Revisiting Aggregation Theory
Moats in the age of token warfare
Today’s piece is written in collaboration with the incredible minds at LI.FI. Since last June, we have been exploring the aggregation of markets in Web3 as a theme with them. This is the first of several pieces we will release with them. Who better to explore how the multi-chain world is being aggregated than the ones laying the infrastructure for it?
SDKs developed by LI.FI empower developers to enable cross-chain applications without worrying about smart contract risks, custody or costs. It allows users to stay within the app when moving assets across chains. Try using Jumper for a demo of how infrastructure released by LI.FI will soon make it possible for users to switch between assets, across chains - at the click of a button. At the lowest price possible.
A year ago, we wrote about aggregation theory in the age of Web3. Aggregators in the Web 2.0 era benefited from collapsing distribution costs and bringing together many service providers. Platforms such as Amazon, Uber, or TikTok benefit from hundreds of providers (vendors, creators, or drivers) catering to users. Users had the benefit of having endless choices. For creators, the use was scale. I tweet on Twitter instead of Lens because the audience base is concentrated on Twitter.
In Web 3.0, aggregators primarily rely on the fact that the cost of verification and trust collapsed. You do not need to worry if a USDC token you swapped on Uniswap is the actual one if you use the correct contract address. Marketplaces like Blur do not have to spend resources verifying if each NFT traded on the platform is authentic. The network bears that cost.
Aggregators in Web3 could make it easier to check the price of an asset or find where they are listed by checking on-chain data. Over the last year, most aggregators have focused on bringing together on-chain data sets and making them consumable for users. This data could be about price, yield, NFTs or pathways to bridge assets.
The assumption at the time was that monopolies would be built by firms that expand fast enough as aggregator interfaces. I specifically quoted Nansen, Gem and Zerion as examples at the time. Ironically enough, with the benefit of hindsight, my assumptions were wrong. And that’s what I wanted to write about today.
Don't get me wrong. Gem was acquired by OpenSea a few months later. Nansen raised $75 million, and Zerion did a $12 million raise in October. So my assumptions were correct if I looked at these as an investor. Each of these products is a category leader in its own right, but what intrigued me to write this piece was that the relative monopoly I presumed they would have does not yet exist. Instead, they have all faced competition emerging over the year. It is a desirable feature in emerging sectors.
So what has happened in the years since? As I had written in "Royalty Wars" Gem's (and OpenSea's) relative monopoly has come into question with Blur's release in the market. Similarly, Arkham Intelligence has combined an exciting UI, a possible token launch, and clever marketing tactics involving token rewards for referrals to take on Nansen. Zerion may be comfortable, but Uniswap's new wallet launch could eat into their market share.
Do you see a trend here? Aggregators that existed historically without a token and grew comfortably with equity backers are now at risk thanks to firms offering tokens to users. This concept of “community ownership” will matter much as we go deeper into a bear market, as the limited number of consumers still sticking around want to maximize every dollar they spend. In addition, there is a novelty to receiving rewards for using a platform instead of paying money to access it.
So, on one side, firms that were cash flow positive for a long time will see declining revenue, and on the other, they will see users flocking to a competitor. Is this sustainable? Absolutely not. But it is a wedge worth acknowledging. Here is how it works
Firms launch a product that teases a token. Even better if the launch is linked to a referral program. Arkham Intelligence offers tokens for referring users to their platform. Given the possibility of an airdrop, an ever-increasing number of users spend time on the product. This is a feature, not a bug.
It is an incredible way to stress-test products, reduce CAC, and bootstrap network effects in a product. The challenge emerges with retention. Users often move on to a different product once the token rewards are no longer offered. So most developers who "tease" a token don't know how extensive their user base is.
The guy below summarises the philosophical underpinnings of the average person in crypto today. So deep and profound. Very symbolic of the self-interest driving our world.
And for what it's worth, there is a historical trend of users abandoning token release projects for an incumbent in the past. The trap comes from the fact that founders (may) believe users acquired through token incentives are sticky. Under ideal conditions, the graph between token incentives given and users for a product should look like the one below.
