The continuous development of the application layer of cryptocurrencies will generate significant real-world value for crypto assets.
Table of Contents:
Application Layer
Bitcoin
Ethereum
Positive reflexivity
Splitting the application layer
Application matrix
Blockchain use cases in the top 3 quadrants.
Quadrant 1: Fully on-chain economy
Quadrant 2: Programmable finance
Quadrant 3: Off-chain applications
Developing the application layer
End of reflexivity era
Introduction:
The emergence of AI in the crypto field as a “first-class citizen,” the advantages of crypto robot agents, and front-end applications.
Background:
The rise of application chains: exploring the next frontiers of blockchain scalability.
A general blockchain stores the state and provides the logic of that state, with the state referred to as assets and the logic referred to as applications. For example, Ethereum stores assets like Ether and Dai in the state, which can be used in applications like Uniswap and Aave. The state and logic together form what we call the application layer.
The cryptocurrency economy began with the introduction of Bitcoin in 2009. Bitcoin is a simple blockchain with limited state, inflexible logic, and inefficient infrastructure, which limits its applications.
Then came Ethereum, which introduced a flexible logic layer through its new blockchain-native virtual machine. It also allowed anyone to create their own crypto assets on the same network. Ethereum thus expanded both the state layer and the logic layer.
However, Ethereum’s infrastructure is still limited. Since its establishment in 2015, most of the Ethereum research community’s efforts have focused on improving its infrastructure to support the application layer. Rollups and Danksharding have increased throughput, and account abstraction has enhanced user experience. MEV infrastructure can provide better price execution. However, after 8 years, many people are still puzzled about what we have built at the application layer. Yes, we can trade AAVE on Uniswap and borrow UNI on Aave, but where are the real-world demands? Where are the use cases?
Today, blockchain has strong reflexivity. There is a wall between the cryptocurrency economy and the real world, making it difficult for cryptocurrencies to attract the real world beyond speculation. Previous bull markets, such as the DeFi boom from 2020 to 2021, were driven by speculation, and the explosive growth of new native tokens and protocols triggered reflexivity: speculation drove activity, which in turn drove more speculation.
Reflexivity refers to a circular relationship between cause and effect. Reflexive relationships are bidirectional, where the cause and effect mutually influence each other, making it difficult to determine which is the cause or the effect.
It can be foreseen that this loop will not continue indefinitely. Eventually, the party must end, and positive reflexivity will turn into negative reflexivity. Speculation will be mistaken for product-market fit, while exploration of real use cases remains. Even two years later, many are still searching for ways to scale on-chain activity. To understand how to develop the application layer, we need to study it more closely.
The application layer has two components: state and logic. The state represents data, and the logic represents computation. Both the state and logic can be on-chain or off-chain. We present a four-quadrant matrix:
Each quadrant represents different applications. So far, most blockchain applications are in Quadrant 1, which represents the use of native crypto assets in on-chain protocols. Quadrant 2 involves bringing real-world assets onto the chain and using them in protocols. Quadrant 3 covers the use of native crypto assets off-chain. Everything else falls into Quadrant 4. If both the state and logic are not on-chain, then it is not a blockchain application.
The fully on-chain economy centered around native crypto applications. Currently, most on-chain activities belong to this quadrant. These endogenous applications are inherently reflexive, which is one of the reasons for the volatility and speculative nature of the cryptocurrency market.
From a positive perspective, this incentivizes users and developers to enter the crypto economy. Additionally, while these applications are cyclical, they do contain some real value. Despite the controversy surrounding speculation and gambling, they are indeed real use cases. However, we all hope that the crypto economy is not just an on-chain casino. Peer-to-peer payments can also be achieved using native crypto assets, but stability and scalability are lacking.
To go beyond speculation and inefficient financial services, we need to go beyond Quadrant 1.
Another category of blockchain applications is bringing real-world assets (RWAs) onto the chain. These assets can benefit from the global, programmable, and composable nature of the crypto market. Those who question the value of native crypto assets often understand this quadrant, as summarized by the mantra “blockchain, not crypto” or the meme of “tokenization.”
