Cashflows in Crypto

There persists a widespread misunderstanding that crypto possesses no intrinsic value due to its absence of cashflows. I suspect this fallacy arises from the public tendency to equate crypto solely with Bitcoin, and Bitcoin with digital gold – “Since gold does not produce cash flows, so mustn’t crypto. Quod Erat Demonstrandum!”

The below chart shows the top 25 crypto projects by revenue in the past year. This makes it clear: crypto can generate revenues! Admittedly, the absolute level of revenues in the industry is still modest. But bear in mind that even the most mature projects in Ethereum-land or Solana-land are still in kindergarten or elementary school, contra the S&P500 constituents which have a median age of 52.

In this article, we examine four crypto protocols with distinct revenue models: Ethereum (earns transaction fees), Uniswap (earns trading fees), Lido (earns commission) and MakerDAO (earns net interest income). Let’s dive in.

1. Ethereum ($ETH)

a) What does it do?

For those unfamiliar with how blockchains and decentralised applications (DApps) work at a high level, I recommend my previous post on the Web3 Technology Stack. In general, a value exchange between two parties requires two key steps:

1) tallying up who owes what to whom (i.e. compute) and

2) validating that a transaction has occurred and updating the new account balance (i.e. consensus).

Simply put, Ethereum is in the business of selling these two key functionalities of compute and consensus to settle transactions. Because Ethereum is an open platform, any developer can build new applications on top of it called DApps (Decentralised Applications) to take advantage of the ledger’s secure settlement.

b) How does it make money?

Ethereum earns revenue through transaction fees, known as "gas fees". Gas fees are paid by users of DApps to have their transactions computed and stored on the Ethereum ledger. In the current state of the web, businesses bear the costs of compute and storage provided by cloud computing services like Amazon Web Services (AWS). In the blockchain world, users themselves shoulder these expenses, which are essentially Ethereum's revenues.

Just as revenues are determined by Quantity sold * Unit price, Ethereum’s transaction fees are calculated by Gas used * Price per unit of gas, where:

Gas is the measure for how much computational resource is required to process a transaction. Simple operations, like a user sending some ETH to another, have low gas intensity. Complex operations, like pricing derivatives with the Black-Scholes formula for an options protocol, are more computationally intensive and require higher gas.
Price per unit of gas is denominated in Ethereum’s currency ETH, specifically in gwei (a subunit of ETH). 1 billion gwei is equal to 1 ETH. Price per unit of gas consists of two components: the base fee, dynamically set by the network based on demand (higher during network congestion), and the priority fee, set by the user as a tip to the validator. Validators have the authority to prioritise transactions based on the gas prices offered (see diagram below). This means gas prices are determined through a competitive bidding mechanism where users compete to have their transactions included in blocks.

Putting it all together, Ethereum’s transaction fees paid by users is Gas * (base fee + priority fee).

For example, let's say Alice wants to send Bob 1 ETH. The transaction’s computational work is 21,000 gas, base fee is 10 gwei and Alice includes a tip of 2 gwei. Then Alice’s total gas fee would be 21,000 x (10 + 2) = 252,000 gwei or 0.000252 ETH.

Simplified flow of how user transactions get included in Ethereum

c) How has revenue progressed?

Ethereum saw a meteoric rise over 2020 and 2021, with revenues peaking in early 2022 at over 3.5 million ETH. In dollar terms, this was nearly $11 billion. Note revenue is much more volatile in $ due to the price volatility of ETH itself.

With the industry’s downturn in 2022, transaction fees have declined materially: >65% in ETH terms and >80% in $ terms. Increased demand and user adoption through useful applications will be required for Ethereum to regain momentum.

Transaction fees analysis by sectors is useful for gauging where demand is coming from. As the below chart shows, the primary demand driver is decentralised finance (DeFi).

What is DeFi?

DeFi (short for Decentralised Finance) refers to financial activities facilitated by blockchain technology. CeFi (centralised Finance) refers to the traditional financial system that relies on centralised intermediaries like banks.

In the early days of voice communication, the world relied on telephone operators to manually connect phone calls between parties. Eventually, the role of the middleman became obsolete as automatic switches and routing systems made it possible for people to connect calls directly.

