Among the crypto development and investor communities, the most popular term is “protocol,” and for good reason. Everyone is building a protocol (and presumably these protocols offer investors and employees some way to generate returns).

A protocol is not a thing; it’s an abstract concept, a set of rules. It is by definition impossible to invest in a protocol, as there is nothing to invest in. Crypto investors don’t actually invest in protocols, but in scarce assets that are necessary to make certain kinds of protocols work.

Some protocols’ native assets capture value. Others don’t.

In this essay, we’ll examine layer 1 and layer 2 protocols in the context of value capture, and propose value capture frameworks for each layer.

Value Capture At Layer 1

Layer 1 tokens exist for only one reason: to secure the chain against 51% attacks.

Let’s explore this idea.

One of the more popular visions among crypto enthusiasts is the idea that there will be many chains—thousands or even millions. Some chains will run the same protocol (e.g. many small chains using the vanilla ethermint protocol), and others will run unique protocols (e.g. Solana, Dfinity, Algorand, Ethereum, Bitcoin, Monero, etc.).

However, the number of chains that can persist in the long run is finite. We already have evidence that supports this hypothesis: 13 chains have been 51% attacked. And it’s not just the long tail of assets. Ethereum Classic, Bitcoin Gold, and Verge were 51% attacked when they were in the top 20 coins by market cap. These chains are limping along and not yet dead. However, they have a near 0% probability of recovery.

Given this: why would users choose to store their wealth in a chain that’s been 51% attacked when they can choose to store their wealth in a chain that hasn’t been?

The breakthrough that made Bitcoin possible was not in technology, cryptography, or distributed systems, but in game theory. The breakthrough of Bitcoin was the proof of work (POW) consensus algorithm in which miners are compensated for maintaining the ledger by receiving newly minted Bitcoin and the incentives are structured as such that independent miners act in the best interest of the network because of the value of those mined Bitcoin.

We can compare the security of blockchains by measuring the cost of conducting a 51% attack. To conduct a 51% attack, an attacker needs to spend more than the chain’s security budget (SB). We can quantify SB in USD terms as follows:

SB = aggregate network value * inflation rate + transaction fees

Note that this provides a floor, not a ceiling, for network security. There may be supply constraints in the ASIC market for POW coins making it even more difficult to conduct a 51% attack.

To keep the math simple, let’s say the market cap of Bitcoin is $100B. Today, inflation in Bitcoin is about 4% annually. For simplicity, let’s round transaction fees down to 0 (in practice, miners generate the vast majority of their revenues from inflation, not transaction fees). It’s thus rational for honest, economically motivated miners to spend up to $4B ($100B * 4%) per year to mine Bitcoin. We can therefore say the SB of Bitcoin is $4B / year.

It’s clear from this simple math that security is primarily a function of network value because there is unlikely to be high inflation in the largest blockchain networks. While there are valid arguments for 0%, 1%, and 2% inflation, it’s extremely unlikely that people will opt into a global, state-free money that inflates > 5% annually in the long run.

Because security is primarily a function of network value, there is a natural network effect: the more valuable a chain is, the more secure it is. The more secure it is, the easier it becomes for the next marginal user to justify storing their wealth in that chain.

This is why it’s not possible to maintain an equilibrium in the medium or long run in which more than a handful of chains exist. Why would users choose to store their wealth in the 7th most valuable/secure chain?

Given the intrinsic differences between proof of work and proof of stake systems, we should expect for the foreseeable future to have a few chains, if for no other reason than they have unique consensus algorithms. Going all-in on a single consensus model at this stage is premature given how young these systems are.

Interoperability Chains

This naturally begs the question: what about interoperability chains like Cosmos (ATOM) and Polkadot (DOT)? Both chains relay messages between other chains, and charge a fee to users for doing so. Additionally, Polkadot provides consensus safety to its parachains for a fee.

Thus ATOMs and DOTs are yield-generating assets, and can be valued as a function of cash flows. Both the Cosmos and Polkadot teams have expressed that they don’t expect their respective native tokens to be used as currencies in their respective ecosystems. We agree, and do not expect ATOMs and DOTs to become money either.

Given that 1) the native tokens for interoperability chains are unlikely to be money 2) the only purpose of a chain it secure itself against 51% attacks, and 3) the largest market that a native token can strive to be is global, state-free money, it’s not clear if interoperability chains can survive in the long run.

We do however expect Cosmos and Polkadot to thrive in the coming years as the Web3 Stack is clearly becoming more heterogeneous rather than homogenous as developers run experiments and explore different trade-offs at every layer of the stack.

Value Capture At Layer 2

The only way a layer 2 protocol can capture value is if it stores some sort of external and valuable state.

This is an abstract concept. To best understand this, let’s compare a few layer 2 assets:

The 0x protocol is among the most widely used protocols built on the Ethereum blockchain. It allows any two parties to trustlessly trade digital assets without relying on a 3rd party.

Excluding the token balances of ZRX holders, on the surface it does not appear that the asset-exchange function of the 0x contract stores any state. Either a trade happens, or it doesn’t. After processing a transaction, the state of the 0x asset-swap contract remains unchanged.

