NFTs > ERCs
DeFi is doing it wrong.
tl;dr: Protocols should move away from value capture from utility and lean into their only advantage: branding and marketing.Β Every protocol should be launching an NFT. Not doing so is an existential risk to the platform.
Setting the stage
It is a fact that defi protocols are in many ways the first 10x improvement in the crypto ecosystem to gain mainstream adoption. But, where defi lost the plot is when they introduced non-essential tokens and afforded those tokens some promised or realized measure of governance or value accrual.
These tokens are worthless. Not just today, but tomorrow and forever forward, and in this article Iβd like to propose another, potentially non-obvious way out of this hole.Β
The average defi protocol is down 75% against eth over the last year
Letβs agree on the problem
The archetype we will explore to understand the flaws in the current protocol revenue-capture model is Uniswap and the Uni token. Uniswap is the most widely used and user-friendly decentralized spot exchange today. In 2020 they airdropped 400 $UNI tokens to any address that had ever made even a single transaction on the platform. These tokens provide users with the ability to propose and vote on governance proposals that direct funds from the Uniswap DAOβs treasury to public goods. You can read more about it at gov.uniswap.org
But the current market capitalization of the Uni token is ~$4B and the value of all the liquid assets in Uni treasury is only ~$2B. So for the Uni token to command a premium to the value of all assets in the Uni treasury, there must be some other promise that token holders expect to be realized in the future.
The tantalizing narrative that drove early price appreciation is that, as the platform becomes more popular and the volume increases dramatically, at some point in time in the future, you too, Mrs. $UNI Tokenholder, will have some claim on the revenues that the protocol generates. Everyone sees how Binance, FTX, and Coinbase generate billions of dollars extracting exorbitant fees off every trade, and the narrative-driving question is βwhat if we returned those fees to βthe Peopleβ?β
There are a few fundamental flaws in the logic that Uni tokenholders will ever be able to capture value from the protocol in the way that centralized exchanges do. The first being that the real service you are paying for when you use Coinbase, or Binance, or FTX has almost nothing to do with aggregating liquidity.Β
What you are paying for is infrastructure:
Crypto infrastructure - Custody for a plethora of assets across (n) L1 protocols and bridging deposits/withdrawals between those protocols (Binance is the best here)
Technological Infrastructure - Trading at volume or at higher frequencies is still advantaged on central orderbooks or through proprietary dealing (FTX is the best here)
Regulatory/Compliance Infrastructure - Handle fiat currency conversion and custody, especially for retail customers (Coinbase is the best here)
Liquidity aggregation on these platforms is just a by-product of being best-in-class at one or more of the above bullets. No decentralized exchange at this stage can compete with any CEX on any of the points above.Β
Instead, the primary value proposition of Uniswap or any defi protocol with a front-end is improved user experience. I can read about a new erc-20 token on Twitter and then buy that same token on Uniswap in about 3 clicks and 180 seconds. Compare that to the endless amounts of user data I must supply, frequent downtime/9-5 EST execution window, and the capricious corporate malevolence I experience when I try and do the same on Robinhood.
The problem here is that when your moat is predicated entirely on UX and design, your product isnβt defensible. There is no monopoly. All of the smart contracts and most of the meaningful technological infrastructure is open-source (which is why Uniswap changed their licensing).
Facebook owns identity, Google owns the data, Amazon owns logistics. Uniswap owns a front-end that can be copy-pasted into Figma and cloned ad infinitum.
What does this mean for $UNI tokenholders? Well it means that if tokenholders were to ever vote to return some % of fees generated by the protocol to tokenholders (probably through some sort of burn mechanism a la $MKR) they would compromise on the core value proposition of the platform. It would necessarily impact the user experience in a negative way.
A third-party (the tokenholder) is unnecessarily introduced into the transaction between the users and the liquidity providers, purely for the purpose of extracting rent from the system and to indirect and intangible benefit to the two parties engaging in the transaction. Good luck getting that through.
Liquidity providers don't want to share their fee revenue, and users donβt want to pay more in fees.