The current financial system, in some ways, still operates like the old world of communications. Banks and other financial services are like telephone operators that connect parties to a financial transaction. Often transactions are slow (payment systems like SWIFT were built in the 70’s) and expensive due to middleman fees. Services can also be unavailable to those who live in regions without banks or do not meet the criteria to open accounts.

Blockchains like Ethereum have unlocked DeFi, which drives down costs and enhances efficiency by enabling direct, peer-to-peer transactions. DeFi also promotes financial inclusion, as users only require internet access to avail themselves of services. Numerous DApps automating trading, borrowing and lending have the potential to disrupt the global financial industry. We will next explore Uniswap, which is one of Ethereum’s leading DeFi application.

2. Uniswap ($UNI)

a) What does it do?

Uniswap is a DEX (Decentralised Exchange) platform on Ethereum. It allows users to trade cryptourrencies without the need for a central intermediary like Coinbase. All transactions are on-chain (executed and recorded on the blockchain) and non-custodial, meaning users have full control over their funds throughout the trading process rather than assets being held by the exchange.

Uniswap is the dominant player with >70% of the DEX market. Over time, DEX’s have been gaining market share from their centralised counterparts like Coinbase, Binance and Kraken.

b) How does it work?

Uniswap enables trading differently than for example Coinbase. Traditional exchanges utilise an order book, which lists the buy and sell orders of traders, then matches them based on compatible prices.

Uniswap on the other hand relies on liquidity pools. Liquidity pools are reserves of token pairs (e.g. ETH & USDC) which are contributed by Liquidity Providers (LPs). Anyone can become an LP by depositing an equivalent value of each underlying token. Traders then trade against these liquidity pools, rather than directly against each other. This design, called an Automated Maket Maker (AMM), has gained popularity in the DeFi ecosystem as an alternative to order book-based trading systems. Advantages of AMMs include no counterparty risk and lower barriers for becoming a market maker. A disadvantage however is that there could be a lack of price efficiency. AMMs operate based on a predefined mathematical formula to determine prices. As a result, prices offered may not always reflect the true asset value (although in reality, much of price differences gets arbitraged away by traders). This can lead to slippage and potentially unfavourable trading prices, particularly for larger trades.

The motivation for being an LP is to earn trading fees. When LPs deposit tokens into a pool, they receive LP tokens representing their ownership stake. As the pool accumulates trading fees, the value of LP tokens increases. LPs can redeem their tokens anytime to withdraw liquidity and claim their share of fees.

Consider the above example where an LP adds 10 ETH and 20,000 USDC (i.e. 1 ETH = 2,000 USDC) to an existing ETH-USDC pool. This create a pool with 100 ETH and 200,000 USDC, giving the LP a 10% share. The LP is entitled to 10% of the pool’s trading fees paid by the trader.

c) How does it make money?

Uniswap's fees are a function of Trading volume and Take rate.

Trading Volume: Uniswap, since launching in 2018, has facilitated ~$1.5 trillion in trading volumes. Trading volumes, which are positively correlated with crypto prices, have been negatively affected by the crypto market downturn.
Take Rate: Uniswap’s take rate has changed with version upgrades. V1 and V2 had a model of fixed 30 basis point (bps) fees, while V3, released in May 2021, introduced a tiered system consisting of 5 bps, 30 bps and 100 bps for different pools. This mix shift has compressed the average take rate from 30 bps to approximately 15 bps. UNI token holders can propose and vote on additional fee levels.

Currently, Uniswap directs all trading fees to LPs without allocating any portion to the Uniswap DAO/tokenholders. This strategy aims to strengthen its network effect and maintain a competitive edge over rivals, perhaps similar to traditional tech platforms’ reinvestment model of sacrificing short-term profitability to build a moat. The optimal allocation of protocol fees between providers of work (in this case LPs) and providers of capital (i.e. tokenholders) is a recurring debate in crypto communities. The Uniswap DAO has also previously discussed implementing a "fee switch" to redirect some fees to UNI tokenholders, but the proposal was not passed due to concerns about timing and the resultant liquidity levels. An added concern, particularly in the US, is whether sharing fees with the UNI holders would classify Uniswap as an unregistered security. As Uniswap solidifies its network effect and regulatory clarity improves, the fee allocation strategy may evolve.

3. Lido Finance ($LDO)

a) What does it do & how does it work?

