Exploring the Fat Protocol Thesis

Published in

Coinmonks

6 min readJul 4, 2023

The Fat Protocol Thesis was first discussed by Joel Monegro. The Original is in the references below!

The fat protocol thesis is an investment thesis that suggests that the value of decentralized protocols or layer 1s (Like ETH SOL AVAX etc), will grow faster than the value of the applications built on top of them. The thesis is based on the idea that decentralized protocols (referred to as chains) provide the underlying infrastructure for a wide range of applications, and that the value of these protocols is not reflected in the value of the individual applications built on top of them.

At first glance, this sort of makes sense intuitively, of course, the underlying infrastructure supporting our favourite applications should accrue value right? But this wasn’t always the case. If we think about our internet today, most of the value accrual occurs on the application layer. Investors and early innovators of protocols like TCP/IP, and HTTP never really had that much value accrue to them. Instead, the biggest gains were seen in our super applications like Facebook, Amazon and all the other tech giants we know and love today.

So what makes blockchain any different?

According to the fat protocol thesis, there are two main reasons:

Shared data layer
Tokens with reflexivity

Shared data layer

“by replicating and storing user data across an open and decentralized network rather than individual applications controlling access to disparate silos of information, we reduce the barriers to entry for new players and create a more vibrant and competitive ecosystem of products and services on top.”

This extract from the original article says it all. Since the data layer on the blockchain is decentralised and accessible to all, companies building applications no longer have to build infrastructure to silo data. Since all applications build on top of the same set of data, you get several competitors that are all interoperable with each other just because they are built on top of the same protocol. So no one application has control and exceptional value accrual in terms of user data within the same underlying chain.

Tokens with Reflexivity

The second component, which is the chain’s native token, creates a reflexive cycle that promotes adoption. Since most layer 1s use their native token to operate. The more activity there is on a chain, the more the token appreciates (generally). This creates a reflexive cycle as the token appreciates, it attracts early builders and developers, which become stakeholders financially incentivised to generate value for the chain, which increases activity for the chain and increases the value of their tokens, and so on.

Yes, this means that any initial adoption is driven by speculation, but as long as you’re not an outright scam, it’s probably a good thing. You’ll always need speculators to lead the charge in building and innovating.

This dynamic has a noteworthy impact on the distribution of value. Because the success of the application layer fuels more speculative activity at the chain layer, the Fat Protocol Thesis argues that the market cap of the chain always increases more quickly than the total value of the applications built on top. This is because the value of the chain is derived from the network effects of its users and developers, which are likely to grow over time, whereas the value of individual applications is more limited and dependent on their ability to attract and retain users. The final result is a lively and competitive ecosystem of applications with the bulk value given to a large pool of shareholders, together with a common data layer that significantly lowers entry barriers to entry. Thus Tokenized protocols become “thick” and their applications “thin”.

Value accrual does not equal investment returns

The validity of the Fat Protocol Thesis has been widely debated. Whether or not the value of decentralised protocols is dependent on the success of its application or vice versa is not the point of this article. One point I would like to mention is that the Fat Protocol Thesis was written years ago and many alternate layer 1s didn’t exist yet. Having a shared data layer on one blockchain assumes that all applications are built on top of the same chain. Im not sure that will be the case, especially as we see more application-specific blockchains spring up in recent years. Regardless, I think we can easily see that if all the applications on a certain chain gains success, the activity and value of the underlying protocol should increase in tandem as well (assuming that the underlying native token has sufficient scarcity). What’s important to note is that it can be easily misunderstood that value accrual is equal to investment returns, however, it is not.

A simple example: Let’s say that you have an application that is valued at $1 million, which is built on top of a protocol valued at $500 million. The application manages to attract new users and appreciates $2 million (a 100% increase in value). However, we can see that a $1 million value increase to the protocol layer would bring its value only to $501 million, which is not a 100% increase in your investments.

Of course, this doesn’t mean that you should just ape “App” coins and pray it gains adoption. To me, investing in the protocol layer is a bet that the general ecosystem of applications built on top of it will continue to accrue value, without being exposed to the risk of a specific application. Maybe this could mean that you don’t get the 10x in a day sort of returns that you seek, but you are also less likely to get rugged.

Applying to Crypto Primitives

Taking this a step further, we can also start to see that the hierarchy of applications on top of the blockchain is not entirely flat as well. We start to see applications build on top of each other. Look at applications like Curve, it has a whole bunch of other applications built on top of it to bring more benefits to more users. Perhaps we can start to think of applications that create new primitives and building blocks similar to a protocol itself. Even recently with GMX, we see new applications using their native token GLP, as a primitive for yield-bearing products on other applications (like RageTrade). each already Perhaps we can apply “The Fat Protocol Thesis” to Crypto primitives as well. Can we expect aggregators and products built on top of GMX to outperform GMX itself? I can’t say for sure.

The point is, looking at how value accrues to an ecosystem is generally a good way to think about how you want to position your portfolio. Though the technical stack of the blockchain is constantly changing, the Fat Protocol Thesis highlights the importance of understanding the underlying economics and incentives at play.