Polymarket's trajectory, however, tells a more nuanced story.

Metrics at Their Peak and the Aftermath

At the height of the election frenzy, Polymarket achieved remarkable metrics:

• Daily Active Wallets (DAW): Climaxed at 50,000 users.

• Daily Transactions: Peaked at over 500,000.

• Daily Volume: Reached a staggering $350 million on November 6th.

• Cumulative Open Interest: Surpassed $720 million.

Following the resolution of the US election markets, these numbers predictably fell. After one month and at approximately 30,000, DAW almost halved from its all-time-high, but managed to maintain similar levels of activity as the weeks just preceding the election day.

Similarly, transactions dropped to around 200,000 per day, matching activity levels of October. Daily volume stabilized at about $40 million, again the same levels of October. Open interest took the hardest hit, falling 7x to $100 million but showing signs of a gradual rebound, and one month after resolution it’s already back to almost $250 million.

Despite the drop-off in activity, Polymarket has retained a resilient core of users. The data reveals several key insights.

Retention Beyond the Elections: Many users initially drawn by the US election markets likely transitioned to other prediction categories, such as the Federal Reserve’s interest rate decisions, geopolitical conflicts, cryptocurrency price movements, and above all sports events. This retention speaks to Polymarket’s ability to engage users beyond a single, marquee event. Interestingly, the average bet size has been picking up again after a sharp drop.

Diversity: Despite the dominance of election-related markets during the peak, currently almost 30% of the daily unique wallets has never placed any bet related to that event.

Since the end of the US election, the total number of daily unique wallets (blue) has remained relatively stable, suggesting that the influx of new users is limited, or is offset by existing users who became inactive. At the same time, the number of daily wallets that never engaged with US election markets (red) has been increasing significantly since the end of October, after remaining low during the campaign’s climax in the summer 2024. Correspondingly, the ratio of non-election market participants (yellow) has also risen to about 25%, showing that the relative importance of non-election-related activity is growing compared to election-focused markets. Overall, the number of unique daily wallets that never engaged with US-related markets has increased dramatically during the past year and currently represent about a quarter of all users.

This suggests that the US election markets acted as a catalyst, drawing attention to Polymarket and attracting new users. These new cohorts likely joined the platform after the resolution of the election markets and began engaging with other markets. Meanwhile, users primarily focused on election markets likely reduced their participation. As a result, the total user base remained stable, but there was a noticeable shift in user composition and activity, leading to a significant increase in the ratio of non-election-focused users.

Challenges: With two unresolved election-related markets accounting for almost $100 million of open interest, another big drop is expected when these markets close in January. Until another high-profile event captures global attention, sports markets are likely to dominate the platform’s activity.

The Role of US Elections as a Catalyst

The US elections clearly served as a strong gateway, bringing prediction markets to a wider audience. However, Polymarket has demonstrated its capacity to turn this spike in interest around a single issue into ongoing user engagement. This success could be attributed to Polymarket's ability to strike a balance between speculation (betting) and utility (information).

This unique blend has allowed the platform to create a durable, sustainable product that continues to attract and retain users, as reflected by the growing popularity of its app compared to other major media outlets:

A Sustainable Future?

Polymarket’s post-election resilience illustrates the platform’s maturation and adaptability. Unlike Augur, whose activity cratered after its peak, Polymarket has retained a significant portion of its user base and volume. This resilience points to a sustainable ecosystem that thrives on a blend of speculation, information discovery, and diverse market offerings.

As Polymarket looks to the future, its challenge will be to maintain momentum in the absence of singular, high-stakes events like the US elections. The coming months will test whether the platform can attract users with other types of markets, continuing to bridge the gap between entertainment and information. While I anticipate a second surge of new users and activity during the next election cycle, four years is a significant timespan—especially in crypto. During this period, numerous new apps are likely to emerge, potentially replacing Polymarket as it once did with Augur and other early prediction market platforms.

Extra: The Comparison with Augur

Augur’s story, when examined more closely, also reveals a more nuanced and interesting narrative than it might initially seem.

First, it's important to understand the differences in timeline and the structure of its election markets compared to Polymarket. While Polymarket had one major US election market that resolved almost immediately after the vote in November 2020 and experienced a sharp drop in value shortly thereafter, Augur's timeline was more eventful. Augur, and its main interface Catnip, had three major election-related markets, each with different resolution dates:

1. The first market, "Will Donald Trump win the 2020 elections?", expired on January 8, 2021, and was resolved without disputes by January 10, 2021.

2. Another market, "Who will win the 2020 election?", expired on December 20th but was only resolved on January 14, 2021 due to a long dispute, and saw around $250k in volume and $160k in open interest.

3. The largest Trump-related market, again "Will Donald Trump win the 2020 elections?" with about $12 million in open interest, expired on January 22, 2021, but it was only settled after a dispute period on February 11, 2021.

The delays in market resolution were partly due to the immature dispute resolution mechanisms adopted by Augur, and partly due to the legal challenges mounted by Trump against the election results.

Another important detail is how the total value locked is measured. While Augur's TVL in USD saw a sudden drop from a peak of $13 million to $3 million—more than a 4x decline—the picture changes when measured in ETH. The outflow of TVL started earlier and occurred more gradually than it did when viewed in USD. More importantly, Augur’s TVL in ETH plummeted from 19,000 ETH to just 700 ETH, a catastrophic 20x decrease that far surpassed Polymarket’s 7x drop in TVL. This difference is primarily due to the rapid rise in the price of ETH during those weeks.

Polymarket has emerged as a rising star in consumer crypto, especially driven by the upcoming U.S. presidential election and the related events. Many crypto experts have praised Polymarket’s success in achieving product-market fit, notably without relying on tokens or external incentives. As of this writing, Polymarket has once again hit an all-time high in daily and monthly active users, as well as in daily and monthly transactions. In terms of total volume, it is nearing $500 million in monthly trades for the third consecutive month.

Besides its success in most metrics, observers have praised its role as a more timely and nuanced source of information compared to traditional media, polls, and other public opinion channels. As Nassim Nicholas Taleb wrote in Skin in the Game: Hidden Asymmetries in Daily Life, “Don’t tell me what you “think”, just tell me what’s in your portfolio.”

In August, Bloomberg even started including Polymarket’s odds in its terminal service as an additional data source for analytics.

Let's explore the differences between prediction markets like Polymarket and traditional polls, along with other proxies of public opinion, such as social media and expert commentary. Each of these channels helps us gauge sentiment and make forecasts about future events.

Grassroots vs. Top-Down Dynamics

• Polymarket, like other permissionless prediction markets (e.g., Drift’s BET on Solana, or Wintermute’s OutcomeMarket, an open-source multichain US election prediction market), operates as a fully decentralized, blockchain-based platform. Since anyone can create new markets and place bets, these prediction markets are inherently grassroots. The financial skin-in-the-game, combined with the need to exploit information asymmetry to win, motivates participants to gather and act on the best possible information, making the platform expertise-dense.

• Expert commentary from outlets like The New York Times, The Economist, and The Wall Street Journal is highly expertise-dense, often with reputational stakes. However, these opinions represent a limited subset, strictly aligned with editorial guidelines, which makes them highly top-down.

• Traditional polls (e.g., YouGov, Ipsos, Pew Research) focus on gauging political convictions and beliefs rather than expectations. They typically rely on limited randomized sampling with mixed expertise, lacking the financial incentives that drive better-informed predictions in markets like Polymarket. Traditional polls are driven by deliberate research design choices which may also include biases, so it’s more towards the top-down approach.

• Social media allows everyone to express their opinions, making it grassroots by nature. However, centralized platforms are driven by highly-opinionated algorithms and selective censorship, making them far less grassroots compared to platforms like Polymarket. Moreover, fake news and disinformation campaigns, often driven by swarms of bots, create a high-noise, low-signal environment, making it difficult to filter out informed opinions and verified facts. This lowers the overall quality of discourse, leading to a tendency toward dilettantism.

Intention vs. Expectation

Polls and prediction markets fundamentally ask different questions. In the context of a political election, traditional polls ask, "Who will you vote for?"—capturing individual intentions and preferences. Prediction markets, however, ask, "Who do you think will win?"—with financial incentives for accurate predictions, regardless of personal preferences. These two perspectives—intention versus expectation—often don’t align. The possibility of hedging against undesired outcomes further complicates the distinction (e.g., betting on Trump while supporting Biden). While both methods aim to forecast future events, this difference explains why poll results and prediction markets often diverge.

Influence on Event Outcomes

Another element to consider when thinking about prediction markets is the degree of influence that the user placing the bet has on the event. This variance makes multi-domain bets significantly different from sports-only bets.

In some cases, prediction markets reflect events where participants have direct influence over the outcomes, as is seen in elections. Here, the market dynamics can mirror the collective actions and decisions of voters, though it’s worth noting that U.S. citizens are not permitted to use platforms like Polymarket for this purpose.

In other scenarios, such as with inflation or economic policies, the influence is more indirect. Market expectations can shape behaviors that, in turn, influence outcomes. For instance, if households expect an interest rate cut, they may delay spending in anticipation of a more favorable economic environment. When this kind of behavior becomes widespread, it can help keep inflation low, potentially encouraging the central bank to actually lower interest rates. This is a classic case of a self-fulfilling prophecy, where the expectation of an event (the rate cut) leads to actions that bring about the expected outcome.

Finally, there are also events where participants have no influence at all, such as in sports competitions or natural phenomena. Here, prediction markets are purely speculative, as participants cannot affect the final outcome in any way.

Financial Upside and Volatility

Since prediction markets work 24/7 and reward accuracy, participants in Polymarket are far more reactive to real-time news than poll respondents. This volatility, which represent another major unique characteristic compared to traditional channels, can lead to more reactive and accurate measurements, but it can also skew market results, as it seemed the case in the disparity between Polymarket's odds and traditional polls during the 2024 Biden-Trump election campaign.

Case study: the Biden-Trump 2024 Election Dynamics

Throughout 2024, Polymarket consistently showed Trump with a lead of several percentage points over Biden, even when traditional polls indicated a much closer race. Furthermore, the gap fluctuated significantly following major events, such as the first public debate or the attempted assassination of Trump. In contrast, traditional polls remained more stable throughout. Many commentators expected market forces and arbitrage to correct this gap, but it persisted until Biden's official withdrawal. On the other hand, looking at traditional polls, we would have thought that Biden had similar chances of winning as Trump. This looked like the typical example of extreme volatility of prediction markets.

This chart clearly shows the significant impact the first debate had on public opinion, with bets in favor of Biden plummeting from nearly 40% to around 10% within just a few days. Interestingly, by the time the official withdrawal was announced, Polymarket had already priced in the outcome, with Biden's odds hovering close to 0%. In contrast, traditional polls continued reporting similar percentages as before.

This apparent distortion actually reveals a powerful dynamic: Polymarket participants likely anticipated Biden’s potential withdrawal (a scenario with its own dedicated market on Polymarket), and adjusted their bets accordingly, which led to consistently lower betting on Biden. In other words, Biden's chances of winning might have been lower because the market had already factored in the possibility of his withdrawal. If Biden’s candidacy had remained secure, the chances of him winning over Trump may have been higher, with numbers similar to what traditional polls kept showing until the official withdrawal.

Not coincidentally, with Biden officially out of the race and the looming possibility of withdrawal canceled from the equation, Polymarket’s election market (Harris vs. Trump) has stabilized and almost perfectly aligned with traditional media polls.

This chart illustrates how Polymarket’s bets in favor of Harris shifted after the first debate and, more notably, following Joe Biden's official withdrawal. Interestingly, odds for Trump also declined with Biden's announcement, eventually reverting to levels more in line with traditional polls.

In traditional polls, the probability that a specific candidate may win can be inferred by the amount of perspective votes the candidate receives compared to the total votes:

This reflects a binary view, where pollsters assess only the relative support between candidates, without accounting for complex external factors.

In prediction markets, on the other hand, participants often incorporate second-order considerations, such as the possibility of unexpected events (e.g., a candidate withdrawing). So, the equation for estimating the probability could be expanded to:

This additional factor—Biden’s potential withdrawal—demonstrates how prediction markets account for broader scenarios, leading to different results compared to traditional polls and commentary channels. By considering factors like withdrawals, scandals, or health issues, prediction markets capture not just head-to-head probabilities, but also second-order and tangentially-related events.

This distinction highlights the value of prediction markets as more dynamic and nuanced predictive tools for complex events.

In the growing landscape of crypto consumer applications, Polymarket has emerged as the most successful product in the first half of 2024. Launched in 2020, this platform leverages blockchain technology to create a hybrid-decentralized prediction market, allowing users to bet on future outcomes across a wide range of topics.

What sets Polymarket apart is its expansion beyond traditional betting domains. While sports betting has long been popular, both offchain and onchain, Polymarket extends into realms such as politics, economics, and global events. This broad scope allows users to put their money where their mouth is on topics ranging from election outcomes to economic indicators and even geopolitical events.

The concept behind Polymarket aligns closely with the ideas presented in James Surowiecki's "The Wisdom of Crowds." By aggregating predictions from diverse participants on different topics, Polymarket aims to harness collective intelligence, potentially leading to more accurate forecasts than individual expert opinions.

In May 2024, Polymarket's potential was further validated when it secured a substantial $45 million in Series B funding. This investment, backed by notable figures including Peter Thiel's Founders Fund and Ethereum co-founder Vitalik Buterin, signals strong confidence in the platform's future.

How Polymarket Works

At its core, Polymarket operates on a simple principle: users can buy shares representing different outcomes of a future event. Technically, users split one unit of collateral (USDC) into binary outcome tokens or merge them back into collateral, maintaining a market price that sums to one unit of collateral. The price of these shares (Gnosis Conditional Tokens ERC-1155) fluctuates based on market demand, reflecting the collective prediction of the event's likelihood. The position price moves in real-time, like any other token or asset, so users can sell before resolution to make a profit. Otherwise, when the event concludes and the outcome is available, those holding shares of the correct outcome receive a payout of 1 USDC per share.

Polymarket offers two types of markets:

1. Single multi-outcome markets: present straightforward scenarios with multiple possible outcomes for a single question. For instance, “Biden drops out of presidential race?” supports two possible outcomes: Yes or No.

2. Mutually exclusive binary markets: break down complex scenarios into multiple yes/no questions, each focusing on a specific outcome. For instance, “Presidential Election Winner 2024” can be broken down into single questions, each for each candidate (”Will Joe Biden win the 2024 US Presidential Election?” or “Will Donald Trump win the 2024 US Presidential Election?”), each supporting two possible outcomes.

Polymarket is a hybrid-onchain: while order matching is done offchain by a network of operators, all bets are settled on the Polygon blockchain, providing an immutable record of all market activities.

Architecture

Usage and Activity (on July 1st, 2024)

With over 46,000 unique wallets registered, Polymarket has had modest daily active users (DAU). However, since May 2024, the number of DAUs has skyrocketed, leaping from an average of under 300 to over 2,000.

This dramatic increase is punctuated by significant fluctuations—over the past month, DAU varied by as much as 1,000 between peaks and troughs, suggesting that the presence of particularly 'interesting' bets can drive substantial activity.

One such example, and the most notable one, pertains to the US presidential election, the largest market on Polymarket by volume. A dramatic spike occurred on June 28th, the day following the first US presidential debate, with unique wallets interacting on the platform surpassing 3,500 for the first time.

Another interesting take is about the type of markets users engage with. The majority of daily users engage with either NegRisk or CTF markets, evidenced by the total DAU being roughly the sum of DAU for these two market types. Correlation coefficients of 0.19 for both market types suggest a moderate positive relationship between activities in these markets, indicating that participants tend to favor one market type without necessarily participating in the other.

The number of daily transactions has increased sevenfold since May 2024, with a remarkable peak of over 22,000 transactions on June 28th, likely driven by the first US presidential debate. Despite a subsequent decline, the overall level of activity remains significantly higher than pre-debate levels.

Despite the tenfold increase in DAU and daily transactions since May 2024, the rise in daily and monthly volume has been less pronounced. However, June has surpassed May, becoming the highest volume month to date, with the first-ever monthly volume exceeding $100 million. The first US presidential debate again triggered a significant influx of capital, with a $10 million volume on June 28th.

The disparity between the surge in DAU and transactions versus the slower volume growth may indicate an influx of users with lower financial means or risk tolerance, resulting in a decrease in the average bet amount. On June 28th, the average bet amount was 212 USDC for CTF markets and 198 USDC for NegRisk markets. By July 1st, these averages had shifted slightly to 203 and 197 USDC, respectively.

NegRisk markets, despite having a slightly lower average bet amount than CTF markets, have contributed the most to DAU, daily transactions, and overall volume. An inflection point in the monthly volume chart is noticeable around December 2023, shortly after NegRisk markets were introduced.

The Number of txns and average amount per user, per market type chart shows the distribution of unique wallets, the number of bets placed in each market, and the average bet amount. Some users place numerous smaller bets, while others place fewer, larger bets.

June also saw the highest number of questions initialized, serving as a proxy for new markets created, surpassing the previous record set in March 2023.

