If we believe that the blockchain is the infrastructure of transactions, and all actions on the Internet will become transactions, we may inevitably need low-cost protocols and fixed costs.
Original title: " Value Accrual "
Written by JOEL JOHN, SIDDHARTH
Compilation: TechFlow TechFlow
A protocol is a set of rules followed by participants in a system. For example, protocols in the military dictate how people should behave. There is an "agreement" between diplomats that dictates how they interact with each other. A protocol can be thought of as a bundle of rules. In the context of machines, especially computers, a protocol is defined as the rules that dictate how data flows. For example, RSS is a protocol that defines how information about articles is updated in the client. SMTP defines how email flows to your inbox. Protocols are context-specific bundles of rules.
A platform, on the other hand, is an operating system, social network (like Meta) or hardware (ARM/NVIDIA) that enables a set of protocols to run on it. When you use Outlook (an application) on Windows, you use SMTP (protocol) to transfer data to Windows (the platform). There is currently no extended platform native to Web3. Solana's mobile devices may have its operating system fine-tuned to meet industry needs. Ronin has its app store that allows distribution of NFT-enabled games.
But when you consider the scale of Azure, Facebook or iOS, there is no platform of similar scale in Web3. (Most likely because we don't need them yet). In 2019, Samsung and HTC both tried to create hardware-enabled mobile devices, but I think that with the release of tools such as Secure Enclave, the demand for wallet hardware-enabled mobile devices has declined.
What confuses me is the notion that an application can also be a protocol. Take 0x as an example, is it a protocol or an application? Matcha is the application, while 0x is a protocol that multiple DeFi products can link to for liquidity. Similarly, OpenSea has Seaport, their protocol that enables various NFT marketplaces to share liquidity. Do you get the point?
Because the protocol itself has difficulty attracting multiple developers in its early stages, developers often release a companion app to drive activity. If you are a stand-alone application, you will most likely be replaced by other applications. OpenSea lost the royalty war to Blur. But if you're a protocol with multiple applications built on top of it, the chances of complete replacement are much lower.
So if you zoom in a little bit, the strategy over the past few years has been relatively simple.
- Publish an application. Drive liquidity by providing token incentives.
- Evolved to the point where it is now possible to allow third-party apps to take advantage of your liquidity.
- Publish a protocol with a governance token.
Both Compound and Uniswap are examples of this strategy. It just so happens that the core product they released is so powerful that people don't think about applications built on top of the protocol. Products like DeFiSaver, InstaDApp, MetaMask, and Zapper send liquidity into these products. But the bulk of user activity happens on the original product launch, the protocol's native website.
In these cases, teams build moats in two ways.
- First, through distribution, they become the most prestigious brand in the industry.
- Second, the network effect of sending liquidity to them through multiple applications.
In other words, in the world of digital assets, applications can evolve into protocols (or platforms). As roll-ups make it easier for applications to masquerade as L2, we will see more and more applications claiming to be protocols in hopes of boosting their valuations.
Practicality
During the ICO boom, there was no clear definition of what a token could be used for. There is a general consensus that tokens should not engage in activities that would make them securities, but nothing else is clearly stated. People will experiment with dividends, buybacks and burns (like Binance), and the governance rights that come with tokens. The crux of the matter is connecting economic value to something that costs nothing to mint.
Exchange networks such as Bitcoin, Ethereum, and Ripple can claim to require a fraction of the asset to conduct a transaction. As the number of transactions increases, the value of the underlying asset (such as ETH, XRP , etc.) also increases. The cost of doing a transaction on Ethereum is equivalent to a low-cost Android device if someone is minting and you are trying to transfer money at the same time.
This frame of mind is helpful for the valuation of many tokens because their value is based on the revenue generated from transaction fees. Ethereum’s EIP 1559 burns a small portion of its token supply with every transaction, making it a deflationary network. This philosophy works really well when you're a base layer that derives value from transaction volume.
But when you are not a transaction network but an application, requiring users to hold your native assets becomes a hindrance. Imagine if your bank required you to hold their stock every time you took out a loan. Or if the waiter at McDonald's asks how much you hold in their stock before serving you a burger.
If it becomes a requirement to bundle real use cases with underlying assets, it can lead to dire results. Exchanges are well aware of this. This is why Binance or FTX (RIP) never require you to hold their tokens to trade. They just lead you in by giving you a discount for using their tokens.
