Alex Fatuliaj
August 1, 2023
Investor Insight

Fat Application vs Fat Protocol Thesis


TLDR: times are changing, and investor theses should do.

Note: for all intents and purposes, we define “protocols” as Layer 1s, 2s, and 0s.


Each investor has a thesis. Whether Bob is choosing to invest $100 into Bitcoin or HarryPotterObamaSonic10Inu, or a16zcrypto is choosing to invest into Avalanche instead of NEAR.

The thesis generally revolves around two, interrelated, key points:

  1. Risk
  2. Knowledge

1. Investors’ risk appetite is defined by the willingness and capacity to take risk. Risk has a correlated (not causal) relationship with returns: higher risk means lower chances of returns but the returns will be higher, generally speaking, because if they’re not expected to be higher than low-risk investments then that’s not a “high risk” investment but merely a “bad” one.

Investing is like going to the casino – playing the game of statistics with capital on the line. If done correctly, it’s possible to always leave the casino with a small-medium profit. Alternatively, you can always bet on black.

2. “Risk comes from not knowing what you’re doing.”

Risk is a synonym for lack of information. For instance, imagine you go to buy milk.

  • You go to the shop
  • You get to the aisle
  • The milk is sold out

The shop has a n% chance of having milk in stock. You took a risk by going to the shop to buy milk without any information prior.

But, there is some information: going to the shop as soon as it opens almost guarantees there will be milk in stock. Knowing this information significantly reduces risk.

But, you could also call the shop owner and ask them whether there is milk in stock, thereby creating a near-100% chance of milk being in or out of stock (factoring in someone buying it all up between you ending the phone call and you reaching the store). The point is that one can eliminate risk with information.

When it comes to investment, an investor generally invests into the industry that they know best, which reduces risk. What if we were to take that idea further, and not only invest into the best known industry but also into a particular type of company within the industry?

Usually these companies are either benefiting from some sort of monopoly power, or are those without which an industry wouldn’t survive.

An investment yields returns by going up in value, regardless of whether it’s equity or tokens. But what if I was to tell you about a magic investment opportunity that not only grows itself, but also accrues value from everything that comes and grows after it?

Please welcome to the stage: the fat protocol vs fat application thesis debate.

Protocols vs Applications


The idea is simple: in Web2 protocols don’t accrue most of the value from the applications built on top of them, but in Web3 they do. Without HTTP, TCP/IP, etc. nothing on the internet would work, yet value accrues in the applications like Google. That, supposedly, is not the same for Web3.

Let’s analyse.

Who has the most value


Out of the top 10 cryptocurrencies, 8 are protocols, and 2 are applications (USDT and USDC) which aren’t even applications per se but mere stablecoins. At the time of this sentence, 25.07.2023 15:01, Chainlink is the first real application and it is ranked 20th.

Evidently protocols are valued more than applications, by an enormous margin. There are four notable reasons:

  1. Shared data layer – data in Web2 is stored on individual, siloed servers owned by the companies; in Web3 the data is stored on the protocol and utilized by the applications. Hence, the theory goes, this data is responsible for a lot of the value and thus increases protocol valuations.

  2. Transaction fees – given that dApp transaction data is stored on protocols, the blocks holding the data incur the same transaction fee as any protocol-level transactions. This means that all dApps pay tx fees of the protocol they’re built on, which increases the valuations of protocols.

  3. Speculation – investors, given the above notions, invest into protocols because they are a safe bet that accrue the value. Moreover, the greater the protocol’s market cap, the more dApps it attracts, meaning its value goes up more.

On top of the above, tokens are not equity. Although they do represent in some way the value of the company that launched them, and reflect valuation via whatever price the supply and demand factors decide, tokens can be made more illiquid.

  1. Illiquidity – most protocols require staking for Proof of Stake (e.g. 18% of $ETH is staked right now), or have functions like Polkadot requiring a certain amount of staked tokens to use its subnets. This increases token price and valuations due to a reduction in supply instead of an increase in demand.

Seems like investing into protocols is a foolproof strategy.

So what’s the problem?


Among reasons like nepotism and follow-on investing, this thesis, whether conscious or subconscious, is the reason we have so much “infrastructure”.

The same infrastructure that raises at $4Bn valuation to have the following statistics:

P.S. the sudden activity rise from the 14th July is because an Indian social media platform Chingari finished the move from Solana to Aptos (the migration began on the 6th July), but before Chingari (and we’re yet to see how this plays out) Aptos was doing pretty badly for its valuation.

Here’s the problem:

Investors direct the future with investment. Without them, the world would be far behind technologically compared to where it is now. As much as history is written by the victors, the future is written by the investors. The issue is that most investors have an obligation to generate returns for their LPs.

Thus, they go for protocols. There is a positive correlation between the recency of launch and token allocation to insiders and team/foundation for protocols (although the chart below is just for Layer 1s and 0s).

