In the summer of 2016, USV’s Joel Monegro published the so-called Fat Protocols thesis about where value is created in the blockchain / cryptocurrency ecosystem. He argues that investments make the market cap at lower levels always grow faster than the combined value of the applications built on top, since the success of the application layer drives further speculation at the protocol layer. And because of that, the nature of the blockchain tech stack encourages innovation at the protocol and other lower layers. I was curious if that would hold true within different layers of a blockchain protocol’s ecosystem as well.
Since it’s the largest token ecosystem by far, I decided to look into the Ethereum ecosystem to figure this out. Based on data from Coinmarketcap, Ethereum has (by far) the most tokens realized on top with currently >800, the second most are on NEO with only ~25. So I had a look at the top ~250 tokens on Ethereum; down from the top to a market cap of about 5m at the time of writing. The total market cap of these projects was about 10b, so compared to the ~20b of Ethereum, the initial premise of the Fat Protocol thesis seems to hold true. To investigate further, I categorized the projects and mapped the categories that I found into a 4-layered structure (see below).
Looking at number of projects first, there are some interesting observations:
- 67% of the projects are being developed on the application layer (layer 4) with exchanges, payments, and investment projects as the biggest subcategories, each making up about 8% of all projects.
- Second biggest category with 16% are new base layer protocols which haven’t launched their own blockchain yet, which would actually not be part of the Ethereum ecosystem.
- Layer 2 & 3 projects only make up a small minority of projects with 4% and 13% respectively.
Now looking at the aggregate market cap of projects, the picture looks different:
- Layer 4 is still the biggest, but the same 17% of projects on layer 2 and 3 hold an aggregate market cap of 36%, i.e. on average they traded twice as valuable as the rest.
- Biggest subcategories of layer 2 and 3 are Scaling (6%), Stablecoins (6%), and Exchange infrastructure (5%)
- Within the application layer, exchanges stand out most with 17%. However 11% come from Binance Coin alone.
Since category size is influenced by the amount of projects within a category, I calculated the average market cap per category next:
- The top 10 categories are clearly dominated by the lower levels: All level 2 categories and 3 of 7 layer 3 categories are on top.
- Of level 4 categories, only exchanges are clearly on top, again influenced by the market cap of Binance Coin.
Also wanted to compare number of projects to the average market cap. The chart shows the average market cap with a narrow bar on top of the number of projects with a broader bar. The scale for average market cap is on the right, for number of projects on the left. Also, the top 10 categories from the last chart are highlighted in a brighter blue:
- The relation of number of projects vs. average market cap especially stands out for the privacy category; this seems to be a gap in the market.
- The relation in scaling, stablecoins and interoperability also clearly shows above-average traded value
While the Fat Protocol theses clearly holds true when comparing Ethereum with the combined market cap of all the projects built on top of it, it’s not as straight forward on the layers above. Projects on higher layers hold more market cap on aggregate, but projects on lower layers have the higher average market cap.
To some degree, the lower total market cap might well be due to layer 2 & 3 technologies still being in development themselves, and therefore not being used by high-layer projects yet. But not all layer 4 protocols will need all layer 2 & 3 solutions to work. From looking at average market cap, the premise of the Fat Protocol thesis still seems to hold though.
Binance Coin, on the other hand, shows that significant value accrual can take place at the application layer as well, outperforming all individual layer 2 & 3 coins. Even in that case, it’s not outperforming the base layer protocol though.
Then still, the cryptocurrency space is still young, and value is based more on speculation than fundamentals, so we’ll probably have to revisit this in a year or two.
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