According to Questions Statistics, 85% of the initialized questions have been resolved, with 15% still awaiting outcomes. Remarkably, there have been no flagged questions or emergency resolutions, which is surprising for a system relying on an optimistic oracle that accepts challenges, considering there have been instances of disputed outcomes. While disputes have occurred in forums and channels like Discord, they have not escalated to official dispute-resolution mechanisms.

The Number of operators statistic is also notable, with only five operators identified so far. Polymarket, designed as a hybrid on-chain market, relies on a few operators to match orders off-chain.

Navigating Challenges

While Polymarket offers an exciting new way to engage with current events and future predictions, it's not without its challenges. Regulatory issues have been a significant hurdle, with the platform facing legal scrutiny in the United States. In January 2022, Polymarket was required to pay a $1.4 million civil penalty to settle charges with the Commodity Futures Trading Commission (CFTC), and it’s currently forbidden to operate in the US.

Additionally, Polymarket faces potential challenges in enforcing outcomes. Because the events tracked by the bets and conditional tokens occur offchain, the platform depends on oracles to relay outcome information, which in turn relies on individuals to report these outcomes. As the ETH ETF approval case showed, this can lead to misunderstandings or disagreements about specific events and their interpretations. While outcomes can be challenged, similar to the state validation in optimistic rollups, this mechanism hasn’t been used yet.

Another consideration for users is the potential for misleading data. While prediction markets are often seen as more reliable indicators of public opinion than social media, the motivations behind bets can be complex and not necessarily reflect true preferences. Specifically, prediction markets are futures markets that can be used to hedge and protect against unfavourable events. For example, one might bet against the supported political candidate as a hedging strategy (”My favourite candidate lost the elections, but at least I earned some money on Polymarket” or vice versa). This could distort the market's predictive accuracy about future outcomes.

In the lead-up to the 2024 U.S. Presidential Election, Polymarket's predictions show some divergence from traditional polling data. This discrepancy highlights the importance of understanding the underlying dynamics of prediction markets when interpreting their data.

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As we can see, the first US presidential debate on June 27th significantly impacted Polymarket bets and users’ expectations. In contrast, traditional polls showed a much smaller effect. This disparity serves as a cautionary tale: when money is at stake, decisions tend to be more radical and immediate to limit losses or seize opportunities than decisions made based on ideological beliefs.

Reimagining Prediction Markets

Prediction markets like Polymarket have the potential to be even more successful by achieving a balanced blend of information, entertainment, and financial incentives. Currently, the element that may be lacking is comprehensive information. By developing a dedicated area for news and blogs that delve deeper into various topics, prediction markets could add significant value for users and society.

By incorporating information, analysis, and debates from reliable sources, prediction markets like Polymarket can aim to become the next evolution of information delivery. Just as newspapers, television, and social media each revolutionized how we receive information, prediction markets could synthesize these mediums, combining comprehensive information, entertainment through betting and forums, and financial upside.

This shift could help reduce the stigma associated with prediction markets as mere forms of gambling and potentially assist Polymarket in addressing regulatory concerns. Additionally, incorporating links to polls from reputable sources such as 538, The New York Times, or IPSOS would enable users to make more informed decisions.

By integrating these informational resources, Polymarket could better support its users in understanding and predicting outcomes. This would thereby solidify its role as a credible and valuable platform in the prediction market space and potentially transform the landscape of information delivery.

Conclusion

Despite some challenges, Polymarket continues to thrive and innovate, as evidenced by the recent record-high activity levels. This is because Polymarket, unlike traditional prediction markets, transcends geographical and thematic barriers, offering a comprehensive snapshot of global public opinion across multiple areas of interest. Additionally, by building on the blockchain, Polymarket integrates the dynamics of prediction markets with a native financial infrastructure.

Many users now habitually check the Polymarket homepage alongside traditional news sources to gauge global events and public opinion. This trend could only consolidate if Polymarket adopted a more intentional strategy to become a source of reliable information besides a thermometer of public opinion.

As the platform matures and navigates regulatory landscapes, it is poised to play an increasingly significant role in how we predict and prepare for future events.

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Resources:

• Polymarket dashboard on Dune Analytics: https://dune.com/filarm/polymarket-activity

Leveraging the power of Dune to access and interpret blockchain open data, this article explores the growth paths of Lens and Farcaster, two pioneering platforms in the decentralized social (DeSo) space. Farcaster has introduced many innovative web3 features while successfully maintaining a more traditional Web2 approach and catalyzing user engagement within one app. It streamlines the onboarding process without requiring a wallet, manages most interactions off-chain, and incorporates the well-known Facebook’s Open Graph to power Frames. In contrast, Lens is carving out a niche by more purposefully fostering a diverse ecosystem of applications built upon a shared social graph. Lens excels in nurturing the creator economy and enabling direct monetization strategies, paving a new path for platform growth in the decentralized web. While running on different rails, Lens and Farcaster share a common goal and vision and, interestingly, have been converging around some common elements.

A Common Vision

Unlike traditional platforms, which operate in isolation with their own unique social graphs, Lens and Farcaster embrace the web3 concept of composability. Each utilizes a unified protocol that stores identities and a shared social graph, allowing for the development of multiple, fully interoperable applications or clients. Another shared principle is the emphasis on data ownership, granting users complete control over their content and data. Ultimately, both platforms strive to cultivate new economic ecosystems around creator-centric communities.

Despite these commonalities in vision and objectives, the architectures and designs of Farcaster and Lens present some differences:

Decentralization

The most distinctive difference between Farcaster and Lens is the different approach to decentralization and the use of blockchain technology. Farcaster describes itself as a "sufficiently decentralized protocol," highlighting a strategic balance between decentralized elements and user experience. Farcaster aims to integrate on-chain elements selectively, ensuring that the core benefits of decentralization—such as user control over data and identity—are preserved while maintaining a smooth and accessible user experience and ensuring performance and scalability. On the other hand, Lens adopts a more blockchain-centric approach. By embedding more functionalities directly onto the blockchain, including the tokenization of interactions like posts and follows, Lens offers a fully decentralized environment where every action is transparent, verifiable, and inherently resistant to censorship.

Both Farcaster and Lens have integrated with Dune, meaning their data-rich ecosystems are available as intuitive databases, ready to be queried, visualized, and interpreted.

Activity and Ecosystem

Farcaster and Lens have each carved out their niches within the growing field of decentralized social (DeSo), forming robust communities with sustained activity levels.

These Dune counters show that the two apps have similar numbers of total active users.

The two apps have taken different approaches and each has met its own successes. While initially putting a strong emphasis on developer involvement to create a robust ecosystem of applications utilizing the shared protocol, Farcaster has eventually attracted a robust and lively community around its primary client, Warpcast, significantly bolstered by innovative features like Channels and Frames. These features have enhanced user engagement by expanding the functionality of the platform and propelled Farcaster to levels of activity and engagement previously unseen in web3 social, succeeding at winning the same game as web2 incumbents.

Since the beginning, Lens has had a focus on attracting a vibrant community of developers and creators focused on exploring new economic models within social media. While showing slightly less activity in terms of posts and reactions, Lens has excelled in fostering a broader ecosystem where a variety of applications coexist and thrive on a shared protocol layer. This approach has allowed Lens to not just cater to a wider audience but also to encourage a fertile environment for creativity and innovation. By enabling multiple apps to operate over a common infrastructure, Lens has effectively diversified the applications and experiences available to its users, underpinning a vibrant and dynamic network of decentralized social media applications. As a result, Lens has succeeded where many have failed, moving away from the more traditional monolithic approach of web2 social and embodying the ethos of web3 interoperability.

Lens and Farcaster activity comparison by @filarm

Lens Protocol by @sealunch

As the first Lens dashboard on Dune shows, Lens users use a variety of apps built on the shared protocol and social graph, with Hey, Phaver, and Orb capturing the majority of users. The second visualization shows how a majority of Lens users focus on one app, but almost 20% use two apps and almost another 20% use three or more apps. Combined, these two visualizations show signs of a healthy and balanced ecosystem growing on a shared protocol.

A Comparison of Open Actions in Lens and Frames in Farcaster

Lens’ Open Actions allow for a variety of interactions directly from a publication, such as tipping, minting, or swapping NFTs, collecting publications, and participating in on-chain activities like raffles and polls. These actions are executed through modular smart contracts that integrate with the Lens protocol, allowing developers to create diverse functionalities, and facilitating direct monetization and interaction between users.

Frames in Farcaster are essentially mini-applications or widgets that can run within the Farcaster network, offering a range of interactive features. They provide developers with the tools to create interactive and dynamic content directly within the Farcaster environment, enhancing the user experience with diverse applications. Popular frames include reading articles inline from Mirror or Paragraph, minting articles or NFTs, playing simple games like chess or text-adventure games and even purchasing physical goods like cookies. The ability to embed a checkout page within a social feed may be a game changer for e-commerce websites. Frames are designed to be highly flexible and scalable, operating both on-chain and off-chain to optimize performance and scalability. They are part of Farcaster's broader strategy to create a decentralized platform that supports a wide array of social media functions without central control.

While both Open Actions and Frames enhance the capability of their respective platforms by allowing for the integration of diverse functionalities directly into the user interface, they differ in their approach and integration level. Open Actions are deeply embedded into Lens's blockchain environment, leveraging the inherent properties of NFTs and blockchain transactions for interactions. In contrast, Farcaster’s Frames provides a broader range of application-like functionalities that may not necessarily involve blockchain transactions, focusing instead on enhancing the user experience and interaction within the network. Additionally, Open Actions enable users to interact with existing posts, whereas Frames are used to create new posts. Bridging these capabilities, Farcaster has recently introduced Cast Actions, an optional add-on for the Farcaster client. This feature, which users can add to their reaction bar, allows them to perform various activities such as tipping, translating, and upvoting, significantly enhancing user engagement.

Modular systems like Open Actions, Frames, and Cast Actions represent significant advances in how decentralized social networks can offer flexible, user-driven features that go beyond traditional social media functionalities, reflecting the flexible and expansive nature of DeSo.

Grassroot Development

One of the most fascinating aspects of Farcaster is its grassroots-driven development. While the protocol strives to balance decentralization with performance, its growth and innovation are often fueled by its community, which actively engages in shaping its use cases and features. For instance, the practice of tipping posts and contributions with $DEGEN, which was initially distributed to Farcaster users via an airdrop, emerged organically within the community. This has led $DEGEN to become Farcaster's unofficial token, in addition to the official point token, Warp, underscoring the platform’s ability to transform online interactions into tangible value.

This visualization shows how popular the token DEGEN has become within the Farcaster ecosystem, representing by far the most frequent word. It’s worth noting that Dune contains both quantitative and qualitative dashboards, thus helping users and builders gain a much deeper understanding of the context around numbers. For example, by looking at the top words in Farcaster casts, one can understand which topics are most trending and perhaps adapt one's strategy to maximize visibility and engagement.

The $DEGEN phenomenon highlights how user behaviours and interactions, alongside active choices from the core development team, contribute to shaping the platform's evolution. As another example, FarCon, a yearly conference to celebrate the Farcaster ecosystem, was also born from the enthusiasm of some power users, with the core team having no involvement in planning it.

While Lens has been more programmatic in its development, an approach emphasized by the decision to remain permission for almost two years, since going permissionless in February this year, it has experienced a considerable bottom-up development, not dissimilar to Farcaster. BONSAI is a great example, a memecoin that was airdropped to Lens users and quickly became the preferred currency for rewarding engagement and paying for open actions and content in the Lens ecosystem.

Monetization

Protocol monetization

Unlike established web2 social media platforms that racked hundreds of billions by owning data and selling them to advertisers, both Lens and Farcaster’s business models rely on sign-up fees. Joining Lens requires minting a handle, which currently costs $10 and can be paid either with a card or crypto. Farcaster requires creating a profile and renting storage units, each allowing users to store a certain amount of data for one year. Currently, users must pay a sign-up fee of $5, which includes $3 for one storage unit.

Farcaster’s address for Storage Registry currently shows a balance of 431 ETH, about $1.3M. This Dune visualization also shows total revenue north of $1M.

February saw momentum for both Farcaster and Lens in terms of sign-ups. Farcaster’s increase was mostly caused by the excitement for Frames, while Lens saw a sudden surge after becoming permissionless. Since both mostly rely on sign-up fees as revenue sources (since March, following LIP-16, Lens has also been taking a small fee from collections), this has also represented a significant increase in revenue.

User monetization

As far as users’ monetization is concerned, Lens has addressed this more directly and in a top-down fashion compared to Farcaster. In Lens, by protocol design, users can profit from a simple action like Follow by setting a mint price for others to follow them (aka, minting their profile NFT). Also, users can set a price for their publications to be collected as NFTs. Native Tipping is an additional monetization venue, separate from Open Actions, that Hey introduced in April this year.

As these counters by Sealunch show, Lens flipped the meaning of the classic metric ARPU (Average Revenue Per User). While in web2 apps, this metric shows how much each user contributed to the application’s revenue, in Lens it indicates how much users earned for themselves by engaging on the application.

On top of the official monetization features, in March 2024, the MadFi team launched a memecoin called BONSAI. After the first airdrop was distributed to Lens users based on their activity, in a short span, it quickly became the default currency on Lens, overtaking wMATIC as the currency of choice for monetizable content.

Although Farcaster initially lacked built-in monetization features and only recently introduced a more formal tipping mechanism through Cast Actions, users have been able to earn from grassroots tipping practices using $DEGEN, the unofficial token of Farcaster. $DEGEN, initially distributed through airdrops based on user activity, has been used widely within the community for tipping on casts, comments, and other contributions, effectively creating a user-driven economy on the platform.

This mechanism incentivizes high-quality content creation, decentralized curation, and engagement, fostering a vibrant community. Interestingly enough, $DEGEN is one of the first cases where a token is distributed to the community by the community in a truly decentralized and peer-to-peer fashion. This is not dissimilar to Optimism, which allocates grants to projects and contributors based on decisions made through community governance.

Unlike many memecoins that rely solely on hype and speculation, both DEGEN and BONSAI have managed to create utility, becoming an important instrument for content creators to monetize their work and engage with their communities.

Dune can play a crucial role in this value unlock. Facilitating access to blockchain data, allows for detailed insights into not just basic metrics like transactions or Total Value Locked (TVL) but also more granular behaviors. This depth of data is invaluable for projects planning strategic initiatives such as airdrops.

For example, this query from @ilemi shows all Farcaster’s active users, their followers, cast activity, engagement, the channels they are most active, and their associated wallet address.

Overall, it’s great to see intentional, built-in monetization features in Lens. Similarly, it’s great to see spontaneous and grassroots monetization opportunities arising in Farcaster and, recently, Lens. While different in approach, both achieve something that has never been done by web2 social media platforms: recognize all users’ contributions and engagement and reward them seamlessly.

Conclusion

Farcaster and Lens, each taking unique approaches to blockchain and decentralization, have achieved success in different arenas: Lens by cultivating a diverse ecosystem of applications and Farcaster by generating high activity levels within a single client. Their strategies towards monetization also differ, with Farcaster adopting a more grassroots approach and Lens pursuing a more intentional strategy. Despite these differences, their developments reveal a convergence of several key elements. They both operate as a single protocol that supports many independent clients or apps, emphasizes data ownership, and implements add-ons that make posts and interactions richer and more flexible while offering mechanisms for users to actively participate in and shape the apps they use. Additionally, they utilize sign-up fees for protocol monetization and encourage grassroots user monetization through memcoins like DEGEN and BONSAI.

Unlike Web2 social media platforms, where data are locked within company servers, Web3 applications are, by design, open-source and permissionless. This transparency allows users, analysts, and investors to easily access and analyze data, something nearly impossible with legacy platforms where, at best, users can download their personal content and profile information. Dune accelerates this shift, offering an accessible interface that simplifies complex data sets for users regardless of their technical expertise. It enables stakeholders to seamlessly explore user interactions, monetization strategies, and overall dynamics, thereby fostering a deeper understanding of how applications work and how to build on these decentralized protocols. This shift to open-source data is not just a feature of web3—it represents a fundamental change in how digital interactions and economies can be understood and developed.

Resources:

‍Get started with Lens Protocol

Get started with Farcaster

How to create Dune Dashboards

Use Dune API

This analysis was created by Dune community Wizard, Filippo Armani. The views and opinions expressed in this article are solely those of the author(s) and do not necessarily reflect the official position of Dune.

The gaming industry is rapidly evolving, and blockchain technology is set to transform how we play and interact with games. As the leading Ethereum scaling solution, Arbitrum has recently announced the Gaming Catalyst Program (GCP) to position itself as a prime destination for games.

The Arbitrum Gaming Catalyst Program

The Gaming Catalyst Program (GCP) is an ambitious initiative aimed at positioning Arbitrum as a leading blockchain for game developers. Despite Arbitrum's success as the leading optimistic rollup, especially in the decentralized finance (DeFi) sector, its presence in the gaming vertical remains below expectations.

While rival optimistic rollup Optimism has been also lagging behind, other chains like BNB and Polygon have been thriving thanks to gaming applications. The GCP aims to leverage the network's success in decentralized finance (DeFi) and replicate it within the gaming sector, targeting rapid growth and quality enhancement in gaming through a substantial allocation of resources and support to game developers.

