DeFi Protocols: The Next Business Model Frontier

I used to think Facebook and Google had the best set up of any business ever created:

1. Global scale — their product is relevant to everyone, and everyone has access, (theoretically.) It has the potential to be a huge business.
2. Network effects — as more people use their product, it gets better for all users. It has extremely strong economic moat.
3. Zero marginal cost — deploying software to more customers costs next to nothing. Very low capital intensity to scale means no equity dilution.
4. Product costs nothing to produce — content is created by their users, the people of the internet do the work for them. They take a toll from internet traffic volume without having to pay to create it themselves.

Google and Facebook are in a world of their own when compared to other businesses — their “economic physics” are exceptional. Like a race car with low weight, high horsepower, and large tires, it’s destined to be fast, or in this case, extremely valuable.

It makes other businesses, despite also being well known and valuable, seem like last year’s model in comparison:

1. Global scale — Coca-Cola: touches almost every human on earth, but even with bottling plants owned by third parties, there are marginal costs and it took them seven decades to reach global distribution.
2. Network effects — AT&T: the classic form of a network, physical infrastructure. Cost billions of dollars to deploy, and hundreds of millions more to maintain.
3. Zero marginal cost — pick most SaaS companies: no cost to deploy a new instance of the software, but significant cost to develop it, market it, sell it, and keep customers using it because there is no network effect and competition is always cropping up.
4. Product costs nothing to produce — Uber: drivers provide the cars and the manual effort to drive them, but managing that diverse base of drivers and marketing to customers is costly, particularly when the average consumer can only afford to pay so much for a ride.

Ok, so how do DeFi protocols fit into this?

1. Global scale — Yes: for the first time in finance, DeFi protocols make it possible for frictionless transactions between anyone on Earth.
2. Network effects — Yes: as a protocol’s governance token increases in value, network incentives increase.
3. Zero marginal cost — Yes: incentives built into the underlying blockchain network facilitate runtime at no cost to the protocol. Code-based search functions and aggregators find products based on performance and features.
4. Product costs nothing to produce — Yes: in the case of protocols offering financial products, the DeFi ecosystem provides supply and demand for risk capital. Non-fungible assets are provided by their owners or creators.

There is also something entirely unique to DeFi:

1. Zero fixed costs — Anything that a modern tech company would pay for as part of their fixed costs of running the business i.e. “operational overhead”, don’t exist for a protocol. Every dollar of fee revenue is effectively a dollar of earnings.

This is a concept that is only possible for a completely decentralized autonomous organization (DAO). Participants in the organization are incentivized directly with ownership of governance tokens, and those tokens in turn receive some portion of the fees earned by the protocol. Another way of looking at it is that the governance and management of the protocol is created by its users. Decentralized organizations take the Facebook and Google model one step further — not only is the product effectively created by its users but the platform itself is also created by its users (following the protocol’s transition to decentralization). It’s telling that Facebook itself has spent years and hundreds of millions developing, Diem (formerly Libra), its own blockchain technology.

So what is that worth?

Even the best-run traditional businesses have after-tax margins of 30% or less. So, for every dollar that company earns, it produces 30 cents in earnings, Facebook and Google included. Most fast-growing tech companies don’t produce any earnings at all.

On the other hand, nearly every dollar that a DeFi protocol earns is a dollar of earnings.

The protocol doesn’t pay directly for an office, sales and marketing expense, cloud computing and hosting, etc. Often times there is a foundation or other treasury of governance tokens that is used specifically to incentivize a founding team to continue scaling and driving the decentralization of the protocol, but the tokens granted to them are clearly defined in the protocol’s token distribution model. Unlike centralized organizations, there is no way to layer additional expenses onto the fee stream that is owned by the governance token holders.

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