asymmetry actually prevents contributors from fulfilling their role (chase chapman). however, this level of transparency also means that dao operators will be held accountable 24/7. contributors will expect rapid responses and open communication at all times. at the same time, anonymity among the contributor base provides less transparency and lowers accountability. since the best collective decisions are the product of disagreement and contest, not consensus or compromise, it will get rough in the Discord. dao operators need mental health benefits and support. burnout is extremely common among community managers, but it’s also preventable. while complete transparency seems like the simplest property to design for, it has the most underestimated impact on dao operators.

it’s completely mindblowing what a group of internet strangers can do when empowered by collective ownership and decision making. we can accomplish even more if we start designing daos in a way that embraces their unique properties: Autonomy, Emergence, Complexity, Agency, and Transparency. If these properties will be disruptive to what you’re trying to achieve, a dao might not be the best structure to accomplish your goal.

https://twitter.com/lalalavendr/status/1499760045692796929

*this doesn’t mean that daos can’t build products, they can and have, it just means that daos may be far more effective at organizing other types of activities, considering their inherent properties

we’re still figuring out what great dao design looks like and we have a long way to go. daos are constantly evolving, so the best approach today may not be the best approach tomorrow. i still believe these design principles are useful, even if we disagree about them, because they start a conversation that hopefully moves us all forward, together, and isn’t that the whole point anyway?

If you liked my thoughts on daos, check out my earlier thoughts on DeFi, DeFi 2.0, and Web3 Social

Thanks to pet3rpan for discussions on this topic and for feedback from: Diana Chen, Chase Chapman, Meg Lister, Ben Schecter, and Vishal Kankani

*originally published on May 5th, 2021

While still experimental, DeFi has matured enormously since I first wrote about it in June 2019. As DeFi protocols roll out v2s and v3s, I took a fresh look at the industry and how it is evolving. After many years in finance, I’ve realized most of what moves markets comes down to four financial primitives: liquidity, leverage, risk, and arbitrage. This article outlines the evolution of DeFi through the lens of each.

This article outlines financial primitives, or the core building blocks of financial markets, which are distinct from software or cryptographic primitives. This article assumes some knowledge of finance, crypto, and DeFi and is not comprehensive in its coverage of protocols.

Financial Primitive 1: Liquidity

Almost everything comes down to liquidity, but we consistently underestimate its importance. Higher liquidity results in tighter spreads and greater market efficiency. Lower liquidity exaggerates market movements and amplifies sell-offs. It creates a flywheel on the way up but a cliff on the way down.

v1 DeFi was a liquidity vacuum that relied on captive capital. The term captive capital refers to underutilized capital locked in protocols or inefficiently allocated within them. It results in opportunity costs as this capital could otherwise earn higher returns, either inside or outside of the protocol. The first DeFi protocols depended on captive capital: MakerDAO required a minimum 150% collateralization ratio, lending protocols had not yet embraced superfluid collateral (a v2 innovation led by Compound), and Uniswap’s liquidity was inefficiently distributed across a -∞ to ∞ price curve.

The opportunity cost of captive capital scaled along with DeFi and now v2s and v3s are fighting to achieve greater capital efficiency.

Collateral as Liquidity

Stablecoins play an enormous role in DeFi. Fiat-backed stablecoins are problematic (centralization, regulation, potential competition from CBDCs) and cryptocollateralized stablecoins present the most viable alternative. However, v1s relied on overcollateralization to maintain their peg and haven’t been able to scale. Purely algorithmic, uncollateralized stablecoins have never performed as intended and v2 attempts seem subject to the same shortcomings (incentive mechanisms that perform well above the peg, but not below).

Many of the latest iterations of stablecoins (FEI, OHM, FLOAT, FRAX) leverage protocol controlled value (PCV). This is a concept in which the collateral backing a stablecoin is not redeemable by users but rather is owned by the protocol (which decides whether/how to invest it, can use it to restore the peg, etc.) This is similar to a treasury or insurance fund, but is distinct in that PCV can be immediately converted into liquidity (an AMM pool). Launch issues aside, FEI’s PCV enabled it to become the largest liquidity provider (LP) on Uniswap. Aave v2 similarly blurs the line between collateral and liquidity by allowing borrowers to pay off their debt with existing collateral. Proof of Liquidity creates a similar dynamic for staking derivatives, which are covered in more detail below.

DeFi v1 figured out how to use liquidity as collateral (LP tokens). v2 and v3 protocols are figuring out how to convert collateral into liquidity.

