The Fat Protocol Thesis has proven to be true for monolithic architectures, with the blockchain network itself, rather than the applications built on top of it, capturing most of the value created by blockchain technology to date. Emerging technology in the blockchain space is iterating on monolithic architectures, where all elements of blockspace production are handled by the same blockchain network, and pushing toward a modular stack with multiple discrete networks interacting to enable decentralized computing at scale.
The objective of our research is to determine how value will flow across the modular world, in hope of providing insight into which portions of the stack will accrue the most value as demand for blockspace grows by orders of magnitude in the coming decade. Given the length of this piece, we posted a condensed version here.
Saying goodbye to FPT?
The “Fat Protocol Thesis” has been the defining concept with respect to value accrual in crypto assets.
The reason why the fat protocol thesis has been so compelling is twofold:
First, it appears to be true. The chart below shows that of the non-bitcoin crypto currency value, “smart contract chains”, or L1s, comprise nearly 80% of the $300 billion in fully diluted market capitalization:
Second, and this was the case before the data existed to prove it, the fundamental premise was intuitive and logical.
Two key factors that drive the fat protocol thesis: monetary premium and network effects. These will be explained in depth in the following sections.
The relevance of the Fat Protocol Thesis will be challenged as monolithic blockchains integrate with or are replaced by modular architectures. By definition, modular architectures fracture the value-creating services of blockchains across many distinct components of the consensus compute stack.
Will this value shift to one component in the modular stack? Or will it be distributed evenly?
Will the pie grow overall, or will competition among the components cause it to shrink?
How does this impact computing hardware for nodes and staking economics?
Just like monolithic L1s, monetary premium and network effects will guide the answers to these questions for the modular stack.
This is the first post in a multi-part series exploring these questions.
We will begin with Part 1, examining the current monolithic value flows and how they have defined the Fat Protocol Thesis.
In Part 2, we will move towards the current state of layer 2s, the first step of unbundling monolithic blockchains.
Part 3 will explore the future stack that will utilize existing L1s and discrete data availability and consensus services, the final phase of monolithic unbundling.
Part 4 will introduce the attractive qualities and outstanding questions for app-specific roll-ups. This may represent the final frontier or end-state blockchain architecture.
Part I: Monolithic Economics and Value
What is a “Monolithic” blockchain?
The prototypical concept of a single monolithic blockchain, like Bitcoin or Ethereum, functions as a vertically integrated producer of blockspace. “Blockspace” is the computational and state storage capacity required to execute smart contracts.
Monolithic L1 blockchains have a native token, which they use to accept gas fees and pay validator rewards. In order for a blockchain to exist, it needs a decentralized network of validators.
This is in essence a sovereign economic system - the blockchain itself has the ability to determine its own monetary policy, which then has the potential to drive a Monetary Premium to its token, which is the primary component of the network’s value (also known as fully-diluted value, or FDV).
Disaggregating the value of a blockchain
There are two components of value for a proof-of-stake blockchain network - intrinsic value, and monetary premium. For reasons we will discuss, monolithic Layer 1 blockchains produce a token that combines properties from two otherwise distinct types of asset: those of a purely financial asset, AND those of a monetary asset.
The Intrinsic value of any financial asset is defined by its future cash flows. The Discounted Cash Flow analysis (DCF) is a simple mathematical calculation that determines the current value of an asset that has future cash flows.
The Financial Asset properties of a proof-of-stake layer 1 token are centered around the future cash flows that a holder receives for staking, also referred to as staking yield.
This value is straightforward to observe, just like any other financial asset. Comparable financial assets like equity shares and bonds entitle the owner to cash flows simply through ownership.
However, requiring L1 token holders to stake in order to initiate cash flow is a unique feature among financial assets. Buy the token, stake it, and generate a future stream of cash flows. This is a critical distinction.
Accordingly, the portion of staked tokens (the “staking ratio”) defines the staking yield. Staking fees in the native token, divided by staked tokens, equal the staking yield.
Because those cash flows are a function of on-chain revenues (gas fees), the actual “value” (in dollar terms) of the staked tokens are primarily driven by the level of real yield that the market demands.
This is similar to any other yield-bearing financial asset like stocks, real estate, and bonds. High relative real yields will drive investors to buy the asset, raising its price in dollar terms and lowering the yield - the same is true in reverse when real yields are too low.
Monetary Premium arises from the money-like properties of an asset. Money is a medium of exchange and a store of value.
This is the second component of value for an L1 token.
