Original author: HOPYDOC

Original compilation: MarsBit, MK

Evaluating app chains has always been one of the trickier tasks for investment analysts because app chains function at a basic level like standalone applications but inherit the characteristics of the protocol or what is now called the base layer. , such as security and data availability.

Therefore, it is unfair to apply the transaction multiples of independent applications to the application chain; but at the same time, due to the obvious differences in the value accumulation mechanism, it is difficult to argue that the application chain should trade at the multiple of the base layer. Take Injectives run this year, for example, which was widely viewed as a re-rating trade. When the team announced ecosystem funds backed by the likes of Pantera Capital and Jump Crypto to support building other applications on top of application-specific layers, the market began to view AppChain as a protocol.

Injective announces $150 million ecosystem fund

This piqued my interest in the first generation of Fat Protocol Thesis because I think that by understanding the evolution of how the market views the value of blockchain, it will give me some ideas on how to consider current application chains. value; or specifically, an application chain with an ecosystem.

Fat Protocol Thesis (Fat Protocol Theory)

Fat protocol theory was originally proposed by Joel Monegro in August 2016 while still at Union Square Venture; the discussion revolves around the fact that encryption protocols should theoretically capture more value than the applications built on them.

In short, this argument suggests that what we now call base layer protocols offer two unique core value propositions or sources of value accrual and therefore should always be considered more valuable than applications; or simply, Justify some pretty astronomical valuations; they come from

• A permissionless shared data layer; the blockchain effectively lowers the barrier to entry for more new players, leading to more intense competitive dynamics in the system, and more importantly, makes possible the combination of each other, thereby promoting the protocols increase.

• A positive feedback loop that drives the speculative value of native network tokens; as rising token prices attract the attention of developers and investors, this is then converted into labor or capital invested in the ecosystem and kickstarts the flywheel of its speculative value.

• As an extension, the protocol can capture the value created by the application layer through increased demand for the native token, typically in the form of fees; so in theory, the more transactions the application brings to the protocol layer, the more value the protocol can capture The more.

Why the “Fat Protocol” is no longer relevant

Fat Protocol Theory has subsequently experienced numerous debates about its timeliness, as the proposition was made in the age of maximization, when the concepts of modularity and application-specific chains did not even exist.

The market subsequently believed that the Fat Protocol Theory was not fully applicable to the current market structure for the following reasons:

• Overwhelming abundance of block space; judging from the number of newly minted Alternative Layer 1 in the previous cycle, the protocol layer can no longer retain the value created by the application, as the abundance of block space compresses what users pay for the same transaction volume s price.

• The rise of modular blockchains; effectively decomposing the functionality of a blockchain into execution, data availability, and settlement, resulting in cheaper data availability solutions, further compressing the cost that users pay for the shared data layer in the original paper cost.

• Convenience of multi-chain; applications can easily be launched on multiple chains and even interact across chains with the help of interoperability tools like LayerZero, so the dependence on a single protocol has been significantly reduced, weakening the original paper positive feedback loop.

App Chain Thesis (Application Chain Theory)

With the introduction of App Chain Thesis, the demise of Fat Protocol Theory has come. Utility Chain is a blockchain built for a specific use case; its design enjoys several advantages, including the following:

• Better value accumulation mechanism; native network tokens can be used for security purposes, causing the supply of tokens to decrease; and value can also be derived from the blockchains business model.

• Customizability; developers are free to customize any configuration in the technology stack to achieve specific purposes, such as throughput and finality, and make trade-offs based on the needs of the application.

• For example, the latest dYdX v4 is implemented on a chain driven by Cosmos-SDK; this ensures that traders no longer need to pay gas fees for transactions; instead, fees will be charged based on the size of the transaction, which imitates the centralized The experience of trading on the trading platform.

That said, app chains inherently have some shortcomings, so the concept hasn’t quite caught on yet, for the following reasons:

Liquidity fragmentation and composability; native assets can only exist in specific application chains, and unless specific assets are highly sought-after and supported by interoperable products, they cannot interact with assets in other chains.

Limited security; in theory, the security of the application chain is only guaranteed by a portion of the fully diluted valuation, depending on the consensus mechanism; but the reduction in token value will linearly affect the security level of the blockchain.

Agreement’s business model

If we think about the business model of the protocol or base layer; users are actually paying gas fees for the protocol in order to correctly store transaction data and settle their transactions through the consensus mechanism.

