Exploring the Value of Web3 Protocol Layer: Earning from Economic Models or Providing Low-Cost Services to the Community?

Authors: JOEL JOHN, SIDDHARTH

Compiled by: Deep Tide TechFlow

A protocol is a set of rules that participants in a system follow. For example, protocols in the military dictate how people should act. There is a "protocol" among diplomats that governs how they interact with each other. Protocols can be seen 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 instance, RSS is a protocol that defines how information about articles is updated in a client. SMTP defines how emails flow to inboxes. Protocols are context-specific bundles of rules.

On the other hand, a platform is an operating system, a social network (like Meta), or hardware (ARM/NVIDIA) that allows a set of protocols to run on it. When you use Outlook (an application) on Windows (a platform), you are using SMTP (a protocol) to transfer data to Windows. Currently, there is no Web3-native platform that has been scaled. Solana's mobile devices may have their operating system, fine-tuned to meet industry needs. Ronin has its app store that allows the distribution of NFT-supported games.

However, when you consider the scale of Azure, Facebook, or iOS, you will find that there are no platforms of similar scale in Web3. (This is likely because we don’t need them yet). In 2019, both Samsung and HTC attempted to create mobile devices that supported hardware, but I believe the demand for mobile devices that support wallet hardware has decreased with the release of tools like Secure Enclave.

What confuses me is that applications can also be a concept of protocols. Take 0x as an example, is it a protocol or an application? Matcha is an application, while 0x is a protocol that multiple DeFi products can associate with to obtain liquidity. Similarly, OpenSea has Seaport, and their protocol allows various NFT markets to share liquidity. Do you understand the point?

Because in the early stages, it is difficult for protocols themselves to attract multiple developers, developers often release an accompanying application to drive activity. If you are a standalone application, you are likely to be replaced by other applications. OpenSea lost to Blur in the royalty war. But if you are a protocol with multiple applications built on it, the likelihood of being completely replaced is greatly reduced.

So, if you zoom out a bit, the strategy over the past few years has been relatively simple.

• Launch an application. Drive liquidity by providing token incentives.

• Scale to a certain extent, now allowing third-party applications to leverage your liquidity.

• Release a protocol with governance tokens.

Compound and Uniswap are examples of this strategy. Coincidentally, the core products they released are so robust that people do not consider building applications on top of the protocol. Products like DeFiSaver, InstaDApp, MetaMask, and Zapper send liquidity into these products. But most user activity occurs on the originally released product, which is the native website of the protocol.

In these cases, teams build a moat in two ways.

1. First, through distribution, they become the most reputable brand in the industry.

2. Second, through the network effects generated by sending liquidity to them via multiple applications.

In other words, in the realm of digital assets, applications can evolve into protocols (or platforms). As Roll-ups make it easier for applications to masquerade as L2s, we will see more and more applications claiming to be protocols in hopes of increasing their valuations.

Utility

During the ICO boom, there was no clear definition of the utility of tokens. It was generally believed that tokens should not engage in activities that could make them securities, and there were no other clear stipulations. People would attempt dividends, buybacks, and burns (like Binance), along with governance rights that come with tokens. The crux of the issue lies in linking economic value to something that can be minted at no cost.

Trading networks like Bitcoin, Ethereum, and Ripple can claim that conducting transactions requires a small portion of the asset. As the number of transactions increases, the value of the underlying assets (like ETH, XRP, etc.) also rises. The cost of transacting on Ethereum is equivalent to a low-cost Android device if someone is minting at the same time you are trying to transfer.

This framework of thinking is helpful for valuing many tokens, as their value is based on the revenue generated from transaction fees. Ethereum's EIP 1559 burns a small portion of the token supply with each transaction, making it a deflationary network. When you are a foundational layer that derives value from transaction volume, this concept is very effective.

But when you are an application rather than a trading network, requiring users to hold your native asset becomes a hindrance. Imagine if your bank required you to hold their stock every time you took out a loan. Or if a McDonald's employee asked how many of their stocks you held before serving you a burger.

If tying real use cases to the underlying asset becomes a requirement, it leads to terrible outcomes. Exchanges are very aware of this. That’s why Binance or FTX (RIP) never required you to hold their tokens to trade. They simply guided you to use their tokens by offering you discounts.

