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MEMO W18 MAY 2024

There are only few very successful things that the people want over and over again. - xh3b4sd

We have recently come across conversations about how to value blockchain networks. Those conversations have been sparked by Tokenterminal's financial statements, which are generated for any notable L1 blockchain and DeFi application. Those financial statements calculate profitability metrics that we discussed in our most recent Powerlaw memo. Profitability here is defined as earnings, which is basically revenue minus expenses. There is a lot to unpack with this seemingly simple calculation, because the issue with any statistic is always where the data comes from and of which quality it actually is. There are other issues like methodology, consistency and plain data availability. Those issues are a given for us now and what we want to rather focus on here is the definition of expenses that proof of stake blockchain networks have to bring to bear in order to operate properly. What made me write down all of my thoughts here was the opinion raised by some people in the industry, that token issuance is not a pure expense to the extend that those tokens are issued. The argument I have heard being expressed was that issuance is only an expense if token holders get diluted by said issuance. And dilution here can be prevented by simply staking said tokens. I think this line of thinking is flawed and sounds rather constructed in order to fit some existing formula or world view. What is being mistakenly conflated here are the desires of two different entities, namely the system and the individual, or the network and the staker. I think Tokenterminal generates financial statements for the system. And the arguments against this methodology of profitability argue for the staker. That means the legitimacy of the generated financial statements and the arguments against them, at best, talk past one another. And then there is the following mechanic to be considered. From first principles, token issuance increases the quantity of money as Russell Napier would put it. The quantity of money is the gas of the engine, and whether your share of the total supply remains intact has no bearing on the fact that tokens are issued in order to keep the system alive. The liveliness of the system is a necessity which, in the context of proof of stake blockchain networks, is achieved by paying validators to secure the network. That payment to validators is an expense for the overall network as an entity. That expense and its necessity is true and good regardless of an individuals share of the total market cap. And I would further argue that merely maintaining an individual's share of the market cap is not good enough for keeping real dilution at bay, because staking implies risks. Additionally, in second order consequences, token issuance does not automatically guarantee proportionally deeper markets that guarantee an individuals execution price if the tokens in questions would have to be sold. Arguably the last point here is a rather weak proposition, but granted, token issuance causes inevitable dislocations within the underlying system that cannot be simply protected against by mere staking, even if you get the full rate of staking rewards, which most stakers simply do not get due to delegated or liquid staking mechanisms, which in turn adds more risk to those positions. So the purpose of staking in the context of proof of stake blockchain networks is not to prevent dilution for stakers, but rather to secure the network. And all of these considerations ignore additional dilutive second order effects of delegated or liquid staking mechanisms. Saying token issuance is not an expense when you stake is like saying inflation is not real as long as you only hold treasury bills. That is simply wrong, because the market is more complex. And simply backing the nation state by holding its debt instruments does not automatically imply that your purchasing power remains intact, because it does not. In fact, the real world is showing us every day how the quantity of money is causing incomprehensible dislocations in the markets over decades. And all of that is to say that an increased quantity of money is in fact a cost for the system and the individual alike, even if those costs take a long time to unfold. And thus token issuance is clearly an expense for any proof of stake blockchain network in my eyes, whether you stake your tokens or not. The question for the system will always be how much you have to pay in order to stay alive. Keeping your individual share of the market cap does not change that, especially not in measures of risk adjusted returns.

An interesting thought I came across past week is summarized in this memo's quote above. From a product or service design perspective there are many things you can come up with in order to make people go like "oh cool, I like this". Appeal on first sight is not worth a lot in our day and age if there is no second look taken. All of those one trick pony kind of things have a very short half-life. Mapping that insight to blockchain networks, it is actually the networks themselves that get used every day. Ethereum blockspace is not only cool once. It is being used and demanded over and over again. The same is true for Bitcoin and Solana blockspace today. The lines between infrastructure and applications are quite blurry at times in crypto land. Services that have been demanded and frequently used so far in crypto land are one, storing value, two, exchanging tokens, and three, taking on debt. All our successful experiments can be put in those three categories in one form or another: Tether, Bitcoin, Uniswap, Maker, etc. I am intentionally leaving out the casino aspect of crypto. Arguably, the casino aspect was the first feature of it all, and it still is the main driver keeping this industry alive across cycles, until proven otherwise. I have not much to offer in this section other than the mere idea that the thing that some people find interesting once may not be the thing that will still be relevant tomorrow. Reading this, that might appear obvious to you, dear reader. Though, if anything, look out for those things that people want to use over and over again. If something is being used over and over again, that very fact for that very thing will likely always be true. So if anything, try to get the big things right.

Here are some numbers for you. EIP-1559 activated over 1,000 days ago, and ever since we have burned almost 4.3 million ETH, simply based on the usage of the chain. Anecdotally I have heard that 10 billion USD of altcoin supply inflation is now hitting the market every month. This inflation has to go somewhere eventually and I think everything that is neither Bitcoin nor Ethereum, while inflating away, will have a very hard time to survive this cycle. Similarly, I have now seen all rent paid to Ethereum L1 by the L2 rollups going below 100,000 USD per day. This is the rollup centric roadmap scaling Ethereum right there, because at the same time the L2 user base hovers around 5 million recorded active addresses on a weekly basis. I thought that the blockspace and data availability issues we had in the past will all get commoditized away by fierce competition within a free market. And then you got to wonder how all of the alternative DA solutions can possibly remain relevant in the long term, because even if we 100x the current data availability demand, the bills are not likely to get paid by just making data available. Interesting times ahead!

At last, I would like to invite anyone of my readers to reach out, if there are any questions or ideas for collaboration. I want to write about your startup, strategic execution and elegant mental models. My brand archetypes are sage, outlaw, magician and creator. If you would like me on your cap table as an angel investor, then feel free to send your pitch my way. If you would like my feedback or engage in an interesting conversation, then I am happy to chat or have a nice dinner over some sweet red wine. If you are a writer yourself, then I would love to talk about the art of writing and maybe get your feedback on my writings here. If you think we should work on something cool together, then please reach out and let's be friends.

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