Unfortunately, liquidity alone does not result in stability. The real reason stablecoins collapse is a crisis of confidence below the peg. Addressing captive capital is not sufficient. Sound economic mechanisms are required to keep the stablecoin near its peg over time, and mechanism design is hard. Purely algorithmic stablecoins (Basis Cash, Empty Set Dollar) have struggled with mechanisms that require confidence in the future peg exactly when the present peg is failing. So-called Direct Incentives, which penalize trades away from the peg and reward trades towards the peg, end up pulling liquidity out of the system at the exact moment it’s most needed.¹⁰ Severe sell penalties mimic constrained liquidity and keep more capital captive, which is the problem we’re trying to solve in the first place. Other models attempt to solve for confidence first and improve capital efficiency over time, beginning with a fully collateralized token and letting the market adjust the collateralization ratio dynamically. As confidence goes up, so does capital efficiency. FRAX uses this model, but is currently backed by a basket of fiat-backed stablecoins. While the mechanism appears to be working, it’s unclear how it would hold up were it exclusively collateralized by uncensorable assets.

While the newest generation of stablecoins are focused on lowering collateralization requirements, we need to solve for confidence in the peg (effective mechanism design) before capital efficiency.

Liquidity as a Liability

We can’t talk about liquidity without talking about Uniswap, the dominant AMM. Uniswap played an important role in the rise of yield farming and liquidity mining, which, in turn, played an important role in Uniswap’s trajectory. After we learned (the hard way) that liquidity is not a moat, the focus moved from acquiring it to retaining it. Competing AMMs began moving up the stack to add higher moat/margin services like lending (Kashi Lending), borrowing a page from traditional fintech: acquire users cheaply and upsell credit products. Instead, Uniswap fundamentally rethought the AMM liquidity mechanism, resulting in a v3 that improves capital efficiency by up to 4000x, in special cases.⁷

While v1 AMMs were a 0 to 1 innovation, they were also inefficient since they required liquidity for prices that might never be reached. For example, if ETH were in the $200 range, and there was $10M in an ETH/DAI pool, up to 25% of the liquidity pool might exist for buying ETH below $10 or above $5,000.⁵ In this example, it is highly unlikely that liquidity would be needed at those levels. Maintaining this constant price curve resulted in low turnover (~20%) as $5B in locked capital translates to only $1B in volume.¹ The even spread of liquidity over the entire range also means that very little liquidity is concentrated where a pair does most of its trading. Curve recognized this early on, creating an AMM specifically for stablecoins, which are designed to trade in a tight range.

Uniswap v3 addresses these issues and, in the process, moves closer to a limit order book in that LPs can now specify a price range over which to provide liquidity (ie. ETH/USDC from $1800 to $2200). This change should result in almost all trading occurring in a few buckets around the mid-market price, improving liquidity where it’s most needed. More concentrated liquidity should also reduce inventory risk, which results in both wasted capital and exposure to assets that LPs don’t want to hold. For example, if an LP posts $500 for an ETH/DAI pair but is confident that the ETH price will go up, then they’ve taken on exposure to an asset (DAI) that they don’t want to hold (ETH opportunity cost) and are holding $500 of DAI only to buy ETH as it falls, which they think is unlikely. Uniswap v3’s concentrated liquidity provision reduces this risk by enabling LPs to significantly increase their exposure to preferred assets.¹³ Balancer v2 also attempts to reduce inventory risk by introducing Asset Managers, which allow LPs to lend out one side of a pair when it’s not being used as swap liquidity. Yearn’s Stablecredit utilizes a similar functionality.

The next generation of AMMs require less capital but result in more liquidity.

Liquidity Trade-offs

Superfluid collateral is a v1 concept that refers to the ability to tokenize locked capital (collateral or liquidity) in order to access liquidity or gain leverage on that capital. Staking derivatives extend this concept to staked assets (assets that secure proof-of-stake networks) via stake tokens (stETH, rtokens) that essentially allow staked capital to be deployed more productively elsewhere. Proponents of staking derivatives argue that without them, network token liquidity will suffer as a large portion of outstanding supply will remain captive. There are also concerns that validators won’t be incentivized to stake if/when they can earn higher returns on capital deposited elsewhere (DeFi protocols). In theory, staking derivatives could increase the percentage of ETH staked from 15–30% to 80–100%, since it removes the additional costs of staking compared to not staking.¹⁴

Staking derivatives also allow for the creation of new financial instruments. For example, the cash flows “guaranteed” by proof-of-stake rewards can enable products that look similar to coupon-bearing bonds (Terra’s bAssets, Blockswap). These instruments can be used to generate sustainable, stable, and relatively high yields (as in Anchor Protocol), which may onboard more mainstream users to DeFi.

