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How to Analyse a Web3 Protocol
A Template for Independent Research
Hello everyone and welcome to Genesis Block!
You must be confused about this newsletter that’s landed up in your inbox - when did I sign up for this? What is a Genesis Block?
Well, me (Sid Shah, @96siddharthshah) decided to start a podcast and newsletter alongside Yash Palod (@yoshi_eth2) and Sid Sanghvi (@sidsanghvi7), and, going forwards, I’m going to be publishing newsletters under the Genesis Block umbrella rather than Tech Tok.
We’re going to be more heavily focused on the Web3 ecosystem, rather than on FinTech in general, and are aiming to explore three themes: fundamentally analysing Web3 protocols, discussing broader trends and themes, and interviewing people within the Web3 ecosystem.
Today, in our first article to accompany our first podcast ‘How to Analyse a Web3 Protocol’ (listen on Spotify and watch on YouTube), we want to start you off on your Web3 journey by introducing you to our process of analysing a Web3 protocol. We’ll cover many important factors to keep an eye on, and touch upon some nuances of the space. Feel free to use this as a template, and please comment if you find additional factors to include!
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How to Analyse a Web3 Protocol
A Template for Independent Research
What is a Cryptocurrency? ₿
A cryptocurrency is a fungible digital asset that allows its holders to utilize a blockchain network.
What does this imply?
As you may know, a blockchain network is essentially a ledger of transactions (transactions may be of different types depending on the function of the blockchain) chained together using cryptography. A block is a set of transactions on the network which, when proved, is immutably added to the previous set of blocks proved before it, hence creating a permanent and unchangeable record of transactions without the need for an intermediary confirming them. These transactions happen with the native ‘cryptocurrency’ created specifically to operate on the blockchain. Users can utilize the currency either to use the underlying function the blockchain was created for (e.g., accessing computing power), or transfer currency to another user. This process is so secure because the intermediaries (miners and stakers) mentioned previously who validate transactions are incentivised to validate them correctly by receiving the cryptocurrency of the underlying blockchain as rewards.
Understanding the Web3 Value Stack 🧱
A blockchain network as described above is only the base layer in the crypto value stack. These blockchain networks are referred to as Layer 1 blockchains. They are known as Layer 1 (or L1) because they allow other types of crypto protocols to be built on top of them. Some of the most common L1’s today include Ethereum, Solana, Avalanche, etc. There are two different types of L1s:
Asset Ledger — The blockchain network’s ledger’s function is to track who owns how much of the native blockchain coin and what they are using it for, e.g., Ethereum, Solana, Avalanche.
Storage Ledger — The blockchain network’s ledger’s function is to track who is storing data on the blockchain and how much they are storing, e.g., Filecoin, Arweave, Sia.
So L1’s like Ethereum have a ledger of transactions that essentially tell us who owns how much ETH.
But what is ETH used for? To access computing power.
Through something known as a smart contract (this property is available on other Layer 1 blockchains as well in slightly varied forms). A smart contract is basically code or a program that can be written to the blockchain and executed. Once written to the blockchain it will live on the blockchain forever or until the underlying blockchain itself somehow shuts down. This allows developers to create decentralized applications (dApps) that run on the blockchain instead of a traditional centralized server. The dApps can be created such that they have their own unique standardized token (currency) to operate their protocol. dApps can then be used to create more dApps on top of them if they have useful properties. This concept is known as composability and introduces us to the power of open-source software that can, in parallel, accrue value as well via crypto tokens. The primary applications have been seen in a new form of finance called decentralized finance or ‘DeFi’.
The below image demonstrates the Web3 Value Stack with its different layers:
The applications that run on Layer 1 blockchains are of different types.
Decentralised Exchange (DEX)
This is a decentralised exchange or ‘DEX’ that allows users to swap one crypto token for another. Traditionally, exchanges run on an order-book with buyers and sellers being matched by the exchange in return for a fee. DEXs, on the other hand, facilitate the pooling of assets from which people can exchange tokens using the Automated Market Maker model. The entities who provide liquidity to these pools are compensated with a trading fee. So now the user is exchanging from a pool of assets instead of finding someone on the other side of their trade. This allows anyone to become a market-maker and profit from trading fees. The underlying DEX also has a token which is usually used to govern the protocol and, in some cases, also gets a cut of the trading fees. Examples of DEXs are Uniswap, Sushiswap, and Curve.
Borrowing & Lending
Borrowing and lending protocols allow users to lend (in fiat or in crypto) and earn interest on it or borrow from a pool of assets after depositing some underlying collateral. Some examples are Compound and Aave. The underlying protocol token in this case is again used for governance of the protocol but also used as a backstop for liquidation risk with lenders being compensated with this token if the protocol fails.
Stablecoins are crypto tokens that are either collaterally or algorithmically pegged to the value of another asset. The most common use case of this is dollar pegged stablecoins which are pegged to the US dollar within a certain range. These stablecoins can be used on various different blockchains to buy and sell different tokens. They are meant to have the security of blockchains and the price stability of the underlying asset they are pegged to, e.g., DAI, USDT, USDC. However, as we’ve seen with the LUNA/UST implosion, stablecoin designs are still extremely nascent and have not been definitively proven yet.
