In 2016, Joel Monegro of Union Square Ventures published a seminal paper on how cryptocurrency protocols will be able to capture more value than the dapps on them. In other words, the “fat protocol theory” states that for every dollar of value captured by the application layer, the protocol layer will be able to capture at least the same dollar, if not more, because the application layer needs to utilize the native protocol token to support all interactive.
This paper is critical in determining where the value of cryptocurrencies lies, where investors should invest, and how to think about the application and protocol layers. Unfortunately, due to a series of recent developments, we find this theory under a lot of pressure and explore whether the “fat protocol theory” can be pronounced dead. The importance of understanding this theory is that it influences how we allocate our investment focus to protocols or dapps, and our perception when first entering. Ashwath of Delphi Research noted that “the soundness of the fat protocol theory is key to Ethereum’s continued dominance .”
The main reasons for the decline of this theory include the following:
- Reduction of Monopoly: Multi-chain Dapp/Dapp Branding
- Exaggerated network effects: long-term protocol competition leads to lower fees
- The Reffal Curve: The Role of Roll-Ups to Reduce Aggregate Demand
- A New Thinking Framework for L1 Value Capture: Currency Pair Country
Why “Fat Protocol Theory” Makes Sense
Fat Protocol Theory is based on 3 main descriptions of the interaction between protocols and dapps:
- Any dapp built on top of the protocol requires the protocol’s native token to support any transactions within the dapp.
- Cloning dapps and attracting users is much easier than cloning protocols and attracting users, which gives protocols a more monopolistic competitive position relative to dapps.
- Therefore, the protocol will capture more value than the dapp, because the value capture of the protocol will be reflected in any transaction (value creation) processed by the dapp layer, not to mention the value that the dapp itself will capture.
Measuring the cracks in the fat protocol theory
LedgerPrime’s Joel John noted that the first cracks in the fat protocol theory emerged when capital-intensive use cases such as stablecoins emerged. With stablecoins like Tether driving the adoption of ERC-20 tokens, the market cap of ETH has not risen proportionally as the market cap of stablecoins has risen, suggesting a fundamental emergence of the protocol/application value capture relationship break (at least for stablecoins).
The main proof of the fat protocol theory is that we should expect the market capitalization of dapps on Ethereum to be a fraction of the market capitalization of Ethereum itself. And another situation can be described as “flipping”.
The idea is that a temporary speculative bubble in dapp valuations can exist, but must fundamentally recover below ETH’s market cap. However, since the paper was published, we have seen long-term instances of ERC-20 dapp layer market cap exceeding ETH market cap since 2020 , 2021 , and 2022 (320b v 311b).
(Snapshot: Calculated by summing the market capitalization of the 308 largest ERC-20 tokens on CoinMarketCap on February 20, 2022)
On the one hand, it can be said that the “flip” of dapp market value is the result of a temporary speculative bubble in dapp valuation, and we should expect the market value of ETH to return to the market value of its related dapps in the long term. On the other hand, it may reflect a growing dapp-product-market fit in a mature crypto ecosystem. Furthermore, it can be argued that the current divergence is underestimated. A centralized organization that interacts with the protocol may contribute to the development of the protocol, but not necessarily reflect its value capture in the token. A good example is Opensea or Coinbase, where the value capture of these organizations is reflected in the value of their company’s equity, not tokens that are not issued.
Exaggerated network effects: long-term protocol competition leads to lower fees
Joel’s paper was written in an era of overwhelming sentiment towards single-chain maximalists. It seems that the protocol provides the ultimate network effect that is difficult to replicate. But we see today that due to ETH’s scalability issues, as well as capital/financial incentives in general, there is a strong incentive for competing and increasingly specialized protocols to emerge.
One of the main ways to capture value at the protocol level is through the transaction/gas fees the protocol captures in the transactions it facilitates.
The emergence of cross-chain infrastructure helps facilitate an increasingly sustainable multi-chain world. Protocol competition then creates an incentive to reduce protocol fees, even if mechanisms for value capture exist (see Solana’s rent-free fees ).
Limitations of Multichain Dapps and Forks
A Dapp built on a single ecosystem limits their user base, which will be increasingly unsustainable given the prevalence of multiple competing protocols. Dapps will increasingly adopt a multi-homed approach, i.e. ensuring native interoperability between multiple protocols to prevent being “stuck” on one. For example, increasing ETH gas fees have seen Dapps and cryptocurrency holders migrate to alternative L1s such as AVAX, SOL, etc. Dapps see this trend and are able to diversify their product/user base by offering multiple integrations to serve communities across multiple protocol ecosystems. An example of this phenomenon is that AAVE is built on Polygon and AVAX. As Dragonfly Capital pointed out, “Binance Smart Chain (now BNB Chain) taught everyone: if you don’t launch here, we’ll just launch your fork and take your earnings”.