However, staked assets are unique from collateral in that they are not just a promise to pay, but rather they are a security mechanism. I would like to see more research on the associated security costs, but it’s clear that design matters. Some designs, particularly those that enable staking derivatives to move cross-chain, allow for a transformation of risk (from endogenous to exogenous) that could impact the underlying game theory that helps secure public networks.¹¹ In contrast, Proof of Liquidity converts staked capital into liquidity for the underlying network token in a way that balances capital efficiency and network security, which should be the main priority.

Financial Primitive 2: Leverage

Leverage amplifies gains (it’s the ultimate in capital efficiency) but also dramatically accelerates losses. Creating leverage is easy, controlling it is hard. We love it, until we hate it.

There have been countless TradFi market crashes due to excessive and/or hidden leverage. In the last six months alone, we saw the market impact of Archegos (which was highly levered) and the Gamestop levered short squeeze (140% of Gamestop’s float was sold short). In the crypto markets, we recently saw $10B in liquidations in 24 hours, in part due to cascading liquidations of leveraged long positions. This served as a sort of stress test for the crypto markets, and some DeFi protocols were pretty stressed.

Leverage is easy in DeFi , controlling it is still hard.

Creating Leverage

Much of the frenzied activity during the DeFi Summer of 2020 was driven by active leverage strategies that relied on recursive yield farming and liquidity mining. While this activity has died down since then, we are starting to see new leverage mechanisms emerge. Element’s Yield Token Compounding is one example. When a user deposits collateral via Element, two tokens are minted: a principal token and a yield token. Let’s say a user deposited principal of 10 ETH at 20% APY. The token holder can sell the principal token at a discount. At a fixed rate yield of 10%, they would receive 9 ETH while maintaining exposure to the interest paid on all 10 ETH over time via the yield token. The user could then open a new position with the remaining 9 ETH and repeat, achieving up to 6.5x leverage.³ The ability to earn interest on the full principal amount, while being able to access the loan’s NPV, is unique relative to earlier lending protocols.

While there have been several protocols that aimed to achieve undercollateralized lending in DeFi, it remains mostly conceptual. While CREAM v2 strives to achieve zero-collateral protocol-to-protocol lending via the Iron Bank, it’s only available to whitelisted partners and parameters will be determined directly by the CREAM team, highlighting current limitations. Instead, Alchemix approaches the problem from a completely different angle, allowing borrowers to benefit from overcollateralization. For example, a user that deposits 1000 DAI can access 500 alUSD. The 1000 DAI is put into a Yearn vault to earn yield, which is used to pay down the loan over time. The alternative would be to make an upfront purchase of $500 and then invest the unspent $500, which will obviously earn less yield than $1000 would ($280 less, assuming a 25% APY over 2 years).¹⁵ Again, borrowers benefit from earning interest on the full principal amount while still being able to access a discounted portion of the principal.

New lending protocols utilize the time value of money and the separation of principal and yield to allow users to benefit from (over)collateralization.

Cross-Collateral Complexity

While the early DeFi ecosystem relied mostly on recursive loops denominated in one asset (ETH), v2s expanded the complexity of lending protocols by allowing for multi-collateral systems, in which n assets can be borrowed against m collateral. Single-Collateral Dai evolved into Multi-Collateral Dai, Compound supported cross-collateral money markets, which Aave and CREAM expanded on by supporting more and more assets. Yearn’s StableCredit protocol allows users to mint synthetic debt positions to essentially swap collateral (functionality which Aave v2 supports via flash loans). Some protocols take it a step further and pool exposure to all of these assets, spreading counterparty risk across users. On Synthetix, when the value of any synthetic asset minted on the protocol increases, it raises the value of total debt in the system, while a user’s ownership of the total debt pool remains constant. This can result in outcomes where a user’s debt balance increases due to a price increase of an asset to which they have no direct exposure.² This cross-collateral complexity and cross-asset exposure improves functionality but also increases the likelihood of market contagion, whereby a sell-off in one asset causes a sell-off in others.