But what happens in reality, is that the initial influx of users almost entirely abandon the project as token incentives reduce. They have no reason to continue contributing to the product without the incentives that attracted them in the first place. This phenomenon has plagued DeFi and P2E over the last two years.
Users who accumulated tokens and held on to them are the new “community” members, wondering when the asset price would surge enough for them to exit.
(Look at me, pointing out market participants are rational actors that act in self-interest.)
My original thesis of simply clubbing feature sets from multiple products into a single interface, using blockchains as the infrastructure backbone, as a lasting moat was likely wrong. I wondered why leaders with a relative edge lose it to others in Web3. Binance toppled Coinbase, and they, in turn, faced competition from FTX. OpenSea saw competition from Blur. Sky Mavis, the maker of Axie Infinity, will likely face heat as new entrants like Illuvium come to the market. Why do users leave over time in Web3? And what would it take to retain a user long enough?
What can be a moat in Web3 when everyone can release a version of you with a token embedded in it? I have been thinking about this because we live in a market of narrative rotation. Every quarter, there's a new "hot" thing. This is why VCs on my feed go from being experts on remote work to handling geopolitical tensions in Taiwan overnight.
Surely, it works if you are trading in and out of assets (which, FWIW, is the "use-case" for most people in crypto). But if you want to build an asset base (like equity in Google or Apple) that grows over time, rotating between assets is likely a bad idea
You eventually want what you spend time, money, or energy on to grow without active management. And the only way to do that is if a product can do two things: first and foremost, retain the users they already have; secondly, expand aggressively enough to keep competition from eating into its market share. How do you go about doing that? (You know it's a bear market when one has to start thinking about moats and retention)
Competition is for losers
Part of what can explain this phenomenon is ranking firms on a spectrum that ranges between novelty and convenience. During the early days, primitives like NFTs were novelties that attracted people who would go to great lengths to try the product.
We are comfortable handling seed phrases for wallets and dealing with on-ramps because the novelty of using "digital money" intrigues us sufficiently. Notice how users are curious about Ordinals; you will realize how much patience a user has.
Part of the reason for this patience is the profit element of being early to a trend. Speculation and profit motives drives users through rough experiences.
On the other end of the spectrum are high convenience tools we rely on daily. Amazon is one instance of an aggregator that has us hooked on convenience. Consumers may benefit from buying from niche stores that are not on Amazon, and it is possible that the vendor's pricing on Amazon is off.
But when making a decision, Amazon requires you to worry the least about payment methods, delivery times, or customer support. This "savings" in mental effort translates to higher spending (of attention or capital) on the aggregator.
Many sellers come to Amazon precisely because they understand that consumer behaviour in the marketplace differs from what they would have seen if the user had come directly to the store.
Tim Wu’s piece from 2018 summarises the lengths people go to for convenience.
We are willing to pay a premium for convenience, of course — more than we often realize we are willing to pay. During the late 1990s, for example, technologies of music distribution like Napster made it possible to get music online at no cost, and lots of people availed themselves of the option. But though it remains easy to get music free, no one really does it anymore. Why? Because the introduction of the iTunes store in 2003 made buying music even more convenient than illegally downloading it. Convenient beat out free.
Going back to the spectrum I had initially mentioned, novel technologies often pay users to try them out. In contrast, highly convenient applications have users paying exorbitant sums if it appeals to their desires for convenience.
The challenge most consumer-facing apps today have is that they are bang in the middle, what I call the "valley of death." They are neither so novel that a person wants to bother with what they have built, nor are they convenient enough to be relied on without external concern. Skiff, Coinbase Card, and Mirror are good at being on the convenience spectrum of this equation, as they can replace their traditional comparables.
But take themes like gaming, lending, or identity, and you will see why these themes don’t scale on-chain yet.
Most applications in the middle make the fatal mistake of competing with one another. First, through advertisements and hiring, running up CAC and employment costs. Then, through toxic memes and covert narratives against their peers. As Peter Thiel would put it: competition is for losers.
There are generally no winners when startups begin competing in small, niche markets. In his words, the only way a startup can transition from the struggle for survival is to have monopolistic profits. But how does one get there?
