When network effects are absent, what is the competitive moat for Web3 projects?

Original Title: 《Building A Competitive Advantage in Web3》

Author: Eliot Couvat

Compiled by: Deep Tide TechFlow

As we know today, Web3 is reshaping every aspect of business. The data portability in Web3 may represent one of the most significant social shifts in years, transferring power from platforms to users.

This new paradigm creates enormous opportunities for newcomers, making it easier to challenge established companies, but it also brings new challenges for large firms—new moats must be created beyond data lock-in and network effects.

As the community lead at Coinvise, this is a new paradigm I often contemplate. How can Coinvise fully leverage data interoperability? What kind of moat can we build to retain our users in the long term?

These questions will only become increasingly important for thousands of Web3 startups. So I want to share my thoughts here and explore how we are overcoming these challenges.

Without further ado, let’s get started.

1 - The Three Pillars of Competitiveness in the Collaborative Economy

Before we begin, since we will frequently use the term "moat" in this article, what is a "moat"?

A moat is defined as:

"The ability of a business to maintain a competitive advantage, which is expected to help it fend off competition and remain profitable in the future."

Let me tell you, building a moat in Web3 is far more complex than in Web2.

In Web2, the most successful companies in the world have competitive advantages. The most famous competitive advantage is the concept of "network effects," where data is kept behind walled gardens, and the more users enter the platform, the more valuable the platform becomes.

But as Jad Esber and Scott Kominers explain in Why Build in Web3, network effects are no longer effective in Web3:

The ability for users to transfer data from one platform to another introduces a new source of competitive pressure and may require companies to update their business strategies.

Some might argue that with the emergence of Web3, tokens have come along, and this new variable can create network effects by driving new users to reach a utility threshold that exceeds economic utility. However, I still doubt whether it allows newcomers to create a true moat through network effects in the long term.

The network effects of tokens can help overcome the cold start problem, but they do not change the fundamentally interoperable and composable structure of Web3.

Building a moat in Web3 is more challenging than in Web2 because we have never had digital currencies, digital ownership, or internet-native digital organizations before. Everything needs to be rethought, with more (and new) dimensions and possibilities, making it hard to know where to start.

So is there something that can replace the beloved Web2 network effects by leveraging the new capabilities of Web3?

Well, I’m not smart enough to answer this question alone, but fortunately, we have Twitter, and some brilliant minds have taken the time to explore some possibilities.

In a tweet, David Phelps shared his different views on how Web3 companies can build moats:

In Web3, costs are low, technology is open-source, and content is platform-agnostic. These factors kill Web2 moats. So **what are the moats of Web3? I believe there are only three: ** Liquidity; Community; Composability.

For him, there are three main options:

• Liquidity - Having ample liquidity enables faster transactions and more balanced pricing. Liquidity is a flywheel that attracts users, providing more liquidity, which in turn attracts more users.
• Community - Some say, "Technology is not a moat; community is." They are right—technology can be copied, but people cannot.
• Composability - If you create a module that can easily integrate with 1000 products, you will gain attention, validation, and audit verification, attracting more demand.

I have appreciated David's thoughts for some time (he is highly respected in the field), so we will delve into these three principles as a guide to enhancing competitiveness in a space defined by openness and collaboration.

2 - Liquidity as a Pillar of Competitiveness

While theoretically, having a lot of liquidity seems like a great competitive advantage, in practice, history shows that (alone) liquidity is not enough to retain users in the long term.

DeFi exchanges like Uniswap have been incentivizing users to concentrate liquidity in their exchanges by offering high APY (annual percentage yield - i.e., high returns on investment).

However, once better yields are available elsewhere, users leave…

Don’t get me wrong. I completely understand that deep liquidity means price stability and lower risk for users, and DEXs (decentralized exchanges) are very interested in retaining liquidity providers. But unfortunately, the incentives here are not consistent, which is not what liquidity providers are looking for.

As Ian Lee said, liquidity providers are "emotionless, yield-hungry barbarians who put their funds into the highest-return opportunities."

For these reasons, I seriously doubt whether new companies can create moats solely based on liquidity.