Controlling Leverage

Composability enables rapid innovation, but it also means that money legos can quickly become money dominos. Despite on-chain transparency, the difficulty of creating a cohesive view of leverage compounded across protocols means there is currently no easy way to understand how much credit is commodity credit versus circulation credit,⁹ which has implications for the solvency of the system. Solvency is particularly important in a system that, by design, has no lender of last resort. Additionally, while centralized venues liquidate underwater collateral themselves, avoiding counterparty risk, decentralized protocols rely on third-party liquidators to remove underwater debt from their balance sheets. These liquidators can choose to purchase underwater collateral from the protocol at a discount, but they can also choose not to, due to volatility, network congestion, and/or other market factors.¹² Liquity attempts to overcome this issue by creating a pool of funds that can be used for liquidations. In this model, LPs agree in advance that their liquidity will be used to buy collateral at a discount during liquidation periods. While this enables the protocol to lower loan collateralization ratios to 110% and offer a fixed rate of 0% interest, LPs could end up buying collateral as prices are falling, which could come at a much higher cost.

Financial Primitive 3: Risk

There is one ratio that is nearly inescapable in finance: risk/reward. The idea is simple: higher returns require more risk. With one exception (financial primitive 4), it is extremely difficult, if not impossible, to break this ratio.

When markets are new, risk is mostly expressed in binary terms: risk-on or risk-off. As markets evolve, and the composition of risk is better understood, risk transfer mechanisms develop, as does a sliding scale of risk that allows market participants to express individual risk tolerance.

Binary Risk

Volatility products allow market participants to take a binary view on market risk and are a critical piece of market infrastructure. The VIX, an index representing the market’s estimate of future volatility, is a cornerstone of traditional financial markets. CeFi markets already offer some vol products (FTX MOVE), but DeFi markets have few equivalents. Protocols like Volmex are working to create a volatility index while Benchmark Protocol’s stablecoin uses the VIX as an input to its stability mechanism. INDEX Coop seems like a natural candidate for a DeFi native volatility index and Opyn has expressed interest in creating a “DeFi VIX” as well.

Risk on a Sliding Scale

Emerging DeFi protocols are developing “risk-matching engines” to pair market participants that prefer less risk with those that prefer more. Most are approaching this via multi-token systems that separate speculative versus non-speculative aspects of a protocol and redistribute cash flows accordingly (Saffron, BarnBridge, Element). For example, Element splits principal and yield, allowing users to purchase the NPV of the principal (basically a zero-coupon bond) or take up to 10x leveraged exposure to the yield.⁸ BarnBridge splits cash flows into fixed yield and variable yield. Variable yield holders get upside above a fixed rate but subsidize the fixed yield token holders in the case of a shortfall. Similarly, Saffron splits risk into senior and junior tranches. Senior tranches except lower yields in exchange for coverage from junior tranches in the event that things go south. More yield = more risk.

These programmable risk protocols enable peer-to-peer risk transfer and allow users to bet on different parts of the capital structure. Risk-averse capital (like corporate treasuries) may prefer to buy the senior tranche, while Degens chasing yield may prefer junior tranches. Greater expressivity of risk tolerance is a positive development for DeFi markets and there is nothing inherently dangerous about tranching.

Risk tranches have become toxic in the past, namely when they’ve tried to circumvent the risk/reward ratio. The CDO² will forever be my favorite example of clever financial engineering, packaged to look like a riskless instrument when it was actually full of risk.

Financial Primitive 4: Arbitrage

There is one important exception to the risk/reward ratio and that is arbitrage. Arbitrage creates (theoretically) riskless profit opportunities and it plays a critical role in price discovery, which is one of the things smart contract platforms are best suited for.⁴ The Kimchi premium is a perfect example. Buy an asset for $55,000 in the U.S. and sell the same asset for $65,000 in South Korea. Riskless profit.

Arbitrage is required for many DeFi protocols to function properly and needs to be considered in the design of any protocol. Uniswap is heavily reliant on arbitrageurs to maintain price discovery. Arbitrageurs rebalance portfolios on Balancer. Some argue that MakerDAO’s scale is limited due to the infeasibility of arbitraging CDPs. Miners on Stacks are incentivized to mine on the chain by arbitraging the BTC-STX rate.⁶ Yearn’s StableCredit relies on arbitrage rather than governance to maintain stability in the system. 1inch, Yearn, ParaSwap, and Rari can all be used as vehicles for arbitrage. ThorChain and Serum will be crucial to enabling cross-chain arbitrage as DeFi protocols launch across Layer 1s. As DeFi struggles to scale, avoidance of gas costs will present a temporary arbitrage opportunity, which is increasingly shaping v2/v3 design (Aave v2 collateral swaps, dydx’s gasless order book, Balancer v2s pooled assets, Sushiswap’s BentoBox).

