During the surge in liquidity brought on by a bull market, TVL was the preferred metric for investors to measure the success of an agreement and its use.
Today, liquidity is drying up and attention has shifted to basic income and profitability metrics.
Fundamentals have always been important. The bull market only obscured them, but did not rule them out.
It is important to remember that the DeFi protocol is the founding enterprise. Even the oldest are only a few years old, and many agreements are only a few months old. It is unrealistic to demand immediate profitability now.
However, the auditability and transparency of blockchain gives us a unique ability to better understand these protocols and assess the path to profitability.
People like to think of DeFi as a single whole, but each type of DeFi protocol runs a different business from each other, and their competitive advantages, revenue quality, and pricing power vary.
In a mature market, such as TradFi or Web2, you would expect projects with higher revenue quality and higher pricing power to deal at richer valuations than those with lower quality and lower revenues.
So, which DeFi protocols have the best business models?
To find out, we delved into the business models of four different types of protocols: decentralized exchanges (spot and perpetual), lending markets (excess and low collateral), asset management agreements, and liquidity pledge agreements.
1. Decentralized exchanges
- Description: Refers to an exchange agreement that operates spot or perpetual futures trading.
- Examples: Uniswap, Curve, Balancer, GMX, dYdX, Perpetual Protocol
- How to make money: Both spot and perpetual futures exchanges derive their income from trading fees. While the distribution varies from exchange to exchange, these fees are distributed between the protocol and the liquidity providers of the DEX, who typically choose to distribute some (or all) of their share to token holders.
? Income quality: moderate
DEX’s revenue quality is moderate.
DEX revenue is difficult to predict because trading volume is related to market activity. While exchanges will have a considerable volume in any period of volatility, whether up or down, trading activity tends to increase in bull markets and decline in bear markets over a longer period of time.
DEX revenues can be high or low, depending on the exchange.
This is because different DEX choose to incentivize liquidity to varying degrees in order to gain market share.
For example, dYdX has given $539.1 million in incentives over the past year, with an operating loss of $226.8 million and a profit margin of -73%.
However, other exchanges like Perpetual Protocol have managed to remain profitable, issuing only $5.9 million in tokens and making a profit of $10.9 million at a profit margin of 64.6%.
Whether frugal or positive growth will pay off in the long run remains to be seen.
? Pricing power: Low/Medium
Spot and derivatives DEXs differ in pricing power.
Spot DEXs are vulnerable to fee compression in the long run because they don’t manage risk, are easy to fork, and have low conversion costs for traders looking for the best swap execution.
While some liquidity and trading volume may be loyal to individual exchanges because of their brand awareness and trust in the user base, spot DEX is still vulnerable to the price wars we see in centralized exchanges. Initial signs of this are already starting to emerge as Uniswap has already added a 1 bps fee level to certain token pairs, primarily stablecoins <> stablecoins.
DEXs that offer leveraged trading, such as perpetuals, are less susceptible to these pricing pressures than spot exchanges. One reason for this is that these exchanges require their DAO and core teams to actively govern and maintain exchanges to manage risk, as these stakeholders are responsible for parameters such as going to new markets and setting margin ratios.
In addition, DEX, which provides synthetic leverage, only needs a safe price feedback to enter new markets, which can easily distinguish it from other competitors by supporting novel assets.
These two factors mean that, as a whole, DEX, to borrow a phrase from TradFi, should be able to keep the fee HFL (higher and lasts longer).
- Description: Refers to an over-collateralized or low-collateralized lending agreement.
- example：Aave, Compound, Euler Finance, Maple Finance, TrueFi
- How to make money: The over-mortgaged lending market generates revenue by taking a cut of the interest paid to lenders. The low-mortgage lending market generates income by charging initiation fees, some of which are also cut of the interest paid to lenders.
? Revenue quality: low
The quality of income on lending platforms is not high.
Interest income in both the over-collateralized and low-mortgage lending markets is unpredictable. This is because it, like transaction fees, depends on market conditions.
The demand for borrowing is positively correlated with price action because the demand for leverage increases when prices rise and the demand for leverage decreases when prices fall.
Startup fees for low-mortgage lenders are also unpredictable, as the demand for low-mortgage lenders is premised on the same factors.
Source: Token Terminal
In addition, the profit margins of lenders are very low compared to other DeFi protocols, as they have to actively release tokens to attract liquidity and gain market share, with an average TTM (tracking twelve-month) profit margin in the loan market – 829%.
? Pricing power: medium/strong
Over-collateralized and low-mortgage lending platforms have varying degrees of pricing power.
