“Seeing Yourself Through My Eyes” – Demot Kennedy, “Lost”
We have spent a considerable amount of time studying the field of collateralized lending protocols at Reverie. This area is attractive to us as investors because it is filled with uncertainty (opportunities often exist in ambiguous markets) and is highly active (dozens of projects are set to launch in the collateralized lending space in the next 12 months).
During our exploration of the collateralized lending market, we have made some observations about its future development. Many aspects are still emerging, so what is true today may not be applicable tomorrow. Nevertheless, we wanted to share some preliminary insights into the business dynamics of the collateralized lending market.
Leverage Support from LRTs
Currently, LRTs (Liquidity Re-collateralization Tokens) like Etherfi/Renzo hold a strong position in the collateralized lending supply chain. They are advantageous as they are positioned close to both the supply side (collateral providers) and the demand side (AVS, or Active Validation Services). As a result, LRTs have the ability to (i) determine their fee structure and (ii) influence the fee structure of underlying markets such as EigenLayer and Symbiotic. Given their powerful position, we can expect the collateralized lending market to introduce first-party LRTs to control the power of third-party LRTs.
Leverage Support from AVS/Collateral Providers
The best markets have two characteristics: a decentralized supply side and a decentralized demand side. To understand this intuitively, it is helpful to consider the opposite scenario where either the supply side or the demand side (or both) are concentrated (AVS refers to Active Validation Nodes).
Imagine a simple apple trading market where the largest apple seller controls more than 50% of the apple supply. In this case, if the market operator decides to increase the market fee from 5% to 10%, the large apple seller may threaten to take their business elsewhere.
Similarly, on the demand side, if the largest apple buyer controls more than 50% of the apple demand, she can also threaten to use another market (or buy directly from the apple supplier) if the market operator increases the market fee.
Applying this to the collateralized lending market, if the ultimate market structure is concentrated on the AVS side (where the top 10% of AVS account for more than 50% of the revenue) or the collateral provider side (where the top 10% of collateral providers account for more than 50% of the deposits), the natural result is a weakened ability of the market itself to charge fees (thus the market valuation should decrease as well).
Although there is currently not enough data to strictly validate this point, our intuition suggests that power laws will apply here as well: large AVS will capture the majority of total payment volume, giving them bargaining power over market fees.
Competition for Exclusive AVS
From the perspective of each collateralized lending market, anything that can be done and cannot be done by competitors is worth trying. The simplest way to differentiate is by offering exclusive access to AVS for collateral providers – whether it be first-party AVS like EigenDA or third-party AVS obtained through exclusive partnerships. This concept is similar to Sony developing exclusive games for PS5 to drive hardware sales.
Given these dynamics, we expect collateralized lending markets to take action, such as launching more first-party AVS or securing exclusive agreements with third-party AVS. In short, we will see a battle for AVS in the coming months.
AVS Subsidies
AVS needs to pay fees to operators/collateral providers for the services they provide. This effectively means that AVS needs to have their own tokens, ETH/USDC, or possibly points/future airdrops to pay operators/collateral providers. However, since most AVS currently are early-stage startups without tokens, large balance sheets, or well-designed point systems/airdrops, signing contracts with operators/collateral providers is a cumbersome process (most of EigenLayer’s partnerships are customized contracts negotiated privately).
In short, it is a situation where a customer wants to purchase services but may not have enough funds at the moment, although they may be in a good financial position.
To facilitate business development, collateralized lending markets are likely to provide upfront payments to operators/collateral providers, which can be paid through their own tokens, balance sheet assets, or by issuing “cloud points” that AVS can spend with operators/collateral providers. In return for the prepayment, it is expected that AVS will commit to airdrop or distribute tokens to the collateralized lending market. Alternatively, the collateralized lending market can prepay the money to AVS to persuade them to choose their market over competitors.
In summary, we expect intense competition among collateralized lending markets through subsidies to AVS’s expenses in the next 12 to 24 months. Similar to the market dynamics of Uber and Lyft, the market with the most funds/tokens is likely to emerge victorious.
