Ryan Chern

DeFi vs L1 Token Economics

2021 was a great year for crypto. Amongst a sea of others, Solana stood out among the L1 crowd by garnering outsized attention for its astronomical price increase and its low transaction costs.

However, DeFi tokens did not enjoy the same price increase/value capture (e.g. Uniswap, Compound).

Because DeFi tokens are (typically) a “governance token” — providing no future rights to cash flows, etc. — they are priced and not valued.

To be sure, governance tokens do direct the direction of the protocol but I would argue that this is effectively meaningless. More on this in a later post.

L1s, on the other hand, can be valued by the present value of discounted future cash flows on that chain. What are those cash flows?

MEV (for the most part).

What is MEV?

MEV stands for Miner Extractable Value. To use an analogy, MEV is to crypto as HFT (high frequency trading) is to TradFi. As an oversimplified explanation, they pursue arbitrage opportunities to keep prices across assets in equilibrium. The key difference between them is that HFTs are predicated on speed/co-location to servers (Michael Lewis’s Flash Boys was dedicated to exploring this) while MEV is predicated on staking/validators (in a POS system).

In a world where POS becomes the dominant consensus mechanism (which it likely will), L1s become the dominant value capture mechanism because they are directly correlated with “you” (the arbitrageur) winning the “block”. And as the winner of the block, you can choose your arbitrage transaction as the transaction and the ordering of the other transactions of the block.

Paradigm wrote about this trend a while back, noting in a blog post that “[t]he rate at which MEV accumulates on a given blockchain is generally proportional to the complexity of its application-layer behavior.”

Applications in crypto have only gotten more complex over the past year. Just in DeFi, we can see new protocols for decentralized on-chain options/perpetual futures (PsyOptions, Mango) and algorithmic stablecoins (UXD). The proliferation of composable applications is growing and will very likely keep growing at an incredible rate, especially as transaction throughput increases across L1s.

This means that MEV is only going to become a more important part of the narrative even though normal users may only feel the effects through an “invisible tax” via artificially increased prices across assets.

The Future of MEV

It will be worth keeping an eye on MEV activity via not only on-chain metrics but also the quantity of institutional players spinning up MEV activity and the relative number/size of the teams. My base case/best guess is that what we see in TradFi today — consolidation such that a small number of firms receive the outsized profit (Citadel, etc.) — will also occur in crypto.

The dynamics of these groups — traditional hedge fund-type companies, DAOs, individuals — could look very different than TradFi but that also remains to be seen.