Original text:《Lifetime Value for Crypto Businesses》
Written by: KERMAN KOHLI, Founder, ARCx
Compiled by: Shenchao TechFlow
Around this time last year, I started writing about crypto businesses and how their unit economics were broken in a way that made most of the industry a joke. It wasn’t until FTX crashed that people really started paying attention to it.
Since then, I have not only thought about these problems, but also built the necessary components to solve them. Until then, I'll share some additional thinking I've done on a conceptual framework to help think about these questions.
Lifetime Value (LTV)
Probably one of the most important metrics for any business. It represents the value of fees a customer earns for the business over their lifetime. Now the key here is that each business earns fees in a different way, so a deep understanding of the mechanics is required to understand the creation and subsequent capture of value. The following is a rough conceptual framework for thinking about different categories of questions.
These are all on a per-user basis, so of course it is common sense that more users will earn more revenue, but the key factor here is that the quality of those users matters.
chain
While networks are not equivalent to businesses in their purest sense, knowing how much fees each user brings in on average can tell you a lot about the health of the chain. This is a challenge for high-throughput L1 and L2 networks, as their fees are much lower compared to Ethereum. They need to show higher activity or add complementary services that earn the majority of their revenue (e.g. a movie theater, where the movie costs very little, but the real money is in the snack bar).
For chain/general computing platform, our calculation formula is: Fees Paid = complexity of transaction (Gas) * calculation price (Gas price).
This means that the two dimensions that computing platforms (chain and L1) should think about are:
How do you increase the complexity of transactions? DeFi is one example, and blockchain games are another (as long as the gameplay takes place on-chain).
How to continuously increase the average price of computation (Gas price)? When Ethereum's Gas price fluctuates extremely, Ethereum's transaction fees will increase significantly. In addition, continuous activity is another dimension to increase the transaction fees paid by each user.
This is not an exhaustive framework, but rather levers that should be studied.
DEX
Decentralized exchanges (DEX) have a simpler framework for understanding their customer lifetime value because there are really only two aspects to consider: Fees Paid = Transaction Size * Transaction Fee (Fee Rate %).
The two dimensions that DEX needs to optimize are:
How can I increase the average transaction size that occurs on my DEX? This can be achieved by focusing on specific verticals (e.g., Curve’s strategy for stablecoins) or long-tail speculative coins (Uniswap). Although both are trying to take market share from each other.
How do I increase the average transaction fee I can charge per exchange? This is where the NFT markets are getting hammered because they are playing a “limit down” game where not only are transaction fees 0%, but unit economics are negative due to the incentives to pay.
Borrowing
Any lending protocol has the same unit economics, and how they solve these challenges is up to them, but from a key perspective their equation is as follows: Fees Paid = Profit earned by lenders (%) * Fee percentage of profit (%).
For both dimensions, you need to be operating at scale to make sense:
How to increase the profits that lenders can earn? This is probably the least optimized variable, because in a market where the underlying asset can increase 10x in a year, borrowers are relatively insensitive to price (stablecoins are an exception). However, few borrowers are willing to pay more than double-digit fees, which means the best case scenario is 10% (which is already on the high side).
How do you capture a portion of the profits that a lender earns? This makes things tricky because the profits are already very small and capturing a portion of the profits will make things even more difficult. For example, Aave takes 10% of the profits that lenders earn, but assuming that the lender earns 5% for stablecoins, then 50 basis points is the pure income for Aave and the value of that customer.
Stablecoins
Stablecoins are everyone's favorite business because it means you get a money printing machine, and normally, to drive these businesses, you need to spend a lot of money to attract customers through liquidity incentives. However, to show why these businesses are so profitable, you only need to look at their fee structure: Fees Paid = Interest Rate Charged * Value of Borrowed Assets.
That’s it. You set the interest rate and encourage borrowers to borrow as much of the asset as possible. When thinking about your two levers, all you need to understand is:
How do I ensure that I can charge the highest possible interest rate while still being competitive? This depends a lot on what my competitors (money markets) are doing and the cost I pay for liquidity.
How do you get borrowers to borrow as much assets as possible? This is challenging because the quality of the assets will determine the risk of the platform and your ability to remain solvent.
Any money you make is your profit. The only problem is that it costs you to ensure your stablecoin remains pegged or has built-in strong demand backing.
Yield Aggregator
This basically covers any service that says "give me your money and I'll make you the most money." These businesses are great when they first launch, but the biggest challenges are defensibility and negative network effects. The fee structure is similar to lending businesses, but the underlying business mechanics are different.
Fees Paid = Deposit size * Profit earned by depositor * Performance fee (%).
The reason I include deposit size here is that the more funds a yield aggregator has, the less yield it generates for other users. In fact, it has a negative network effect!
As a yield aggregator, you definitely want to have a large pool of funds so that you can earn more profits and capture performance fees. The only challenge is that you don’t want too many funds because you will have trouble generating growing profits for all your depositors, which will reduce your performance fees.
The biggest challenge you face in order to increase the profits earned by depositors is that any strategy you deploy on-chain can be copied by anyone - and very quickly. And, you are squeezed on both sides.
Performance fees. This is also a very difficult vector to optimize because any percentage you charge your depositors, they can technically cut you out and go directly to the source. It's like LPs investing directly in startups that their VC fund discovered.
Conclusion
As you can see, each crypto primitive provides a business very similar to what you see in the real world, but with slightly different mechanics due to the slightly different nature of the environment they operate in. Furthermore, the relationship between cost and profit is a nuanced one, in which there is an element of “incentive elasticity”.