Moats In The Crypto-Asset Ecosystem
Forming a multi-year, let alone a multi-decade, investment thesis around a crypto-asset might appear to be a fool’s errand; one can be forgiven for thinking that the industry is too volatile, experimental, and nascent to justify such a long-term perspective. To the contrary, I will argue that there are several crypto-assets that a long-term investor can confidently invest in with the intention of holding until at least the end of the decade. In order to justify this optimism I will first introduce Warren Buffett’s notion of a moat, before distinguishing between four broad categories of moat that an asset or business can possess. Following this, several crypto-assets with strong moats will be contrasted against those lacking an equivalent enduring competitive advantage.
Moats
To begin with, it will prove useful to briefly distinguish between a competitive advantage and a moat. A competitive advantage in the domain of investing highlights any profitable asymmetry that exists between one or more rival businesses. A competitive advantage allows the business that possesses it to outcompete rival businesses that are not fortunate enough to posses this advantage. As an example, suppose there are two competing companies, Alpha and Beta, which each produce widgets for use in the wider economy. Suppose further that Alpha has secured a 10% discount with their supplier of raw materials for the remainder of the financial year. Unfortunately for Beta, they were unable to secure an equivalent discount and, as a result, Alpha has a competitive advantage over Beta due to their lower cost of production of widgets.
In this example, the competitive advantage that Alpha has over Beta is limited to the remainder of the financial year. In the event that a competitive advantage is enduring, for any number of reasons, it may more accurately be described as a moat. The difference, therefore, between a competitive advantage and a moat is that a moat represents a special kind of competitive advantage that is “sticky” in an important sense, and one that proves particularly difficult for competitors to dislodge or to replicate. Thus, while all moats are competitive advantages, not every competitive advantage is a moat. Warren Buffett famously articulated this idea in a 1999 Fortune article where he states:
The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors.
In addition to introducing the notion of a moat, this distinction between the success of an industry and the success of individual companies within the industry strikes me as particularly germane for the crypto-asset ecosystem over the remainder of this decade. I take it as both obvious and uncontroversial that the crypto-asset industry will experience an enormous amount of growth and adoption in the coming years. What is far less obvious, however, is the identification of those assets or companies that will not only survive, but thrive throughout this transition. Despite first appearances it is not a contradiction to be bullish on the crypto-asset industry as a whole, while remaining bearish on the overwhelming majority of assets within the industry. Historically, this kind of divergence is typical. Consider this historical snap-shot of the top ten crypto-assets by market capitalisation on the first of January 2014.
Aside from the top three assets of Bitcoin, Litecoin, and XRP, the remaining assets have entirely disappeared and receive no market attention whatsoever. Any investor who formed a multi-year investment thesis around Namecoin has been thoroughly disappointed. Such poor results, of course, being despite the fact that the entire crypto-asset industry has expanded by approximately 10,000% over the proceeding eight years. With this in mind, it seems quite likely that many of the largest crypto-assets that exist at the beginning of 2022, will either no longer exist or will have considerably underperformed the rest of the crypto-asset industry over the next eight years to 2030.
One mental model and set of heuristics that can help long-term investors identify those crypto-assets that will outcompete rivals is Buffett’s notion of a moat. An appreciation for this concept can be thought of as especially useful in an industry that is characterised by open-sourced development and the rampant (and encouraged) copying of code between projects. Given that it is an every-day occurrence for successful projects to be copied and slightly modified before being redeployed, it behoves the long-term investor to identify those assets, or the properties of successful assets, that may not be easily copied. One’s inability to copy an asset, or the profitable aspects of an asset, is nothing other than the implicit recognition that this asset or business has an enduring competitive advantage; that it has a moat.
Four Varieties of Moat
Before examining several crypto-assets that do, and do not, have large moats, it will be instructive to examine four different methods of achieving a sustainable competitive advantage. Firstly, businesses that can consistently produce their products or services at a lower cost than competitors can be described as having a “low production cost moat.” Typically, low production cost moats are the result of large businesses with economies of scale, whereby the marginal cost to produce a good or service is lower than that incurred by competitors due to the sheer magnitude of production that occurs. Returning to and slightly modifying the example of the two widget producers, Alpha and Beta; if Alpha produces one thousand times more widgets than Beta it is likely that Alpha has a lower marginal cost of production for each widget. This may occur in several ways. For instance, Alpha may receive a discount from their raw materials supplier because they purchase these materials in bulk. Alternatively, Alpha may, on a relative basis, have to hire fewer employees than Beta to achieve similar results (e.g. only one accountant is required for each business despite the huge disparity in widget production). However the low production cost moat is achieved, it enables a business to persistently undercut competitors on the sale of their goods or services. Simply put, Alpha is able to sustainably sell their widgets for a profit at a price that would be unprofitable for Beta.
