Revisiting the Fat Protocol Theory: The Value Capture Ability of the Protocol Layer is Diminishing

Source: Messy Problems

Original Author: Chia Jeng Yang, Messari Analyst

Compiled by: Biscuit, Chain Catcher

In 2016, Joel Monegro from Union Square Ventures published a public paper on Fat Protocols. The Fat Protocol theory suggests that crypto protocols can capture more value than Dapps; for every dollar of value captured at the Dapp layer, the protocol layer can capture the same or even more value, as the application layer relies on the protocol layer to support all interactions.

This paper is crucial for determining the value of cryptocurrencies, guiding investors' investment directions, and understanding the relationship between the application layer and the protocol layer. Unfortunately, due to a recent series of events, opponents have challenged this paper and attempted to overturn some of the arguments of the Fat Protocol theory. The importance of this paper lies in its direct impact on investors' allocation between multi-chain protocols and Dapps. Ashwath from Delphi Research pointed out, "This article on the Fat Protocol theory is directly related to whether Ethereum will continue to dominate."

The arguments questioning this theory include:

• Erosion of monopoly: Multi-chain Dapps and Dapp brand effects
• Exaggerated network effects: Protocol competition leading to lower Gas fees
• Reffal curve: The role of Roll-Ups in reducing total demand
• A new framework for L1 value capture: Currency or nation

Why does the Fat Protocol theory make sense?

The Fat Protocol theory is based on three elements of interaction between protocols and Dapps:

• Any Dapp built on a protocol requires the protocol's native token to support transactions within the Dapp.
• In attracting users, cloning a Dapp is much easier than cloning a protocol, as protocols are more irreplaceable compared to Dapps.
• Protocols capture more value than Dapps because the value capture of a protocol will be reflected in any transactions (value creation) processed at the application layer, which includes the value captured by the Dapp itself.

Flaws in the Fat Protocol theory

Joel John from LedgerPrime pointed out that stablecoins have exposed the first flaw in the Fat Protocol theory. With stablecoins like Tether launching ERC-20 tokens, the market cap of ETH did not rise alongside the market cap of stablecoins, indicating a breakdown in the linkage between protocol and Dapp value capture (at least for stablecoins).

The main argument of the Fat Protocol theory is that the market cap of Dapps on Ethereum is only a small fraction of Ethereum's own market cap. However, this situation has now been "flipped."

Considering that Dapp valuations may have speculative bubbles, in the long run, Dapp valuations will inevitably be lower than the market cap of ETH. However, since the paper was published, there have been multiple instances where the market cap of ERC-20 application layers has exceeded that of ETH since 2020, 2021, and 2022 (320b vs 311b).

(Snapshot: Calculated by summing the market caps of the top 308 ERC-20 tokens on CoinMarketCap as of February 20, 2022)

On one hand, the "flip" in Dapp market cap may be the result of a speculative bubble in Dapp valuations, suggesting that in the long run, the market cap of ETH will be higher than that of its underlying Dapp market cap. On the other hand, this may reflect an increasing market fit of Dapp products in a mature crypto ecosystem, which further undermines the Fat Protocol theory.

Moreover, the current market's Dapp market cap gap is underestimated. Centralized organizations interacting with protocols may also contribute to protocol development but do not necessarily reflect their value solely through tokens. For example, organizations like Opensea or Coinbase derive value reflected in their company's equity rather than in unreleased tokens.

Exaggerated network effects: Protocol competition leading to lower fees

Joel's paper was completed during an era dominated by single-chainism, where protocols provided almost irreplaceable network effects. Today, the scalability of ETH and the incentives for project parties have injected strong momentum into multi-chain development.

The main way protocols capture value is by facilitating on-chain transactions, from which they capture Gas fees.

Cross-chain infrastructure helps facilitate an increasingly sustainable multi-chain world. Even according to the value capture mechanism of protocols, protocols will lower Gas fees to compete with each other (see Solana's rent exemption policy).

Multi-chain Dapps & Forking limitations

Given the popularity of various protocol ecosystems, Dapps that only build on a single ecosystem are at a disadvantage in expanding their user base. More and more Dapps will be deployed across multiple chains to avoid being "stuck" on one protocol. For example, rising ETH Gas fees have led Dapps and token holders to migrate to alternative L1s like AVAX, SOL, etc. This trend allows Dapps to diversify their products and user bases by providing multiple integrated services to various communities. The AAVE project based on Polygon and AVAX is a good example, as pointed out by Dragonfly Capital—BSC taught Dapp project parties one thing: if you don't launch on my platform, we will only release a fork of yours and take the benefits that should belong to you.

