The success of every company, from tech giants to century-old enterprises, can be attributed to its moat. Whether it’s network effects, switching costs, or economies of scale, the moat ultimately allows companies to evade the natural laws of competition and sustainably capture value.

Although defense capability is often an afterthought in the considerations of investors in the crypto market, I believe that the concept of moats is even more important in the context of the crypto market. This is because three unique structural differences support crypto applications:

1. Forkability: The forkability of the application implies that the barriers to entry into the crypto market are inherently lower.
2. Composability: Due to the interoperability of applications and protocols, the conversion cost for users is naturally lower.
3. Based on the acquisition of Token: The ability to use Token incentives as an effective user acquisition tool means that the acquisition cost (CAC) of encryption projects is also lower in structure.

These unique features collectively accelerate the effect of the competition rules of encryption applications. Once an application opens the ‘cost switch’, not only will there be countless other indistinguishable applications that provide similar but cheaper user experiences, but there may also be some applications that actually use Token subsidies and points to pay users.

Taken to the extreme, without moats, 99% of applications will inevitably experience vicious competition and cannot escape commercialization.

Although we have many precedents and inspirations to understand moats in the traditional market, there is a lack of corresponding frameworks to consider these structural differences. This article aims to fill this gap, delve into the fundamental elements of sustainable moats, and identify a few applications that can sustainably capture value based on this foundation.

A New Framework for Assessing Application Defense Capabilities

Warren Buffett, the king of defense capability, has a simple yet effective heuristic method for identifying companies with strong defense capabilities. He asks himself, if I had a billion dollars to establish a competitor company, could I take significant market share from that company?

By slightly adjusting this framework, we can apply the same logic to the crypto market while taking into account the structural differences mentioned above:

If I fork this application and provide a $50 million token subsidy, can I take over and maintain market share?

By answering this question, you naturally simulate the law of competition. If the answer is yes, then emerging forks or indistinguishable competitors are likely to erode the market share of the application in the near future. On the contrary, if the answer is no, then the application defaults to having what I believe are the core features of every defensive encryption application:

The ‘cannot fork’ and ‘cannot subsidize’ features

To better understand my point, let’s take Aave as an example. If I were to fork Aave today, no one would use my forked version because it lacks the Liquidity that users borrow and lend. Therefore, the Total Value Locked (TVL) and the network effects of bilateral markets like Aave constitute its ‘unforkable’ characteristics.

However, while TVL does provide a certain degree of defense for the currency market, the subtlety lies in asking whether these features can also resist subsidies. Imagine if a well-capitalized team not only forked Aave, but also designed a good $50 million incentive program to attract Aave users. Assuming that competitors are able to reach a competitive Liquidity scale, due to the fundamentally indistinguishable nature of the currency market, users may not have much motivation to switch back to Aave.

It should be clear that I don’t think anyone will be able to successfully attract Aave’s users in the short term. Subsidizing $12 billion in TVL is not a trivial task. However, I think there is a risk of losing significant market share for other currency markets that have not yet reached this scale. Kamino provides us with a recent precedent in the Solana ecosystem.

In addition, it is worth noting that while larger currency markets like Aave may not be affected by emerging competitors, they may not be able to fully resist adjacent applications seeking horizontal integration. Spark is the lending department of MakerDAO, and after launching its own Aave fork in August 2023, it has already captured over 18% of the market share from Aave. Given Maker’s market positioning, they are able to attract and retain users as a logical extension to MakerDAO. Maker protocol.

As a result, in the absence of some less susceptible features (such as CDPs embedded in the Decentralized Finance marketplace), the structural defenses of lending protocols may not be as strong as one might think. By asking yourself again – if I fork the app and offer $50 million in tokens, will I be able to capture and maintain market share? - I think for most currency markets, the answer is actually yes.

Decentralizationexchange

The popularity of aggregators and alternative front-ends has made the issue of defense more complex in the DEX market. Historically, if you ask me which model is more defensive - DEX or aggregator - my answer is obviously DEX. Ultimately, the front-end only observes the back-end from different perspectives, and the conversion cost between aggregators is essentially low.