Secondly, a business may, either deliberately or otherwise, make it difficult for customers to abandon them for competitors. This kind of enduring competitive advantage may be described as a “high switching costs moat.” As an example, suppose that the widgets produced by Alpha have a unique set of grooves in them that necessitate a complimentary set of ridges in all of the machinery they are integrated into. In comparison, the widgets produced by Beta lack these grooves, meaning that the widgets produced by each company are not easily interchangeable. Ideally, the grooves in Alpha’s widgets will provide some kind of benefit to customers, although this need not occur for this kind of moat to exist. To see this, notice how any disgruntled Alpha customer must incur the high up-front cost of modifying the concomitant machinery if they are to switch to using Beta’s widgets. Thus, once a customer has chosen to use either Alpha or Beta widgets they are unlikely to change their supplier, even if they are slightly displeased with the quality of widget being supplied to them. Any disparity in market share between Alpha and Beta is likely to persist due to the high switching costs entailed with customers taking their business elsewhere and, more importantly, any innovative or disruptive widget producer will struggle to seize market share from the incumbents of Alpha and Beta. Notice how this state of affairs can create a collective action problem for consumers of widgets; Alpha and Beta in this scenario may not be motivated to provide the best quality widget for the lowest price, but instead motivated to increase the switching costs that their customers must incur were they to purchase widgets from another manufacturer. It is easy to see how this can result in a Pareto inefficient equilibrium for those purchasing widgets from either Alpha or Beta.
Thirdly, the value of the good or service provided by a company may increase as the market share that this company commands increases. This form of moat is known as a “network effects moat,” and is very difficult to dislodge once it has been established. Admittedly stretching credulity, imagine that the widgets produced by Alpha have the peculiar quality of becoming more efficient as more people use them. This feature creates a snowball effect where as more and more people adopt Alpha’s widgets, each incremental customer is motivated to use them over competitors due to the variation in efficiency that already exists. This, in turn, increases the efficiency of Alpha’s widgets and further entrenches dominance that Alpha has over the widget market. Amusingly and reflexively, everyone will purchase widgets from Alpha because everyone purchases widgets from Alpha. Once this kind of network effect has been established it is almost impossible for a competitor like Beta to overcome because of the huge advantage that exists for new and existing users of Alpha’s widgets. The only viable strategy available for Beta is to produce a widget that offers an enormous comparative advantage for customers such that each Alpha customer is unilaterally motivated to purchase their widgets from Beta, regardless of how everyone else behaves. There exists a similarity, therefore, between a high switching costs moat and a network effects moat; each creates an incentive for customers to remain loyal to their supplier of widgets, although the method of achieving this incentive is importantly different.
Finally, a business may have a unique and enduring competitive advantage over rivals due to their intangible assets. Unsurprisingly, this form of moat is known as an “intangible asset moat.” There are many different forms of intangible assets and, consequently, there are many different kinds of intangible asset moats. One common example is the existence of a strong and respected company brand. Alpha, for instance, might have gained a robust reputation of producing reliable and efficient widgets after decades of production. Customers, then, might prefer to purchase widgets from Alpha despite the presence of cheaper and functionally equivalent widgets offered by Beta. Alternatively, Alpha may own a set of design patents, trademarks, or copyrights that confer a lasting competitive advantage. Similarly, Alpha may be blessed with intangible assets like strong industry or governmental connections, a dominant geographic positioning, or a healthy internal company culture. In all cases, these advantages may be difficult to recognise and isolate, however they can have a profound impact on the success of a business over time.