Moreover, there is an increasing recognition of the brand value of Dapps. Uniswap's expansion to the AVAX public chain is likely to be more successful than a forked version of Uniswap on Polygon, as Uniswap can leverage existing liquidity relationships, manpower, capital, revenue, etc., to shape its brand value. Even if Uniswap previously had no experience operating on the Polygon public chain, consumers may trust Uniswap's multi-chain version more due to its brand effect.

These developments weaken the monopoly of the protocol layer in value capture.

Roll-Up theory

"You mentioned ETH's L2, like protocols such as Polygon!"

L2 helps address some key issues of ETH and maintain ETH's transaction volume. However, as L2 merges small transactions into a single L1 transaction, it will reduce the Gas fees for transactions of the same volume of ETH.

An argument similar to tax revenue is that lower transaction costs (tax rates) can still generate higher total demand for ETH (tax revenue), as this will help increase the frequency of Dapp development/transactions.

This theory is called the Reffal curve of protocol value capture, named in honor of economist Mr. Reffal (/s). The above explains the theoretical impact of ETH L2 on L1 ETH demand, and this theory is also widely applicable to any alternative L1 and its Gas schemes. Notably, the area to the right of Reffal curve B cannot exist from the perspective of the Fat Protocol theory, as it presupposes that protocols are in a monopolistic position. The curve to the right of B indicates that users and Dapps switch to alternative L1s for transactions.

According to the Reffal curve, as competition between protocols intensifies and L2 Gas fees decrease, it is more likely to approach point A rather than point B. Ethereum single-chain advocates will not believe in a scenario moving from point C and approaching point B, while multi-chain supporters will find themselves standing on the side of point A, as alternative L1s can quickly take market share from ETH. If macro trends in cryptocurrencies drive transaction volume and demand to continue rising far beyond the services that existing capacity can provide, then multi-chain supporters may find themselves at point B.

Given the elastic price cost of ETH Gas (calculated by Vitalik in 2018) is greater than 1 (i.e., price elasticity, where demand changes more than price changes), a decrease in Gas prices is more likely to push multi-chain supporters towards the C side rather than the A side.

Considering that throughput can be infinitely scalable in alt-L1s, developing quality crypto projects is more challenging than increasing transaction throughput; my personal view is A.

Currency or Nation?

The most controversial discussion of the Fat Protocol is that the method of evaluating protocols is using currency rather than GDP. As Nick Hotz from Arca pointed out, for example, in the United States, the money supply is about $20 billion, while equity is $50 billion, and the ratio of money supply to equity varies based on the value that the government (protocol layer) provides to its companies (application layer).

Revisiting the fundamental points of the Fat Protocol theory helps to understand protocols more intuitively, but it also further undermines the Fat Protocol theory.

This is because if protocols are viewed as currency rather than GDP, the total market cap of the underlying blockchain/currency supply does not necessarily need to exceed the market cap of the Dapp layer.

Nick Hotz further pointed out that while the Fat Protocol theory was ahead of its time, its success primarily stemmed from a lack of alternative investment venues and the inherent lack of attractiveness of the applications themselves, which do not necessarily derive value from the protocol. Given the increase in market fit of numerous Dapp products since Joel wrote the Fat Protocol theory in 2016, this theory also shows limitations.

Why is it important for portfolio construction?

On one hand, the correct argument of the Fat Protocol theory is that the value capture ability of the protocol layer is greater. However, currently, the value capture ability of the protocol layer is declining. In fact, high returns for quality investors come from protocols rather than Dapps. For example, Solana reached a token market cap of $100 billion after 4 years.

It can be concluded that the growth of TVL/utilization beyond a certain point does not correspondingly increase protocol value. Given the denial of the single-protocol monopoly era, revisiting the Fat Protocol theory has financial guidance significance (or venture capital significance) for investments and increases the share of Dapps in the portfolio.

The Fat Protocol theory leaves behind some principles that have stood the test of time. While investors can profit in the short term by betting on emerging protocols, they should be mindful to allocate more of their portfolio to Dapps, which is a way to hedge against intensified protocol competition. Since 2018, the theory has shown flaws and limitations and has been impacted by the development of multi-chain, such as the increased market fit of Dapp products, multi-chain competition effects, and exaggerated blockchain network effects. The Dapp:protocol market cap ratio has raised doubts about future viability. However, so far, investing in protocols remains the most robust medium- to short-term strategy.

Thanks to Jose L Sampedro Mazon, Chiyoung Kim, and Mike Giampapa for their comments, although I do not agree with your views.