Fortunately, David has different strengths, and we have two potential competitive advantages left to explore: community and composability.

3 - Community as a Pillar of Competitiveness

In a recent tweet, Alex Masmej stated, "Liquidity is indifferent; social experience is not."

In five years, almost no trading of the Uniswap protocol comes from the Uniswap UI (aggregators have captured a large volume of trades). NFTs may be different—because the Web3 experience is more subjective, the popularity of top UIs may follow an exponential law. Liquidity is indifferent, but social experience is not.

I must admit, I completely agree with his view. The "social experience," which we can translate as "community," is everything in Web3.

3.1 - You Can Copy Technology

Since Web3 data resides on open ledgers, newcomers can investigate the number of NFTs or social tokens held by competitors to understand their level of involvement, making it much harder to attack new networks.

Due to this principle of composability—meaning data is interoperable and allows any app to communicate and operate—new projects can easily incentivize specific users to switch to them through "vampire attack" strategies. Essentially, by identifying high-value users from competitor projects through accessible data and creating a "somewhat" similar project, they can offer strong enough incentives to "suck" high-value users from your platform.

This is what LooksRare did to Opensea (NFT marketplace) and SushiSwap did to Uniswap (cryptocurrency exchange), and we will see more and more vampire attacks in the future; it is inevitable.

3.2 - But You Cannot Copy People

For these reasons, new Web3 startups must double down on community.

Community and culture are the real changes and the things that can form a moat. Without a strong social experience, your existing user base may leave when more exciting protocols emerge, taking their tokens and patronage with them.

While Web3 facilitates newcomers to replicate established companies, it also provides new power to these companies.

In fact, users enjoy the economic rewards of participating in Web3 networks. They receive substantial returns for the time they invest in helping to build it. As the utility of the platform increases over time, more people will want to participate in its digital economy, and tokens will capture value, rewarding the hard work of early contributors. Web3 is about profit-sharing and income tokenization.

New entrants must leverage these new tools to share ownership and build trust at scale, attracting new members eager to help achieve ambitious goals. In this new Web3 world where community is everything, retaining active members will become one of the most important skills.

4 - Composability as a Pillar of Competitiveness

Finally, composability may be the source of vampire attacks, but it is also the best way to create a moat. In Web3, it is much easier for users to migrate from one platform to another.

In Web2, there are two concepts that allow companies to create network effects.

1. Switching Costs ------ Describes the difficulty or cost for users to switch from one product to another.
2. Multi-homing Costs ------ Describes the ease (or likelihood) of using multiple competing networks simultaneously.

The problem is that in Web3, these costs are almost zero. All-in-one DAO tools like Meta that can attract all users do not really work because we do not live in such an "all or nothing" space. Web3 users can almost freely transfer their data from one platform to another, effectively encouraging the use of multiple platforms.

Web3 is a modular space where users have specific purposes and needs, and they can find tools to execute this and piece them together. Everything in Web3 is interconnected, and reprocessing data from one platform to another is no problem.

Therefore, Web3 startups should not fear composability but embrace it.

The ability for communities to carry tokens is a feature, not a bug. It will force platform builders to design bridges between protocols and platforms to incentivize a circular economy. If users continue to transact with you through their chosen new platform, they are not lost users. If you have already met them there, they won’t be lost no matter where they go.

Conclusion

As this article shows, community and composability are key to creating moats.

But this concept itself implies a limitation on movement. Similarly, a moat is defined as the ability of a business to maintain a competitive advantage, which is expected to help it fend off competition. However, if we are building an industry proud of its interoperability, we should also shift our perspective from gatekeeping to bridge-building.

We should focus on building bridges that allow users to browse Web3 at will while establishing sustainable data flows between platforms to encourage a circular economy. Web3 is an open-source positive-sum game that companies simply cannot compete against.

As Jad Esber and Scott Kominers quoted:

Web3 is based on the premise that there is an alternative to monetizing user-acquired data—building open platforms that share value directly with users will create more value for everyone, including the platforms.

For these reasons, building a Web3 moat will require companies to redefine their structures and business models from the ground up. They will have to focus on building bridges (composability) and take pleasure in doing so, which will create more value.