Outlier Ventures: How Do CEXs Build Economic Moats Towards Open Source?

Written by: Jasper De Maere, Outlier Ventures

Compiled by: Peng SUN, Foresight News

The competition for crypto users is taking on new forms. We see that exchanges are transitioning from closed systems to open systems as they adopt Web3 wallets, build EVM L2s, and implement the Lightning Network, leveraging existing infrastructure. We are excited about these developments and believe they reflect the differentiated value proposition of existing open-source Web3 networks. As previous technology cycles have shown, companies entering open-source networks need to have different gameplay. We believe that community and innovation are the keys to success, and these factors will determine the extent to which exchanges and financial institutions engage with open source.

Open Source

"Open source" is a broad definition used in software, simply put, it means anyone can inspect, modify, and enhance the source code. There are different types of open source, such as libraries, networks, and infrastructure. We focus on open-source Web3 networks and infrastructure, such as blockchain and wallet solutions.

Innovation is Key

In this brief article, we emphasize the importance of innovation in open-source networks. It is a key factor for the long-term success of the network and a mechanism to compete against other networks that overly pursue economic value.

Exchanges on the Path to Open Source

In the past two months, we have seen centralized crypto exchanges announce a series of announcements transitioning from closed systems to open-source systems, including upcoming Layer 2 and Layer 3 wallets.

Exchange Announcement Timeline

Convergence

Since 2022, we have seen DEXs and CEXs converge functionally, as evidenced by the shift from CEXs to open-source exchanges. We believe there are two key drivers behind the development of CEXs:

• Products: People want to develop new and exciting DeFi products that require innovation, such as EVM compatibility, zero-knowledge proofs, and multi-party computation, which can only be achieved through blockchain technology.
• Liquidity: Although CEX liquidity still far exceeds that of DEXs (CEX at $3 trillion monthly, while DEX at $31 billion monthly), CEXs are still seeking to increase DeFi liquidity. Liquidity on CEXs is often concentrated in blue-chip assets like BTC and ETH. Users will benefit from access to DEX liquidity pools for long-tail low market cap tokens, as it becomes increasingly difficult for CEXs to maintain and manage liquidity for these tokens.

As CEXs continue to embed open-source infrastructure into their products, the lines between CEXs and DEXs will become increasingly blurred. We are excited about this development as it indicates that decentralized open-source networks (Web3) not only provide users with an alternative to centralized options but also directly influence centralized institutions, pushing them towards a more inclusive and efficient ecosystem.

We believe that cryptocurrency exchanges are the first among many financial services to transition to open-source systems. While we have not yet seen banks or asset management companies adopt open-source systems, we know they are experimenting with permissioned blockchains and Web2.5 wallets.

Open Source Economic Moat

Many believe that entities (protocols, companies, etc.) cannot capture value in open-source systems. The ability to fork networks or copy code leads many to believe that entities will be eliminated if they become too commercialized.

They are correct, except for network effects. The economic moats commonly used by Web2 platforms have some relevance to open-source systems. The difference is that in Web3 open-source networks, users control and participate in the value they create for the network.

Closed networks and open-source networks generate and maintain network effects in fundamentally different ways. The generation of open-source network effects depends on the successful execution of two things:

• Community

"Open-source networks are the accumulation of community efforts"

The existence of open-source networks relies on the community. The Web3 community plays a crucial role in driving the development, recognition, and adoption of blockchain projects. Traditional enterprises strive to plan internal product development. The same applies in the open-source space. Exchanges operating in an open-source manner need to put in the same effort to prioritize and build their L2 communities. A strong community will generate network effects among different users, who will increasingly benefit from the scale and quality of the community.

• Innovation

"Innovation ensures that open-source networks remain relevant and competitive"

Innovation plays a key role in reinforcing and expanding network effects. When innovative features, services, or technologies are introduced into the network, more users will participate. Through innovation, the network can remain relevant, attracting not only existing users but also achieving user growth. Innovation also brings a sense of achievement and progress to communities built on open-source networks.

In summary, we believe that exchanges entering the open-source space through their L2s need to continue to stimulate community interest in their products through innovation and community building.

Web3 Network Effects

We are seeing increasing evidence that Web3 protocols are successfully capturing value. By creating network effects, Web3 protocols become more valuable for each user, which can generate network effects. Users can switch to new applications simply by forking code, but this is not without cost. Leaving the protocol and its users incurs switching costs.

Without affecting community voting, we believe that the recent debate within the Uniswap community regarding its fee conversion proposal is an example of how network effects create economic moats, even in open-source networks. In short, Uniswap Labs proposed a new proposal to introduce a 0.15% trading fee in its frontend and wallets.

We believe that there are currently no cases of open-source networks overly pursuing commercial value. However, if this trend continues, then innovation will be the key to balance. Due to network effects, simply forking a network and using open-source code to rebuild it is not a real solution. We need innovation to create new value propositions and add differentiated utility for users.

"Neutral" vs. "Company" Open Source

Exchanges are launching their own L2s, attempting to expand their product suite and leverage DeFi liquidity. Now that these L2s supported by centralized institutions are online, we can see two types of L2s with different strategies:

• Neutral L2 - L2s without a pre-existing customer base or large centralized institutional support.
• Company L2 - L2s as extensions of large centralized institutional product services, expanding into the open-source space.

The success of these two approaches depends on different strategies, from seamless access for existing users to attracting successful DApps launched on the L2 ecosystem. While there are subtle differences in strategy, innovation is a priority for both sides. Actively promoting innovation within open networks is crucial for ensuring their long-term success. When we encourage communities to create and innovate, open systems will thrive. We believe there will be a close positive correlation between future innovations and the success of different L2s.

Conclusion

At Outlier Ventures, we are excited to discover and confirm the new trend of open-source systems. Certain inefficiencies observed in closed systems will no longer exist in open-source systems. This is why we hope to see CEXs' L2 strategies shift towards a focus on innovation and community. We believe that successful innovation and community building will play a more significant role in determining the overall success of these institutions.