We refer to this quadrant as programmable finance. It involves developers bringing bonds, stocks, commodities, or other traditional financial instruments into programmable markets, thus unlocking more accessibility, expressiveness, and efficiency.
The most successful RWAs so far are centralized stablecoins. Stablecoins provide a globally accessible and affordable way to obtain USD and have been described as the “killer app” of cryptocurrencies. The total market value of USDC and USDT has reached $114 billion.
Programmable finance has been widely discussed in other areas. These applications have sparked institutional interest in blockchain technology and will be a major driver of its growth. However, we believe they are just part of a more extensive crypto economy.
The final category of applications is those with on-chain state and off-chain logic. These digital-native assets with off-chain applications are the most overlooked category of crypto assets.
The simplest example is social assets. In the previous NFT craze, many NFTs were seen as representations of identity. Bored Apes, Punks, and other well-known NFTs allow their owners to showcase their status or indicate membership in exclusive communities. The challenge faced by these NFTs is that their social value is closely tied to price and novelty, both of which can quickly erode. Fortunately, this flaw is specific to those NFTs and not an inherent characteristic of all social assets. A more mature crypto economy will provide more robust social assets.
The off-chain logic of social assets is how we behave off-chain. In this way, social assets serve as coordination tools. Since everyone agrees on the state of the Ethereum blockchain, we can organize our actions in the real world around that state. For example, we can use social assets to provide opportunities to attend concerts or prove membership in communities like Zuzalu. The value of storing these social assets on the blockchain instead of centralized databases depends on the specific case, but it may benefit from the blockchain’s trust neutrality, sovereignty, permanence, censorship resistance, financialization, or interoperability with other parts of the crypto economy.
Applications in Quadrant 3 can also provide advantages of crypto technology. Consider gaming, where traditional games can support certain on-chain state while keeping most of the game logic off-chain. Then, these assets gain external demand through their in-game utility or social value.
Token gating unlocks more use cases. Friend.tech, despite its flaws, has achieved directional success in showcasing the intersection of social assets and token gating. We suspect many exciting applications can be built in this category. Another recent example is Orb Land. Orb is an NFT that provides exclusive access to certain celebrities. Orb owners have the right to ask questions to the respective celebrity at a certain rhythm (e.g., every 7 days). Orb also has an additional feature where Orb Market is a radical market that allows anyone to buy any Orb from another person at a fixed price anytime.
The decentralized physical infrastructure (dePIN) project also falls into Quadrant 3. These tokens incentivize real-world activities such as mapping roads or installing hotspots, solving the cold-start problem.
Not everything neatly fits into these quadrants. Each application has some degree of exogenous purpose. Again, there must be some real-world use case (some “off-chain logic”) to qualify as useful. And in practice, most applications have their logic partially on-chain and partially off-chain. However, as a mental model, we find this framework helpful in reasoning about the application layer.
Based on the latest developments in the ecosystem, we have formed two reverse perspectives on how to develop the application layer.
Our first reverse perspective is that, for now, asset innovation is more important than application innovation. Yes, we need better decentralized exchanges, but more importantly, we need to create assets that are truly worth trading. The latter is an easier path to sustainable scaling of on-chain activity. We encourage more teams to bring novel assets onto the chain.
Our second reverse perspective is that, in the medium to short term, Quadrant 3 is more important than Quadrant 2. RWAs have broad prospects in the crypto economy. However, for now, we believe bringing native crypto assets into the real world is more important than bringing RWAs onto the chain. The former are “real-world assets” of their own kind and have more unexplored, unconstrained design space.
As Quadrants 2 and 3 occupy a larger proportion of the crypto economy, the market’s reflexivity will decrease. Once we have external demand for crypto assets and protocols, Quadrant 1 will become less cyclical. Suddenly, Uniswap is no longer just a speculative engine but also a decentralized business with relatively stable demand.
Real-world use cases weaken the reflexivity of the crypto economy, and over time, the market will become more non-causal. By “non-causal,” we mean that the demand for blockchain applications does not come from the blockchain itself, which we believe is the closest antonym to “reflexivity” that we can find.
The final state of the application layer will be far less reflexive than it is today and will generate tremendous real-world value. We will eventually achieve this.
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Tags:
bitcoin
ETH
RWA
Blockchain Applications