What happens when co-operation turns into competition?

The Great Merger Movement: DeFi Edition

Why We Should Expect Consolidation in Decentralized Finance

This post tries to explain why the current experimentation in DeFi should eventually be followed by a wave of consolidating acquisitions from the leading DeFi protocols.

From fragmentation to consolidation

Most new industries start fragmented and consolidate as they mature. They often progress predictably through a clear consolidation life cycle:

1. Opening: a single start-up emerges from a newly deregulated industry.
2. Scale: major players begin to emerge, buying up competitors and forming empires.
3. Focus: companies focus on expanding their core business and continuing to aggressively outgrow the competition.
4. Balance and alliance: large companies form alliances with their peers because growth is now more challenging; firms defend their leading positions.

DeFi is still in the highly fragmented opening phase where a high number of similar protocols tackle same and/or adjacent use cases.

Synthetic asset protocols abound

The easiest approach to categorize DeFi protocols would be to put them all into the same basket, since all financial instruments, in the end, are derivatives on money.

But, taking a more practical approach, this post considers synthetic asset protocols — such as MakerDAO, UMA, Synthetix, Yield, Opyn, etc. — that all seem to work according to a similar formula: require users to deposit collateral in one asset, mint a synthetic asset against that collateral, and have the value of the synthetic asset track a predefined price feed.

Although, these protocols do differ in terms of the parameters that steer the process of synthetic asset creation and redemption.

These differences become clear when we look at, for example, what collateral assets are supported (crypto-native/crypto dollars), how much collateral needs to be deposited at all times to secure the synthetic assets, what price feeds are used (what synthetic assets are supported), and how their prices are determined (on-chain vs. reactive oracle).

Not all fragmentation is bad

There are several good reasons for similar DeFi protocols to co-exist at this stage of the industry’s maturity.

First, it makes sense for protocols to initially focus on one synthetic asset — for example, a stablecoin — before expanding into others. Offering multiple synthetics increases governance complexity. Increasing complexity can be tackled by hiring professional management teams with clear-cut responsibilities, something that MakerDAO is already experimenting with.

Second, an abundance of experimentation is also a result of the economic opportunity lying on the horizon. The DeFi space has plenty of room to grow, which means that there’s no reason for founders to throw in the towel just yet.

Finally, one reason not directly tied to the nascency of the space: it is beneficial for users if there are always at least a few viable alternatives available for a specific use case. Crypto emerged as a counter-reaction to the too-big-to-fail organizations of traditional finance — it’s important for DeFi not to repeat that same mistake in an Internet-native environment.

Protocols can manage multiple synthetic assets

Traditional financial institutions manage multiple different (synthetic) assets at the same time. Since crypto protocols are software-based instantiations of these institutions, there’s no reason why they couldn’t support multiple different synthetic assets as well — as we’ve seen with for example the Synthetix protocol. The key to expanding the scope of supported assets (governance) is to either eliminate or minimize governance altogether or to delegate governance to a professional management team.

Decentralized or community governance does not equal to everyone globally participating in the governance of a crypto protocol. Rather, it means that open-source organizations have eliminated all artificial barriers for participation. Although, it’s logical that the stakeholders with the most skin-in-the-game (core team and major investors) tend to, at least initially, lead the governance efforts.

Protocols grow through network effects

Similar to companies, protocols grow as a result of network effects. The larger a protocol becomes, the more it could make sense for it to expand through acquisitions, instead of developing everything in-house.

When we look at DeFi protocol governance, we can see that it consists of two primary components: collateral and oracle management.

• Collateral management has network effects. It is better for a protocol to have a large, diversified, and liquid pool of collateral — instead of a small, undiversified, and illiquid pool of collateral. Size of the collateral pool increases the issuance capacity, diversification lowers risk, and liquidity improves security and usability.

Side note: MakerDAO and Compound recently introduced support for crypto dollars such as USDT and USDC. This was welcomed with some critique, which we think is partly unfair. Using crypto dollars as collateral does not affect the open-source nature of a project like MakerDAO or Compound in the long-run.

First, the support for those assets is decided through governance, which means that the support can always be withdrawn later.

Second, should the crypto dollars in question be seized, this would only affect the specific synthetic assets backed by them — the protocol itself would not be affected (potential reputational harm aside).

Third, since a majority of Main Street will enter crypto to improve transaction efficiency — not because of a distrust in the US dollar — adopting crypto dollars makes sense. The demand for crypto-native money (BTC & ETH) will most likely be a result of Main Street users experiencing issues or limitations when transacting with crypto dollars.

Finally, if the governing stakeholders think that the pros of adding crypto dollars outweigh the risks, they should be incentivized to add size, diversification, and liquidity to their collateral pools using crypto dollars.

• Oracle management has network effects. The longer a token holder-managed oracle works without fault — in other words, the better it is designed — the more it should attract usage over time.

Since both collateral and oracle management have network effects built into them, it is feasible to expect that a handful of extremely valuable protocols will emerge as a result of the experimentation phase that DeFi is currently undergoing.

Large protocols grow through M&A

Let’s contemplate a scenario where MakerDAO has been successful in growing the adoption of its stablecoin DAI, and the protocol is now looking to grow by introducing DAI-backed synthetic assets (which have been on the MakerDAO roadmap for a few years already).

Let’s also consider that UMA has simultaneously been able to build highly successful and liquid synthetic token contracts for three different synthetic assets: sGold, sS&P500, and sTSLA.

Now, MakerDAO could start from scratch by replicating these contracts, or it could decide to acquire UMA and its contracts and bring them under the governance (oracle) of MKR token holders. MKR token holders would then be entitled to the cash flows from sGold, sS&P500, and sTSLA contracts.

The acquisition price would be determined by calculating the NPV of the discounted cash flows for UMA’s three contracts and adding them together. To boost the offer, MKR token holders would most likely also include some kind of acquisition premium in their offer to UMA token holders.

Let’s assume that MKR token holders would value UMA’s contracts at $300 million (including the acquisition premium) and that UMA’s token holders would vote in favor of the acquisition offer.

The acquisition could occur so that MKR token holders issue new MKR tokens to the value of $300 million and either sell them on the open market and then use the proceeds to pay for the acquisition or issue the tokens directly to UMA token holders.

In both cases, the UMA tokens received in exchange for the acquisition payment would be burned and the governance of UMA’s synthetic asset contracts would move under the governance of MKR token holders.

Conclusion

DeFi is still in its experimentation phase with a proliferation of different protocols tackling similar or adjacent use cases with highly similar protocol designs.

As the best practices for collateral and oracle management become more clear, we should see a handful of protocols emerge as clear “winners”. The winning protocols would then have the incentive to boost their growth through protocol M&A.

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