The TradFi incumbent advantage
We know that web3 is a better foundation for the financial system, but better doesn’t mean it will be adopted.
TradFi is centuries old technology, and that gives it enormous incumbent advantage. Founders working in DeFi are consequently at a disadvantage in many dimensions. If you are starting a DeFi startup, you need a clear-eyed understanding of these disadvantages, and plan your business to mitigate them as best you can.
TradFi advantage #1: The 99.9% problem
99.9% of global GDP is on TradFi.
If you are a DeFi startup, and your company is premised on the transactional use case of money, you are off the bat shrinking your total addressable market by 1000x.
The economic activity naturally taking place on blockchains is limited to darkweb, drugs, NFT purchases, GameFi, and some API purchases. Everything else is TradFi. While cryptocurrencies have hit the mainstream for speculation and store of value uses of money, they are still a niche application for the transactional use case.
You can observe this effect empirically. Look at the top cryptocurrency startups, both centralized and decentralized. They all deal with either speculation and store of value (exchanges like Binance and Coinbase), or they deal with unit of account (stablecoins like Tether and USDC). The only crypto unicorn dealing with the transactional use case is OpenSea (NFTs) and various darkweb markets.
Founders have a few choices here. You can do a DeFi idea that does not build on top of transaction flow: focus on speculation and store of value, or maybe a new stablecoin. This takes you down a tried and true path, but you’re also facing crowded competition. Alternatively, you can look at bridge services. Credit cards that let you spend your crypto are one example. Finally, you can target the 0.1% of global GDP that is on the blockchain, and wait for it to grow.
TradFi advantage #2: The mother of all network effects
Marketplace startups are the hardest to build, and also the most valuable. The network effect from a marketplace means users will suffer through terrible UX to play where all the activity is. Ebay is the ultimate example.
There is no stronger network effect than the existing financial system. Every normal person on the planet uses the TradFi payment system and TradFi financial services. Credit cards are universally accepted, fiat currency is universally accepted, stock exchanges work with banks, and so on.
Anything from DeFi is incompatible with the current, actually deployed financial system. Examples abound: your Compound.finance loan does not build your credit score, your Coinbase account can’t receive paycheck deposits, and USDC is not accepted at SafeWay.
It is a small miracle that DeFi exists at all, and a testament to just how terrible the traditional system is.
Founders in DeFi need to mitigate the network effect somehow. There are two options, each with pros and cons.
The first is to be completely independent of TradFi. Uniswap, Aave and Liquity are examples of this approach: they all have zero knowledge of the TradFi system. This approach lets you operate in the technically clean world of web3, but it also limits you to a tiny fragment of global transactions (see #1 above).
The second option is to offer bridge services. Tether and Goldfinch are examples of this approach: they provide a tool that interfaces between the two systems. This approach opens up a huge market, but at a cost: you are now afflicted with all the pain and dysfunction of TradFi banking.
TradFi advantage #3: It is the default
Nobody makes a choice to use TradFi. They use it because it is the default system, and they don’t care about alternatives.
Choosing the default has many advantages. If you choose the default, you are blameless if the default has problems. Choosing the default takes no thought, and lets you focus on other things. Everyone else chooses the default, which gives you safety in numbers.
Fortunately this challenge is common to all startups, and we can borrow from the standard Silicon Valley playbook to address it: focus on underserved markets, understand your users, focus on pain points and mitigate objections. This is why Goldfinch is targeting African and Latin America: their banking services are poor compared to United States and Europe.
Similarly, if you can offer a 10x better experience, even if it has a 10x downside, do it. MakerDAO loans have a 10x better experience in that loan approval is instant and purely in crypto, and this appeals to a subset of the lending market that is willing to tolerate the 10x downside of liquidation risk.
TradFi advantage #4: Production tested
Everyone has a plan until they get hit.
I love to criticize TradFi for all its flaws and mountain of kludges, but nevertheless it has a huge advantage: TradFi is production tested. It has been deployed in the real world, processed trillions of every unit of currency, millions and millions of daily transactions, and lived through euphoric bull markets and deep crashes. However badly the system works, it does work.
By contrast cryptocurrency is brand new, and barely tested. Bitcoin is a literal teenager. Ethereum is still in grade school. This past month we are seeing the first liquidity crisis in DeFi, and the numbers aren’t even in the billions. TradFi banks laugh at a billion dollar liquidity crunch.
And if you are a DeFi founder, this applies doubly. Your product, by definition, is completely untested. Maybe it performs under stress, maybe it doesn’t. It’s one thing for a web 2.0 startup to be untested. The risk factor for those is an embarrassing photo or a missed meeting. A bug in a new DeFi protocol can easily lose hundreds of millions of dollars.
There is no real answer here for DeFi founders. You can be careful when you code, but how will your customer know if you were careful enough? You can get your code audited, but didn’t save Wormhole. And even if your code is perfect, market conditions can wreck you.
TradFi advantage #5: Clear regulation
TradFi banking and money services have decades and decades of established practice around regulation. The legal risks of acting in TradFi are well understood and unsurprising. This benefits businesses who may be comfortable with other risks (market risk, execution risk, etc.) but do not want exposure to legal risk and associated jail time.
In comparison, the regulation around DeFi is unclear and subject to random enforcement.
On the unclear side, look at the most basic question in DeFi: are ERC-20 tokens securities under US law? If the answer is yes, then you cannot sell them to US persons. Some of the tokens are certainly securities, and some probably not. But no one can know with certainty which is which, and they are all available for purchase by anyone on Uniswap.
On the random enforcement side, just look at the FBI’s charge of an OpenSea employee for insider trading. Out of all the fraud, money laundering, and ponzis taking place in cryptocurrency, why did the US government go after a low level startup employee making a few hundred thousand in profit? The answer is the US government doesn’t know what it’s doing, and they are acting randomly in who they target with enforcement
DeFi founders have two takeaways here. First, protect yourself legally as much as you can. Be aware that the regulation is unclear, and the enforcement can be random or arbitrary. Limit your personal liability. Second, understand the legal implications in your dealings with customers. If you are Uniswap, what happens when someone lists a security on your protocol? If you provide a service to TradFi, understand their regulations and how it interfaces with the uncertainty in DeFi.
Slowly and then all at once
The advantages above are all incumbent advantages, not inherent advantages. Incumbent advantages are based on Metcalfe’s law, and Metcalfe’s law is a double edged sword. The value of a network increases super-linearly with growth, and it also decreases super-linearly as a competitor takes market share.
DeFi has shown sufficient inherent advantage over TradFi to gain a foothold, and as it grows, TradFi’s incumbent advantage will decrease super-linearly.