Many tokens that we now refer to as governance tokens are actually hidden utility tokens. That is to say, their utility stems from the idea that they can be used to govern the network itself. There is currently debate about whether DeFi has truly achieved decentralized governance, but the basic assumption is that holding an asset helps express opinions on how the product operates.

For many DeFi projects, this means the ability to change fee variables, supported assets, and other random financial features. In this case, token holders do not receive income from the product, but the tokens they hold "govern" a treasury that could generate income. Therefore, if a product generates $100 million in fees for users, then a multiple based on that number is relevant when considering fair valuation. The P/E ratios of Compound and Aave align with what we see in listed fintech companies. The market is driven by narratives in the short term, but over time it will revert to rationality.

The market is a narrative machine that occasionally exacerbates hype. When this happens, the valuation of a platform is more influenced by the narratives it can drive rather than just the fees it generates. Simply put, if a thousand people notice that ten people are using a dApp, then the valuation of that token may be higher than the fees generated by those ten users.

This is because, due to the liquidity characteristics of digital assets, capital allocators outnumber users. Take Compound as an example; Compound has over 212,000 people holding tokens in wallets outside of exchanges. In the past month, about 2,000 people have used Compound for loans. By Web3 standards, this 1% ratio is still a healthy number.

Ashwath Damodaran refers to this situation as the large market illusion. In a paper he wrote in 2019, he explored how multiple venture capital firms bet on similar themes, assuming all their bets would eventually win. We are seeing this in the AI space now.

Billions of dollars flow into multiple companies engaged in the same endeavor, assuming the market is large enough to support them all. Venture capital firms invest capital hoping that the startups they invest in can stand out and capture enough market share to justify a higher valuation. Given the patterns we often see in startups, many companies will fail. We are seeing this shift in the digital asset space as well.

When a small number of users appear, individuals rush to trade some asset. Typically, people believe that utility will continue to rise and match valuations. Soon, a new product emerges, complete with shiny token airdrops. Users flock elsewhere, and valuations drop as the market reprices the platform's underutilization.

dApps vs Protocols

Now that we have established some basic economic concepts about how protocols and applications generate revenue, it is worth examining which of the two generates more fees. The chart above does not include Bitcoin and Ethereum because they have first-mover advantages. It also does not include Solana, in case you were wondering. You will notice that applications like Uniswap and OpenSea generate significantly more revenue than the average protocol. This may conflict with the notion that protocols should be more valuable than applications, as value flows downward (toward the infrastructure that supports it).

This is why simply citing "fat protocols" as a basis for supporting new second-layer solutions is misguided. Mature applications on Ethereum can generate more fees than relatively young entire protocols.

There is a reason for this. dApps tend to make money by capturing a small portion of the transactions on them. Your fees are proportional to the amount of capital flowing through the product and your fee rate. Uniswap and OpenSea are able to earn nearly $2.8 billion because they have a high velocity of money (the frequency of asset turnover) and an executable fee rate that passes value to users.

For protocols, raising the fee rate as usage increases can undermine network effects unless the use case justifies it. Let me explain. If your livelihood depends on Bitcoin, paying a transfer fee equivalent to a week's income in emerging markets is acceptable. But once the fees rise, it is no longer acceptable for everyone. The immutability and decentralization of Bitcoin are characteristics that make people willing to pay a high premium.

The rates of Bitcoin are justified by:

• The Lindy effect of the network;

• Its decentralization and immutability.

But when you introduce stablecoins issued by centralized entities, the market will reprice the willingness to pay for the protocol. This is why Tron is the center of stablecoin activity. Here is a way to quantify it. Last week, the average USDC transfer amount on Ethereum was nearly $60,000. On Arbitrum, that number dropped to $9,000. And on Polygon, it was only $1,500. Using "average" as a metric here can be debated, but the assumption is that as fees decrease, transactions below $100 become possible. The point I am trying to illustrate is:

• We assume that as the number of transactions increases and transaction costs rise, the protocol becomes more valuable.

• However, high costs often undermine the network effects of users concentrating 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 accumulated wealth through ETH, the ICO boom, the NFT boom, and the DeFi boom, along with the robust infrastructure that allows people to trade, lend, and borrow. When you build on a new hot second-layer solution, you hope users will bridge their assets and use your product. It’s like starting a business in a new country. Sure, you face less competition, but there are also fewer users.

