New DeFi projects are springing up like mushrooms and billions of dollars‘ worth of crypto are being stuck in them. Decentralised Finance offers users open, borderless, censorship-free financial services. Although many of these protocols have their own unique crypto-economic designs, most share a common business model.
According to Ryan Selkis of Messari, the core of this business model is the balance of a protocol. This can be defined as the total amount of assets under management. Understanding this model can provide insight into how these protocols work and how they can defend themselves against competition and capture value.
Protocols steer finance
TheFi protocols are coordination mechanisms that define rules and provide incentives to facilitate financial activities. Most DeFi projects do this by crowdsourcing resources from their communities and using those resources productively. For example, Uniswap collects resources from users and uses them productively to create markets. Users provide their capital to protocols in exchange for value. These value streams can either be intrinsic to the system, such as liquidity gained governance tokens, or extrinsic to the system, such as fees paid in stablecoins and other crypto assets.
How much value a protocol creates for users depends on how effectively a protocol can make money from its balance sheet.
Derived from traditional banks
The generation of income from the balance sheet as a business model is not new. It is how banks have been generating cash flow for millennia. In the simplest model, banks absorb capital in the form of debt (such as deposits) and then generate that capital through financial services such as loans such as mortgages.
BeFi works in a similar way, but without a third party in the middle leading the activity or a country’s legal system enforcing agreements between stakeholders. DeFi protocols are merely rule niches that facilitate activity between parties, with disputes being enforced by means of smart contracts on public blockchains.
Money is not fixed
DeFi protocols raise capital by selling tokens, preserving protocol income and crowdsourcing liquidity. The latter is often described as total value locked, but this is misleading. Nothing is locked when users provide liquidity to protocols. Users essentially lend their capital to an unsecured protocol, knowing that it is allocated according to a codified set of rules, with the ability to withdraw it whenever they wish.
Protocols retain the privilege to manage users‘ capital only to the extent that they continue to provide compelling reasons to park capital with them. When those reasons disappear, capital can flee in the blink of an eye.
The main reasons why users keep capital in a protocol is because of fees, token rewards and security. Most importantly, users keep their capital in a protocol only as long as they believe in the protocol’s ability to create value with that capital. In the case of a badly written smart contract, or a manipulated oracle, users very quickly take their money from the protocol.
After a summer in which DeFi came into the spotlight, it is no longer a secret that DeFi protocols create real economic value. These protocols now store billions of dollars in assets and facilitate billions of dollars in financial activities every day. They give users decentralised access to open, borderless, censorship-free financial services. DeFi protocols create rules and incentives to build balance sheets and provide financial services in a way that creates value for all stakeholders in the protocol. And there is no bank involved.