143 - UNIChain is Inevitable with Dan Elitzer

Welcome to Bankless, where we explore the frontier of internet money and internet finance. This is how to get started, how to get better, how to front run the opportunity. This is Ryan Sean Adams. I'm here with David Hoffman, and we're here to help you become more bankless. Guys, this is an episode about Uniswap, about the Unichain, about the app chain thesis. That thesis plainly stated is every big DeFi app is going to have its own chain, including Uniswap. That's what Dan Elitzer says today. How will this reshape crypto? Is the question. Where do we find opportunities if Dan is right? And does this thesis even make sense? That's what we get into today. A few takeaways for you. Number one, we go through the case for why Uniswap is going to have its own chain. That is the thesis here. We also go through the economic argument, why Dan thinks there's an inevitable economic incentive for large DeFi applications like Uniswap to start their own chain. We get into the true trading costs of using Uniswap and who gets the revenue from these trading costs. Also, objections to this app chain thesis. We talk composability, we talk user experience. Dave and I have our own objections as well. And then finally, number four if the app chain thesis wins, does that mean Ethereum has to lose? No, maybe. It depends. That's the answer.

How about this whole competition between Ethereum and Cosmos? This is a recurring theme on Banklist that we get into a bit more today. David, why are we talking about this subject and what should listeners pay attention to in today's episode?

First, Dan is using Uniswap simply as the largest and biggest DeFi app on Ethereum. It's the one that produces the most block space demand. It burns the most ether out of any other DeFi app. So he's not picking Uniswap as a special case. He's picking Uniswap as simply because it's the biggest. And the general thesis is the bigger DeFi app you are, the bigger the DeFi app becomes, the more likely it is that it will produce its own independent chain. And so since Uniswap is the biggest chain, we're using Uniswap as the thing to talk about, as the premier example is why Uniswap has the largest incentive to produce its own app chain, but it's not the only one. The general theory is all DeFi apps, when they hit a certain threshold, will produce their own chain. And so that's the first thing to look out for is like, how do we measure that threshold? What is that threshold? How do we consider the incentives for DeFi apps as they become larger to produce their own chain? So that's the first thing to consider. I think people should also just think about in what ways does this tilt the balance of power from ETH, the money, to DeFi token, the asset? How does that change that game? And also just consider who wins here: the Cosmos app chain or the Ethereum layer three role apps, if you will. And so I think those are the three main things to consider in this podcast.

Of course, premium subs. You can stick around after the episode. David and I have a debrief episode where we talk about our thoughts on this episode. It's our episode after the episode. Can I say episode again?

If you want that episode, then become a premium subscriber. David, I've got some thoughts for you in that episode. I'm not sure I wholly subscribe to the app chain thesis. I think parts of it I identify with and make sense to me. Other parts I'm not sure about. So I want to talk to you in more detail about kind of my thoughts on what Dan presented today. What do you want to talk about in the debrief?

I think the thing I want to talk about most is parse apart the different DeFi app categories, where some categories might be better suited for a sovereign app chain versus some categories which might not be. Like I think there's an argument to make that DEXs produce a stronger argument for an app chain than borrowing and lending protocols. So I want to dive in on that subject and then debrief.

Of course, the debrief is only for our premium subscribers, so join us there. If you are a premium subscriber, you get a whole separate RSS feed that is dedicated to you. Guys, we're gonna get right to the episode with Dan.

Bankless Nation, I'd like to introduce you to Dan Elitzer, a co-founder at Nascent. And I previously met Dan while he was also working at IDO Collab Ventures. And he's been on the frontier of crypto innovations as long as I can remember. Dan, welcome back to Bankless. It is good to have you back.

Thanks, David. It's always great to be here with you guys.

