Crypto Business Models

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Crypto is now filled with networks that have entire ecosystems of applications on top with their own methods of value capture.

Sure there are a small subset of builders “in it for the tech”, but crypto has increasingly trended towards crypto as a business model, even at the application / protocol level.

For every passionate engineer, there has to be a commercially-motivated business person who slots their technical brilliance into the market. Of course, this can also be done by just one person.

The path of building the future of finance mandates that there is a market for the tech that gets built. Otherwise, you end up with a bunch of cool tech that no one uses. This ghost tech is not disruptive in any way. That doesn’t mean just go for the tried and true. In fact, more experimentation is best in crypto which still has so much greenfield space to build on. All it means is that projects should aim to create or serve real markets along the way.

The Layer 2 Business Model

With two layer 2 airdrops in the month of June, it’s a good time to cover exactly how Layer 2s think at a business level. These are not all going to be money-losing tech startups burning VC money on their way to unicorn valuations!

Layer 2s essentially batch transactions and send these batches to Layer 1 for settlement. This lets L2s provide low gas costs and higher throughput to users than a congested Layer 1.

To generate these transactions, L2s still need users. These users need applications to use. Users interact with applications and generate transactions. Those transactions produce gas fees. Part of these gas fees paid by users goes towards paying for L1 settlement (e.g. Base pays gas on Ethereum). The other part is kept by “sequencers” as revenue. This makes sense, since running software and handling the tasks of transaction ordering, batching, and submission is a service sequencers are providing to the L2.

Currently, L2s are largely centralized and sequencer revenue is internalized. That’s why we consider L2s to be more like “businesses”, and also partly why you see a proliferation of L2s (huge fees if successful!)

Source: Token Terminal

Based on data from Token Terminal, YTD revenue for the leading layer 2s was $154 million, with Base capturing a third of the market share. Note that as an Optimism “Superchain”, Base gives 15% of its sequencer revenue to Optimism.

What does this tell us about L2s? Activity, as defined by transactions is the most important thing. Sure, there are long-term business reasons for L2s to want to avoid certain activities (obviously anything illegal is a risk) but overall, these L2s don’t really need to care about what people do onchain, only that they do something.

This topic is quite interesting in the context of the recent Blast airdrop. Blast actually redirects sequencer fees to the dApps the fees came from. How do the earn revenue? Well, the gas fees operate on a maturity schedule of 30 days, where instant claiming gets a 50% rebate, and claiming after 30 days gets 100%. Blast’s sequencers will receive the remaining gas dApps that claim prior to maturity. This is quite useful for dApps because running a protocol, contrary to popular opinion, is not free! Depending on the protocol it can be gas intensive.

The bigger takeaway? Gas costs are a race to zero, so L2s are user-maxxing. In other words, whoever gets the most users, wins. How might a L2 do that? Applications!

The L2 arms race is all about the applications which draw users in and keep them engaged (and actively transacting). Building a breakout application isn’t that easy, and in crypto it’s common for successful applications to be ported across different ecosystems to capture any obvious market demand. That means it’s actually quite a competitive industry, despite still being somewhat early in the adoption cycle.

To compete L2s generally want 1) some unique factor/thesis for user acquisition and 2) some form of lock-in/incentives for applications to build on their L2 over somewhere else.

Base is a good example of an L2 with an angle that is difficult to replicate. The Coinbase marketing engine brings in both non-crypto retail users as well as crypto native speculators who use the ecosystem in anticipation of more retail users in the future. The corporate backing of Base is quite evident in their focus on use cases that go beyond purely financial, such as decentralized social like Farcaster. This also benefits Optimism, which may have far less retail user penetration but is able to capture some of the growth of Base by making its OP Stack available to them.

Blast on the other hand takes an entirely different approach, creating an ecosystem that offers 1) native yield and 2) gas rebates to dApps. While most of the attention is focused on the user “casino” for gold, points, and Blast tokens, there is in fact a deeper underlying value for builders if they can find a way to use the native yield or gas rebates towards a unique value proposition.

dApps

There are far too many nuances across dApps / protocols to cover every type of business model but we can boil down nearly every major crypto protocol in one word: marketplace.

Crypto dApps and protocols are almost all marketplaces. Some examples:

• Miners and users transactions

• Borrowers and lenders

• Liquidity providers and traders

The above examples are of course massively simplified. Most crypto protocols are multi-sided marketplaces.

Take Maker for example. Its marketplace participants are:

• Borrowers (CDP holders)

• Lenders (Dai holders)

• Liquidators who participate in auctions

• Governance participants (MKR holders)

Matching supply and demand across all these participants requires a careful balance between the technical aspects of a protocol and coordination of enough high-value attention (i.e. capital providers) to execute.

In terms of value capture, most of DeFi operates on a fee structure that takes a percentage fee on whatever value is created (yield) or exchanged (swaps).

Maker’s revenue sources are:

1. Stability fee (interest rate paid by borrowers)

2. Liquidation penalties (fees when borrowers are liquidated)

P.S. We built an entire course that breaks down how DeFi protocols work in-depth at the Academy, check it out if you’re interested in diving in at a foundational level.

Symbiosis

The magic happens when the ecosystem layer (L1/L2) and the application layer work in unison to create a unique user experience with a high degree of lock-in. Crypto is the home of any and every incentivized experience you could think of. Blast directly incentivizes usage of certain applications through “gold” and “points” which earn users Blast tokens. These incentives along with native yield can make it such that projects can reduce their fees, which also benefits Blast by locking in more apps to their ecosystem. Other L2s operate grant programs through which projects are directly compensated for building specific projects that meet the L2’s goals.

This is in stark contrast to last cycle. In the 2021 era, we saw DeFi protocols and DAOs that had formed huge treasuries issue grants to build out their surrounding ecosystems on Ethereum L1 (or do nothing at all!). With so much venture capital funding having moved to the infrastructure layer, the L2s now fund or incentivize projects and initiatives in a competition for the best dApps.

Why is this Important?

It’s important to understand that the L2 ecosystem has become the focal point of the cryptoverse (at least as it pertains to Ethereum). There have been a lot of critiques of this model due to the “fragmented liquidity” created by these L2s as capital on one chain cannot be used without transferring it to another chain. This creates inefficiencies (and smaller scale opportunities). We offer a different perspective: liquidity within the winning ecosystems will be sufficient to meet most needs. Whales can, and still do, use Ethereum mainnet.

As an example, if Base can onboard a large group of its Coinbase users the liquidity will chase this userbase. The only reason people are not as bullish on Base is because Base does not have a token (and may not have one). To that we say.. should’ve bought some $COIN!

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Disclaimer: None of this is to be deemed legal or financial advice of any kind. These are opinions from an anonymous group of cartoon animals with Wall Street and Software backgrounds.

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