The Fat Protocol Thesis 🙇🏽♀️
Layer 1 & Layer 2 blockchain solutions
Hi there!
Over this past weekend, I had a conversation with a friend who is heavily into crypto investing and building his overall financial portfolio. Most financial advisors will tell you that a diversified portfolio is the way to go — and I couldn’t agree more. What you choose to invest in will likely vary based on your risk tolerance and stage of life. On one hand, my friend is progressing in his career and hyper focused on real estate investing and crypto. On the other hand, I’m headed to business school in the fall (life update! 🥳) and don’t have as much flexibility to take risks because these loans won’t pay themselves LOL. While I’m planning to be a bit more financially conservative (AKA “not buying anymore NFTs”) over these next few months in preparation for school, the one investment I may not pause is my monthly recurring Ethereum deposits.
Okay, hear me out. I talk about Ethereum a lot on this platform, but I like to think it’s for good reason. The conversation with my friend this past weekend only further confirmed this because of an article he sent me from 2018 that breaks down our topic for today: The Fat Protocol Thesis.
Before we get into it, let’s level set and talk about…
The Scalability Issue with Blockchains ⛓
According to Binance, “Scalability is one of the reasons hindering global crypto adoption. As demand for cryptocurrencies increases, pressure to scale blockchain protocols will also mount.”
Side note: You may be wondering “What are protocols?” Simply put, they are “components of Blockchain technologies that enable information to be shared automatically across cryptocurrency networks securely and reliably. In computing, protocols are essentially rules that define how data is allowed to be transferred between different computer systems.” — Chetu
One of the main solutions for overcoming this scalability problem is the introduction of Layer 1 solutions. Layer 1 blockchains are a set of solutions that improve the base protocol itself to make the overall system way more scalable. Some examples of operating Layer 1 blockchains include our faves: Bitcoin and Ethereum. However, what we’re realizing is that Bitcoin is most affected by these scalability issues, since the underlying network relies on the increase in the number of miners to ensure higher transaction throughput and volumes.
The Fat Protocol Thesis 🐖
The name cracks me up every time, but the author of this article coined the “Fat Protocol Thesis” phrase. Note that when the author mentions the “application layer”, they are referring to Layer 2. In short, Layer 2 is “a secondary framework or protocol that is built on top of an existing blockchain system. The main goal of these protocols is to solve the transaction speed and scaling difficulties that are being faced by the major cryptocurrency networks.” Read the excerpt below:
“You know protocols.
SMTP for email transfer, HTTP for hyperlinks, TCP/IP for data transfer. Every application you use is built on top of those protocols. Facebook, Google, Amazon, would not be able to exist without these protocols. Since the advent of the internet, the majority of value has accrued to the applications on top of pre-existing protocols, and the protocols themselves have not generated much wealth for the people who invested in them.
The underlying argument of the fat protocol thesis is that blockchain technology can fundamentally flip that dynamic and change it such that the protocol layer accrues more value than the application layer. The theory posits two main reasons why this happens:
Shared data layer
Speculative token attachment
First: the shared data allows for user data to be held in a central place (namely the protocol/blockchain) and to be shared equally among the applications built on top. Historically data was siloed and barriers to entry were large. With a shared data center, it’s easier for companies to build on top and for them to work together. For example, it takes quite a bit of effort to transfer your assets from Robinhood to E-trade (built on different bases), but it’s seamless to do so between Coinbase and Binance.
Second: the speculative token attachment encourages building and speculation on early stage protocols, as any application built on top of the protocol will increase it’s value and create a loop of value creation. As applications are built, the protocol accrues more value. As the protocol accrues value, people are incentivized to build applications. Since the tokens are needed to access & use the protocol, they go up in value the more a protocol is used. It’s a virtuous cycle.
Due to the protocol gaining value linearly with application usage, the theory posits that that applications cannot accrue value larger than that of the underlying protocol.”
My Thoughts on the Thesis 💡
There has rarely ever been a moment in history where the average person, like you and me, could invest in these foundational layers of technology. What typically happens is the VC sharks and ultra wealthy get exclusive access, only further perpetuating the economic gaps that exist, especially for underserved communities. The beauty of this moment in time is that, if we’re able and interested, we can make the choice to invest however much we’d like in the success of this new technology—whether it’s Bitcoin, Ethereum, or any other Layer 1 or Layer 2 blockchain. As I always state, this is not financial advice, but consider these posts your weekly reminder that the one of the last industries (finance) is being disrupted by technology and we have the opportunity to invest now. At the earliest stages.
I mentioned my desire to continue investing in Ethereum, even though I’ll be living off loans lol. This is because I believe deeply that this specific blockchain technology will serve as the base (Layer 1 solution) for the next Google or Amazon or Meta to be built. As we look ahead at Ethereum Merge, I’m even more confident in the potential upside of this technology. :)
That’s all for this week, friends! Check out the video below for more Layer 1 vs. Layer 2 content.
If you have questions, drop them here.
This week’s recommended action: Check out this video breaking down Layer 1 vs. Layer 2 protocols!
I always say my goal is to know enough to be dangerous. This video does an amazing job at breaking down how Layer 1 blockchains differ from Layer 2, but also how they’re connected! Take 3 mins and watch it — I promise it’ll be helpful :)