Excess block space and the reshuffling valuation logic

Original Title: EXPECTED VALUE IN CRYPTO & BUILDING INFINITE BLOCKSPACE
Original Author: Michael Dempsey, CompoundVC
Original Compiler: Kaori, BlockBeats

Editor's Note: MPMichael Dempsey from CompoundVC believes that there are currently too many people working on new L1/L2/LST and other infrastructures, while there is a shortage of people trying to build new crypto applications. Therefore, he elaborates on his views regarding the expected value of cryptocurrencies and the construction of infinite blockspace, focusing on why this situation occurs, how it happens, and how we can address this existing issue.

I recently revisited three excellent (in my view, canonical) earlier cryptocurrency posts that shaped many people's perceptions of value capture in cryptocurrencies (fat protocols, thin applications, crypto tokens, and the upcoming era of protocol innovation).

Power Laws and Normal Distributions in Cryptocurrency

The original fat protocol paper was well understood in terms of L1 value accumulation, but this also means that you see more long-tail dynamics in Dapps, which implies less power law from the perspective of success opportunity percentages (i.e., many tokens will be worth something, while very few will become zero, as I wrote previously).

What we see in the bull market (or perhaps the entire cryptocurrency market) is a shift in how people view expected value.

This leads us to a logical conclusion: Nowadays, most developers believe that the most extreme EV (expected value) move is to build new L1 or L2, rather than Dapps or application-centric protocols, which leads to further fragmentation of the world and a large amount of useless blockspace. Subsequently, they take downgrade measures to build abstraction layers to siphon some value from L1/L2, such as in LSTs.

Some may argue that this dynamic is due to the fee structure and "defensiveness" of blockspace relative to Dapps in cryptocurrency. As the data above shows, L1 and L2 constitute most of the accumulated economic value capture in today's cryptocurrency. This, combined with a deeper analysis of blockspace business models, explains the massive FDV of various L1s like Ethereum (more practically, at this point, things like zombie L1s and smaller scope-dominating L2s like Arbitrum, which also leverage terminal network premiums gained from crypto protocols, with speculators willing to model network scale and penetration for many years to come and pay for it today, leading to high multiples).

That said, when you look at the 365-day fee tracking of all protocols on Token Terminal, this is somewhat impractical, as the speed of various DeFi protocols far exceeds the value of higher blockspace.

Of course, fees in 2024 are not a perfect measure, as there are many other value determinants, including defensiveness, terminal scalability, net profits of protocols, and even theoretically the ability of tokens to capture capital flows.

We recently saw the latter tested for the first time through the proposal to enable UNI fee accumulation, as the market reassessed the potential for "worthless governance tokens" to acquire tangible value, leading to a rapid increase in transactions of other DeFi protocols.

So, yes, blockspace is a good business (perhaps a clean business with lower regulatory barriers), but if we peel back the veil of ignorance, the reality is that today there exists a flywheel effect between founders and investors, or a perverse incentive mechanism of a vicious cycle, which leads to the continuous creation of blockspace.

The Big Fund Phenomenon

Investors raise more funds and need to deploy more capital in search of increasingly larger returns. This strategy is easiest to implement by investing in capital-intensive projects. All this capital needs to find returns to justify the creation and liquidity of billions of dollars in FDV.

We can look at the top 100 tokens by market cap and see that red represents tokens that belong within this framework. As seen, very few protocols worth billions of dollars are not effectively new types of blockspace or are not siphoning off infrastructure value. If you use FDV instead of market cap, the situation does not improve.

For someone like me (and our company Compound) who hopes to see the long-term prospects of crypto materialize, I believe that this cycle of venture capital and founder blockspace inflation will erode the ecosystem (some might argue it has already happened) and is likely to lead to louder debates between monolithic and modular chains, which are actually not important and have made almost no progress.

Every cycle, we get new blockspace, underutilized L1s and L2s experience some value erosion, and perhaps from time to time, new value capture that looks very much like L1 narratives (data availability, restaking, etc.) will insert itself into a slightly smaller flywheel, followed by a wave of imitators and nth versions of these protocols, descending along the "roller coaster of the euthanasia of incredible billion-dollar FDV tokens."

The best part is that these tokens may still be more valuable than real applications with actual use and utility.

This dynamic of existence is net negative for cryptocurrency for two reasons:

1) It hinders new experiments because capital markets prefer existing scripts and the risk/reward is skewed downward.

2) It only slightly increases the adoption rate of cryptocurrencies.

There was a time when many areas at the infrastructure layer needed innovation. We needed more blockspace, faster virtual machines, better fiat-to-crypto rails, better wallet onboarding, etc., to enable new use cases. Now we are in a state no longer constrained by technology.

You can basically build anything you want on-chain for early adopter types (of which there are many), and soon provide tools for early majority/majority type users across much of the world.

Changing Expected Value

If we take a step back and think about how to change people's perceptions of expected value in cryptocurrency, we can substantially alter the trajectory of cryptocurrency development, rather than just slightly pushing the industry forward.

There are about three clear and logical paths for these subsequent steps that ideally would lead to acquiring value in more diverse ways and building meaningful protocols and Dapps.

