TLDR
- This paper explains the revenue stream of DeFi protocols to help investors and users understand the growth, sustainability, and security of different protocols.
- The authors discuss the business model of three DeFi protocol domains, abstract the general business model and identify key DeFi actors and actions.
- The authors conclude by asking research questions on subjects such as the valuation of similar governance tokens, the regulatory sustainability of DeFi business models, and more.
Core Research Question
What are the common elements in the business models of DeFi platforms, and how do the protocols make a profit?
Citation
Xu, T. and Xu, J., 2022. A Short Survey on Business Models of Decentralized Finance (DeFi) Protocols. [2202.07742] A Short Survey on Business Models of Decentralized Finance (DeFi) Protocols
Background
- DeFi Protocol: Provides open, non-custodial, permissionless, and composable variations of classical financial services in exchange for fees on asset movements such as borrowing, swapping or investing.
- Composable: Participants can arbitrarily create novel and complex financial services by combining functions and services from multiple existing DeFi protocols.
- Non-custodial: Participants are the custodians of their own assets.
- Permissionless: Participants can interact with services without requiring authorization.
- Total Value Locked (TVL): the general value of all crypto assets in a DeFi protocol or DeFi protocols. It covers assets for transactions, lending, and borrowing. TVL shows a protocol’s current usability based on the number of active users.
- Liquidity Pools: Liquidity pools are a mechanism by which users can pool their assets in a DEX’s smart contracts to provide asset liquidity for traders to swap between currencies.
- Investor: Lenders, liquidity providers, or vault users that undertake the protocol’s underlying risks, such as protocol misbehavior, impermanent loss, or rug-pulls, by depositing his assets for passive income.
- User: Borrowers, buyers, traders, or other active actors using the protocol on the go through borrowing or swapping and pays fees for the movement of assets.
- DeFi Financial Service: Lending pools, liquidity pools, vaults, or other protocols that use smart contracts to let investors and users interact indirectly; it locks investor assets, satisfies user requests, and prevents protocol misuse.
Summary
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Since 2021, DeFi TVL has notably surged. Prospective investors are interested in identifying the business models with steady and constant revenue streams before investing in the underlying project.
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The authors group DeFi protocols into three domains: Protocols for Loanable Funds (PLFs), Decentralized Exchanges (DEXs), and Yield Aggregators.
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Protocols for Loanable Funds / Lending Protocol
- Protocols like Maker, Aave, and Compound let users lend and borrow digital assets. Lenders deposit assets in the pool and get interest from fees paid by borrowers. Borrowers also deposit collateral before taking the loans; the loans are over-collateralized to encourage payback.
- Business Model: The PLF’s cash flows depend on the interest rate model, the underlying demand and supply, and the total amount borrowed. The interest rate model can be linear, non-linear, or kinked. The interest is split proportionally among lenders, and the PLF takes a percentage. Some PLFs offer flash loans with fixed or no interest rates to generate more revenues for the protocol.
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DEXs / Liquidity Pools / AMMs
- These services allow users to trade or swap cryptos through smart contracts called automated market makers (AMMs). The AMM pools funds from investors called Liquidity Providers (LP), who in turn get LP tokens representing their share of ownership of the pool.
- Business Model: DEXs generally adopt the maker-taker model where fees paid by buyers are split proportionally between liquidity providers, and a percentage goes to the protocol’s treasury. This percentage is the primary income source for DEXs. The Swap fees may be dynamic and set by the users or fixed.
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Yield Aggregators /Yield Optimization Protocols
- These protocols generate returns measured in annual percentage yields (APY) for investors through strategies that may be too expensive or complex for individual investors. Such strategies include finding the best lending interest rates, borrowing assets, and leveraging another position by exploiting different protocols like Compound and Uniswap.
- Business Model: The strategy’s performance dictates the protocol’s cash flow. The protocol earns commission fees from the strategy’s profit. YearnFinance v2, for example, applies 20% as a performance fee and an additional 2% as a management fee.
Method
- The researchers surveyed, analyzed, and compared the business models of three major DeFi domains. They identified the common actors and services that access the domains.
- This was then abstracted to create a generalized framework for DeFi business models based on shared attributes, services, and actors in the DeFi domains.
Results
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The authors found that the general models employed in DeFi is similar to the concept of “Two-Sided Markets” in classical finance. In “Two-Sided Markets” the investor provides liquidity to the financial service that peer users can use. The protocol and investors then receive income from fees paid by protocol users.
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Finally, the authors provide a table grouping actors and services in DeFi and showing the differences in naming conventions.
DeFi Protocol Smart Contract Investor User Financial Service PLFs Lending Pool Lender Borrower Loan DEXs Liquidity Pool Liquidity Provider Buyer/Trader Exchange Yield Aggregators Vault Vault User - Asset Management
Discussion and Key Takeaways
- The authors provide a general abstract of DeFi business models; this could in later research be used to develop a formal approach to valuing tokens.
- The authors also mention some strategies for generating increased revenue utilized by different protocols. It will be great to see formal research on how specific strategies like facilitating flash loans affect the entire DeFi ecosystem.
- DeFi TVL since the release of the paper has risen and fallen. Investors and builders will highly benefit from research comparing the performance of protocols by the business model adopted.
Implications and Follow-ups
- Value Investing: Does adopting a value investment strategy, which pays off often in classical finance, generate similar or higher returns in crypto-assets?
- Voting Power: Why are similar DAO tokens having the same business models and providing the same services priced differently?
- Regulatory Issues: What DeFi business models are sustainable and economically secure given the different regulatory regimes worldwide?
Applicability
- The study creates a generalized framework of business models adopted by DeFi protocols. This generalized framework encourages further research on the sustainability of different DeFi platforms in divergent economic, technical, and regulatory contexts.
- This research breaks down DeFi’s service business model and helps investors and users understand which protocols have sound fundamentals and reliable cash flows.