Crypto protocols are changing the defensibility of financial businesses.
Network effects are becoming weaker, while brand effects are getting stronger. New moats like stakeholder ownership are coming into play. If you’re building in crypto, you should know what these moats are, how to create them, and how to compete against businesses that have them.
Traditional exchanges could create network effects through liquidity. US T-Bond futures were traded almost entirely on the CBOT Exchange for decades after their launch in the 70s. They were first to market which attracted liquidity, which led to the best prices, which attracted more liquidity. Each trader made the network more valuable and created a flywheel. CBOT’s followers had a tough sell. What trader would endure the costs to move and pay more for each trade?
Liquidity doesn’t create defensibility in crypto. Assets are identical and can move between exchanges through blockchains. Exchange aggregators can split trades across markets to get the best prices. Blockchains can coordinate supplier moves, bootstrapping network effects on new markets. When suppliers and users can move freely, marketplaces like exchanges lose defensibility.
Platforms1, on the other hand, create network effects when they aren’t interoperable. Ethereum has a community of developers building tools, which attracts more developers and users. Competing blockchains must convince developers to switch and rewrite years’ worth of software. Because the value isn’t transferrable, Ethereum has a strong moat. These network effects reward first-movers and work against all kinds of competitors.
The only way to compete is to go after the problem with a very different vision. Expanding the market brings new users who can be acquired at low costs. Ethereum’s vision of a world computer attracted new developers into crypto who were never interested in Bitcoin.
Imagine that you rented apartments on Airbnb in 2008. For every $100 you make, Airbnb throws in $5 of stock. It’s now 2010, your stock has tripled and you think Airbnb is onto something. How much would a competitor have to pay you to list? Much more than $5 for starters. If it’s not equity, you may not even do it. What if they become successful and your Airbnb equity becomes worth much less?
Startups use equity grants to hire people they couldn’t otherwise afford. Crypto startups have realized that they can do it with other stakeholders. Uniswap, a decentralized crypto exchange, is giving away 60% of its ownership tokens to early users and liquidity providers. As Uniswap grows, these tokens will rise in value and incentivize users to stay.
Stakeholder ownership can work for any company, but it’s particularly strong for aggregators who need suppliers. Ownership makes them financially and emotionally invested in your business. It has unbounded upside, so the better you do the harder it is to poach them. This is unique to crypto, because blockchain tokens have made it easy to grant bits of ownership to many supporters. Shared ownership defends against all types of competitors by raising the cost of acquiring your users.
Stakeholder ownership is contestable if it isn’t combined with strong network effects. There’s a window of opportunity when the market leader hasn’t emerged yet (or makes a big mistake). That’s when you can get users with your own tokens at reasonable prices.
Well-intended government regulations create huge moats for incumbents. Dodd-Frank was meant to protect consumers from another crisis but handed banks the keys to an oligopoly. There were 1266 bank charters issued from 2000-2009. Only 18 have been issued since the rules changed, leaving big banks free to dabble in account fraud and money laundering. Regulations are why it’s faster and cheaper to buy a bank in the USA than it is to start one.
Regulations protect crypto businesses too. Coinbase worked proactively with regulators when rules were unclear. They signed up millions of users before regulations arrived. This let them spread the costs of compliance over many users bringing down marginal costs. If you want to take away their customers now, you’ll have to cough up a few million dollars for licenses first.
Regulatory moats emerge when gatekeepers change rules and raise the costs of doing business. To leverage it, you must be operating in a grey area before this happens and work closely with regulators. When regulations come into play, you get years to comply, while new startups can’t make a single dollar until they’re licensed. Regulatory moats only work against startups. They offer little protection against deep-pocketed competitors who can play the long game.
If you’re trying to break into a license raj, marginal costs of compliance make it hard to go head-on. Instead, you can play the regulatory arbitrage game by launching in a jurisdiction with favorable rules. Binance grew faster than Coinbase despite a late launch by incorporating in Malta. This let them sidestep regulations and offer more assets. Creating a decentralized protocol is another path since they’re globally available and hard to shut down.
People pay for brand names when they face big risks that they can’t mitigate. For instance, tech startups usually choose one of the big five to lead their IPO. Morgan Stanley gets the big deals even though the end product is identical. No one buying shares on Robinhood knows or cares who the IPO lead was. But the transaction is risky, and a bad IPO could lose millions. Startups are not public market experts and they try to reduce risk by working with a bank that has a history of doing it well.
Coinbase has one of the strongest trust moats in crypto. People know that exchanges get hacked but have no way of measuring their security. As a proxy, they choose the one they saw in the news, the one their friends use or the one that seems regulated. Buying $100 of Bitcoin costs you $3 on Coinbase, $0.50 on Coinbase Pro and $0.10 on Binance. A 30x difference for the exact same Bitcoin! People are willing to pay the fee because they fear losing their Bitcoin much more.
Trust moats emerge when the risks are complicated and large sums are involved. Because of this, almost every crypto product can create a trust moat, but there’s no shortcut. It develops over time through communications and actions that reinforce trust. The moat is effective against startups and incumbents that haven’t created one.
Strong brands don’t create winner-take-all effects. You can go after the users they can’t serve: price-sensitive customers. Binance’s low fees attracted market makers willing to take a little risk for more reward. It’s important to remember that this only gets your foot in the door. You’re still vulnerable to competitors until you find a path to defensibility.
In 2000, Blockbuster was the market leader in video rentals. Their business model hinged on late fees, which was almost a fifth of their revenue. Netflix counter-positioned by renting movies online and eliminating late fees and physical stores. If Blockbuster offered online rentals without late fees, they’d go into the red. Their brick-and-mortar business was dependent on the margins. So they ignored Netflix for years because they didn’t think they could expand outside their beachhead. We all know how that story ends.
A common meme is that crypto will disrupt remittances with low transaction costs. But remittances are expensive because of FX risk and the first and last mile problem2. Making the transfer cheaper is a nice improvement, but isn’t a counter position. Banking is a different story. US Banks make $11.6 billion in overdraft fees, engage in shady business and have abysmal NPS scores. Regulations also give them a barrier against startups. With the right money legos, you can counter position by cutting fees and making up margins in lower compliance and distribution costs.
Counter-positioning3 is a single target play against an incumbent. It’s only a partial strategy because it doesn’t protect you against other startups. But when executed well it’s effective at taking out a moated incumbent. It’s one of the few strategies that work for latecomers. The important part is to keep a low profile and attract customers, not attention.
Defending against a counter position is hard, and there aren’t many good examples of it. In theory, the incumbent can see the new model, kill their cash cow and outplay the newcomer. But this is very hard to do in practice at large companies. They rarely make this move until it’s too late.
The moats we’ve talked about are powerful, but they have some important limitations:
They’re not a substitute for product-market fit. You must build something that people want before you can understand out how to defend it.
They can be used for good or evil. Innovative companies use them to move spending from ads to building better products. Lazy companies use them to rent-seek until they get disrupted.
They’re going to change again. Regulations and ownership are evolving with crypto and this is just a snapshot of what’s possible today.
Thanks to Linda Xie, Lenny Rachitsky, Avichal Garg and Dan Robinson for help with drafts.
Accepting and delivering money is expensive because people often want to use cash at either end. You have to deal with physical locations, fraud and all that expensive stuff. ↩