Decentralized Finance (DeFi) not only has the potential to disrupt the traditional finance industry, the technology represents a new system of aggregating human and financial capital. DeFi protocols remove long-standing intermediaries, giving more people the opportunity to contribute to emerging online communities. In addition, projects encourage persistent progress by rewarding the most active and value-added participants. As a result, the DeFi ecosystem is building a more open and productive digital economy.
Leveraging blockchain technology and smart contracts, DeFi applications provide novel ways of organizing financial markets. For example, the traditional financial industry relies on large institutions to “market make” by providing liquidity for both the buy and sell side of every trade. These institutions are viewed as necessary infrastructure and receive large profits in return for their services. However, DeFi has proven otherwise. Automated market makers (AMMs), such as Uniswap and Sushiswap, allow individuals to trade directly with pools of user funds (“liquidity pools”). Instead of superfluous rent-seeking institutions monopolizing bid/ask spreads, trading fees on AMMs flow directly to their users. AMMs also lower the barrier of entry for new (“long-tail”) cryptoassets to trade on the market, as a broader base of market participants can now provide liquidity for them.
AMMs, as well as peer-to-peer money markets (such as Aave and Compound) and decentralized insurance (Nexus Mutual), are part of a movement away from incumbent power structures that exacerbate inequality and stifle innovation. Like dragons sleeping atop their treasure hoards, traditional financial institutions protect proprietary information and profits at all costs. On the other hand, all DeFi projects are based on open-source code that anyone can build upon. This creates transparency, which reduces the risk of censorship and corruption, while strengthening trust and collaboration.
Through new mechanisms of bootstrapping network effects and managing collective resources, DeFi undermines the power of the siloed institutions of today’s financial system and tears down the walled gardens of traditional industry. In addition, new distributed governance and incentive systems expand the opportunity for individuals to participate in the growth of the industry, completely transforming existing social and economic structures and encouraging the creation and sharing of knowledge like never before.
BOOTSTRAPPING NETWORK EFFECTS
Network effects are one of the most powerful forces today. They create Schelling Points within the digital world, as people are naturally pulled towards the biggest, and thereby most useful, internet communities and applications. Unintentional human coordination, driven by network effects, has created the majority of value on the internet.
By harnessing self-reinforcing user acquisition and utility maximization loops, the biggest tech companies (Facebook, Google, etc.) have become some of the most dominant organizations in history. However, most of the profits and influence from their unprecedented growth have accrued to a small group of insiders, rather than the users who, by participating on their apps, sustain their value. Proprietary algorithms and obfuscated balance sheets restrict the flow of knowledge and capital, while the sheer gravity of network effects squashes potential competition. Combined, these factors limit potential progress and innovation within the digital space.
The DeFi model offers an alternate vision of the future.
Most DeFi apps leverage novel mechanisms, such as liquidity mining and decentralized governance, to attract users, distribute rewards, and create value for their communities. Liquidity mining is the process of offering a native token (or “cryptoasset”) in exchange for engaging with a protocol, and is one of the reasons yields in crypto are so high. This can happen both when a project is launched, or to boost participation within an existing project.
For example, the money market protocol Compound distributes their token, COMP, to both borrowers and lenders on their platform. COMP is a governance token that comes with the right to vote on key protocol changes and has a price determined in the market. This process has no corollary in the real world. It’s as if a bank paid people in tradable equity shares simply for borrowing and lending at their institution. Through liquidity mining, Compound effectively bootstrapped network effects for its platform. COMP rewards caused more people to deposit money on Compound, increasing liquidity and improving rates for borrowers. After implementing the program on June 15, 2020, total value locked (TVL) on Compound, or the current amount staked on the platform, increased ~5x in a week.
Any team in DeFi looking to start a project can do this. Aave, another money market protocol, implemented a token distribution program of their own at the end of April, when their TVL already hovered around $6 billion, only to eclipse $12 billion two weeks later.
The ability to bootstrap network effects using a token distribution program lowers barriers to entry and increases competition by incentivizing people to participate in various communities, rather than sticking with the biggest one. In addition, early success is shared with the community and governance power is more widely distributed as liquidity mining progresses. Users become large stakeholders aligned towards the project’s long-term success.
As more individuals are given a voice, a massive amount of intellectual potential is unlocked.
However, liquidity mining comes with a few considerations. First, the project must deliver value for its users and token holders. By finding product-market fit and ensuring the token accrues a portion of protocol revenue, holders are incentivized to hold, instead of immediately sell the token after earning it. Second, the project must ensure that the token is sufficiently distributed to avoid centralized influences. Finally, the token should be distributed to the most engaged and value-added participants, rather than rent-seeking holders. As Yearn developer Andre Cronje states, “building in DeFi sucks" because passive holders usually share in as much upside as active core developers and community members. Yearn famously gave away its YFI token in what would be one of the first “fair launches” in DeFi. This proved great for building an initial following, but poor at rewarding team members and incentivizing future contributions. New projects should design token distribution mechanisms that ensure value flows to active participants, such as those who participate in governance, engage with the protocol, and strengthen the community.
MANAGING COLLECTIVE RESOURCES
Due to the recent bull market, DeFi projects currently have a lot of money. These treasuries are used to attract team members and contributors to further develop the protocol and grow the network. Ways to do this include the aforementioned liquidity mining, grants programs, and spending managed by a Decentralized Autonomous Organization (DAO).
Unlike traditional companies, whose cash and investment allocation is left to the discretion of executives, boards of directors, and majority shareholders, protocol treasuries are managed by DAOs, which allow for greater accessibility, accountability, and transparency. While the definition of a DAO continues to evolve, DAOs offer a way to coordinate human and financial capital on a blockchain. And because blockchains are open databases, the actions and assets of DAOs can be viewed by anyone. How a DAO spends its money is generally determined by a community of token holders, who vote on allocations and ways to spend the money most productively.