And so, Dan, you have a good track record of making very precise predictions that have, I think, basically all come true pretty closely to as described. You wrote about the concept of composable collateral called superfluid collateral, is what you called it, in like February of 2019. And this was before a lot of DeFi apps really did stitch themselves together. And so you got that one. You wrote about the perils of liquid staking derivatives. The article was called The Death of Ethereum, the D E T H of Ethereum, the Delegated ETH of Ethereum. Two whole years before liquid staking derivatives even existed. Now we are coming into a head with some of those conversations today. You also wrote about DeFi yield farming after you saw the writing on the wall, not due to compounds governance token, but due to an even earlier experiment from FutureSwap in April of 2020. And so, Dan, your track record of very few but very precise articles has been really, really strong. And you recently wrote a new article titled UniChain is inevitable. How a Uniswap app specific chain is inevitable. And this is, I think, not just a prediction for Uniswap, but for every single DeFi app with sufficient activity on Ethereum might produce its own app centric chain. So, Dan, that is the topic of today's show. But first, before we get into the show, how do you feel about your track record? It's pretty damn good. Can you just reflect on that for a moment?

Have you ever been wrong, Dan?

I've been very wrong. And I think, you know, I feel fortunate to have done a decent job calling out some trends. I think the level of precision hasn't always been there. And one of the things that I tried to make clear in this latest piece is

my degree of confidence is very high that app chains and app specific rollups, someone actually shared the term roll app with me recently that I love.

Wait, not roll up, roll app.

Roll app. Yeah, I loved that. But I'm very confident that these will be an important part of the ecosystem

in the future.

I'm really bad at nailing timing. So I said, you know, it's probably about three plus years out till there's major, major players at the scale that we think of as like large L1s and such today that are happening via these application specific chains or roll ups. But it seems inevitable to me that it is going to happen.

Well, I think we can definitely relate to that at Bankless, where at the top of the 2021 bull market, we were all about roll-ups, roll-ups, roll-ups, and everyone else was like alt layer ones, alt layer ones, alt layer ones. But now in the bear market, it definitely seems to be a roll-ups world. As we go into this thesis, I just want to ask, you titled the article, Why UniChain is inevitable, saying like Uniswap will eventually produce its own chain. But this is not necessarily about Uniswap. We're just using Uniswap as like a very easy and obvious application to discuss while talking about the general idea of uh role apps or app specific layer ones. Is that a fair summary, fair analysis?

Yeah, well, I would say that it doesn't mean that all DeFi apps are going to do this. And as a number of people have pointed out, there are some things like games that might have less benefit from composability, uh especially atomic composability within their application. Those may be the first ones to do it. We just saw OP craft announced along with Optimism and Lattice working together on this. And that's an example of kind of an application-specific rollup. And I think that is something that seems very obvious, where there might be a little bit of difference in opinion as how much this is applicable also to DeFi. I believe it is very applicable to DeFi, not necessarily every protocol or application in DeFi, but to many of them, once they reach, I would say, some level of escape velocity, it's going to become important that they have this as one of the tools in their bag. It doesn't mean that Uniswap or other applications will cease to have deployments and meaningful deployments on Ethereum or Optimism or Arbitrum or any of these roll-ups or other chains. It just means that there's a large incentive for them to consider making the place that they try to funnel users to the extent that they have a more direct connection with them and the ability to redirect them there. They're going to want to migrate a significant chunk of the activity to their own roll-up or chain.

Okay, and just to really drive this point home, you're not making this like sweeping blanket statement that every single DeFi app will produce its own chain.

No, certainly not.

But I think as listeners go through this episode and kind of hear some of the arguments and theses and motivations, listeners might be able to decide for themselves. Like at some point, some DeFi app using this model that we're about to talk on this podcast, the incentives might like tip over to like, okay, now with these incentives, if you like take everything into account, the incentive to produce an app, role app, or app specific layer one will become significant. And this is the kind of the nuance to unpack here.