Many of what we now call governance tokens are actually hidden utility tokens. That said, their utility stems from the idea that they can be used to govern the network itself. There is now debate as to whether DeFi has truly decentralized governance, but the underlying assumption is that holding an asset helps express an opinion on how the product operates.
For many DeFi projects, this means being able to change fee variables, supported assets, and other random features involving finance. In this case, token holders do not receive income from the product, but the tokens they hold "manage" a treasury that may earn income. So if a product generates $100 million in fees for users, multiples based on that number are relevant when considering fair valuation. Compound's and AAVE 's P/E ratios are in line with what we see among listed fintech companies. Markets are driven by narratives in the short term, but return to rationality over time.
The market is a narrative machine, fueling hype from time to time. When this happens, the platform's valuation is driven more by the narrative it is able to fuel than just by the fees it generates. In simple terms, if a thousand people notice that ten people are using a dApp, the token's valuation is likely to be higher than the fees generated by those ten users.
This is because, due to the liquid nature of digital assets, there are more capital allocators than users. Take Compound as an example. Compound has more than 212,000 people storing tokens in wallets outside the exchange. In the past month, about 2,000 people have used Compound to take out loans. By Web3 standards, 1% is still a healthy number.
Ashwath Damodaran calls this situation the Great Market Illusion. A paper he wrote in 2019 explored the bets made by multiple venture capital firms on similar themes, assuming that all of their bets would eventually turn out to be winners. We are seeing this happening now in the field of artificial intelligence.
Billions of dollars flow into multiple companies doing the same thing, assuming the market is big enough to support them all. VCs throw capital in the hope that the startups they invest in will stand out and have a large enough market share to justify higher valuations. Given the patterns we often see in startups, many companies fail. We have also seen this change in the digital asset space.
When a small group of users shows up, individuals flock to trade a certain asset. Typically, it is assumed that utility will continue to rise and match valuations. Soon, a new product appeared with an AirDrop of shiny tokens. Users flocked elsewhere, and valuations fell as the market repriced the lack of platform adoption.
dApps vs protocols
Now that we've established some basic economic concepts of how protocols and applications make money, it's worth looking at which of the two generates more fees. The chart above excludes Bitcoin and Ethereum because of their first-mover advantage. It also doesn't include Solana, in case you had doubts. You'll notice that apps like Uniswap and OpenSea earn much more than the average protocol. This may conflict with the notion that protocols should be more valuable than applications, since value flows downwards (to the infrastructure that supports it).
This is why it would be wrong to just cite "fat protocols" as arguments in favor of new layer 2 solutions. Mature applications on Ethereum can generate more fees than the relatively young entire protocol.
There is a reason for this. dApps tend to make money by capturing a fraction of the transactions on them. Your fee is proportional to the amount of capital flowing through the product and your fee scale. Uniswap and OpenSea were able to earn nearly $2.8 billion because of their high velocity of money (how often assets change) and enforceable fee ratios that pass value on to users.
For protocols, forcing a higher percentage of fees as usage grows destroys network effects unless the use case justifies it. let me explain. If your life depends on Bitcoin, it is acceptable to pay transfer fees equivalent to a week's income in emerging markets. But it is not that once the handling fee is increased, it will not be acceptable to everyone. Bitcoin's immutability and decentralization are features that people are willing to pay a hefty premium for.
Bitcoin’s rate is justified by the following factors:
- The Lindy effect of the network;
- Its decentralization and immutability.
But when you introduce a stablecoin issued by a centralized institution, the market will re-price the willingness to pay for the protocol. This is why Tron is at the center of stablecoin activity. The following is a quantitative method. The average USDC transfer on Ethereum last week was nearly $60,000. On Arbitrum, that number drops to $9,000. And on Polygon, it's only $1,500. Using "average" as a metric here is open to debate, but the assumption is that as fees fall, transactions below $100 become possible. The point I'm trying to make is:
- We hypothesize that protocols become more valuable as the number of transactions increases and transaction costs increase.
- But high costs tend to undermine the network effect of concentrating users on a single network and drive them elsewhere over time.
This is why dApps on emerging chains have never reached the critical velocity to create sufficient fees. When you launch a DeFi product on Ethereum today, you are leveraging the network effects of users who have amassed wealth through ETH, the ICO boom, the NFT boom, and the DeFi boom, and the robust infrastructure that allows people to trade, lend, and borrow. When you build on the new hot second-layer solution, you want users to bridge their assets and use your product. It's like setting up a business in a new country. Sure, you face less competition, but you also have fewer users.
