Layer 1 Protocols: Still the trade of the century?
Layer 1 protocols have captured the most value in crypto to date, however, this is unlikely to persist
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The internet and modern computing is built on a set of network protocols that allow us to send messages, connect to various devices and generally interact with each other online. These protocols themselves are a bit of an alphabet soup: TCP/IP, IPv6, and HTTPS etc. However, the robustness of these protocols is why we’ve been able to get to the current state of technological development.
In a similar manner, decentralised applications are also built on protocols that enable them to run in a secure and distributed manner. In the past, these protocols haven’t been able to capture value, however, in crypto land, these infrastructure layer protocols – commonly known as Layer 1 protocols – have been able to capture value through their native tokens. Currently, this layer has served as the most attractive value proposition for crypto, however, early indications suggest that this phenomenon may not persist over time.
What is a Layer 1 protocol?
Whilst most people have probably heard of Ethereum as the second-largest cryptocurrency (US$480 billion market cap), the rise in the popularity of the token has also led to the rise of many other projects known as Layer 1 protocols. Layer 1 protocols like Ethereum provide the foundational infrastructure for other projects to be built on top of these protocols. To provide a real-world analogy, Amazon relies upon logistics networks, warehouses and various modes of transportation to deliver its goods. Likewise, Ethereum and other Layer 1 protocols provide the baseline functionality for other projects to integrate with so that individual projects don't need to build their own infrastructure.
The most common examples of Layer 1 protocols are Ethereum, Solana, Binance Smart Chain, Avalanche and Polkadot. Around each of these Layer 1s is a unique ecosystem of projects. Each of these Layer 1s has different characteristics that determine its speed, security and decentralisation. As a result, depending on the type of application being built, certain Layer 1s are better suited.
Excluding Bitcoin, Layer 1s allow developers to write and deploy smart contracts. Smart contracts are effectively predefined programs that execute once a set of conditions have been met. For example, if you wanted to claim insurance after a car accident, you could simply fill in your details, attach the required files and receive your claim in minutes rather than days. To date, smart contracts have been used in various areas such as verifying COVID-19 passports, supporting remittance payments and of course in blockchain native applications such as DeFi, NFTs and DAOs.
Unlike traditional open-source protocol layers such as HTTP and SMTP, all Layer 1 networks have a native token that provides ownership and access to the protocol's resources. You use a protocol's token to pay for network services such as engaging in transactions, minting new tokens and using smart contracts. This creates a unique opportunity in that you can invest in the underlying infrastructure, whilst also participating in the value capture through your own project or by investing in other projects within the respective Layer 1's ecosystem.
So what Layer 1s exist?
To give you a better view of the differences between Layer 1s, let's break down what makes some of the more notable ones special.
Ethereum has garnered all the developer and consumer attention through its first mover advantage. Ethereum is effectively a programmable blockchain that lets anyone build decentralised apps on top of it. Ethereum is Turing complete and composable meaning that you can solve any reasonable computational problem using smart contracts, and construct a chain of inputs and outputs from various functions leading to an exponential number of functions.
In normal speak, what that means is you can pretty much build whatever application that exists today completely on Ethereum. And that's exactly what happened in 2020 and 2021. Volumes traded on decentralised exchanges like Uniswap or Sushiswap skyrocketed, and NFT sales exploded as OpenSea started to gain mainstream adoption.
However, as more people and applications onboard onto Ethereum, the network is facing severe throughput issues in the form of slow transaction speeds and high costs per transaction. This, in turn, has led to a multitude of newer Layer 1 protocols looking to overtake Ethereum's level of usage.
This is where Solana has been able to take market share from Ethereum. Built on Rust, Solana has attracted newer developers to crypto by lowering the barriers to entry to developing on top of the protocol. In addition, Solana is fast and cheap. It can process as many as 50,000 transactions per second with each transaction costing $0.00025 on average.
As a result, Solana is positioning itself as the decentralised finance blockchain as it is able to facilitate full-style central limit order books with FTX serving as the marquee app built on top of Solana. This is due to its unique consensus mechanism, Proof of History, which creates a historical record that proves an event/transaction has occurred at a specific moment in time. Whilst other blockchains need validators to communicate with each other to agree that time has passed, each Solana validator maintains its own clock by encoding the passage of time in a verifiable function.
However, in order to pull this off, Solana makes a few tradeoffs which can be off-putting for decentralisation maximalists. Solana can be taken offline if needed by the core team (which last occurred in September 2021), highlighting a potential lack of decentralisation. Moreover, Solana is being used as the alternate blockchain to Ethereum which works well for some applications but not all.
