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Key Takeaways:
- Ultimately, like Airlines, AMMs sell a commodity: liquidity. Differentiation on the demand-side is difficult as customers mostly care about execution
- While liquidity is a moat, given the fact that AMMs are open and forkable, and both VCs and retail investors alike are content to continuously subsidise new competitors, it’s unclear how AMMs will ever be able to extract significant value
Despite being a large, important and, over the last few decades, growing, industry, airline profit margins have historically been negative (or over the last decade, in the high single digits)
Source: Centre for Aviation
There are various reasons for this: high fixed and variable costs, high competition and lack of differentiation, unprofitable airlines kept alive by optimistic investors or generous governments, etc. Ultimately the problem stems from the fact that seats on an airplane going to city X are commodities. Passengers don’t particularly care what logo is plastered on the side of the plane as long as it gets them where they want to go.
As I pointed out in my post about “Aggregation theory and liquidity wars”, liquidity is very similar. Customers (traders) ultimately don’t care what website they’re using as long as they’re getting the best execution possible. This being the case, I argued differentiation would have to happen on the supply-side as LPs are the real customers of AMMs.
That being said, this also puts into question the value of governance tokens, particularly for networks that don’t offer meaningful supply-side differentiation. While liquidity is a network effect/moat since it provides better execution (similar to how scale with airlines helps amortise fixed costs), any value extraction by governance token holders will immediately hamper execution and thus the size of their moat.
Given that these networks are open and forkable, that both VCs and retail investors alike are content to continue subsidising governance token launches, it seems likely that competition will remain high for the near future. By consequence, the ability for leaders to exert market power will remain low.
One example here is Curve. Curve is undoubtedly one of the most successful dApps in DeFi, finding instant product market fit with its hyper-efficient stablecoin to stable coin AMM.
Nevertheless, it currently generates roughly $50M volume/day on $1B deposits. At the current 0.04% trading fee, this equates to a 0.73% yield for LPs (and 0% for CRV holders).
While this fee could arguably be increased and begin to flow to CRV holders instead of LPs since the latter are being subsidised by 35-90% APYs on yield farming (as per Andrew Kang’s proposal), this would still represent an infinitesimal yield taking into accounts Curve’s $10B fully diluted valuation. In addition, this yield can only be removed from LPs entirely while it being subsidised by extremely large yield farming APYs, a practice unlikely to be sustainable in the long-term. Finally, the increased value extraction also opens up opportunities for lower-cost competitors to emerge and gain market share, and we expect to see more and more of this happen.
While this paints a grim picture for AMM governance token fundamentals as investments, as consumers we should be happy as competition results in lower margins and greater consumer surplus. Just as fierce airline competition resulted in cheap air travel and Instagram/bucket list culture, AMM competition is likely to lead to hyper efficient trading, especially as L2 solutions and scalable L1s like Solana come to market.
To be clear, we believe all AMMs have tremendous short and medium-term upside given the overall growth we see happening in DeFi and crypto markets more broadly. However, it’s always important to keep in mind the long-term dynamics and these projects’ ability to establish a defensible moat.
In all cases, we remain bullish on AMMs that can build meaningful supply-side differentiation or those that have tokens that serve a genuinely necessary role in the ecosystem . Most importantly, we also remain bullish on crypto projects’ ability to adapt and reinvent themselves, and it’s certainly possible that AMMs use their liquidity to expand into new markets with more defensible moats (e.g. pegged tokens). As always, we look forward to following and reacting to the innovation.