Building a DeFi Moat - Part 2: Constructing a Moat

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In Part 1, we explored the question of sustainable defensibility in DeFi and why it is a challenge (and in some cases nearly impossible!).

Now let’s take a look at what teams can do to build and maintain a competitive advantage.

Technological Moats in DeFi

With the exception of attempting to seek state-sponsored protections like Uniswap copyrighting their code before publishing it to the public blockchain, there are only a few things a protocol can rely on to fence out copycats, and they really are only guaranteed to slow them down.

Projects can:

• Keep their frontend code closed-source (at the cost of losing transparency and community input on security standards)
• Continue to innovate so that copycats are always left slightly behind with an inferior product
• Focus on building other moats apart from technology (i.e. liquidity, integrations, trust in brand, sticky or invested users, etc.)
• Find security in complexity (Tokemak is a good example, and has seen few attempts at forks)
• Upgradability - build modularly to allow for replacing individual components as needed

Is Liquidity a Moat?

Liquidity might spring to mind when you think of some of the larger protocols and what defines their ability to maintain market position.

However, as we noted in Part 1, as liquidity becomes a commodity via aggregators and portfolio management frontends, a small increase in efficiency has the potential to dethrone a giant, and token incentive-driven liquidity is often fleeting.

A few cases that come to mind where liquidity may constitute a greater moat:

• Sticky liquidity, for example Curve, where investors have locked up their CRV tokens for 3+ years, and are now incentivized to continue to provide liquidity to the system. Surpassing critical mass, liquidity can be a moat if it’s circular (literally).
• Edge cases of token value capture: Tokemak, Bancor, and THORchain are good examples of the few projects that have managed to ‘pair’ their tokens against others to create an enormous boost in both liquidity and token value

With Tokemak’s ‘liquidity for sale’ approach, we see yet another example of liquidity becoming a commodity, and any protocol with a large enough treasury being able to direct liquidity to itself.

Trust

How do you, as a user, control against the possibility of smart contract exploits? Apart from diversifying, you may ask yourself:

• Has the protocol stood the test of time? Curve is going on two years with billions in deposits, which is a hefty incentive for a black hat!
• Has the protocol invested in audits, and if so, of what calibre? Gnosis Safe has gone through the process of formal verification, and has likely boxed out competition with who must invest significant time and money to achieve the same bar.
• How responsive is the core team to feedback? Maintaining the trust of the community is equally as important.

Integrations

Perhaps one of the widest moats is to be used as a building block. This not only increases revenue through third-party use, but has the potential to lead to entire economies built on your protocol. For example, DeFi primitives like options enable endless constructs, and a protocol like Opyn may not have foreseen the success of Ribbon Finance in generating demand for their primitives with a new, innovative product.

Capitalizing the Treasury

As DAO-to-DAO token swaps become more mainstream, a project’s treasury may be one of its biggest moats. Having sway in the direction of liquidity and funds with which to form D2D partnerships will become an increasingly important resource and may be necessary to maintain relevance. Tokemak provides a great example of leveraging token swaps to capitalize its system.

The launch of any token incentives should expect to result in revenue/treasury growth as well, and should be, in most cases, a bootstrapping mechanism for increased runway. Dydx’s launch is a good example, where volume-based token mining translated into (through protocol fees) a war chest with which Dydx will be able to build for years. The insertion of a liquidity pool into the mix to provide market makers with even more capital with which to create deep liquidity (and thus enable higher volume) was a smart move, and it all comes back to Dydx in the form of fees.

And diversify!

What good is a treasury if it evaporates when you need it most! All treasuries should push to diversify out of their native tokens (and preferably into a range of growth and stable assets).

Ability to Backstop Losses

The ability of a protocol to backstop losses with its treasury, or with protocol insurance, also helps increase trust and widen the moat.

Plan for Leadership Change

As we saw in Part 1, being able to defend the castle from within is of equal importance to a moat. Every company, blockchain protocol, and even community will have times where leadership needs to be questioned and change introduced.

Many governance structures in DeFi have not yet defined processes for replacing core positions, and while it is nice to give the whole community input on what to do, it can make it hard to make quick and efficient decisions.

There is a reason that companies have evolved into having a board of directors, and while some protocols may be able to achieve the critical mass required to attract enough community contributors to form a true flat hierarchy, most will not, especially the new protocols that more typically resemble startups.

Conclusion

In Part 1 we explored the challenges that potentially prevent a DeFi protocol from maintaining a competitive advantage over the long-run, and in Part 2 we visited a few ways to build a defensible position. The broader question of ‘can you build a DeFi moat’ in my mind remains unanswered; I’m not convinced that you can (at least yet). But in the meantime, there are definitely a few ways to build a competitive advantage that will fend off attacks for some time, at least until new innovations require structural upgrades and we have to start digging all over again!