Yeah, and one of the analogies I like to use here is looking back at some web 2 platforms. Like look at Zynga doing Farmville and other games on Facebook as a platform and King Digital games and folks like that. They were paying these huge taxes and they were very much at the whims of the platform they were on that was not just trying to optimize for game playing. It was trying to optimize for a whole bunch of different types of users and use cases. And there was a large tax then associated also with being active on these platforms. And so the smart game publishers started saying, okay, how can we move and do a native mobile app? How can we do a web app? How can we more directly own this relationship with the users and avoid certain types of platform risks and platform taxes? And we're seeing that play again with certain, again, game publishers and some streamers and others who love the distribution of the App Store and the Google Play Store early on. But once you've gotten to a certain size, you have a certain amount of economic activity, a certain number of customers who highly value your application, you're going to necessarily look to say, how do I reduce the take rate that some of these other platforms are charging me? And how do I ultimately maintain better control over the user experience so that I can better deliver to my users and to my community?

Okay, so what's interesting is we're starting to get into the why, the economics of why. And I want to return to the kind of that the Uniswap example, because this is a really interesting example you pick. But before we do that, every thesis has to have a prediction, obviously, that can be invalidated. And if this is maybe something we're calling kind of the app chain thesis, if you will, or roll apps or the world of layer ones, either the cosmos world or the Ethereum world, something like that, or maybe some combination of both. What does that mean exactly? Like what is the prediction on the other side? So you said just now, Dan, that it doesn't mean every single DeFi thing app will roll its own app chain. But I think it probably does mean we are maybe, in your opinion, entering a new era, kind of an app chain era where these things will be much more common, maybe as common as DeFi apps were on layer one, maybe even more common. What are kind of the predictions of the app chain thesis? How can we tell if you're actually right, you know, two years from now, Dan, about this?

Yeah, I would say, you know, you guys did a fantastic conversation with Sonny and Zachy the other week talking about the Cosmos ecosystem and how that is developing. I think if we start to see more people using Cosmos chains, I don't know what the kind of user numbers are that we would want to put on this, or maybe I hadn't actually thought about quantifying this in a way that is falsifiable. But if we see something like the top five highest user count or highest volume DeFi applications, if in five years the top five all have a sovereign chain as something that they have.

Launched and is active, then I would say this has played out. It does not necessarily mean the majority of the activity attributable to say Uniswap or Compound or somebody like that is necessarily all happening on that chain, but that it is a core component of their strategy and of their economics.

So that would be a paradigm shift. And let me make sure I understood you correctly. So you put some time ranges on that, five years or something. But like you're envisioning a world where we go to like CoinGecko and we look for the top DeFi apps, right? And you know, the top, say, five DeFi apps all have their own chain. And that chain could either be something in the Cosmos world where it's kind of a layer one mesh network side chain type of thing, or it could also be a roll app, which is kind of like an Ethereum secured roll up that also has some of its own sovereignty and is kind of its own chain.

Uh that's also largely a part of the Ethereum layer three narrative. So roll apps and layer threes are largely synonymous. So just to put that into listeners' heads.

And so if we see that, Dan, that would be like, okay, and that's a big paradigm shift. Cause right now, when we envision like, okay, I don't know what are the top five DeFi tokens right now or usage. It's like Uniswap, you know, Lend, MKR, what you're predicting is all of these will have their own app chains, essentially.

Yes. I think the prediction is like at the bigger that they get, the more likely they are to produce a chain.

Yes, let's dig into that. And I think the example that you select is actually a really good example. You're actually going for the big one, which is Uniswap. And the thing I like about Uniswap as an example is that it's our purest representation of DeFi at some layer. It's very much on-chain. You can easily see something like DYDX with kind of an order book, that needing its own sort of order book app chain, but like Uniswap having its own app chain, that is a tough one. It's hard for people to wrap their minds around. It's also very interesting in that it's like the highest usage, highest volume, biggest DeFi app that we have. And also I would argue that it requires a lot of composability, doesn't it? I mean, you have to have all of these ERC20 tokens and other DeFi apps kind of like interacting with it in some way. And so you've picked off a really hard one in order to prove your case. But the case, I think, starts with economics. That's to me like I always like the economic arguments because those are the arguments that always tend to be like sticky regardless of people's opinions. Can we start here though? Because you start your post and you talk about the three costs to trading on Uniswap. There's a swap fee cost to LPs, which I think people notice. There's also this transaction fee cost to validators, which is kind of like a gas fee. And there's also MEV. Can you talk about those three buckets of cost in trading on Uniswap and how the economics kind of converge to incent a DeFi app like Uniswap to pursue the app chain model?