Although the original paper may not be very timely, the advantage of the fat protocol era is that there is a clear division of labor between protocols and applications;

• The protocol is actually looking for ways to make users pay for security and data availability; and working to retain users and applications in their respective ecosystems to maximize composability and direct value accumulation (in the form of gas fees)

• Even with the rise of second layer, the protocol is really just moving from customer-centric to business-centric; the aim is to extract as much value as possible, with data availability and consensus fees paid for by rollups

• Applications, on the other hand, are competing for anything that can bring a competitive advantage to their business; and this sometimes results in a lack of value accumulation, such as how Uniswap maximizes the depth of liquidity without a clear channel for funds flow.

This division of labor has given birth to many multi-billion dollar applications such as Uniswap and OpenSea. For applications, they essentially outsource other important parts of the blockchain to the protocol level so that they can focus on the things that make the application work and be successful.

However, for the protocol itself, with the emergence of modular blockchains and the enrichment of blockspace, the current business model is gradually and inevitably breaking down; therefore, the protocol is becoming thinner.

Application chain business model

The business models of application-specific chains are significantly different; although on the surface, both protocols and application chains operate as base layers

• The application chain does not require users to pay for the storage of transaction data in the form of gas fees; rather, users are actually paying for the application itself; for example, Osmosis implements a protocol for receiver fees that ultimately flow to the Token holders

• However, ApplicationChain also provides everything a protocol should do; from providing a shared data layer to settling transactions and providing an appropriate level of security for the blockchain; and most importantly, applications being sufficiently competitive with each other

• The advantages of this business model design are a mixture of the following aspects, which should be considered more sustainable and defensible even in the future as the market structure evolves and expands

• Users are essentially paying for a service where the market agrees on a certain price; for example, Injective takes a cut of the trading fees on its perpetual futures exchanges, and the market generally agrees that perpetual futures exchanges should charge fees; and there are some Higher fees charged by GMX and Gains Network

• Contrary to what the market generally believes, there should be no fees for providing shared data and consensus; and consistent competition to provide cheaper solutions, effectively making it a zero-cost race

• Value accumulation is not linearly related to the number of trades, but to other variables that drive the success of the application; for example, Injectives value accumulation is a function of perpetual futures trading volume, while Osmosiss value accumulation is a function of spot trading volume

In short, Utility Chain’s business model fits well with the current market structure in hindsight; as the protocol is accumulating value from more sustainable sources. Expanding on this, it got me thinking about what would happen if AppChain took things a step further and amplified the benefits at the protocol level.

Fat application chain discussion

The changes of the times and market dynamics have given rise to what I call the Fat application chain discussion; we have witnessed application chains such as Injective and Osmosis working hard to build their own ecosystems in order to achieve a win-win situation.

• Application Chain no longer competes with other base layers or protocols with lower gas fees; instead it has found a more defensive and sustainable business model, which the market recognizes; it effectively solves the first-generation Fat The issue of value accumulation in the Agreement Discourse.

• On the other hand, when more applications decide to build on the application chain, the application chain can also enjoy a positive feedback loop; thus effectively solving the problems of liquidity fragmentation and limited combinability stemming from the application chain architecture.

• At the same time, the application chain provides a shared data layer, allowing other applications to be deployed on the application chain itself; promoting the prosperity of the ecosystem, and subsequently attracting the interest of developers and investors, may drive the price performance of the network.

• Most importantly, it solves the cold-start problem that many other tier 1 or rollups may face; because many application chains start out as applications looking for better composability.

Therefore, the application chain trying to build an ecosystem does not become thin, but shows a clear path to becoming Fat and staying Fat; if reasonable, it may present an attractive investment case.

Injective postmortem

As mentioned in the previous part of the article, Injective’s outstanding performance this year proves the “Fat application chain theory”. Starting from an independent perpetual futures application chain, Injective ran a typical order book model and was the first to adopt zero gas fees to avoid malicious MEVs from running before.

In terms of value accumulation, Injective essentially burns 60% of all transaction fees managed by community-led auctions, thereby creating deflationary pressure on the entire token supply. The remaining 40% is taken by relayers to incentivize the depth of liquidity on the exchange. In other words, the value accumulation of $INJ tokens is a function of transaction volume, not transaction count like other alternative protocols.

The $INJ token can also be used as collateral backing for derivatives, serving as an alternative to stablecoins in other derivatives markets. Additionally, Injective integrated with Skip Protocol in February this year to return MEV proceeds to shareholders and strengthen the early case for value accumulation.

