Understanding User Dynamics in DeFi

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This research was originally posted on October 16, 2022.

Most of us don't understand the user dynamics in web3, especially in DeFi.

Let me show you how user dynamics affect any DeFi platform you use.

In DeFi, three factors determine the motivation for a user to use that said platform:

  1. Participation cost: Do I need to hold the native token or incur a participation cost to meet potential trade counterparties (i.e., to join the community)

  2. Transaction motive: How many tokens do I need to hold and/or stake (which depends on platform liquidity) to get a voting share of the platform?

  3. Investment motive: How can I leverage my participation cost to benefit from the expected (increased/decreased) future token price?\ This motive splits the community into two parts: short-term & long-term HODLERS.

This split is a crucial factor to consider because this determines the kind of investment strategies users use on the platform.

With this, the platform achieves two important things:

  1. It allows for interesting dynamics (e.g., HODL, variable speculators) within the platform.

  2. It allows for the platform ecosystem to self-regulate. (e.g., adaptive governance, boundaries b/w investment strategies, etc.)

Currently, most platforms lack this motive due to

  1. the implicit (lack of) participation cost (e.g., high token price on any excellent performing asset pair, undefined governance or roadmap, etc.),\ or

  2. the unrealistic (lack of) investment motive (e.g., ETH/USD parity, strict tax regulations, etc.), which leads to the concentration of funding over the platform; users that are often termed as "whales".

Trading platforms rely on strong investment incentives to attract users. The speculative nature of the market allows investors to borrow on one token and recoup their investment with abnormal % returns in a short time.

This is not always realistic in a DeFi setting.

Another form of restricting profitability is a capital risk, i.e., $10k/user is too much to invest in the marketplace to realize a substantial return. Too big of a network effect to allow a beginner to create a product whose integration requires specialized implementation.

DeFi platforms must balance network effect with more technical implementation (e.g., smart contract adaptation) needed to create value for the user.

As we advance, we will see more crypto uses cases as a currency for value transfer. However, it will be more for payments and less as a speculative asset.

The hope is to enter a new economic era in which speculation is replaced by production, and research gives way to testing.

To summarize:

New user adoption exhibits an externality on others, but the investment motive also introduces an emphasized situation where two things improve or worsen in the existing user base.

The inverse is significant enough to form a network effect.

The strong network effect triggers the declining network cost, which in the long term impacts the attraction of long-only investment in the ecosystem.

Thank you for reading through. I’d appreciate it if you shared this with your friends who would enjoy reading it.

You can contact me here: 0xArhat

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