Key Components of the GCP include:

• Comprehensive Support for Game Builders: The program offers essential resources such as funding, mentorship, and technical assistance to expedite the development and launch of games on Arbitrum.

• Strategic Investment in Talent and Projects: By focusing on high-potential projects and top industry talent, the GCP aims to enhance the quality of games and ensure efficient use of resources.

• Partnerships with Established Publishers: A substantial portion of the program's funds (160 million ARB, or 80% of the total budget) is allocated to publishers with established expertise and networks in the gaming industry. This approach allows Arbitrum to tap into existing infrastructures and relationships, accelerating the growth and success of its gaming ecosystem without having to build everything in-house.

• Infrastructure and Tooling: An integral component of the program is its focus on developing essential gaming infrastructure and tooling, with 20% of the total grants—amounting to 40 million ARB—earmarked for this purpose. This strategic allocation is designed to address current gaps in the ecosystem, such as enhancing game engine compatibility, optimizing mobile infrastructure, and implementing advanced payment solutions.

• Development of Engaging and Retentive Games: The goal is to create games that not only attract but also retain players, supported by a Venture Team and an expert Council to maintain high standards.

• Diversification into Gaming: While continuing to strengthen its DeFi applications, Arbitrum aims to expand its use cases by building a robust gaming platform, thereby attracting a wider audience.

The GCP plans to allocate a total of 200 million ARB over two years to achieve these objectives, with the vision of establishing Arbitrum as a prime destination for game developers. As a comparison, other blockchains have launched the following gaming-focused grants and incentive programs:

• Immutable: $500M Ecosystem Fund from June 17, 2022

• Ronin: 150M RON or ~$390M at the time of writing from January 27, 2022

• Avalanche: 4M AVAX or ~$130M fund from March 8, 2022

• Polygon: is currently raising a $100M fund together with Immutable

• Solana: $150M grant program from November 26, 2022

• Optimism: $2M retroactive grant to on-chain games from January 11, 2024

Leveraging DeFi to Boost Gaming

While starting with a delay, Arbitrum may have some edge over other blockchains. In particular, Arbitrum can capitalize on its strong DeFi sector to create a synergistic relationship between the gaming and DeFi verticals. By leveraging the deep liquidity and capital within its DeFi ecosystem, Arbitrum could create new opportunities for users to invest in and support nascent gaming projects, fostering growth within the gaming industry while benefiting from the existing infrastructure and user base of its DeFi sector.

Some potential ways Arbitrum could connect its DeFi and gaming verticals include:

1. Launchpad: Arbitrum could develop a gaming launchpad that allows DeFi users to directly invest in new or emerging gaming projects. This could create a bridge between the two sectors, allowing DeFi users to deploy capital and earn additional yields while supporting the growth of the gaming ecosystem.

2. GameFi: By combining elements of gaming and DeFi, GameFi projects can let players earn rewards or in-game assets through various gameplay activities and then seamlessly invest them in DeFi protocols.

3. NFT Marketplace: Arbitrum could integrate its DeFi sector with marketplaces for gaming-related NFTs, enabling users to trade and invest in gaming assets. This could create a new avenue for users to participate in gaming projects and potentially earn yields from their investments.

Conclusion

While other blockchains may currently have a head start over Arbitrum in the gaming sector, the GCP arrives at an opportune timing as the blockchain gaming trend is still in its nascent stages. With this initiative, Arbitrum is not just catching up but is strategically positioning itself to lead in this emerging market. As the blockchain gaming landscape continues to evolve, Arbitrum's proactive approach and substantial investment signify its commitment to leveraging its advanced tech stack to become a prime destination for game developers and a leading player in the expansive future of blockchain gaming.

This article covers the period from March 23rd, 2023, to March 23rd, 2024, with snapshots taken on March 23rd, 2024. When comparing the OP Stack with the Arbitrum ecosystem, all chains operating within each respective ecosystem should be considered. However, among these chains, Base emerged as the primary contributor in terms of daily transactions, Total Value Locked (TVL), and revenue. Hence, the present evaluation only considers the impact of Base on the OP Stack.

Metrics Comparison

Token price

As mentioned in the introduction, the price of OP has been constantly higher than ARB, and the difference has widened since December 2023. Since then, OP has maintained almost double the value of ARB. At March 23, 2024, OP price was $3.41 while ARB was $1.60.

Circulating supply

(at March 23rd, 2024)

As a reminder, Optimism launched its native token OP on May 31st, 2022, while Arbitrum launched ARB almost a year later, on March 23rd, 2023. Circulating supply changed when Optimism unlocked 387 million tokens on May 31st, 2023, about 9% of the total token supply. The unlock raised the circulating supply by a massive 114%. Similarly, on March 16th, 2024, Arbitrum unlocked 1.1 billion ARB tokens. The amount is around 76% of the circulating supply. As of March 23rd, 2024, the circulating supply is the following:

• OP: 1,006,141,600 (23.43% of the total and max supply)

• ARB: 2,653,939,384 (26.53% of the total, but not of the max supply, which is uncapped).

Market Cap

(at March 23rd, 2024)

As a result of the recent massive unlock of ARB, Arbitrum’s market cap is currently higher than OP’s, despite the ARB token price being about half of OP's.

• OP market cap (at March 23rd, 2024): $3,458,387,903

• ARB market cap (at March 23rd, 2024): $4,241,023,327

Fully Diluted Market Cap

This metrics, which represents the market cap if the max supply was in circulation, so price*max.supply, is similar for the two blockchains. Since ARB doesn’t have max. supply, total supply is used instead:

• OP: $14,663,018,349

• ARB: $16,004,000,000

To sum up, Optimism has been performing much better in terms of valuation (token price and market cap). Does this find justification in its superior metrics?

Daily transactions volume

Base's dramatic increase in the number of daily transactions (over 3x increase, from an average of 400k to over 1.5 million) reflects rapid adoption growth. However, Arbitrum has maintained a similar level of activity throughout the whole period, and only when considering the OP Stack as a whole can Optimism surpass Arbitrum.

Total Value Locked (TVL)

When considering TVL, Arbitrum has been able to maintain a consistent and considerable edge over Optimism, Base, and the OP Stack as a whole.

Interestingly, it seems that Arbitrum’s total TVL has been increasing while Optimism’s has been slightly decreasing in favour of Base. A hypothesis can be made that Base has been ‘cannibalizing’ market share from Optimism.

Ecosystem

When examining the ecosystems developed around these two chains, it's important to consider both the number of projects and protocols launched on each chain, as well as the number of additional chains launched within their respective stacks. Arbitrum Orbit highlights the potential for launching L3 chains settling on Arbitrum, whereas the OP Stack enables projects to launch L2s united in the so-called ‘Superchain’ and settle directly on Ethereum.

Number of projects

As of March 23rd, 2024, DefiLlama reported 566 protocols built on Arbitrum, 223 on Optimism and 238 on Base. Even summing up Optimism and Base, Arbitrum still leads in the number of protocols and apps built on it.

Arbitrum Orbit vs OP Stack

A major winning point for Optimism (actually, the OP Stack) is the number and quality of projects launching an L2 chain, which drives additional monetary and branding value to the OP token. While Base and other L2 chains do not utilize OP as their native gas token, the revenue generated by their sequencers is distributed to the Optimism Collective to support OP RPG Funds. Notably, Base has committed to allocating 15% of its revenue to the Optimism Collective. It’s interesting to note that while Arbitrum hosts more projects in terms of apps and protocols, the OP Stack has attracted more projects that are willing to launch a semi-independent chain.

Revenue

Looking at the revenue generated by the OP Stack (Optimism and Base), it closely mirrors that of Arbitrum. While Base may have diverted a portion of transactions from Optimism (as evidenced by the Daily Transactions Volume section), it's reasonable to claim that Base had a positive overall impact on the revenue of the OP Stack.

Prior to the launch of Dencun, Arbitrum maintained a significant margin advantage, implying that the costs associated with Optimism and Base were higher than those of Arbitrum (Optimism even experienced several days of negative margins). However, following the deployment of Dencun and ArbOS (both of which had the effect of lowering fees), this trend changed: Arbitrum's L2 fees (and subsequently its revenue) notably decreased, thereby reducing the margin (calculated as L2 fees minus L1 costs) and margin percentage (calculated as (L2 fees minus L1 costs) divided by L2 fees).

Revenue Multiples or Price-to-Sales (P/S) Ratio

Revenue multiples are a type of valuation metric that compares a company's market value to its revenue. They are calculated as Market Cap (the current price per share multiplied by the total number of outstanding shares) divided by Total Revenue in a selected period, typically a year. A higher ratio typically indicates that the company is being valued more highly by the market compared to its sales revenue, suggesting potential overvaluation. Conversely, a lower ratio may indicate possible undervaluation. Various factors, including future growth prospects, market sentiment, and competitive advantages, might influence perception and hence the P/S ratio.

P/S Ratio Applied to Blockchains

This type of valuation model is equally applicable to blockchains, given their nature as platforms that offer a product (blockspace), generate revenue (users’ fees), and are represented in the market by their shares (tokens).

These are the P/S ratio values for Optimism, OP Stack (Optimism and Base), and Arbitrum, for the period considered:

• P/S ratio for Optimism: 75

• P/S ratio for the OP Stack (Optimism + Base): 47*

• P/S ratio for Arbitrum: 56

*The price is OP token price, and the revenue is the combined revenue of Optimism and Base over the considered period.

Optimism's high P/S ratio of 75 may seem to suggest that the market has placed a premium on its revenue compared to its sales. Conversely, Arbitrum's P/S ratio of 56 indicates a somewhat lower valuation in relation to its sales, possibly reflecting different investor sentiments or growth prospects. From this reading, it seems that the valuation of ARB more closely matches the performance, while OP may be overvalued. This was probably the case until the launch of Base.

When factoring in Base as a contributor to the OP Stack, the scenario is reversed. The combined P/S ratio for the OP Stack drops to 47, signalling that Base considerably influences the overall valuation. This suggests that investors perceive additional value in the combined ecosystem offered by the OP Stack, leveraging the synergies between Optimism, Base, and the other L2s that chose this infrastructure. When looking at the broader picture, the OP token's price currently appears less overvalued compared to ARB.

In addition to comparing different blockchains, examining the Price-to-Sales (P/S) ratios of these blockchains alongside traditional sectors of the economy proves to be intriguing. For instance, industries such as Biotechnology and Software often exhibit high revenue multiples due to their substantial growth prospects and significant role in fostering innovation. Biotechnology sectors, for instance, have demonstrated multiples as high as 17.75. Among large tech companies, Amazon boasts the lowest P/S ratio, just above 3, while Alphabet and Apple are both hovering around 6. Meta's P/S ratio sits slightly above 10, while Microsoft's around 13. NVIDIA stands out with a much higher P/S ratio of above 35, closely resembling the 47 of the OP Stack. This similarity suggests that digital infrastructure plays a pivotal role in facilitating a diverse range of digital companies, products, and services, thus justifying their relatively higher valuation metrics. Nevertheless, other microchip manufacturers like Qualcomm and Intel present significantly lower P/S ratios, approximately 5 and 3, respectively. This contrast underscores the nuanced nature of revenue multiples and underscores the importance of considering multiple factors when evaluating valuation metrics.

The significant disparity in revenue multiples between these rollups and traditional companies may stem from the fact that blockchains function more akin to infrastructure rather than individual entities or products. Infrastructure benefits from what could be described as a "double network effect". Essentially, most decentralized applications (dApps) and projects launched on a blockchain thrive on network effects: as more users engage with the platform, its attractiveness increases, leading to further user adoption (first order of network effect). In the same way, as more projects and dApps decide to build on a blockchain, others are incentivized to follow suit, attracted by potential synergies and benefits, such as deeper liquidity (second order of network effect).

In the case of rollup-as-a-service platforms like Arbitrum and Optimism, there may even be a third layer of network effects at play. Beyond the aforementioned dual network effects (users and dApps), there exists a third dynamic where the more blockchains are built on each respective stack, the greater the likelihood that additional projects will choose to do the same in the future. This triple network effect can catalyze exponential revenue growth, providing justification for a higher Price-to-Sales (P/S) ratio.

Conclusion

The analysis of market dynamics between Optimism and Arbitrum reveals a fascinating dissonance. Despite Arbitrum showcasing superior metrics in various aspects such as transaction volume, project proliferation, Total Value Locked (TVL), revenue, and profitability compared to Optimism, the price of ARB consistently lags behind that of Optimism, prompting speculation about Optimism's potential overvaluation. While at a first glance this seems to be the case, factoring in the significant contribution of Base reveals a different and more nuanced picture, one where the P/S for the OP Stack is lower, and hence possibly less overvalued, than for Arbitrum.

Furthermore, comparing the revenue multiples of these blockchains with traditional sectors of the economy underscores the unique dynamics of blockchain platforms as infrastructure rather than individual entities. The triple network effects enjoyed by rollup-as-a-service platforms like Arbitrum and Optimism may account for some of these disparities, although further research would surely help shed a brighter light on this topic.

As a final note, it's worth noting that since the conclusion of the observed period, Base has undergone significant growth in terms of daily transactions, TVL, and revenue. As a result, it's likely that the revenue multiple for the OP Stack has already shifted. A forthcoming update will provide insight into these changes.

In the vibrant social media ecosystem, content and engagement—likes, comments, shares, and follows—operate as the primary ‘currency’, buying visibility and influence and driving the success of influencers, brands, and content creators. This digital economy, underpinned by the scarce resource of user attention, resembles traditional economies in many ways. And just like some traditional economies, legacy social media platforms have been experiencing a unique form of inflation characterized by an oversupply of content and engagement that paradoxically diminished their value, akin to traditional economic inflation, where an excess of currency reduces purchasing power.

More Currency, Less Value

As social media platforms have matured, the volume of content and the corresponding engagement metrics have surged. Twitter’s users generated about 5,000 daily tweets in 2007, while they produce over 500 million today. In 2024, Instagram users upload over 100 million photos and videos daily, and over 1 billion stories are shared daily across Facebook apps. As noted by Facebook itself, already in 2014 an average Facebook user sees up to 1,500 stories in their News Feed per login, which can skyrocket to 15,000 for those with extensive networks. Yet, despite the increase in this 'currency' (or because of that), the engagement rate and reach for most content creators, especially those in the middle and long tail of the distribution, have experienced a decline. Studies, such as one by Edgerank Checker, had shown that the average Facebook Page's organic reach dramatically decreased from approximately 100% of followers in 2007 when they launched to 16% in 2012 to 6% in 2016. In 2024, the average engagement rate per page on Facebook is just around 0.07% (Facebook photo posts have the highest engagement at 0.12%, while Facebook link posts have the lowest at 0.03%).

This phenomenon reflects a saturated market where the value of each engagement unit decreases, making it harder for content to stand out and achieve significant reach without substantial investment in paid promotion. Much like how an increased money supply with an unchanged goods supply reduces the value of money and lowers the purchasing power. Despite having more units of currency, citizens are impoverished. Notably, nowadays, it takes many more posts, likes, comments, etc., to obtain reach and gain visibility and the consequent benefits on social media. For someone just starting on a legacy platform, accumulating enough social currency to ‘buy’ visibility and influence is a daunting mission, not dissimilar to young adults struggling to purchase homes in the real-world economy. Only established and early influencers, akin to financially secure households, can stand a chance to preserve their purchasing power and navigate this inflating economy.

The decline in organic reach has been more severe for mid and lower-tier users. As a result, a small fraction of top content creators capture a disproportionate share of attention and engagement, while the vast majority find it increasingly challenging to achieve visibility. This increasingly skewed distribution of engagement highlights a widening gap akin to income inequality in the real economy, where wealth concentration leads to reduced economic mobility and opportunities.

As the organic reach has tended to zero, many brands and marketers have turned to paid advertisements to ensure visibility on users' feeds. This shift towards a "pay-to-play" model has been a crucial part of legacy social media platforms’ evolution into more ad-centric businesses. Eventually, however, even the competition for ad space has escalated and led to increased costs, making it more challenging for new entrants or smaller brands to compete.

Emerging Platforms: A Return to Equilibrium?

Emerging social media platforms offer an alternative by potentially resetting the inflationary spiral. These platforms, with their smaller, more engaged communities, can provide a more equitable distribution of engagement and reach. Platforms like Warpcast and Lenster stand out by offering a more balanced experience, where users can engage deeply without the stress of competing for likes and followers and the overwhelming challenge of catching up with massive accounts. These new digital squares provide a space where genuine connections are more achievable, allowing for a focused discussion on a few topics of interest. This depth, coupled with the flexibility and convenience of crypto rails (e.g. payments via Frames), can lead to more fruitful collaboration and economic opportunities. For those looking to build an audience, investing in such emerging platforms can be more rewarding, as efforts yield greater visibility and impact.