v1s focused on cross-protocol arbitrage, v2s/v3s are focusing on chain-cross arbitrage

Arbitrage increases market efficiency (the degree to which market prices reflect all available, relevant information) but it also results in narrower spreads and normalized yields, eliminating temporary advantages between protocols. As market efficiency increases, so does competition. True protocol innovation, and not just incrementalism, will be required to maintain dominance in this environment.

v2 and v3 DeFi protocols will need to innovate across all four financial primitives, as their interconnected nature is what drives markets. Without arbitrage, stablecoins can’t scale. Without liquidity, there is no ability to arbitrage. Leverage lets you take more risk, and risk transfer can let you take on more leverage. Importantly, DeFi enables entirely new financial primitives, such as flash loans, that have no traditional counterpart. Protocols that solve for all of these primitives, and/or that create novel ones, will lead the way for the next generation of DeFi. I can’t wait to see v4 and v5.

Compare to my earlier thoughts on DeFi: What it Is and Isn’t and get in touch!

Thank you to Alex Pruden, Eddy Lazzarin, Dmitriy Berenzon and Luca Cosentino for feedback.

References

1. Haseeb Qureshi on Uniswap v3

2. Synthetix Staking FAQ’s

3. Element Finance: Unlocking Capital Efficiency: A DeFi User’s Journey Through Element

4. Sam Bankman Fried of FTX on Unchained

5. Hayden Adams of Uniswap on Bankless

6. Muneeb Ali of Stacks on Epicenter Podcast

7. Uniswap v3

8. Will Villanueva of Element on Bankless

9. Caitlin Long on credit in DeFi

10. Sam Kazemian of FRAX on Direct Incentives

11. Terra: Liquid Staking: A Discussion of its Risks and Benefits

12. Gauntlet: Aave Market Risk Assessment

13. Hayden Adams on Uniswap v3

14. Paradigm: On Staking Pools and Staking Derivatives

15. Bankless: How to Take Out a Self Repaying Loan

Early conversations about blockchain-based social networks were mostly focused on what could be accomplished by leveraging a different data structure, centering the conversation on “data ownership,” privacy, and digital identity. The switching argument was values-based and not compelling enough for most to deal with any degree of friction on decentralized networks.

Now, as social networks begin to blend with DeFi, the switching argument is about economic incentives, rather than moral imperatives, and the novel functionality they offer: publicly trade and display cultural symbols; invest with and in your friends; earn your way into exclusive social circles; connect directly with your favorite creators; prove ownership of digital assets. Eventually, activity on these networks will create an open social graph that is used to offer better DeFi rates and/or lower collateralization ratios. These new social networks combine social and financial capital, making them approachable to the mainstream in a way that DeFi wasn’t. Everyone understands social capital.

https://twitter.com/StaniKulechov/status/1427681957291376643

Arguing about whether DeFi is more important than NFTs or whether NFTs, DAOs, or Social Tokens will reign as the dominant social networks of web3 misses the point. Their interconnectedness is what makes web3 so powerful. NFTs create an impetus for people to quickly spin up DAOs, which then serve as NFT market makers. NFTs will act as keys to DAOs, governed according to social token ownership. The metaverse is comprised of the combination of these things, which, in turn, only increase the importance of being able to prove digital ownership. DeFi makes these networks possible and all the activity on these networks will be used to amplify DeFi. Save the tribalism for Punks vs. Apes.

https://twitter.com/ianIDEO/status/1429156970645233670

Web3 is Not a Protest, it’s Closer to a Cultural Movement

To understand what’s happening with web3, we need to quickly revisit the shortcomings of web2 social networks. In short, web2 platforms own your online identity and social graph and hold all the power, the business model is extractive to the user and the incentives create a terrible user experience (low signal engagement, disinformation, high ad load, etc.) Web2 social networks suffered as they scaled, weakly connecting people within an increasingly less exclusive network. Web2 lost any sense of belonging.

Social networks combined with elements of DeFi flip many of the web2 incentives but they’ll still be subject to the worst of human nature (after all social networks are built on human interactions.) They’ll still revolve around status and image, but should be much higher signal as web3 is built around ownership rather than indication. Web3 still requires you to be part of a club/clique to participate, but it clearly specifies the process and cost of joining. Web3’s immutable ledger creates accountability where web2 has none, and on-chain interaction encourages less noise and higher quality engagement. It’s still signaling, but it’s more costly and, therefore, more credible.

