DeFi Value Flows: Understanding DeFi Business Models and Revenues

This article builds upon the technological concepts covered in DeFi Ecosystem: Primitives and Technology Stack by providing an overview of the new value channels created by the technology. By focusing on the value flows within a single EVM chain, the goal is to provide a framework for recognising value flows between:

• Traditional finance and decentralised finance
• EVM compatible chains
• Dapps on the same chain

Through this conceptual overview, it lays the groundwork for deeper dives into how value is created/redistributed at the ecosystem level as various DeFi primitives are mixed-and-matched. Value in the DeFi space is built progressively by stacking different primitives on top of each other. This has to be done with the recognition that a DeFi stack is as fragile as its weakest link and therefore risks have to be managed accordingly.

As with any other market, value flows are coordinated by 3 parties:

• Supply Side: A user who provides a resource in exchange for a fee. Aside from the standard assets for trade (i.e. fiat, tokens, etc.), suppliers can also provide resources such as data or even hardware rental.
• Demand Side: A user who acquires a resource through compensating the seller for their opportunity cost. There are multiple reasons that a buyer absorbs the acquisition fee, from resource utilisation to speculating on the future price of the asset.
• Service Provider (i.e. Protocol): Facilitator of the transaction which charges a portion of the transaction value for the convenience provided to both sellers and buyers. In the case of DeFi, this refers to the individual protocols and their respective smart contracts.

It is important to note that supply and demand side factors not only redistributes value within a chain but also incentivises external in/outflows of ecosystem value. This is particularly noticeable during the earlier days of a chain as new user participation in on-chain activities necessitates value transfer from an external source in order to acquire on-chain assets.

Critically, financial value tends to have monopolistic tendencies due to the market benefits of liquidity. As such, the creation of an active ecosystem for value transfer is contingent upon achieving a baseline level of liquidity to spur further value creation. With this in mind, we can now start to build our ecosystem value stack.

Assets: Value Creation

The most basic form of value creation is via on-chain token demand. In the DeFi context, these will refer to ERC20/721 tokens which specifies a standard interface for token interoperability across decentralised applications. Given the subjectivity of valuations, the focus here is to identify key use cases which make a token more valuable relative to another asset.

While speculation is an important mechanism guiding the market towards a “true” value, it is unhelpful in this context as it does not provide direct insights into the relative desirability of an asset. As such, demand drivers based on speculation are ignored in this article in the interest of readability.

Whether a token results in a net positive valuation for the chain depends on how the tokens are sourced. Value transfer from one on-chain token to the next results in a net neutral valuation at the ecosystem level. In order to grow the ecosystem, tokens must be sourced via external capital. To this end, there are a few classes of tokens whose use cases incentivise a net positive inward value flow:

For a description of each token type, you can refer to The Web3 Stack: Assets. Demand for the token will grow organically based on each individual’s valuation of the above use cases. Having covered why each token has value, we can now progress to how the value is moved.

Liquidity: Value Movements

The diagram above summarises all the major DeFi value flows in a single picture. Given the composability of DeFi, some oversimplifications had to be made but the above should suffice as a starting point. The assets overview in the previous section serves as the base to start building our value stack from the bottom up:

Tokens

The units of account which represent tradable tokenised value. Value accrues to the tokens based on its use case. A token’s market capitalisation serves as a rough gauge of its value. All value captured by tokens contributes a net positive value base protocol which they are hosted on.

Market Leverage

Through collateralising tokens, lending markets are able to provide leverage which increases capital efficiency.

• Lending: Token holders supply their dormant tokens to the lending protocol which provides them with a lending interest as a reward for the opportunity costs. Demand for lending drives a borrow interest which is the lending interest plus the protocol fees.

Liquidity Multiplier

Token interoperability on the open markets enables deep liquidity to form. This recirculation of value between tokens is crucial in driving Dapp growth as its use cases depends on token accessibility.

• DEXes: Tokens holders supply tokens to the DEX protocol which enables yield to be generated through market making. Buyers are charged a trading fee for the convenience which covers the liquidity provision yield and the protocol fees.
• Marketplaces: A trading model which is more suited for non-fungible tokens whereby information discovery is critical. NFTs are supplied to the protocol with an asking price whereupon it is placed in the open market pending a willing buyer. Both suppliers and buyers might be charged a protocol fee for the convenience.
• Derivatives Market: Generates secondary value by creating a market for trading risks. On-chain value can be amplified directly through collateralised derivative contracts or indirectly via a funding rate market. In the first case, the token holder collateralises their tokens to earn part of the risk premium paid by the buyer. On the other hand, both parties pay a risk premium in order to benefit from movements in token prices.
• Insurance: Token holders supply tokens to the insurance protocol which enables them to earn yields for underwriting certain policies. Insurance buyers pay a policy premium which covers the underwriting costs plus the protocol fees. Payout determination can be either through a voting process or event driven code.

