How vertical integration enables protocols to become the dominant players in the capital ecosystem.

Written by: @Decentralisedco

Translated by: AididiaoJP, Foresight News

Today's story is about what makes protocols anti-fragile and how tokens can be used as leverages to amplify ecosystems. In the weeks following the hack event, we delved deep into the Hyperliquid ecosystem. Soon we discovered that protocols in this industry are building formidable moats through vertical integration.

This article explores how leaders in the Web3 space maintain their moats.

I frequently use terms like "supply-side aggregator," "demand-side aggregator," and "vertically integrated capital ecosystem" in this article. For clarity:

• A supply-side aggregator refers to aggregating differentiated market participants to offer commoditized products (e.g. Uber).
• A demand-side aggregator refers to expanding products to groups that appear similar externally (e.g. Amazon).
• A vertically integrated capital aggregator refers to a financial entity that integrates multiple parts of the ecosystem together to offer various products to users at the same location.

Blockchain is a monetary track. The value of a protocol lies in its economic output. Composability and real-time verifiability allow blockchain-native businesses to achieve vertical integration. Tokens enable participants in the stack to gain incentives through shared media. Teams that aim for every part of the stack to capture value possess moats. Vertical integration helps accelerate capital flow within the ecosystem. If done well, it will become a source of revenue.

Uber aggregates passengers across the city, positioning itself as a demand aggregator, and Swiggy does the same. You might think there’s not much difference between ordinary passengers or hungry people; they can be commoditized. Therefore, as a platform, Uber can extract 30% from each aggregated "commodity" (i.e., human users). Restaurants hate this, and so do drivers. They all try to bypass the platform by enabling users to pay in cash directly.

Passengers (or me) understand that the platform's ability to implement a reputation system is what adds value; hence, they don’t engage in cash transactions today.

You can see similar cases on Jupiter on Solana. Its early influence came from its ability to route orders across exchanges and provide users with the best prices. Unlike restaurants and drivers, Jupiter aggregates trading venues for my WIF buy orders.

However, Substack and Spotify operate on different parallel tracks. Spotify pays up to 70% of its revenue to record labels. Last year, it paid $1.375 billion to rights holders from $20.22 billion in revenue. For every dollar of revenue generated, only $0.04 ultimately reaches the artist's hands. Substack only takes 10% from the fees I pay to newsletter authors. It neither commoditizes readers nor authors; it simply positions itself as a tool. Perhaps this is intentional—if it has pricing power, authors on the platform may leave directly.

Spotify operates somewhat loosely as a supply-side aggregator due to its collaboration with numerous record labels, while Substack positions itself as a demand-side aggregator without pricing power, relying on its readership.

These applications each aggregate different sides of the market. However, their ability to accumulate capital (or pricing power) depends on how tightly they integrate within the ecosystem. We will soon see another version of this.

Web2 native aggregators have leveraged massive users brought by two forces:

Moore's Law has drastically reduced the cost of smartphones. There are 800 million smartphone users in India alone. Today, about 5.5 billion people are online globally.

The cost of the internet has decreased, alongside a rapid decline in bandwidth costs.

In contrast, cryptocurrencies as an economy have a much smaller TAM. By the best estimates, around 560 million users have interacted with cryptocurrency. Last month, the number of active wallets in DeFi was about 10 million. These are entirely different economies with very different sets of rules.

One relies on attention, while the other relies on the flow of funds within wallet links. We often confuse behaviors in the attention economy with those in the trading economy. For instance, user behavior in prediction markets differs from that on Instagram.

Revisiting Aggregation

Three years ago, when I first wrote about aggregators, I believed that blockchains reduced the costs of verification and trust. The initial promise of the internet was access, allowing you to buy goods from Temu in Shenzhen while sitting in your pajamas in New York. I thought blockchain could enable real-time verification and settle transactions with suppliers at very low costs. In other words, I predicted this would be the direction the industry would take.

In 2022, I wrote:

"We believe that blockchain will give rise to a whole new class of markets that can instantly verify on-chain events. This will significantly reduce the costs of large-scale verification of intellectual property, thus creating new business models."

In the years that followed, new markets indeed launched. NFTs saw trading volumes reach about $100 billion since then. Perpetual contract settlement amounts reached roughly $14.6 trillion. Decentralized exchanges' settlement amounts were about $10.8 trillion. The understanding that technology will be used to settle transactions with anonymous counterparts globally was correct.

However, it must also be pointed out that OpenSea's trading volume has dropped from around $5 billion then to approximately $70 million this month.