Additionally, there is a growing recognition of the value of brand equity to dapps. Since Uniswap has the ability to leverage existing liquidity relationships, talent, capital, distribution, etc., its expansion to another competing chain like AVAX is likely to be more successful than a third-party Uniswap fork on Polygon. Consumers are also more likely to trust Uniswap given the brand equity Uniswap has built before (even without experience on Polygon).
The premise of monopoly value capture at the protocol layer has been weakened by these developments.
The role of Roll-Up
“But you mentioned L2s on ETH like Polygon!”
L2s help to help address some of ETH’s key limitations and preserve transaction volumes on ETH. However, as L2s roll-up consolidates more transactions into one L1 transaction, it will reduce the amount of ETH required for the same amount of transactions.
One argument is that, similar to tax revenue, lower transaction costs (tax revenue) can still generate higher total ETH demand (tax revenue), as this will help increase the speed of dapp development/transaction.
Reffal curve of protocol value acquisition; X-axis is protocol gas fee; Y-axis is protocol value acquisition
I created the theory above and called it the Reffal curve of protocol value capture, to show my respect to Mr. Reffal (/s), my economics teacher. While we talk about this theory in relation to ETH L2s and their impact on L1 ETH demand, it is also broadly applicable to any alternative L1s and their internal gas policies. It should be noted that the Reffal curve, especially the region to the right of B, cannot exist in the view of fat protocol theory, since it assumes a monopoly view of the protocol. Here, the curve to the right of B indicates that users and dapps fork or switch to other L1s for transactions.
According to the Reffal curve, with increased protocol competition and reduced L2s gas fees, I believe we are more likely to see a situation closer to point A than to point B. Ethereum maximalists would disagree and think we’re going from point C to a situation closer to point B, while proponents of the multi-chain world may find themselves on the side of point A as alternative L1 has been able to move from ETH Take market share in their hands, or, if they believe that the macro trends in cryptocurrencies will drive volume/demand far beyond what current capabilities can handle, then they will also believe in point B.
An objection might be that, given what we know about the price elasticity of ETH gas costs ( last calculated by Vitalik in 2018 ) above 1 (i.e. price elasticity, the change in demand is greater than the change in price). Therefore, a drop in gas price will be more likely to bring us into the C side rather than the A side.
And I personally think it’s point A, because our bottleneck in the quality of cryptocurrency projects is far greater than transaction volume, especially considering the throughput of alt-L1 that is basically infinitely scalable.
currency and country
One of the most useful criticisms to emerge from the fat protocol theory debate is the use of currency rather than GDP as a means of evaluating protocols. As pointed out by Arca’s Nick Hotz , in the case of the United States, where the money supply is worth about $2 billion and the equity capital is $5 billion, the ratio of money supply to equity capital is based on the government (L1) for its company (native) application) will vary depending on how much value is provided.
The reshaping of the basic viewpoint of protocol value helps to have a more intuitive understanding of the protocol, but also further weakens the theory of fat protocol.
This is because the total market capitalization of the underlying blockchain/money supply does not necessarily need to exceed the market capitalization of the dapp layer if we consider the protocol to be currency rather than GDP.
Nick Hotz further pointed out that while fat protocol theory has been very profitable and ahead of its time, the main driver of its success is due to the lack of other investment venues, and the lack of traction from the application itself, not necessarily from the protocol level value acquisition motivation. Given the amount of relative dapp product-market fit we have seen since Joel wrote Fat Protocol Theory in 2016, Fat Protocol Theory is showing its limitations.
Why it matters for portfolio construction
On the one hand, “fat protocol theory” fundamentally gets the right conclusion that there is greater value capture at the protocol level, but we’ve seen compression of value capture at the protocol level. However, it is indisputable that even today, the best performing investors still see their returns coming from the protocol rather than the dapp. For example, Solana reached a token value of 100 billion market cap after 4 years.
At the very least, we can conclude that an increase in TVL/usage beyond a certain level does not increase the protocol value accordingly. This has interesting implications for whether growth investments in mature protocols necessarily make financial sense (in the sense of venture capital), given the denial of the monopolistic single-protocol world. Its negation also increases the value capture potential of the dapp layer and increases exposure to dapps in the portfolio.
The fat protocol theory leaves us with some principles that have stood the test of time so far, and while we can expect investing in emerging protocols to continue to be profitable in the near term, we should expect more portfolio allocation into dapps as a a way to intensify competition for hedging agreements. Since 2018, cracks and limitations of the theory have formed and are under pressure from widespread developments such as increasing dapp product-market fit, multi-chain competition, and exaggerated blockchain network effects such as dapps : as evidenced by the protocol’s market cap ratio. However, the protocol’s returns so far have said that its investment strategy in the short/medium term makes some sense, although we are no longer confident in its long-term viability.
Finally, thanks to Jose L Sampedro Mazon, Chiyoung Kim, Mike Giampapa for their thoughts/comments (ideas do not imply endorsement).
Posted by:CoinYuppie，Reprinted with attribution to:https://coinyuppie.com/the-decline-of-fat-protocol-theory-and-its-implications-for-building-crypto-portfolios/
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