Original title: Make Applications Great Again

Original author: Adrian

Original translation: Luffy, Foresight News

In every crypto cycle in history, the most lucrative returns on investment have been achieved by early betting on new underlying infrastructure primitives (PoW, smart contracts, PoS, high throughput, modularity, etc.). If we look at the top 25 tokens on CoinGecko, we will find that there are only two that are not native tokens of L1 blockchains (excluding pegged assets): Uniswap and Shiba Inu. This phenomenon was first theorized in 2016 by Joel Monegro, who proposed the "Fat Protocol Theory." Monegro believes that the biggest difference between Web3 and Web2 in terms of value accumulation is that the value accumulated by the cryptocurrency base layer is greater than the sum of the value captured by the applications built on it, and the value comes from:

· The blockchain has a shared data layer on which transactions are settled, thereby promoting positive-sum competition and enabling permissionless composability.

· Token appreciation -> Introducing speculative participants -> Initial speculators converted to users -> Users + token appreciation attract developers and more users, etc. This path forms a positive flywheel.

Fast forward to 2024, the original argument has survived numerous industry debates, and several structural changes in industry dynamics have occurred that challenge the original claims of the Fat Protocol Theory:

1. Commoditization of Blockspace: With Ethereum blockspace at a premium, competing L1s have risen and become asset class definers. Competing L1s are often valued in the billions of dollars, and builders and investors are attracted to competing L1s almost every cycle, with new "differentiated" blockchains emerging every cycle, which excite investors and users, but ultimately become "ghost chains" (such as Cardano). While there are exceptions, in general, this has led to a market with too much blockspace and not enough users or applications to support it.

2. Modularity of the base layer: As the number of specialized modular components increases, the definition of "base layer" becomes increasingly complex, not to mention the value generated by deconstructing each layer of the stack. However, in my opinion, this shift is certain:

· Value in modular blockchains is decentralized across the stack, and for a single component (e.g. Celestia) to receive a higher valuation than the integrated base layer requires its component (e.g. DA) to become the most valuable component in the stack and build “applications” on top of it, resulting in more usage and fee income than the integrated system;

· Competition between modular solutions drives cheaper execution/data availability solutions, further reducing fees for users

3. Towards a future of “chain abstraction”: Modularity inherently creates fragmentation in the ecosystem, leading to cumbersome user experiences. For developers, this means too many choices for where to deploy applications; for users, this means overcoming many obstacles to get from application A on chain X to application B on chain Y. Fortunately, many of our smart people are building a new future where users can interact with crypto applications without knowing the underlying chain. This vision is called “chain abstraction”. The question now is, where will value accrue in the future of chain abstraction?

I believe crypto applications are the primary beneficiaries of the shift in how we build infrastructure. Specifically, intent-centric trading supply chains, with order flow exclusivity and intangible assets such as user experience and brand, will increasingly become the moat for killer applications, allowing them to be commercialized more efficiently than today.

Exclusivity of Order Flow

The MEV landscape has changed dramatically since the Ethereum merger and the introduction of Flashbots, MEV-Boost. The dark forest that was once dominated by searchers has now evolved into a partially commoditized order flow market, and the current MEV supply chain is dominated by validators, who capture ~90% of MEV in the form of bids from every participant in the supply chain.

Ethereum's MEV Supply Chain

Validators extract most of the extractable value from order flow, which makes most participants in the trading supply chain unhappy. Users want to be compensated for generating order flow, applications want to retain value from users' order flow, and searchers and builders want greater profits. Therefore, value-seeking participants have adapted to this change and they have tried multiple strategies to extract alpha, one of which is searcher-builder integration. The idea is that the higher the certainty of inclusion of the searcher's packaged block, the higher the profit. A large amount of data and literature shows that exclusivity is the key to capturing value in a competitive market, and applications with the most valuable traffic will have pricing power.

This is similar to Robinhood’s business model. Robinhood maintains a “zero-fee” trading model by selling order flow to market makers and taking kickbacks. Market makers like Citadel are willing to pay for order flow because they are able to profit from arbitrage and information asymmetry.

