What is Fat Protocol Theory (FPT)?

Fat protocol theory is a thesis put forward by Joel Monegro of Union Square Ventures’ that suggests that the value in blockchains would accrue at the base protocol layer instead of the application layer. This is the opposite of the internet, where apps built on top of the protocol layer are worth trillions while the protocols themselves held little to no value., such as Facebook or Google, to name a few.

Those that bought into Monegro’s thesis and invested in promising protocol layers at the time have seen incredible returns on their investment. Think of Ethereum, Solana, Cosmos, Avalanche, and other smart contract protocols, and their astounding growth over the years.

However, several developments within the crypto space have threatened the validity of the fat protocol theory after 6 years. Some experts believe this has certain implications for the crypto revolution. According to Chia Jeng Yang of Saison Capital, the FPT is outdated. He offers some reasons as to why the theory is declining.

These reasons include reduced monopolism due to the rise in multichain apps, overstated network effects due to long term protocol competition leading to lower fees, a reffal curve where roll-ups reduced total demand, the rise of a new school of thought where L1 value capture pits currency vs. nations, and the fact that fat protocols accrue value based on a lack of alternative places to invest. However, an abundance of different apps now means investors have plenty of options at their disposal.

Let us explore some of these points in detail.

Overstated Network Effects

As mentioned earlier, the FPT was written at a time when a multichain world did not exist, and there was limited competition within the crypto sector. Fast forward six years later, numerous smart contract platforms such as Avalanche and Solana are competing to get a piece of Ethereum’s market share. Additionally, mainstream adoption of crypto has brought about blockchain skeptics who are simply searching for the easiest and cheapest app.

There is a chance that mainstream users will never need to purchase protocol tokens directly since apps such as Synapse, a cross-chain bridge, already give users enough native tokens for gas costs, thus laying the foundation for more apps to be designed in a similar manner. Therefore, users might not have the need to hoard tokens, as they have over the past six years.

Rollups and the Reffal Curve

There is a chance that scaling solutions that tie scalability to token demand could provide a rebuttal to the Reffal Curve. For instance, Avalanche’s subnet design requires each subnet to stake 2,000 AVAX to join the network. Using the protocol as an example, demand for scalability is positively correlated with demand for protocol tokens, mitigating the decline in value capture seen in section C of the Reffal Curve. The assumption is that demand for scaling within one ecosystem is sufficient to incentivize applications to pay the 2000 AVAX stake instead of scaling across ecosystems. Polkadot and Cosmos are a few other ecosystems with a similar correlation between scaling and token demand.

Lack of Alternatives to Fat Protocols

Kel of Messari Research is unconvinced whether traditional institutional investors who are notorious for their risk-aversion when it comes to crypto “will jump into the deep end of Pool 2 crypto applications.” This is despite the fact that there are more legit apps now compared to 2016 when FPT first came about. Therefore, he expects large institutions to be drawn to the slightly less “ponzinomic” yields of the protocols, especially in light of persistent inflation rates that have not been seen in over 50 years. He adds that early sentiment around the Ethereum Merge suggests this may already be the case.

Another researcher at Messari, who goes by the name Sami, adds that while he partially agrees with Kel’s point, we are already witnessing traditional investors shift focus from protocol layers to the applications being built on top as protocol layer valuations skyrocket. For example, the Arweave network provides dividends to L2 token holders each time a user interacts with the app that is built on top of the protocol. This value capture dynamic could prove stronger and more attractive to investors compared to holding the protocol layer’s token.