1. Effective Duopoly/Oligopoly of Base Chains

With the transformation of smartphones and each OEM having its own operating system and application ecosystem, mobile devices experienced a paradigm similar to what we see in cryptocurrency today. Blackberry, PalmOS, Windows Phone, Android, iOS, and many other operating systems meant that the desire for a phone + operating system combination was fragmented. Eventually, two dominant ecosystems emerged: iOS and Android.

Many have compared Solana and Ethereum (as Android has various software branches, the value of the Google Play store accumulates in a way similar to how EVM works, with value being able to accumulate from L2/L3 to the ETH settlement layer).

This would lead to +EV moves being to develop Dapps that dominate the duopoly (or both), as well as fragmentation solutions like Restake or Chain-Clusters from Arbitrum Research to capture value.

This is the best outcome for driving long-term value in cryptocurrency, as it would structurally force innovation into the application layer and create a flywheel that enhances the total market cap of cryptocurrency through the coordination of Dapps and L1.

2. A Future of Decentralized/Decentralized/Centralized/Application Chains, where people in Cosmos might appreciate it for the theory of application chains, while centralized players might like it for the trustlessness it eliminates (What’s up with JPMChain)

This is a decentralized range Frankenstein model, where value capture might be siphoned off by participants carefully curating various "blockchain" fragments, perhaps similar to how AWS, Azure, and GCP extract (and realize) primary value from traditional software and more novel AI software applications.

Solana token expansion 4 is another interesting framework in this world that could create a stepping stone again, where we could see cryptocurrency undergo a "centralized → decentralized" dynamic over many cycles, with "bundling → unbundling" loops appearing in software.

3. We are just continuously launching new tokens with high FDV and creating new narratives around blockspace due to speculation and money.

This future is bleak, and I won't waste words discussing it further, but it is a very real future. I recommend reading perhaps a somewhat roundabout nihilism, using her as an example.

What Needs to Happen?

To drive the future that many true believers in cryptocurrency hope for, some core things need to change:

1) We must create longer-term, more complex token lock-ups.

Whether you are talking to founders or investors, this statement will be met with constant nods… and then almost no change. This leads to the second question:

If we all claim we want to do this, who is responsible for making it happen?

Investors say they cannot push for longer lock-up periods because they would lose deals with other companies willing to accept shorter lock-up periods. Founders say investors also want shorter lock-up periods, and longer lock-ups may make it difficult to retain talent.

In this world, this could be driven by larger funds/limited partners of these funds. There is also the possibility that in a world where your given project can fork with fast vesting tokens, a portion of founders might push for this as a statement.

The dark horse and most likely candidate is the community, as the broader ecosystem may force change. We have recently seen this, as the Starkware team was effectively bullied into changing their team and investor unlock timelines.

In a world of longer-term, more complex token unlocks, if you launch useless blockspace, retail and the community typically have years to dump their tokens on you and use the market as a weighing machine before investors and teams can capture value. This would deter the 100th L1.

Moreover, this would require Dapps to consider longer-term product development cycles and value capture, rather than developing unsustainable or long-term appreciating products that still allow groups to extract capital from the ecosystem and enrich the star products of teams and investors.

In all cases, you could tie unlocks to time + (less playable) milestones to somewhat overcome the apparent structural disadvantage that people might perceive you have compared to teams with faster token unlocks.

2) We need some breakthrough non-infrastructure protocols.

Aave/Compound/Maker/Uniswap, etc., have created value from a token perspective and driven new use cases for smart contracts, thus incentivizing a generation of builders into DeFi. This has created an ecosystem of DeFi builders that should compound over multiple cycles.

Other large-scale victories, such as Helium, RNDR, Livepeer, or more, may be needed to continue expanding beyond 10B+ FDV (and beyond zombie L1s) to change the tide, making building within DePIN or other categories look worthwhile. I am confident in this space and many others, as prices will drive activity, shifting from one category to another, with winners paving the way for each category and inspiring new ambitious shots.

3) I find myself sometimes returning to the concept of superstructure.

While I think these are overly idealistic when considering Eth and Solana or any other oligopoly that has emerged in the cryptocurrency space, the idea that the value of Dapps can achieve net positive value without too much unnecessary drag on "profits" is intriguing.

In other words, if we could simplify infrastructure and middleware, as we like to do when arguing for smart contracts, we could imagine a world where all cryptocurrency builders' incentives lie in Dapps that can bring actual use cases and expanded users, where the choice should not be based on what L1/L2 to build on, but rather what tokens users want to hold to continuously capture the value created by that protocol.

Madness or Change

The current fragmentation and overextension of blockspace may simply be a natural result of the early ecosystem figuring out what is meaningful and what is not, and the early financialization of cryptocurrency has led to greater difficulty in the short term. Long-term optimization. We may ultimately find a few dominant L1s and L2s, while the token value structure of the past decade will become a unique memory of "early" cryptocurrency.

Regardless, I am clear that as we enter a new cycle of capital flow, user adoption, and quantity increase, the best path for cryptocurrency is for expected value to lean more towards applications, away from infrastructure. In fact, it is existential.

The end result may look like a more benign cycle of infrastructure and application development, similar to the cycles described in the myth of the infrastructure phase.

Ultimately, we got what we demanded from cryptocurrency.

If L1s and L2s and restaking protocols continue to accumulate the vast majority of resources, we will keep searching for applications, use cases, and futures that will never materialize.

With this potential outcome, I am reminded of the saying:

"The definition of madness is doing the same thing over and over again, expecting different results."