Facebook, Instagram, Google can all compromise on user experience because they have some monopoly that allows them to retain users while still providing an absolutely worse user experience when they serve ads to generate revenue. They are protected from competition because their moat has little to do with user experience.Β
If Uniswap were to ever attempt to share fee revenue with tokenholders, the immediate impact would be a migration of a meaningful % of liquidity and demand to a platform, probably created overnight, that was an identical product experience, except without the fee sharing mechanism.Β
Iβve talked about Uniswap in this scenario just to paint an example, but this is the reality that 99% of all defi protocol tokens face. There is no moat around utility to monetize when the cost of replicating that utility is $0.
An Alternative Path Forward.Β
What if instead these DeFi protocols thought of themselves as brands and fought on the only ground that matters:
Memetic Mindshare
You need people to want to continue to use your products and services especially when you canβt bank on an infrastructural moat. How do Gucci, LVMH, and other designer brands protect their business when consumer good manufacturing is inherently a fungible service in the age of globalization? The answer is branding. Crypto is more similar to designer fashion than any other form of digital or analog enterprise. The only moats in crypto are branding and physical infrastructure.Β
A good example of a project that is already taking this approach (albeit not seriously enough) is what DYDX is doing with Hedgies.Β
The virtues of NFTs over ERCs
Superior Visual BrandingΒ
Tokens are terrible marketing. They have no visual identity, thereβs no way for me to easily show other users on twitter, discord, instagram, whatever that I own X token, that I align with the values of its creators, that I contribute to the project in a material way, because no one can see tokens.
NFTs solve this problem, and allow for more emotional investment in abstract projects and ideas. NFTs can make complex, intangible financial protocols concrete and approachable.
Tokens are garbage.
Better Governance
First, its immediately apparent that NFTs are better for a decentralized governance model when we consider that thereβs a visual identity assigned to the voter which is more digestable than a 0x1234β¦ address.
More importantly, the distribution of voting power is also much more even.
The largest BAYC whale has 117 bored apes, which (if BAYC assigned 1 vote to 1 each NFT) would mean that the whale has 58.5 times the voting power of the median BAYC owner (assuming the median BAYC owner holds 2 bored apes).
The largest $UNI Whale owns some $4.5M tokens (ballpark), and assuming the median $UNI holder controls approximately 400 $UNI tokens (the amount of the initial airdropped)β¦ the largest UNI whale has approximately 11,250x the voting power of the median $UNI holder.
Tokens are garbage.
Lock-in
Imagine bridging your favorite cryptopunk or bored ape over to a Layer-2 or other Layer 1 chain. If that doesnβt give you chills, then I think you havenβt been paying attention to any of the most recent hacks, or havenβt pondered the philosophical implications of teleportation and how that paradox applies to bridging unique assets between chains.
Fungible tokens make on-chain provenance irrelevant. This is great when I want to find the cheapest fastest execution venue for a trade and am just looking for exposure, but it is deleterious to brand value. The opposite is true of NFTs. Chain provenance is everything, protocol selection is everything. When I want to buy Ethereum NFTs I use Opensea. When I want to buy Solana NFTs I use Magic Eden. When I want exposure to an erc-20 token, I first go to my favorite centralized exchange, then I turn to the cheapest decentralized exchange (regardless of what chain its on), and, if that fails, I will look at the cheapest venue on Ethereum.
You can see this dynamic play out to the extreme when observing the balkanization of DeFi compared to the NFT ecosystem. Why is it that every new L1 has an entirely independent DeFi ecosystem with different brands, different DEXes, lending protocols, etc., but the same does not hold true for NFTs. Opensea has a monopoly on NFT volume, and that is only increasing as a % of market share. Magic Eden on Solana has a similar monopoly on Solana NFTs.
Whatβs the solution?
Iβll end on this note: DeFi protocols are playing the wrong game. They are trying to create value for investors in a way that can be priced an understood through traditional financial modeling: free cash flows, dividends, revenue sharing, etc. However those models only make sense in a context where the business behind it has some monopoly that can protect those metrics from competition. DeFi protocols have no such luxury.
The only competitive advantage for digital businesses in the Internet Age is mindshare, and they have absolutely failed to catalyze community investment and involvement around their products. The omens are already there, ignore at your own peril. Launch an NFT, build a community, play the right game, or otherwise fade into irrelevancy.