Crypto protocols: in search of the emerging winners

Published on
November 25, 2020
Chandar Lal
Crypto protocols: in search of the emerging winners

We continue to witness a Cambrian explosion of public blockchain development. In recent years, the fabric of the decentralised web has begun to be woven, and the social contract of money is being rewritten. Bitcoin and later Ethereum are the two platforms on this movement was catalysed. In this post, we explore what comes next.

As new base layer blockchain protocols emerge, we see new technical and economic possibilities – as well as plenty of hype, investor speculation, and developer tribalism. How do we separate the signal from the noise, and see the outline of the emerging winners through the fog?

Joel Monegro’s Fat Protocols thesis is now four years old. It posited that “the market cap of the protocol always grows faster than the combined value of the applications built on top”, and can be credited with drawing investor interest at the protocol layer. Since then, the Bitcoin and Ethereum protocols have grown both in value and developer activity – the former now nudging an all-time high. At the same time, new protocols are emerging to challenge their hegemony.

So, what’s the problem to be solved? In summary: no truly scalable, natively programmable blockchain has yet reached mainstream adoption – yet this seems a prerequisite for the crypto ecosystem to grow sustainably. Bitcoin and Ethereum each have their challenges and limitations:

  • Scaling Bitcoin beyond the store-of-value use case is contingent on the success of the Layer 2 / sidechain ecosystem, with off-chain initiatives promising to enable new applications and address innate main chain scalability challenges. Blockstream, in our portfolio, is a key player here.
  • Ethereum has grown as the foundational blockchain on which decentralised finance depends – but now it appears to be bursting at the seams, with gas prices skyrocketing due to developer demand and scalability limitations. Ethereum 2.0 promises many solutions, but its path to deployment has been long. Vitalik Buterin’s notorious scalability trilemma remains unsolved, and structural governance questions persist.
  • In their current incarnations, Proof-of-Work models may fundamentally not provide sufficient transaction throughput to serve growing demand.

How will this be resolved? There are several plausible views on the number of successful public Layer 1 protocols: zero, one or many.

  • Zero is what is says on the tin: no chain matures to solve this problem in any reasonable timeframe. This obviously wouldn’t be a great eventual outcome for long-term holders or VC investors – but given the potential asymmetrical outcome, is not a sufficient reason to preclude interest in the space
  • One is the maximalist camp: that one blockchain will emerge to rule them all. Historically, the Bitcoin community has been most closely associated with this view (predicated on scaling Layer 2)
  • Many: A third hypothesis is that multiple public blockchains will co-exist, each serving distinct needs and gaining value as the ecosystem matures (perhaps consolidating or linking over time)

At a high level, the rationale for "many" is:

  1. Different use cases call for different architectures. The DeFi boom has taken place on Ethereum rather than Bitcoin, because the former historically was a more viable platform on which to build dapps and smart contracts. New use cases will drive further innovation and competition at the protocol layer, as developers go where it’s easy to build.
  2. Interoperability between public blockchains could weaken the network effects of Bitcoin and indeed Ethereum: why be limited to developing on these protocols if assets can be transferred freely cross-chain?
  3. New Proof-of-Stake protocols offer scalability by design. This will enable wider developer participation at low cost, in turn attracting investor interest. Staking will further widen investor participation and reduce the volatility of the underlying token – creating a virtuous cycle of growth as new protocols become sustainable environments for investors and developers alike.
  4. Developers of new protocols can monetise their efforts directly by holding the associated token – this incentivises further innovation at the protocol layer (and has in some cases delivered venture-scale returns in relatively short time).

Hence, new protocols have surfaced, and developers are beginning to vote with their feet. New entrants have built meaningful market cap – including Polkadot, Cosmos, Algorand, and more recently, NEAR and Solana.

What would it take for these newer blockchains to reach durable mainstream adoption? The key foundations are:

  • Enablement of new applications. For new protocols, a large developer ecosystem is a vital indicator of success. We’re excited by those offering accessible devtools / SDKs that allow dapps and smart contracts to be built in popular languages. NEAR’s proposition of quick dapp deployment using Rust / AssemblyScript is a great example.
  • Scalability and consensus. Protocol innovation is often about seeking the most efficient way to agree on an immutable and decentralised ledger. The move away from Proof-of-Work is key: we think the future may involve a widespread shift from computationally-intensive mining to Proof-of-Stake algorithms. Algorand’s Byzantine Agreement protocol, for example, promises to bridge the potential trade-off between scalability and security.
  • Security: Users’ trust is an obvious hygiene factor for users to hold high-value assets, and build enterprise applications. By definition, new protocols lack the security inherent in a very high hashrate (hence the much-feared 51% attack) – and must be able to articulate fault-tolerance at the protocol layer.
  • Governance / decentralisation: As a new protocols scales, a key challenge is to democratically align the incentives of its growing stakeholder base, while maintaining the necessary structural decentralisation.
  • Interoperability: Numerous protocols focus on the search for a standard mechanism to share assets between blockchains. If a common standard emerges, this may create a dramatic growth in liquidity and smooth token-specific price volatility. Cosmos and Polkadot are building a growing bank of use cases (our portfolio company Centrifuge being active in the Polkadot ecosystem).

As the chessboard of new protocols arranges itself, there is scope for great optimism. New protocols may attract a virtuous circle of developer and investor interest, creating new economic value and serving new use cases. There is also plenty of uncertainty.

Will the existing leaders (Bitcoin and/or Ethereum) be able to organically evolve to overcome their current challenges, to maintain their first-mover advantage and early leadership? Will Proof-of-Stake protocols provide the security needed at scale to attract wide user bases? Will protocol tokens be regulated in the way that conventional securities are? And as the dust settles on these questions, which protocols – if any – will eventually become successful?

If you are working on something that will help us navigate this idea maze, we’d love to chat.