Research Summary: A Short Survey on Business Models of Decentralized Finance (DeFi) Protocols

Good questions! I’d recommend you give this a try, don’t invest your savings but can bond an LP position with just a few dollars (equivalent). The following hypothetical is based on my understanding which might not be entirely accurate - hopefully others can illuminate if there’s more to the story.

Say I have equal amounts of Osmo and Atom. I swap those tokens for an LP token which represents the overall portion of the pool that my holdings represent (a very small percentage unless you’re a whale or investing in very small pool). Now I don’t hold equal amounts of Osmo & Atom; I hold a token that entitles me to my share of the entire pool. To make the liquidity available and put it to work (and generate return and rewards), I then bond my LP token. Once bonded, rewards in Osmo are paid out on daily basis - if externally incentivized, additional rewards might be paid out in whatever token is currently subsidizing liquidity. The reward/revenue rate depends on the bonding period. You can bond and agree to unlock periods of 1 day, 7 days or 14 days - the short term pays much less than the long term. So now you’ve invested equal amounts of two tokens into an LP position, and bonded to make liquidity available for token swaps on DEX (decentralized exchange) and to receive daily share of revenue (fees generated by swaps) and rewards (subsidized liquidity).

Why remove liquidity? To get my money back! First need unbond LP position and wait 1, 7 or 14 days. Once unbonded, withdraw the tokens which swaps the LP token for equal amounts of Osmo & Atom (or whatever pair), but that doesn’t mean I get the same number of tokens that I did when deposited. Why? Because the value of both these tokens vary significantly, and the constitution of the LP itself changes as others provide & remove liquidity.

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Hi @Yeoriton56

Fascinating question! I thought about it for a while and reached the conclusion that free flash loans are loss leaders for lending protocols; the product exists to attract users to other (revenue generating) products of the platform.

The higher the risks of a loan, the higher the interest rate. So theoretically, a risk-free loan (like flash loans) should have zero interest rates. Something akin to perfect competition in economics.

How do they generate revenue? They offer multiple products; free flash loans incentivize usage of other platform products (collateralized lending and more).

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@tomideadeoye I suspected the revenue generation would be indirect, and this indeed confirms it.

Thanks for your response, it all makes sense to me now.

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On the price difference between similar DAO tokens

Twins born on the same day do not have equal influence(Tyler and Cameron Winklevoss are a perfect example). How then do we expect DAO tokens launched in the same year and operate the same business model to have the same price?

$MKR and $AAVE are the DAO tokens of Maker and Aave Liquidity Protocols respectively. I decided to pick them as a case study to further this question by @tomideadeoye for three reasons:

  • They are DAO tokens launched in the year 2017
  • Their protocols both have the same business models: lending protocols
  • They are hosted primarily on the Ethereum blockchain.

Notwithstanding these significant similarities, there is a massive price difference between these two tokens. As of the time of writing this, MKR trades at $931.62 per token while AAVE trades at $87.92 per token. That’s about $843 difference!

In this post, I will explain three major factors causing this price difference with inspiration from Yhlas Sovbetov’s research paper. The factors considered are:

  • Supply and Demand
  • Investors and services provided
  • Total value locked

If you are an investor or trader, this will probably help you make a better informed decision on these two tokens.

Supply and demand
One of the primary factors investors consider before investing into a cryptocurrency is its maximum supply. Investors tend to be attracted to fixed asset tokens as they are deflationary on the long term. Bitcoin is a good example of a fixed supply cryptocurrency at 21million coins.

Both MKR and AAVE tokens are fixed asset tokens with maximum supplies of 1,005,577 MKR coins and 16,000,000 AAVE coins

Looking at these figures, the supply of $MKR is much less than that of $AAVE. In economics they say, the less the supply the more the demand thus the higher the price. This justifies $MKR higher price.

Investors and services provided
One of the most important factors in a cryptocurrency project is the community behind it. The people invested in a project can influence others in making their investment decisions.

Maker protocol started offering lending service before Aave protocol. As early as 2018, the Maker protocol was already running its lending service. Aave on the other hand experienced some setbacks which led to its name change and token switch. It was originally known as EthLend and the token was called LEND.

This early advantage gave the maker protocol an edge over the Aave protocol in terms of trust and reputation. More investors got more acquainted with Maker because the more the year of service the more the trust it wielded.

Apart from the MKR tokens, Maker also had DAI as a stable coin. DAI is one of the most popular stable coins today with about a $6bmarket cap. This is another interesting service and edge that Aave lacks.

Total value locked
Total value locked (TVL) measures the amount of funds held in a DeFi protocol. You can argue that this is a secondary factor as it is a function of the investors and investment in a DeFi protocol. The more the investment, the higher the TVL.

According to Defillama, the TVL locked in Maker protocol is $7.74b while that of AAVE is $4.95b. This is a positive point for MKR as it gives investors more confidence to invest in the token.

In the long run, more money invested in MKR leads to higher token price considering that it has a smaller token supply.

Conclusion
There are so many factors that cause price differences in DAO tokens. This post highlights three of such factors causing the price difference between MKR and AAVE tokens. This way it establishes why the MKR token is more priced than the Aave token.

If there are other factors you have in mind, you can directly reply to this post to further this discussion.

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@Ulysses Awesome post.

Also wanted to point out that despite MKR being worth more than AAVE, the market cap (as of 10/25) of AAVE is ~$1,192,372,718 versus ~$938,753,420 for MKR. So even though the total supply of MKR is less than AAVE and it has a larger TVL, the market cap of MKR is about 80% that of AAVE. But… if you add in DAI, (~$6,235,429,038), Maker has a much larger market footprint.

