Valuing app chains has always been one of more tricky tasks as an investment analyst because app chains function like a standalone application fundamentally but inherits features of a protocol or what we now call a base layer such as security and data availability.

It is therefore unfair to apply trading multiple of standalone applications to app chains; but also it is tough to argue app chains should be trading at multiples of a base layer given the stark difference in value accrual mechanism.

As a case in point; Injective’s rally this year is widely considered as a re rating trade. The market started to value the app chain as a protocol when the team announced an ecosystem fund backed by the likes of Pantera Capital and Jump Crypto supporting other applications to be built on top of the app specific layer.

The 150mn Ecosystem Fund Announcement by Injective

It prompted my interest over the first generation “Fat Protocol Thesis” as I thought by understanding the evolution of what the market perceives as the value of a blockchain would it give me some ideas on how to think about the current value of app chains; or app chains with an ecosystem to be specific.

The “Fat Protocol Thesis”

The “Fat Protocol Thesis” is initially mentioned by Joel Monegro when he was still with Union Square Venture in August 2016; and the thesis revolves around how crypto protocols should theoretically be capturing more value than the collective value captured by applications built on top of them.

To put it simply; the thesis suggested that protocols or what we call base layer now offer two unique core value proposition or sources of value accrual and hence should always be considered as more valuable than applications; or simply justify some very astronomical valuation; they come from

the permissionless shared data layer; in which blockchains effectively lower the barrier to entry of more newer players leading to a more competitive dynamics across the system and more importantly enable composability among each other which propels the growth of the protocol

the positive feedback loop that propels the speculative value of the native network tokens; as token price appreciation draws attention from developers and investors which would then be converted into manpower or capital invested into the ecosystem and kickstart the flywheel of its speculative value

as an extension; protocols could capture value created by the applications layer as demand of the native token increase and that would usually come in the form of gas fees; and hence theoretically the more transactions applications bring into the protocol level; the more value would the protocol be able to capture.

Why “Fat Protocol” Isn’t Relevant Anymore

The “Fat Protocol” thesis has then gone through numerous debates on its timeliness as the claim was made in the maximalist generation where concepts such as modularity and app chain specific chains are not even existent.

The market subsequently argues that the “Fat Protocol” thesis is not entirely applicable to the current market structure given the following reasons

overwhelming abundance of blockspace; as evidenced by the number of newly minted alternatively layer 1 in the previous cycle; the protocol layer could no longer retain value created by applications as the abundance of blockspace squeezes the price paid by users for the same amount of transaction

the rise of modular blockchains; which effectively splits the function of blockchains into execution; data availability and settlement; resulting in cheaper data availability solutions that further squeezes the fees users are paying for the shared data layer as in the original thesis

ease of multi chain; as applications could easily launch on multiple chains or even interact in a cross chain with the help of interoperability tools such as LayerZero; and hence the stickiness to one single protocol has significantly diminished which weakened the positive feedback loop in the original thesis

The “App Chain Thesis”

The demise of the “Fat Protocol Thesis” comes with the introduction of the “App Chain Thesis”. App chains are blockchains that are built for a specific use cases; and the design enjoys certain merits including the following points

better value accrual mechanism; as native network tokens could be staked for security purposes which causes supply sink of the token; and also be deriving value from the business model of the blockchains

customisability; developers could freely customise any configuration in the technology stack for specific purposes such as throughput and finality and make trades offs according to what works better for the application

For instance the latest dYdX v4 is implemented on a Cosmos-SDK powered chain; which promises that traders would no longer be paying gas fees for trading; but instead fees would be taken based on the size of the trade which mimics the experience of trading on a centralised exchange platform.

Chorus One Research on dYdX v4

That being said; app chains come natively with some drawbacks and hence the concept has not entirely taken off yet given the following reasons

liquidity fragmentation and composability; as native assets residing within the specific app chains could not interact with assets in other chains unless specific assets are highly sought after and be supported by interoperability products

limited security; app chains are theoretically only secured by a portion of the fully diluted valuation depending on the consensus mechanism; but the reduction of token value would linearly affect the level of security of the blockchain

Business Model of Protocols

If we think about the business model of protocols or base layers; users are effectively paying gas fees in exchange for the protocols to properly store transaction data through the consensus mechanism and settle their transactions.