Sure. Well, the first cost, the kind of swap fees, that's something that if you look at token terminal or any of these tracking sites, that's always emphasized as kind of like the revenue, whatever from the protocol. This is actually trading fees. But Uniswap has framed it as a, you know, initially 30 basis point fee and others from day one. But if you think about it, it's really enforcing a spread because it's not being extracted by a third party. But

Everybody calls it a fee. So let's take it as a fee. That's the place where the fee switch, literally that we call it in Uniswap, is positioned to be able to take a slice of those kind of swap fees.

That's what people have typically thought of the universe these are the costs traders pay. And this is where if uni token holders want to kind of capture any value here, they would flip the fee switch and take a piece of that.

Importantly, it's what Uniswap has control over. Yes. So like while there's nuance here, like, is this revenue for the Uniswap protocol? Well, no, it's revenue actually for the liquidity providers, but the Uniswap protocol has control over it. And so that's why we've kind of like lumped it together as like this is Uniswap revenue.

Right. Then the next piece is actually the transaction fee, right? The Ethereum transaction fee where you're paying gas to get a transaction confirmed, included on the Ethereum blockchain. And

That has been a very significant piece. And the analysis that I was able to do was kind of looking at Dune dashboards and other things that I could find. And it was easier for me just to look at kind of the mean trade data rather than looking at median. And obviously, for smaller trades, the fixed fee associated with making that trade, that transaction is going to be a much larger piece of it. There are some very large trades that I my understanding is that it has skewed up what we look at as the average trade size, but you have a pretty similar portion of the fee being paid by a trader going in the form of this fixed transaction fee. And if you comp that to

a centralized exchange.

If you're trading on Coinbase or FTX or anywhere,

there's no fixed fee. You're paying just that kind of variable,

you know, percent of your transaction that is being charged by the exchange. There's no fixed fee saying you want to trade $1 or $1 million, you're still going to pay a $5 fee or 50 cent fee. That just doesn't exist in a centralized exchange world. And it's very economically inefficient if you're looking at it just through the lens of a trader.

And so that is a meaningful component. I would say, especially during the bull market that we saw in 2021, there was, I would say, for smaller traders, often there probably a lot of trades that didn't happen

because you were seeing the majority of the trade cost, the trade size, even get eaten up in a transaction fee just to get that fee on chain. And it fluctuated so much. So having this, I would say, like fixed fee that's irregardless of trade size, there is a fee, but also having that vary in the size based on the activity going on on Ethereum overall.

That's really bad UX. And it represents a huge cost being paid by traders that

could be controlled better through the use of a role app or or app chain.

We'll talk about how a role app or app chain can actually produce more control by the actual app later on then show. But really just to emphasize this, we've talked about two costs so far. The 30 basis points cost that Uniswap the app charges to go to liquidity providers, which Uniswap controls, and that's considered revenue for the protocol. The next cost that we've talked about is the gas fee cost. And you're saying just like that's outside, that's external to the Uniswap protocol. That's something that Ethereum kind of loosely controls, kind of dictates to Uniswap, you must pay this in order for a transaction to go through. And the chart that Ryan was showing on the screen just a second ago showed that in like over 2021, that costs range from $10 to $80. You're taking this example and saying $80 compared to what Coinbase or FTX charges you is like insane. An $80 transaction fee on a trade, like you need to be trading something like much larger than like $1,000 for that to be just like economically viable or cost competitive with other exchange mechanisms. So you're saying this fixed cost that comes externally to Uniswap has prevented a significant amount of trading activity happening during this time of high gas fees and is just like overall bad UX and bad economics for Uniswap, the app. Is that a good summary of where we are so far?