Lido Finance is the leading liquid staking provider for Ethereum and other Proof-of-Stake blockchains. To understand what liquid staking is, let us revisit what staking is first.

What is staking? In a Proof-of-Stake blockchain, staking is a process where individuals pledge their tokens as collateral to safeguard the network. Validators, responsible for processing user transactions and earning the associated fees, are required to commit to honest behaviour by staking their tokens. If a validator behaves maliciously, their staked tokens are taken away or “slashed.” The collective value of all of the tokens at stake represents the overall security of the network; when there is a higher value at stake, validators have a stronger incentive to act honestly. At the time of writing, Ethereum’s tokenholders have staked 17% of the total ETH supply (20.89 million out of 120.21 million tokens). This translates to nearly $40 billion of security for the Ethereum blockchain. Staking yield is simply the validator’s fees divided by the value of the tokens staked. Currently the staking yield is around 5.5% for DIY validators.

Challenges with staking: Staking faces two main challenges. Firstly, most tokenholders lack the technical knowledge to become a validator on their own. As a result, they often rely on staking-as-a-service providers, who run validator services for a portion of the staking yield. Secondly, while a higher staking ratio enhances blockchain security, it reduces the number of tokens available for on-chain transactions.

Liquid staking as a solution: Liquid staking protocols like Lido aim to address these challenges. Tokenholders can outsource their staking responsibilities to Lido, which works in the background with reputable node operators to run Ethereum validators. Additionally, Lido tackles the liquidity problem by issuing liquid staking tokens (LSTs) to stakers. These LSTs represent the value of the staked tokens and can be freely traded or used in other DeFi applications.

As the diagram shows, a tokenholder who deposits 1 ETH with Lido receives 1 Lido Staked Ether (stETH). stETH is a liquid staking token which trades nearly on par with its underlying asset, ETH. Currently there is $14 billion worth of stETH in circulation, making it the 7th largest token by market capitalisation. stETH has gained widespread acceptance as a currency and collateral in Ethereum DeFi, contributing to Lido’s network effect. Lido currently holds over 30% of the Ethereum staking market share, surpassing its closest competitor Coinbase which holds 10%.

b) How does it make money?

Lido's revenues are a function of ETH deposits and ETH staking yield.

ETH deposits depend on the amount of ETH staked and Lido's market share. Since Ethereum's Shapella upgrade in April 2023 enabled stakers to withdraw their staked ETH for the first time, staking participation has risen from 15% to 17% in just over two months. During this time, Lido has marginally gained market share from 31% to 32%.
ETH staking yield consists of Consensus Layer and Execution Layer Rewards. Consensus Layer rewards depend on the amount of ETH staked and follow an algorithmic formula (166.323 x sqrt(# of ETH staked)). As more ETH is staked, Consensus Layer rewards decrease. Execution Layer Rewards are influenced by the demand for Ethereum transactions and can vary based on network traffic.

Lido allocates 90% of protocol revenues to stakers and divides the remaining 10% equally between node operators and the Lido DAO's treasury. LDO tokenholders collectively own the treasury and vote on how the funds should be utilised to further develop the protocol.

4. MakerDAO ($MKR)

a) What does it do?

MakerDAO, founded in 2015, is a bank built on Ethereum. It offers instant secured loans. Secure lending refers to a type of lending where borrowers provide collateral to take out a loan. The collateral acts as a form of security for the lender; if the borrower fails to repay the loan, the lender can seize and sell the collateral to recover the outstanding debt. A common example of secure lending is a mortgage. Homeowners can get a loan in USD from a bank by pledging their house as collateral.

Similarly, MakerDAO users borrow Dai (Maker’s stablecoin soft-pegged to USD) by locking up their crypto assets such as ETH or BTC as collateral in Maker’s “vault.” Due to crypto’s volatility, MakerDAO requires overcollateralisation, meaning users must offer more collateral value than the borrowed amount.

Like mortgages, Maker vaults have a maximum Loan-to-Value (LTV) determined by $MKR tokenholders based on the perceived collateral risk. Below are the top five Maker vaults with their maximum LTVs and current borrowing rates. If a borrower exceeds the LTV limit, their position is liquidated to cover the debt.