Although the original thesis might be less timely; the merits to the “Fat Protocol” era is that protocols and applications have clear division of labour;

protocols are effectively seeking ways to get users pay for security and data availability; and aim at retaining users and application within their respective ecosystem to maximize the positive feedback loop for composability and direct value accrual in the form of gas fees

even with the rise of layer 2; protocols are effectively only pivoting from a to-customer focus to a to-business focus; aiming to extract as much value as possible with rollups paying for data availability and consensus

applications on the other hand are competing for whatever brings a competitive edge to their business; and this could sometimes comes with the lack of value accrual such as how Uniswap maximized for the depth of liquidity without a clear path of channeling cash flow to token holders

The division of labour minted many multi billion dollar applications with the likes of Uniswap and OpenSea. To applications; they are essentially outsourcing other important parts of the blockchain to the protocol level such that they could focus on what makes the applications work and successful.

However to the protocols themselves; the current form of doing business is gradually and inevitably crumbling with the emergence of modular blockchains and the abundance of blockspace as aforementioned; and hence protocols are becoming “thinner”.

Business Model of App Chains

The business model for application specific chains has a stark difference; although optically both protocols and app chains are functioning as a base layer

app chains are not asking users to pay for storing transaction data in the form of gas fee; but instead users are effectively paying for the applications themselves; for instance Osmosis implements a protocol taker fee which would eventually flow to token holders as a form of yield

however app chains are also offering everything that a protocol is supposed to do; ranging from offering the shared data layer to settling the transactions and providing the level of security of a proper blockchain; and most importantly an application that is competitive enough against each other

The merits to this business model design is a hybrid of the following which should be considered as more sustainable and more defensible even as the market structure evolves and scales in the future

users are effectively paying for services that the market agrees to a certain price; for instance Injective takes a cut from the trading fees from its perpetual future exchanges and the market generally agrees that perpetual futures exchanges should be taking a fee; and there are exchanges that take even higher fees such as GMX and Gains Network

as opposed to the market generally thinks that offering shared data and consensus should not warrant a fee; and are unanimously competing to offer a cheaper solution effectively making it a race to zero

value accrual does not scale linearly with the number of transaction; but instead scales with other variables that drives the success of the application; for instance the value accrual of Injective is a function of perpetual futures trading volume and for Osmosis it is a function of spot trading volume

In a nutshell; the business model of app chains turns out to be a natural fit in the current market structure in hindsight; since the protocol is accruing value from a more sustainable source. As an extension to that; it makes me think what if app chains take a step further and amplify the merits of the protocol level by combining both.

The “Fat App Chain Thesis”

The changes of times and market dynamics gives rise to what I call the “Fat App Chain” thesis; as we witness that app chains are trying to build out their own ecosystems to get the best of both worlds such as Injective and Osmosis

app chains are no longer competing with alternative base layer or protocols with lower gas fees; but instead they figured out a more defensible and sustainable business model which the market agrees a fair price to; it effectively solves the value accrual problem of the first generation “Fat Protocol Thesis”

on another hand app chains could also enjoy the positive feedback loop when more applications decided to build on top of the app chain; which effectively solves for the liquidity fragmentation and limited composability problem that inherits from the app chain architecture

also app chains offer the shared data layer which enables the deployment of other applications on the app chain itself; driving the proliferation of the ecosystem and subsequently interest from developers and investors that could potentially propel the price performance of the network

most importantly it solves for the cold start problem that many alternative layer 1 or rollups might suffer from; as many app chains started as an application itself with users looking for better composability

Hence; app chains that are trying to build an ecosystem are not getting any “thinner”; but instead they showcase a clear path to be “fat” and most importantly to stay “fat”; and could very much present an attractive investment case if that makes sense.

Post Mortem of Injective

As mentioned in the earlier part of the article; Injective’s impressive run this year demonstrated the “Fat App Chain Thesis”. Starting out as a standalone perpetual futures app chains; Injective runs the typical orderbook model; and pioneered zero gas to avoid malicious MEV such as front running.

In terms of value accrual; Injective essentially burns 60% of all exchanges’ fees managed by a community led auction; hence causing a deflationary pressure to the entire token supply. The remaining 40% is taken by relayers to incentivize the depth of liquidity in the exchange. In other words; value accrual of the $INJ token is a function of trading volume instead of transaction count like other alternative protocols.

The native $INJ token could also be used as collateral backing for derivatives which serves as an alternative to stablecoins unlike in other derivatives markets. Also, Injective integrated with Skip Protocol to return MEV proceeds to stakers and strengthen the value accrual case earlier this year in February.

Injective was trading at the 130mn back in the beginning of 2023 and the market subsequently re rated the token upwards when the Injective ecosystem fund announcement came out; and renowned venture capitalists are supporting their effort to build out an entire ecosystem on top of the orderbook.

