Can open source protocols have moats?

January 20, 2023 Stan

Wow, lots of green in the charts – I forgot what it’s like to have Crypto give me dopamine hits 😂.

This week we’ll be talking about:

Are there Moats in Crypto? A framework for analyzing competitive advantages.
The Liquid Staking Wars. The market’s getting ready for the upcoming Shanghai upgrade.
Around the Web. Curve overtook Uniswap TVL, El Salvador passed Digital Assets law, and more.

Let’s Dive in!

📉 THE MARKETS

“A strong ability to defend established markets against new competitors is essential for a sound investment.” Phil Fisher

How Can Protocols Defend Itself?

“The most important thing in evaluating businesses is figuring out how big the moat is around the business” – Warren Buffet

Back in the day, Castles were targets. And one way the Castles learned to defend themselves was by digging ditches around it, and filling it with water.

(Fun fact: Moats never had alligators in them. There’s no way they’d survive)

Well, it’s harder to invade a castle when it’s surrounded by water, the bridge is up, and arrows are shooting at ya. The moat helped the castle defend itself.

Protocols and dApps operate like businesses. And anytime a company is successful, there’s going to be competition. It has to defend itself from all the copycats to survive in the long term.

So one framework that helps me evaluate protocols is to think about moats – this is even more important in crypto where it’s so easy to fork code.

What Are Moats: Moats are competitive advantages of a company (or protocol) have that cannot be easily mimicked by competitors. Hamilton Helmer’s “7 Powers” is an excellent framework for identifying moats. (He refers to them as Powers)

There are only 7 powers in business:

Warren Buffett refuses to invest in companies without a moat.

Understanding the Moat concept can help you identify better Crypto investments.

Here are the 7 Moats that you should look for:

— Edgy – The DeFi Edge 🗡️ (@thedefiedge) January 12, 2023

#1 Scale Economies

In many businesses, per-unit costs decline as the volume increases. So, achieving high-volume is a competitive advantage.

Take McDonald’s. While buying raw materials, they have the scale economies to negotiate for rock-bottom prices. On the other hand, a small burger restaurant can’t compete in the pricing department.

(It has to use another strategy. For example, ShakeShack avoided direct competition by going gourmet)

Crypto Example: Bitcoin mining. As $BTC’s price rose, many big players entered the mining game. They have scale economies. You can’t compete with a small boy operation.

This started to create centralization issues, and it’s part of the reason why Ethereum transitioned to Proof of Stake.

#2 Network Economies

As the number of users increase, some businesses become more valuable: apps like Facebook, Twitter, and Tinder for example.

To just write the code for an app like Tinder, it’ll cost around 50k. But it was sold for $3 billion. Why?

Network economies.

(Imagine a Tinder for Crypto investors. I sure as hell wouldn’t use it – complete sausage fest)

Crypto Example: Ethereum. Some Alt L1s are faster and cheaper than Ethereum. Still, they face an uphill battle against Ethereum due to their network effects.

Large amount of users →
Attracts more developers →
Creates awesome dapps →
Attracts more users →
Flywheel effect

#3 Counter Positioning

This is power reserved for newcomers who creates superior business model. The incumbents can’t adopt it – trying to do so will cannibalize parts of their business.

Kodak invented digital cameras in the 1970s, but they didn’t pivot. They were hesitant to cannibalize its cash-cow businesses in film photography.

Stock photo companies know A.I. photos are the future, but adopting it would kill their existing business model.

Crypto Example: MusicNFTs. They will offer a much better experience for artists and fans. Record companies can capitalize on this potential. But, they won’t. It’ll cut them out of the picture.

#4 Switching Costs

People don’t like change. Change means they’ve to learn new skills.

For example, I use only Apple products. Quite a few of my favorite apps are iOS only. It’ll be difficult for me to shift from Apple to Android. Doing so would mean that I’ll have to learn too many new softwares.

That’s the power of Switching costs.

Crypto Example: MetaMask dominates web3 wallets. It’s a pain in the ass to switch over and set everything up again. People are so used to Metamask at this point.

#5 Branding

People trust good brands. And that is a competitive power.

Does a Rolex tell the time better than a cheap Seiko? No.
Does a Chanel bag hold items better than a Michael Kors? No.

Branding power allows companies to charge a premium price.

Crypto Example: Bored Ape Yacht Club. Anyone can create a 10k PFP collection, but one brand is in a league of its own. Fueled by celebrity endorsements and pop culture, BAYC has gone mainstream. The brand helped them sell $300m+ of virtual land.

#6 Cornered Resources

Preferential access to limited and desired resources is a huge competitive advantage. Empires fought over spices, salt, silk, and gold. The modern world is fighting over oil and semiconductors.

DeFi protocols are fighting for liquidity. The Curve wars exemplify this.

Crypto Example: Curve controls so much liquidity in DeFi. Acquiring veCRV tokens (and Convex) allows you to vote on which Curve pools more rewards. So protocols fight for veCRV tokens because it can increase their token’s liquidity.
You have protocols such as Frax Finance and Redacted Cartel trying to acquire valuable governance tokens. This gives them power.

#7 Process Power

Mastery over a superior process is itself a form of power. This will result in improved product and lower cost.

SpaceX has mastered reusable rockets. A competitor cannot just master it
Toyota’s Toyota Production System eliminates waste and improves efficiency.
TikTok’s algorithm has mastered the art of showing people exactly what they’d be interested in.

In crypto, it’s all about creating processes for lower fees and more efficiency.

Uniswap V3 – its concentrated liquidity model is a process for improving capital efficiency.
Curve Finance – The StableSwap invariant Formula

These are the 7 forms of power identified by Hamilton Helmer. This will be helpful in evaluating long-term investments. However, this will NOT be helpful in short-term shitcoin trade.

