Issue 17: The skinny fat protocol thesis

This issue of the newsletter takes a look at how the Fat Protocol Thesis is changing as layer 2 activity starts to explode.

Issue 17: The skinny fat protocol thesis

Will the explosion of layer 2s change blockchain economics?

For a long time, the Fat Protocol Thesis has dominated how people have thought about and invested in decentralized blockchain networks.

Simply put, the Fat Protocol Thesis explains that as apps and services are built on top of layer 1 networks (like Bitcoin and Ethereum, for example) value will eventually accrue to the underlying network (or protocol).

This is different from the way that the legacy internet works. Traditionally, internet protocols like HTTP, the web browsing standard, or SMTP, the email protocol, aren’t valuable as standalone things. You can’t trade HTTP or SMTP.

Instead, the value of the legacy internet accrues at the application level. Google, Facebook, Netflix, etc., are built as apps on the internet. An email newsletter like this one is built on email protocols. In all of those instances, the value is at the client or app level.

This architecture creates some of the issues we are seeing with the legacy internet. Clients and apps are incentivized to build walled gardens by controlling and owning data. The app-owned data model leads to the kinds of monetization strategies that have become so dominant, basically optimizing for attention and mass media advertising.

But there is an alternative.

The basic idea behind blockchain networks is to flip the value system around so that networks themselves have a mechanism to incentivize participation and growth. It makes it possible to own the foundational network at the bottom of the monetization funnel. This leads to client and app architecture that are designed to share data (or at least make data less exclusive from a monetization aspect) resulting in greater interoperability and customization.

The economics favor the underlying network and those incentives pay for things like decentralization and security, which attracts all kinds of developers and builders. It’s a new way of creating digital infrastructure.

Bringing this back to the Fat Protocol Thesis, the basic idea is that in legacy internet networks, the underlying network was skinny (in terms of value capture) while the client/app level was fat (lots of value capture).

Blockchain networks, on the other hand, capture value at the protocol level (making the network level itself fat) while apps and clients are “skinny,” or more like top-of-funnel activities.

But what if the way we understand blockchain value accrual is changing? What if instead of an established layer 1 being a fat protocol, because of new ways of scaling and building on top of layer 1s, blockchain networks are now becoming “skinny fat”?

How the Fat Protocol Thesis is changing

By now you might be wondering why we are talking about the Fat Protocol Thesis at all.

When I first wrote about the Fat Protocol Thesis back in 2017, it was still a fresh idea, and it had a lot of utility even for people coming to blockchain or crypto investing for the first time.

As a quick recap, the Fat Protocol Thesis was articulated by Joel Monegro, a venture capital investor. Monegro spent time studying early blockchain networks and noticed how despite the explosion of consumer apps and the launch of new tokens, the underlying blockchain infrastructure was winning in terms of collecting transaction and usage fees.

This, of course, as described above, was different from the way that traditional protocols worked before, and so the change in dynamics became noteworthy enough to become defined as a distinctive framework idea.

The utility of the Fat Protocol Thesis is that it helped people (especially investors) think about where to pay attention at times when there are new crypto companies launching and new flashy projects.

The Fat Protocol Thesis came about during the initial coin offering (ICO)-craze. During that time new tokens were launching and getting listed on exchanges with little more than a whitepaper and some viral marketing, creating a shiny object effect.

In some ways, the ICO situation of 2016-2017 felt a lot like the memecoin mania happening now. People were chasing outlandish ICO valuations and then getting wrecked when it turned out that most of the projects were not surprisingly nothing more than vaporware.

Today, meme investors are surfing waves of hype and trying to enter and exit before the waves of market sentiment change.

But back in the day, if you understood the idea of protocol investing or the Fat Protocol Thesis, it was easier to sit back and just stay focused on the underlying layer 1 and not chase ICOs or other strands of market hype.

In that regard, the Fat Protocol Thesis is still really useful. While the underlying infrastructure or layer 1 will continue to benefit from the build-out of a new modular system and its resulting layer 2s, layer 3s, and beyond, some interesting things are happening to the blockchain value funnel.