As of the time of writing; Injective is trading at more than 1.3bn; gaining more than 10x year to date outperforming most of the alternative tokens in the market. That being said; metrics have not hugely improved since the expansion and Injective is still averaging a daily trading volume of 10mn; which gives an annualized value accrual (in the form of burnt tokens) of approximately 4mn.

Nothing much has changed but the “Fat Protocol Thesis” essentially intersects with the “App Chain Thesis” in this pivot. Injective enjoy the merits of the being both the base layer and an app chain; and at the same time avoiding major drawbacks of both

positive feedback loop still applies; as investors committing capital to building out the ecosystem attracts developers and projects kickstarting the speculative value of the native network token; which indirectly solves for the level of security the chain inherit as valued as an app chain previously

value accrual part is not affected by the fee competition; as Injective is not taking gas fee to start with but profits from the trading volume; and most importantly accrues value also by offering security and the shared data layer

liquidity fragmentation and composability problem is being solved; as native assets on the chain have more use cases now within the app chain now

In conclusion, Injective trying to build an ecosystem found a clear path to be “fat” and most importantly to stay “fat”; and therefore could very much present an attractive investment case even in the longer run.

What About Sei?

It is hard to replicate Injective’s wonder once again. Sei, which is widely considered as Injective’s closest comparable in the industry might not see a similar trajectory. Both operating as an order book; the native token of $SEI does not accrue value in the same way as Injective does; but instead it functions as native gas token for the network.

Tokenomics of Sei

This small difference essentially inherits the legacy problem with the “Fat Protocol Thesis”; and places Sei in the same battlefield as other alternative layers.

the positive feedback loop still exists and is applicable; as Sei is backed by numerous high profile investors in the industry but the capital injected has yet attracted developers onto the platform to propel the growth of the network

value accrual is the legacy pain point that has yet to be solved and Sei inherits that part; the blockchain does not effectively take any meaningful fee from gas by offering the shared data layer and the security level

liquidity fragmentation and composability problem is not entirely relevant as the app chain positioned themselves as a standalone ecosystem; instead of having to interact with other chains in the Cosmos ecosystem

Osmosis could be the next in line

The “Fat App Chain Thesis” received the first validation in the market with the success of Injective; and now is high time to look for another opportunity that follows the similar logic to replicate the play.

Osmosis could be the next in line; as the team slowly built out an ecosystem around the AMM based app chain with DeFi primitives like Mars protocol offering a money market; and Levana Protocol offering the perpetual future exchanges and more. The protocol also turned on the taker fees from its spot trading volume; effectively brings value accrual to token holders for the first time.

As an app chain standalone and the liquidity hub on Cosmos; Osmosis does not print impressive numbers with an average daily spot trading volume of 6mn. Partially driven by the muted level of DeFi activities on Cosmos; the $OSMO token price has been on a down only trend since earlier this year from $1.10 highest to $0.30 now.

Once again; the “Fat Protocol Thesis” is gradually intersecting with the “App Chain Thesis” in the Osmosis case; but some more validations are required to kick off the entire price rally as the following

the positive feedback loop is still lacking; the Osmosis community is strong and strategically aligned with the entire Cosmos ecosystem attracting teams to deploy applications on the app chain itself; but investors seem not to have been pouring money into the ecosystem yet

value accrual is again not affected by the fee competition; Osmosis implemented a 10 bps protocol taker fee and profits as a function of spot trading volume; and at the same time also accrues value by offering security and the shared data layer

the caveat here is that the protocol taker fees might eat into the unit economics of traders and arbitrageurs; which might affect spot trading volume in the longer run unless Osmosis managed to build a sustainable moat around protocol liquidity

liquidity fragmentation and composability problem is slowly being solved; as native assets on the chain could be used in other DeFi primitives on the chain

Conclusion

When the $INJ rallied earlier in the year; I thought the event is one off as the market is effectively re rating the tokens from applying the trading multiples of perpetual futures exchanges to that of protocol layer; and that token price would stop propelling once the price adjustment is completed.

It turns out to be one of my biggest miss this year. As I reflected on the fundamental logic behind the move; combining both the “fat protocols” and “app chains” actually minted one of most hated rally as it solves legacy problems on both sides; and speculative value is injected into the system alongside institutional investors’ capital to kickstart the flywheel.

I believe more app chains are going with this route in the coming months; as most of them are looking to diversify their product offering and retain value within the system other than competing with each other on the application level. The “Fat App Chain Thesis” could create more wonders in the public market.

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