On the value capture of Layer 1, Layer 2 and Layer 3
Editor's Note: This article comes fromChain News ChainNews, the original text comes frommulticoin.capitalEditor's Note: This article comes from
Chain News ChainNews
, the original text comes from
, Author: Kyle Samani, co-founder of Multicoin Capital, an encrypted asset investment institution, Compiler: Ryan Chen, reprinted with authorization by Odaily.
In 2016, Joel Monégro, an analyst at the venture capital firm Union Square Ventures (USV), published the famous "Fat Protocols" view, arguing that in the blockchain technology stack, due to data open source, plus tokens In the design of the incentive system, the value will be concentrated in the protocol layer, and only a small part of the value will be distributed in the application layer. This point of view has driven many investors to bet on the underlying public chain of the blockchain. Later, Joel Monégro left Union Square Ventures to form his own blockchain investment fund Placeholder, but his partner Chris Burniske recently revised the "fat protocol" theory and proposed that the underlying public in the blockchain technology stack It is difficult for the chain to capture the value in the ecology.
Another well-known blockchain investment institution, Multicoin Capital, recently joined the discussion, proposing a theoretical framework to explain how Layer 1, Layer 2, and Layer 3 protocols capture value.
In addition, the public chain project Nervos has just released the economic model proposal of Nervos CKB. Kevin Wang, the co-founder of the project, also wrote a special article that the smart contract platform should have the function of value storage and capture the value in the ecology. The entire ecology provides security guarantees, which has become one of the focal points of the Nervos CKB economic model design.
A protocol is not an item; it is an abstraction, a set of rules. In theory, investing in an agreement is nonsense, because there is no object to invest in. Investors in cryptoassets are not actually investing in the protocol, but in the scarce assets needed to make some kind of protocol work.
Some protocols’ native assets are able to capture the value generated by the protocol, while others are not.
In this article, we will evaluate Layer 1, Layer 2, and Layer 3 protocols from the perspective of value capture, and try to propose a theoretical framework to explain how they can capture value.
secondary title
Value Capture at Layer 1
The existence of Layer 1 tokens is to make this underlying public chain resistant to 51% attacks.
Let's explain this concept further.
One of the more popular views among crypto enthusiasts is that there will be thousands of chains in the future. There are some chains that will run on the same protocol, for example, chains using the ethermint protocol ), while others will run on their own unique protocols (such as Solana, Dfinity, Algorand, Ethereum, Bitcoin, Monero, etc.).
However, only a limited number of chains survive long-term. We have seen evidence to support this claim: 13 chains have been 51% attacked so far (note that they are not small market cap chains). Ethereum Classic, Bitcoin Gold, and Verge all suffered 51% attacks when they were still in the top 20 by market capitalization, and these chains are usually decimated after a 51% attack with little chance of recovery return.
When users can choose a blockchain that has not experienced 51% attacks to preserve their wealth, why should they choose a blockchain that has experienced 51% attacks?
The reason why Bitcoin exists and operates so far is that the major breakthrough is not in the level of technology, encryption algorithm or distributed system, but in the design of game theory. The breakthrough of Bitcoin lies in the proof-of-work (PoW) consensus algorithm, which allows miners to obtain block rewards in the process of maintaining this ledger, and due to the incentives brought by mining Bitcoin, the behavior of independent miners conforms to the network's optimal best interest.
We were able to compare the security of blockchains by calculating the implementation cost of a 51% attack. In order to implement a 51% attack, an attacker needs to spend more than the blockchain security budget (Security Budget). We were able to quantify the security budget as follows (in USD):
Security Budget = Total Network Value × Inflation Rate + Transaction Fee
It should be noted that this formula calculates the minimum value of the network security budget, not the maximum value. For blockchains using PoW, there may be restrictions on the market supply of ASIC mining machines, making it more difficult to implement 51% attacks.
Let's do a simple calculation, assuming that the market value of Bitcoin is 100 billion US dollars. At present, the annual inflation rate of Bitcoin is 4%. For the sake of simple calculation, we set the service fee as 0, because in fact, most of the income of miners comes from the newly issued Bitcoin, not the transaction fee. In this way, for honest and rational miners driven by economic interests, the cost of mining Bitcoin will be paid up to 4 billion US dollars per year, so we can say that the security budget of Bitcoin is 4 billion per year.
Since security depends on the market cap of the network, there is a natural network effect here: the more valuable a chain is, the more secure it is; the more secure it is, the more likely it is to be chosen by the next marginal user to store assets.
