Why does the "Fat Protocol Theory" no longer work in the current encryption environment?

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

The "Fat Protocol Thesis" has done great harm to the field and set us back several years.

In fact, I like the "Fat Protocol Thesis" very much, and if you haven't read it, I strongly recommend you to read it.

The simple version of this theory is that protocols (such as blockchains) will capture more value than the applications built on them.Why? Part of the reason is that the moat of crypto applications is weak (they are easily copied). But the main reason is that the success of applications will drive users to accumulate protocol tokens for use, thereby creating network effects for blockchains, because each application will drive up the token price of the chain it is built on.

In 2016, this was an extremely forward-looking argument. I would also like to add one of my points about why protocols can have greater value than applications: protocol tokens are 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 contracts) that guarantees the validity of transactions, while collecting "taxes" for the ecosystem. Applications, on the other hand, are usually just ordinary business entities that generate revenue.

Of course, the market value of a currency is usually highly correlated to the GDP generated by everything built on it, and is therefore often much larger than the market value of a company. This is why I believe that protocols are often more valuable than applications.

This is the problem. The past decade has verified the "fat protocol theory" in many ways, and it reached a climax in the past year. As everyone knows, the market value of chains has crushed the market value of applications. Protocols often raise funds at valuations of hundreds of millions of dollars without products, while applications with dedicated users have a hard time raising funds.

To understand how much the market buys into the “fat protocol thesis” — to the point of irrationality — just look at the recent valuations of the highly fungible, random Layer 2 (L2) chains.

These L2s don’t meet any of the requirements of the “fat protocol thesis” because their tokens don’t need to be used for transactions at all — in fact, these L2s don’t even need tokens. But in crypto, narratives are often stronger than logic, and many of these L2s have easily reached nine-figure valuations while applications have struggled with valuation.

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

We’ve heard the “chain first” issue many times: a blockchain is only valuable if there are valuable applications on it. The chains themselves will say this, too, emphasizing their huge performance improvements. “Of course we need to expand blockspace,” they say, “because the next top app will need it.” But in a world where apps have failed for a full decade, very few people want to build or fund more apps.

This is interesting, but unfortunately, the logic of “we need to fund apps for blockchain to succeed” will never be enough for VCs to invest in an entire category they believe will fail. The idea that apps will help blockchains become valuable is attractive, but it’s not a compelling argument if no one believes that apps themselves are valuable.

Therefore, I want to propose a “Fat App Thesis.” I’ll point out that there’s a point that has been true throughout the history of the Internet, to the point that I think it’s even a little boring:In fact, most of the value in crypto today is in apps.

There are three reasons, in increasing order of importance:

The first and most speculative reason is simply historical cycles. Applications are severely undervalued, while protocols are severely overvalued, for the reasons outlined above. The internet tends to go back and forth between ten-year cycles of infrastructure and applications, and we are at the tail end of a massive infrastructure boom where we created amazing technology that is finally working (which was not true two years ago). Now is the time for applications to shine, and they have never been more undervalued.

The second, more compelling reason is that applications and protocols have swapped places since the "fat protocol theory" was proposed in 2016. Back then, applications were mostly interchangeable forks of each other's trading tools, and chains were walled gardens with huge liquidity moats. But things have changed dramatically. Today, applications cannot completely copy each other (e.g. Sushiswap) because their real moat is users.

At the same time, chains don't even need much liquidity to support future social applications, unless they are targeting DeFi applications that need liquidity (e.g. @berachain). More importantly, as cross-chain solutions and chain abstractions emerge, allowing users to seamlessly use applications and bridge across ecosystems without knowing which chain they are using, liquidity itself is collapsing as a moat for most chains. Today, chains are largely interchangeable — not applications.

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

Users will congregate where other users are. This is why only a few applications will win in the end — because users will eventually gravitate to each other into a few unique internet “cities”.

This is also why I suspect there is so much bearishness on applications today (inside and outside of crypto): a few applications won a decade ago, and since then, it’s been hard to compete with their user attention. Frankly, it’s hard to come up with new application ideas because of the limitations of Web2 — specifically app store fees, closed APIs, and the inability to easily spend money.

But on-chain technologies enable entirely new app experiences, with economic and reputational upside that never existed before: they eliminate app store fees, open up public blockchain APIs, and let users easily spend and save money. So here’s my theory. I believe some of these apps will win, too. As internet history has always shown, they will become “super apps” that take up the majority of block space.

I could be wrong, very wrong. This era may be different than the past. We may see millions of mini-apps flourish, like all the apps on Telegram, and I would be very happy about that.

But I suspect we’re in a short-lived era of apps, because the design space for new apps has only just opened up in the past two years — and crypto apps that were built entirely on “token price going up” will eventually collapse as “token price going down”. We don’t talk about this enough, but all signs point to this era ending. What’s really exciting about crypto apps today is that the next generation of prediction markets, competitions, NFC chips, DePINs, and even e-cigarettes no longer rely on token price appreciation as a use case. For the first time, crypto is a means, not an end.

What I mean by this is that apps can actually win in the long run and start taking up all the block space we’ve been generating for years. So what happens next? These apps can do something innovative. They can return money to users, rather than the Apple App Store, to incentivize their growth. They can collect revenue from every click. Ultimately, they can generate huge revenues, only a small fraction of which will go to the chain.

I’ve said before that chains don’t need huge revenues to get huge valuations, because they should be valued based on something like GDP. But when most of the GDP is generated by a few apps, it’s worth asking the question: Who is really the “fattest”? Is it still the chain? Or is it more likely to be the app?

Finally, I want to say that I’m not pessimistic about chains—not at all. Many chains are not interchangeable due to their unique virtual machines (VMs) or opcodes (e.g. @solana, @irys_xyz, @movementlabsxyz, @eclipsefnd), native incentive mechanisms (e.g. @berachain), high performance in a familiar VM (@mega_eth, @monad_xyz), or specific permissioned implementations (@repyhlabs, @celestiaorg). Applications built on these chains can only be implemented on these chains. Ultimately, even if only a few applications win market share, investing in chains is still the best way to invest in those applications.

We like to think there is a war between infrastructure and applications as they compete for private market capital. But there is actually no real war of value between the two - the two complement each other and cannot survive without each other. Beyond that, I suspect most applications will also operate like protocols themselves, becoming the foundation for others to build on.

Still, 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 to infrastructure. But what we need to realize is that this is also a huge missed opportunity.

The next major wave of value will flow to applications, and only a very small number of people in this ecosystem are willing to take the risk to try to capture it.