It's like running the only Starbucks on Mars. Is it interesting? possible. Can you make money? maybe not.
Community as Moat
We've been thinking deeply about what a moat is in Web3. Because unlike other industries, most applications in cryptocurrency are known for two characteristics.
- open source: you let anyone copy what you build;
- Capital Flow: You allow users to leave with their funds at any time.
Despite these two characteristics, Uniswap, AAVE , and Compound have maintained a relative advantage in what they do over the years. Multiple DeFi products have replicated Compound, but failed miserably in this one. So what is the moat for these products?
In this industry, the simplest measure of moat is liquidity. If you are a capital-intensive product, liquidity is the amount of money available to facilitate transactions in the product. If you're a consumer application, like a game, fluidity is attention. In both cases, the key factor driving liquidity or capital is community. So in Web3, the only real moat is the community. What keeps early community participants alive is capital incentives or product utility.
A product that dramatically improves user experience like ChatGPT doesn't need to provide incentives for users to attract them. Blockchain technology enables applications that occasionally do similar magic. DeFi crossed this chasm in the golden age of AMM and permissionless lending, coming to life in June 2020, an era we miss and call it “DeFi Summer”.
A large user base looking to make a quick buck with an AirDrop might look like a community. But it's not. In the long run, this is a "cost" to the network, because the buyer of the tokens has to provide them with sufficient liquidity if you want to maintain the price. For example, it was revealed yesterday that 93% of tokens held in Arkham Intelligence wallets were transferred instantly. Are those sold members community members or a cost to the network?
If they buy back strategically, they can become community members. But as long as they don't need tokens to use the platform, they have no incentive to buy back. They can distribute this money among hundreds of other tokens. DeFi products like Compound and Uniswap not only have communities of token holders, but thousands of individuals holding billions of dollars in their products’ liquidity pools.
You can copy their codebase, but you can’t copy their liquidity pool long enough without building a committed community. Capital incentives help preserve communities over the long term.
Capital incentives can be in the form of tokens that reward users for performing functions on the network. For example, people who provide Filecoin storage receive tokens for their contribution. Joining the network early is also another way in which capital incentives accumulate to users. Bitcoin and Ethereum are similar in this regard, as their early adopters amassed riches through early participation and patience.
The capital allocation needs of users are transcended through a shared culture. Bored Apes and the many GMs or WAGMI we saw on Twitter during the last bull run is one example of this. Culture helps individuals align their identities and keeps individuals within them longer. Culture cannot be measured in a quantifiable way, but the excitement we see around EthCC or Solana's Hackerhouses is an example of this. It provides a mechanism for individuals to build, connect and conceive without investing capital in engaging in conversation.
Protocols can't run on vibes alone, you need people to build on top of it. Developers are a combination of culture and capital, a tool that helps to retain users for a long time. If you think of the protocol as a country, developers build utilities that will keep users (citizens?) on the network long-term. Protocols can charge fees, just like highways can charge tolls. But if the fees are too high, they will drive users elsewhere. Viewed through this lens, it becomes clear that if the use case is relevant to consumers, the protocol may not be designed to make money at all.
Moats in Web3 are formed by users sticking with the network for an extended period of time to facilitate economic transactions in applications. Each network has the same set of dApps using the same code but with different brands, and separately sells the idea of "lower transaction fees" as a unique selling point. We will soon have decentralized ecosystems and user attention will be divided. It is true that capital will flow to these ecosystems via exchanges in the short term as users transact, but they will soon become dead cities like EOS .
In the real world, you cannot duplicate a country. There is no mechanism to expand the size of the land within the borders of the country (without violence or economic coherence). This is why people are forced to concentrate in central hubs, which have historically been ports. London, Mumbai and Hong Kong are all similar in this respect. The concentration of people helps drive network effects within cities. Rents are skyrocketing, but that means faster groceries and better service.
In the digital realm, users are forced into an ecosystem because of the way intellectual property works and product suites expand. Google's launch of its search engine, Gmail (2004), Android (2005), Youtube (2006) all contributed to our stickiness to the ecosystem. Users who sign up for Gmail inevitably enter Alphabet's suite of other products. Apple and Meta have similar strategies of centralizing users within their ecosystems.