Firms in Web3 have only three levers they can focus on if they want to be independent of tokens as a lever for growth: cost, use case, and distribution. Some instances of this have played out in the past, so let me break these down individually.
Stablecoins have become the killer use case for crypto because they offer an exponentially better experience than traditional banking worldwide. Innovations like UPI in India may be more cost-effective for domestic payments, but moving money across countries in South East Asia, Europe or Africa, or simply moving balances between bank accounts in the US, makes on-chain transfers more sensible.
From the user's perspective, the cost incurred is not solely in the amount of money spent on the transfer, but also the time and mental bandwidth allocated to moving money. Debit cards did for e-commerce what stablecoins did for remittance: they collapsed the cognitive load required to do a transfer. Compare this with most consumer-facing yield-generation mobile apps. You could offer a percentage or two more in yield in dollar terms, but the value proposition fails when you account for the risk of collapse.
Distribution can become a moat if you aggregate niche users in an emergent sector. Think about how Compound and Aave unlocked an entirely new lending market. Few people saw any value in tying up $100 worth of Ethereum to take a loan of $50. But there was a market for it that was not being served. Primarily people who were crypto-wealthy that did not want to sell their assets in a bear market.
You would be mistaken to presume people with no access to lines of credit in emerging markets drive DeFi lending volume. It is the crypto-wealthy that uses it. A demographic that was previously underbanked. Becoming the "hub" for all things related to a niche allows you to drive attention to single features. Coingecko and Zerion are two businesses that did this well.
Given that the firm's marginal cost for prompting a user to a new feature is next to nothing, it becomes cost-effective to iterate and add new sources of revenue to the product itself. This is why players like WeChat (in SEA), Careem (in the Middle East) and PayTM (in India) tend to do well.
When players like Uniswap release wallets, they are effectively trying to aggregate users in an interface where more features (like their NFT marketplace) can be pushed at lower costs.
Tools like ENS, Tornado Cash and Skiff have carved out their unique user bases. These users rely on the product for what a traditional alternative cannot offer today. For example, Facebook does not tie your wallet address to your identity. Your bank does not provide the privacy Tornado cash does.
You get the gist. These are products where users are sticky as often; there are no alternatives that rank up to what the product does. First movers in new use cases take a while to educate users and make them aware of what a utility does. But they also have the advantage of capturing large chunks of a new market.
During the early days of LocalBitcoins, it was the only place to trade peer-to-peer. It helped them aggregate liquidity for on-ramps in emerging markets like India and kept them a leader until 2016. (RIP LocalBitcoins)
Bear markets are tough to scale by focusing on any of these levers. The examples I have mentioned above have been through multiple market cycles. Part of what empowered Axie Infinity to rise to the prominence it did was that the team was building for two years before 2020. The “muscle” required to build community, maintain tokens & balance investor interests (of selling tokens) with those of users (of earning tokens) was formed by the team by the time the next bull market came.
This explains why developer tools & infrastructure plays are all the rage from a venture investing point of view when the markets are down. To battle a lack of interest from retail users, you focus on the business-to-business side of things. You build shovels for developers, who take it upon themselves to onboard retail users.
Prominent players like Coinbase recognise this. This is why they release tools like their wallet APIs in the bear market. One of the places we see this live is with bridges. We have been close enough to watch LI.FI aggregate the multi-chain ecosystem to note how teams have been playing this.
From Novelty to Convenience
LI.FI, a play on the word "Liquid Finance," is a multi-chain liquidity aggregator that provides SDKs for developers who want to make their app or users multi-chain.
Suppose Metamask or OpenSea wants to make it easy for developers to enable users to move assets between chains like Polygon to Ethereum. , LI.FI provides a simple SDK that determines the best route across bridges and DEXs to transfer that capital, so developers can focus on what they do best.
Several players are in the same business, but I use LI.FI as an example because they have practically ticked off the boxes I mentioned above. (Additionally, Philipp initially shared how he sees aggregation evolving eight months back with me, and I have been using it as a basis for this piece). But let's return to LI.FI's strategy.
A few things they have been doing checked off the moats I mentioned earlier.