In order for an asset to be held for future transactions, users must not worry about its future value. One of the things that makes them not worry is credible long-term scarcity.
Credible long term scarcity is a requirement for something to be money, but not sufficient to make it so. It must also be used as a medium of exchange.
By virtue of an L1 blockchain requiring payment of gas fees in its native token, sufficient utilization of that blockchain forces users to treat the token as a medium of exchange, and thus creates the potential for Monetary Premium.
Accordingly, a token that is not directly used for paying gas fees, incentivizing validators, and creating network effects at the execution layer accordingly will never be subject to monetary premium. This describes the vast majority of crypto tokens now and to be created in the future - they will be valued solely as financial assets using a DCF analysis to determine their intrinsic value.
Market Cap = Intrinsic Value of staked tokens + Monetary Premium of floating tokens
A staked token cannot function as money because it is staked, and is thus behaving like a financial asset. A token that is not staked can be used as a medium of exchange, and thus is behaving like a monetary asset. Combining the value of both sets of tokens results in the total value of the network.
Because only a subset of tokens will be staked at any given time, whatever staking yield is available to staked tokens (the analog to discounted cash flows on the token) will apply only to that fraction that is staked.
Therefore, the portion of market cap consisting of intrinsic value for a Proof-of-Stake token is set by its staking yield, but Monetary Premium is the value of the network over and above that value.
From a financial asset perspective, investors seeking to stake and earn staking yields will be concerned with the internal economics of the blockchain - where is their yield coming from?
From a monetary asset perspective, holders seeking to store value or transact will be concerned with the credibility of its long term scarcity - is their value being inflated away?
In both cases, the sustainability of that blockchain’s economics will determine the answer.
At a high level, there’s really only one economic model that matters for a blockchain, which we call the “Economic Balance” and defines the sustainability of the network:
Gas Fee Revenue - Validator Rewards = Economic Balance
The question then for all blockchains is, when will positive Economic Balance be achieved? What happens before you get there? And what happens after you have achieved positive Economic Balance?
Before a positive Economic Balance has been achieved, inflation of the native token by minting and issuing more tokens is required to support validator rewards. Inflationary systems are unstable. In order for a blockchain to persist, it must eventually be able to achieve at least neutral economic balance, if not economic surplus.
After an economic surplus is achieved, a blockchain can be said to be “sustainable” - the token rewards to compensate validators are covered by the token fee income from actual users. The surplus gas fees can be accumulated in the blockchain treasury for future investments, be used to increase validator compensation, reduce gas fees, or be burned to share gas fee value among token holders.
Inflation rate varies by a margin of approximately 5% across the four chains in our analysis. 5% inflation may not seem like a lot, but compounded over 7 years results in a 40% erosion of value.
Why is the Economic Balance so different across chains?
Gas fees are charged for every transaction on-chain in the native currency of that blockchain.
At time zero (the “genesis block”), there are no gas fees to pay these validators, because there are no dApps or users of those dApps. So, instead, a blockchain can mint an indefinite number of its own token and supply those to validators who are willing to provide the blockspace production services to bootstrap on-chain activity.
All blockchains start life with a negative economic balance. In theory, their lifecycle should look something like this:
Over time, the goal is for gas fees to increase such that they are sufficient to cover validator rewards, flipping to a positive Economic Balance.
Given that each chain has its own sovereign economy, each is able to determine the gas fee per unit of blockspace (or fees per transaction). Clearly there is a large variance across chains in the fees they charge users.
Understandably, many chains have sought to disrupt Ethereum’s “high gas fees” with lower gas fees as a primary value proposition. The economic consequences of this strategy will become more apparent as we continue with our analysis.
Another way to look at this is that users are willing to pay very different amounts for a similar type of transaction, which points to the reality that blockspace is not a commodity or fungible (yet).
The next piece of the Economic Balance equation to consider are the validator rewards themselves - often not discussed, but the most important part of the standalone L1 model as this defines the cost to produce blockspace.
In order to be a standalone L1, a dedicated validator set is required. Without a standalone validator set, an L1 cannot (among many other non-economic things) charge gas fees in its native token, which is the basis for forming a sovereign economic system.
Individual node operators that choose to participate in an L1’s validator set and stake the native token are rational economic actors in the long run, meaning that they demand a satisfactory return on time and capital.
Supply and demand from investors seeking to stake the native token based on its attributes as a financial asset is what determines the intrinsic value of the native token at any given time.
Staking yields drive the economic incentives for rational actors to participate in supporting a network. A negative Economic Balance leads to inflation - as the Economic Balance becomes more negative, so too does inflation, which then requires a greater nominal yield paid to validators to offset the deleterious effects of inflation.