Markets emerge, evolve, and then perish, just like many things in life. In the process, they leave us fuel for thought. Sid believes speculation in cryptocurrency is a characteristic rather than a flaw. All new markets in their early stages are unclear; participants do not know what they are buying or understand why something holds value. Novelty is embedded in pricing. As rationality returns, valuations become effective, and bubbles fade into memory. Both NFTs and DeFi have gone through such cycles of frenzy.

These bubbles are vital for stress testing and validating the monetary tracks that ultimately support markets like Hyperliquid.

This reminds me of the experiences in the crypto space over the past few weeks. In the Drift and Kelp incidents, approximately $578 million was hacked over the last three weeks. In the past twelve months, around $1.7 billion has been stolen according to DeFi and crypto protocols tracked by DefiLlama. In the same period, total DeFi protocol revenue was about $3.42 billion.

In other words, over the past year, for every $1 of DeFi revenue earned, about $0.50 was lost due to hacking.

Meanwhile, we see more and more applications being launched, with the software itself becoming commoditized. The number of applications submitted to the App Store this quarter increased by 84% compared to the same period last year. At the same time, we observe two forces at work: more software competes for fewer users' attention, while a handful of platforms dominate most of the revenue created in the crypto space.

Now we realize that this industry loses $0.50 for every $1 earned. The turning point is steep—but please continue to think with me.

If we break down the $3.5 billion revenue created by decentralized channels, you quickly spot a pattern. About 40% comes from derivatives platforms, with Hyperliquid alone contributing approximately $902 million. The second largest category is decentralized exchanges, with the leader Uniswap generating about $927 million in fees. Lending platforms like MakerDAO rank third, totaling around $500 million in revenue. Their common trait is that they are all capital-intensive businesses.

Unlike products that can be built with a few lines of code on a Saturday afternoon, they require patient capital coordination, willing to take risks associated with these platforms.

This is where you realize the main difference between Web2 aggregators and Web3 native aggregators. Because blockchains are primarily tools for transferring funds and verifying whether transactions adhere to a set of rules laid out by developers—they only become valuable when they can engage in capital-intensive operations. Perpetual contract exchanges can repeatedly invest large sums in productive uses within the same day. Lending platforms extract a small portion from the substantial returns generated.

For example, Aave earned about $123 million from the $920 million in generated returns over the past year. But such aggregators can only dominate the market when they hold three key things simultaneously:

• Supply side (liquidity)
• Demand side (users)
• Distribution

Hyperliquid is a unique beast in this regard. It has paid nearly $100 million in code fees to builders, but the vast majority of its revenue comes from its native front end. It retains the best users while expanding the surface area for new users to engage with the protocol.

But what’s the logic behind this? One theory is that in Web3, distribution is a toll. Large protocols tend to own and retain their best users. When you notice the revenue created by decentralized exchanges compared to the on-chain aggregators routing orders, you start to understand this.

On Ethereum, aggregators account for 36% of all DEX transaction volume. On Solana, this percentage can drop to about 7% depending on the month. Kyber, 1inch, CoW, and ParaSwap together have generated only around $112 million in fees since their launch. Meanwhile, Uniswap, which dominates most of the transactional volume as a standalone exchange, has accrued lifetime fees of about $5.5 billion. You can see similar phenomena on Hyperliquid.

The code from builders accounts for only about 6% of Hyperliquid’s cumulative $1.1 billion revenue. MetaMask’s deep integration on Ethereum earned $184 million in fees through swaps last year. Phantom generated about $180 million, but considering this is a vast ecosystem, that's just a small fraction. These products can only function when built upon a single protocol that possesses liquidity and economic activity.

These products are capable of attracting and retaining users precisely because they have deep liquidity. From this perspective—capital in cryptocurrency is no longer a commoditized product. It is the most necessary ingredient. The vertical integration of capital provides participants with more reasons to remain within the ecosystem. In such a system, capital brings more liquidity because it can be directed into productive uses.

Capital is not a moat; it is the result of vertical integration. Vertical integration is the moat, and capital is merely a byproduct.

It’s important to note that this model only works when there’s no incentive to park capital. Don’t believe it? Take a look at any pre-launch protocol with an airdrop plan, and you will understand, or observe the countless L2s struggling to create value.