At the beginning of 2023, Injective was trading at 130 mn, and the market subsequently adjusted the token valuation upwards following the Injective Ecosystem Fund announcement; prominent venture capitalists are backing their efforts to build the entire ecosystem on top of the order book.

At the time of writing, Injective has a trading value of over $1.3 billion and is up more than 10x year-to-date, outpacing most other tokens on the market. That said, metrics have not improved dramatically since the expansion, and Injective’s daily trading volume remains at 10 million, which makes annualized value accumulation in the form of burned tokens around 4 million.

There are no major changes, but the Fat protocol discussion basically intersects with the application chain discussion of this shift. Injective enjoys the dual advantages of the base layer and the application chain, while avoiding the main disadvantages of both.

• The positive feedback loop still applies; investors invest in building the ecosystem, attracting developers and projects, initiating the speculative value of native network tokens, which indirectly solves the issue of the security level of the chain that was previously evaluated as an application chain.

• The value accumulation component is not subject to fee competition; instead of charging gas fees from the start, Injective monetizes transaction volume; and it adds value by providing a layer of security and shared data.

• Liquidity fragmentation and composability issues are resolved; now on-chain native assets have more use cases in application chains.

Overall, Injectives attempt to build an ecosystem has found a clear path to becoming Fat and staying Fat; therefore, it may present an attractive investment case even over the longer term.

So what do you think of Sei?

It will be difficult to replicate the magic of Injective again. Sei is widely considered Injectives closest comparable in the industry and likely wont see a similar trajectory. Both operate as an order book; $SEIs native token does not generate value like Injective does; but instead, it acts as the networks native gas token.

This minor difference essentially inherits the legacy of Fat Protocol Thesis and puts Sei on the same battlefield as other alternative layers.

• The positive feedback loop is still alive and well; as Sei is backed by a number of high-profile investors in the industry, the infusion of capital has yet to attract developers to the platform to fuel the growth of the network.

• Value accrual is a legacy pain point that has not yet been solved, and Sei inherits this part; the blockchain does not effectively capture any meaningful fees from Gas by providing a shared data layer and security level.

• Liquidity fragmentation and composability issues are not entirely related, as application chains position themselves as an independent ecosystem; rather than having to interact with other chains in the Cosmos ecosystem.

Osmosis could be the next step.

The Fat App Chain Thesis (Fat App Chain Thesis) has been verified for the first time in the market with the success of Injective; now it is time to look for another opportunity to follow similar logic to replicate this gameplay.

Osmosis may be the next step; as the team is slowly building an ecosystem around AMM-based application chains, such as the Mars protocol providing a currency market; and the Levana protocol providing a perpetual futures exchange. The protocol also unlocks market maker fees from its spot trading volume; effectively bringing value accumulation to token holders for the first time.

As an application chain and liquidity center on Cosmos; Osmosiss average daily spot trading volume is 6 million, which is not impressive. This is partly due to waning DeFi activity on Cosmos; the price of the $OSMO token has been on a downward trend since the beginning of the year, falling from a high of $1.10 to now $0.30.

Once again, the “Fat Protocol Thesis” is gradually converging with the “App Chain Thesis” in the case of Osmosis; but more verification is needed to kick-start the entire price increase, as discussed below

• Positive feedback loops are still lacking; the Osmosis community is strong and strategically aligned with the entire Cosmos ecosystem, attracting teams to deploy applications on the application chain; but investors do not seem to have invested money in the ecosystem yet

• Value accumulation is once again independent of fee competition; Osmosis implements 10 bps protocol market maker fees and monetizes based on spot volume; while adding value by providing security and a shared data layer

• The caveat here is that protocol market maker fees could erode unit economics for traders and arbitrageurs; this could impact spot volumes in the long term unless Osmosis manages to build a sustainable barrier around protocol liquidity

• Liquidity fragmentation and composability issues are being addressed; assets native to the chain can be used in other DeFi primitives on the chain

in conclusion

When $INJ rallied earlier this year, I thought it was a one-time event as the market was actually revaluing the token, applying perpetual futures exchange trading multiples to the protocol layer; and the token price would Stop advancing after the price adjustment is complete.

This turned out to be one of my biggest mistakes of the year. When I reflect on the basic logic behind it; combining Fat Protocol and Application Chain actually creates the most annoying backlash because it solves the legacy issues of both parties; and speculative value is injected along with capital from institutional investors system to start the flywheel.

I believe more application chains will take this approach in the coming months; as most of them are looking to diversify their product offerings and retain value within the system rather than compete with each other at the application level. Fat App Chain Thesis may create more miracles in the public market.