How they are achieving success, even during tumultuous times
One of the main themes of 2022 has been protocols continuing to build useful applications despite the tough market conditions. It remains a core thesis that some of the largest businesses of the future are likely being built as we speak, in the digital assets space. This commentary will highlight some examples of this thesis and paint a picture of how these businesses will continue to thrive into the next bull market, securing market share in their respective sectors.
When finding protocols with sound fundamentals that will thrive in the coming years, it is imperative to look under the hood at their specific growth strategy and current progress. There are countless ways to measure this growth and the probability of success, and it varies depending on the type of business being analyzed. For example, the infrastructure layer of the stack, such as Layer 1 and Layer 2 blockchains, will have a different measure of success compared to a decentralized application built on the underlying blockchains. We will get into some detail in the following sections in order to paint a picture of what growth and progress looks like. Then, we will use these metrics to predict the types of businesses and assets that will come out of this bear market in a position of strength.
Infrastructure Layer vs Application Layer
When looking at fundamentals for digital assets, it is important to understand the difference between the infrastructure layer and application layer. The Fat Protocol Thesis theorizes that the application layer will accrue less value than the infrastructure layer in Web3, contrary to Web2, where the application layer accrued a large majority of the value. This difference can be attributed to the fact that blockchains are inherently money-centric, as Bitcoin was the first asset to gain real traction. The underlying blockchains have a native token used for gas (network transaction fees), like Ethereum’s ETH. The fact that owning ETH is necessary for paying gas to validators to transact on the network gives ETH some inherent value depending on the demand for Ethereum block space. A similar dynamic plays out with other blockchains, and their underlying tokens have varying valuations depending on the usage of the respective blockchain.
If we contrast the above with decentralized applications that are built on the underlying blockchains, we must look at valuation from a different lens. Many applications do have a native token, although the actual utility of each token varies greatly. Governance tokens can be used to vote on changes to the protocol, can be locked to direct yield toward certain pools of liquidity, and can be held to accrue a portion of the fees the protocol generates from operations, to name a few. These examples are far from all-encompassing, and as the technology advances we are very likely to see new token use cases emerge.
Metrics that Matter
Firstly, for the infrastructure layer, one of the things that matters most in the long run is organic usage on the network and steady growth of both active users and transactions. We have seen in the past with businesses such as Facebook that the power of a network is a function of its user base. As a user base gets larger, it is more valuable, as the amount of potential interactions increases exponentially, according to Metcalfe’s Law. There are other metrics to consider, such as protocol fees, security, and number of applications running on a network, but at the end of the day, you need users to interact with a network regularly to retain value. Active users and transactions are useful proxies to track the health of a network.
Looking at the application layer, we can track active users and transactions as well as look at other metrics to estimate its rate of growth. Since many of these decentralized applications (“dapps”) are in their early stages of development, it is important to focus on growth rather than how much revenue is distributed to token holders. Similar to high-growth tech stocks, many protocols employ a strategy of growing their user base and tackling monetization at a later date once they have established a strong competitive advantage. With regards to other metrics, overall revenue or fees that a protocol is generating can give a sense of the recurring organic usage the business is generating.
As an example, we can look at the chart below to understand the value Uniswap brings. Uniswap is a decentralized exchange that allows users to swap tokens in a simple interface. The protocol has one of the largest and most consistent user bases of any dapp, averaging around 30,000 daily active users. Uniswap’s volumes are cyclical due to the nature of the industry’s boom and bust cycles, but the protocol has facilitated over $1 Trillion in volume since May 2020. This has resulted in ~$2.5B in fees being generated, and 100% of these fees have been distributed to the liquidity providers. There is an ongoing discussion about whether to distribute a percentage of these fees to UNI token holders, which could potentially be a big driver of value for the UNI token in the future.
Furthermore, Uniswap has only spent around $67M in token incentives to bootstrap usage (user acquisition cost). When comparing this “cost” of the protocol to the fees generated since launch, the business is extremely profitable.
Aave is a decentralized lending protocol that gives users the ability to lend their assets to earn yield as well as borrow against the collateral. Since inception, Aave has facilitated billions of dollars in loans and generated about $458M in fees in the form of interest paid by borrowers.
Again, due to the cyclical nature of the digital assets space, borrowing volumes peaked in late 2021 with the peak in prices, but the number of active users has accelerated beyond that. One may anticipate borrowing volumes to follow the active user counts as the market picks back up.
Similarly to Uniswap, Aave has given token incentives to acquire users. The below chart shows weekly token incentives paid by Aave. Many of these incentives came in 2021, and the rate has diminished precipitously in the latter half of 2022. The acceleration of active users has shown that this strategy has been fruitful.
A Note on Monetization
As mentioned before, many teams are focused on growth in these initial stages and intend to tackle monetization later. We have already seen impressive volumes from the likes of Uniswap and Aave, as well as other applications. Continuing on this path of aggressive growth and then finding creative ways to distribute some share of that revenue to token holders (and/or the protocol treasury) is a compelling strategy to give application tokens more value.
The income statement for a distributed network has not been a popular discussion topic even within the digital asset community, but this will likely become more and more relevant as the space evolves, new fundamentally driven funds enter the market, and the protocols themselves enter their profitability phase. As protocols mature, more sophisticated valuation frameworks will be developed, similar to how traditional finance has frameworks to value other asset classes on a fundamental basis.
Despite high fee revenue generation for a number of protocols, they typically have had to spend significantly on incentives to drive user engagement and adoption as they maximize user growth in the early phases of their evolution. There are players in the market who have yet to turn on their “fee switch” in an attempt to prioritize growth and benefit from the immense network effects that protocols in this space experience. The prospect of future monetization once a strong user base is established is extremely enticing to us.
Scalability and its Impact on Decentralized Application Growth
One factor limiting the growth of decentralized applications is the scalability of blockchains. However, over the past year, lots of progress have been made in this area, as other Layer 1 blockchains began to offer faster speeds and lower transaction costs than Ethereum Mainnet, for example. Additionally, Ethereum has made progress on its own scaling roadmap, as Layer 2 rollups such as Optimism and Arbitrum have gained real traction, especially in the second half of 2022. This theme will likely continue to benefit dapp growth, as faster and cheaper infrastructure will allow for more usage and new use cases to emerge.
An example of this is Aave’s V3, which launched in March of 2022. The daily active user count has since increased substantially, likely due in part to V3 featuring money markets on chains such as Avalanche and Optimism.
However, this benefit is not unique to Aave, as many applications have now and will continue to launch on multiple chains in order to access each unique community and user base to increase reach and revenues. Below highlights how significant the growth of other chains has been, as Arbitrum and Optimism daily transactions are quickly approaching Ethereum’s. It seems that it is only a matter of time before L2 rollup chains’ daily transactions surpass that of Ethereum, much like Solana and Polygon already have. All of this is favorable for the growth of applications, their user base, and growing revenue.
The Future is Bright
Despite the drawdown in digital asset prices and all of the events that happened in 2022 so far, the top projects continue to build and increase their competitive advantage. There are very promising metrics for select protocols and applications, and those who continue to build on this momentum are set to benefit the most when market conditions improve. Sound businesses are being built with increasing revenues and user bases, and scalability is fostering an environment that is ripe for growth. It is important to continue to monitor this growth and understand how applications will benefit from the infrastructure improvements we are witnessing, because as the critical infrastructure of these new applications and businesses continue to build out, there will likely be an increased emphasis on the application layer. The dapps focused on growth and a competitive moat are positioned to dominate the space in the coming years, and it is important to identify these assets early and join them for the ride.