On the contrary, considering that DEX has the Liquidity layer, the cost of converting to alternative DEX with less Liquidity is much higher. Doing so would mean more Slippage and poorer net execution. Therefore, considering that Liquidity is unforkable and more difficult to subsidize on a scale, I would argue that DEX is significantly stronger in defensibility.

Although I expect this situation to continue in the long run, I believe the trend may tilt towards the front end, capturing more value. My thoughts can be summed up in four reasons:

1)- Liquidity is more like a commodity than you think

Similar to TVL, although Liquidity is inherently “non-forkable”, it is not immune to subsidies. In the history of Decentralized Finance, many precedents seem to emphasize this logic (e.g., SushiSwap’s vampire attack). The structurally unstable nature of the futures market also reflects the fact that relying solely on Liquidity cannot serve as a sustainable moat. Countless emerging futures DEXs are able to quickly gain market share because the barrier to launching Liquidity is inherently low.

In less than 10 months, Hyperliquid has become the most popular volume-based futures DEX, surpassing dYdX and GMX, which once held over 50% of the entire futures market.

2. -The front end is evolving

Today, the most popular “aggregator” is actually an intent-based front-end. These front-ends will outsource to a network of “solvers” who compete to provide users with the best execution. Importantly, some intent-based DEXs also leverage off-chain Liquidity sources (i.e. CEXs, market makers). This allows these front-ends to bypass the Liquidity bootstrapping phase and immediately offer competitively strong and typically better executions. This intuitively weakens on-chain Liquidity as a moat for existing DEXs.

3. -The front end has terminal user relationships

On the basis of having user attention, the front end has disproportionate bargaining power. This enables the front end to achieve exclusive transactions or subsequent vertical integration.

With its intuitive front-end and control over end users, Jupiter has now become the fourth largest on-chain futures DEX. In addition, Jupiter has successfully integrated its own launch platform and SOL LST, and plans to build its own RFQ/solving model. Given Jupiter’s close connection with end users, the premium of JUP is somewhat reasonable, although I expect this gap to narrow.

In addition, as the ultimate front end, no one is closer to the end user than Wallet. By specifically owning retail users in the mobile environment, Wallet has gained the most valuable order flow - the “fee-insensitive flow”. Due to the inherently higher conversion cost of Wallet, this enables Wallet providers like MetaMask to strategically sell convenience to retail users rather than execution, accumulating more than $290 million in fees.

In addition, although MEVSupply Chain will continue to evolve, one thing will become increasingly clear - value accumulates disproportionately in the hands of the entity with exclusive access to order flow.

In other words, all sustained initiatives to reallocate MEV, whether at the Application Layer (such as LVR-aware DEXs) or closer to the bottom (such as mempools and TEEs based on encryption), will disproportionately benefit protocols and applications that are closest to the source of the order flow. This means that protocols and applications will become increasingly ‘thin’, while wallets and other front-ends will become ‘thick’ due to their proximity to end-users.

In the future report “Obesity Wallet Theory”, I will further explore this point.

Conceptual Application Moat

To be clear, I expect that the Liquidity network effect will result in a winner-takes-all market in terms of scale. However, I also believe that we are still far from this future. Therefore, considering Liquidity alone, it may still prove to be an ineffective moat in the short to medium term.

On the contrary, I believe that Liquidity and TVL are more of a prerequisite, and the real defensive ability may come from intangible assets such as brand, differentiation on the basis of better user experience, and most importantly, constantly launching new features and products.

This means that Uniswap’s ability to overcome Sushi’s vampire attack is a result of its “beyond innovation” capability. Similarly, Hyperliquid’s rapid rise can be attributed to the team’s ability to build the most intuitive futures DEX ever and continuously roll out new features.

Simply put, although Liquidity and TVL can indeed be subsidized by emerging competitors, a team that never stops innovating cannot be replaced. Therefore, I expect a high correlation to exist between applications that can continuously capture value and teams that constantly innovate. In an industry where a moat is almost impossible to appear, this is undoubtedly the strongest defense source.

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