They started with a focus on businesses as opposed to retail users. If you capture the long tail of developers building applications that may need cross-chain transfers, you don’t worry much about attracting users directly.
Firms using the product save time on research and maintenance. In a bear market, you want to conserve as many resources as possible. So by default, the sales for a product like LI.FI becomes relatively more straightforward.
From the end user's perspective, an aggregator offers the best cost basis for a transfer. So there’s a desire to use products that have integrated their SDK.
They are generally the first to integrate new chains—the frontiers where competition is scarce.
And lastly, their target group is primarily the last participants to leave crypto. Generally, the ones speculating and trading in the industry, a year into a bear market, are power users whom you do not spend much money educating.
Now, don't get me wrong. LI.FI is not the only bridge aggregator in the market, and it is hard to see how any of them will build their moats despite checking off the boxes of cost, demographic, and use-case that I mentioned above. But what specifically interests me is how they can evolve from a tool of novelty to one of convenience.
During the earliest days, users relied on bridges because the process involved painfully waiting for transfers from exchanges. Instead of a few clicks, you had to move money through a centralized platform, undergo security checks, and hope the money came through.
Surely, DeFi degens are sending billions of dollars across chains today, but the average person, like your friend from high school, does not care enough to do all that.
So how do you survive when the novelty wears off? If you notice how Nansen and LI.FI have operated, you can see the answer by observing who they sell to. LI.FI sells primarily to developers. Yesterday, Nansen launched Query- a tool for businesses and larger funds to access Nansen’s data directly. They claim it is sixty times faster than their closest peer regarding querying data. So why are both these firms focusing on developers?
It has to do with the fact that a firm can simultaneously be a tool of novelty and convenience if it sells to power users. For example, a developer deciding whether to integrate with LI.FI - generally has a simple calculation at the back of their mind. Does the aggregator effectively cost less time and capital than integrating individual bridges?
Similarly, for anyone working with Nansen query, the question is does the tool save enough time and energy to warrant its costs. If the cost incurred to do it in-house is lower than what it would cost to pay a third party (like LI.FI), the decision maker would much rather go with not building things from scratch.
The fastest way for a firm to escape through the valley I mentioned on the novelty to convenience spectrum referred to in the image above is to focus on a handful of users that pay high sums of money because your product is now a tool of convenience. This gives products just enough runway for sufficient user interest to build up and become the preferred tool of convenience.
I spoke to Alex from Nansen about this framework - and he put it differently. Users seek value regardless of market conditions. In a bear market, enterprises & networks are the largest customers. They require very specific data sets often unavailable from third-party vendors. Tweaking products to sell to them, to a point where they see the value, means you see more revenue and less competition.
Back to Basics
When I wrote about aggregation a year ago, I mistook a product feature (using blockchains) for a moat. Since then, DeFi yield aggregators have launched aplenty, and most have failed. Simply integrating blockchains may not mean much if a competitor can launch with the same features and better UX, or if they tease a token like Gem did with Blur. In this environment, thinking about what can truly differentiate products is necessary.
As I write these words, a few patterns become painfully evident. Firstly, the cost of acquiring users in a bear market will be through the roof as retail interest is low. Unless a product has exceptional novelty or convenience, it's in an odd position. Secondly, businesses that build for other firms (B2B) may be able to compound growth sufficiently for survival and then dominate in a bull market, like FalconX.
Thirdly, if poorly designed, tokens are a temporary moat and a long-term liability. Very few communities have meaningfully accrued value to the token over a long enough period.
When you consider niches like gaming or DeFi for retail markets, it becomes clear that the average person does not care about which chain or how decentralized things are. They care about the value they can derive from it. Blockchains can help increase the value an end user can get. But founders may often get caught in the trap of building for and selling to VCs (or token traders) without moats built on cost, convenience, and community.
It's a bit of a cynical take, but one that's worth considering.
I’ll see you guys next week with some work we are doing on Ordinals.
1. I am an investor in Nansen and Li.Fi
2. Siddharth Jain is an investor in Socket
3. Both of us were early investors in Gem.
4. We continue to invest in infrastructure aggregators with a B2B focus
5. None of this is financial advice.
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