Navigating the Economy of Social Media

The landscape of social media mirrors the complexities of real-world economies, marked by the inflation of its unique currency—engagement and content. As legacy platforms battle with the dilution of value amidst an abundance of posts and interactions, emerging platforms present an opportunity to recalibrate the scales of the digital economy. As we move forward, the balance between quantity and quality, between widespread reach and impactful engagement, will define the currency of social media and its capacity to connect, influence, and enrich our digital lives.

Ode to open data

A final quick note about data. Collecting data for this article was challenging, which also prevented me from doing further analysis on the relationship between the amount of content, engagement, and attention for social media platforms. Web2 companies’ data are few (specific metrics are closely held and generally not publicly disclosed in detailed historical series), scattered around, fragmented, and inconsistent. This is painfully obvious after being used to the seamless accessibility and transparency of web3 data (go Dune!).

We may never appreciate this paradigm shift enough.

From Social Credits to Village Work-Points

China's social structures, including the widely discussed social credit system, often draw global attention. However, a lesser-known but equally fascinating model is the ‘work-point system’ (gongfen, 工分) utilized in some ethnic minority villages. One such example is Langde Shangzhai, a Miao village nestled in the mountains of Guizhou Province, employing the work-point system to manage tourism. This system, while designed for a completely different context, surprisingly shares parallels with incentive mechanisms seen in crypto projects.

The Cooperative Tourism Model

Following the principle of "every villager contributes to the construction of the village, so everyone should benefit from tourism development”, Langde Shangzhai has adopted a community-driven tourism model centred around the ‘work-point system’. Inspired by the rural collective economy of China's agricultural collectivization period, Langde Shangzhai's work-point system represents a cooperative approach to tourism, emphasizing fair distribution of tourism benefits, including revenue sharing, equal opportunities, and support for vulnerable villagers (for example, elderly villagers who do not perform but only accompany events still receive corresponding work-points). Similar to crypto projects, wherein tasks are rewarded with tokens and sometimes points as a stepping stone, villagers earn points for various contributions to tourism activities, such as performing traditional Miao dances and songs for tourists. Similar to onchain points in crypto projects, these points are distributed based on the quantity and quality of work performed.

From Performance to Profit

In both contexts, points serve as the basis for distributing rewards. In Langde Shangzhai, these points translate into shares of tourism revenue, which mainly come from performance fees charged to tourist groups. Twenty-five percent of the tourism income is retained for the village's common development fund. The remaining income is fairly distributed monthly based on the work points earned by participating villagers, mirroring the crypto’s token airdrops or the protocol revenue share implemented by Zora, Mirror and more.

Evolving Incentives for Community Prosperity

To facilitate the distribution of work-points, Langde Shangzhai deploys work-point cards. Each work-point card lists various items (such as types of performances, types of clothing, and types of hairstyles) and corresponding work-points (1-12 points). For example, if a girl in the village wears the local long-skirt Miao costume, wears a complete set of Miao silver ornaments, and styles her hair in a traditional high bun, she will earn 8 points; if her shoes are not cloth shoes, she earns 1 point less, totalling 7 points; if she doesn't style her hair in a high bun, she earns 3 points less, totalling 5 points; if she greets tourists at the village gate upon their arrival, she will earn an additional 2 points; if she also serves wine to tourists, she will earn another 3 points. What sets apart the work-point system is its flexibility to adapt to the evolving needs of the village. Much like how crypto projects adjust incentive structures to align with changing objectives, activities in Langde Shangzhai earn different point values based on the village's priorities for enhancing the tourist experience. This can change over time, ensuring the system remains responsive to the community's objectives and the evolving tourism landscape.

The work-point system also implements its own mechanism to prevent Sybil attacks. Work-point cards are personally distributed after each tourism ritual and performance. Villagers who participate earn points, but those arriving late or leaving early miss out. Additionally, those involved in distributing and registering points also earn them. The allocation process undergoes periodic revisions to ensure fairness and prevent free-riding, demonstrating its adaptability and commitment to equitable distribution of benefits.

The Double-Edged Sword of Incentive Systems

The work-point model is not without its limitations. Echoing criticisms aimed at certain crypto incentive programs, such as incentivizing short-term gains over long-term sustainability, the work-point system might unintentionally discourage villagers from engaging in other productive activities. Such a narrow focus risks hindering the broader development of the village and makes the community more vulnerable by funnelling resources into a singular activity and reducing diversification. This echoes concerns about "airdrop farmers’ in crypto, who focus solely on maximizing token rewards without contributing meaningfully to project growth and long-term sustainability and success.

Despite its flaws, Langde Shangzhai's work-point system underscores the importance of community participation. Research indicates that tourism on a smaller scale, especially when it involves direct engagement from community members, yields more favourable outcomes for individuals compared to more extensive developments lacking such participation. When able to participate to the upside, community members recognize the value of collective effort in sustaining their tourism-driven economy. The lessons learned from their experiences provide meaningful food for thought for crypto projects facing the task of fostering sustained participation and commitment.

Bridging Traditional Practices and Crypto Innovations

By drawing parallels between Langde Shangzhai’s work-point system and similar incentive mechanisms in crypto projects, we are once again reminded that the point systems or the reward programs implemented by crypto projects are unique in their modality but not in their philosophy: to foster collaboration, incentivize community participation, and fairly distribute value. Albeit belonging to different socio-economic contexts, the experience of cooperatives embodied by Langde Shangzhai offers valuable insights for the design and evolution of reward systems in crypto projects.

Suggested readings:

1. Huang, Y. (25 Apr. 2022). Work Point System in Rural China. Leiden, The Netherlands: Brill. https://doi.org/10.1163/9789004513082

2. Xianghong Feng & Qiaoyang Li (2020) Poverty alleviation, community participation, and the issue of scale in ethnic tourism in China, Asian Anthropology, 19:4, 233-256, DOI: 10.1080/1683478X.2020.1778154

Economies of scale describe the phenomenon where producing more units of a product or service on a larger scale generally leads to lower average input costs per unit. This is due to the inverse relationship between the per-unit fixed cost and the quantity produced. As the quantity of output increases, the per-unit fixed cost tends to decrease, making production more cost-efficient with scale. In short, economies of scale make the product marginally more effective with each incremental input.

In blockchains, economies of scale mean lower costs per transaction as the output (or better, the throughput, so how many transactions the blockchain can process in a given amount of time) increases. For rollups, this efficiency could also apply to the amount of data posted to Ethereum and the cost per Mb of data posted. Chris Ahn writes:

Unfortunately, blockchains typically exhibit diseconomies of scale, where incremental usage makes the network marginally more expensive to use. Because blockchains have competitive fee markets for blockspace, more usage drives up the cost of blockspace.

Is it really so? This short article analyses the existence of cost-efficiency economies of scale in the two major Ethereum rollups, Arbitrum and Optimism, controlling 50% and 25% of the market share, respectively. The analysis focuses on producer economies of scale, achieved by companies or products when the average cost per unit of production decreases as the scale of operations increases, rather than user economies of scale, enjoyed by end users when the cost per unit of the product or service decreases as the scale of consumption increases.

Data are extrapolated and elaborated from Dune Analytics, specifically from contributors @0xKofi and @MSilb7. The analysis covers 2023, from January 1st to December 31st.

Rollups Operational Costs

From the user perspective, every optimistic rollup transaction has two cost components: an L2 (execution) fee and an L1 (data) fee. At a high level, the L2 fee is the cost to execute the transactions on the L2, and the L1 fee is the estimated cost to publish transactions on L1 (in a rollup batch). While the L2 execution fee resembles the traditional fees on Ethereum (gas cost * gas price), the L1 data fee is unique to optimistic rollups because the transaction data for all rollup transactions must be published to Ethereum (or, in the future, other Data Availability layers, possibly making this fee component cheaper).

• L2 execution fee. This is the amount paid to the rollup nodes as compensation for computational and storage costs incurred in processing transactions, much like gas fees on Ethereum. Currently, the node (Sequencer) is a single, centralized entity in most rollups, run by OP Foundation on Optimism and Offchain Labs on Arbitrum. Rollup nodes charge lower transaction fees since L2s have higher processing capacities and aren't faced with network congestions that force validators on Ethereum to prioritize transactions with higher fees. Importantly, in Optimism, the Sequencer only gets the priority fees, while the base fee is burned due to EIP-1559 implementation. On the contrary, Arbitrum currently implements a first-come-first-served policy and doesn’t have a public mempool, meaning there is no priority fee.

• The L1 data fee covers the expense of publishing transaction data on L1, essentially representing the cost of ensuring Ethereum-equivalent security. Optimistic rollups publish transaction data and block headers (consisting of the previous block header hash, state root, batch root) to Ethereum as calldata. Optimistic rollups can mitigate the cost of writing data to L1 by consolidating multiple transactions into a single batch, thereby spreading the gas costs across multiple transactions. The L1 security fee is directed towards Ethereum block producers. Overall, the L1 fee depends on the size of the transaction in bytes, the current gas price on Ethereum, and several small parameters. Publishing data is expensive and makes up 80-90% of L2 users' transaction fees. In the case of Arbitrum, ArbOS dynamically adjusts the pricing of L1 gas to ensure that the amount collected in L1 gas fees closely aligns with the long-term costs that need to be covered.

L1 Fees Formulas

Tx Data Gas Cost in Optimism is the gas cost of the transaction given its size after compression. Fixed Overhead cost in Optimism is similar to Rewards in Arbitrum, and Dynamic Overhead is similar to Dynamic Adjustments.

It’s important to highlight that while L2 execution fees are a cost for users, they can be considered revenue for the L2 since the Sequencer is currently a single identity managed by the rollup itself, meaning the entirety of the L2 execution fees accrues to the L2’s treasury (Optimism uses these funds to support public goods). Therefore, when analyzing the cost structures and dynamics from the L2 perspective, only L1 data fees are considered.

The scatter plots below represent the relationship between the number of transactions versus the cost per transaction and the amount of posted calldata in Mb versus the cost per Mb.

From a visual perspective, Optimism displays an inverse relationship between each couple of variables, while the same doesn’t happen for Arbitrum. A deeper analysis with correlation coefficients confirms that the variables considered have opposite correlations in the two rollups.

In Optimism, a moderate negative correlation exists (-0.25) between the amount of data posted to Ethereum (in Mb) and the cost per Mb, indicating that as the amount posted increases, the cost per Mb decreases. This suggests potential economies of scale or efficiency gains with larger data volumes. Additionally, a negative correlation (-0.36) between the number of transactions processed and the cost per transaction suggests that as transaction volumes increase, the cost per transaction tends to decrease, implying further economies of scale or operational efficiencies with higher transaction volumes. Conversely, in Arbitrum, a moderate positive correlation (0.37) between the amount of data posted to Ethereum and the cost per Mb suggests that as data volume increases, the cost per Mb tends to increase, potentially indicating diseconomies of scale compared to Optimism. Similarly, a positive correlation (0.26) between the number of transactions and the cost per transaction implies that as transaction volumes rise, the cost per transaction tends to increase, reflecting potential differences in cost structures or operational dynamics that may lead to diseconomies of scale.

Considerations

Economies of scale can arise from various factors, including optimization of network infrastructure, spreading fixed costs, and implementing batching strategies, among others. A more comprehensive dataset could enhance our understanding of the underlying forces driving these correlations. For instance, different fee structures might be another contributing factor. Take, for example, Optimism, which calculates the transaction size (distinguishing between zero and non-zero bytes, leading to different costs akin to Ethereum) along with associated gas costs. In contrast, Arbitrum dynamically computes the L1 fee based on an estimated transaction size (without distinguishing between zero and non-zero bytes, but charging a uniform 16 gas per byte) and gas cost, incorporating dynamic and flexible additional components. Furthermore, in Arbitrum, a transaction incurs L1 gas fees only if it is part of a sequencer batch and not sent directly to the L2 contract on the L1, whereas this distinction does not seem to apply to Optimism.

In addition to expanding the dataset and considering additional variables, a more rigorous research methodology, such as regression analysis, could help determine whether a causal relationship exists between the variables rather than just a correlation.

Finally, it could be interesting to extend the analysis to other rollups. Base, which gained considerable steam despite representing only about 3% of the market share, is not considered in this analysis as it’s built on the OP Stack and only officially launched on August 9th, 2023. Nonetheless, including Base in future examinations may yield valuable insights, as initial observations suggest that it may exhibit even stronger economies of scale than Optimism.

Farcaster has cultivated a devoted and engaged community of individuals who share common interests, namely crypto and Web3. This achievement can largely be attributed to the deliberate curation of its initial user base by co-founder Dan Romero, who spent time and effort personally selecting and admitting users.

Besides this, some factors have also played a crucial role in driving initial adoption:

• Like Lens Protocol, the architecture comprises one protocol, Farcaster, over which a limitless number of clients can be built in a permissionless manner. Warpcast, the first and largest among these clients, functions similarly to apps built on a shared blockchain protocol. This approach means users can benefit from various experiences and UIs while still being able to use one single account.

• The commitment to sufficient decentralization has been part of Farcaster's ethos from its inception. This approach emphasizes balancing on-chain innovative features with a smooth and high-quality user experience. Unlike Lens Protocol, the only on-chain component is the FarcasterID, which ensures the user’s identity is fully decentralized, secure, and interoperable while limiting spam. On the contrary, all profiles, casts, and social connections reside within a decentralised peer-to-peer Hub network.

• In June 2023, Warpcast introduced Channels, specialized sections tailored to specific topics akin to subreddits on Reddit. Many of these Channels have evolved into vibrant communities in their own right, adding depth and organization to Warpcast’s interactions.

• In January 2024, Warpcast unveiled Frames, an innovative feature empowering users to transform any cast into an interactive application directly within the platform. By leveraging Facebook's OpenGraph standard, Frames enable the creation of dynamic and authenticated experiences on Farcaster, including polls, live feeds, checkout payment gateways, and interactive galleries. This feature adds significant value for users and provides developers with a platform to experiment and iterate on minimum-viable products before scaling them into fully-fledged applications. Frames streamline user engagement by eliminating the need to navigate to external pages or applications. To date, over 200,000 frames have been created.

The confluence of these features, coupled with the hands-on and pragmatic approach of the Farcaster team and the meticulous selection of initial users, has proven immensely fruitful. In recent weeks, Farcaster has experienced a tenfold increase in user adoption, surpassing the 180,000 total users and 130,000 monthly active users in February.

Notably, most of Farcaster's user base originates from Crypto Twitter (CT), particularly from the non-degenerate subset. Predominantly composed of developers and researchers, this demographic contributes to the platform's exceptional atmosphere characterized by meaningful conversations, minimal spam, and a rapid proliferation of diverse use cases following the introduction of Frames. As Haseeb Qureshi aptly observes in a dedicated episode of the Chopping Block, it is uncommon for a consumer-oriented crypto application to foster such a vibrant community without explicit economic incentives, embodying a genuine sense of purpose.

This core user group found in Farcaster what Twitter (X) used to offer: a high-signal, low-noise environment for in-depth discussions on crypto and Web3-related topics. Dan Romero encapsulates this ethos, describing Farcaster as combining the user-friendly nature of a Twitter-like feed with the depth of Reddit threads.

Can Farcaster Scale?

Can Farcaster expand its user base beyond the Ethereum circle and the crypto industry? Co-founder Dan Romero acknowledges the necessity of articulating Farcaster's value proposition more intuitively to appeal to the broader user base, devoid of jargon such as decentralization or crypto. With over 180,000 total users and approximately 86,000 unique connected addresses—indicative of core users who have integrated one or more wallet addresses with their Farcaster IDs—the platform exhibits promising engagement metrics but still lags far behind Web2 incumbents. In 2023, Twitter boasted an all-time high of 550 million active users, with other estimates placing the average at around 400 million. A similar number for Reddit. Achieving this scale level presents a formidable challenge not only for Web3 or Web2.5 applications but also for Web2, as demonstrated by the experiences of Clubhouse, Threads, and BeReal.

Besides absolute numbers, looking at engagement across different user tiers is also useful. @ilemi created this fantastic Dune dashboard where he divides Farcasters users into five categories, measured weekly:

As it emerges from this visualization, almost all Farcasters users haven’t been quite silent and haven’t cast at all in the past 14 days. A similar trend can be found in Channels, 97% of which have five or fewer casts per week:

It’s clear that directly competing with web2 social media platforms will require very strong unique selling points and features, primitives that were not possible before and that Farcaster uniquely enables. Will Frames be enough?

The Paradox of Permissionless Composability

While Farcaster and Warpcast were used interchangeably, it’s crucial to remember that Farcaster is the underlying protocol, and Warpcast is just one of the numerous potential clients built atop it. This makes a big difference when it comes to scaling. Web3 openly aims to avert monopolies and walled ecosystems by fostering open-source and permissionlessly composable structures. Although monopolies may still emerge, as exemplified by Uniswap's dominance thanks to its strong branding and trust score, the decentralized nature of Web3 encourages competition and the proliferation of a myriad of applications, each catering to specific user subsets, making it challenging for applications to achieve widespread adoption. At the same time, distinguishing between the protocol and the application built atop is important when considering monetization. Unlike Web2 giants that thrive on ad monetization through data monopolies, Web3 applications must explore alternative revenue streams. For Farcaster as the protocol, there may be greater potential to accumulate value than individual clients. Currently, Farcaster charges its users $5 to sign up, partly covering storage fees to host the data generated by daily use ($5 per year covers 5,000 posts, 2,500 reactions, and 2,500 followers). Additionally, clients building on Farcaster can also charge their own fees. Finally, users can purchase Warpcast points called Warps. To date, Farcaster has generated over $600,000 in revenue, while Warpcast, as a client, hasn’t figured out a viable monetization strategy yet. While the protocol may be more likely to accrue fees and revenue, it's plausible that it could eventually distribute a share of that revenue to different clients based on their level of engagement, akin to the concept of public good funding in the OP Stack.