Whilst traditional Layer 1 protocols like Ethereum and Solana are capable of creating decentralised finance ecosystems, they are unable to handle the various storage and state requirements of running a social media application. For example, Facebook has numerous states that need to be accounted for, such as likes on a post, number of comments and the number of followers for a specific account etc. DeSo is specifically built to handle all of these states and more.
Whilst it’s possible to hack together a solution using off-chain elements, this goes against the ethos of ensuring all data from a network is transparent and verifiable. DeSo was built on the thesis that current social networks are highly centralised and policed. As a result, all actions taken on a social network such as BitClout (enabled by DeSo) are independently verifiable. DeSo natively supports various indexes that allow posts to be ordered by timestamp, profiles to launch and manage their own token, collect NFT bids and tips from users.
Following on from DeSo, Polkadot takes an interesting approach towards the blockchain tradeoff problem. Polkadot effectively connects multiple chains together to a single network, allowing them to process transactions and events in a parallel manner whilst still ensuring security and verifiability. Each chain in the network can be purpose built for specific use cases, rather than being forced to accept a one-size-fits all solution.
Polkadot is collaborative by design. Given its multi-chain approach, it is interoperable between other layer 1 protocols and can bridge blockchains. Moreover, to make changes to most blockchains, they need to undergo a forking process which effectively pushes all validators on to the new codebase. In the case of Polkadot, there is no need to fork, as upgrades are pushed through a transparent on-chain governance system.
As more blockchain applications are fleshed out, it’s likely we see more specific-use layer 1 protocols being used over general purpose blockchains.
Fat Protocol Theory
As mentioned above, unlike traditional Web1.0/2.0 infrastructure, it's possible to capture value at the base infrastructure layer in crypto. To date, the bulk of value capture has occurred at the protocol layer, with the application layer capturing a minority share of value. As such, this market dynamic was coined the ‘Fat Protocol Thesis’ by Joel Monegro in 2016, and is clearly shown in the number of layer 1 protocols that exist and their combined market capitalisation.
The reason this phenomenon has occurred is largely due to value in a shared data layer and speculation. Traditionally, data is gated and serves as a constraint for new entrants into any market. With a shared base data layer, it's easier for an application to be built on top and to work together to grow as an ecosystem. More importantly, due to this shared data layer, developers tend to build on top of a single blockchain (similar to what Daniele Sestagalli has been building on Avalanche).
This in turn leads to greater speculation and increased positive sentiment around a certain blockchain. As most investors realise, investing in the pipes and plumbing of new markets is where outsized investment returns are made. In light of that, people flock to specific Layer 1s that talented developers are building on top of. This then attracts more developers to build on top of that blockchain and boosts further speculation - effectively creating a flywheel effect. As a result, the market cap of the protocol is likely to grow faster than the cumulative value of the applications built on top.
The Layer 1 trade has worked phenomenally well since Ethereum's ICO, and will likely continue to work well for the next 3-5 years. However, there are a few emerging headwinds for this play.
Negating the Fat Protocol Thesis
At the moment, each blockchain is like its own railroad without switches to merge on to other railway tracks. For true adoption of crypto as the finance layer for society, there needs to be a state of interoperability between different blockchains. In an ideal world, you would be able to seamlessly hop between applications built on Solana to Ethereum and then to Polkadot and back again. At the moment, the bridging infrastructure is still being built out. As the bridging layer becomes more prominent, the underlying blockchain an application is built on becomes less relevant.
As this plays out, the actual blockchain an application is built on becomes less relevant, and only serves as the initial input for a developer when deciding which chain to use. As a result this will likely cause layer 1 tokens to function as commodities rather than a speculative asset. However, unlike physical commodities, protocols and tokens are able to instil various dynamics that can fundamentally shift the supply and demand in the market. Controlling the burn and emission rates of new tokens and creating different utility for holding the token may cause Layer 1s to act as a blended speculative/commodity asset. However, the tipping point for this market shift is unknown given the nascency of crypto.
The Future of Layer 1 Protocols
With a rotation out of Layer 1 protocols, it poses the question around what profile of applications will capture the most value. Sticking to the infrastructure layer theme, we can move up from Layer 1 into the bridging layer, but also infrastructure for specific Web3 projects. As posited above, bridges are likely to become highly relevant as the proliferation of Layer 1 blockchains continue. As a result, their value creation in connecting a fragmented market is incredibly high and will likely capture a percentage of the throughput.
On the Web3 infrastructure side, products that enable people to interact with and engage in Web3 activities are likely to perform well. For example, DAO tooling is an incredibly underserved but valuable market. DAOs are likely to start replacing traditional corporations, and to provide the infrastructure for this shift to happen is incredibly valuable. In that same vein, the on and off ramps into crypto are progressively improving, and providing people with good UX when interacting with Web3 will likely capture a large amount of value.
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