With these four broad kinds of moats in mind, it will be possible to identify those crypto-assets that possess a lasting competitive advantage, as well as those that have no such moat. Before moving on, however, it should be recognised that the previous four categories are by no means exhaustive, nor are they exclusive; there certainly can exist other forms of moat and a company may have more than one form of moat at any given time. Intuitively, the more moats a company has, the more likely it is to be a sound long-term investment, provided, of course, that the price of the asset is attractive. A business may have each of the four moats above and yet still represent a poor investment if it is trading at 10,000 price to earnings ratio (or perhaps it’s a very early stage growth company). Concerns regarding price and “fair value” will be put to one side in the upcoming discussion, with the reader left to determine for themselves what an attractive price consists of. Moreover, the following discussion should not be taken as a comprehensive investment thesis or investment advice, but simply my analysis of crypto-asset moats that presently exist. While it is safe to assume that I own those assets that I argue have strong moats, I take no responsibility (either positively or negatively) for the decisions you make with your own money. With all of those caveats out of the way, let’s get to the juicy bit.
Crypto-Assets With Strong Moats
First and foremost, Bitcoin has several insurmountable moats and is easily the safest long-term investment in the crypto-asset ecosystem. Bitcoin is, without question, the most decentralised, permissionless, and trustless crypto-asset in existence. Without recapitulating the entire bull case for Bitcoin, these facts act as a very powerful moat that any competitor must overcome if they are to realistically threaten Bitcoin as the dominant non-sovereign money. Furthermore, as Trace Mayer has famously articulated, Bitcoin has several complimentary network effects that contribute to its dominance in the industry. One of which being that Bitcoin remains one of the most highly liquid crypto-assets, making it feasible for high-net wealth individuals, corporations, or nation states to take a position without moving the market, something that is not possible with most crypto-assets. Bitcoin can also boast several intangible asset moats that no other crypto-asset can ever replicate. For instance, Bitcoin was the first crypto-asset ever created and it kick-started the entire industry, this fact alone is a very powerful intangible asset. Equally, consider the fact that basically everyone on Earth has heard of Bitcoin, even if most don’t have the faintest sense of what it is or why it’s valuable. The same may not be said of any other crypto-asset, even Ethereum. Anecdotally, I’ve witnessed new entrants into the space treat Bitcoin as a type rather than a token; meaning that they think all crypto-assets are bitcoins, and might say something like, “I just bought some XRP bitcoins.” This degree of memetic dominance should not be underestimated. Legally, Bitcoin is recognised as a commodity in the U.S. and this provides a degree of legal assurance that is currently absent with most other crypto-assets. Finally, Bitcoin is defended by a community of religious zealots who will continue to purchase and advocate for it regardless of market movements or wider societal opinion. While this might sound ridiculous to an outsider, these individuals would literally die for Bitcoin if they thought it was necessary; how many gold bugs could say the same? All of these moats, when taken together, will undoubtedly contribute to the long-term success of Bitcoin as an investment.
Essentially everything that was just articulated about Bitcoin also applies to Ethereum, although to a lesser extent. Ethereum is a very decentralised network, it is highly liquid, it has a very strong and widely recognised brand, it was the first smart-contract platform giving it an enviable provenance that can never be replicated, it is also recognised as a commodity in the U.S., and it has a tight-knit community of religious zealots. All of these are significant moats that competitors will struggle to overcome. Unlike Bitcoin, however, Ethereum has many viable competitors that arguably outcompete it on several important metrics; the two most relevant being transaction costs and scalability. Furthermore, unlike Bitcoin it is not clear that ether, the base asset of Ethereum, needs to increase in value for Ethereum, the network, to be successful. Conversely, there is no world where Bitcoin, the network, succeeds while the underlying asset persistently falls in value. I have elsewhere written extensively about how the coding standard and programming language underlying Ethereum might remain dominant despite the Ethereum network losing market share. While this seems unlikely to completely undermine Ethereum given the moats just highlighted, it is a non-trivial possibility that Ethereum continues to lose market share in the years to come. The race for the dominant smart-contract platform is ongoing, and it is certainly Ethereum’s race to lose.
With the two largest and most obvious crypto-assets out of the way, it will be useful to move into more obscure territory. Lido Finance, which I have also written extensively about, strikes me as a very unique asset with several deep moats. Firstly, Lido might be one of the few crypto-assets/businesses that have a low production cost moat. The low-cost ability to integrate a wide, and growing, number of proof of stake coins into their business in order to issue staking derivatives is unmatched due to the scale they have already achieved. Moreover, Lido can be thought to have high switching costs moat for validating node operators as well. Any validating node operator faces a high up-front cost, in the form of logistics and capital expenditure, if they were to abandon Lido for another staking derivatives operation like Rocket Pool. This contributes to the long-term success of Lido by making the core operation of Lido Finance very robust when moving forward. Finally, the staking derivatives offered Lido also benefit from a network effects moat. stETH is rapidly gaining traction and liquidity in the wider Defi ecosystem (e.g. it is a form of collateral backing Dai in Maker), thereby entrenching market dominance for Lido Finance in the years to come.