This is why in the medium and long term, an equilibrium state where multiple chains coexist is unlikely to exist. Just imagine why users choose to store assets on the seventh most valuable/safe chain?
There are inherent differences between PoW and PoS systems, so we should expect that for the foreseeable future, there will be a small number of chains with their own different consensus algorithms. It is immature to bet all on a single consensus model at this stage, after all, these chains have not yet passed the test of time.
secondary title
Blockchains that Provide Interoperability
This naturally begs the question: what about interoperability-focused blockchains like Cosmos (token: ATOM) and Polkadot (token: DOT)? Both chains relay messages between other blockchains and charge users a fee. Additionally, Polkadot provides consensus security for its forks for a fee.
Therefore, ATOM and DOT are yield-generating assets that can be valued through cash flow. Both the Cosmos and Polkadot teams have stated that they do not expect their respective native tokens to be used as currencies within their respective ecosystems. Likewise, we do not expect ATOMs and DOTs to become currencies.
Consider these three factors:
1. It is difficult for the native token of the interoperable blockchain to become a currency;2. The only purpose of a chain is to protect itself against 51% attacks;
So in the long run,
Whether blockchains that offer interoperability will survive is a question.
However, we are optimistic about the development of Polkdot and Cosmos in recent years, because the Web 3 stack is clearly becoming more diverse rather than homogeneous as developers continue to experiment and explore different trade-offs at each layer of the Web 3 stack.
secondary title
Value Capture at Layer 2
For Layer 2 protocols, the only way to capture value is to store some kind of external, valuable state.
This is an abstract concept, in order to better understand this, let's compare some Layer 2 assets:
0x Protocol (Token: ZRX)
The 0x protocol is one of the most widely used protocols built on Ethereum. It enables any two parties to complete digital asset transactions without trust and without relying on a third party.Regardless of the token balance of the ZRX holder, it appears that the asset exchange function of the 0x contract does not store any state. A transaction either happens or it doesn't. After executing a transaction, the state of the 0x asset swap contract remains unchanged.
Outside of the actual asset exchange contracts, the 0x protocol maintains several pieces of external state about user preferences and network-level governance. Although these states are external to the protocol, they are worthless states. In other words, these stored states have no measurable market value.
But there may be at least one more way the 0x protocol can capture value: governance.
This is the explicit goal of creating out-of-protocol state (voting by token holders). Governance becomes very interesting when others build higher-level protocols and applications on top of the 0x core protocol. If these external protocols really need to rely on the 0x protocol, and are driven by interests and want to see this protocol develop in a specific direction (or not), they will actively participate in governance, or they will fork themselves, just like DDEX recently do that.
While this is an interesting hypothesis, it remains to be seen whether governance is inherently valuable. At least in theory, yes, but we're skeptical.
Basic Attention Token (Token: BAT)
BAT is a de facto stateless protocol. The core part of the protocol itself does not store any state other than the BAT owner account balance. It is a dedicated payment currency, and if it is not redesigned, it will eventually suffer from transaction speed problems.
Although the BAT protocol is de facto stateless within the Ethereum network, it is not stateless outside the Ethereum network. In other words, in the Brave browser (Translator's Note: The browser used by BAT), which has about five million monthly active users, only BAT payments are supported. Brave's team also has a financial incentive not to change this, because they have a lot of BAT in their hands. As Brave users increase, BAT's protocol external state will become larger and larger. The external state of these protocols cannot be forked, so BAT cannot be forked away.
Brave is an interesting case study. On an abstract basis, BAT should not capture any value, and from another perspective, BAT benefits from a lot of exogenous efforts by the Brave team. Lacking changes in the token mechanism, we don't think BAT will capture value in the long run, but at least for now, the existence of external protocol states does allow BAT to prove some value.
Augur (Token: REP)
Augur saves two valuable states. The first is obvious: all outstanding prediction markets have assets locked in Augur's contracts. Even if someone forks Augur, it is impossible for him to fork the ether locked in the Augur contract.
The second valuable state that Augur preserves is harder to understand, but is actually more important in the long run (than the first). Augur is a global, censorship-resistant prediction market and a decentralized oracle. These two functions are closely related.
Augur is a very innovative concept, which also means it is unproven and it may fail. Every successful prediction market is a cornerstone to prove the establishment of the system. In order to be able to support billions of dollars in trading volume, participants in prediction markets need to be confident that the system will not collapse, and the only way to do that is to see every market resolved honestly and efficiently.
