Profit Models Unmasked

Originally a thread on X/Twitter:

Have you ever used a product and wondered how the business behind it is making money?

The answer should be obvious for financial products so when it’s a mystery you better watch out.

Here’s why this matters in #crypto and #DeFi in particular:

Financial service products are incredibly basic on the surface and very complex behind the scenes.

They typically solve problems in one of five major categories: Storage of money, movement of money, lending of money, investing money and transference of risk.

It doesn’t take a genius to figure out how most Banking products work and how they make money.

To be clear, building and managing a financial services product isn’t always easy, but understanding how profit can be generated by a well-managed product is.

For instance, the most popular of all financial products is the storage and protection of money (deposits).

This is a hugely valuable product and most customers don’t appreciate that it’s a service they should be willing to pay for!

By allowing money to be stored and accessed digitally, Banks have taken on responsibilities that otherwise would have to be managed directly by consumers and business owners.

Imagine the risk you’d be assuming if you were forced to hold all your money in physical fiat currency.

You’d have to securely store and pay for security to prevent thieves from stealing your money. You’d have to pay for insurance to reimburse losses due to tragic events like fires and floods. You’d have to assume the risk that the fiat currency you have isn’t counterfeit.

Given all the benefits that a Bank provides for storing your money, why do they PAY YOU to store your money? It’s a strange concept when you stop to think about it.

The answer is that they have a multi-pronged business model that can make money using your money.

The first prong: Payments

Banks make money when money is moved out of your account through certain channels. For instance, debit cards runs over Visa/MC rails and Banks capture revenue. Guess who pays for this? Businesses do.

The second prong: Lending

Banks make money by lending money to consumers and businesses. Well managed lending businesses are the bread and butter of profitability at most Banks but they need a stable source of capital to back the loans. A good source of capital is deposits.

So when a Bank pays you to entrust your money to them it’s a rational decision backed by an understandable business model. They can only afford to pay out an amount that’s less than the amount they make using your deposits, but the model is solid and resilient.

This leads us to #defi and the absolute, unconditional, mandatory, vital, essential, compulsory need for investors to do the work to understand how a dApp makes money.

Investing capital without an understanding of how it will be used is a recipe for disaster!

It’s a good start if a dApp is backed by a business model that generates more cash than it pays out.

But it’s important to go through the exercise of understanding how safe your money is and what events would have to occur to impair your investment.

Don’t be lazy. Do the work.

But what if the profit model isn’t obvious?

Multi-Stage Model

It’s possible that you’re investing in a risky “multi-stage” business. In these models, Stage 1 is focused on adoption and functionality build. Stage 2 is focused on monetization.

If you’re involved with one of these businesses, you’re getting paid to be a guinea pig.

And if you’re involved with one of these businesses you need to know how safe and secure your investment is. If adoption slows or the model fails, will your investment be impaired?

Adoption Model

Some dApps pay you to switch your business from another platform to theirs.

If you’re involved with one of these businesses, rewards are a substitute for marketing expenses with the expectation that you’ll continue using the service once you try it.

Is the new platform superior to the old platform and therefore will be sticky? If adoption slows, what happens? Are the rewards “free” or are you being enticed to stake capital to earn additional returns?

These are things you need to study and internalize.

Please Look At The Shiny Object

It’s also possible that when you dig into the economics of a dApp, there’s an obvious shift of value “upstream” from new users to older users (or directly to the Founding team) without any underlying business that supports the exchange.

If you’re involved with one of these businesses then you need to internalize that you’ve made a mistake.

Paying existing investors with funds collected from new investors is a Ponzi scheme. Requiring a constant flow of new money to survive can’t last forever.

So when you see dApps that pay crazy yields or tokens with economic incentives that seem too good to be true, the obvious next step is to ask “is it rational?”

If you can’t figure out where the incentives are coming from and why they’re durable then you should just move on.