Because of scaling and monetization issues, Farcaster may be better positioned to scale to hundreds of millions of users, while it might be harder for Warpcast because it has to compete with potentially hundreds of other clients utilizing the same social graph and data layer.

Should Farcaster Scale?

In light of this core challenge, a more fundamental question is whether Farcaster should actively pursue mass scalability or focus on delivering a premium experience and continuously pushing the boundaries of Web3 social. Paul Graham, the co-founder of Y Combinator, famously wrote, “Do things that don’t scale”, elevating it to a mantra and one of the most pivotal pieces of advice at the accelerator. While the 2013 startup playbook, albeit cautious and methodical, still emphasized eventual scaling, new applications may interpret Graham's advice more literally. Drawing from Li Jin's "Love/Fame" framework, crypto-powered products can cater to niche communities rather than striving for universal appeal. Li Jin writes:

In contrast to web2, where the ad-based business model exerts pressure to trend towards social media and entertainment products, crypto uniquely makes it possible for love-based networks to thrive.

By focusing on a selected demographic, namely non-mercenary crypto enthusiasts, Farcaster may preserve its unique vibes, differentiating itself from mainstream social media platforms like Twitter, while crypto-unique-enabled monetization features could represent a viable path to financial sustainability.

The success of Patagonia, a brand renowned for its unwavering commitment to values and quality over scale and profit, is a testament to the potential benefits of niche-focused growth. Patagonia's adherence to sustainable practices and premium craftsmanship has cultivated a loyal following at the intersection between environmental advocates and outdoor enthusiasts. In Yvon Chouinard's memoir, "Let My People Go Surfing," he emphasizes the importance of focusing on core users (“We recognize that we make the most profit by selling to our loyal customers”) and prioritizing product excellence over profit maximization (“At Patagonia, making a profit is not the goal, because the Zen master would say profits happen ‘when you do everything else right.”)

Scaling, or scaling too fast, may obfuscate the core value proposition of Farcaster/Warpcast and dilute the vibes that initially made it so special in the current ecosystem. Recent developments, particularly the introduction of Frames, have seen an influx of financial speculation and involvement from the degenerate subset of crypto users. This trend is evident in the proliferation of Frames related to mints (especially the ‘recast-to-mint’ mechanic initiated by @jacopo.eth and streamlined a couple of days later by Manifold), airdrops and other similar speculative use cases. The list of trending words reveals this trend:

Looking at the most trending Channels also reveals a similar pattern, with Channels linked to airdrop farming and other speculative use cases driving a consistent share of the total activity:

While it would be a mistake to dismiss memecoins solely as speculative assets, as they often generate subcultures and robust communities driven by entertainment as well as financial incentives, the proliferation of this type of content may gradually erode Farcaster's original user base by deterring individuals seeking deeper content and interactions.

A Quick Comparison with Lens Protocol

Lens Protocol, often regarded as a competitor to Farcaster, may have a stronger appeal to broader audiences due to its focus on general categories of users like 'creators' and specific monetization features such as 'Collect' posts, giving anyone the opportunity to earn money by creating engaging content. Interestingly, Lens Protocol diverges from Farcaster in several key aspects:

1. It emphasizes on-chain components, aiming to incorporate as many features as possible into the blockchain, including accounts, content, and interactions.

2. Despite having been operational for nearly two years, Lens Protocol remains in a closed beta phase, meaning new users cannot create accounts in a permissionless manner and instead rely on invites from existing users.

3. Lens Protocol places greater emphasis on supporting creators and offering monetization features like Collect posts, as opposed to fostering in-depth discussions and threads like Farcaster.

4. Interestingly, in July 2023, Lens Protocol released Open Actions, a feature that resembles Farcaster's Frames but hasn't garnered the same reception level.

Despite being in closed beta, Lens Protocol has amassed over 125,000 total users, a figure comparable to Farcaster, and has generated over $7 million in revenue.

Crucially, the Lens users, not the protocol itself, primarily benefit from this revenue stream. The emphasis on making diverse monetization channels accessible to all users is arguably Lens Protocol's most innovative and exciting proposition, positioning it as a promising candidate for scaling beyond the crypto industry.

In conclusion, Farcaster might not need to measure its success against Web2 social media platforms, as the social media and consumer product landscape more broadly are shifting toward fragmentation and niche communities (a trend accelerated by AI-ubquoutous generated content). Thanks to new business models and monetization strategies, choosing not to scale is now a deliberate choice rather than a necessity for crypto applications. While unconventional, this approach could be preferable, allowing projects to conserve resources and preserve the unique vibes and engagement of their core communities and power users. This strategy mirrors the successful trajectory of brands like Patagonia. Farcaster, and especially Warpcast, may opt for this path, sustaining its momentum and focusing on cutting-edge features and experiences tailored to its ideal user base.

Perhaps, it could turn out being memecoins communities.

The transformative landscape of AI, set to contribute $15 trillion to the global GDP by 2030, presents a complex web of interconnected issues like data access, compensation, and evolving work dynamics. As we disentangle it and analyze each component, a logical progression unfolds that ultimately underscores blockchain potential in addressing data utility, individual economic value, and ownership.

Data utility (1): Data is the new oil, as it’s become the most important resource to power our technology and economies. For over a decade, companies have been hunting for as much data as possible to maximize profit from ad monetization. This process was almost seamless since users voluntarily give away their data whenever they sign in for a new application or service. With AI, companies’ hunger for more data as raw material/fuel for AI models has been getting more voracious, and even more than before, it’s happening without data creators’ approval. The New York Times suing ChatGPT for utilizing thousands of its articles without permission underscored the necessity of establishing consent and attribution in data usage for AI training purposes.

Data Utility (2): Balancing privacy with the desire to harness value from one's data is a crucial consideration. While safeguarding privacy remains non-negotiable, there is a potential pitfall wherein individuals, in their pursuit of privacy preservation, may overlook the strategic and purposeful management of their data assets. Data, unlike oil, increases value as it is shared and used. Whether contributing to AI dataset training, supporting marketing initiatives, or aiding pharmaceutical research, individuals should aspire to extract value while upholding privacy and maintaining control over their personal information. Recognizing that an open data flow can yield tangible benefits that enhance individuals' lives is essential.

Individual Economic Value: Although AI has the potential to empower individuals, it also poses the risk of accelerating unemployment and exacerbating social inequality. According to MIT Sloan School of Management professor Erik Brynjolfsson, technological advancement has led to productivity growth without a proportional increase in employment or income, a trend accelerated by AI. While there is disagreement among experts about whether AI will lead to mass unemployment, there is a growing consensus that it will worsen social inequality. This could occur through the displacement of middle-class jobs and the erosion of median income.

The potential loss of jobs places individuals at risk of diminished economic value. This matters because preserving citizens' economic value has been a driving force behind societal reforms throughout history. For instance, social welfare programs were introduced in Bismarck's Germany partly to ensure a robust and capable workforce and military. The absence of economic value may diminish the governments’ incentive to implement such policies, potentially ushering in a cyberpunk dystopia where private corporations wield significant power while governments play a marginal role.

Proving Ownership (1): In such a scenario, citizens' economic worth may be reduced to the value of the data they generate. To harness this value, however, it’s key that individuals can prove and exercise ownership over them. To address these concerns, data trusts emerged as a system and legal entity designed to manage individuals' data on their behalf. This approach aimed to safeguard data ownership, making it easier for individuals to retain control over their digital footprint and extract value from them.

Proving Ownership (2): However, as technology advances, a more robust solution has come to the forefront—blockchain technology. Blockchain not only satisfies the fundamental functionalities of data trusts but also provides a superior infrastructure that ensures data ownership, privacy, and full control. By establishing an open, transparent, and trustless data ledger and marketplace, blockchains solve the attribution problem by establishing a clear and transparent proof of ownership. Smart contracts replace third-party middlemen and become the enforcers of data agreements, ensuring users maintain complete control over their data. Furthermore, thanks to technologies like encryption and zero-knowledge proof, users can decide whether and under what conditions they wish to sell their data without revealing anything about it. This revolutionary system can streamline the data-sharing process, allowing individuals to systematically share and sell their data at a granular level with selected parties, all under their specified terms and conditions while preserving full control.

By capturing economic value and redistributing it to data providers, blockchain creates a robust financial instrument acting like a universal basic income, reducing the need for taxation or reliance on a welfare state and mitigating economic inequalities stemming from AI-driven transformation. Speaking about AI, data ownership, and value, Chris Dixon wrote in his recently released book Read Write Own:

in the long run, we are still going to need an economic covenant between AI systems and content providers. Al will always need new data to stay up to date. The world evolves: tastes change, new genres emerge, things get invented. There will be new subjects to describe and represent. The people who create content that feeds AI systems will need to be compensated.

Just in the same days, Jacob from Zora wrote a compelling article echoing this idea:

AI is a fundamental breakthrough technology, and with that comes disruption of incumbent systems. However, when paired with crypto that disruption can very well be a massively positive unlock in value capture for a lot of the entities it is disrupting.

Examples of practical applications

• Ocean Protocol is an open-source protocol with the mission to spread the benefits of AI by equalizing the opportunity to access and monetize data. Ocean Protocol leverages a few primitives to enable on-ramp for data services into crypto ecosystems, which then any application can use. This composability enables crypto wallets to behave like data wallets, crypto exchanges as data marketplaces, DAOs as data coops, datatoken-backed stable assets, and more. Overall, Ocean protocol enables the monetization of private data while preserving privacy.

• Víctor González et al. propose a Blockchain-based IoT Data Marketplace (BIDM) where Internet of Things (IoT) data producers and consumers can share data in a decentralised and trustworthy manner. In such a marketplace, owners of IoT infrastructures can expose the observations that their devices generate while retaining control over who accesses each observation and directly getting revenues according to the price they have set.

• The Tony Blair Institute For Global Change recently proposed an NHS Data Trust to: “capitalise on the opportunities of health data. Owned and controlled by the NHS in collaboration with trusted external partners, the NHSDT would treat NHS data as a competitive asset whose value can be realised for the benefit of the public. This would involve providing anonymised data to research entities, including biotech companies, in return for financial profit that would then benefit our health service. A transparent governance model would ensure that our data remain safe and that NHSDT’s operations align with public-health objectives, not private capital’s.”

Besides adopting an off-chain and trusted architecture, this last application introduces a different method for realizing value for individuals. Instead of letting private companies purchase data directly from individuals, data generated within the public sector, like healthcare data, is here sold and monetized by the public sector itself. This allows the public sector to become self-sustaining, offering free and high-quality services to citizens and potentially reducing the need to pay taxes to fund these services. The attainment of this objective would be significantly enhanced through the use of blockchain and zero-knowledge technology, where citizens would have the option to participate, receiving a tax cut, or opt out, maintaining the existing taxation cost.

In contrast to the current scenario where users give up ownership and control of their data to a few corporations, or a scenario where data flow is halted for privacy reasons, and even a future where third-party middlemen manage and monetize data on individuals’ behalf, blockchain emerges as the most effective and fair solution for addressing concerns related to data privacy and usage. The unlock brought by blockchain would benefit individuals by ensuring fair economic compensation at one’s conditions; the private sector by opening up extensive data in an unprecedented categorized manner, enhancing data indexing and extraction efficiency; and the public sector as streamlined and straightforward access to vast datasets would expedite research and enhance the quality of public policy and governance.

Actionable Steps for Leaders

Leaders in both private and public sectors can support the adoption of blockchain to reshape the future of data ownership and AI:

1. Explore Data Sharing Use Cases: Cultivate collaborations that leverage blockchain for secure data sharing, consumption and monetization.

2. Establish Blockchain Data Cooperatives: Utilize blockchain to create cooperatives within professional associations, trade unions, and smart cities, allowing members to collectively manage and monetize their data.

3. Enshrine Data Property Rights in Law: Recognize blockchain as a cornerstone for data property rights, emphasizing mutual ownership for a decentralized AI economy.

4. Create a Regulatory Framework for Blockchain Data Assets: Develop clear regulations allowing the tokenization of datasets as tangible assets, using blockchain to create new digital assets for data trusts that can be traded in regulated exchanges.

In conclusion, standing at the crossroads of AI, data, and society, blockchain emerges as the catalyst for a more inclusive, transparent, and user-centric approach to data ownership and consumption. By enabling open data flow while guaranteeing privacy and removing unnecessary intermediaries, blockchain lays the foundation for a future where individuals have greater control over their data, fostering a more equitable and collaborative AI-driven economy.

About Blockspace

Blockchains, often portrayed as abstract and speculative financial products, are, in reality, tangible technological systems with precise product and business models. Serving as distributed global computers, blockchains produce blockspace—the opportunity for anyone to include transactions in a block and inscribe state changes on a distributed ledger.

The cost for users to access blockspace is expressed in gas fees, with each operation requiring a fixed gas amount and the gas price fluctuating based on demand. The cost for the blockchain and blockspace producers is intricately tied to its security since gas fees, alongside block rewards, are used to pay validators or miners in transaction validation and network security. The more nodes participate in approving transactions, the more secure the network is. Each blockchain (layer 1) uses its native token to reward validators and miners.

Like companies, blockchains exhibit varying spending patterns and levels of efficiency on security and fee earnings. For instance, Bitcoin, with an issuance rate of around 1.8%, invests heavily in security but also earns substantial fees. In contrast, Avalanche, with an issuance rate exceeding 3.5%, spends significantly on security but may not earn as much in fees. Finally, Ethereum, the first blockchain with a deflationary token supply, typically shows a negative issuance rate, meaning it collects more fees than it spends on operating and securing the network.

Categorizing Blockspace

If blockspace is the product, blockchains themselves function as market infrastructure, facilitating the production of blockspace and the coordination of supply and demand, a balance that is ideally reflected in the blockchain’s token price. Talking about Proof of Work blockchains, Leo Zhang and Georgios Konstantopoulos write:

The ultimate purpose of the entire mining industry is serving as a decentralized transparent clearinghouse for a single commodity: the blockspace.

Blockchains produce a resource consumed by end users and establish a market infrastructure, leading to a growing belief that blockspace should be considered a commodity. As further articulated by Leo Zhang and Georgios Konstantopoulos, blockspace fuels the essence of all cryptocurrency networks, with miners as producers, mining pools as auctioneers, and users as bidders in the blockspace market.

Interestingly, the current debate between the SEC and the CTFC has neglected the concept of blockspace and solely focused on cryptocurrencies and tokens. By doing so, it ignores any distinction between blockchain protocols (Layer 1 and 2, responsible for producing blockspace) and other dApps that offer a diverse range of services. This article seeks to redirect attention to the concept of blockspace, analyzing it within the framework of commodities. This discussion not only holds intriguing intellectual considerations but also carries significant practical implications.

The Properties of Commodities

The 1936 Commodity Exchange Act (CEA) defines commodities in the following way:

The term “commodity” means wheat, cotton, rice, corn, oats, barley, rye, flaxseed, grain sorghums, mill feeds, butter, eggs, Solanum tuberosum (Irish potatoes), wool, wool tops, fats and oils (including lard, tallow, cottonseed oil, peanut oil, soybean oil, and all other fats and oils), cottonseed meal, cottonseed, peanuts, soybeans, soybean meal, livestock, livestock products, and frozen concentrated orange juice, and all other goods and articles, except onions (as provided by section 13–1 of this title) and motion picture box office receipts (or any index, measure, value, or data related to such receipts), and all services, rights, and interests (except motion picture box office receipts, or any index, measure, value or data related to such receipts) in which contracts for future delivery are presently or in the future dealt in.

According to this arguably dated definition, commodities are physical goods with contracts for future delivery that are presently or in the future dealt in. On top of these two official criteria, commodities typically show a few properties: fungibility, consumability, scarcity, volatility and tradability.

Fungibility

Commodities are economic goods with full or substantial fungibility, meaning there is no product differentiation, and they are interchangeable with other goods of the same type. Unlike finished products, commodities of the same type are all fundamentally the same, and it doesn’t matter to the consumer who produces them.

Those who oppose the idea of blockspace as a commodity would argue that different chains have different trade-offs between security, decentralization and performance, with users generally exhibiting strong preferences for one or a pair of these properties. Different communities and ecosystems form around specific design choices, and the term ‘maxi’ applied to Bitcoin or Ethereum supporters represents an intensification of this trend. Chris Dixon says:

Most blockspace will not be fungible, in my view, which will limit the financialization. While blockspace may be fungible within a single chain, between blockchains, there will be technical trade-offs in areas such as security and performance. More importantly, different blockchains have different communities around them.