The over-mortgage lending market should be able to maintain a degree of pricing power, as these agreements benefit from strong brand awareness and user trust, and the DAO it manages requires a lot of risk management to ensure its proper functioning.
This creates barriers to entry for challengers, and while a large incentive fork has proven to attract billions of TVLs, this liquidity is not sticky in the long run for these reasons.
However, the low-mortgage lending market has stronger pricing power because they focus on compliance and institutional clients (hedge funds, venture capital firms, and market makers) and therefore benefit from higher barriers to entry from competitors. In addition, since they provide these entities with very valuable differentiated services, these agreements should be able to continue to charge initiation fees while remaining unaffected by fee compression for the foreseeable future.
3. Asset Management Agreement
Description: Refers to the protocol for operating the yield generation library, as well as the agreement to create and maintain a structured product.
example：Yearn Finance, Badger DAO, Index Coop, Galleon DAO
How they make money: Asset management agreements generate revenue from AUM-based management fees, performance fees and/or coinage and redemption fees for structured products.
? Income quality: high
The income of asset management companies is of high quality.
This is because revenue from asset management agreements is more predictable than many others, and AUM-based management fees or revenues generated over a predetermined period of time are recurring.
Due to its stability, this form of income is considered the gold standard for traditional investors. However, it should be noted that the predictability of performance and seigniorage/redemption fees is lower because, like trading and interest income, these revenue streams depend heavily on market conditions.
Asset management agreements benefit from very high profit margins.
These protocols usually do not require the issuance of large token rewards, as both the yield vault and the structured product inherently generate their own yield.
For example, two asset management agreements, Yearn and Index Coop, have generated $49.0 million in revenue and $3.8 million in revenue over the past year, respectively, and $0 and $355,000 on token releases, respectively.
? Pricing power: Strong
Asset management agreements have strong pricing power.
Due to the considerable risk being managed, asset management protocols are likely not to be affected by compression. While the strategy that generates the benefits can be replicated, users have shown a tendency to place their funds in asset management agreements with strong commitments to security, even if they offer lower returns and higher fee structures than their competitors.
In addition, given that many individual structured products differ greatly from each other, it may take some time for the industry to converge on a single, standardized fee structure, which helps to further protect the pricing power of asset management agreements.
4. Liquidity pledge
- Description: Refers to an agreement to issue liquid pledge derivatives (LSDs).
- Examples: Lido, Rocket Pool, StakeWise
- How to make money: Liquidity pledge agreements earn revenue by taking commissions from the total pledge rewards earned by validators. The staking reward consists of an issuance fee, a transaction fee, and an MEV.
? Income quality: moderate
The revenue quality of liquidity pledge agreements is moderate.
LSD publishers’ revenues are somewhat predictable because block offerings are tied to the staked participation rate, which changes slowly over time. On the other hand, revenue from trading fees and MEVs is less predictable because it is highly correlated with market conditions and volatility.
LSD issuers also benefit from earning fees entirely on ETH (or other L1 native assets). This means that as these assets (hopefully) appreciate over the long term, their earnings value can increase substantially in dollars.
While liquidity pledge agreements like Lido have had to spend a lot of money to incentivize liquidity so far, as their network effects take shape, they could have strong profit margins in the long run (more on that below).
? Pricing power: Strong
Liquidity pledge agreements have strong pricing power.
These protocols benefit from strong network effects due to the deep liquidity and integration of their LSDs. This network effect increases the cost of switching between users, as large stakers will be less inclined to hold and use LSD providers with poor liquidity and utility.
Liquidity pledge agreements also benefit from high barriers to entry from competitors as these agreements are not easily forked because proper management of these agreements requires complex technology, as well as pledge queues and withdrawal delays due to the illiquidity of the underlying deposit.
These competitive advantages mean that liquidity pledge agreements should be able to maintain their current market position for the foreseeable future.
As we have seen, not all DeFi protocols are created equal.
Each type of protocol has its own unique business model with varying degrees of revenue quality and pricing power.
An interesting takeaway from this assessment is the advantages of asset management business models, which combine high-quality revenue with strong pricing power.
While yield-generating libraries like Yearn’s operations have become quite attractive, protocols that adopt this business model have yet to see the same level of success as exchanges, loan agreements, or LSD issuers, knowing that YFI is the only asset management token ranked in the top 15 by market capitalization.
Posted by:CoinYuppie，Reprinted with attribution to:https://coinyuppie.com/dex-lending-asset-management-and-liquidity-pledge-in-a-bear-market-which-business-model-is-better/
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