Clarifying the Core of the Crypto Ecosystem - The Current and Future of Dapps

Original Title: Fundamental Value in Crypto Part III: dApp Ecosystems

Author: Grayscale

Compiled by: Dalin Think Tank

The application layer of crypto is a breeding ground for innovation, where cutting-edge financial concepts, complex coordination mechanisms, and evolving business models come to life. Decentralized applications (Dapps) fundamentally change the way we transact (whether lending or voting). In the final part of our three-part Tokenomics series, we hope readers will gain a clear understanding of the Dapp ecosystem and how to achieve greater success in the backend operations of the Full Dapp model. As we delve deeper into the crypto ecosystem and protocols, Decentralized applications (Dapps) represent the intersection of the dream of everyday decentralized alternatives with reality. From trading platforms and lending to interconnected gaming economies in the metaverse, protocols built on smart contract platforms are at the forefront of the decentralized revolution.

What are Dapps, and how do they differ from traditional applications?

Traditional web applications, such as Facebook and Twitter, run on servers owned and operated by centralized organizations, managed by a single entity. This gives controlling entities certain freedoms to manage the applications of this network. In contrast, Dapps operate on decentralized, transparent computer networks, free from the control of any specific institution. The emphasis on decentralization and transparency benefits the design of certain applications, particularly those that thrive on the absence of intermediaries.

As a result, many of the more successful Dapps are found in the financial and governance sectors. For example, Dapps like Uniswap and MakerDAO provide users with a way to exchange or lend assets directly with other users in a trustless manner, saving significant time by eliminating the need for a banking intermediary or broker. Additionally, due to the inherent transparency of blockchain, many protocols have organized themselves into "Decentralized Autonomous Organizations (DAOs)" that collectively make decisions about the direction of the Dapp through governance voting. Many Dapps are also open-source: users can audit their internal operations before participating in the application. Dapps are not without drawbacks. Firstly, Dapps are often slower. Decentralized networks can become congested. Since Ethereum's main chain can only process about 10-15 transactions per second, a high volume of transactions in a short period can lead to queue congestion. For application developers, it should not be the case that slower distributed servers replace faster centralized servers. In some instances, this is true: Google's research indicates that for every additional second a mobile site takes to load, the conversion rate drops by 20%. Below, we summarize some pros and cons of Dapps: High-Level Valuation of Dapps

Dapps are more diverse and encompass a wide range of use cases compared to the smart contract platforms that support them. Given the differences in use cases, they can be categorized into addressable markets and economic models. Here are some higher-level considerations for investing in Dapp Tokens:

• Analyze use cases and total addressable market (TAM): Assess the problems the Dapp aims to solve, its solutions, and its potential market. Research competitors and evaluate the Dapp's competitive advantages. For instance, how crowded is the current market? If the Dapp succeeds, how large will the market be? Is there an addressable potential market in the world of traditional applications?

• Study the technology of the Dapp: Understand the underlying smart contract platform and other technologies used to build the Dapp, as well as specific features and functionalities of the Dapp. Does the underlying smart contract platform have a rich ecosystem? Do the functionalities or technologies of the underlying smart contracts align with those of the Dapp?

• Evaluate the team: Investigate the background of the team developing the Dapp. Consider whether the team's projects have a track record and the likelihood of them delivering on their promises. Do they have any negative pasts? Or are there problematic individuals on their team?

• Assess the market behavior of the Token: Look at the trading volume, liquidity, and historical prices of the Token. Is the liquidity of the Token sufficient for purchases? Or is there significant slippage when trying to build a position?

• Understand the Token economic model: Analyze the project's Token economic model, including the supply, distribution, and potential of the Token. What is the vesting schedule for the Token? Even if the Dapp provides excellent services, what value does the token hold? Understanding how the Token is empowered and generated is an important yet often overlooked aspect of evaluating any protocol.

• Review the regulatory environment: Understand the regulatory environment for crypto assets in your jurisdiction and how it affects the Dapp and its Token.

• Monitor community engagement and adoption: Pay attention to community engagement metrics, such as the number of active users, transaction volume, and adoption. Questioning the metrics of the Dapp is beneficial: is this organic demand, or is it a product of "vampire attacks"?

• Stay updated: Track any updates or announcements from the project, such as new partnerships, integrations, or developments related to the Dapp or its Token. A good way to do this is to follow governance forum posts. For many Dapps, potential updates are often debated in forum posts, and reading these can provide insight into the factions and opinions within the community.