Nonetheless, if multichain interoperability becomes a reality as prominent projects like LayerZero seem to believe, then blockspace will increasingly become homogeneous and interchangeable like a commodity. Users won’t need to know which chain they are on. Perhaps they won’t even know they are using a blockchain at all. As Karl Marx put it: "From the taste of wheat, it is not possible to tell who produced it, a Russian serf, a French peasant or an English capitalist.”

Looking at the present situation, it’s also important to highlight a distinction whereby differentiation and network effects may be crucial for certain use cases but less important for others. For instance, DeFi generally requires deep liquidity, so LPs and users wishing to swap tokens may prefer to trade on blockchains with higher TVLs. On the other hand, transferring stablecoins as payments, say sending native USDC, may be less sensitive to the specific ecosystems and rather look at the cost. If the prices continued to converge as they have, users' utility wouldn't vary by choosing one blockchain or another.

Finally, even if blockspace retained slight differences in underlying security, decentralization, and performance, this wouldn’t preclude it from being considered a commodity. In fact, commodities are often categorized into different grades, reflecting their quality. For instance, in the case of oil, different grades depict specific properties, such as density, sulfur content, and geographic origin, but they can all be grouped under the umbrella of 'crude oil’ or ‘petroleum' as a commodity.

Consumability and Scarcity

One of the most notable differences with securities is that commodities are physical goods that can be consumed directly by end users or used as raw materials to manufacture finished products. At the same time, both hard commodities (oil, minerals, etc) and soft resources (agricultural products) are finite or somewhat scarce.

This is the ‘use-value’ (or utility) concept Karl Marx refers to in his Critique of Political Economy:

To begin with, a commodity, in the language of the English economists, is “any thing necessary, useful or pleasant in life,” an object of human wants, a means of existence in the widest sense of the term. Use-value as an aspect of the commodity coincides with the physical palpable existence of the commodity. […] A use-value has value only in use, and is realized only in the process of consumption.

In other words, a commodity needs to have a practical purpose or be valuable in some way to people. Similar to commodities, blockspace is valuable and useful to users who want to get their transactions into the new state of a blockchain. Like commodities, blockspace is consumed, and this process is irreversible. As noted by Will Nuelle, consumers essentially purchase the right to utilize computing and bandwidth resources for a fixed period and storage over an indefinite duration. Computation and bandwidth are immediately consumed, and storage is indefinitely consumed since nothing can be removed from the blockchain to ‘free up space’. In other words, blockspace cannot be reused. Because blockspace needs intensive (and physical) resources like electricity, computation and hardware to be produced, and because they cannot be reused, it’s a scarce and limited resource. In fact, it’s even more limited than traditional commodities, since even increasing input (hashrate) won’t lead to increased production of blockspace, but only stronger security. Leo Zhang and Georgios Konstantopoulos write:

[…] unlike most commodity markets, more producers doesn’t mean an increase in the supply of blockspace. The supply of blockspace is determined by block size and the average block time.

Volatility and Tradability

Because commodities are either extracted from or grown on physical land, their production is often subject to various external factors like weather conditions and geopolitical events, alongside supply and demand fluctuations. These factors can lead to unpredictable availability and significant price volatility. Tradability in commodity markets was initially designed to help producers manage risks associated with external factors and hedge against price volatility. It’s important to note that the value of commodities comes from being tradable and exchangeable with others, what Marx called ‘exchange-value’.

Like commodities, blockspace is a resource that needs to be extracted (‘mined’ in Proof of Work blockchains) by a decentralized network of node operators, who face an upfront investment in hardware or staked tokens. At the same time, demand for blockspace quantified through fees that users attach to their transactions varies over time, making the blockspace business highly volatile. Blockchains serve as markets for the production, sale and usage of blockspace, striving to optimize demand and offer and assign the most accurate price to users’ utility (timely inclusion in a block).

This is an important endeavour because, as mentioned, the level of uncertainty in this business is quite high. On the production side,

The rewards node operators receive are liable to volatility: the spot price, transaction fees, and the probability of finding that block all factor into the uncertainty of rewards.

An efficient market, aka the blockchains, would ideally offset and hedge validators/miners’ capital and operational risks with things like staking derivatives, re-staking, or other more sophisticated solutions like Alkimiya:

Until now, none of these strategies or structured products have enabled users to gain exposure to the value of blockspace directly. As a specific example, the value of blockspace often gets bid up heavily during token airdrops, NFT mints, or days where the market is volatile and on-chain activity is high in general. Investing in blockspace via swap-integrated products allows buyers to take a directional bet on event-driven network congestion and profit off these expected events.

On the consumption side, blockchain users purchase and consume blockspace, similar to how they purchase and consume oil or wheat. When the blockspace demand increases, users can either pay higher fees or get included in later blocks. In both these scenarios, users incur a loss.

Leo Zhang and Georgios Konstantopoulos summarize this double-sided uncertainty well:

For miners, blockspace in the future has lower time value due to uncertainties in price, network difficulty, and fees. For users, blockspace in the future has lower time value because of the uncertainty in the profitability and the utility of their transaction.

In this scenario, the blockchains’ native tokens can serve as a first instrument to mitigate the risks of price volatility, both for producers and consumers. When blockspace demand and usage increase, the token will likely appreciate. Ethereum has an additional catalyser for this reaction: EIP-1559. Burning ETH used to pay base fees ensures that the rise in blockspace demand reflects in the ETH price, as heightened demand for blockspace leads to increased base fee burning, which in turn contributes to the deflationary supply of ETH. In essence, surges in blockspace demand directly benefit ETH holders.

By selling the tokens earned through fees and block rewards, blockspace producers can mitigate losses during periods of low activity and reduced income. Conversely, users can partially hedge against increased network costs during peak activity by purchasing tokens when prices are low.

In this context, tokens serve as derivatives representing the value of the underlying resource—blockspace—much like traditional commodities in derivative markets.

Blockspace Between Fungibility and Consumability

Among the properties analyzed so far, tradability, volatility, and scarcity may apply to other categories of products, such as securities, albeit with some differences. If we really wanted to simplify this analysis and see where blockspace resembles commodities, we could narrow it down to a two-dimensional analysis and focus on two properties: fungibility and consumability.

While commodities’s value is linked to their usability in various industries or for end consumers, securities are not consumable in themselves as they represent financial instruments and ownership in an entity. Moreover, their value is derived from factors such as the financial performance of the issuing entity, which makes each unique and different from others, or ‘non-fungible’. On the contrary, commodities are completely fungible and interchangeable.

Blockspace could be placed somewhere in between, with high levels of consumability and mid-levels of fungibility. If interoperability and modularity approaches prevail, blockchains will likely converge toward similar prices and performance, making blockspace effectively fungible (Blockspace*).

Another noteworthy property often associated with commodities, setting them apart from securities, is physicality: traditionally, commodities have been tangible goods or raw materials. However, it must be recognized that the current legislation pertaining to commodities is somewhat outdated, exemplified by peculiar exclusions such as onions. The evolving landscape of digital resources introduces a new dimension to this consideration, as items like bandwidth could potentially be regarded as commodities. As regulatory frameworks adapt to the digital era, there's a possibility that the definition of commodities may expand to encompass non-physical assets.

Why Does it Matter?

Discussing whether blockspace can be deemed a commodity is not merely an intellectual exercise but also carries practical implications.

If blockspace is recognized as a commodity, tokens of these blockchains could be viewed as derivatives, providing a means for participants to hedge against the volatility and risks inherent in the production and consumption of blockspace. This novel framework of blockspace as a commodity and token as a derivative tries to surpass the ongoing debate among regulatory bodies, particularly the SEC, CFTC, and the broader crypto community, regarding whether tokens should be categorized as securities. In this context, the argument is made that the CFTC, with its regulatory oversight of commodity futures, holds greater authority in shaping this discourse.

It's essential to note that this analysis and conclusion specifically pertain to layer 1s—full-fledged blockchain protocols whose primary product is blockspace. This framework may not necessarily apply to other protocols or applications with diverse offerings such as DeFi, games, social platforms, and more.

On a broader scale, this conceptual shift calls for reevaluating and updating the definition of commodities. Applying Marxist criteria, which insist on commodities displaying both use-value and exchange-value, demonstrates the seamless applicability of these principles to blockspace despite its digital nature. The outdated assumption that consumable items must be physical is rendered obsolete in the Internet era, where virtual resources like blockspace, bandwidth, and cloud storage have become indispensable products in the daily lives of billions. As technologies and markets progress, the regulatory landscape surrounding asset classification must remain flexible, subject to interpretation, and adaptive to change.

In a previous article, I discussed the relationship between the crypto industry and modern state institutions, exploring the possibility of preserving crypto's core values without threatening established states’ prerogatives like the monopoly over the monetary system and the military. A narrow yet viable route to reconcile these conflicting requirements is conceivable, and it may be facilitated by certain crucial infrastructure components, with zero-knowledge proofs standing out as a primary candidate.

The ideas presented in that article are relevant and complementary to the present discussion. While the first article considered the ideological and symbolic payoffs at stake in the confrontation between the crypto industry and governments, this piece approaches this relationship from an economic/rational perspective. Specifically, it delves into the costs and benefits that various outcomes of this confrontation may have for both sides. To achieve this, it employs game theory, particularly the Exit, Voice, Loyalty (EVL) game, as a tool to gain deeper insights into the decisions of the involved parties.

The EVL model is an extensive form game that examines interactions typically involving negative changes to one player's environment by another player. The two players are usually represented as the Citizen and the State. The game starts with the Citizen reacting to the negative change, which could be a new policy or law introduced by the State, and it unfolds sequentially like a chess game. The Citizen's initial possible responses are to Comply (abide by the new rule or law), Exit (avoid the new policy by taking some alternative action, like moving money abroad to avoid a new tax), or use Voice (complain or participate in other more or less organized ways to protest against the new law). The game concludes if the Citizen selects Exit or Comply. However, when the Citizen opts for Voice, it becomes the State's turn to decide between ignoring or responding (acknowledging the Citizen's concerns and reconsidering the new policy).

The EVL game can help us better understand and perhaps predict the outcome of the ongoing conflict between the crypto industry, represented by two major exchanges (Coinbase and Binance.US) and the US government, represented by the Securities and Exchange Commission (SEC), the federal agency that has been most active in confronting the crypto industry. The background move that ignites the game is the SEC’s commitment to introduce a new regulatory framework that categorizes most tokens as securities, excluding BTC and ETH, due to their ascertained decentralized nature. If such legislation were to pass, it would have significant implications for US-based exchanges like Coinbase and Binance.US. These exchanges would have to comply with various rules and regulations that apply to securities brokers and dealers, such as registering with the SEC, filing periodic reports, conducting audits, maintaining records, implementing anti-money laundering and customer protection measures, and paying trading fees to the SEC. As Coinbase team puts it in their 2022 Annual Report to the SEC:

Further, we believe increasingly strict legal and regulatory requirements and additional regulatory investigations and enforcement, any of which could occur or intensify, may continue to result in changes to our business, as well as increased costs, and supervision and examination for ourselves, our agents, and service providers. Moreover, new laws, regulations, or interpretations may result in additional litigation, regulatory investigations, and enforcement or other actions, including preventing or delaying us from offering certain products or services offered by our competitors or could impact how we offer such products and services. Adverse changes to, or our failure to comply with, any laws and regulations have had, and may continue to have, an adverse effect on our reputation and brand and our business, operating results, and financial condition.

Alternatively, crypto exchanges might opt to stop trading tokens considered securities by the SEC or relocate their operations to jurisdictions with more favourable crypto regulations. Nevertheless, these options could also entail risks and trade-offs, such as losing market share and customer loyalty, particularly if other nations do not adopt similarly stringent measures.

It's important to note that the two exchanges considered, Coinbase and Binance.US, occupy different market positions, with Coinbase deriving most of its revenue from the US market while Binance holds a dominant position internationally. These differing market conditions produce different cost-benefit structures, which in turn are expected to lead to different outcomes of the EVL game.

In summary, this real-world scenario provides a unique opportunity for a practical application of the theoretical framework of the EVL game. Unlike the typical EVL game, which relies on assumptions about variable values and relationships in payoffs, in this case, we can utilize real-life, specific data to set up and solve the game.

Setting Up the EVL Game

An extensive form game consists of choice nodes linked in a sequence. Choice nodes are points at which a player must choose an action. The choice nodes are linked to other choice nodes or outcomes by branches. The branches represent the actions that can be taken at each choice node. The branches lead to either another choice node or a terminal node. A terminal node is a place where the game ends. Each terminal node represents a possible outcome of the game and is labelled with the payoffs earned by each player in that outcome. The entire specification of choice nodes and branches is called a game tree because it resembles a tree.

Variables

In adapting the traditional game model to mirror the ongoing real-life situation, I've introduced and modified variables and payoffs for a more accurate representation.

• I represents the value of the benefit regulators took from the crypto industry. In this context, it is equivalent to the yearly revenue from the entire US market (encompassing all tokens). Unlike the conventional EVL model, I is not symmetrical for both parties (in the traditional game, 1 is the value of the benefit, either earned by the Citizen or the State, depending on the outcome). This assumption arises from the belief that if the new regulatory framework were enacted, crypto exchanges would cease trading most assets, resulting in no earnings for the SEC. For references to 2022 revenue, here for Coinbase and here for Binance.US.

• L represents the value of the crypto industry for the US government if the crypto industry complies and tokens are securities. This value is operationalized using the 2022 federal income tax rate (21%) for BTC and ETH, the only two tokens that wouldn’t be considered securities and hence could be traded. No fees on securities, which currently are set as $8 per $1 million traded, are factored in, as it is assumed that exchanges would rather delist tokens categorized as securities than face the compliance and monetary costs associated with trading them. The percentage of trading represented by ETH and BTC for Coinbase can be found here and for Binance.US here.

• L1 represents the value of the crypto industry for the US government in the event that the SEC decides to listen to the exchanges’ lobbying efforts and tokens are not considered securities. In this case, the SEC would not earn fees from the trading volume of these assets but would gain more in terms of net income tax (21% federal income tax on the full revenue from the US, I).

• E represents the value of Exit, operationalized as the 2022 revenue generated internationally (US excluded). To estimate Coinbase's revenue breakdown by geography, you can refer to this source, and for Binance.US, you can find relevant information here.

• c the cost of using voice is represented by the cost of lobbying the US Congress in 2022. Source here.

• p stands for the revenue generated from trading ETH and BTC in the US in 2022, assuming that these are the only assets left if the SEC prevails and the crypto industry complies. I assume it's the same percentage of trading volume for these tokens.

Strategies and Payoffs

It’s now possible to use these variables to express the payoff formulas for each player:

• exit: Should Coinbase and Binance.US opt for an immediate exit, they would retain revenue solely from business conducted outside the United States (E). In this scenario, the SEC would not generate any revenue since all crypto-related activity would relocate outside the United States. This diverges from the traditional game model, where the State typically gains the payoff associated with the extracted benefit. The assumption of a payoff equal to zero holds unless the SEC views implementing strict regulations as a victory in itself, irrespective of how many companies it impacts and how much business and revenue it loses.

• comply: If Coinbase and Binance.US decided to comply immediately, they could earn revenue from BTC and ETH trading only (p), given that they would be compelled, or it would be economically convenient, to delist other assets, now considered securities. Their overseas revenue would also remain intact (E). The SEC could earn income tax, albeit limited (L), compared to that generated if the exchanges could trade all assets (L1). In the traditional game model, the Citizen is assigned a payoff of 0, while the State receives a combined payoff of I+L. I assigned p+L to the exchange, because those components of the revenue should still be factored in, and I chose not to assign the SEC the payoff I because that represents the value earned by the exchange, which wouldn’t transfer to the SEC in case of compliance (like perhaps a tax in the traditional EVL game). In other words, in this particular instantiation, the payoffs are not symmetrical, and the game is a non-zero-sum game.

• lobby_answer: In the event of a successful lobbying effort and the classification of tokens as non-securities, Coinbase and Binance.US would have the potential to continue enjoying revenue from all trading pairs. The SEC would benefit from substantial income taxes generated by the two thriving businesses, although it would not gain fees from securities trading. Exchanges are assigned a payoff equivalent to their domestic and international revenue, as a domestic win wouldn’t necessitate renouncing the international business. This differs from the traditional EVL game, where the Citizen's successful use of Voice automatically excludes the payoff associated with Exit (E). Once again, the payoffs are not mutually exclusive, leading to a non-zero-sum game.

• lobby_exit: In the case of an unsuccessful lobbying effort and the subsequent decision to exit the United States, Coinbase and Binance would incur the cost of lobbying (c) while continuing to enjoy the economic upside from overseas activities (E). The SEC wouldn’t obtain any material benefit from this outcome.

• lobby_comply: In the event of an unsuccessful lobbying effort and the eventual decision to comply with the new SEC regulatory framework, and assuming that all tokens classified as securities would be delisted, Coinbase and Binance.US would only be able to retain the revenue generated by BTC and ETH and would face the cost of lobbying, c. Their overseas revenue (E) would remain unaffected. The SEC could earn income tax, but limited (L) compared to the full ones generated if the exchanges could trade all assets (L1).