Personalized Guidance
From “I want to launch an AVS” to actually putting it into production is not as simple as it seems, especially for small teams with limited R&D resources. Teams need to address questions such as how much security to purchase, how long to purchase security for, how much to pay operators/collateral providers, what to penalize, and how much to penalize.
Best practices will eventually emerge, but until then, collateralized lending markets will need to guide AVS teams through these questions. It is worth noting that EigenLayer currently does not have payment or penalty mechanisms.
For this reason, we expect winning collateralized lending markets to resemble enterprise sales, providing integrated/service help for customers to smoothly onboard their products.
Development of AVS
The most successful AVS may gradually move away from collateralized lending markets and start using their own tokens or revenue to purchase security. Today, the incentives from collateralized lending markets are most important for smaller projects that do not have the time, funds, brand, or connections to recruit a set of validators. However, as projects scale, they may shift towards recruiting their own validators and using their own more valuable tokens to ensure network security. This situation is similar to the stages of market development, where the most successful customers gradually develop independently, and market operators need to be prepared for it.
Cryptocurrency SaaS as a One-Stop Service
To illustrate this observation, let’s first look at some software history: cloud service providers like AWS enable developers to easily access everything they need to launch applications or web services (e.g., hosting, storage, and computing). By significantly reducing the cost and time required to develop software, a specialized class of web services emerged. Cloud service providers combined first-party cloud services with a multitude of “microservices” available within their platforms, making them one-stop service providers for everything you need beyond core business logic.
Collateralized lending markets like EigenLayer aim to create a similar set of microservices for Web3. For example, before EigenLayer, cryptographic microservices could centralize their offline components entirely (and pass this risk on to their customers) or bear the cost of bootstrapping a set of operators and economic shares to purchase security.
Collateralized lending markets may break this trade-off of microservices – if they work as expected, you will be able to prioritize security without sacrificing cost and market speed.
Let’s say you are developing a low-cost, high-performance zk-rollup. If you go to a collateralized lending market like EigenLayer, you will have multiple core service options such as DAs and bridging for easy access. Throughout this process, you will see dozens of other AVS microservices that you can integrate with.
The more microservices collateralized lending markets offer, the better the user experience – there is no longer a need to evaluate service features and security from dozens of independent providers as applications can purchase all the services they need from one collateralized lending market. As a result, users may come for X service but stay for Y and Z services.
Certain AVS will have network effects (e.g., preconfs/pre-configurations)
So far, collateralized lending use cases have largely focused on exporting validators and economic shares from Ethereum. However, there is another category of “inward” collateralized lending use cases that can add functionality to Ethereum’s consensus without the need to change protocols.
The idea is simple – allow validators to choose additional commitments on proposed blocks in exchange for payment, and hold them accountable through penalties if they fail to fulfill those commitments. We suspect that only a few types of commitments will have enough demand to attract high levels of participation, but the value flowing through these commitment flows could be substantial.
Unlike “external” collateralized lending use cases, the effectiveness of these use cases is directly related to the participation of validators. In other words, even if you are willing to pay to be included in a block, it won’t be very useful if only 1 out of every 10 validators chooses to honor that commitment.
However, if every validator chooses a given commitment, the guarantee behind it will be equivalent to the guarantee provided by the Ethereum protocol itself (i.e., valid blocks). Based on this logic, we can expect this category to have strong network effects, as users of AVS will benefit from every marginal validator that chooses to join the commitment market.
Although this category of AVS is still in its early stages, the logical distribution channel to facilitate these use cases may be through Ethereum client utilities and plugins (e.g., Reth). Similar to how proposers are separate from builders, it seems likely that proposers will outsource this work to specialized participants in exchange for a share of the income.
It is unclear what form these AVS will take. While it is possible for one entity to create a generic market for any type of commitment, we suspect it is more likely to see a few participants focusing on specific demand sources (e.g., L2 interoperability-driven demand for L1 DeFi).
