"Fat Application Chain" Theory: The Growth Path of Application Chains
Applying the trading multiples of independent applications to application chains is unfair, but due to the obvious differences in value accumulation mechanisms, it is difficult to argue that application chains should be traded at the multiples of the underlying layer.Author: HOPYDOC
Compiled by: MarsBit, MK
Evaluating app chains has always been one of the trickiest tasks for investment analysts, as app chains function similarly to standalone applications at a fundamental level, but inherit characteristics of the protocol or what is now referred to as the base layer, such as security and data availability.
Therefore, applying the trading multiples of standalone applications to app chains is unfair; but at the same time, due to the obvious differences in value accumulation mechanisms, it is hard to argue that app chains should trade at the multiples of the base layer. Taking the rise of Injective this year as an example, it is widely regarded as a re-rating trade. When the team announced support from ecosystem funds backed by Pantera Capital and Jump Crypto to build other applications on top of the application-specific layer, the market began to view app chains as protocols.
Injective's announced $150 million ecosystem fund
This sparked my interest in the first-generation "Fat Protocol Thesis," as I believe that understanding the evolution of how the market perceives the value of blockchains will give me some insights into how to consider the current value of app chains; or more specifically, app chains with ecosystems.
"Fat Protocol Thesis"
The "Fat Protocol Thesis" was originally proposed by Joel Monegro in August 2016 while he was still at Union Square Ventures; the thesis revolves around the idea that crypto protocols should theoretically capture more value than the applications built on top of them.
In short, this argument suggests that what we now refer to as the base layer protocols provide two unique core value propositions or sources of value accumulation, and therefore should always be viewed as more valuable than applications; or simply put, it provides a rationale for some very astronomical valuations; they come from:
Permissionless shared data layers: Blockchains effectively lower the barrier to entry for more new players, leading to more intense competitive dynamics within the system, and more importantly, enabling composability between them, thereby driving the growth of protocols.
Positive feedback loops driving the speculative value of native network tokens: The rise in token prices attracts the attention of developers and investors, which then translates into human or capital investment into the ecosystem, kickstarting its speculative value flywheel.
As an extension, protocols can capture the value created by the application layer through increased demand for native tokens, which typically manifests in the form of transaction fees; thus theoretically, the more transactions applications bring to the protocol layer, the more value the protocol can capture.
Why "Fat Protocol" is No Longer Relevant
The "Fat Protocol Thesis" subsequently underwent numerous debates regarding its timeliness, as this assertion was made during the era of maximization, when the concepts of modularity and application-specific chains did not even exist.
The market subsequently deemed that the "Fat Protocol Thesis" does not fully apply to the current market structure for the following reasons:
Overwhelming abundance of block space: Based on the number of alternative Layer 1s minted in the previous cycle, the protocol layer can no longer retain the value created by applications, as the abundance of block space compresses the prices users pay for equivalent transaction volumes.
The rise of modular blockchains: Effectively decomposing blockchain functionalities into execution, data availability, and settlement, resulting in cheaper data availability solutions, further compressing the fees users pay for the shared data layer in the original paper.
The convenience of multi-chain: Applications can easily launch on multiple chains and can even interact across chains with interoperability tools like LayerZero, significantly reducing reliance on a single protocol, thereby weakening the positive feedback loop in the original paper.
"App Chain Thesis"
With the introduction of the "App Chain Thesis," the demise of the "Fat Protocol Thesis" has arrived. App chains are blockchains built for specific use cases; their design enjoys several advantages, including:
Better value accumulation mechanisms: Native network tokens can be used for security purposes, leading to a decrease in token supply; and they can also derive value from the blockchain's business model.
Customizability: Developers can freely customize any configuration in the tech stack to achieve specific purposes, such as throughput and finality, and make trade-offs based on application needs.
For example, the latest dYdX v4 is implemented on a chain driven by Cosmos-SDK; this ensures that traders no longer need to pay gas fees for transactions; instead, they are charged based on the size of the transaction, mimicking the experience of trading on centralized exchanges.
Chorus One's research on dYdX v4
That said, app chains inherently have some drawbacks, which is why this concept has not fully gained popularity, for the following reasons:
Liquidity fragmentation and composability; native assets can only exist within specific app chains, and unless a particular asset is highly sought after and supported by interoperability products, they cannot interact with assets on other chains.
Limited security; theoretically, the security of an app chain is only guaranteed by a portion of the fully diluted valuation, depending on the consensus mechanism; however, a decrease in token value will linearly impact the security level of the blockchain.
Business Models of Protocols
If we consider the business model of protocols or base layers; users are essentially paying gas fees to the protocol to correctly store transaction data through the consensus mechanism and settle their transactions.