The Liquid Staking Wars are Coming

Last week, we shared several narratives we’re looking at in 2023 – one of them was Liquid Staking Derivatives.

And they’ve been pumping the past few days!

Above are charts of $LDO (Lido), $RPL (RocketPool), and $FIS (StaFi)

Even though I touched upon it briefly last week, I want to take a deeper dive into it.

What Are Liquid Staking Derivatives (LSDs)? On 2022 September 15th, Ethereum transitioned from Proof-of-work to Proof-of-stake (PoS).

In PoS, $ETH is staked for running the Ethereum network. You get rewards for staking $ETH. But, there’s a small problem. Once you stake your $ETH. They’re stuck – you cannot transact, trade, or use it as a collateral.

Liquid Staking solves this illiquidity problem.

You can deposit your $ETH with a Liquid Staking provider. They will take your $ETH and stake it. In return for your $ETH, you will get a token that is liquid.

A few examples include:

stETH (Lido)
rETH (Rocketpool)
And frxETH (Frax Finance)

These liquid tokens are redeemable for your original $ETH. These liquid tokens are called Liquid Staking Derivatives (LSD).

Why are they pumping now: Remember The Merge? There was something I left out about it. When they transitioned to PoS, they didn’t enable the withdrawal of staked Ether. They pushed it to a later upgrade.

Details on the Shanghai Update: If everything goes right, it should happen in March 2023. The highlight: it enables withdrawals of staked Ether.

Here’s why that’s a big deal:

It might enable crazy new yield strategies.
Withdrawals will derisk $ETH staking in a big way.
Liquid Staking Derivatives (LSD) can directly swap between LSD and $ETH.
Users can take their staked $ETH from Lido to decentralized alternatives, such as RocketPool. This will address the centralization issues in Ethereum staking.

These centralization issues are actually pretty big.

Ethereum LSD market

Source: DefiLlamma

Currently, Lido controls over 74% of TVL locked in Ethereum Liquid Staking Derivatives. They’re dominated because:

They had the first mover advantage.
Until now, withdrawals weren’t possible. So once $ETH was staked through Lido, there was no way to change it.

Lido is not a fully decentralized staking protocol. It only has around 30 whitelisted validators. This is a problem. Once withdrawals are enabled, people might take their Ether to more decentralized alternatives such as Rocketpool.

Other protocols such as StakeWise look good from a numbers perspective. Much of the competition will be determined by who manages to attract new stakers.

3/ If we analyze the market share/MC ratio (which is better the higher it is), it looks even more impressive, with the two tokens standing just behind the market leader, Lido pic.twitter.com/sGCaJKuWjC

— Karl (@karl_0x) January 2, 2023

We have entered the phase in which this narrative is blowing up. Even though these are good bets in the long-term, there’s a high probability that Shanghai upgrade is going to be a sell-the-news event.

📰 What’s Happening

Industry News:

Amazon Web Services announces partnership with Avalanche. Their aim is to bring blockchain technology to enterprises, institutions and governments.

El Salvador legislative assembly passed the digital assets law. This law grants digital assets legal backing. This will pay the way for Bitcoin bonds.

y00ts NFT collection was granted $3 million by Polygon. y00ts had announced that they’ll leave Solana and join Polygon.

Twitter is developing a “Coins” feature. This will allow users to reward individual tweets with “Coins”. These coins can be purchased with Fiat money.

Huobi was facing intense pressure this week. A spike in withdrawals, layoffs, and rumors led to this FUD. On Jan 6, almost $61 Million was withdrawn from the exchange.

DeFi Bites:

Gitcoin is starting an ‘Alpha’ round to test the decentralized funding protocol. This will run from Jan 17 to Jan 31.

Consensys opened up testnet for its zkEVM. Currently, this invite is limited for people who had signed up for its waitlist.

Yearn Finance releases Permissionless Vault Factory. This will allow anyone to create a vault. Vaults are used to deposit a crypto asset to accrue yield through various investment strategies.

Curve Finance overtook Uniswap in terms of Total Value Locked. However, this doesn’t mean Curve dominance. While Uniswap has 440,000 unique active wallets, Curve only has 13,700.

AI-related tokens are making waves in the market. The cause is the hype surrounding tech such as ChatGPT. I mentioned last week that I think Crypto A.I. projects are bullshit imo – lots of scams trying to capitalize off of A.I..

Crypto Twitter 🧠

1/ On The Digital Rights Charter

The fundamental premise of 6529 is that the same constitutional rights that exist in the physical world should apply in the digital world.

It is a premise that constitutional democracies are good, even when we use computers.

— 6529 (@punk6529) January 7, 2023

There are enough projects in the depths of hell right now with ridiculously low market caps that make it possible to do very well in 2023…

On the flip side, there are numerous unreleased projects with zero-to-one innovation that will also come online.

So, here is my list… pic.twitter.com/2UCJbj9AjH

— blocmates. (@blocmatesdotcom) January 12, 2023

My crypto ideas for 2023 🧵 pic.twitter.com/BKJd0dBjR0

— Aylo (@alpha_pls) January 11, 2023

There are still open questions despite the revelations from Cameron and Barry today.

The letters both require a precise, careful read.

Here are the open questions to get to clarity.

— Ram Ahluwalia, crypto CFA (@ramahluwalia) January 11, 2023

a hierarchy of metrics:
1. net profit (the E in P/E ratio)
2. gross profit (profit before OpEx aka salaries etc)
3. protocol revenue (portion that does or can accrue to tokenholders) net of incentives
4. revenue (protocol revenue + cost of revenue aka LP yield)
5. volume
6. TVL

— Keone (@keoneHD) January 2, 2023