Decentralized business: An overview of revenue models in the DeFi ecosystem

The world of decentralized finance (DeFi) can seem novel and fun at first - until teams behind these DeFi protocols started to think about ways to make money.  

After all, protocols don’t develop themselves. To maintain and improve a DeFi protocol, especially those that are in their early stage, a team is needed and that team needs to survive, through donations, venture funding, or generating revenues through the protocols they have launched. 

Just last week, decentralized exchange dYdX announced that they would start charging trading fees, while MakerDAO has long pioneered the token model, where holders of the governance token MKR vote on issues in the ecosystem while collecting interest as compensation. 

However, unlike other tech companies, DeFi projects are also tasked to carry the torch of "decentralization." This idea renders the picture of a single entity profiting from its vantage point as the protocol builder unpalatable to some. 

As dYdX founder Antonio Juliano told The Block: 

"In many ways, it's similar to any tech company: build a valuable product, then capture value on that product. The main unique consideration is how to achieve decentralization while also capturing value."

We take a look at some of the business models in DeFi and talk to both protocol developers and VC to see what potential paths to monetization might look like.

The Fee Model

Charging fees is a tried and true business model for most financial services firms. In crypto, centralized exchanges such as Coinbase and Binance have long taken a cut out of every trade they facilitate. 

In DeFi, non-custodial crypto bank Dharma takes 10% out of the interest earned by lenders, a mechanism that the firm believes aligns the team’s objectives with users’ interest. dYdX’s new fee structure aims to incentivize traders to increase platform liquidity by placing larger trades for lower fees. Revenues generated will, in part, be used to cover gas fees, which every Ethereum-based transaction incurs and has previously been paid for by dYdX itself. 

“Charging trading fees is a tried and tested revenue model for exchanges that will align our revenue with the actual usage of the product. Users will pay for a product that has liquidity and solves problems for them, and we believe we've built that,” said Juliano. 

Although straightforward, the fee model also entitles a single entity to profit in a financial ecosystem that is designed to be decentralized, contradictory to the DeFi ethos. And, perhaps more pressingly, this one single entity may also regulatory scrutiny. Once a DeFi protocol starts to implement a fee structure that allows one company to profit, it then dangerously resembles a regular crypto exchange, many of which, such as Deribit, BitMEX, and Binance cannot legally serve U.S. users. 

“Providing financial services and then having these fees back... that just looks like a normal exchange or a money market or other financial products. And so you're probably subject to a lot of regulations,” said Dragonfly Capital junior partner Tom Schmidt, whose firm invests heavily in DeFi projects. 

For those that are in the U.S. – such as Coinbase and Binance – the process of determining which regulatory jurisdictions they fall under and applying for licenses is in itself an onerous endeavor. Such a journey is one that could bear down a young startup with limited capital. As such, DeFi projects largely operate in the grey area due to the lack of regulatory clarity. 

“There are a number of financial regulators in the U.S., all of which have different definitions of what constitutes an ‘exchange.” Based on guidance put out by regulators and advice of our counsel, we believe we are complying with all applicable regulations,” Juliano explained. 

The Token Model

If the crux of the problem is one single entity making profits, then governance tokens may be a viable alternative. 

The idea behind the governance token is to distribute decision making power among users within the ecosystem. These token holders can, in turn, determine whether to implement a certain value capture mechanism to generate returns on their holdings. 

For example, holders of MakerDAO’s governance token MKR can stake and vote on decisions that impact the protocol. They act as the last buyer should the collateral in the system not enough to cover all existing Dai, and as a reward, they receive interest paid by Dai borrowers. 

Additionally, since MKR is traded on the open market, the Maker Foundation, a non-profit that supports the protocol, can sell MKR to fund their operations. Case in point, the foundation raised $27.5 million from Dragonfly Capital and Paradigm in December by selling around 5.5% of the total MKR supply. 

Compound recently announced its own governance token, COMP. Although details of how the tokens will be distributed and utilized are still pending, it is likely that COMP holders will vote of system parameters, and in return receive some percentage of interest accrued across the platform, according to Schmidt. 

“I think that's the beauty of something that has traction and then adding governance on top all of it,” said Schmidt. “I expect it is very likely that one of the first thing COMP holders vote for is to create some sort of fee-accruing mechanism to COMP tokens.” 

dYdX may also consider the token model in the future, said Juliano. For now, however, the company still deems the mechanism immature and may incur technical challenges that distract the team. 

“There are many areas in which a token could be beneficial to dYdX, including governance, collateral of last resort, and growth marketing. However, tokens also bring a high amount of technical lock-in and distraction, which could negatively impact the product progress of dYdX,” said Juliano.  

Alternatives?

Besides the token and fee models, Juliano doesn’t believe that there are “any other ways to generate venture style returns.” 

However, Dharma COO Brendan Forster noted that public-good funding, where projects receive donations, could also be a feasible revenue model in the future. 

“There is a lot of experimentation and investigation of public-good funding… [However] I don’t think its nearly at the phase of maturity where it is able to support a diverse and innovative ecosystem,” said Forster. 

Indeed, earlier this year, Ethereum research group, Optimism (previously Plasma Group), announced that it had pivoted from a non-profit entity to a for-profit business supported by venture funding. Although not a DeFi project per se, the team faces a similar challenge of providing services to the community while maintaining its daily operation. 

"Raising for non-profit is a full-time job of piecing together a hundred different small donations just so you can make the next paycheck. With a for-profit company, you raised once and you are good for however long [that sustains you], and you can offer things like benefits and health insurance," Optimism CEO Jinglan Wang told The Block at the time. 

At the center of all kinds of revenue business experiments is to solve one problem: how to reasonably extract and distribute value among both protocol builders and protocol participants.

“For decentralized protocol, you want to start small, nimble, agile focusing on building something people want and then you get sufficiently large, you want to decentralize,” said Schmidt. 

Update: this story previously stated that Dharma is a peer to peer lending platform and it charges 1% of the yield generated by user funds. It has since been updated to correctly reflect that the company is a non-custodial crypto bank and it charges 10% of the interest generated by user funds.