Although the original paper may not have been very timely, the advantage of the "Fat Protocol" era was that there was a clear division of labor between protocols and applications;
Protocols are essentially looking for ways to make users pay for security and data availability; and are committed to retaining users and applications within their respective ecosystems to maximize composability and direct value accumulation (in the form of gas fees).
Even with the rise of Layer 2s, protocols have effectively shifted from being customer-centric to business-centric; aiming to extract as much value as possible, with rollups paying for data availability and consensus costs.
On the other hand, applications are competing for anything that can provide them with a competitive advantage; and this sometimes leads to a lack of value accumulation, such as how Uniswap maximizes liquidity depth without a clear flow of funds.
This division of labor has birthed many applications worth billions of dollars, such as Uniswap and OpenSea. For applications, they are essentially outsourcing other important parts of the blockchain to the protocol level, allowing them to focus on what makes the application run smoothly and successfully.
However, for the protocols themselves, with the emergence of modular blockchains and the abundance of blockspace, the current business model is gradually and inevitably collapsing; thus, protocols are becoming "thinner."
Business Models of App Chains
The business model of application-specific chains is significantly different; although on the surface, both protocols and app chains operate as base layers.
App chains do not require users to pay for the storage of transaction data in the form of gas fees; rather, users are actually paying for the application itself; for example, Osmosis implements a protocol receiver fee that ultimately flows to token holders in the form of revenue.
However, app chains also provide everything that protocols should do; from providing shared data layers to settling transactions and providing appropriate levels of security for the blockchain; most importantly, applications are sufficiently competitive with each other.
The advantages of this business model design are a mixture of the following aspects, which should be considered more sustainable and defensible, even in the face of future market structure evolution and expansion:
Users are essentially paying for the service of market consensus on a certain price; for example, Injective takes a portion of the trading fees from its perpetual futures exchange, and the market generally believes that perpetual futures exchanges should charge fees; and there are some exchanges that charge higher fees, such as GMX and Gains Network.
Unlike the market's general belief that providing shared data and consensus should not incur fees; and consistently competing to provide cheaper solutions, effectively making it a zero-cost competition.
Value accumulation is not linearly related to transaction volume, but rather to other variables that drive the success of applications; for example, Injective's value accumulation is a function of perpetual futures trading volume, while Osmosis's value accumulation is a function of spot trading volume.
In short, the business model of app chains fits very well with the current market structure in hindsight; because protocols are accumulating value from more sustainable sources. Extending to this point, it makes me wonder what would happen if app chains further took action and amplified the advantages at the protocol level.
"Fat App Chain Thesis"
The changes of the times and market dynamics have given rise to what I call the "Fat App Chain Thesis"; we are witnessing app chains like Injective and Osmosis striving to build their own ecosystems for a win-win outcome.
App chains are no longer competing with other base layers or protocols that have lower gas fees; instead, they have found a more defensible and sustainable business model, which the market recognizes; it effectively addresses the value accumulation issues in the first-generation "Fat Protocol Thesis."
On the other hand, as more applications decide to build on app chains, app chains can also enjoy positive feedback loops; effectively addressing the liquidity fragmentation and limited composability issues stemming from the app chain architecture.
At the same time, app chains provide shared data layers, allowing other applications to deploy on the app chain itself; driving the prosperity of the ecosystem, which subsequently attracts the interest of developers and investors, potentially boosting the network's price performance.
Most importantly, it addresses many cold start problems that other Layer 1s or rollups may face; as many app chains initially started as applications seeking better composability.
Thus, app chains attempting to build ecosystems have not become "thin," but rather demonstrate a clear path to becoming "Fat" and remaining "Fat"; if reasonable, it could present an attractive investment case.
Post-Analysis of Injective
As mentioned in the earlier part of the article, Injective's outstanding performance this year proves the "Fat App Chain Thesis." Starting as an independent perpetual futures app chain, Injective operates a typical order book model and was the first to adopt zero gas fees to avoid malicious MEV as previously run.
In terms of value accumulation, Injective essentially burns 60% of all trading fees managed by community-led auctions, thereby exerting deflationary pressure on the entire token supply. The remaining 40% is taken by relayers to incentivize the liquidity depth of the exchange. In other words, the value accumulation of the $INJ token is a function of trading volume, rather than the transaction count like other alternative protocols.
Explanation from Injective documentation
The native $INJ token can also be used as collateral support for derivatives, serving as an alternative to stablecoins in other derivatives markets. Additionally, Injective integrated with Skip Protocol earlier this year to return MEV profits to shareholders, strengthening the early value accumulation case.