In-Depth Study of DAPPs

We applied a general framework of supply and demand as a valuation method for payment Tokens and smart contract platforms. However, due to the diversity of Dapps, we chose to focus on specific industry frameworks and case studies within the DeFi ecosystem, where the most enduring Tokens have been utilized in both bull and bear markets. We will provide an overview of each sector, key metrics to consider, and an analysis of the current economic models of the protocols. We hope this report gives readers a certain understanding of the Dapp ecosystem and the technical aspects of successful Dapps.

Decentralized Trading Platforms

The history of Automated Market Makers (AMMs) began in 2016 when Decentralized Exchanges (DEXs) first emerged as alternatives to centralized trading platforms. Some early DEXs, such as 0x and Kyber Network based on Ethereum, used simple order book systems where users could place buy and sell orders, and the trading platform would match them to execute trades. However, these early DEXs faced several challenges. Order book trading requires both buyers and sellers for each transaction, and newer crypto asset projects may struggle to find both parties willing to trade. These issues, caused by low liquidity, diminished the appeal of DEXs. To overcome these challenges, developers began experimenting with new trading mechanisms that did not require order matching, such as AMMs. The first AMM to gain significant attention was Uniswap, launched in 2018. Uniswap's unique approach uses a formula called "constant product" to determine asset prices based on the amount of liquidity available. This was groundbreaking because it allowed Uniswap to provide liquidity for on-chain assets to anyone and eliminated the need for order matching. The success of Uniswap inspired the development of other AMMs, such as Sushiswap, Balancer, and Curve, each with its own innovations, such as multi-asset pools and governance mechanisms.

Leading DEX Projects The top two DEXs dominate the market, accounting for over 90% of total DEX trading volume. In this section, we will outline the two largest DEXs on Ethereum: Uniswap and Curve Finance, how they work, and their economic models.

Uniswap: The Decentralized Unicorn

As one of the earliest DEXs, Uniswap boasts the highest trading volume. Uniswap V3 has over twice the ETH/USD liquidity compared to Binance and Coinbase. Achieving such a high level of liquidity in a Dapp that has only existed for a few years is a significant accomplishment compared to established centralized institutions.

Uniswap Economic Model

Uniswap's Token, UNI, was airdropped to wallets that had traded on Uniswap before September 2020. A total of 1 billion UNI were minted and distributed as follows, with Tokens for the team, investors, and advisors being released over four years. Currently, UNI only provides governance voting to holders. Governance proposals are a voting mechanism that allows Token holders to suggest changes to the underlying protocol. While UNI holders do not directly benefit from underlying mechanisms (such as trading fees), they may be incentivized to accumulate more UNI. Figure: Initial UNI Distribution

Curve: The King of Stablecoin Swaps

Currently, based on total value locked (TVL), Curve Finance (Curve) is the largest DEX.

Curve Finance is a unique trading platform that focuses on low-slippage trading between similar assets.

More specifically, Curve's liquidity pools are optimized for trades between stablecoins (like USDC/USDT) and assets pegged to the same underlying value (like StETH/ETH, WETH). Since Curve provides the highest liquidity for low-volatility asset trading, users have flocked to the platform, accumulating over $250 billion in total trading volume since its inception on November 2, 2018.

Curve Economic Model

The supply distribution of Curve's CRV Token is similar to Uniswap's UNI Token but has a longer Token release schedule:

Figure: Initial CRV Distribution

CRV itself allows for voting, staking, and boosting. Voting is straightforward: it allows users to propose and vote on various governance proposals. Staking CRV allows users to lock up CRV and earn veCRV (voting escrowed CRV) for a fixed period in exchange for 50% of the protocol's trading fees.

Boosting is an incentive mechanism that allows CRV stakers to allocate which asset trading pairs receive more CRV rewards. Many protocols seek to increase the liquidity of their Tokens by listing on Curve Finance. Protocols can incentivize usage by offering their own Tokens as rewards, but this approach is often costly as it dilutes the team's Token supply.

Many protocols have found that using CRV as a reward provides a cheaper way to incentivize usage than using their own Tokens. Outsourcing CRV rewards to avoid spending their own Tokens has become popular among new projects wanting to utilize Curve's liquidity, leading to a competition to acquire as much CRV as possible, known as the "Curve War." This is an interesting case study on DeFi incentive mechanisms.