The power of open treasuries, community-based governance, and radical transparency alters the concept of labor and compensation. Every project looks to allocate its resources towards the greatest value-added contributors - those individuals who improve its product, grow the user base, and engage the community. Currently, DAOs make it possible for contributors to build up reputations (assigned by fellow contributors based on past work) and get paid based on their contributions. An example includes Yearn’s, Coordinape, which is an application used to assign compensation and distribute capital in a decentralized environment with no top down management or HR department.
Protocols with large treasuries, including Aave, Compound, and Uniswap, have also started grants programs. These are open forums where participants can submit proposals to build on top of the protocol or expand the ecosystem, and receive funding to support their work. Once again, this does not occur within traditional industries, which are dominated by closed-door decision making and hierarchical power structures. DeFi opens the opportunity for anyone to materially impact billion dollar projects, while projects open their wallets to incentivize individuals to contribute. The impact this will have on DeFi, the crypto industry, as well as our economic framework of capital allocation and innovation, cannot be overstated.
As Larry Sukernik predicts, “unlocking the treasury” will be one of the biggest developments over the next year. I believe that community treasuries already provide another way of accruing value to token holders, as bigger treasuries imply greater future development (consider the UNI market cap, which is ~8x greater than SUSHI despite the latter providing a direct fee-capture mechanism for token holders). While the market already recognizes this, it is just a matter of time before we start seeing real-world impact.
SHARING KNOWLEDGE
In his book, World After Capital, Albert Wenger states, “Producing more knowledge is essential to human progress.” Humans do this through what Wenger calls the “Knowledge Loop,” whereby an individual learns something, creates something, and then shares that knowledge, which becomes the foundation for further learning. Only by encouraging this process will human beings continue to solve problems and overcome our greatest challenges.
The capital allocation mechanisms of DeFi represent a new structure of economic activity, within which a wider array of participants can create and share knowledge. The ability to bootstrap network effects through token distribution increases competition and encourages iteration and disruption. Open and transparent management of collective resources not only gives more people the opportunity to contribute, but also financially incentivizes them to do so.
As more people commit their labor and ideas, DeFi has the potential to aggregate knowledge at a larger scale than ever before.
Within this system of human coordination, greater opportunity leads to greater equality, and more knowledge leads to more progress. Instead of jobs and information insulated within companies and institutions, DeFi encourages free flowing capital, which boosts intellectual freedom. Wenger explains, “We don’t know in advance what information will turn out to be the basis for knowledge, so it makes sense to retain as much information as possible and make access to it as broad as possible.” Only with open channels of information can human progress continue.
However, our digital world of information abundance can quickly become overwhelming, which poses vital questions. How do we allocate attention? How do we determine truth? How do we agree on a hierarchy of values? Without a shared set of beliefs and values, coordination and progress is impossible.
Thus, small online communities, in which it is easier to agree on basic rules and principles, will lead the way forward. Within these communities, human and financial capital will be shared openly, which will allow them to flourish. Near frictionless entrance and exit from these communities will allow participants to find communities that align with their values and ensure fair rules around labor and compensation.
Today, DAOs are forming the foundation of this vision. DAOs offer a new transparent coordination mechanism and lower barriers to participate in the rapidly expanding cryptoeconomy.
Through small online communities, humans will be able to manage the chaos of the digital world and leverage information abundance to accelerate progress.
CONCLUSION
Despite the dominance of zero-sum market philosophy in crypto, the industry, and in particular DeFi, is a positive-sum game. The DeFi economy creates a positive feedback loop where more contribution leads to more innovation, which leads to better products and more users, which leads to bigger rewards and further contribution. And while token price volatility can be noisy, the entire industry encourages the speculation and experimentation that is integral to innovation. Creating a new financial system will never be a smooth journey.
Still, there are many hurdles to overcome, two of which I will highlight here. First, various asymmetries have allowed a few participants, or “whales,” to accumulate a disproportionate amount of tokens and influence. This can be explained as a side effect of innovation, where early entrants are rewarded for taking risk. But crypto is a fundamentally more inclusive and fair industry. Because barriers to participate are lower, individuals face less switching costs to “vote with their feet” and leave applications or communities they don’t agree with. And because the entire DeFi ecosystem runs on open-source code, anyone can develop an application that performs identical functions and incorporates a more equitable token distribution. This increases competition and allows people to choose the community whose governance structure best aligns with their principles.
Second, distributed governance is hard. Solutions today include both on and off-chain voting, but token holders aren’t always the most engaged or motivated participants. As a result, too much decentralization can ossify innovation. For the most part, the solution thus far has been what Jesse Walden called, “Progressive Decentralization,” whereby core development teams incrementally cede power to the community. I support this mechanism for ensuring the fast innovation required in DeFi. However, in the future I believe teams will devise alternative token distribution schemes, which will more greatly reward contribution and punish passivity (through inflation). This challenge is a question of incentives, and the correct incentives will motivate engaged participation.
DeFi is special because it opens opportunity to everyone, which improves capital allocation and expands knowledge sharing. The next step is to focus rewards on the quality of contribution, rather than amount monetary investment. Rewarding human capital over financial capital. This will further even the playing field and ensure profits flow to the most value-added community members.
We have to remember that we live in the physical world, not the digital. The most important thing is fostering human productivity and creativity. By incentivizing participation and strengthening collaboration, DeFi takes us closer to ensuring more sustainable and equitable progress in the future.