Any business engaged in capital aggregation is, to some extent, a target for hacks. Drift became a target because it had about $570 million TVL. KelpDAO was targeted due to holding about $1.6 billion in re-staked ETH. Hyperliquid, with around $2 billion in user deposits on its bridge, became one of the most valuable targets in the field. You can see similar cases with Ronin (about $625 million) and Nomad (about $190 million).

Because blockchain-native businesses need significant capital to create value, we face a dynamic: to win, one must remain vulnerable until secure mechanisms and systems to freeze funds flow are in place.

Even owning capital doesn’t guarantee success; significant TVL itself does not ensure success. In an economy, idle or underutilized capital can become liabilities in the face of hacking. That’s why protocols will try to differentiate themselves through the economic output they can generate, starting from niche use cases.

CHIP (the company behind USDAI) has issued about $100 million in loans this quarter, with a pipeline of $1.5 billion advancing, these higher-risk tranches are expected to yield about 16% APY this year.

The highest risk pools on Maple have an APY of around 15–20%, comparable or higher than the 12.6% APY currently in the USDC pool on Aave. It aggregates borrowers that can leverage protocol liquidity to create economic output.

Naturally, Hyperliquid serves as the best example of how supply-side aggregators can put capital to meaningful use. In the past year, Hyperliquid has generated approximately $942 million in revenue, with an average TVL of around $3.5 billion. By very rough calculations, every $1 parked in the protocol circulates approximately 285 times a year, producing about $0.30 in fees for every $1 TVL, compared to about $0.05 in fees generated by Aave for every $1 TVL in its lending market.

In a market where consumer preferences are not yet fixed and investor loyalty is low, capital will flow to where the best results are achieved. When considering hacking risks, investors will demand risk premiums. Currently, perpetual contract exchanges are the only places able to repeatedly put idle capital to productive use on-chain and generate fees.

I initially believed Hyperliquid was merely a supply-side aggregator that provided capital to users willing to trade on-chain. This has been my argument. This is indeed correct. However, when considering how it uses tokens to incentivize vertical integration, this argument falls apart. But before we continue, let me first explain how the vertically integrated ecosystem operates.

Ticketmaster is responsible for 70% of major live performances in the U.S. It extracts 30% from the ticket you purchase for Justin Bieber's singing old songs at Coachella because it owns the venue, promotes the tour, ensures you can buy merchandise at the concert, and coordinates with sponsors. The 30% you pay is 15 times Stripe's processing fee for online ticket costs. But you are willing to pay this premium because Ticketmaster has achieved vertical integration in the value chain.

You have a market illusion: artists, venues, and fans are all participants, yet no one can contest Ticketmaster's cut. The same goes for Apple's App Store. Apple handles curating the store, charging fees, ensuring the devices work properly, and bringing millions of users already accustomed to the "ding" of Apple Pay—even if you subscribe to another app you will never use.

Vertical Integration in Cryptocurrency

Protocols have begun to slowly implement the same logic.

In Web3, without vertical integration making it easier for capital providers to collaborate, capital providers can be seen as commoditized. Users will not have loyalty before the ecosystem integrates into a cumulative experience that cannot be replicated elsewhere.

For Maple, this integration requires years of experience dealing with hedge funds and market makers. For Centrifuge, integration involves acquiring nearly $1 billion from Grove for the JAAA bond issuance for Janus Henderson. They are not capturing fragmented and abstract parts of the economy; rather, they are offering better products to end users through vertical integration. In doing so, they create moats that cannot be quickly replicated overnight.

Maple's years of underwriting experience or Centrifuge's moat as a trusted capital coordinator is the moat in a world where capital and relationships are the only things hard to replicate.

Companies engaged in vertical aggregation may routinely hand off certain segments of the stack to third parties. Part of this is due to the fact that doing so does not yield significant economic benefits. Maple has custodial or MetaMask issue its own card, which may not bring substantial profits compared to the capital generated in swaps and credit underwriting.

However, when a business grows exponentially, having the entire stack is where competitive advantages are built. This also partly explains the mergers and acquisitions within the industry.

When a company achieves vertical integration, you are not competing against a singular product. The battle is over the comprehensive experiences users gain within it. On Hyperliquid, once HIP-4 goes live, users can deposit for free (through Native Markets), participate in prediction market positions, and trade those positions as collateral against its perpetual products. Its risk engine makes this experience possible. And it’s worth mentioning that even in today’s traditional finance, without merchant banks, this wouldn’t be feasible.

Hyperliquid has users, funding channels, a risk engine, a trading interface, liquidity, and token issuance rights. To compete with it, new businesses would mean fighting on six different fronts simultaneously.

