When predicting how the cryptocurrency economy will evolve, many people have looked to the start of the internet itself. They imagine certain standards or protocols becoming dominant, with value accruing in the application layers.
But cryptocurrencies are different.
Value is captured within a coin’s economy rather than just in its code and in the way an application is monetized. In addition, value (measured by price and market cap) keeps moving from layer one (L1), like Bitcoin and Ethereum, to layer two (L2) and application protocols that are being built on top of L1, such as Cosmos, Hiro and Uniswap.
With full interoperability, and with blockchain agnostic protocols such as The Graph, L1 blockchains may become just rails with fees attached. Most value will move into agnostic protocols and use-specific blockchains.
To understand where value is being captured and on what layer it is being created, it’s useful to review the evolution of L1 and L2 over the last decade.
One coin to rule them all (2011–2015)
That was the approach of Bitcoiners in the early days, myself among them. There was one blockchain and one platform to power all digital asset use cases and applications.
When people started to think about the technology beyond bitcoin as a currency, the first technologies to market were protocols developed on top of Bitcoin, such as Colored Coins, Counterparty and Mastercoin (Omni), then referred to as “Bitcoin 2.0.”
In 2012, when I started working on Colored Coins with a group of early Bitcoiners (Vitalik Buterin among them), not many were thinking beyond building on top of Bitcoin. To me at least, it was 100% clear that Bitcoin would be the only significant platform, and that by using L2, it would create digital asset use cases leading to the decentralization of finance (DeFi).
Others, such as the founders of Ethereum, Ripple and more, were confident that a second wave of innovation could evolve without building it on top of Bitcoin, given Bitcoin's limitations and governance principles. They were convinced that a better platform could be built to suit all kinds of use cases.
Developers spent years trying to “solve” Bitcoin problems. But maybe people finally realized there is no problem to solve. Bitcoin is what it is.
That phase of evolution envisioned a blockchain as a protocol standard, like the “TCP IP standard,” as a layer on top of Bitcoin.
The 'sandbox period' and ERC-20s (2015–2019)
With the Bitcoin blockchain not able to satisfy the innovation needs of the use cases that had been built on Colored Coins and other Bitcoin 2.0 layers, and with the acceleration of Ethereum-based innovation, all the cool kids started to build on top of Ethereum. It was a much better platform for testing, scaling and creating far more complex use cases in one of the biggest financial sandboxes in the world.
The ICO (initial coin offering) period of 2017–2018 saw funding for many different use cases, along with a growing community of developers and a critical mass using Metamask. It became clear that Ethereum was taking the lead, becoming the go-to place to build your blockchain dream use cases. The ERC-20 standard won.
The Ethereum community invented DeFi and made it the killer real-life use case. With Bancor being one of the first, a full industry started to form, including alternatives for loans, flash loans, yield farming and more. It quickly became the go-to for building applications, while Bitcoin was left behind as a platform, becoming maybe what it was “only” supposed to be – new and better gold. At the same time, new generic sandbox platforms started to emerge, including Polkadot and Cardano created by Ethereum's founders.
Use-specific blockchain interoperability (2019–2025)
It is close to impossible to develop a blockchain that perfectly fits all use cases. For example, using blockchain for micropayments is different than using it for NFTs. You can still develop NFT applications and use them on top of Ethereum. But wouldn't you prefer a blockchain and an ecosystem of tools tailored for your specific use case?
On the back of the painful gas fees attached to using Ethereum (which also proves an incredible market fit for DeFi), there are talented teams, such as Cardano and Polkadot, trying to build other sandbox blockchain approaches like ETH, adding better scale, interoperability and other features.
As we are still in an emerging technology phase, anything and everything can happen. But the question that is most interesting to investors is where most of the value will be captured in terms of layers?
The answer, I believe, depends on the use case.
I believe that in some use cases, value will be captured on L1, and with some use cases, value will be captured on L2.
L1 and L2 value capture
More blockchains are choosing a niche market, understanding they cannot win in the race of a “blockchain for everything,” and deciding to be the go-to blockchain for a specific market. This is where we will see value being captured on L1 being the “go to“ blockchain for a specific use case. I envision this trend will keep accelerating.
Take the USDC stablecoin. Will you send your dollars on an expensive and slow blockchain, such as Bitcoin or Ethereum? Or will you use a fast and low fees- based network, such as Algorand, that is focusing its resources on building the financial rails?
FLOW was built for the NFT market and developed by the leading team that had experienced the disadvantages of using Ethereum with CryptoKitties. In my opinion, FLOW is one of the most exciting consumer-based blockchains, working with the National Basketball Association and other big players.
We used to think that L1 should always be more valuable than L2 as all L2 protocols are being built on the foundation of an L1. It’s kind of similar to thinking of an app (L2) being built only on top of IOS (L1) and being worth more than the Apple stock. While rarely possible in the centralized world with Apple owning the app store, this is easily possible in the crypto decentralized world.
For example, The Graph is one of the projects that makes you question that assumption. Its agnostic approach creates value on top of different L1 chains as well as for users looking to index the different chains.
In the long term, I foresee each blockchain L1 will be “tagged” with a specific market, becoming the “blockchain for...” Those with no specific identity, that are trying to be a bit “better,” might “lose” their value to L2 while being measured only by their fees, just like banks today.