Basic Metrics for DEXs Measuring the demand for specific automated market makers requires understanding how AMMs work. Unlike the order book model we see in traditional finance, which requires active buyers and sellers, AMMs do not. Instead, most AMM architectures are "liquidity pools." Liquidity pools allow users to provide liquidity in the form of assets in exchange for trading fees and other rewards. Liquidity pools also enable users to create liquidity for any on-chain asset without intermediaries.

Here are some metrics that can be used to measure AMM demand:

Different Economic Models of DEX Projects One way to visualize how different participants accumulate value on DEXs is through the application of different economic models. Unit economic models analyze the relationship between revenue and costs and can help people understand how the project operates. To create a simple model, first take the average trading volume and average trading fees. Average trading volume can usually be found from the resources listed above, while trading fees can be calculated by taking a rough average of the Mining Pool fees (set by the application) or by looking at the official application documentation. Next, consider who receives the fees. Typically, there are three components involved:

1. Protocol treasury: DAO treasuries are often used to pay for operational expenses, invest in growth, and act as a buffer during difficult times. Occasionally, some protocols directly allocate a portion of the trading fees earned to the protocol treasury.

2. Token holders: Some Tokens allow users to stake their native Tokens in exchange for trading fees. For example, Curve Finance allows users to lock their CRV for variable amounts of time in exchange for 50% of total trading fees.

3. Liquidity pool providers: Typically, liquidity providers receive the majority of trading fees as they provide asset liquidity for various trading pairs. Depending on the protocol, the fee breakdown may vary due to protocol governance.

Using this, we can predict future protocol revenue and fee details by multiplying trading volume by fees: It should be noted that crypto trading volume is highly elastic. When timing is right, trading volume can be very high, and vice versa. Trading volume in one week may differ significantly from another week.

Lending Protocols

Decentralized lending protocols like Aave, Compound, and MakerDAO allow users to borrow and lend various assets, including crypto assets, stablecoins, and even non-fungible tokens (NFTs). These protocols use smart contracts to automate the lending process, eliminating the need for intermediaries and allowing for greater transparency and security. One of the most popular features of these protocols is the ability to earn interest on deposited assets. This is known as "single asset farming" and has become increasingly popular in recent years.

Lending protocols also facilitate the growth of decentralized finance (DeFi) and attract a wide range of users, from retail investors to institutional players. These protocols have also spurred innovation in areas such as flash loans and decentralized stablecoins, which we will introduce below.

Major Participants in Lending

Similar to DEXs, only a few large projects dominate the lending space. The three major lending protocols—MakerDAO, Aave, and Compound—account for over $13 billion in total trading volume and have unique features that attract users to their platforms. In terms of total amounts borrowed in dollars on Ethereum, these three protocols account for approximately 96% of the entire market. In this section, we will focus on Aave and MakerDAO, how they work, and provide a brief overview of their economic models.

Aave: The Ghost-Themed Crypto Asset Bank

Aave (formerly known as ETHLend) is classified as a collateralized debt market (CDM) protocol and can be seen as a lender that allows users to deposit assets and borrow against other depositors' assets. This is similar to traditional banks: users provide assets and can collateralize their deposits by paying interest. Interest rates are variable, and the higher the utilization rate of a specific asset, the higher the rate for suppliers. If a borrower's collateral position falls below a certain loan-to-value (LTV) ratio, their collateral will enter automatic liquidation. Aave also allows users to use "flash loans," enabling individuals to borrow any asset without collateral, as long as the asset is returned within the same block. "Flash loans," which do not exist in traditional finance, have become a popular method for arbitrage and refinancing: arbitrageurs can trade at mismatched prices using flash loans, while refinancers can immediately switch from high-interest loans to low-interest loans.

AAVE Economic Model

The initial supply of Aave Tokens was distributed to founders and investors:

Figure: Initial AAVE Distribution

Aave has two main use cases: governance and staking. The governance function is similar to other protocols. Aave allows participants to propose and vote on changes and improvements to the protocol. Staking allows users to lock Aave and earn rewards from protocol fees or emissions by taking on primary risks in the event of a liquidity crisis, auctioning off these Tokens. In this case, stakers act as partial insurance for Aave: they are rewarded for helping maintain the protocol.

MakerDAO: The Central Bank of Crypto Assets

MakerDAO (Maker) is a project based on collateralized debt positions (CDPs) that provides users with over-collateralized loan positions for their deposits. Unlike collateralized debt markets where only deposited assets are borrowed, CDPs actually create new Tokens—a stablecoin pegged to the US dollar.