Turning, briefly, to the stablecoin market. USDC, or the parent company, Circle, appears very well positioned to dominate in its field in the years to come. This is primarily due to the network effects of their product (USDC) and the strong U.S. regulatory connections they have fostered, which is a very valuable intangible asset. While Tether (USDT) remains a larger and more liquid stablecoin at the time of writing, it suffers from a poor reputation with many concerned, probably unjustifiably, that they are running a fractional reserve system and that they are therefore under-collateralised. Institutional asset managers, I assume, would be unwilling to use USDT while being more confident to avail themselves of the utility of USDC given the regulatory and industry connections they have developed. The one concern moving forward for Circle is that they may be a victim of their own success; in the event that the U.S. Government/Federal Reserve wants to issue their own central bank digital currency (CBDC), they may simply co-opt and seize USDC rather than attempt to create their own stablecoin from scratch. This is certainly what I would do if I were in such a position. How beneficial such a seizure would be for the shareholders of Circle is unclear.
Before addressing those crypto-assets that do have strong moats there are several honourable mentions that have some degree of enduring competitive advantage, often in the form of a strong brand, community, or wider Defi integration, but that nonetheless may still share a similar long-term fate to Namecoin. These include, in no particular order, Chainlink, Maker/Dai, Monero, ENS, CryptoPunks, Yearn Finance, Ledger, Convex Finance, and Terra Luna/UST (I’m sure I’ve overlooked several terrific projects, forgive me). All of these crypto-assets/businesses are well positioned to survive and thrive over the coming decade, although none of them are almost certain winners due to insurmountable moats in the same way that Bitcoin, Ethereum, Lido, and Circle appear to be. A useful heuristic that I have used to help distinguish between these merely good, as opposed to the great, projects is asking myself the question of whether I would be comfortable with 10% of my net wealth sitting in any of these assets while I was in a coma until 2030? For me, only Bitcoin, Ethereum, Lido, and Circle pass this test, their powerful moats being the primary reason for my confidence.
Crypto-Assets With Weak Or Absent Moats
As was highlighted above, the crypto-asset industry is characterised by rampant copying and the cross-pollination of ideas and code. The open-sourced and permissionless nature of development is a boon for innovation and growth, although it also undermines value capture and any form of rent seeking. For users, this is very beneficial due to the fact that this form extreme competition and capitalism drives down fees and incentivises constant improvements in the services being offered. For builders or investors, however, it poses a serious challenge due to the ever-present possibility that one’s project, which may have been painstakingly developed over months, will be copied, slightly altered, and redeployed elsewhere to instant success. Those familiar with the crypto-asset ecosystem have seen this dynamic play out many times before. Consider, for instance, the Sushiswap vampire attack of Uniswap, the endless supply of Shiba Inu (Doge) clones, or the 50+ Olympus DAO forks that proliferated in the crypto-asset ecosystem several months ago. In each case, there is nothing special about the original product that can’t be copied; the code can be copied, the utility can be copied, and, due to the constant desire for participants to be “early” to a new opportunity, even the communities can be copied (although this is the hardest part of a successful fork). This is why, as Buffett alluded to above, one should not conflate the utility of a project with it being a sound long-term investment.
As an example, Uniswap undoubtedly provides an enormous level of utility to the Ethereum network, however, it remains, in my opinion, a poor long-term investment. It might be argued that Uniswap has several intangible asset moats, such as a strong brand and developer community, and while there is some truth to this, these factors alone are insufficient in my mind to justify any capital allocation given that there are hundreds of functionally equivalent Uniswap forks across every smart-contract platform that exists. It could also be argued that Uniswap has a network effects moat due to the high level of liquidity that exists for the protocol. But again, this can be easily replicated by an upstart rival through the use of a generous liquidity mining scheme. “But Uniswap V3 is different!” I hear you shout; perhaps it is, and honestly I am not well informed enough on the specifics to confidently argue one way or another, but even if it is, the moat that exists would not be the Uniswap V3 protocol, per se, but the developers who built Uniswap V3. This community of developers is, at best, a weak moat and not one that I am confident will persist for the remainder of the decade. All decentralised exchanges and aggregators, therefore, currently lack any form of significant moat.