Observing Intrinsic Value
For simplicity, if we first assume that all owners of an L1 token are interested solely in the financial asset properties of the token, then the supply and demand of that token on the open market is driven by the staking yield available to validators.
Just like stock market investors set stock prices by seeking certain price to earnings ratios (or bond investors seeking a certain yield, or real estate investors seeking a certain cap rate), assets with higher prospects of yield growth will result in a higher multiple (or lower yield) - conversely, deep value and high anxiety companies are priced at lower multiples.
The same is true for bonds and in particular, sovereign bonds. Global currencies are similar to blockchain native tokens, in that each currency fluctuates in the market based on the monetary policy of that country and the internal economics of the country.
Investors in sovereign bonds seek to earn a similar real yield across currencies (adjusted for inflation). Truly open economies will generally be subject to forward interest rate parity where arbitrageurs will force real bond rates to converge through supply and demand for bonds denominated in the base currency.
Typically US treasuries trade at the lowest real rate because the US dollar is viewed as the currency most likely to remain stable over the long term (and thus most likely to present risk-free bond yields).
Real Intrinsic Value
We propose that staking economics in Proof-of-Stake blockchains will eventually converge on the same rational investment behavior as sovereign debt and will exhibit similar pricing mechanics.
Like the US dollar, all staking yields will be priced based on Ethereum staking yield as the primary source of risk-free yield. The solidly positive Economic Balance of Ethereum, particularly in contrast to other popular chains, seems to support the probability of this outcome.
Accordingly, if we assume that all staking rewards for proof-of-stake blockchains should have equal forward real yields (similar to the forward interest rate parity), we adjust the staked value downward such that the available real returns are equivalent to the risk-free real return, we arrive at the real intrinsic value of each token.
In order to maintain real interest rate parity, the market value of staked assets would have to decline significantly. The only exception is Ethereum, which would increase due to the bonus real return offered by the deflationary mechanics of token burning.
Solana is the most extreme; the real yield available to stakers is only sufficient to compensate $221m worth of staked SOL at 3.99%. This would represent a 94% decline from the current staked value of $3.8b.
Speculative Intrinsic value
Certainly most sophisticated token stakers are aware of the above calculation and have some price appreciation of the native token embedded in their total return expectations, as implied by the substantial difference in real yields that are currently available.
This expected price appreciation can be thought of as the speculative component of Financial Asset tokens anchored in an intrinsic value analysis - rational economic actors are staking assets with the expectation that the underlying asset will appreciate. However, without a positive Economic Balance, the basis for that price appreciation is entirely based on speculation, particularly in the face of an inflationary system with limited prospects of achieving Economic Balance. Sure, nominal yields can be boosted with additional token rewards, but without many fold growth in gas fees, this would just exacerbate long term inflationary issues.
There is no other explanation other than speculation. Otherwise token holders would prefer to stake the risk-free asset and receive higher real returns from token rewards financed by real gas fees paid by users (as opposed to rewards financed with inflation).
Extracting Monetary Premium
If we subtract the staked value from the total market cap, we can extract an implied Montary Premium. The difference between the total staked amount and the intrinsic value is the “speculative intrinsic value” described above, which represents holders of the token that are treating it as a financial asset and speculating on a future increase in Intrinsic Value. It can be argued that this speculative intrinsic value is a component of Monetary Premium because it is the result of token holders willing to suspend disbelief about the plausible scarcity of the token due to inflation, both for financial asset purposes as well as monetary purposes.
However, only sustainable systems can achieve a true Monetary Premium. As mentioned before, Monetary Premium arises from the money-like properties of an asset, which is dependent on credible long-term scarcity, which we now know is only possible with neutral to positive Economic Balance or reasonable near term prospects of the same.
Accordingly, today's “Monetary Premium” for tokens that are based on unsustainable systems is speculation on some future Monetary Premium, which is speculation on future Economic Balance.
An astute reader might argue that according to the logic above, Monetary Premium is a byproduct of Staking Ratio - the ratio of the number of tokens that are staked to the total number of floating tokens. Increasing the number of staked tokens within a validator set increases speculative intrinsic value, or in Ethereum’s case, reduces real yields (holding gas fees constant).
Let's explore this.
As the fundamentals for establishing Intrinsic Value improve, so do the supply/demand based mechanics for monetary premium via the staking ratio.
Above we have the “staking ratio smile”, defined by “boundary effects” when the staking ratio gets close to the boundaries of its range, either zero or 100 percent.