I think you’re absolutely correct:

There are so many factors that cause price differences in DAO tokens.

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@notthatintodefi wonderful insight there. It’s good that you highlighted the nuances for a deeper understanding.

Discussion Summary Content Categories

The following discussion content categories are commonly occurring in healthy forum threads and are worth identifying and highlighting in a Discussion Summary comment.

Points of Disagreement

  • @wmflies disagreed with @zube.paul and Ryan Clements’ point of views. Zube.Paul, in line with Ryan Clements, believes that there are replicated models of the infamous TerraUSD whose failure is imminent. In other words, Zube.paul infers that there could be something inherently wrong with the model.

  • But Wmflies counters that, stating that those biased with the model are only focused on their pocket as the algorithmic stablecoin model is probably a big competitor to their businesses.

  • @notthatintodefi suggests that, based on recent history, TerraUSD wasn’t robust, but Wmflies argues that it was robust until its failure citing the actions of Terra’s key player as part of the weakness.

Unresolved Questions

  • @Twan asked a very important question which was supported by Notthatintodefi. The question is about using borrowed crypto assets for financing business ideas on DeFi. She likened it to Traditional Finance (TradFi) where entrepreneurs borrow funds from financial institutions using their businesses as collateral:

  • “For PLFs, maximizing interest margin is at the core of their profit model. However, in traditional finance, banks lend money to businesses that sell or produce consumable* products and/or services. Do similar businesses like that exist at scale in the DeFi world? If not, how do the users of PLFs justify the interest margin in borrowing? *consumable as, not for investing”

  • @Henry asked two questions about regulation which are yet to be answered:

  1. “Who is responsible for investigating monetary wrongdoing that happens across boundaries, conventions, and DeFi applications?”

  2. "Who might authorize the guidelines, and how might they implement them?

Points of Consensus

  • Twan noted that the three DeFi business models of PLF, DEX, and Yield Aggregators seem synonymous with the Traditional finance (TradFi) primitives of Banks, Stock Brokers, and Mutual Funds respectively.

  • @Tomideadeoye agreed to this. Tomideadeoye added that the significant difference is the technology (blockchain) that one runs on. He, however, noted slight differences in characteristics against TradFi pointing out concepts like automatic liquidations, keepers, and composability that TradFi cannot afford.

  • Both Wmflies and Notthatintodefi agreed that an unbiased post-mortem on TerraUSD is important. The goal being to understand what went wrong so that other blockchain projects can avoid it.

Offered Solutions

  • @Austin_jul simultaneously proposed a problem and a solution. He believed that there are so many DeFi lenders but few borrowers to borrow the fund due to over-collateralization. He proposed Soulbound tokens as means of digital identity for collateral instead crypto-tokens or coins which over-collateralized.

  • Wmflies offered solutions to discussion questions by @Amazingdez. The questions were on the sustainability of DeFi, probable future elimination of gas fees, and using a Dex for swap. Wmflies’ was of the opinion that sustainability of DeFi depends on politics and legal actors’ decisions. He also added that gas fees are a necessary part of running a protocol and might never be removed. Finally, he provided a link on how to conduct a DeFi swap.

  • Based on the business model of the failed TerraUSD, Wmflies proposed an unbiased post-mortem be done to clarify if the failure of the model was from an inherent property or something else that can be checked.

  • Tomideadeoye resolved @Yeoriton’s argument that if flash loans provided by some DeFi protocols do not have Interest Rates, how do the protocols then make a profit? He proposed that flash loans in that case served as a marketing means to attract users to use the protocols’ services.

  • @Ulysses proposed an answer to Tomideadeoye’s question on comparing similar DAO tokens with the same business model but different prices. Ulysses provided a comparison between Maker ($MKR) and Aave ($Aave) tokens.

Identification of Consequences

  • “For yield aggregators, their job is to invest the locked assets from their clients for a higher profit. Given that they can only invest in DeFi products (otherwise it defeats the purpose of DeFi), they must be turning to the other two types of businesses for opportunities.”

  • The above comment by Twan, although not directly stated, suggests possible redundancy in the business models.

  • The importance of conducting an unbiased post-mortem for the TerraUSD business model, as suggested by Wmflies, is to know exactly what went wrong to avoid it. If the post-mortem is not done, other blockchain projects could adopt it blindly causing a repetition of history.

  • As suggested by Austin_jul for use of Soulbound tokens as collateral for borrowing, this might not be enough to serve as collateral. Soulbound tokens cannot be transferred or sold to make a profit. The only thing lenders can hold onto is the individual’s reputation which might be worth little or nothing.

Unexplored Territory in Discussion

  • This summary is a practical and easily relatable one. There are still areas yet to be explored in the discussion:

  • A comparison of the three models to find out which is most effective.

  • A conscientious analysis of a sample protocol practicing each of the business models. This should be accompanied by data on the profits, fees, and claims supporting the implementation of the business model in question.

  • A comparison of two or more protocols running the same business model for a more practical understanding. This can be done independently for the three business models.

  • Thoughts on what can be improved about the present business models to make them better.

  • Suggestion and breakdown of novel DeFi business models that will be more profitable than the explored three.

  • As highlighted by the contributor, “Value Investing: Does adopting a value investment strategy, which pays off often in classical finance, generate similar or higher returns in crypto-assets?”

Key Resources Used

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Wow, a lengthy and well detailed work… Nice one👍

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This is helpful because it can serve as a point of reference for further discussion.

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