It’s like running the only Starbucks on Mars. Interesting? Maybe. Profitable? Probably not.

Community as a Moat

We have been deeply considering what the moat in Web3 is. Because unlike other industries, most applications in cryptocurrency are known for two characteristics.

1. Open Source: You allow anyone to replicate what you have built;

2. Capital Mobility: You allow users to leave with their funds at any time.

Despite having these two characteristics, Uniswap, Aave, and Compound have maintained a relative advantage in what they do over the years. Multiple DeFi products once copied Compound, but ultimately faced disastrous outcomes. So what is the moat of these products?

In this industry, the simplest measure of a moat is liquidity. If you are a capital-intensive product, liquidity is the amount of funds available to facilitate product transactions. If you are a consumer application, like a game, liquidity is attention. In both cases, the key driver of liquidity or capital is the community. So in Web3, the only real moat is the community. What keeps early community participants retained is capital incentives or product utility.

Products like ChatGPT, which significantly improve user experience, do not need to provide incentives to attract users. Blockchain technology occasionally produces similar magic for applications. DeFi crossed this chasm during the golden age of AMMs and permissionless lending, which revived in June 2020, a time we nostalgically refer to as "DeFi Summer."

A large user base seeking to make quick money through airdrops may appear to be a community. But it is not. In the long run, this is a "cost" to the network because if you want to maintain price, buyers of the tokens must provide sufficient liquidity. For example, news emerged yesterday that 93% of the tokens held in Arkham Intelligence wallets were immediately transferred. Were those selling members community members or a cost to the network?

If they strategically repurchased, they could become community members. But as long as they do not need the tokens to use the platform, they have no incentive to repurchase. They can allocate that money to hundreds of other tokens. DeFi products like Compound and Uniswap not only have token holder communities but also thousands of individuals leaving billions of dollars in their product's liquidity pools.

You can replicate their codebase, but without building a steadfast community, you cannot replicate their liquidity pools for long enough. Capital incentives help retain the community in the long term.

Capital incentives can be rewards given to users in the form of tokens for executing functions on the network. For example, those providing Filecoin storage receive tokens for their contributions. Early participation in the network is another way capital incentives accumulate for users. Bitcoin and Ethereum are similar in this regard, as their early adopters accumulated significant wealth through early participation and patient holding.

Users' capital allocation needs are transcended through shared culture. Bored Apes and the numerous GMs or WAGMIs we saw on Twitter during the last bull market are examples of this. Culture helps individuals align their identities and keeps them engaged for longer. Culture cannot be measured in a quantifiable way, but the excitement we see around EthCC or Solana's Hackerhouses is one such example. It provides individuals with a mechanism to build, connect, and conceive without having to invest capital to participate in the conversation.

Protocols cannot run solely on vibes; you need people to build on them. Developers are the means by which culture and capital combine to help retain users in the long term. If we view a protocol as a country, the practical tools built by developers will keep users (citizens?) on the network for the long term. Protocols can charge fees, just as highways can charge tolls. But if the fees are too high, they will drive users elsewhere. From this perspective, it is clear that if the use case is consumer-related, the protocol may not be designed to make money at all.

The moat in Web3 is formed by users persistently using the network to facilitate economic transactions within applications. Each network has the same set of dApps using the same code but branding them differently and selling the idea of "lower transaction fees" as a unique selling point. We will soon have decentralized ecosystems where users' attention will be dispersed. Indeed, capital will flow into these ecosystems through exchanges in the short term as users transact, but they will quickly turn into ghost towns like EOS.

In the real world, you cannot replicate a country. There is no mechanism to expand land within borders (without violence or economic consensus). This is why people are forced to concentrate in central hubs, which have historically been ports. London, Mumbai, and Hong Kong are similar in this regard. The concentration of people helps drive network effects within cities. Rents soar, but that means faster groceries and better services.

In the digital realm, due to the way intellectual property operates and the expansion of product suites, users are forced to concentrate within a single ecosystem. Google's launch of its search engine, Gmail (2004), Android (2005), and YouTube (2006) has all contributed to our increased stickiness to that ecosystem. Users who register for Gmail inevitably enter Alphabet's other product suite. Apple and Meta also have similar strategies to concentrate users within their ecosystems.

