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Written by Erik Weijers 25 days ago

Fat protocol or fat apps - where will the money flow?

Is most of the value in the crypto world going to be in the base layer? In other words, the blockchains like Ethereum and Bitcoin? Or will the applications built on them be the winners? Think Uniswap or Aave. This is the main question many followers of crypto are asking.

Investing in crypto has a different premise than investing in traditional Internet companies. With the Internet, there is relatively less money to be made on the basic architecture. The applications that were built on it: that's where you could only get rich as an investor. To give an example: Cisco Systems, which builds hardware for the Internet, has only 10% of the market value of Google.

Why is this? Because with crypto, the base layer itself - the blockchain - is a financial tool in which you can invest. In fact, Bitcoin and Ethereum have a currency, while TCP/IP, the communication protocol of the Internet, does not. That's the beauty of crypto: you can invest in the popularity of the basic layer itself. And that has paid off nicely over the last ten years.

Are applications becoming more independent?

The idea has always been: the more apps that are built on, for example, Ethereum, the greater the need for block space on Ethereum and therefore the higher the value of ETH. The base layer (blockchain) has a pull: all apps want to go to an ecosystem where the developers and users are. Indeed, we have witnessed this unfolding in the last two years.

But the reasoning that has been gaining traction in crypto circles lately is that the apps now are big enough to pull their own weight. Consider Uniswap, the largest decentralized trading platform on Ethereum. Uniswap's volume of transaction fees is already about as high as Ethereum itself.

Of course, Uniswap and many similar apps still run on the base layer of, in Uni's case, Ethereum - but they won't be dependent on it for every transaction in the future. What about this and what does it mean for the price of Ether?

Correlation between number of transactions and price

Let's look at Ethereum, as an example. There is a fundamental relationship between the number of transactions on Ethereum and the price of Ether. The higher the number of transactions, the higher the price. Therefore, the popularity of DeFi and NFTs in 2020/21 led to sharply higher prices of Ether in 2021. The problem for users though was that the transaction costs (gas fees) were no longer affordable: they quickly amounted to tens of dollars or even hundreds of dollars in ETH for a simple token swap on Uniswap...

Naturally, developers worked feverishly on solutions to divert transactions away from Ethereum's base layer. For example, Polygon's zk-rollup machine. Zk-rollups bundle a truck load of transactions - tens of thousands even. Such a bundle of transactions is thus handled on a Layer 2 and must then be settled on Ethereum itself in one transaction. That transaction is very expensive but, of course, places a much smaller burden on Ethereum's base layer than if the Layer 2 did not handle the bundling.

So the highway that is Ethereum is relieved by all the Layer 2 side roads. But that also simply means: less demand for Ethereum blockspace. And less demand means a lower price of Ether. And thus we could end up in a situation like with the traditional internet, where the applications themselves become the most valuable.

The question is how this will develop in the coming months and years. It is conceivable that the exponential growth will shift from Ethereum to the applications that run on it. And the same argument applies to the alternative Layer 1s (Solana, Avalanche, etcetera) and their application layer.

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