On-chain Liquidity

In order to support a decentralised financial market, value is also circulated at the blockchain protocol layer. These markets are essential to ensure the security of the ecosystem as a whole. Value on this base layer can also be tokenised so as to interoperate with Dapps.

• Tx Settlement: Every transaction requires a tx/gas fee in order to incentivise finality on the blockchain. Depending on the consensus mechanism, a validator’s resources are put at risk in order to receive the transaction fees (i.e. mining rigs, coins, etc). Depending on protocol rules, validators might also receive coinbase rewards (i.e. mining rewards). Additionally, the protocol might define a fee burn mechanism which is used to decrease token supply. Changes in coin supply without any external capital results in appreciation/deprecation of the per coin value.
• Staking Infrastructure: Validators may also pay a hosting premium to delegate certain staking responsibilities to staking infrastructure providers. These services can include payment for compute resources or even staking funds on behalf of the validator. Delegation of proof-of-stake coins results in the minting of liquid staking tokens which can be further traded on Dapps.
• Storage: Data still has to be stored on a hard drive somewhere and this memory space can be very expensive depending on the underlying chain design. Storage protocols have created a market whereby data can be encrypted and reliably stored across a network of devices at a lower cost with only a proof being stored on the main chain. Buyers pay a memory rental fee which covers the costs of leasing storage as well as the protocol fees.
• Oracles/Data: Many on-chain applications require a secured and reliable external data feed to compliment on-chain data (i.e. price, off-chain data, etc.). Such data can be purchased for a fee from oracles/data providers. Majority of this data usage fee will be channeled towards incentivising data providers to report accurate and timely data.
• Launchpad: Such protocols enable the bootstrapping of value when launching a Dapp token. Through raising a pool of funds consisting of coins/tokens, the value is transferred to the newly minted Dapp tokens. A portion of the funds raised goes towards incentivising distribution through bookmaking fees. Furthermore, a protocol fee might be deducted in exchange for the bootstrapping services.

Cross-chain Liquidity

Given the replicability of code, all the technology above can be easily deployed on another chain. Consequently, the value captured by each chain will be decided by the market as assets are collectively swapped through cross-chain technologies. With use cases being equal, the user experience at the main chain layer will determine the relative valuations of tokens across various chains.

• Bridges: Token holders are incentivised to supply liquidity to the cross-chain bridge in exchange for a portion of the swap fees. Depending on the bridging method, value can be completely transferred between chains if the token is burned on the origin chain and minted on the destination chain. Alternatively, tokens on the origin chain can be locked and acts as collateral for wrapped tokens on a destination chain. The bridging protocol will usually charge a protocol fee for this service.

Crypto On/Off-Ramps

The final category targets the movement of value from/to the traditional economy. Currently, as crypto has yet to establish itself as a key part of modern life, much of the “value” still resides in traditional finance. Moreover, given that the majority of the world’s population have never owned crypto, these ramps are a critical piece of infrastructure to allow value to be transferred to the crypto space.

• Fiat: The value stored in fiat is usually transferred into the crypto space via the minting of the equivalent value of fiat-backed stablecoins. Consequently, such stablecoins usually require the corresponding fiat value to be held in an account with a traditional bank. While value is not directly transferred into crypto, stablecoins play a key role as a medium-of-exchange.
• Token Collateral: By custodising real world assets (i.e. gold, property, art, etc.), these services enable tokens to be collateralised by the value of the underlying asset. Depending on the type of asset, these tokens can generate additional value by enabling ecosystems to be built on top of the proof of ownership.

Valuing The DeFi Ecosystem on a Chain

The total value of an ecosystem starts with the tokens that have been deployed on the chain. As tokens serve as a value reserve, its “true” value will be largely driven by its use case. The total value locked in tokens can then be leveraged through lending protocols.

This leveraged value then enables liquidity to form which encourages value redistribution towards the best use cases. Deep liquidity also incentivises external inflows of value as there will be opportunities for yield as well as capital appreciation.

Opportunities for value accrual also presents itself in the servicing of these financial markets. In DeFi, many of these services deal with the physical resources required for computing, network, and storage. There is also a significant market for accurate off-chain data.

At the chain level, net flows of value will be determined by the movement of assets between other chains as well as between the traditional finance system. Changes in on-chain token supply will have to be accompanied by a positive inflow of value from external sources to be sustainable at the current scale.

Looking towards the future, if and when crypto becomes more integral to modern life, value accrual will depend less on crypto on/off-ramps. New use cases will drive demand growth which results in more of societal value being allocated to the crypto space. While value is subjective, it will always have a strong tendency to flow towards use cases with the best incentives.

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