One of the main investment themes of 2021 was the alternative blockchain networks, the base networks or layer 1s, competing against Ethereum for decentralized applications.
Investments in protocols @solana, Polygon, Fantom, Near, Avalanche, Arbitrum, Cosmos, Polkadot and others, as well as layer 2 companion protocols, became increasingly profitable.
These protocols are manufacturers of a particular good – decentralized computation. Such computation can power any type of software, but is particularly apt for digital scarcity, property rights and provenance. Decentralized computation has a supply, a certain amount of demand and a variable price in the cost of gas. Not dinosaur bone gas, but the digital one used to turn on the global network machines.
Lex Sokolin, a CoinDesk columnist, is global fintech co-head at ConsenSys, a Brooklyn, N.Y.-based blockchain software company. The following is adapted from his Fintech Blueprint newsletter.
The other framework is a war over developers to build applications within particular standards regimes. This is the story of Betamax vs. VHS, Apple vs. Windows, iOS vs. Android as well as the Chinese super apps. There exist some number of relevant platforms – let's say more than one but fewer than five – which can provide substitute versions of a particular operating stratum. Those platforms are valuable only if gardened by third-party gardeners, i.e., the developers that make the applications.
If there are many applications, users appear and use them. Users often have the highest willingness to pay. You might think Facebook is free, but remember you paid $1,000 to Apple (AAPL) for the privilege of having a phone. Thereafter, if there are users in your platform, developers value that as a distribution channel in addition to a technology enabler. Such viral loops can create positive network effects, which allow certain equilibria to hold, and others to collapse.
So layer 1s do both – they provide the computational unit as well as the market context in which that computational unit is generated and executed.
So shouldn’t incumbents like Ethereum win this power law game? Well, not if there are ways to bribe and overpower the game. You can see that play out today in the value locked, i.e., collateral, moving around things like Terra, Avalanche, and (still) Binance Smart Chain. In September 2020, Ethereum had 90% of the assets on the market, and today it has about 50%. It is important to understand how and why.
Here’s an example. Avalanche is launching a $290 million incentive program to grow the applications built on its technology. The protocol’s fully diluted market cap is about $30 billion today. So we are talking about a 1% spend of the market cap on platform growth and recursive customer acquisition.
The Solana, FTX, Silicon Valley story is also a good example. For Ethereum, ConsenSys played the role of ecosystem fund in the early days, eventually generating sufficient building and adoption by the community.
At a meta level, these funds are a commitment of some amount of the protocol’s token supply for marketing and user acquisition. The users are applications builders, and they bring the consequent retail users thereafter. The recursive motion is that once applications are built and people spend their money on purchasing the protocol’s product, which if you remember is decentralized computation, the value of that computation rises, at least for some time.
It’s the same thing as Microsoft (MSFT) or Apple giving developers grants to be first in a new operating system. Or PayPal (PYPL) and Wells Fargo (WFC) paying new users a $100 reward for opening an account. It’s the same thing as enterprise launching corporate venture arms to capture innovation, and redirect it to that enterprise’s core business, like cloud for AWS or money movement for Visa (V) and Mastercard (MA). It’s also the same thing as liquidity mining rewards for Compound or Uniswap.
The story of infrastructure
Hopefully, we are making obvious points – spend on marketing, grow your adoption against others, build in profitability, use profitability to grow share. We thought Ethereum had this on lock, but the reality is that there’s a lot more risk capital out there wanting to recreate a layer 1 investment return profile. We can imagine $10 billion ecosystem funds doing battle in 2024 for governments, giant tech companies and other industrial whales (large holders).
All this subsidy boils down to the supply and demand of decentralized computation. If we create lots of competing rails that manufacture computation, that capacity may or may not be consumed.
To that end, here’s a useful reminder about what happened to telecoms around the year 2000. Telecom companies were busy laying new capacity for the internet, and competing on generating more bandwidth for usage that hadn’t yet materialized. This physical investment led to oversupply. As demand from builders fell as their startups evaporated, so did the value of the infrastructure.
If we zoom out a bit further, here is the revenue pool of telecoms through and after the Internet pop. Very obviously, the internet is here to stay and the collapse of a particular price bubble holds no real meaning that informs long term fundamental trends.
Being an internet bear forever in 2003 means you've generated a mental block for yourself from understanding the world. And yet, being a bear around revenue and valuation of a particular infrastructure sector is another story – and a rational expectation. Trends like commoditization and Moore’s law overpowered the ability of these companies to hold price, even as demand sky-rocketed.
We are as bullish as anyone out there on Web 3, and won’t regurgitate the core thesis. But the astute observer should watch the layer 1 competition with long-term clarity. A bunch of current growth is powered by marketing and financial incentives, such that well-positioned people can generate a lot of wealth through new token issuance. It’s like IPOing your telecom, and using the stock to fund internet apps on your network. That might get a short-term pop but doesn’t feel like the right, sustainable or sensible equilibrium of fundamental progress. How quaint, indeed.
We also shouldn’t forget that the most valuable Internet companies are not the Ciscos of the world, but those providing media (Google, Facebook) and commerce (Amazon) – the core value prop of Web 1 and Web 2. One should pause to think about the relationship of Apple (hardware access) and AWS (centralized computation) to the whole thing, but that’s for another day. And in Web 3, the “value” is in the $ value.
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