For new applications coming online, accessing even a small part of this is far better than building upon a new protocol like Monad, which has only accumulated a derivatives trading volume of $2.6 billion (spread across its five perpetual protocols).

Integrated ecosystems like Hyperliquid will attract developers, more integrations, headlines, and happy token holders.

Exchanges have also seen this shift. Coinbase acquired Deribit, owns custodial services, jointly issues USDC with Circle while generating revenue from reserves, has extensive wallet infrastructure, and possesses funding channels in over 100 countries. It also launched its own chain in pursuit of a vertically integrated experience. Admittedly, Coinbase might be a bit premature in its pursuit of retail users who clearly don’t want to "mint" content on blockchain or use Farcaster.

Coinbase’s integrations exist in a loose form but are hidden behind layers of bureaucracy, regulatory hurdles, and internal priorities. This may partly explain the main difference between open integration systems and closed systems. As a $60 billion market cap exchange, Coinbase has little incentive to pursue marginal developers.

In contrast, Hyperliquid benefits from developing its core channel into the best trading venue while creating an ecosystem and generating value for the underlying token.

In this context, tokens are part of the integration as they are the shared matrix that maintains these integrations alive and valuable. This is why the industry confuses tokenized protocols with tokenized businesses. The premise of tokenized protocols is that third-party developers can easily build on them. It incentivizes people to guide value (down) towards the token—often in the form of market buybacks.

Companies like Robinhood and Coinbase are powerful economic players, but they cannot replicate the core owners of Hyperliquid—the operator network.

The protocols' airdrops ensure that those who own them are those who contribute economically. They possess enough tokens to drive value towards it. Hyperliquid is committed to this cause by utilizing 99% of its revenue for buying back tokens from the market. Imagine a publicly traded company using 100% of its revenue to buy back employee ESOPs. We might see people's acceptance of capitalism increase.

That’s why the industry is evolving—whether we like it culturally or not. Solana focuses on immutability, Ethereum on censorship resistance and open source, but you will see the industry adjusting its ideology according to business realities.

While Hyperliquid is a beautiful garden, it is a walled garden. To my knowledge, its source code is not open-source. The workings of its risk engine cannot be verified either. Maple’s risk underwriting parameters are also not public. As a lender, I may not even know who underwrites the loans on USDAI.

Negotiating with Chaos

If for every $1 of revenue created, $0.50 is lost to hacking, an economy cannot be built. If founders are held accountable for hundreds of millions of TVL parked on their products, they will rush toward AI. Whenever a hack occurs, we are eager to wish for stablecoins to be frozen. This often translates into centralization.

The vertical integration stack ultimately needs to relinquish complete decentralization for economic progress.

This is not a new story on the internet. In the late 1990s, there were great dreams of an open internet that allowed free speech without consequences. Yahoo once auctioned Nazi memorabilia until a French court intervened in 2000. Tim Wu delves deep into this in his book “Who Controls the Internet?” The story of the internet, or rather the story of all human commercial networks, is that complete decentralization gives way to a moderated version where partial control is relinquished for economic interaction.

We accept diluted versions of the original vision so that commerce can scale because without dilution, chaos will follow.

This tremendous energy expansion is reflected in how we describe those eras: the "wild" west, the "bubble" of the internet. Perhaps cryptocurrency is also experiencing similar expansion and energy convergence. I explored these topics in depth in the following article last year.

What Does This Mean for Founders?

Observe the data of MetaMask and Phantom. These businesses earn more than most L2s because they are downstream of ecosystems that possess huge economic output. Building bridges and exchanges where there’s no liquidity and users is no longer a viable business model, especially when accompanied by the pains of hacks. You should build where liquidity and users are present today.

Imitating vertically integrated products overnight may be impossible, but you can build upon them.

Operating systems also have experienced similar patterns. When Blackberry declined and iOS became dominant, developers had to choose where to build. We see similar situations in the crypto space. Only this time, capital incentives may keep developers blindly adhering for longer.

Platforms and protocols on the internet are very similar to this. We may not like the rules embedded within them, but they keep things functioning.

In the era of vertical integrators, we might increasingly agree on some rules to ensure our funds remain around while the economy we invest a lot of time in can continue to scale. The trend is pointing in this direction. Stablecoins, RWAs, perpetual contract exchanges with closed risk engines, lending platforms with unknown risk underwriters, and off-chain RFQ products like Derive all point to the same trend.

That is, vertical integration capital aggregators willing to relinquish the dream of complete decentralization for progress.