Source: Messari

Now, one can deduce that to compete with Ethereum a new L1 needs a lot more capital, for marketing, grants, R&D, and so on. But we all know that the reason for such amounts of fundraising is due to the fat protocol thesis: when faced with a lot of demand for allocation, the projects started to give more allocation to the investors and themselves at higher valuations.

For investors though that doesn’t matter; investing into L1s is simply a safe, yet high-return investment, even at ridiculous valuations.

Asking investors to stop investing into cash grabs with ridiculous valuations and instead invest into projects that will improve the space and accelerate mass adoption will not yield results because the cash-grabs yield returns for everyone involved, and investors have an obligation to their LPs before the industry itself.

They’re not damaging the industry per se, they’re just not improving it. One could argue that if we’re coasting we’re going downhill, but that’s not the point of this article.

The point is that protocols will not be generating returns for much longer.

Why is the Fat Protocol Thesis no longer applicable


Let’s look at the 4 aforementioned reasons that support the fat protocol thesis and explain why two of them are irrelevant and the other two are not competitive advantages.

1. Data on L1s does not hold much value: sovereignty is a pretty popular buzzword. As an industry we’re aiming to give users ownership of their data (you know, the data that has actual value behind it); protocols only store transaction data, which, in a decentralized world, is only useful as a ledger and not much more. In other words, the data Google has on us is stupendously more valuable than transaction data Ethereum has about our wallet. And in other yet similar words, the data that an application will get on us (i.e. how much our wallets spend on what) will be more valuable than what Ethereum gets.

2. Gasless transactions: when it comes to Layer 1s in particular, aren’t we aiming for gasless transactions? Well, that means that protocols won’t be earning much revenue from the dApps built on top of them. So yes, more dApps and more transactions on a particular protocol is great for marketing, but not for value accrual. This is a nuanced point however, because protocols need to have transaction fees in order to uphold network security (nobody wants to validate for free) – so where do we go? Well, that’s up for debate. But one thing is for certain: dApps go for security, or low fees; if they opt for the former, they go to Ethereum. Afterall, Ethereum has ~43% of all L1 volume. So new L1s either have low users, or low value accrual. Which one are you going for, Mr. Investor?

3. Speculation: speculators go for protocols because investors go for protocols and hype them up. Once the hype around them dies out, the speculators will simply go for applications, so the point of illiquidity is appliable to applications as well.

4. Illiquidity: staking is a very popular feature in applications as well as in protocols. Staking for governance, lower fees, yield, participation, and so on, have been common token utilities for a long time. Applications also reduce their supply, so the point about illiquidity is similarly appliable to applications as well.

Now, let’s assess additional points as to why the Fat Protocol Thesis is weak.

5. Token value accrual: dApp tokenomics are being designed for the token to accrue most of the value of the application. Protocols earn revenue from tx fees, whereas dApps earn revenues from standard business revenue streams – product sales, ads, tx fees, interest, etc. – and sthe token are being designed to accrue this value via buybacks, or revenue redistributions. Which one will yield greater returns for an investor?

6. Competition: similarly, how much competition is too much? Institutions are using Hedera, and Web3 is using Ethereum and its L2s (Polygon, Arbitrum, Optimism, and zkSync). Did someone say Solana? No, those aren’t real transactions. Anyway, until we actually have more users, more infrastructure is not needed.

That being said, there are protocols being created and launched for specific use-cases or regions which avoid competition with Ethereum or other protocols, the same way that a pen designed for use in the International Space Station (in 0 gravity) will not be competing with Bic.

Long story short, protocols have the value they have because of the idea within the industry that they accrue value. In reality, only Ethereum has ever accrued any sort of meaningful value, and even that is dropping as its gas fees are lowering.

The value behind the Fat Protocol Thesis is pure speculation, held up by investors and trickled down to retail who don’t know any better.

Firstly, protocols don’t accrue value. It’s not in their interest to (if they want to attract users with low transaction fees (given that’s the only thing they can attract users with, since Ethereum has security covered, and its L2s have speed covered)).

Secondly, even though Ethereum generates a lot of revenue, that revenue isn’t distributed to investors (i.e. token holders), but to validators. Only in times that Ethereum becomes deflationary do token holders have value accrual.

The perfect example of this is Tron Network and USDT: Tron has a market cap of $7Bn, whilst USDT, an application on top of Tron, has a market cap of $84Bn. Yes, USDT is a stablecoin which isn’t an application per se, but my point is that if protocols don’t actually accrue value of the applications built on top of them, as evidenced by Tron and USDT, other than in the form of transaction fees (which they want to reduce), then investing into protocols will stop generating such high returns once the hype around them stops.

Personally, I wouldn’t want to be one of the last investors to leave this hype train.


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