Assumptions

While this case study provides substantial real-world data to construct the game model, certain choices and assumptions are required.

• I have chosen to ignore a considerable yet challenging-to-quantify cost that the SEC and the US would incur should the crypto industry decide to relocate (Exit). This cost would come from the missed jobs and economic output generated by the open-source industry, which Electric Capital estimates in the range of trillions of dollars. It’s also hard to estimate the positive spillovers that blockchain R&D would have on other sectors, including advancement in cryptography (e.g., zero-knowledge technology) or improvements in the financial industry.

• Similarly, it’s hard to factor in the amplifying effects of a positive regulatory framework on the exchange businesses, as more users would be encouraged to participate.

• The potential cascading impact of either positive or negative legislation in a major market like the United States on other countries has also been disregarded in this analysis.

• Finally, this study exclusively considered economic payoffs since they are easily quantifiable. For instance, the symbolic value of remaining in the US, especially for an exchange like Coinbase, funded and led by an American citizen, is ignored. Similarly, the ideological value of preserving the fundamental elements of the blockchain (decentralization, permissionless access, open-source) can be safely ignored because the player Citizen is here represented by two centralized exchanges that run on proprietary services and implement KYC and AML procedures, which makes them more similar to traditional web2 companies.

Representing the EVL Game

This is how the EVL game can be represented with its nodes (the players), edges (the choices) and the associated newly defined payoffs:

As previously discussed, the generic variables can be replaced with actual numerical values taken from the real-life scenario:

What immediately stands out from these data is that Coinbase’s overseas revenue represents a small portion of its total revenue, as the exchange has a small market share outside the US. Moreover, it’s still uncertain whether it will be able to recoup most of it in the coming months, despite the major effort placed in the so-called ‘Go Broad, Go Deep’ strategy for international expansion. Almost specularly, Binance.US revenue pales compared to Binance's global revenue, illustrating a situation where the exchange struggles to gain significant market shares within the US.

Notably, Coinbase's lobbying expenses significantly outweigh those of Binance.US, indicating differing degrees of commitment to this strategy. It's possible that Binance.US and other exchanges, recognizing Coinbase's strong interest in influencing US crypto policy and sharing the conviction that crypto-friendly regulations benefit the entire industry, may opt for a more passive approach and limit their lobbying efforts, becoming somewhat free riders.

Solving the EVL Game

Based on the numerical payoffs, we would expect that the choices made by the two exchanges would differ, leading to a distinct approach to solving the EVL game. EVL games can be solved using backward induction, a method used to compute subgame perfect equilibria in sequential games. The method consists of starting from the last node and choosing the outcome that maximizes the payoff while also anticipating the most likely choice by the other player.

In these applications of the EVL game, the last choice belongs to the exchanges, which would choose to comply over exit if the SEC rejected its requests and went ahead with a hostile regulatory framework. Even if it predicts that the exchange would comply, the SEC, at the preceding node, would still obtain a higher payoff by choosing to answer since conceding a favourable regulatory framework would have a higher economic payoff than implementing a strict regulation and eventually having the exchange remain in the US but with less economic activity. This is because, with the two exchanges fully operational in the US, the US federal government could earn more in federal income tax and benefit from the overall wealth generated by the two companies (employment, positive externalities, edge in tech innovation, etc.). Based on this assumption, the exchange would, as its first move, choose to lobby because it would expect that, based on purely economic interests, the SEC and the US government would choose to accommodate crypto’s requests and create an appealing environment for the industry to prosper. The subgame perfect equilibrium for this game is: (Lobby, Comply; Answer).

Contrary to initial expectations, and despite their contrasting cost/benefit structures and market positions, the EVL game and its corresponding payoff structure reveal that there's no discernible difference in incentives between Coinbase and Binance.US, and the solution to the game is the same. These findings reflect real-life observations as both exchanges have, for years, been engaged in discussions with the US government in the rational belief that a rigorous but favourable regulation would benefit the two sides and the US economy as a whole.

While the absolute payoffs suggest that the most likely outcomes are identical for both exchanges, the key distinction lies in the margin between the highest payoff and the other options. Notably, Coinbase stands to gain significantly more from lobbying compared to any other outcome (with a payoff over 1.5 times that of the second-best option, Comply). On the other hand, Binance.US is less dependent on lobbying and could achieve similar payoffs by either adhering to strict regulations or exiting the US market entirely. This unique nuance plays a pivotal role in influencing their future strategies.

For instance, if lobbying the U.S. government becomes increasingly costly, Binance might choose to give up and either comply with stringent regulations or withdraw from the US market altogether. However, if regulatory compliance also became more complex and expensive or legal challenges from agencies like the SEC escalated, Binance would probably be better off with a temporary exit from the US market. A concrete example of this strategic adjustment can be observed in Binance.US's recent suspension of dollar deposits and withdrawals, citing the SEC's "extremely aggressive and intimidating tactics," making banking partners hesitant to engage with the crypto sector. These decisions are expected to erode Binance's market share in the US, reducing its appetite for prolonged regulatory battles. On the other hand, Coinbase has been sustaining considerable costs to remain compliant and be able to keep pushing toward a better regulatory framework. For instance, for the year ended December 31, 2022, Coinbase faced an increase of $75.1 million in settlement costs largely due to a one-time settlement cost accrual of $50 million with NYDFS and an additional increase of $71 million in professional services due to higher legal fees related to litigation, regulatory, compliance and business consulting. This overall $146.1 million in costs associated with settlement and compliance are not factored in in the present analysis as part of the cost (c) of lobbying, albeit having a considerable weight on crypto exchanges’ future strategies.

While the exchanges’ observed behaviour mirrors the one predicted by the game, the SEC's unyielding commitment to the crypto industry crackdown is a notable deviation from the anticipated outcomes in our application of the EVL game. The SEC's most favourable economic outcome would be achieved through cooperative engagement with the crypto industry (answer). This collaboration would involve the creation of a well-balanced and favourable regulatory framework, providing ample operational freedom on which the industry could flourish while ensuring essential user protections. However, the SEC's current stance and actions defy conventional economic rationality, arousing suspicions of an unwarranted agenda and strengthening arguments that ideological motivations may be at play.

Charting a Course for the Future

The game-theory analysis proposed in this article offers an optimistic perspective on the ongoing regulatory struggle in the cryptocurrency industry. Unlike the theoretical assumptions in Exit, Voice, Loyalty (EVL) games, this real-world data application produces a non-zero-sum game where everyone can benefit economically by fostering a favourable regulatory framework that nurtures the crypto industry's growth within the United States.

Interestingly, the actions of both Coinbase and Binance.US closely follow the game’s predictions, emphasizing the rationality of their lobbying efforts. Nevertheless, the durability of this situation depends on various factors, including the escalating costs associated with lobbying, lawsuits, and overall compliance. It's conceivable that should these costs continue to grow, Binance.US may ultimately choose to exit the U.S. market, while Coinbase might persist in its endeavours and potentially even comply with the new regulatory framework. In stark contrast with these rational strategies, the actions of the SEC appear to deviate from the rational behaviour predicted by the game, highlighting inconsistency in its approach.

While Coinbase and Binance.US only partially represent the blockchain industry and its values, centralized exchanges are still necessary as they facilitate on and off-ramp and provide a bridge between fiat and crypto. Moreover, Chainalysis’ latest data reveal that North America accounts for nearly a quarter of global transaction volume, underlining the substantial influence of this region on the entire industry.

The choices made in this pivotal regulatory arena undeniably set a precedent that will shape the future of the blockchain and cryptocurrency industry worldwide.

Recently, scientists at CERN have answered this question by performing a high-tech version of Galileo’s famous experiment of dropping objects from the Leaning Tower of Pisa. They created and cooled antihydrogen atoms, the simplest form of antimatter, and released them from a magnetic trap. They observed that antihydrogen atoms fell downwards at the same rate as normal hydrogen atoms within experimental error. This means that antimatter is not immune to gravity but rather obeys the same laws as normal matter.

This discovery has some interesting parallels with the world of crypto, where technology and products have been unlocking unprecedented use cases and mechanics that are different and sometimes opposite from those of traditional finance and businesses. For example, crypto enables peer-to-peer transactions without intermediaries, decentralized governance without central authorities, and programmable money without borders. Also, crypto consumer products generally aim at giving back to users, distributing shares of value to those who have contributed to generating it. During the last bull cycle, pumped by a general bubble in the tech industry and the real economy, we were somehow led to believe that crypto end consumer protocols and products were immune to the same basic principles as other traditional products, such as the need for real and sustainable revenue streams and the need to charge some fees to users. We thought that, because of new blockchain-enabled mechanics like native tokens, these products could escape the fundamental laws of economics.

It turned out it was never the case, and for how innovative and disruptive these products are, they are still subject to some core tenets:

• Consumption is the objective of economic activity, and production is its means. The end goal is consumption, which means protocols and apps need to create something that other people want or need, which requires a strenuous process in the search for product-market-fit.

• Production has costs. To produce something valuable, protocols and apps need to incur some costs, which need to be accounted for and covered.

• Productivity determines the wage rate. DAO members need to be productive to get retribution, and in general, users of a protocol or app need to bring tangible contributions to be eligible for rewards like airdrops.

• Money is not wealth. Money accrues wealth so long as it has purchase power. Tokens are not making protocols and apps suddenly wealthy if that token has no value outside the protocol itself (see FTX’s FTT or Binance’s BNB).

Just like antimatter is not exempt from gravity, crypto protocols and apps are not exempt from the business laws that govern our economy. Crypto products must generate tangible value for their users and stakeholders, differentiate themselves from their competitors, and find sustainable ways to monetize and generate profit. Otherwise, they risk being annihilated by market forces or regulatory actions. Successful crypto protocols and products are those that have managed to find a consistent and tangible revenue stream while redistributing value to those who contributed to their success, decentralize while maintaining efficiency, and open source their code while ensuring defensibility. Experiments that confirm this of this include Ethereum, MakerDAO, Aave, zkSync, and consumer applications like Friend.Tech.

While the notion of revolutionary crypto protocols challenging established economic norms was captivating, realising that they in fact align with well-known principles is a clarifying moment. It allows us to redirect our efforts towards building valuable, sustainable solutions that can compete and resonate with a broader audience. No longer should we hesitate when questioned about the value of a project's tokens, which should always stem from a tangible source and clear economic mechanisms. With this newfound clarity, we can foster a stronger foundation for the crypto industry's growth and mainstream acceptance.

However, in this seemingly utopian vision lies a fundamental conundrum - a clash between the ethos of blockchain and the traditional stronghold of the state over money.

Defining the Conundrum

Since the Peace of Westphalia in 1648, which ended the Thirty Years' War, modern nation-states have been claiming the inviolability of borders and non-interference in their domestic affairs, grounding their sovereignty over their population on some fundamental pillars:

1. Monopoly over the Use of Force: Modern nation-states have maintained a monopoly over the legitimate use of violence and force within their defined territorial boundaries. This involves having a standing military, police force, and legal framework to enforce laws, maintain internal security, and protect citizens.

2. Monopoly over Taxation and Revenue Generation: Nation-states possess the exclusive authority to levy taxes on their residents and entities within their territory. This revenue generation through taxation allows the state to fund public services, infrastructure, and essential functions, including the military.

3. Monopoly over Currency: Nation-states have the exclusive authority to issue and regulate their own currency, enabling them to control monetary policy, manage inflation, set interest rates, and facilitate economic transactions within their borders and with other States.

By promising an alternative and independent financial layer, inclusive of digital decentralized currencies (cryptocurrencies and other tokens) and independent monetary policies (tokenomics), crypto fundamentally threatens the States’ monopoly over Currency. If citizens were allowed to transact with an independent currency without the State’s involvement, the State would struggle to collect tax, which in turn would undermine its ability to pay for public services. Most importantly, the State would struggle to pay for the military.

We can see then that these three monopolies of the nation-states are closely intertwined, and challenging one would inherently question the others. This holds true unless we undergo a profound reevaluation of the fundamental concepts that underpin the modern State and society.

The conundrum faced by blockchain, then, becomes evident:

Can we establish a truly decentralized and permissionless financial layer without unraveling the traditional fabric of governance and society, where States maintain a monopoly over money?

In essence, can we go bankless without going stateless? The answer holds profound implications for the blockchain industry and the future of finance, the state, and how we navigate this digital revolution.

Exploring Different Perspectives

Eric Vorhees, a devoted libertarian and a fervent advocate of crypto's founding principles, calls for establishing a permissionless and decentralized financial layer as part of a clear separation between money and the State, akin to the Enlightenment philosophers' call to detach religion from politics. In line with the libertarian ideology, this represents just the first step toward a world with minimal or no state intervention, and where the free market would self-regulate and adjust to achieve the maximum utility.

While blockchain's potential for financial liberation is tantalizing, we cannot overlook the critical role played by governments. Governments are the bedrock for social stability, security, and essential infrastructure, including critical aspects such as energy, which is vital for developing technology like blockchain. Although some resources are now being facilitated by private entities, exemplified by Starlink--Elon Musk's private satellite network providing internet access--certain functions such as maintaining security through military and police should not be outsourced to private entities.

It's crucial to recognize that modern states and the democracy we currently practice have operated for merely a fraction of human history and are not set in stone. Recently, these fundamental institutions seem to face persistent challenges, dramatically evident in the declining levels of voter turnout at all major elections. In the economic sphere, concerns persist regarding the stability and resilience of the global financial and banking systems, along with challenges central banks encounter concerning money issuance, public debt, and uncontrolled inflation. Clearly, institutions must adapt to the evolving historical context to remain relevant, requiring a collective effort to explore alternative approaches.

While blockchain undeniably holds great potential in facilitating collective action and capital mobilization (for example via Decentralized Autonomous Organizations, or DAOs), potentially enabling individuals to self-organize for providing essential public goods, they have yet to demonstrate their maturity. Replacing the State with all its core functionalities remains a considerable distance away.

The Future of Crypto: What Lies Ahead

As blockchain gains traction, established institutions are beginning to embrace this disruptive technology. However, their approach often entails selectively extracting components that suit specific needs--such as fast finality and settling for international transactions and automated processes for continuous asset trading--diluting the revolutionary nature of blockchain. Private blockchains (launched by Citibank, JPMorgan, and Goldman Sachs), central bank digital currencies (CBDCs), and institution-driven crypto adoption (Fidelity, Citadel, and Blackrock pushing for RWA trading and crypto ETFs) raise concerns about the loss of blockchain's decentralized, permissionless, and transparent nature.

The central issue here is whether blockchain will be embraced but distorted by institutions, serve as a true instrument of empowerment for individuals in a challenge to the traditional financial monopolies, or perhaps something in between. Vitalik Butherin recently co-authored a paper called ‘Blockchain Privacy and Regulatory Compliance: Towards a Practical Equilibrium’, which describes a system allowing users “to publish a zero-knowledge proof, demonstrating that their funds (do not) originate from known (un-)lawful sources, without publicly revealing their entire transaction graph”. Zero-knowledge technology, which generally allows a prover to demonstrate to a verifier that a claim is true without giving out any information about that claim, may indeed hold the key to reconciling the seemingly inextricable conflict between the core principles of blockchain and the regulatory compliance necessary for a harmonious coexistence with traditional institutions.

Embracing the Debate for a Prosperous Future

The clash between blockchain's revolutionary potential and the traditional role of the state in macroeconomics and finance is a defining issue for crypto. It's a narrative that extends beyond the realm of finance, touching upon the essence of societal governance and individual empowerment. It is also at the heart of the actions of regulatory bodies like the SEC and the pushback against crypto projects. The debate about securities, or the rejection of Bitcoin spot ETFs, is a natural expression of this central struggle: the attempt to integrate a decentralized, permissionless financial layer within the established framework while questioning the power and authority of the government and the State.

In considering the trajectory of blockchain and crypto, two plausible scenarios take shape. The first is where crypto gets widely adopted yet at the cost of losing its key revolutionary elements to fit into the traditional frameworks. The second envisions crypto preserving its core features, but remaining confined to a small segment of users, without ever fully realizing its revolutionary potential. There is a third, less probable, yet worth pursuing, outcome, one that could be fulfilled by zero-knowledge technology: crypto achieving widespread adoption, fortifying the foundation of future institutions, all while preserving its essential components, and coexisting harmoniously with traditional government and state institutions. These potential paths underscore the critical juncture at which blockchain technology currently stands, presenting a pivotal choice that will shape the future of finance and governance.

Blockchain technology is undergoing a significant shift - transitioning from the monolithic model, where a single blockchain handles all functions including execution, consensus, settling, and data availability (as seen in Ethereum), to a modular design. This paradigm envisions a plug-and-play architecture, where each component of the blockchain stack is outsourced to a marketplace of third-party providers, enabling different blockchains to combine distinct elements for various functionalities. For instance, an optimistic rollup on the OP Stack could serve as the execution layer, supplemented by a zk proof from third-party providers like RISC Zero. Ethereum would serve for settlement and consensus, while data availability could be ensured through platforms such as Celestia, Espresso, or others. In addition, third-party providers like LayerZero and CCIP could facilitate cross-chain interoperability, restaking protocols like EigenLayer could provide a shared network of validators for consensus, and MEV marketplaces and decentralized build blocker networks like Flashbots SUAVE could complete the stack.