At the beginning of 2023, Injective's trading value was $130 million, and after the announcement of the Injective ecosystem fund, the market subsequently adjusted the token's valuation upward; well-known venture capitalists are supporting their efforts to build an entire ecosystem on top of the order book.
As of writing, Injective's trading value exceeds $1.3 billion, with a year-to-date increase of over 10 times, surpassing most other tokens in the market. That said, since the expansion, the metrics have not significantly improved, with Injective's daily trading volume remaining at $10 million, leading to an annualized value accumulation of approximately $4 million in the form of burned tokens.
Nothing has changed significantly, but the "Fat Protocol Thesis" essentially intersects with this shift towards the "App Chain Thesis." Injective enjoys the dual advantages of being a base layer and an app chain while avoiding the main drawbacks of both.
The positive feedback loop still applies; investors are investing in building ecosystems, attracting developers and projects, kickstarting the speculative value of the native network token, which indirectly addresses the previous security level issues of chains evaluated as app chains.
The value accumulation part is not affected by fee competition; Injective does not charge gas fees from the start but profits from trading volume; and increases value by providing security and shared data layers.
Liquidity fragmentation and composability issues are resolved; now the native assets on the chain have more use cases within the app chain.
Overall, Injective's attempt to build an ecosystem has found a clear path to becoming "Fat" and remaining "Fat"; thus, even over the long term, it could present an attractive investment case.
How to View Sei
It is difficult to replicate the miracle of Injective again. Sei is widely regarded as the closest comparable company to Injective in the industry and may not see a similar trajectory. Both operate as order books; the native token of $SEI does not generate value like Injective; rather, it serves as the native gas token for the network.
Sei's tokenomics
This slight difference essentially inherits the legacy issues of the "Fat Protocol Thesis" and places Sei in the same battleground as other alternative layers.
The positive feedback loop still exists and is applicable; Sei has received support from numerous well-known investors in the industry, but the injected capital has yet to attract developers to the platform to drive network growth.
Value accumulation remains an unresolved legacy pain point, which Sei inherits; the blockchain does not effectively derive any meaningful fees from gas by providing shared data layers and security levels.
Liquidity fragmentation and composability issues are not entirely relevant, as app chains position themselves as independent ecosystems; rather than having to interact with other chains in the Cosmos ecosystem.
Osmosis may be the next link.
The "Fat App Chain Thesis" has received its first validation in the market through the success of Injective; now is the time to look for another that follows a similar logic to replicate this playbook.
Osmosis may be the next link; as the team has slowly built an ecosystem around AMM-based app chains, such as Mars Protocol providing a money market; and Levana Protocol offering a perpetual futures exchange, among others. The protocol has also opened up market maker fees from its spot trading volume; effectively bringing value accumulation to token holders for the first time.
As an app chain and liquidity hub on Cosmos; Osmosis's average daily spot trading volume is $6 million, which is not impressive. Part of the reason is due to the weakening of DeFi activity on Cosmos; the price of the $OSMO token has been on a downward trend since the beginning of the year, dropping from a high of $1.10 to now $0.30.
Once again, the "Fat Protocol Thesis" gradually intersects with the "App Chain Thesis" in the case of Osmosis; but more validation is needed to kickstart the entire price surge, as follows:
The positive feedback loop still lacks: The Osmosis community is strong and strategically aligned with the entire Cosmos ecosystem, attracting teams to deploy applications on the app chain; but investors seem to have yet to inject funds into the ecosystem.
Value accumulation is again unaffected by fee competition: Osmosis has implemented a 10 bps protocol market maker fee and profits based on spot trading volume; while also increasing value by providing security and shared data layers.
The caveat here is that the protocol market maker fees may erode the unit economics for traders and arbitrageurs; this could impact spot trading volume in the long term unless Osmosis manages to build a sustainable barrier around protocol liquidity.
Liquidity fragmentation and composability issues are being addressed; native assets on the chain can be used in other DeFi primitives on the chain.
Conclusion
When $INJ rebounded earlier this year, I thought it was a one-time event, as the market was effectively re-evaluating the token, applying the trading multiples of perpetual futures exchanges to the protocol layer; and the token price would stop advancing after the price adjustment was completed.
It turned out to be one of my biggest mistakes this year. When I reflect on the underlying logic; combining the "Fat Protocol" and "App Chain" has actually created the most detestable rebound, as it addresses the legacy issues of both sides; and speculative value was injected into the system along with capital from institutional investors to kickstart the flywheel.
I believe more app chains will adopt this approach in the coming months; as most of them are seeking to diversify product offerings and retain value within the system, rather than competing with each other at the application level. The "Fat App Chain Thesis" may create more miracles in the public market.