If someone wanted to fork Augur and change the distribution of tokens, market participants would question the motives of the fork. The full value of REP is given by all rational participants in the market who are willing to honestly report information off-chain. If someone forks REP and changes the distribution of tokens, it should be viewed with suspicion and assumed to have malicious intent by the individual/team/company who forked REP.
In addition, the historical development of Augur provides an endorsement for the future accuracy of the Augur protocol. That said, many market participants would not take a risk on the platform of such an innovative dispute resolution system without seeing the system in action. History is a valuable state that cannot be forked, creating more defensibility and value capture for REP.
Livepeer (Token: LPT)
Next to be evaluated is Livepeer, a Layer 2 work token that powers video transcoding networks. For a long time, many people in the crypto community believed that work token networks on Layer 2 could not capture value, and this is not true.
Livepeer, like all work token networks on Layer 2, requires all workers to register on the chain by holding LPT. The more demand for services on the Livepeer network, the more benefits paid to LPT holders, resulting in higher LPT prices. If the demand for Livepeer transcoding services increases, more honest transcoders will compete with each other for these needs, making the entire network safer. If someone forks Livepeer and creates their own tokens, then this new generation Coins will only be a fraction of the price of LPT, because forking will not bring about a community with the same demand side (players) and supply side (transcoders).
All layer 2 work token networks like Keep, The Graph, and SKALE benefit from this economic security network effect, not just Livepeer.
secondary title
Value Capture at Layer 3
text
I would like to use the following concepts to talk about how Layer 3 services on the blockchain can capture value. First of all, we need to define Layer 3 services: This refers to services built on the underlying public chain and some intermediate layer protocols, which can be extracted for consumers to use.
To give concrete examples of these services, we will use two examples of Layer 3 applications. Two examples of these are Veil and Radar Relay.
Veil is essentially a service for both creating and participating in Augur-powered prediction markets and trading derivatives on those markets through the 0x protocol. Obviously, these two supporting middle layer protocols sit on top of the Ethereum blockchain.
Augur prediction market user interface
The user interface of the Augur prediction market For many people, the user interface of Veil is simpler and more friendly. Veil creates value by simplifying the experience of ordinary users. Redeem their positions at a fee of 1% before finalizing.
Radar Relay is a non-custodial exchange built on the 0x protocol. Of course, its underlying layer is the Ethereum blockchain. Radar Relay initially charged sellers and buyers 0.45% in ZRX and 0.70% in ZRX, but later dropped these fees in order to attract user interest. But if they want sustainable development, they will probably still have to take the road of charging in the future.
text
What is the framework for analyzing Layer 3 value capture?
Assessing the value of these Layer 3 platforms is usually done by analyzing interest in their current charging models. It seems simple, similar to how we measure existing businesses and value them.
However, there are other factors that need to be factored into the consideration, such as the risk of the layers upon which these services are built, as each layer below these services has its own risk profile.
For example, Radar Relay needs to consider risk factors related to the Ethereum protocol (measured through the Layer 1 framework) and 0x governance risk. If a governance decision affects or disrupts a business built on top of 0x, there is a cost associated with voting to consider - this can be more than 51% of the voting power on the protocol, rather than forking the protocol just to satisfy one's own needs (Think of the lesson of the Hydro protocol forking from the 0x protocol).
Similarly, if Ethereum governance decisions affect middle-layer protocols like 0x, there will be corresponding costs. However, the main cost to consider when looking at these base layer protocols is the risk of attacking the blockchain network, as outlined in a previous framework by Kyle Samani of Multicoin in his article. If the underlying public chain is severely damaged by attacks, it is difficult to simply move to another protocol, because the latter may not provide all the content of the business you have built. You not only need a new basic public chain, but also need to rebuild the middle layer protocol to build the business.
Taking Veil as an example, they not only have to worry about the decisions and compromises of the base protocol, but also the decisions and risks related to the two middle layer protocols, Augur and 0x. The more you integrate with Layer 3 services, the more risk you incur.
Veil — risk: dependency;
0x and Augur — risks: protocol failure, governance;
Ethereum — Risks: Network Compromise, Governance.
text
Attention must be paid to the risks associated with Layer 3 protocols
It should be noted that most of these Layer 3 services are not necessary. For example, even without the help of Veil or Radar Relay, some of the services they provide may be implemented in other ways, but the user experience they provide is what makes It's something that creates value. Think about it, as a user, do I want to use Augur's client, or do I want to use the simple experience Veil provides to trade derivatives on existing markets?
