By David Phelps

Translation: Shan Ouba, Golden Finance

The “Fat Protocol Thesis” has done enormous damage to this field and set us back several years.

I actually really enjoyed “The Fat Protocol Theory” and highly recommend you read it if you haven’t already.

The simple version of this theory is that protocols (e.g., blockchains) will capture more value than the applications built on them. Why? Partly because crypto applications have weaker moats (they are easily copied). But mostly because the success of applications will drive users to accumulate protocol tokens for use, creating a network effect for the blockchain because each application drives up the token price of the chain it is built on.

This was a very forward-looking argument in 2016. I would also like to add my own point of view on why protocols can have greater value than applications: protocol tokens are similar to the national currency of a digital country. They not only serve as a medium of exchange, but also represent a legal order (smart contracts) that guarantees the validity of transactions, while collecting "taxes" for the ecosystem. Applications, on the other hand, are usually just ordinary commercial entities that generate income.

Of course, the market cap of a currency is often highly correlated to the GDP generated by everything built on it, and therefore tends to be much larger than the market cap of a company. This is why I believe that protocols are often more valuable than applications.

This is the problem. The past decade has validated the "fat protocol theory" in many ways, and it reached its climax in the past year. As we all know, the market value of chains has crushed the market value of applications. Protocols can often raise funds at valuations of hundreds of millions of dollars without products, while applications with dedicated users have a hard time raising funds.

To understand the extent to which the market buys into the “fat protocol theory” — even to the point of irrationality — just look at the recent valuations of highly fungible, random Layer 2 (L2) chains.

These L2s do not meet any of the requirements of the “fat protocol theory” because their tokens do not need to be used for transactions at all - in fact, these L2s do not even need tokens. But in the crypto space, narratives are often more powerful than logic, and many of these L2s have easily reached nine-figure valuations, while applications have struggled with valuation.

(Of course, I think some L2s will be truly valuable, like @mega_eth and @movementlabsxyz, but that’s another topic.)

We hear this a lot about the “chain-first” problem: a blockchain is only valuable if there are valuable applications on top of it. The chains themselves will say this, too, emphasizing their massive performance improvements. “Of course we need to expand blockspace,” they say, “because the next top application will need it.” But in a world where applications have failed for a full decade, very few people want to build or fund more applications.

This is interesting, but unfortunately the logic of “we need to fund applications for blockchain to succeed” will never be enough to get VCs to invest in an entire category they believe will fail. The idea that applications will help blockchain become valuable is attractive, but if no one believes that the applications themselves are valuable, then the argument is not convincing enough.

So I want to propose a Fat App Thesis, where I argue that there’s a point that’s been true throughout the history of the internet, to the point where I think it’s a little boring: in reality, most of the value in crypto today is in apps.

There are three reasons, in increasing order of importance:

The first and most speculative reason is simply historical cycles. Applications are massively undervalued, while protocols are massively overvalued, for the reasons stated above. The Internet tends to go back and forth between ten-year cycles of infrastructure and applications, and we are at the end of a massive infrastructure boom where we created amazing technology that is finally working (which was not true two years ago). Now is the time for applications to shine, and they have never been more undervalued.

The second, more compelling reason is that applications and protocols have swapped places since the "fat protocol theory" was proposed in 2016. At that time, applications were mostly interchangeable forks of each other's trading tools, and chains were walled gardens with huge liquidity moats. But things have changed dramatically. Today, applications cannot completely copy each other (such as Sushiswap) because their real moat is users.

At the same time, chains don’t even need much liquidity to support future social applications, unless they are targeting DeFi applications that require liquidity (like @berachain). More importantly, with the emergence of cross-chain solutions and chain abstractions that allow users to seamlessly use applications and bridge across ecosystems without knowing the chain they are using, liquidity as a moat for most chains is itself collapsing. Today, chains are largely interchangeable - not applications.

But this brings us to the third and most important reason:

When liquidity is no longer a moat, users become the moat.

Users congregate where other users are. That’s why only a few apps ultimately win out — because users eventually gravitate toward each other into a few unique internet “cities.”

This is also why I suspect there is so much pessimism about apps today (inside and outside of crypto): a few apps won a decade ago, and since then it’s been hard to compete with their user attention. Frankly, with the limitations of Web2 — specifically app store fees, closed APIs, and the inability to easily spend money — it’s hard for anyone to come up with new app ideas.

But on-chain technologies enable entirely new app experiences that offer economic and reputational upside that simply haven’t been available in the past: they eliminate app store fees, open up public blockchain APIs, and make it easy for users to spend and save money. So here’s my theory. I believe some of these apps will win, too. As internet history has consistently shown, they will become “super apps” that take up the majority of block space.

I could be wrong, very wrong. This era could be different. We could see millions of mini apps flourishing, like all the apps on Telegram, and I would be very happy about that.

But I suspect we are in a short-lived era of apps, as the design space for new apps has only just opened up in the past two years — and crypto apps that were built entirely on “token price going up” will eventually collapse with “token price going down.” We don’t talk about this enough, but all signs point to this era ending. What’s really exciting about crypto apps today is that the next generation of prediction markets, competitions, NFC chips, DePINs, and even e-cigarettes no longer rely on token price going up as a use case. For the first time, crypto is a means, not an end.

I mean, apps can actually win in the long term and start taking up all the block space we've been generating for years. So what happens next? These apps can do something innovative. They can give money back to the user, rather than the Apple App Store, to incentivize growth. They can collect revenue from every click. Ultimately, they can generate a huge amount of revenue, and only a small portion of it will go to the chain.

I've said before that chains don't need huge revenues to get huge valuations, because they should be valued based on something like GDP. But when most of the GDP is generated by a few applications, it's worth asking a question: Who is really the "fattest"? Is it still the chains? Or is it more likely the applications?

Finally, I want to say that I am not pessimistic about chains - not at all. Many chains are not interchangeable due to their unique virtual machines (VMs) or opcodes (such as @solana, @irys_xyz, @movementlabsxyz, @eclipsefnd), native incentive mechanisms (such as @berachain), high performance in familiar VMs (@mega_eth, @monad_xyz), or specific permissioned implementations (@repyhlabs, @celestiaorg). Applications built on these chains can only be implemented on these chains. Ultimately, even if only a few applications win market share, investing in the chain is still the best way to invest in these applications.

We like to think there is a war between infrastructure and applications as they compete for private market dollars. But there is no real war of value between the two - they complement each other and cannot survive without each other. Beyond that, I suspect most applications will also operate like protocols themselves, becoming the foundation for others to build on.

But despite all of this, we not only acted as if there was a war, we acted as if infrastructure had already won. We are realizing that this is fatal for infrastructure. But what we need to realize is that this is also a huge missed opportunity.

The next major wave of value will flow to applications, and only a very small number of people in this ecosystem are willing to take the risk to try to capture it.