This post covers the economics of monolithic blockchains (L1s). It is the first post in a multi-part series discussing the economics and value capture of blockchains today and how they are likely to evolve in the future as modular blockspace production services go live.
This is a condensed version. For the full 20 page analysis refer here.
Defining an “L1”
- L1s are defined as vertically integrated producers of blockspace. L1s have their own native token for accepting gas fees and paying validator rewards, which means that they are sovereign economic systems with the ability to determine their own monetary policy.
- There are two components of value for a proof-of-stake L1 blockchain that sum together to form FDV: intrinsic value and monetary premium.
- Intrinsic value is a function of the real staking yield, which is the nominal staking yield less the token inflation rate.
- Monetary premium arises from the money-like properties of being a medium of exchange and store of value.
- L1 tokens are unique to other assets in that the same token can either behave like a financial asset when staked or as a monetary asset when unstaked.
- The sustainability of a given monolithic blockchain is determined by its "Economic Balance", which is the difference between gas fee revenue and validator rewards.
- Economic Balance determines the real staking yield, which in turn determines the Intrinsic Value of a network.
- As the most sustainable L1, all other L1 tokens will converge on a similar real yield to ETH. We can calculate the real intrinsic value under this assumption.
Two conditions must be met in order obtain true Monetary Premium:
- Sovereignty: The token must be issued by a network that is a sovereign economic system (i.e. it has its own validator set). This excludes dApp governance tokens that rely on a blockspace producing platform, as well as any other modular stack component that relies on a third party service (i.e. an L2 that relies on ETH for settlement and DA). The network must denominate its revenues (gas fees) and its expenses (validator/sequencer etc. rewards) in its native token (although it may accept other tokens as payment)
- Sustainability: In the long term, monetary premium can only occur if there is neutral to positive economic balance, because tokens will not be treated like money if they are not plausibly scarce.
So far, Ethereum is the only sovereign L1 to have achieved positive economic balance.
- The total value of an L1 is the sum of intrinsic value of staked tokens and monetary premium of floating tokens.
- It's impossible to estimate the fair value of a monolithic blockchain's monetary premium in absolute dollar terms as its value is relative to other blockchain networks.
- We call this the "Country Theory of L1s," using a foreign exchange analogy to estimate the relative value of L1 tokens to each other.
- L1 prices will fluctuate based on their relative fundamentals to each other, with Ethereum likely acting as the standard bearer for other L1s.
The factors that drive the notional value of a blockchain's Monetary Premium are:
- Staking Ratio (% of tokens staked relative to the total FDV) - increasing staking ratio should tend to increase prices. A high staking ratio is likely to arrive at a lower equilibrium ratio, the opposite is true of a low staking ratio.
- Real Staking Yield - a high real staking yield will drive the staking ratio up, which should tend to increase prices.
- Positive Economic Balance - increasing on-chain activity leads to higher aggregate gas fees, which means less inflation (or more deflation); all else being equal, this should increase prices.
- Network effects arise when blockspace quality draws in talented dApp developers, which then draws in more dApp developers due to the composability (i.e. continuous atomic interoperability) of smart contracts on the same execution layer (i.e. the same L1 blockchain).
- Blockspace quality is a function (in part) of the sustainability of the economic system, when security is created through the value of tokens staked on validators.
- The interaction between blockspace quality and network effects, which ultimately create the mechanics for monetary premium, can be visualized as two interlocking flywheels:
- Considering the talent and investment that has gone into L1s to date, and yet there is only one that is truly sustainable, goes to show how incredibly difficult sustainability is to achieve.
- As a result, we believe scalable blockspace will rely primarily on vertical scaling solutions on Ethereum rather than many standalone chains that require their own sovereign economic systems and the sustainability challenges that come with them.
If you have any questions or feedback, I'd love to discuss. Please reach out to me on twitter @RennickPalley or through email@example.com. And as mentioned above, the full version of this analysis can be found here.
And finally, thank you to Ravi Kaza, Jefferey Sun, Drew Meyers, Mathijs van Esch, Eshita Nandini, and Marceu for taking the time to review and give feedback.
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