These types of protocols usually automate the process of lending, or in other words, liquidity provisioning. A protocol like Yearn Finance is built on top of protocols like Aave and Compound to find the best sources of yield on different markets. This showcases the composability of crypto where protocols can be built and used on top of other protocols.
Protocols like Alchemix or Prism take composability one step further. We suggest reading about these protocols independently as they are fairly complex and beyond the scope of this article. But these protocols show us that composability has allowed us to create financial products which would never be possible traditionally.
Other Assorted Use Cases
Another use case for dApps is in the creative world including games. Games can now be created such that they run on decentralized platforms. This allows them to create their own in-game currencies that support in-game economies. These tokens can then be exchanged for other forms of crypto or even fiat currency. This has created a completely new form of income for gamers who can now play-to-earn e.g., Axie Infinity. dApps have also allowed for the creation of virtual worlds like Decentraland or Sandbox wherein users can buy land or items using in game currency, which can then be sold in the future. This is powerful because these games and virtual lands are decentralized, secure, and will potentially run forever. Hence your ownership of digital assets is meant to be guaranteed.
dApps can also be created for music streaming (Audius), video sharing (Theta), and many other use cases, such as oracles, options trading protocols, etc. We suggest you research these terms as well. The prospects are limitless. But by and large, most crypto tokens can be broken down into these few types.
Now that we have understood the basics of the different types of crypto tokens, let us understand how to research and value them.
Analysis of a Crypto Protocol 💡
A crypto protocol is a network just like Facebook. Hence it experiences network effects which grow the value of the protocol exponentially as users grow and hence the token itself grows in value. Therefore, we need to analyse different types of metrics and intangibles to ensure that network effects flywheel is in full flow.
Firstly, we need to understand where the protocol is in the value stack. It is likely that the protocol will be an iteration of one of the concepts covered above. Is it a dApp? Is it an infrastructure product or a Web3 social media play? What blockchain is it built on? These are all key concepts to assess right off the bat. Below is a non-exhaustive list of the different types of protocols:
Layer 1 / Layer 2 Protocols
DeFi (this category is too broad so we’re mentioning just one recent, unique application)
Metagovernance – holding one DAO’s token in order to influence decisions in another DAO(s)
Oracles – Translates real-world (off-chain) data to smart contracts (on-chain).
Indexing and Querying – Indexing data from networks like Ethereum and querying it.
Data Streams / Portability – Storing streams of data (i.e., data models) that are composable and reusable across applications.
Media / Social Media
This information will be available in the whitepaper of the project which can be found on its website.
Using the Protocol
Go to the website and use the protocol itself. You will be surprised at how much you can learn from this simple action. It’s important to get your hands dirty. You’ll be able to understand the UI and UX, what works and doesn’t work, and critically analyse the protocol. It’s incredible how underrated it is to act like a consumer and experience the protocol itself – you don’t know if it’s good, unless you try it out!
Read about the founding team and verify their track record in the space. Previous work on other protocols is a plus. This is just like analysing a regular VC investment – knowing whether the founders or the team have relevant subject matter expertise that can be applied to the Web3 world always provides more comfort.
Take Tokemak as an example. Carson Cook, the founder, has years of relevant experience with market making in the TradFi and crypto space, along with enviable credentials of a PhD in physics, a master’s degree in Electrical Engineering, and being an ex-McKinsey consultant. While this doesn’t mean the protocol can’t fail, it at least signifies that the team at the helm is competent. A counter-example (in hindsight…) may be Do Kwon, who was apparently behind another earlier failed stablecoin, Basis Cash. Now this example is only relevant in hindsight because no one knew that before the Terra collapse, but a similar thought process can be applied to assessing founding teams and whether they’re in it for a quick buck or around for the long haul. Another relevant example is the Azuki NFT collection, whose founder Zagabond was behind two NFT projects that previously pumped-and-dumped. Would we be comfortable buying Azuki’s, however cool the PFPs look and however strong their community is? No. That is the importance of a good, trustworthy team.
The best way to get this information is by browsing for it or looking up the founders on social media. Looking up their LinkedIn’s, watching their interviews, listening to their podcasts, or reading their work will also give you keen insights into their thought processes and motivations.
Identify the financial backers of the protocol. Good protocols are usually backed by some of the largest crypto VC funds (Multicoin, a16z, Electric Capital, Dragonfly, etc.). This, however, is no silver bullet – Terraform Labs was backed by Jump Capital, 3 Arrows Capital has just collapsed amidst its (degen) hands in every single pie and relying on the goodwill of institutions that are in it only to make money may not be a sound strategy going forward. Indeed, it may highlight a risk that should be avoided. Even so, having strong financial backing behind a protocol is predominantly a good sign.
Again, browsing for this would be useful, but also use resources like Crunchbase or the protocol’s own website to find this information.
Tokenomics refers to the economics of a crypto token, containing within its remit any factor that pertains to the value of a token. The tokenomics for a protocol are usually expanded upon in its whitepaper, and help users deeply understand the functionality and objectives of the protocol’s token. Most of these factors can be found on websites like CoinMarketCap or CoinGecko.