In the future, the dynamics that made early blockchain protocols so fat might be a little bit different because layer 1s won't accrue as much of the value from transactions and onchain activity.

Is Base skinny fat?

Let’s take a look at how this is all coming together in the wild.

We’ll use Base as an example because it’s a great way to illustrate some of the developing skinny fat dynamics.

In the recent past, we’ve covered some other themes and topics that make Base so unique and interesting.

Base Coinbase <> Onchain Crypto
Base from Coinbase is a scaling tech stack designed specifically to make it easier to get more people onchain. Base is helping drive down onchain transaction costs and makes it easy to spin up new blockchain-based apps and services.

Get more background on Base

Without diving too deep into the background, here’s a quick recap of why Base is different:

  • Base is a product of Coinbase, it’s designed as an Ethereum-based layer 2 and is part of the Optimism superchain or the OP stack (which is like a collective of projects working on scaling Ethereum via new kinds of agreed-upon standards, which enhances interoperability and collaboration).
  • Unlike other layer 2s, Base doesn’t have a token. This fact inherently changes the way the project will work from a tokenomics perspective (no token, no tokenomics).
  • Because Base has interplay with a corporate network (or the legacy internet model) there are concerns about its decentralization and how the combo of security and governance would work under a stress test.

While Base doesn’t have a token affiliated with the chain, the value accrued by using Base has to go somewhere. Some of the fees and value generated while using Base go to the underlying layer 1 (in this case, Ethereum), following the Fat Protocol idea.

But some of the fees and value generated also flow to Coinbase directly. Not a token, or not some kind of decentralized system, but Coinbase the corporate network. It’s this attribute that starts to create the new skinny fat protocol thesis.

Coinbase makes money when users transact on Base because the company fills the role of a sequencer or a transaction verifier. Coinbase posts Base transactions to the Ethereum, but it retains part of the fee for its role. The company is the only sequencer that verifies and posts Base transactions.

Here’s where things get interesting. The main value proposition of Base as a token-less layer 2 is that it makes transacting on Ethereum super cheap. This has a lot of utility for onchain apps and services that wouldn’t exist without next-to-nothing transaction fees.

So, in some regards, it’s a win-win for app developers and Coinbase. Onchain apps are starting to explode, and Coinbase is beginning to make a tidy profit on millions of monthly small transactions.

Here’s a rundown from a recent newsletter from Bitwise:

Coinbase charges a fee for this sequencer role. In Q1, for instance, users paid $27.4 million in transaction fees to Base (all those pennies add up), of which Coinbase was able to pocket $15.5 million. In April alone, Coinbase pocketed another $11 million. Nearly all of this money goes straight to Coinbase’s bottom line.
If Base continues to grow, it could reliably deliver $10 million, $20 million, or more in profit to Coinbase each month. In the longer term, if Base becomes the primary network on which developers build applications, Coinbase could end up owning a core piece of crypto infrastructure.

So it’s starting to become clear that we are seeing a change in both blockchain business models and the way that value could flow from scaling networks to underlying layer 1s.

For some, this new business model of adding corporate networks as necessary components to onchain transactions could be problematic. There are a few concerns on this front. Security and decentralization (which are what make blockchain transactions so costly in the first place) are one issue. However, reliance on an intermediary is also an issue as it cuts the cross-grains of the decentralized ethos.

There are several ways that the Skinny Fat Protocol Thesis could play out. We might see consolidation around corporate networks that act as go-betweens and can offer competitive pricing by monopolizing transaction flows. Or we might see other scaling projects try to make plays for accruing transaction fees. All of which could change the underlying layer 1 dynamics.

Who knows, long-term, where the skinny fat protocol model leads? But it will be worth keeping an eye on layer 2 business models, governance structures, and profitability during this next growth cycle.

Let me know what you think. The best place to reach me is @danielmcglynn on Twitter and Warpcast.