What are stablecoins? Stablecoins are digital assets that are pegged to government-backed currencies. They bridge the gap between traditional economies and blockchain-based systems. Dai, with over $4 billion in circulation, is the third-largest stablecoin with 3.5% market share.

The stablecoin market is primarily controlled by USDT and USDC, issued by centralised entities Tether and Circle. In this centralised model, Tether and Circle must maintain an equivalent amount of asset backing in their bank accounts for USDT and USDC minted. Users need to trust that these institutions hold 100% reserves consisting of high-quality assets. External audits can provide some assurance but ultimately these institutions must be properly regulated.

In contrast, Maker's reserves - the crypto collateral backing Dai - are visible on the blockchain. This transparency distinguishes Dai from its centralised counterparts and showcases one of the strengths of DeFi.

b) How does it work?

Maker’s lending activities are automated through smart contracts. They consist of:

Issuing Debt: Maker takes in crypto assets as collateral and issues new Dai loans against the collateral.
Debt Repayment: Borrowers repay the debt (Dai), including accrued interest (called stability fees) which generates lending income for Maker.
Liquidation: In case the collateral value drops below the allowed limit, Maker executes a liquidation process. The collateral is automatically sold, recovering the principal loaned, accrued interest, and a liquidation fee. The remaining collateral value is returned to the borrower.

To maintain Dai's peg to USD, Maker uses three mechanisms:

Stability Fee is the variable interest rate that borrowers pay to borrow Dai. The rate can be adjusted by $MKR tokenholders through governance voting to help steer Dai towards the peg.
For example, if Dai > $1, increasing the stability fee reduces Dai demand to nudge Dai’s price down towards $1. Conversely, if Dai < $1, decreasing the stability fee stimulates Dai demand to nudge Dai’s price up towards $1.
Dai Savings Rate (DSR) is the interest Maker pays to users who lock up Dai. DSR can also be adjusted by $MKR tokenholders to help steer Dai towards the peg (but in the opposite direction as the stability fee).
Peg Stability Module (PSM) is a special vault that allows users to exchange other stablecoins for Dai (e.g. deposit 1 USDC into the PSM to get back 1 Dai) and vice versa. With PSM’s functionality, any deviations of Dai from the peg presents an arbitrage opportunity for traders, who can exploit it to bring the price in line.
If Dai < $1, arbitrageurs buy Dai in the secondary market, deposit Dai into the PSM and get 1 USDC for a profit. This action burns Dai (i.e. reduces Dai supply), pulling up Dai price closer to $1.
If Dai > $1, arbitrageurs deposit USDC into the PSM to mint 1 Dai and sell the Dai in the secondary market for a profit. This action mints Dai (i.e. expands Dai supply), reducing Dai price close to $1.

In summary, Maker and its tokenholders use rate-setting (strategy 1 & 2) to adjust the supply and demand of Dai to help maintain the peg. They also rely on arbitrageurs and the PSM (strategy 3) to absorb any short-term deviations from the peg. This approach has proven effective in maintaining the soft-peg over the years.

c) How does it make money?

Maker has three sources of revenue:

Net interest income: The difference between the interest Dai borrowers pay (stability fees) and what Makers pays to Dai savers (the Dai Savings Rate)
Liquidation income: Fees paid by borrowers when their loans are liquidated, typically exceeding 10% of the loan value. These fees discourage liquidation and cover associated costs.
Trading fees from the PSM.

In 2022, crypto market deleveraging led to reduced demand and lower stability fees for crypto-backed Dai loans. To compensate, Maker has increased Dai loans backed by Real World Assets (RWAs), mainly short-term US Treasury ETFs. This shift has substantially boosted Maker's revenues, which estimated at ~$85 million on a run-rate basis.

Conclusion

Tokens, like stocks and bonds, can have cashflows supporting their intrinsic value. Crypto, previously the domain of speculators and retail gamblers, is arguably entering a phase of maturation that enables analysts to evaluate the fundamental value of projects.

Blockchains are a foundational infrastructure facilitating frictionless value transfer over the internet. And DApps built on blockchains are akin to internet-native businesses with unique revenue models, cost structures, competitive advantages, capital allocation strategies and valuations. As blockchain-based economies progress, we anticipate token prices to align with project fundamentals in a valuation-conscious manner.

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