We originally thought web3 would be built on trust, but turns out it’s actually built on scarcity. The downside is that scarcity networks create FOMO by design, are exclusive by definition, and encourage impulsive behavior as being late carries the risk of being shut out entirely. The benefit is that scarcity will also allow web3 social networks to more effectively scale. The ability to easily spin up DAOs in web3 means that the number of communities can scale rather than the size of the network. Since these communities reward early adopters, gradually converting social capital into financial capital, they offer compounding benefits as they grow.³ An open social graph describing all of this activity would be more powerful than anything that could be built on web2.

https://twitter.com/TrustlessState/status/1429890905163517958

Web3 social networks should also be better at continuously reinventing themselves,² since they determine their own outcomes, in contrast to web2 platforms which lost relevance with many of their users years ago. Web3 participants are (literally) invested in the communities they join, which should help maintain quality over time. The best creators and contributors will migrate to web3, rather than stay on on rent-seeking web2 platforms. Web2 platforms and corporate brands will continue to try, but they cannot reverse engineer these dynamics. This revolution has to occur at the protocol layer.

https://twitter.com/ianIDEO/status/1403753637633875968

We originally thought web3 would be a protest against web2 monopolies but it looks more like a cultural movement. While culture may be the hook that draws new people into the ecosystem, most of the activity currently occurring on these networks is only partially about culture, at best.

If the mantra of web2 was “come for the tool, stay for the network,” the mantra of web3 is probably closer to “come for the culture, stay for the returns.” And the returns are why most people are involved right now.

Each social component of web3 represents a slightly different value system, but they’re all built on the same principle: scarcity.

NFTs: The Content Layer - Not Just a Status Symbol

Web2 analog: NFTs combine elements of Instagram (influence and image) and LinkedIn (status and prestige.) Depending who you ask, owning a Punk is either like owning a Ferrari or having gone to Harvard.

Most people attribute the recent NFT mania to two things 1.) NFTs as a store of value 2.) NFTs as a status symbol. I think it’s true that the market is at least partially driven by people looking for non-$ denominated stores of value in an inflationary environment. Afterall, Visa bought a cryptopunk before they bought bitcoin. But NFTs are also about status (sorry if you thought this was about art). Wealthy people have always used expensive items to signal status, whether it be fine art, yachts, private jets, or handbags.¹ NFTs just make ownership of those items verifiable and public.

It’s not really socially acceptable to have a profile picture (PFP) of your Lambo, but you’re encouraged to display your Punk. MTV Cribs existed to solve this exact problem— how do I flex my otherwise hidden wealth? NFTs.

Public display of these status symbols actually drives more demand for them, playing to our natural mimetic desires. A public ledger also creates bragging rights in that we now have proof that someone got in early, spotted that trend before everyone else, is a die hard fan. Immutable proof that you’re cool. How much would you pay for that?

But there is something more going on with NFTs. It’s not just about status anymore than they’re just a store of value. People held Punks long before they were a flex, and if you ask anyone trading NFTs, they’ll tell you that selling them is the worst part. Maybe that’s because when you sell your NFT, you also lose your tribe. An NFT bonds you with your fellow Apes and communicates to everyone that you belong to a certain group. The public ledger also ties you to a lineage of everyone who has ever owned that NFT. This not only adds a whole new dimension of value to digital art, it elevates you into a new social standing and even ensures your legacy in a way (you’re now an unforgettable part of history.)

https://twitter.com/0xSisyphus/status/1429193578664837121

No Real-time Feedback Loop

A huge tenet of web2 platforms is that they support real-time feedback loops (Reddit, Discord, Twitter, Tik Tok, etc.) NFTs do not right now. NFT markets are illiquid and price discovery is still inefficient. In other words, NFTs aren’t good at conveying real-time information yet, meaning status is mostly inferred. We know it’s worth something, but we don’t really know what.

This won’t last for long. Almost every CeFi exchange is building an NFT marketplace and there are many startups working on the “financialization of NFTs.” However, these inefficiencies are part of what enables outsized financial returns. While DeFi maximalists love to hate NFTs, the NFT market feels pretty degen.

Social Tokens: The Social Graph - Exclusivity

Web2 analog: Social Tokens are similar to TikTok, in that they allow anyone to go viral. They also represent the web2 shift away from crowded networks to private messaging groups, discord servers, etc.