This is further evident in the increasing number of transactions being conducted through private memory pools, which recently hit an all-time high of 30% share on Ethereum. Applications realize that the value of all user order flow is extracted and leaked into the MEV supply chain, and private transactions allow for more customizability and commercialization around sticky users.

https://x.com/mcutler/status/1808281859463565361

I expect this trend to continue as the era of chain abstraction arrives. Under an intent-centric execution model, the trading supply chain is likely to become more fragmented, with applications directing their order flow to the solver network that can provide the most competitive execution, driving solver competition to drive down margins. However, I expect the majority of value capture to move from the base layer (validators) to the user-facing layer, with middleware components being valuable but with low margins. Frontends and applications that can generate valuable order flow will have pricing power over seekers/solvers.

Possible Value Accrual in the Future

We are already seeing this happening today, with lending protocols regaining liquidation bid order flow that would otherwise go to validators, leveraging niche order flow forms from application-specific ordering (e.g., oracle extractable value auctions, Pyth, API3, UMA Oval).

User Experience and Brand as Sustainable Moats

If we further break down the 30% of private transactions mentioned above, most of them come from frontends such as TG Bots, Dexes, and wallets:

Despite the long-held belief that crypto-native users have a low attention span, we are finally seeing some level of retention. Both brand and user experience can be a meaningful moat.

User Experience: Alternative front-end forms that introduce a completely new experience by connecting a wallet on a web application will undoubtedly attract the attention of users who need a specific experience. A good example is Telegram bots such as BananaGun and BONKbot, which have generated $150 million in fees by allowing users to trade Memecoin from the comfort of a Telegram chat.

Brand: Well-known brands in the cryptocurrency space can increase fees by gaining the trust of users. It is well known that fees for in-wallet app swaps are very high, but they are a killer business model because users are willing to pay for the convenience. For example, MetaMask swap generates more than $200 million in fees per year. Uniswap Labs' front-end fee swap has netted $50 million since its launch, and transactions that interact with Uniswap Labs contracts in any way other than the official front-end will not be charged this fee, but Uniswap Labs' revenue is still growing.

This shows that the Lindy effect in applications is consistent with or even more pronounced than infrastructure. Typically, the adoption of new technologies (including cryptocurrencies) follows a sort of S-curve, where as we move from early adopters to mainstream users, the next wave of users will be less mature and therefore less price sensitive, allowing brands that can achieve critical mass to monetize in creative ways.

The S-Curve of Cryptocurrency

Concluding Remarks

As a crypto practitioner primarily focused on infrastructure research and investment, this post is by no means a denial of the value of infrastructure as an investable asset class in crypto, but rather a shift in mindset when thinking about entirely new categories of infrastructure that enable the next generation of applications to serve users above the S-curve. New infrastructure primitives need to bring entirely new use cases at the application level to attract enough attention. At the same time, there is enough evidence that there are sustainable business models at the application level where user ownership directly guides the accumulation of value. Unfortunately, we may have passed the market stage of L1s where betting on every new shiny L1 will bring exponential returns, although those with meaningful differentiation may still be worth investing in.

That said, I’ve spent a lot of time thinking about and understanding the different “infrastructures”:

· AI: an agent economy that automates and improves the end-user experience, a compute and inference marketplace that continuously optimizes resource allocation, and a validation stack that extends the compute capabilities of blockchain virtual machines.

· The CAKE Stack: Many of my points above suggest that I believe we should be moving towards a future of chain abstraction, and that the design choices for most components in the stack remain large. As infrastructure supports chain abstraction, the design space for applications naturally grows and can cause the distinction between application/infrastructure to blur.

· DePIN: I have argued for some time that DePIN is the killer real-world use case for crypto (second only to stablecoins), and that has never changed. DePIN leverages everything that crypto is good at: permissionless coordination of resources through incentives, bootstrapping markets, and decentralized ownership. While each specific type of DePIN network still has specific challenges to solve, validating a solution to the cold start problem is huge, and I’m very excited to see founders with industry expertise bringing their products to crypto.
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