Original title: "Visualising DeFi Value Flows"
Original compilation: ChinaDeFi
Original compilation: ChinaDeFi
This article builds on the technical concepts presented in DeFi Ecosystems: Primitives and Technology Stacks, and outlines the new value channels created by this technology. By focusing on the value streams within a single EVM chain, a framework is provided to identify the value streams between:
Traditional Finance and Decentralized Finance
EVM compatible chain
dApps on the same chain
This conceptual overview allows for a deeper look at how value is created/redistributed at the ecosystem level as various DeFi primitives are mixed and matched. Value in the DeFi space is built incrementally by stacking different primitives together. We must recognize that the DeFi stack is as fragile as its weakest link, and therefore risk must be managed accordingly.
Like any other marketplace, the value stream is coordinated by three parties:
Provider: A user who provides a resource in exchange for a corresponding fee. In addition to standard assets for transactions (i.e. fiat currency, tokens, etc.), suppliers can also provide resources such as data and even hardware rental.
Demand side: Users who obtain resources by compensating sellers for their opportunity costs. The buyer bears the cost of the acquisition for a variety of reasons, ranging from resource utilization to speculation on the asset's future price.
Service Provider (i.e., Protocol): The facilitator of the transaction, which charges a portion of the transaction value for the convenience of buyers and sellers. In the case of DeFi, this refers to individual protocols and their respective smart contracts.
It is important to note that supply and demand side factors not only redistribute value within the chain, but also incentivize the inflow/outflow of external ecosystem value. This is especially evident in the early days of the chain, as new users participating in on-chain activities need to transfer value with external resources in order to acquire on-chain assets.
Crucially, financial values tend to have monopoly tendencies due to the market interest in liquidity. Therefore, creating an active value transfer ecosystem depends on achieving a baseline level of liquidity to stimulate further value creation. With this in mind, we can now start building our ecosystem value stack.
Assets: Value Creation
The most basic form of value creation is through the token demand on the chain. In the context of DeFi, these would refer to ERC 20/721 tokens, which specify a standard interface for token interoperability across decentralized applications. Given the subjectivity of valuation, the focus here is on identifying key use cases that make a token more valuable relative to another asset.
While speculation is an important mechanism for guiding markets towards "true" value, it is not helpful in this case because it does not provide direct insight into the relative desirability of an asset. Therefore, speculation-based demand drivers are ignored in this paper for the sake of readability.
Whether Token will lead to the net present value of the chain depends on the source of Token. In order to develop the ecosystem, Token must be obtained through external capital. To this end, there are some types of tokens whose use cases incentivize a net positive intrinsic value flow:
The demand for the token will grow organically based on everyone's valuation of the above use cases. After introducing why each Token has value, we can now move on to how the value is transferred.
Liquidity: Value Movement
The diagram above summarizes all major DeFi value streams in one picture. The diagram above has been simplified a bit to account for the composability of DeFi, but the above should suffice as a starting point. The asset overview in the previous section is the foundation to start building our value stack from the bottom up:
Token
A unit of account that represents tradable Tokenized value. The value of a token increases according to its use case. A token's market cap is a rough measure of its value. All value captured by tokens is contributed to a NPV base protocol that hosts them.
market leverage
By staking Token, the lending market can provide leverage, thereby improving capital efficiency.
Lending: Token holders provide their dormant tokens to a lending protocol, which provides them with loan interest as an opportunity cost reward. Borrowing demand drives the loan interest, which is the loan interest plus the agreement fee.
liquidity multiplier
Token interoperability in the open market can form deep liquidity. The recycling of value between tokens is critical to driving the growth of dApps, as its use cases depend on the accessibility of tokens.
DEX: Token holders provide Tokens to the DEX protocol to generate income through market making. Buyers are charged transaction fees, which include providing liquidity benefits and protocol fees.
Market: A transaction model more suitable for non-fungible tokens, where information discovery is crucial. The NFT provides the asking price to the agreement, and then puts it on the open market for sale, waiting for a willing buyer to buy it. Both suppliers and buyers may be charged a negotiation fee for convenience.
Derivatives Market: Generate secondary value by creating a market for trading risk. The value on the chain can be magnified directly through mortgage derivatives contracts, or indirectly through the financing rate market. In the first case, token holders stake their tokens to earn a portion of the risk premium paid by the buyer. On the other hand, both parties pay a risk premium in order to benefit from changes in the token price.