Apple takes it to the extreme by owning the entire stack from hardware to payments. Concentrating user groups helps achieve economies of scale. I mention this for a reason, and it comes down to the developers.
If I draw a hierarchy of requirements for early protocols and dApps, it will look like the diagram below. You need developers to:
- form code;
- capital investment;
- Engage users.
Without code, we're just spinning around in circles.
Venture capital firms that have existed since the early 2000's put a lot of emphasis on developers. This is because the number of developers is an accurate measure of the economic activity that may occur on the protocol. Let's say you bought an iPhone because of its camera. There's a good chance you'll end up buying an app that helps you edit images on your device.
So your initial decision (the camera) drives the secondary purchase (the app). With each new application, the ecosystem grows stronger as the suite of products available to users expands. The value proposition of buying a device is no longer just the camera, but the entire ecosystem that is open to the user.
This change was also evident in the early days of the internet. People don't subscribe to the "Internet". In their minds, they're subscribing to a page that summarizes what's happening on the Internet. But the open internet only grew when people realized they could send emails and send awkward text messages to people they liked at school.
Now imagine if there were 20 different Internets competing, each with their listed stock, and application variants with completely different brands and transaction fees. Consumers would be confused and the Internet would not be what it is today. This is where we are in the Web3 native protocol.
value capture
Protocols require massive user liquidity to support emerging applications on top of it. In the era of Rollup upgrades, everyone has the ability to pretend to be the next L2 (second layer scaling solution). However, with each new protocol, we fragment the number of users of Web3-native products. There may come a time when users don't know what the chain or stack behind their tool is. But we are not there yet.
In the meantime, it may be a mistake to hope that each protocol will capture as much fees as full-fledged dApps. First generation blockchain dApps are capital intensive. The next generation may be attention-heavy. There are no large-scale Web3 games yet, because we value transactions more than great games. Blockchain is essentially financial infrastructure. Therefore, it is reasonable to assume that every user wants to transact.
But this way of thinking has held the industry back to a certain extent.
All of this makes me wonder what "value" is. Tokens, like stocks, game items, and other liquid assets, will always have a premium. This premium can fluctuate up or down depending on the hopes or fears of the crowd. Speculation has been a driving factor in financial markets for at least eight centuries. I doubt we're going to change this aspect of human behavior any time soon.
For founders, the message is very clear. You can make money by driving the narrative, even if protocol fees or usage aren't enough. Meme tokens are an extreme version of this. Another way is to build a dApp that generates fees with reasonable multiples. AAVE and Compound have evolved into platforms with this characteristic. Both ways require a lot of work.
The best founders we've seen are able to drive both narrative and platform usage, only one aspect usually leads to disaster. Protocols or applications that offer unparalleled core utility are likely to have higher adoption rates due to their stickiness. This is the embodiment of Peter Thiel's "competition is for losers" point of view. The more crowded the market segment, the lower the probability that new entrants will be able to achieve higher adoption rates or sticky users. All of these only consider user concentration. What about protocol economics?
Anagram's Joe Eagan offers a good analogy here. The best protocols have an Amazon-like incentive for behavior. Amazon was barely profitable for a long time, but the built-in network effects paid off in the long run. The broadest range of sellers on Amazon meets the largest pool of buyers. In the long run, any "successful" protocol will likely have similar properties. The fee is extremely low, and the widest range of applications is built on top of it, so users don't need to go elsewhere to complete their daily functions. The realization of this agreement may be realized through the richness of the data left on the blockchain.
This scenario could be a protocol launching without a token. Instead of charging for new native assets, it can charge in dollars. Imagine paying a transaction fee of $0.0001 in USDC . Users can "top up" their wallets with a dollar for every 10,000 transactions they make from local stores. But the problem is that most base chains cannot do this because their native tokens are required in their security model, and it is not very clear how such a protocol can be profitable. Such a protocol could scale exponentially without requiring users to spend huge sums of money every time protocol usage spikes, as is the case with Ethereum today.
If we believe that the blockchain is the infrastructure of transactions, and all actions on the Internet will become transactions, we may inevitably need low-cost protocols and fixed costs. Or, we could end up with 50 new L2s, each with an extremely high valuation, because the market loves new things. The market can facilitate both, and that's perhaps the beauty of it, both practical and speculative.