Apple takes this to the extreme by owning the entire stack from hardware to payments. Concentrating user bases helps achieve economies of scale. I mention this for a reason, and it boils down to developers.

If I were to draw a hierarchy of needs for early protocols and dApps, it would look like the following. You need developers to:

• Form code;

• Invest capital;

• Attract users.

Without code, we are just spinning our wheels.

Venture capital firms that have existed since the early 2000s have emphasized developers. This is because the number of developers is an accurate measure of the economic activity that could occur on a protocol. Suppose you bought an iPhone because of its camera. It is likely that you will eventually purchase an application that helps you edit images on the device.

Thus, your initial decision (the camera) drives a secondary purchase (the application). With each new application that emerges, the ecosystem becomes stronger as the suite of products available to users expands. The value proposition of purchasing the device is no longer just the camera, but the entire ecosystem open to users.

This change was also evident in the early stages of the internet. People were not subscribing to the "internet." In their minds, they were subscribing to a webpage summarizing what was happening on the internet. But it was only when people realized they could send emails and awkwardly text their crushes at school that the open internet developed.

Now imagine if there were 20 different internets competing, each with their publicly traded stocks and completely different brands and variations of transaction fees. Consumers would be confused, and the internet would not be what it is today. This is where we find ourselves with Web3-native protocols.

Value Capture

Protocols need a significant amount of user liquidity to support the emerging applications on top of them. 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 that emerges, we dilute the number of users for Web3-native products. There may come a time when users do not know the chain or stack behind their tools. But we are not there yet.

In the meantime, hoping that each protocol can capture as much fee revenue as mature dApps may be misguided. The first generation of blockchain dApps was capital-intensive. The next generation may be attention-intensive. There are currently no large-scale Web3 games because we prioritize transactions over excellent gameplay. Blockchain is essentially financial infrastructure. Therefore, it is reasonable to assume that every user wants to transact.

But this mindset has hindered the industry's development to some 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 may fluctuate up and down based on the hopes or fears of the crowd. Speculation has been a driving force in financial markets for at least eight centuries. I doubt we will change this aspect of human behavior anytime soon.

For founders, the information is very clear. You can make money by driving narratives, even if protocol fees or usage are insufficient. Meme tokens are an extreme version of this situation. Another way is to build a dApp that can generate fees and has reasonable multiples. Aave and Compound have evolved into platforms with these characteristics. Both approaches require a significant amount of work.

The best founders we have seen can drive narratives and platform usage, but only one side usually leads to disaster. Protocols or applications that provide unparalleled core utility may have higher acceptance rates due to their stickiness. This embodies Peter Thiel's view that "competition is for losers." The more crowded a market segment is, the lower the probability that new entrants can achieve higher acceptance rates or sticky users. All of this only considers user concentration. What about protocol economics?

Joe Eagan from Anagram presents a good analogy here. The best protocols have a behavior incentive mechanism similar to Amazon. Amazon was nearly unprofitable for a long time, but the inherent network effects paid off in the long run. The most extensive sellers on Amazon meet the largest buyer base. In the long run, any "successful" protocol may have similar attributes. Extremely low fees, with the most extensive applications built on top, so users can complete daily functions without needing to go elsewhere. The monetization of such protocols may be achieved through the richness of the data they leave on the blockchain.

This could mean launching a protocol without a token. It could charge fees in dollars instead of charging for a new native asset. Imagine paying a transaction fee of $0.0001 with USDC. Users could have a dollar "recharged" to their wallets after completing 10,000 transactions at a local store. But the problem is that most underlying chains cannot do this because their native tokens are essential to their security models, and we are unclear how such protocols would profit. Such protocols could scale exponentially without requiring users to spend large amounts of money every time protocol usage surges, as is the case with today's Ethereum.

If we believe that blockchains are the infrastructure for transactions and that all behavior on the internet will become transactional, we may inevitably need low-cost protocols and fixed costs. Or, we may end up with 50 new L2s, each with extremely high valuations because the market loves novelty. The market can facilitate both, and perhaps that is the beauty of it, both utility and speculation.