How to build a moat in web3
The playbook for competitive moats for traditional companies has already been written. Hamilton Helmerâs â7 Powersâ has emerged to be a popular favorite, but other frameworks abound.
When youâre building in web3, youâre (hopefully) buying into the web3 ethos: open, permission-less innovation and avoiding user lock in. Youâre building, knowing full well that anyone can fork your code, copy and paste it and even vampire attack your users. Not all of the seven powers work in web3.
So which powers do work in web3? How do you build a competitive moat? How can you make sure that the problems that have plagued incentivizing open source and public goods funding doesnât afflict you?
Table of contents
- How to build a moat in web3
- Wen Token?
- The 5 power framework for web3 moats
- 1. Brand
- 2. Economies of scale and flywheels
- 3. Network effects
- 4. Viral go to market
- 5. Non extractive mindset
- How to build web3 moats
Wen Token?
Tokens have been a popular choice: offering an economic incentive to contribute, build and stick to a specific platform. Marc Andreessen has said it outright: that tokens add an economic layer to web protocols.
Unfortunately, weâve seen tokens fail time and time again. Apparently, using purely economic incentives for behavioral change is harder than it seems (for reasons Iâll discuss elsewhere)
So beyond a token, how can web3 protocols and companies build competitive moats that help them capture part of the value theyâre creating?
Below is a âfive powerâ framework on moats that web3 projects can utilize, beyond tokens. Iâll explore each one and use Uniswapš as an example for each of the five powers. These arenât unique to web3 companies, but each has unique aspects in implementation for web3 projects vs web2 companies.
I hope this framework will help entrepreneurs evaluate their projects, moats and long term viability and encourage the disuse of tokens when theyâre not needed.
The five powers are:
- Brand
- Economies of Scale
- Network effects
- Viral go to market
- Non extractive mindset
The 5 power framework for web3 moats
1. Brand
Brand in web3 is critical. Despite being a âtrust-lessâ system, the reality is that web3 is the Wild West. New projects are launched each day. Some are real, some are stupid, some are well intentioned but faulty and some are outright scams. Itâs impossible to sift through the noise, especially when to really understand and verify a protocol you have to go layers deep.
For example, you could dive deep into Aave, a trusted protocol, verify everything about it including the sources of liquidity, code and team, and still miss that they rely on Chainlinkâs oracle for their only price feed. And Chainlinkâs feeds are controlled by one 4/9 multsig. Your entire due diligence is useless without understanding that one fault. And this is a good case, with a well trusted brand. Most people donât have the time or ability to dive into protocol and smart contract details and rely onâââbrand.
This is why trust in web3 is so critical. The Lindy effect, which states that the longer something survives the greater its chances of are of continuing to survive, has never been more true than in web3. The longer a project is out there and hasnât suffered a breach, a hack or a scam, the more trustworthy it is.
In web2 you might be tempted to try the newcomer. In web3 you donât mess aroundâââyou go for the blue chips or risk losing your funds.
Brand matters in a world thatâs built on trust where trust and legitimacy is a scarce asset.
While in web2 being first to market can mean releasing a glitchy MVP and seeing a fast follower catch up, in web3 it means earning trust, especially when youâre the team inventing a new protocol design.
It means that your brand is whatâs recognized with the innovation, that youâve had the most time to build, test and iterate and have the deepest understanding in the space. All of these build trust.
Uniswap Example
While many DEXs have forked the original Uniswap contract, Uniswapâs brand is still by far the most trusted and well known DEX brand out there. More tokens are swapped on Uniswap than any other competitor DEXs, despite having been forked and vampire attacked. The ecosystem knows that the Uniswap team are the OGs, are the original innovators and the first to market with new innovations. Theyâve built up and earned trust.
Builder questions:
- Will my brand be recognized with my project?
- Is what Iâm building a project where trust matters?
2. Economies of scale and flywheels
Throughout the 20th century economies of scale were a major moat. In the web2 SaaS world, itâs been left along the wayside. It matters far less to a B2B SaaS built on AWS how many clients it services (although for businesses like AWS economies of scale matter quite a lot).
Web3 protocols can be far more similar to AWS than your classic B2B SaaS. One of the key features of web3 is tokenization and bringing liquidity to where there previously was none. Liquidity follows economies of scale. The more liquidity you have, the easier it is to get more liquidity and the easier it is to build other products on top (Itâs not a classic network effect, as nodes in the network donât necessarily gain a benefit the more nodes join).
Uniswap Example
Uniswap liquidity pools benefit from economies of scale. Liquidity begets more liquidity, and they can offer deeper liquidity in their pools and therefore lower slippage costs than any other DEX, which in turn causes more users to swap on Uniswap.