Beyond the actual asset-swap contract, the 0x protocol stores a few pieces of external state about user preferences and network-level governance. While these pieces of state are external to the protocol, they are not valuable pieces of state. That is, the state being stored does not have measurable, market value.

There is at least one way that the 0x protocol can capture value: governance. This is an explicit decision to create extra-protocol state (coin holder votes). Governance becomes more interesting as others build higher level protocols and applications on top of the core 0x protocol. If these external protocols come to rely on the 0x protocol meaningfully, and are economically motivated to see the protocol evolve in a specific direction (or not evolve), they may actively participate in governance, or they may fork away, as DDEX recently did.

While this is an interesting hypothesis, it remains to be seen if governance is fundamentally value-able. At least on a theoretical basis, it can be, although we are skeptical.

BAT is an effectively stateless protocol. The core protocol itself does not store any state about the network other than the account balances of BAT owners. BAT is a proprietary payment currency, which will if not redesigned ultimately be subject to the velocity problem.

Although the BAT protocol is effectively stateless in the Ethereum network, it’s not stateless outside of the Ethereum network. That is, the Brave browser, which has more than 5M monthly active users, only supports BAT, and the Brave team is economically incentivized not to change this because they own a lot of BAT. As the number of Brave users grows, the extra-protocol state of BAT grows. This extra-protocol state is un-forkable, so BAT can’t be forked out.

Brave is an interesting case study. On an abstract basis, BAT should not capture any value. On the other hand, BAT benefits from a large exogenous effort of the Brave team. Absent changes in the token mechanics, we don’t expect BAT will capture value in the long run, but the existence of this extra-protocol state does justify some value, at least for now.

Augur stores two kinds of valuable state. The first is obvious: there is capital locked in the Augur contracts for all open markets. If someone were to fork Augur, it would be impossible to fork the ETH that’s locked in open Augur markets.

The second form of valuable state that Augur stores is a bit more nuanced, but actually more important in the long run. Augur is both a global, censorship-resistant prediction market and a decentralized oracle. These functions go hand-in-hand.

Augur is a radical concept. There really is nothing like it in the world. That also means it’s untested, and it can fail. Each market that successfully resolves is another proof point that the system works. In order to support billions of dollars of volume, prediction market participants need to know that the system will not implode, and the only way to know that is to see that every market has resolved honestly.

If someone were to fork Augur and change the token distribution, then market participants should question the motivations of the fork. The whole point of REP is that it’s valued by rational market actors who want to report off-chain events honestly. If someone forks REP and changes the token distribution, one should think adversarially and assume that the person/team/company who forked it has malicious intentions.

Furthermore, the history of Augur gives credibility to the future accuracy of the Augur protocol. That is, many market participants will not risk capital on a platform with such a radical dispute resolution system until they’ve seen it work in practice. This is valuable state that cannot be forked out, creating more defensibility and value capture for REP.

Next let’s examine Livepeer, a layer 2 work token that powers a network of video transcoders. I wanted to include a work token specifically because many in the crypto community perpetuate the idea that layer 2 work-token networks cannot capture value. This is simply untrue.

Livepeer is a network that enables distributed transcoding for live streaming videos. In order to gain the right to perform work in the Livepeer network, transcoders must purchase and stake LPT. In exchange for doing so, streamers pay the transcoders in ETH or a stablecoin such as DAI or USDC. As such, LPT can be valued as a function of cash flows using a discounted cash flow (DCF) model.

Livepeer, like all layer 2 work token networks, requires that all workers register themselves in an on-chain registry by staking LPT. The more demand there is for services on the Livepeer network, the more revenue will be paid to LPT holders, justifying a higher LPT price. The more demand for Livepeer’s transcoding services, the more honest transcoders should compete for that demand, making the network as a whole more secure. If someone were to fork Livepeer and create their own token, that token would be worth a fraction of the LPT because the fork would not bring the same community of demand-side (streamers) and supply-side (transcoders) participants with it.

The purpose of a layer 2 work token is to secure the network against malicious actors. Like in the case of layer 1 networks, there is a natural network effect. Why would users want to use a forked network with lower security if they could use a larger network with more security at the same cost? (the Livepeer protocol does not impose any taxes on users, so there isn’t an opportunity to undercut the original network in terms of price)

All layer 2 work-token networks—for example Keep, The Graph, and SKALE—benefit from this economic security network effect, not just Livepeer.

Final Thoughts

Given that all of the code that powers crypto networks is open-source, the only source of defensibility is network effects.

While there are many ways to bootstrap network effects for layer 1 assets, in the long run, we will see consolidation as price volatility between chains is ultimately value-destructive. Layer 2 assets, on the other hand, don’t need to defend themselves against 51% attacks. Instead, they build network effects through the value of the state they contain.

Hat tip to Jesse Walden and Denis Nazarov for conversations that inspired this post.

Disclaimer: Multicoin Capital is a thesis-driven hedge fund that may hold some of the assets discussed in this post.