NFTs have utility beyond collection. One of the things they can be used for is as keys that unlock access to creators and communities.

Social tokens are digital assets backed by the reputation of a brand, individual or community.3 They can be fungible or non-fungible. Supply can be fixed or determined by a bonding curve (so that price increases along with distribution of the token.) They fall into two categories: personal tokens (fan clubs) and community tokens (social circles.) Both give holders exclusive access to a person or community. Personal tokens can be launched more quickly versus community tokens, which require coordinating a group towards a shared vision. However, community tokens may benefit from broader distribution, which has proven important in web2. As of Dec 2020, the total marketcap of all social tokens was $81M, now the marketcap of $FWB (one of the most prominent community tokens) alone is $180M.

All of these tokens rely on the belief that a creator or community will become more valuable tomorrow than it is today. Some represent Income Sharing Agreements (ISA), but others grant access to a newsletter, a private chat, or even a voting system that lets people dictate a creator’s daily habits ($ALEX). The artist Connie Digital rewarded $HUE holders with a shout-out on a virtual billboard. The rapper Lil Yachty issued surprise boxes and virtual parties exclusively to $YACHTY holders. $WHALE issued a social token, backed by top NFTs, that holders can use as a payment method on OpenSea.7 Grammy-award winning musician RAC and NBA point guard Spencer Dinwiddie have also introduced tokens to give fans a stake in their success.⁶ Community tokens often grant access to an exclusive newsletter, discord server, and token-gated IRL events.

A Different Type of Walled Garden?

Scarcity is a double edged sword for social tokens as it means as membership grows, entry becomes inaccessible to most ($FWB membership is now priced at +$14,000). These communities will need to experiment with tiered models, in which entry level membership is lower cost and higher levels of membership can be earned through more active participation. Most token communities are introducing the concept of seasons and performance-based systems to avoid free-rider problems anyway.

While scarcity improves scalability, if it comes at the expense of accessibility, we’ll just end up with a different type of walled garden.

One way to reduce this tendency could be to build these communities on a combination of both fungible and non-fungible tokens. An NFT could serve as the key to a community (and even different cohorts, tiers, or functions within that community) and then social tokens could be used to determine ownership and influence (via governance stake) within that community.

Social tokens have many potential benefits but they also run the greatest risk of amplifying the more toxic dynamics of web2. These risks will be magnified with social tokens that are purely speculative (don’t grant any access or non-financial rewards to holders.) Creators or influencers should have full autonomy over their tokens, or at least be required to opt-in. After all, social tokens invite the public to openly speculate on a person or group’s worth. I can’t think of a scenario in which being able to short a personal social token wouldn’t be problematic. Social tokens quantify popularity and create an in-group. Membership should be earned rather than bought.

Social DAOs: The Aggregation Layer - Social Circles

Web2 analog: DAOs, literally and figuratively, are a Discord. DAOs also enable Wall Street Bets (partybids) to actually win against Wall Street sharks (whales) and turn web3 into a MMORPG.

Amidst this explosion of NFTs and social tokens, DAOs will play the role of aggregator. Aggregators accrued most of the value in web2 and, in web3, DAOs will aggregate by collecting, curating, and moderating.

Decentralized autonomous organizations are internet-native collectives that share resources, build products, and work together toward common goals.5 DAOs aren’t new (remember The DAO circa 2016?) but they’ve seen a recent resurgence. In 2019, DeepDAO only recorded 10 DAOs. That number is now 133. This increase was driven by a variety of factors including the launch of DeFi protocol governance tokens, some legal frameworks out of Wyoming and Delaware (series LLCs), and the rise of the NFT market, which created an impetus for the quick formation of DAOs to pool capital together in pursuit of an otherwise unobtainable NFT. Maybe DAOs become the social clubs of the metaverse.

Social DAOs are the most explicit mechanism by which to combine both social and financial capital. They create digital social circles and can also empower a collective of individuals to flip power dynamics against wealthy individuals. In NFT bidding wars, they can empower a group of individuals to overtake an individual whale (sometimes causing them to switch sides and join the DAO). They also enable co-creation and collective participation in a way that isn’t really possible on web2.

Yes, DAOs are more about community than scarcity. However, they are still scarcity networks as you either have to be asked to join or buy your way in (usually at an increasingly expensive price).