Builder questions:
- What economies of scale can I offer?
- What product or service uniquely benefits from being an early mover in this space?
3. Network effects
Network effects are always tricky. Both in web2 and web3. If you can achieve them, itâs a huge competitive moat, especially for an early mover. Web3 network effects arenât very dissimilar to web2 ones. You first have to understand who or what are the nodes in your network and based on that, work to incentivize those nodes to join. Remember, the definition of a network effect is that the value of the network grows with each additional node, like a telephone network (many companies confuse economies of scale, or flywheels with network effects).
Does Web3 lend itself better to NFX? Iâm not convinced. Web3 is all about ownership and ownership and social networks or network effects donât necessarily go together. Thereâs also an anti network effect at the blockchain level, where more demand, i.e nodes on the network, actually drive up congestion and prices in the form of gas fees. You have to carefully examine your product and natural ânodeâ to see if there is a network effect.
Uniswap Example
Uniswapâs core ânodeâ is a liquidity pool. The more pools, the more utility one gains from using uniswap as a whole. If there was only an ETH<>USDC pool, there wouldnât be much utility. Each additional liquidity pool (USDC<>DAI, DAI<>WBTC etc) adds utility to the network as a whole and to each new user. Be aware that after covering the top XX liquidity pools, adding new nodes has a marginal benefit (similar to adding the billionth Facebook user)
Builder questions:
- What are the nodes in my network that gain value the more nodes join my network?
- Is there a way I can leverage these nodes for my go to market?
- At what point does my network effect taper off?
4. Viral go to market
Some of the best web3 use cases lend themselves naturally to a viral go to market which is an incredibly powerful moat. These use cases tend to be âutilitiesâ: foundational building blocks of the web3 ecosystem. These are building blocks, âweb3 legoâsâ that other protocols use in what theyâre building and drive users to your protocol.
Utilities can be DeFi primitives, oracles or even game elements². Itâs essentially a viral B2B2C go to market.
Uniswap Example
Uniswap enables other protocols to add liquidity to their projects, and the easiest way to do that is byâŚcreating liquidity pools with Uniswap! By building a utility for other web3 projects, those projects then send users back to Uniswap. Naturally, the more projects integrate Uniswap, the more brand, economies of scale and network effects come into play.
This is where permission-less innovation shines through and web3 gives monetization options to things in web2 that didnât have any. Open source libraries are just as critical building blocks in web2, but they donât benefit from the same market forces that web3 enables.
Builder questions:
- Is what youâre building a utility?
- Will other projects integrate what youâre building and thus drive more ânodesâ to your network?
5. Non extractive mindset
While the first four elements of this framework exist in web2, this last one is uniquely web3. Web2 companies achieve customer lock-in through non portable data, closed software and organizational practices (not that these are necessarily badâââjust different). In web3, thatâs not the case and anyone can either leave your protocol, or worseâââfork it and compete. With the added benefit of having a complete list of all of your users and early adopters. The only way to avoid forks and vampire attacks that compete directly with what youâre building is by adopting a non extractive mindset. If youâre extracting unneeded rent, thereâs room for a fork that will compete those margins away. By adopting the Bezos mindset of âyour margin is my opportunityâ and assuming from the get go a âlow marginâ protocol, youâre avoiding future forks and competition and increasing your moat.
Uniswap Example
Uniswapâs swap fee is incredibly low. So low that itâs borderline worthwhile to be a liquidity provider, and thereâs not much room for Uniswapâs âtake rateâ. Had Uniswapâs fee been much higher, the incentive to fork and implement a lower fee fork would have been high and Uniswapâs margin would been cut.
Builder questions:
- Whatâs the lowest extractive fee you can set that maintains your business but prevents forks?
- Who can fork your project and how?
- Why will they fork your project?
How to build web3 moats
If youâre wondering how to build a moat in web3, this âfive powerâ framework offers a way to think about it. Look at your project through the lenses of:
- Brand
- Economies of Scale
- Network effects
- Viral go to market
- Non extractive mindset
Each one has a unique way to shine in web3 projects that doesnât exist in traditional businesses. Leverage those differences.
Footnotes:
- I use âUniswapâ interchangeably between âUniswap.comâ, the frontend built by Uniswap Labs, (the Uniswap company) and the Uniswap protocol/smart contract that other protocols and projects use regardless of their frontend. The core idea is that the backend uses the same Uniswap contract, which accrues the Uniswap protocol fee.
- The best example of what almost (and still might in the future) worked here was âLootâ.
- David Phelps has a good twitter thread on moats in web3.
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