What are boundary effects? Consider this thought experiment - if 90% of the token float was staked, meaning that the underlying fundamentals of the protocol were sufficient to incent a large enough population of token holders to choose to treat their tokens as a financial asset, then the remaining 10% of the float would essentially be “squeezed” - it would be hard to buy, the volume would be relatively low, meaning that anyone seeking to use the token as money for paying gas fees on that chain would drive the price up just by virtue of being a forced buyer in a low-supply market.
This price increase as a result of demand for the token due to its money-like properties (over and above its financial properties) is the true driving force for Monetary Premium, from a valuation perspective.
The same can also play out in reverse - a staking ratio too high can be unwound, where stakers cease to believe in the underlying money-ness of the token, un-stake, sell it, and create a flood of the token on the market that overwhelms the existing floating tokens held as money. This is a death spiral that has been witnessed countless times in crypto, most recently with the Terra blockchain. At a certain point, the value staked to secure a Proof-of-Stake chain is insufficient to operate safely, and the chain is forced to halt.
The reality is that the staking ratio should never get this high - the underlying price of the token would increase (in dollar terms) to the point that marginal stakers would choose to un-stake and sell their token because their expected return had already been achieved due to price appreciation of the token. In addition, the gas fees to sustainably finance validator rewards will likely not be sufficient to maintain the same level of yield previously available at a lower staking ratio, another stabilizing factor with respect to staking ratio.
It's unclear what the equilibrium staking ratio is, but we will likely see it begin to converge on some number after the Shanghai update of Ethereum when un-staking and thus relatively liquid staking (at the validator level) is activated.
What about networks with staking ratios above 50%? This suggests that more than half of token holders (by value) are interested in the token for its financial asset properties, not its money properties. This in and of itself is not necessarily a bad thing, but it’s cause for pause when considering that the actual users of the blockchain who use the token as money should outweigh those holding it as a financial asset. What is the ratio of US dollar holders who also own bonds or Google users who own the stock?
If we approach the price of L1 tokens with the above components in mind, we can reprice the FDV by assembling the component parts.
Starting with the Intrinsic Value defined by the risk-free ETH staking yield as the “floor” value of the network, we can then add the Monetary Premium, which is the set of tokens that are issued but not staked.
In order to do this we need to choose an equilibrium staking ratio - for purpose of this discussion let's assume that number is 30%:
The implied market values as we see above are a bit paradoxical - if ETH staking doubles from mid-teens today to 30%, wouldn’t that drive ETH price in dollar terms up?
Practically that seems to make sense - a network that sees its staking ratio increase is more valuable because it has become more secure (up to a point where the validator rewards are unsustainably high to incent those stakers to remain staked, which is a negative of a high staking ratio).
In short, the equilibrium staking ratio will vary based on the underlying network fundamentals of each network, as well as the behavior and investment objectives of its token-holding community (i.e. highly VC-owned, speculative vs. owned by users).
For example, if on-chain activity doubles such that the gas fees double, then all else equal, the sustainable validator rewards double, doubling staking yield. The market will react to this by doubling the staking ratio to return to the same staking yield we started with.
In theory, this increase in staking ratio should be met by price appreciation of the native token in dollar terms (or relative to other L1 prices).
So, picking a model that assumes a certain Monetary Premium “multiplier” on the intrinsic value to arrive at FDV is convenient but not accurate for finding a price in dollar terms. All else being equal, a staking ratio that increases should cause the FDV in dollar terms to increase, and vice versa, whereas the multiplier methodology above suggests the opposite.
Instead, we need to consider the Monetary Premium component of network value in relation to other networks.
Returning to the example where gas fees double due to an increase in on-chain transactions, driving an increase in native token value in dollar terms, a check on infinite relative price appreciation is the real gas costs per transaction, or in other terms, what we call the “Blockspace Purchasing Power Parity”.
“Blockspace Purchasing Power Parity” is our version of the Economist’s “Big Mac index” - how much does the same transaction cost across chains? Sadly this isn’t as simple as eating a Big Mac in the US, Europe or Asia because blockspace is not a fungible commodity - the quality of blockspace varies across chains.
However, blockspace users will switch to other chains if the relative price on one chain becomes too expensive relative to alternatives. This acts as a limiter on the gas fees a network can collect, relative to the total market size of on-chain activity.
So, the total value of an L1 network can only be understood relative to the value of other blockchain networks, and not in an absolute sense in dollar terms.
