OOne of the main investment themes of 2021 was alternative blockchain networks, core or layer 1 networks, competing with Ethereum for decentralized applications.
Investments in @solana, Polygon, Fantom, Near, Avalanche, Arbitrum, Cosmos, Polkadot and other protocols, as well as companion layer 2 protocols, have become increasingly profitable.
These protocols are makers of a particular good – distributed computing. Such a calculation can power any type of software, but is particularly suited to digital scarcity, property rights and provenance. Decentralized computing 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 ignite the machines of the global network.
CoinDesk columnist Lex Sokolin is co-global head of fintech at ConsenSys, a blockchain software company based in Brooklyn, NY. The following is adapted from his Fintech Master Plan newsletter.
The other framework is a war on developers to build apps under particular standards regimes. It’s the story of Betamax vs. VHS, Apple vs. Windows, iOS vs. Android and Chinese super apps. There are a number of relevant platforms – say more than one but less than five – which can provide alternate versions of a particular operating stratum. These platforms only have value if they are managed by third-party gardeners, i.e. the developers who create the apps.
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If there are many applications, users appear and use them. Users are often the most willing to pay. You might think Facebook is free, but remember you paid Apple (AAPL) $1,000 for the privilege of having a phone. Subsequently, if there are users on your platform, developers value it as a distribution channel in addition to a technology enabler. Such viral loops can create positive network effects, which allow some balances to hold and others to collapse.
So Layer 1s do both – they provide the unit of computation as well as the market context in which that unit of computation is generated and executed.
So shouldn’t incumbents like Ethereum win this power law game? Well, not if there are ways to bribe and dominate the game. You can see that playing out today in value locked, i.e. collateral, moving around things like Terra , Avalanche and (again) Binance Smart Chain. In September 2020, Ethereum held 90% of the assets in the market, and today it holds around 50%. It is important to understand how and why.
Here is an example. Avalanche is launching a $290 million incentive program to develop applications based on its technology. The fully diluted market capitalization of the protocol is approximately $30 billion today. So we’re talking about spending 1% of market cap on growing the platform and acquiring repeat customers.
It’s not a one-size-fits-all strategy, of course. Consider Polygon, which launched a $100 million ecosystem fund to target the growth of decentralized finance (DeFi) last April. For your information, it worked; there is now quite a bit of DeFi on Polygon. We could highlight this achievement for every layer 1 and foundation out there.
the Solana, FTX, Silicon Valley story is also a good example. For Ethereum, ConsenSys acted as an ecosystem fund in the beginning, eventually generating sufficient community build and adoption.
At the meta level, these funds represent a commitment of a certain amount of the protocol’s token supply for marketing and user acquisition. Users are app builders, and they bring in the subsequent business users. The recursive movement is that once applications are built and people spend their money buying the product of the protocol, which if you recall is decentralized computing, the value of that computing increases, at least for some time.
It’s the same as Microsoft (MSFT) or Apple giving developers grants to be first in a new operating system. Or PayPal (PYPL) and Wells Fargo (WFC) giving new users a $100 reward for opening an account. It’s the same as a company launching venture capital arms to capture innovation and redirect it to that company’s core business, like the cloud for AWS or the movement of money for Visa (V ) and Mastercard (MA). This is also the same as liquidity mining rewards for Compound or Uniswap.
The history of infrastructure
I hope we’re making the obvious points: spend on marketing, grow your adoption over others, build profitability, use profitability to increase your market share. We thought Ethereum had this locked in, but the reality is there’s a lot more venture capital out there that wants to recreate a layer 1 ROI profile. We can imagine $10 billion ecosystem funds fighting in 2024 for governments, giant tech companies and other industrial whales (large holders).
All of these subsidies come down to supply and demand for distributed computing. If we create many concurrent rails that manufacture computations, this capacity may or may not be consumed.
To that end, here’s a helpful reminder of what happened to telecommunications around the year 2000. Telecommunications companies were busy building new capacity for the Internet and competing to generate more bandwidth for use that wouldn’t had not yet materialized. This physical investment has led to oversupply. As demand from builders dwindled as their startups evaporated, so did the value of infrastructure.
If we zoom out a bit further, here is the Telecom revenue pool through and after the internet pop. Obviously, the internet is here to stay and the collapse of a particular price bubble has no real significance that sheds light on fundamental long-term trends.
To be an internet bear forever in 2003 means that you mentally blocked yourself from understanding the world. And yet, being a bear around the earnings and valuation of a particular infrastructure sector is another story – and a rational expectation. Trends such as commoditization and Moore’s Law dominated the ability of these companies to maintain prices, even as demand soared.
We are as optimistic as anyone on Web 3 and will not regurgitate the central thesis. But the savvy observer should look at Tier 1 competition with long-term clarity. Much of the current growth is fueled by marketing and financial incentives, so well-placed people can generate a lot of wealth through new token issuances. It’s like taking your telecom IPO and using the stock to fund internet applications on your network. It might have a short-term effect, but it doesn’t seem like the right balance, sustainable or reasonable, of fundamental progress. How picturesque, indeed.
We must also not forget that the most valuable Internet companies are not the Ciscoes of the world, but those that provide media (Google, Facebook) and commerce (Amazon) – the core value of Web 1 and Web 2 We have to pause to think about the relationship of Apple (hardware access) and AWS (centralized computing) to the whole, but that’s for another day. And in Web 3 the “value” is in the $value.
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