This approach aims to relieve the pressure on the foundational chain, Ethereum, allowing it to focus solely on settlement and consensus. At the same time, modularity introduces flexibility and composability, thus widening the scope for blockchain design, accelerating innovation, enhancing user experience, and bringing the industry closer to mass adoption.

Intents

This movement towards modularity partly overlaps with another trend - the advent of intent-based blockchain architecture. The aim is to make the blockchain experience more flexible, nuanced, and sophisticated while also increasing blockchains awareness of the external environment/context. Under the intent-based framework, users express their desired outcomes by signing off-chain orders and delegating the task of achieving them to sophisticated and professional third parties. This concept departs from the current imperative model, where users interact directly with smart contracts by signing on-chain transactions and specifying each parameter explicitly.

Examples of intents-based architecture can be found across various domains, including DEXs (e.g., UniswapX, Arrakis Finance, DefiEdge), block builders, and MEV (e.g., Flashbot SUAVE), and cross-chain interoperability (e.g., LayerZero, CCIP). In all these instances, a decentralized network of operators, acting as third-party providers, interprets users' preferences and executes them efficiently. This off-chain outsourcing allows operators to perform complex tasks that might be challenging on-chain, like combining multiple transactions to generate intricate sequences, executing transactions across multiple chains, enabling gas fee payments in any token, and even capturing MEV. While intent-based protocols promise higher returns to end users and offer flexibility and convenience, they also abstract users' intent, moving away from the fundamental blockchain approach of direct and permissionless interaction with verifiable smart contracts without intermediaries.

The shift towards modularity and intent-based architecture introduces more intermediation between users and the base blockchain, Ethereum, where most state settlement and data posting occur. While this abstraction enriches the user experience, it also introduces complexities, multiplies trust assumptions, and expands the attack surface. As we embark on this path, we must evaluate whether this is a solid and secure trajectory for the future of blockchain technology.

While the incident's resolution is still ongoing and potential ramifications remain, it already elicits some considerations.

1/ Diversification of Price Feed Oracles

The first notable thing about this hack is the role of Chainlink in maintaining price stability across DeFi protocols.

As the hacker drained CRV tokens from Curve's pools and could have triggered a large sell-off, the CRV price on Curve plummeted, resulting in a lack of liquidity. Had other DEXs and DeFi protocols like Aave solely relied on Curve for CRV price feeds, they would have reflected the new heavily discounted price. This could have triggered an almost-immediate domino effect across DeFi, with depositors, LPs, lenders, and other DeFi stakeholders removing their liquidity, swapping their CRV, and closing their positions for contagion fear. While a contagion and a wave of liquidations are still possible, the worst scenario (an immediate chain reaction of liquidations, impossibility to liquidate, and bad debt) was averted thanks to Chainlink’s oracles network. These nodes, forming a decentralized network, rely on a mix of both CEXs and DEXs and both on and off-chain sources for their price feeds, which helped DeFi protocols maintain the CRV price stable while it was tanking on Curve.

This episode highlights the importance of diversification, even when it includes off-chain and centralized sources. The crypto industry should strive for diversification to maximize resilience.

2/ Bounties for MEV Searcher Bots

The second noteworthy takeaway is the role of MEV searcher bots, which have actively thwarted hacks on Curve by front-running hackers’ transactions, producing the largest MEV block rewards in Ethereum’s history. Remarkably, some of these funds were ultimately returned to Curve, highlighting an exciting new application of beneficial MEV utilization, alongside existing practices like arbitrage and liquidations. The most notable example is c0ffeebabe.eth, who frontrun hackers and returned around 2,800 ETH (~ $5.4 million) to Curve. While this time the frontrun happened spontaneously due to inherent economic incentives - the MEV searcher bot came across an opportunity and seized it regardless of its nature - in the future, protocols could proactively incentivize MEV searchers by offering bounties for identifying and thwarting attacks – akin to hiring a private security firm to prevent thefts.

3/ Permissionless Access, Composability, and Decentralization

The inherent strengths of crypto networks – permissionless access and composability – also introduce vulnerabilities. The permissionless nature and open source code enabled hackers to identify and exploit the Vyper vulnerability, while composability across DeFi protocols poses the risk of a domino effect. Specifically, the widespread acceptance of CRV as collateral by various DeFi protocols has unlocked massive liquidity and profit opportunities in the past years, but may now cause a cascading wave of liquidations. Aave v2, for instance, is heavily exposed to Curve founder Micheal Egorov’s massive and well-known borrow position, a $70 million loan collateralized by 33% of the CRV total circulating supply. Gauntlet has previously advised Aave to rely less on CRV due to its shallow liquidity and concentration risk. Egorov’s liquidation price on Aave v2 is $0.376 per CRV. Should the hacker attempt to mass sell the stolen CRV (about 8% of the total supply), the price would further drop, and likely go below the liquidation price. This would be potentially catastrophic, because the massive collateral used by Egorov, combined with the high concentration of CRV, results in a general lack of CRV liquidity in the rest of the ecosystem, which would make it very hard, if not impossible, for Aave to liquidate the loan (because no liquidator could sell those CRV without tanking the price), generating bad debt for the protocol.

While the ecosystem, made of many honest developers and stakeholders, managed to control the damage, every time one of these crises unfolds, we get to discover unsettling truths that have always been under our scrutiny, but always largely ignored. In this case, the second-largest DEX founder holds almost half of the token’s total circulating supply. This is not ok for a self-proclaimed decentralized protocol, and it’s a major red flag that only a few have pointed out. The unique feature of DeFi, which distinguishes it from traditional finance and arguably makes it better, is the transparency and permissionless access, meaning anyone can monitor in real-time the state of each protocol and each participant’s position. We need to get better at overseeing and reporting vulnerabilities and dangerous situations, and better at designing safeguards and mechanisms that protect honest participants and their funds. We need to give more voice to teams like Gauntlet.

This article delves into three prominent solutions at the forefront of the interoperability space: Cosmos IBC, LayerZero, and the recently-released Chainlink Cross-Chain Interoperability Protocol (CCIP). Each brings a unique approach, aiming to break down the barriers that hinder the fluid exchange of value and information across decentralized networks. Due to their novelty and similarities, more emphasis will be put on LayerZero and Chainlink CCIP.

Cosmos IBC

• It’s a blockchain network architecture rather than a messaging protocol like LayerZero and CCIP.

• It allows arbitrary messages to be sent among supported chains, which are the chains (called ‘zones’) built on Cosmos Hub.

• By default, it only works with chains on Cosmos Hub because, due to the Cosmos consensus algorithm Tendermint, it only supports fast finality chains. Cosmos announced that in 2023 they will open up interoperability with other chains, starting with Ethereum.

• Packets of information are communicated from one zone to another by posting Merkle proofs as evidence that the information was sent and received. This mechanism is called inter-blockchain communication, or IBC for short.

• It uses an intermediate chain (Comos Hub) to facilitate consensus. Each zone is responsible for verifying and executing transactions in its zone, but inter-zone tokens or message transfers go through the Cosmos Hub, which relays messages and manages the zones. Zones post block commits to the Hub so that the Hub is up to date with all zones’ states.

• Cosmos Hub ensures the packages posted in the source zone are valid.

LayerZero

• The first trustless omnichain interoperability protocol.

• It’s a low-level communication primitive/messaging protocol upon which dApps (such as cross-chain DEX or multi-chain yield aggregator) can build (thus becoming automatically cross-chain). LayerZero requires apps to build on its protocol, and it doesn’t simply connect existing apps on existing blockchains. However, interoperability is then ensured among all blockchains that have a LayerZero Endpoint.

• LayerZero doesn’t rely on a trusted custodian or intermediate transactions and doesn’t need an intermediary chain or token. Technically, it’s said that it allows the transfer of tokens and messages without requiring cross-chain machine state replication.

• Trustless valid delivery of arbitrary messages and data, not just tokens. Valid delivery = the message m is only delivered to the target chain/app if and only if the transaction t’s header and proof match (which can only happen if the transaction is valid, or if it’s not and Oracle and Relayer collude).

• Two independent entities corroborate the validity of a cross-chain transaction: the Oracle provides the block header, and the Relayer the proof associated with the transaction. For Oracle, LayerZero has integrated Chainlink Decentralized Oracle Networks (DONs). The Relayer is an off-chain service currently provided by LayerZero (but the infrastructure allows for the usage of any arbitrary relayer, meaning that individual dApps are able to choose any chosen relayer, even set their own). There is no trust assumption. The only requirement is independence between these two entities.

• On each supported blockchain, there is an onchain lightweight client (as lightweight as possible to reduce the costs of running smart contracts on L1 chains) as the interface to access the LayerZero messaging protocol (called LayerZero Endpoint). In short, these smart contracts allow users to interact with the protocol and send messages.

• Unlike Cosmos or Polkadot, where communication needs to always go through the relayer chain, incurring extra costs, LayerZero enables the passage of messages without intermediate steps.

• Basically, LayerZero delivers messages (m) and works as a guarantor that the request to get tokens on Chain B from a user on Chain A is valid because some tokens on Chain A have been locked (transaction t). Based on this third-party guarantee, Chain B puts the requested tokens at the disposal of the user. The exchange logic is managed entirely by smart contracts on both chains (source and destination).

Chainlink CCIP

• It’s an inter-chain communication protocol.

• The architecture is similar to LayerZero: there are on-chain smart contracts on both sides of the two blockchains handling the exchange logic and off-chain nodes relaying the messages.

• For oracles, CCIP leverages Chainlink’s extensive Decentralized Oracle Networks, or DONs, high-quality off-chain node operators with verifiable on-chain performance histories. Before CCIP, DONs’ job was to relay off-chain data to on-chain (the main purpose of oracles and Chainlink). Now, they also participate in relaying messages and value across chains. Specifically, DONs bundle transactions and create a Merkle root. This Merkle root is signed by a quorum of oracles nodes part of the Committing DON. The Merkle root is verified and approved by the Active Risk Management (ARM) network. DONs are separated into Committing DONs (provide Merkle root) and Executing DONs (provide transactions proof). Separating this gives the ARM time to monitor and intervene in case of malicious activity.

• CCIP adds extra security with an Active Risk Management (ARM) network, a separate and independent set of off-chain nodes that monitor for malicious activity and that can automatically pause services and protect user funds in case of malicious activity. Specifically, they monitor the Merkle roots committed by the Committing DON (they can bless or curse them). There is also an ARM contract (on-chain) that maintains the list of ARM nodes’ addresses and enables ARM nodes to bless/curse the Merkle roots.

• OnRamp and OffRamp are smart contracts on the source and destination chains. OnRamp basically manages the lock or burn part, while OffRamp ensures the message is authentic by verifying the proof provided by the Executing DON against a committed and blessed Merkle root, and if all is good, interact with the pool to unlock or mint tokens.

• Each token has its own token pool, an abstraction layer over ERC-20 tokens that facilitates OnRamp and OffRamp token-related operations (and that can be set as lock or burn and unlock or mint).

• Transfer arbitrary messages AND tokens. Users can use CCIP to:

  • Arbitrary Messaging: Call smart contract functions on a different blockchain. Multiple messages can be included in one transaction, allowing for multi-step, multi-chain tasks.

  • Transfer tokens to a smart contract or Externally Owned Account (EOA) on a different blockchain. Technically they are not ‘transferred’, but they are locked or burned on the source chain and then unlocked or minted on the destination chain.

  • Programmable Token Transfer: Send arbitrary messages and tokens within the same transaction. This functionality can be used to transfer tokens with instructions on what to do with those tokens to a smart contract on a different blockchain.

• Off-chain reporting (OCR) protocol, which was already used by Chainlink oracle service to secure value on several mainnet blockchains.

Major similarities and differences between LayerZero and Chainlink CCIP

Design

• Both are low-level communication protocols that can be applied to existing blockchains. Chainlink also openly aims to involve traditional financial institutions and connect them with blockchains.

• Both LayerZero and Chainlink CCIP have on-chain components (smart contracts on each side that manage the execution and exchange of tokens) and off-chain ones (networks of nodes that relay messages and provides proofs). LayerZero Endpoints cover the functions of Routers (interface and initiate messaging) and OnRamp/OffRamp (two smart contracts on each side that initiate and execute transactions) in Chainlink CCIP.

Functionalities

Chainlink CCIP seems to allow for more actions than LayerZero, especially with the Programmable Token Transfer.

Security

The separation between Oracle and Relayer in LayerZero resembles the separation between Committing DON and Executing DON in CCIP (one provides Merkle root, the other the transaction proof). However, DON belongs to the same network and thus would make the infrastructure less trustless. This is why, on top of the DON network, CCIP added an extra check with the ARMs, a separate and independent network that monitor DONs’ activity and can pause service and protect users’ funds. All in all, the level of trustlessness of Chainlink CCIP can be compared to the one of LayerZero (two independent networks). For both, the security depends on the separation and independence (aka, more likely that they won’t collude to steal users’ funds) between these two sets of nodes. It’s not clear how this separation can be ensured (individual dApps are unlikely to create their own Relayer, the same way they don’t have their independently-run oracles) or how we can be sure that, despite being separate and independent, they won’t collude anyway.

Conclusion

While still considered the gold standard of cross-chain communication, Cosmos IBC has been facing formidable challenges from LayerZero and Chainlink CCIP, which have introduced novel approaches and additional functionalities. One notable enhancement is their low-level nature and blockchain-agnostic design, which provide greater flexibility in connecting arbitrary blockchains. In response to this competitive pressure, Cosmos is expediting the development of its IBC-Solidity infrastructure, expected to release later this year, which will further intensify the race for cross-chain leadership.

At the same time, the European Union is also up to speed after passing the MiCA body of regulations last May. Despite representing an important milestone, there are mounting concerns that this regulation might already be outdated (it doesn’t cover NFTs, DeFi, or other central components of the blockchain industry) and challenging to implement in real-world scenarios.

The divergence in approach - whether allowing an industry to develop organically, assessing eventual problems, and implementing regulations to address them, or proactively establishing preemptive laws to regulate and shape the nascent industry - makes me wonder about the influence of the legal system (common law or civil law) on entrepreneurship and innovation.

Let's consider the common law, which offers flexibility, adaptability, and a strong emphasis on property rights. Entrepreneurs should thrive in this environment as rulings and laws based on real cases provide clear references. Nevertheless, the process of consolidating legal principles into clear laws often requires a significant amount of time, leaving entrepreneurs operating in a legal gray area for extended periods. This is exactly what happened to Coinbase, XRP, and many other projects in the crypto space. This state of ambiguity and uncertainty could discourage entrepreneurs and incentivize businesses to relocate to other jurisdictions, as Binance and FTX did.

On the other hand, civil law tends to generate comprehensive systems and is generally introduced at an earlier stage, setting boundaries early on and leaving companies and entrepreneurs the opportunity to plan accordingly. While this initial clarity may seem advantageous, the timing and extent of these regimes can potentially stifle innovation and suffocate emerging industries, especially when introduced prematurely, before a thorough understanding of their true potential has been reached. This could be the case for the EU’s bodies of laws and regulations on blockchain in May and AI in June.

More studies and evidence are needed to answer the question: is one legal regime more conducive to propelling innovation? In the meantime, it will be interesting to keep monitoring the development of different legal approaches and assess their impact on entrepreneurship, innovation, and growth of the crypto industry. By fostering an environment that combines regulatory clarity with adaptability and flexibility, governments can enable companies to thrive while safeguarding the interests of all stakeholders.

The key insight of mechanism design is that the outcome of a system is shaped not only by the participants' actions but also by the rules, incentives, and constraints that govern their interactions. In this case, even if web2 companies were to try to change direction, they would still face hard systemic constraints, which would make it a challenging task without undermining their product and financial viability. In fact, the opposite is often the case. As competition fires up and new players emerge, incumbents inevitably move to defend their market share. Like quicksands or knots, the more they move, the more entrenched they get, and the outcome is almost inevitably a tighter and more extractive system (see, for example, what recently happened at Reddit or Twitter as they tried to protect their positions).

Mechanism design’s goal is to design rules or mechanisms that align individual incentives with socially optimal or efficient outcomes. Web3 is promising because it’s founded on a completely new set of incentives and constraints, signifying a transformative shift and offering an alternative vision for the Internet. By integrating decentralized technologies like blockchain and smart contracts, web3 platforms can leverage a native value transfer mechanism. This shift in infrastructure aligns incentives with user ownership, openness, and interoperability, enabling applications to interact and enhance each other's functionalities and developers to leverage existing building blocks to create new experiences. This permissionless and modular approach reduces dependence on single platforms and fosters healthy competition, driving innovation and value creation.

It's time to set off on a journey where the Internet serves as a tool for empowerment, creativity, and collective progress. With web3, we have the chance to reset the rules and build a better digital world for generations to come.