The End Of The Beginning for DeFi: 2.0 is Coming

In his famous 2018 talk, The End of The Beginning, Benedict Evans laid out his view on the large-scale phases of the internet. See if you can spot some analogues with crypto:

“If we think about the first 20 years of the internet, we really did, kind of, the easy things. It didn’t feel terribly easy at the time… but what we did was things that worked with low penetration [ie. low % of society using the internet] and low amounts of capital. It would work with consumers who weren’t comfortable buying online so they were kind of low-touch goods, things you didn’t have to hold in your hand. We tended to build tools rather than build entire stacks. We tended to build information arbitrage. We did sort of price comparison, and plane tickets. Now we do things that need high penetration and lots of capital. We invert all of these assumptions.”

As an example, Evans compares Yelp (first wave) with DoorDash (second wave). Yelp is a tool. It sells information about restaurants to consumers. DoorDash has to manage a three-sided marketplace, including real-time logistics, across an array of independent restaurants nationwide. As Benedict says, “that’s a different kind of business with different assumptions about what the internet looks like”. I believe we’re currently watching crypto make a similar shift.

If you’re familiar with the “S-curve of innovation”, we are cresting the top of “Crypto 1.0”, and simultaneously starting the bottom of “Crypto 2.0”

Crypto 1.0 → 2.0

“Crypto 1.0” — with canonical examples like Uniswap, Compound, and Yearn — are mostly tools that enable financial arbitrage and trading. They are defined by being: 1.) Crypto native, (i.e., only interacting with other parts of the crypto world) 2.) Anonymous, and 3.) Fungible / aggregated.

Many of these traits were driven by technological constraints. Highly expensive L1’s pushed anonymity because requiring much storage per user was too expensive. Similarly, aggregation and fungibility spread out precious gas costs among many users. And DeFi was too new to ask the real world to onboard, so you had to target ‘crypto native’ users.

But the advent of blockchain scaling solutions, plus the increases in usability and social penetration (i.e. crypto DAU’s) are loosening those technical and social constraints. Combined with the building blocks that we earned in 1.0 (e.g. stablecoins, money markets, DEX’s, dev tooling, dApp UI patterns), new crypto companies can come in with “different assumptions about what crypto looks like”.

This new “Crypto 2.0” will be defined by three things:

1.) Real world interactions, 2.) Reputation, and 3.) Less Fungibility.

Let’s dive into each. First, real world interactions — 99.99% of the economy is still in the “real world”. Crypto must start pushing into this realm — or pulling it in — to expand.

Secondly, reputation will be used in all sorts of ways. Stars will use their reputation for NFT’s. Companies will use it to get loans at good rates. Users will build up on-chain reputation for identity purposes. Fund managers will be incentivized to build on-chain track records to attract capital. The list goes on. While pure anonymity will always be prized among some investors, the benefits of reputation are simply too great to ignore for everyone else.

The last piece is less fungibility. This will happen for two reasons. The first is simply that there will be way more tokens to invest in, meaning more fragmentation and therefore less fungibility. Right now, it’s mostly just crypto projects that have tokens. But Crypto 2.0 is enabling their customers to have tokens too. We’re already seeing celebs mint tokens, corporations creating their own debt pools, and thousands of people on BitClout automatically getting their own token on signup.

The second reason for less fungibility is the inexorable logic of efficiency. Enabled by cheaper gas, this will lead to more user specific positions and investment options. Uniswap V3 is a perfect case in point. They moved to non-fungible liquidity positions because the capital efficiency is worth the trade off. Or take things like Curve offering differing tiers of governance power based on how long you lockup their token. Economically speaking, these are strictly better. Uniswap does more volume with less capital, and Curve weights governance power towards long-term aligned users, and away from short term holders. Once you give users any choice, you break fungibility. But you get efficiency in return, and efficiency always wins.

What Will Crypto 2.0 Look Like?

We’re already seeing the beginnings of Crypto 2.0 across multiple verticals. For example, let’s think about NFT’s. The Crypto 1.0 version was CryptoKitties, which was art that wasn’t created or signed by any real person, and was sold to crypto native users.

But earlier this year, we saw glimmers of the Crypto 2.0 version. We saw celebs like Grimes and Kings of Leon selling NFT’s for songs and albums. That checks a lot of the boxes: 1.) Real world celebs, 2.) Less fungible (in fact, non fungible!), and 3.) Relies on reputation to create value. Initially, these celebs are still selling to crypto natives. But the rise of L2’s, increased social awareness, and continued integration of NFT’s into the wider web will bring on millions of non crypto-native people.

Or lending: The crypto 1.0 version is Compound, Aave, Maker. They’re anonymous, crypto native, and use aggregated pools of capital. The Crypto 2.0 version (ie. Goldfinch) will all use reputation as a key driver for ability to borrow. Many will engage real-world companies, and all will end up creating many less fungible pools.

The list goes on, so I put together this chart to compare different verticals.

Crypto 2.0 Will Be 1000x Larger Than Crypto 1.0. Let’s Buidl

What’s so exciting about this next wave is the scale of the opportunity that awaits. For example, the closest analogue of today’s crypto lending is money markets (and even this is probably over stating it). But money markets in traditional fiat represent only about 2% of the entire bond market. And crypto lending itself is literally not even visible when comparing to global bonds (see below).

We think of NFT’s as collectibles now, but really, the market could be tickets, or even clothes.

Social media is one of the largest sectors of the economy, and crypto will finally get to take a shot at it during the next wave. Similarly, merchant payments, the massive segment that built companies like Stripe and Square, will likely finally see some crypto competition.

The markets may be cooling off, but just like in 2018-2020, this is when innovation happens. It’s time to build, and I can’t wait to see what happens next.

Blake West is the co-founder and chief technology officer of Goldfinch, which is building a decentralized, under-collateralized lending protocol on Ethereum. Thanks to @spencernoon for reading a draft of this post.