Why does the "fat protocol theory" no longer work in the current encryption environment?

Author: david phelps Source: X, @divine_economy Translation: Shanooba, Golden Finance

The ‘Fat Protocol Thesis’ has dealt a huge blow to this field and set us back by several years.

In fact, I really like the ‘Fat Protocol Thesis’. I strongly recommend you to read it if you haven’t already.

The simplified version of this theory is that the protocol (such as blockchain) captures more value than the applications built on top of it. Why? Part of the reason is that the moat of encryption applications is weaker (they are easily replicated). But the main reason is that the success of applications will drive users to accumulate protocol tokens for use, thus creating network effects for the blockchain, as each application will drive up the token price of the chain it establishes.

In 2016, this was a forward-looking argument. I would also like to add my opinion to explain why the protocol can have greater value than the application: the protocol token is similar to the national currency of a digital country, which not only serves as a medium of exchange but also represents a legal order (smart contract) that guarantees the validity of transactions, while collecting ‘taxes’ for the ecosystem. Applications, on the other hand, are usually ordinary commercial entities that generate revenue.

Of course, the market capitalization of a currency is usually highly correlated with the GDP generated by everything built on it, so it is often much larger than the market capitalization of a company. That’s why I think protocols are usually more valuable than applications.

That’s the problem. The past decade has validated the “fat protocol thesis” in many ways, and it has reached its peak in the past year. As we all know, the market cap of chains has crushed the market cap of applications. Protocols often receive financing with a valuation of hundreds of millions of dollars without products, while applications with exclusive users have a hard time getting financing.

To understand the market’s level of agreement with the “fat protocol theory” - even to the point of being unreasonable - just look at the recent valuations of those highly interchangeable and random Layer 2 (L2) chains.

These L2 do not meet any requirements of the “fat protocol theory” because their Token is not needed for trading at all—in fact, these L2 do not even need Token. But in the encryption field, narrative is often more powerful than logic, and many of these L2 easily reach valuations in the nine figures, while applications struggle in terms of valuation.

(Of course, I think some L2s will truly have value, like @mega_eth and @movementlabsxyz, but that’s another topic.)

We’ve heard a lot about the issue of “chain supremacy”: a blockchain only has value when there are valuable applications on top of it. The chains themselves also say this, emphasizing their huge performance improvements. “Of course we need to expand the block space,” they say, “because the next top application will need it.” But in a world where an application has failed for a whole decade, only a few people still want to build or fund more applications.

It’s interesting, but unfortunately, the logic of ‘we need to fund applications to make blockchain successful’ will never be enough for venture capitalists to invest in an entire category they believe will fail. The view that applications will help blockchain become valuable is attractive, but if no one believes the applications themselves are valuable, this view is not persuasive enough.

Therefore, I would like to propose a “Fat App Thesis”. What I want to point out is that throughout the history of the Internet, there has been a point of view that has always been true, so much so that I find it a bit boring: In fact, most of the value in the field of encryption today lies in applications.

There are three reasons, in increasing order of importance:

The first and most speculative reason is simply the historical cycle. Applications are severely undervalued, while protocols are severely overvalued, as mentioned above. The internet tends to switch back and forth between infrastructure and application cycles of about a decade. We are now at the end of a major infrastructure boom, during which we have created extraordinary technologies that can finally run (which was not possible two years ago). Now is the time for applications to shine, and they have never been undervalued like they are now.

The second, more convincing reason is that since the proposal of the ‘fat protocol theory’ in 2016, the positions of applications and protocols have been swapped. At that time, applications were mostly interchangeable forks that traded with each other, while chains were walled gardens with huge liquidity moats. However, the situation has changed dramatically. Today, applications cannot fully replicate each other (such as Sushiswap) because their real moat is users.

At the same time, the chain doesn’t even need too much Liquidity to support future social applications, unless they are targeting DeFi applications that require Liquidity (such as @berachain). More importantly, with the emergence of Cross-Chain Interaction solutions and chain abstraction, users can seamlessly use applications and bridge across ecosystems without knowing the chain they are using, and Liquidity as the moat of most chains is collapsing. Today, chains are largely interchangeable - not applications.

But this leads to a third, and most important, reason:
When Liquidity is no longer a moat, users are the moat.

Users will gather where other users are. That’s why only a few apps will ultimately win out - because users will eventually attract each other to a few unique internet ‘cities’.

This is also why I suspect the reason why everyone is so pessimistic about applications today (inside and outside encryption): a few applications won a decade ago, and since then, it has been difficult to compete for their users’ attention. Frankly, limited by the constraints of Web2 - especially application store fees, closed APIs, and the inability to easily spend money - it is difficult for anyone to come up with new application ideas.

But on-chain technology makes it possible for a whole new application experience, bringing unprecedented economic and reputational rise space: they eliminate the cost of app stores, open up public Blockchain APIs, and make it easy for users to spend and save money. So this is my theory. I believe some of these applications will also emerge as winners. As Internet history has consistently shown, they will become ‘super apps’ that occupy most of the Block space.

I may be wrong, very wrong. This era may be different from the past. We may see the thriving development of millions of mini-apps, just like all the apps on Telegram, and I will be very happy about this.

But I suspect we are in a temporary era of applications, because the design space for new applications has only opened up in the past two years - and those encryption applications that are built entirely on the basis of ‘Token pump’ will eventually collapse as ‘Token prices fall’. We haven’t talked enough about this, but all signs indicate that this era is coming to an end. What’s really exciting about encryption applications today is that the next generation of prediction markets, competitions, NFC chips, DePIN, and even e-cigarettes no longer rely on Token pump as a use case. This is the first time that encryption is a means, not an end.

What I mean is that the application can actually win in the long run and start occupying all the Block space that we have been generating for years. So what happens next? These applications can make innovative moves. They can return funds to users instead of the Apple App Store to incentivize their rise. They can generate income from every click. Eventually, they can generate huge revenues, of which only a small portion will flow to the chain.

I have said before that chains do not need huge income to achieve huge valuations, because they should be valued based on something similar to GDP. But when the majority of GDP is generated by a few applications, we deserve to ask a question: Who is truly the “fattest”? Is it still the chains? Or is it more likely to be the applications?

Finally, I want to say that I am not pessimistic about the chain - not pessimistic at all. Many chains are not interchangeable due to their unique Virtual Machine (VM) or opcodes (such as @solana, @irys_xyz, @movementlabsxyz, @eclipsefnd), native incentive mechanisms (such as @berachain), high performance in familiar VMs (@mega_eth, @monad_xyz), or specific permissioned implementations (@repyhlabs, @celestiaorg). Applications built on these chains can only be implemented on these on-chain platforms. In the end, even if only a few applications win market share, investing in the chain is still the best way to invest in these applications.

We like to think of a war between infrastructure and applications, as they compete for private market funds. But in reality, there is no real value war between the two - they complement each other and cannot survive independently. In addition, I suspect that most applications themselves will operate like protocol, becoming the foundation built by others.

However, despite this, we not only act as if there is a war, but also as if infrastructure has won. We are realizing that this is fatal for infrastructure. But what we need to realize is that this is also a huge missed opportunity.

The next wave of value will flow towards applications, and in this ecosystem, only a few are willing to take the risk to seize it.