When a borrower deposits assets like ETH into MakerDAO's "vault," they can withdraw DAI up to a specific collateralization ratio. This is somewhat analogous to credit in traditional finance, where people can borrow dollars against their home equity. The popularity of DAI has exploded since its inception, partly because it was one of the first widely adopted decentralized stablecoins and survived the bear markets of 2017, 2019, and 2020.

Currently, there are approximately $5.9 billion in outstanding DAI, with collateral worth about $8.3 billion locked, corresponding to a collateralization ratio of about 140%. As of January 2023, MakerDAO is the second-largest DeFi protocol by total locked value. Given that Maker mints stablecoins, maintaining the peg requires more incentive structures than a typical lending protocol. From an economic perspective, Maker needs to balance the supply and demand curve of DAI to ensure its price remains at $1.00. To control the supply and demand curve, Maker uses two tools:

1. Stability fee: This is the interest rate for obtaining DAI loans. This is used by Maker to regulate the supply of DAI. For example, if demand for DAI is low, Maker needs to shift the supply curve left (i.e., reduce supply). To incentivize users to repay their DAI loans, Maker increases the stability fee to make borrowing more expensive.

2. DAI Savings Rate (DSR): This is the savings rate for depositing DAI. The savings rate is used to help regulate the demand for DAI. For example, if the supply of DAI increases, Maker can raise the DSR to incentivize users to acquire more DAI. By increasing demand and shifting the demand curve right, the peg can be maintained.

In a sense, Maker's Token is pegged to the US dollar, except that it exists on the blockchain rather than within physical boundaries; it can be viewed as a small-scale economic experiment of a country.

MKR Economic Model

MKR (unlike DAI, which is pegged to another Token) is Maker's native protocol Token and serves two purposes: governance and capital restructuring. MKR governance allows users to vote on quantitative parameter changes for the stability fee, DSR, and other risk parameters. MKR also helps restructure the protocol; if there is a shortfall during liquidation, it sells DAI to recapitalize the system. Essentially, MKR becomes the last line of collateral and absorbs losses when the protocol is under-collateralized. Since MKR holders face dilution whenever there is a shortfall, they are incentivized to govern effectively to protect their interests.

Basic Metrics for Lending

Similar to DEXs, there are some basic metrics to keep in mind when analyzing the situation.

Looking Ahead + Convergence

"Change is life. Stagnation is death. If you don't change, you die. It's that simple. It's that scary." --- Leonard Sweet

Given the rapid adoption of most dApp models and the increasingly concentrated liquidity, there is reason to expect DApps to evolve through a series of smaller, more incremental changes. In fact, even the most successful Dapps by TVL are rapidly iterating their services to capture market share from competitors. Witnessing this, MakerDAO's DAI stablecoin, Aave, and Curve Finance have all announced plans to launch their own stablecoins.

Similarly, given the widespread success of DEXs, lending protocols, and liquidity collateral protocols, a project named Frax has launched Fraxswap (DEX), Fraxlend (lending), and the liquidity staking protocol Frax Ether, horizontally expanding the business model of the Frax protocol to compete with some of the largest players.

Dapp business models are converging. This can partly explain the declining revenues in DEXs and lending protocols within DeFi. As major market liquidity platforms grow, larger participants can afford to lower user fees due to economies of scale. Scale advantages seem to be the largest economic moat in DeFi.

Because the switching costs for Dapps are low, minimizing fees plays a crucial role in attracting users. Stagnation may signify a kind of death marked by a gradual decline in market share. Therefore, a strategy focused on rapidly expanding market share into new business areas becomes a more viable option.

Looking ahead, we expect today's Dapps to expand into more services, from decentralized social networks to real-world asset integration, and we believe they will become more vibrant competitors to traditional companies across all industries.

Conclusion

Protocol development is captivating. Governance structures that once felt outdated have become exciting again: factions vying for rewards. Proxy wars are unfolding around how protocols worth billions of dollars should operate. Traditional financial companies are investing in governance votes to kickstart stagnant protocols. The convergence of these unstoppable competitive interests is prompting more users to think deeply about how the services they currently enjoy should be managed in the future.

The evolution of blockchain technology and the increasing popularity of Dapps have slowly begun to change the way we conduct business and interact with one another. The history of Dapps is still being written, and they are likely to continue evolving and shaping our future in ways we cannot even imagine.