That's a great summary of where we are so far. And now I assume you want to get to that third one that's a very hot topic these days around MEV or maximal extractable value. So this is something that is currently

Being captured by some combination of searchers who are kind of going in there and extracting value via MEV and validators and ultimately ETH holders, right? To the extent with 1559 that we're now seeing a lot of fees burned. You know, to be fair, the fees are getting burned anyway. A lot of the value is then, you know, getting paid to validators for inclusion in these MEV blocks. But there's multiple types of MEV. And the analysis I did was very, very rough. I'm 100% sure it is wrong. I just hoped to get it within effectively an order of magnitude. The analysis that I based that off was done by Zero X that was looking at effectively sandwich attacks, which are when you're trading on Uniswap or in other decks and you have some sort of slippage tolerance that you include there in your transaction. And you say, you know, basically have this trade fail if the price moves outside of these bounds. And what these searchers are doing that are doing these sandwich attacks is they are pushing uh the price. They're basically taking your transaction that you've broadcast into the public mempool and they're putting a transaction in front of it to push the Uniswap pool price.

Gia us to the very edge of what will allow your transaction to go through, having you execute that like a highest price you want to tolerate. And then they're putting another transaction afterwards to kind of like move it back. So they're essentially atomically doing an arbitrage here where you, as a trader, are getting a worse price and they are capturing the difference between what you thought you were going to pay and the most you stated your willingness to pay. Now that is just bad for traders, right? Traders lose the market makers.

The Uniswap customers lose.

But that, to be fair, is not the majority likely of MEV. And we've seen, as was mentioned by Sonny on the Osmosis decks, right? On Cosmos and kind of Cosmos ecosystem, they're partnering with skip protocol to look at another type of MEV, which is just back running, which is just saying, like, look, you've made this trade.

We're not going to try to front run your trade and give you a worse price, but we will back run it and balance out across pools or potentially across other venues to capture an arbitrage opportunity that exists as a result after you've made your trade.

And there is a huge amount of opportunity there. And talking to people far smarter than myself, there is large consensus that that is probably the maj the vast majority of MEV exists there. And it's not harmful to users, but it's a revenue opportunity to be captured. So for the purposes of costs, we really want to look at kind of sandwiching a malicious MEV. And that's also a significant cost. But as we're talking about MEV, I just want to emphasize, and we'll also go back to that later, the revenue possibilities around the non malicious MEV that is still kind of thrown off as a byproduct of trading on the stacks.

So to parse that apart, there's two parts of MEV. There's malicious MEV that like jades customers and is bad for them. And then there's MEV that is universally accepted as like this is good and efficient and just like a rational arbitrage opportunity that doesn't jade customers. And that part can be made significant. And also in the Ethereum composability layer one context, it's hard to prevent the malicious MEV from happening as well.

Yeah, it's not impossible. There are ways to go about it. I've heard some very smart ideas that have not been put into production yet, but a lot of it gets easier to control on a roll app or app chain.

Okay, so let's just summarize this for folks. What the costs are for each of these three areas that you mentioned, and then kind of who gets the money. So what the costs are is kind of what the customer of Uniswap pays. So I'm a Uniswap trader. I just want to swap one asset for another, right? And so we have the swap fees. What does that look like if we're to translate that in terms of a percentage of trade or basis point? That can range, but what's kind of an average size there for the swap fee, the first category we're talking about?

Yeah, so the average size we're looking at there, I believe, was around like 17 basis points. So 0.17% of the average trade.

Got it. And that's because some pools will have a very small fee of zero one percent. Other pools have a one percent. And we're saying the average is about point one seven percent for fees a customer will pay for like the swap fees themselves.

Correct.

And then the transaction fees, when you've looked at that, just at a high level, I know these numbers should be nap back of the napkin.