We Have the Network, but Not the Tools

DAOs are not really DAOs yet, meaning most are not actually decentralized, autonomous, or organized. In theory, DAOs reduce coordination costs. In practice, they might even increase them. Common pain points include: lack of regulatory clarity, keeping up with communications and proposals, treasury management, division of labor, allocating payments to members, (semi)-centralized operations, and community selection and engagement. This last point is becoming more important as DAOs mature and people realize the importance of carefully curating a committed community.

A Social Protocol: The Reputation Layer - Credibility

Web2 analog: Twitter + Facebook, but built on Ethereum. On-chain interactions (NFTs, social tokens, and DAOs) create an open social graph that can be leveraged by social protocols.

All social networks start with identity, create a graph between identities, and then attempt to infer things from that graph (reputation, for example.) In web3, ENS + MetaMask replaces SSO as the de facto log-in, allowing web3 identity to integrate with applications beyond a given identity provider’s ecosystem. Eventually wallets will become more like profiles, with native NFT integration for profile pictures, RabbitHole integration for on-chain resumes, and mirror + NFT marketplaces for on-chain portfolios. Interactions between identities will be combined to create an open social graph. Of course, not all interactions will be on chain, but what settles on-chain will allow developers to:

• Create friend-matching mechanisms based on NFT ownership, DAO membership, social token ownership, and protocol usage

• Better curate communities

• Establish community-based delegated credit based on proven membership in particular DAOs

• Develop a web of trust, the ultimate path towards decentralized reputation and un/undercollateralized lending which ties all of the activity on web3 social networks right back to DeFi again. Social tokens could be used as collateral to bootstrap reputation until we have a full web of trust

https://twitter.com/jbrukh/status/1419773010425401353

It’s Always about Identity

The non-persistence of online identity is probably the biggest obstacle to effectively utilizing this open social graph. As web2 evolved, users moved away from using their real identities. Finsta, anon, and alt accounts became the norm. On web3 people have public .eth addresses complemented by many other private addresses. Identity is important to social protocols, though, because it creates social accountability, which is totally missing in web2 and DeFi. Incentives (different levels of access or better DeFi rates) could be offered for higher levels of attestation, which could include Proof of Humanity, POAP, and Proof of Participation. Incorporating zero-knowledge proofs into these solutions could help balance verification and privacy. Personal social tokens could also be used as a sort of identity proxy, providing an alternative to hardcoding identity on-chain for those that value privacy more highly.

Web3 Will Not Fix Everything

Social exchange theory totally broke down on web2. Key concepts of social exchange theory include reciprocity, fairness and negotiated rules, with information, approval, respect, power, group gain and personal satisfaction among the rewards in successful transactions. Web3 restores critical elements of social exchange.

That said, technology doesn’t eliminate natural human instincts and, therefore, technology alone won’t prevent some of the toxic elements of web2 from creeping into web3.

Web3 will still be about brand and status, cliques and clubs, and one-upping everyone else. Web3 is still addicting — just ask anyone on OpenSea at 4am. Nobody really knows the consequences of day-trading culture and scarcity networks that reward status and profit above all else. People who can’t afford to will lose millions trying to fit in.⁴ This system of in-groups will exacerbate the industry’s lack of diversity.

If web3 really is about culture, then we should ask ourselves how representative the culture we’re talking about is and if these networks are actually open or designed to reinforce preferential attachment models.

https://twitter.com/StaniKulechov/status/1430997412756262914

The biggest opportunity web3 has relative to web2, is that web3 doesn’t have to be zero-sum. It’s multi-player and participants literally have a vested interest in each other and the quality of the communities they build. The value generated by web3 should at least accrue to those creating art, contributing content, and building lasting communities rather than siloed monopolies. Participants will finally have a voice and a vote.

It feels like we are at a web3 inflection point, but we are nowhere near mainstream yet. NFT users are in the lower double digit millions relative to the roughly 4 billion users of web2 social networks. Web2 social networks have generated trillions in marketcap…. imagine what web3 can generate and then consider that it more effectively scales.

Peter Thiel has a theory that the best startups are like cults that believe something true. Web3 certainly feels like a cult and whether it’s about culture, status, or scarcity, people believe that it is true.

Web3. Looks rare 👀

Get in touch!

Thank you to the following for generous feedback: Dylan Hunzeker, Chris Kurdziel, Medha Kothari, and Matt Stephenson

References

1. Status Monkeys

2. Jesse Walden

3. Coophatroopa

4. Proof of Passion

5. Chris Dixon

6. Bankless

7. Individual Before Community: Why Creator Tokens Will Precede Community Tokens