Insurance: Token holders provide Tokens to the insurance agreement, enabling them to earn income by underwriting certain policies. Insurance premiums paid by insurance buyers include underwriting fees and negotiating fees. Payment decisions can be made through voting or event-driven code.
On-chain liquidity
In order to support the decentralized financial market, value is also circulated on the blockchain protocol layer. These marketplaces are critical to securing the entire ecosystem. The value on this base layer can also be tokenized for interoperability with dApps.
Tx settlement: Every transaction requires a Tx /gas fee to incentivize blockchain finality. According to the consensus mechanism, the validator's resources are at risk to obtain the transaction fee Tx settlement: each transaction requires a Tx /gas fee to incentivize the finality of the blockchain. According to the consensus mechanism, the validator's resources are at risk in order to obtain transaction fees (ie miners, coins, etc.). Depending on the protocol rules, validators may also receive Coinbase rewards (i.e. mining rewards). In addition, the protocol can define a fee burning mechanism for reducing Token supply. In the absence of any external capital, changes in the coin supply lead to appreciation/depreciation of the coin value.
Staking infrastructure: Validators can also pay escrow fees to delegate certain staking responsibilities to staking infrastructure providers. These services can include payments for computing resources and even staking on behalf of validators. The authorization of Proof-of-Stake Token enables the minting of Liquidity Mortgage Token, which can be further traded on dApp.
Storage: Data still has to be stored on a hard drive somewhere, and depending on the underlying chain design, this memory space can be prohibitively expensive. The storage protocol creates a market where data can be encrypted and reliably stored at a low cost on a network of devices, requiring only a proof of storage on the main chain. The buyer pays the memory lease fee, which includes the cost of renting the storage as well as the agreement fee.
Oracles/Data: Many on-chain applications require secure and reliable external data to supplement on-chain data (i.e. prices, off-chain data, etc.). These data can be purchased from oracles/data providers for a fee. Most of the data usage fees will be used to incentivize data providers to report accurate and timely data.
Launchpad: Such a protocol will enable value bootstrapping when launching dApp Token. By raising a pool of coins/Tokens, value is transferred to newly issued dApp Tokens. Additionally, an agreement fee may be deducted in exchange for guided services.
Cross-chain liquidity
All of the above techniques can be easily deployed to another chain given the reproducibility of the code. Therefore, when assets are collectively exchanged through cross-chain technology, the value captured by each chain will be determined by the market. In the case of the same use case, the user experience of the main chain layer will determine the relative valuation of Token on each chain.
Bridge: Incentivize Token holders to provide liquidity to the cross-chain bridge in exchange for a portion of transaction fees. Depending on the bridge method, if tokens are burned on the source chain and minted on the target chain, value can be fully transferred between chains. Alternatively, Tokens on the source chain can be locked and used as collateral for packaging Tokens on the target chain. Bridge agreements typically charge an agreement fee for this service.
Cryptocurrency Up/Down Ramps
The last category targets value transfers in the traditional economy. Currently, since cryptocurrencies have not yet become a key part of modern life, most of their "value" still resides in traditional finance. Furthermore, given that most of the world's population has never owned a cryptocurrency, these ramps are the critical infrastructure that allows the transfer of value into the cryptocurrency space.
Fiat Currency: Value stored in fiat currency is often transferred to the crypto space by minting an equivalent value in fiat currency-backed stablecoins. As such, such stablecoins typically require holding a corresponding fiat value in accounts at traditional banks. While value is not transferred directly into cryptocurrencies, stablecoins play a key role as a medium of exchange.
Token Mortgage: By hosting real-world assets (i.e. gold, property, artwork, etc.), these services enable Tokens to be mortgaged against the value of the underlying asset. Depending on the type of asset, these tokens can generate additional value by building an ecosystem on top of proof of ownership.
Evaluating the DeFi ecosystem on-chain
The total value of the ecosystem starts with the Token deployed on the chain. Since the token acts as a store of value, its "true" value will be largely driven by its use case. The total value locked in the Token can then be leveraged through lending protocols.
This leveraged value enables liquidity to be formed, which encourages the redistribution of value to the best use cases. Deep liquidity also incentivizes the inflow of external value, as there will be opportunities for income and capital appreciation.
Opportunities for added value also present themselves in the services of these financial markets. In DeFi, many of these services require the physical resources required for computing, networking, and storage. There is also a large market for accurate off-chain data.
At the chain level, the flow of net value will depend on the flow of assets between other chains and the traditional financial system. Token supply changes on the chain must be accompanied by positive external value inflows in order to remain sustainable at the current scale.
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