That seems reasonable - what's a US dollar worth? It's only understandable in terms of other assets. Investors in sovereign currencies like Dollars, Euros, or Yen don’t think about their value in “market cap” terms, but instead relative to each other based on forward interest rate parity (discussed earlier), and purchasing power parity (PPP).
We propose that L1s should be thought of similarly - after all, they exhibit all of the same characteristics when compared to each other - staking yield as forward interest rate parity, and Blockspace Purchasing Power Parity” as PPP.
We call this the Country Theory of L1s, which we will expand on elsewhere. Functionally, we use the foreign exchange analogy to estimate the relative over / undervaluation of L1 tokens to each other.
Token prices will vary as a constellation - think of Ethereum as the sun, whose position is a function of dollar liquidity flowing in and out of the blockspace industry. Over the long run, liquidity will flow into the space as user demand for blockspace grows.
The price of other L1 tokens (and thus their relative monetary premium, in excess of their intrinsic value) will fluctuate based on their relative fundamentals vs. Ethereum, as the center of gravity of the space (or the US dollar, if you will).
Accordingly, we can list the factors that drive monetary premium up or down:
- Staking Ratio: A low staking ratio implies there is room to increase, so increasing the staking ratio should tend to push prices up in relative terms. The opposite is also true - a high staking ratio is more likely to decline than increase, particularly if real yields are relatively low, so this should tend to push prices down in relative terms.
- Real Staking Yield: A high real staking yield will drive the staking ratio up, as mentioned above should tend to push prices up in relative terms. The opposite is also true.
- 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 tend to push prices up in relative terms. The opposite is also true.
How Protocols Get Fat
Mechanically, monetary premium forms when the value of the native token increases relative to other assets because demand for that token outweighs the supply of it. Staking ratio is the link between the blockchain’s economics and a Monetary Premium.
In other words, monetary premium in Proof-of-Stake blockchains cannot exist without sustainability. Sustainability arises when gas fees are sufficient to cover validator rewards, which we define as a positive Economic Balance. Gas fees are a function of economic activity on-chain, which are driven by blockspace quality and network effects.
Blockspace quality is a function of the sustainability of the economic system, when security is created through the value of tokens staked on validators. Thus, Monetary Premium is a bit circular, which complicates its understanding, particularly in a Proof-of-Stake system.
A second, reinforcing element of the fat protocol thesis are on-chain network effects. The simple definition of a network effect is when increased numbers of people or participants improve the value of a good or service.
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).
The interaction between blockspace quality and network effects, which ultimately create the mechanics for monetary premium, can be visualized as two interlocking flywheels:
With these economic functions in mind, the mechanics for fat protocols become clear:
Gas fees in a sufficient quantity are necessary to provide a Return-on-Investment that is high enough to incentivize independent node operators to participate in a network’s validator set.
Sure, inflation can offset insufficient gas fees, but this is only a temporary solution and will lead to an ecosystem built on quicksand.
Without sufficient validator rewards, a network cannot afford enough independent validators to operate securely. Without security, the blockspace produced by that network is useless.
Thus, a sufficiently large portion of the economic value in a monolithic decentralized network must flow to the blockspace producing validator set for that system to exist at all.
Meanwhile, dApps are largely open source, replicable and largely fungible. Blockspace is not fungible - meaning that the natural forces of economics will drive value capture down for dApps (easily copied means easily competed), and shift that value to the blockspace producer(s), given the scarcity of high quality blockspace.
The nature of a Monetary Premium is not easily quantifiable. It arises as a byproduct of demand relative to floating supply due to its use as "money", which is not to be confused with overvaluation due to speculation. However, it can only exist in a sustainable system.
As the data show, the network value of Monolithic L1 blockchains other than Ethereum are driven primarily by speculative forms of value.
Monetary premium is a byproduct of sustainability, which is a function of gas fees and validator economics. Gas fees are driven by network effects, which arise from the composability of dApps on a shared execution layer and the security afforded by the blockspace produced by the network.
In order to produce truly secure blockspace, which is not dependent on irrational behavior from validators or financial exuberance, a sustainable Economic Balance within the network is paramount. Money-like properties cannot persist in the face of inflation and negative real validator economics.
Accordingly, L1 tokens will likely never be priced as simple discounted cash flow type assets, by virtue of the combination of inherent financial asset value through staking yields and Monetary Premiums from money-like properties.
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.
As we will see in Part 2, the execution layer and settlement, consensus, and data availability have begun to decouple - the early stages of vertical scaling solutions, which will add a new dimension to this economic model.
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 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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