Similar arguments can be made in relation to the borrowing and lending platforms like Aave and Compound. Once more, these projects provide tremendous utility to both users and the wider Ethereum ecosystem, but there is nothing about them that can’t be, and hasn’t been, copied by others. As a testament to this fact, I think it is quite telling that Aave has pivoted to create a mobile-native application, while Compound is developing an inter-operable base-layer blockchain. Certainly, both extensions will improve the utility provided by these businesses, but more importantly, both of these extensions are far more difficult for rivals to copy. A closed sourced mobile application cannot be forked like an open sourced protocol can be, and the maintenance of a distinct blockchain requires significant expertise and resources. Aave and Compound, therefore, while presently lacking moats are moving in the right direction and in the future they might present themselves as attractive long-term investments.
Perhaps more controversially, the host of layer one and layer two smart contract platforms (other than Ethereum) have weak or non-existent moats. As was just argued in relation to Compound, the construction and maintenance of a base layer blockchain is significant, and it is far more difficult for these assets and environments to be copied. However, the over abundance and functional equivalence of these platforms make it very difficult to discern the eventual winners from the losers. Practically speaking, there is no meaningful difference between the EVM environments provided by Avalanche, Fantom, Polygon, Harmony One, and Binance Smart Chain. Proponents of each can quibble about the merits of their blockchain relative to others but, as far as I can tell, there is very little reason to be confident that any one of these will consistently outcompete the others in the years to come. Binance Smart Chain, it could be argued has a moat given the unique integration and support it has with Binance, the centralised exchange. Binance Smart Chain might, therefore, be an exception, although it could also be argued that this degree of blatant centralised control is also a hindrance to its long-term success. The thought being that the Binance Smart Chain might suffer from a reputational and legal/jurisdictional disadvantage in a way that competitors will not. Thus, aside from Ethereum (and perhaps Binance Smart Chain), all of the smart-contract platforms lack meaningful moats.
Finally, and more generally, it might be thought that I have overlooked or under-appreciated the intangible asset moats provided by communities in the crypto-asset ecosystem. Crypto-assets are very heavily influenced by social factors, and an otherwise sound project might be unable to gain traction simply because it fails to achieve any cultural significance. The reason that a strong community does not represent a meaningful moat is that they tend to be very ephemeral in the crypto-asset ecosystem. Due to the high level of risk-taking and innovation that is characteristic of this space, the establishment of a long-term and committed community around any project is exceedingly rare. Is anyone still passionate about Loot? Or how about BCH, XEM, or EOS? I’m sure there are some die-hard supporters for each but for the most part, most market participants quickly abandon the flavour of the month for the next shiny toy that comes along. This is not a criticism, just an observation, and an explanation for why a healthy community is often not the kind of strong intangible asset moat that it might first appear to be. Part of the issue is that once a thriving community has been established, it is very difficult for new entrants to be integrated. New participants, when seeing the enormous price appreciation that early supporters experienced, are often not motivated to join the incumbents, but are instead incentivised to create their own asset and community so that they can, in turn, be early and benefit from the influx of capital that often follows. Very few communities in the crypto-asset ecosystem, I believe, have the staying power to remain culturally relevant throughout the rest of the decade. What’s required for a community to be an intangible asset moat is for the community to be characterised by religious fervour; but generating this kind of zealotry is far easier said than done.
Concluding Remarks
The crypto-asset industry evolves very rapidly, and this poses a considerable challenge to the investor with a multi-year time horizon. Very often, those assets that are attractive short-term investments are not attractive long-term investments. Everything written above concerns a long-term investment perspective exclusively. Your favourite DEX or alternative smart-contract platform significantly outperforming Bitcoin over the next six months will not be an invalidation of the arguments presented here. I have no doubt that many of the assets I argue lack a significant moat will do very well in the short term. Additionally, given the rapid change that this industry witnesses I’m confident that some sections of this piece (i.e. the honourable mentions and the asset classes without significant moats) will be woefully out of date in a very short amount of time, although (hopefully) the assets I highlight as having strong moats will remain compelling long-term investments in the years to come. The thing to kind in mind is that, as history has demonstrated, the overwhelming majority of crypto-assets that exist today will likely not exist by the end of the decade. For those attempting to identify those assets that will survive this ruthless Darwinian and capitalistic competition, Buffett’s notion of a moat can be very instructive.
Thank you for your time!