Some factors to look out for while analysing a project’s tokenomics are:
Token Allocation and Distribution
Most tokens are created in two ways: pre-mines or fair launches. Pre-mining is when tokens are created and distributed amongst some exclusive addresses (devs, founders, early investors) before being released to the public, while a fair launch occurs when a cryptocurrency is mined, earned, owned, and governed by the community/public without any early access to the token for anyone.
While a fair launch is almost always preferable, for better or worse, most protocols today are pre-mined. Therefore, a protocol is not ‘bad’ or ‘worse’ just because the tokens are pre-mined. However, it is important to check whether there is a whale wallet or a bunch of wallets holding a significant proportion of the token supply, because this leads to a risk of the whale dumping all their tokens, inflating the supply, and consequently crashing the token price in an instant.
Although it’s paid, tools like Nansen offer whale-watching capabilities, and if you want to follow someone who actively does it, you can find Onchain Wizard on Substack and read their guide to whale watching.
Token Supply & Release Schedule
There are three types of supply that should be checked – the circulating supply, the total supply, and the maximum supply. The circulating supply is the number of tokens that have been issued so far and are currently in circulation. The total token supply is the number of tokens that exist currently, excluding any burned tokens. Lastly, the max supply of a token is the maximum number of tokens that can ever be generated – famously, this is 21 million for Bitcoin.
Watch out for changes in the circulating supply. If there are too many tokens being released too frequently, or there are tokens due to be released (maybe from vesting for investors), this is a sign that the price of the token is likely to decrease due to holders being able to sell and lock in profits. If, however, token supply increases gradually, then the impact on price is likely to be minimal. For further explanation of token vesting schedules, refer to Cobie’s fantastic article on Incentives Structures.
Check the cap table of the token, which can usually be found in the whitepaper. The cap table reflects the token vesting schedule as well, which dictates the amount of the token that will be released into the market. A ‘good’ allocation will be similar to those listed out in Lauren Stephanian and Cooper Turley’s article around optimising token distribution, but this isn’t a hard and fast rule and sometimes bespoke analysis will need to be done to identify whether the token distribution is optimal.
A key consideration is whether a token is inflationary or deflationary. An inflationary token is like the money we use today. It doesn’t have a maximum supply and will continue to be produced indefinitely. A deflationary model is the opposite, where the token has a maximum supply, such as Bitcoin’s 21 million supply. Most proof of stake blockchains like Ethereum are inflationary since they want to reward validators and participants in the network.
A really inflationary token means that protocols can say that they offer high APYs while just inflating their supply and diluting each individual’s share of the protocol. Look at Terraform Labs’ response to the UST crisis – they just issued a ton of LUNA, which hugely inflated the supply and dropped the price of LUNA down a cliff. Take these high yields offered with a pinch of salt and look under the hood – if it’s too good to be true, it probably is.
Other ways of analysing the token model are by identifying whether the protocol is liquidity mining or is trying to grow its own treasury by selling its native token and receiving other cryptocurrencies or stablecoins in return.
Value Accrual of the Token
How does the token gain value? Does the token create a ‘flywheel effect’, where the incentives of all protocol stakeholders are aligned? If they are, this will create a form of network effects, where more and more users are attracted to the protocol, over time accruing value to the token via fees and staking.
Use The Graph as an example. GRT’s tokenomics create a flywheel, where consumers obtain high-quality data from decentralised indexers who compete to provide the best prices; indexers are incentivised to stake GRT and provide high-quality subgraphs to gain consistent rewards over time; and delegators are incentivised to delegate GRT and earn a higher percentage of fees from smaller, capital-constrained indexers who they are helping to be more competitive in the market.
Learn more about how a token accrues value by reading its whitepaper.
Another aspect of analysing a crypto protocol is to analyse its financial metrics, like:
Total Value Locked (TVL)
The total value locked, or TVL, shows how much money is locked in DeFi protocols and thus helps to get a clear view of the overall health of the DeFi market. It is a type of DeFi adoption indicator. This metric can help compare the market share of different DeFi protocols.
The ease of trading a token is an important metric to analyse, and indeed, one of the main methods through which a token bootstraps its growth. A good proxy is the number of marketplaces the token is listed on, and you can use CoinMarketCap to look at the number of markets the token is listed on to judge how liquid the supply is.
The market cap of a crypto is the same as that of a stock: circulating supply (number of tokens that have been released) multiplied by the price of the token. The fully diluted value (FDV) of a token can also be checked; this refers to the maximum supply multiplied by the current price. The FDV may be a good metric for long-term investors, as it allows them to better judge whether a project’s value is extremely out of line. However, use the FDV cautiously since it can end up inflating the total value of a project. It is pretty unlikely for a token to be valued the same if 1 million tokens are on the market and if 10 million tokens are on the market. Supply dynamics come into play, which is why FDV should just be used as a pointer or an additional piece of information while analysing a protocol, rather than being the centrepiece of the analysis.
Protocol Revenue & Ratios (P/S, P/E, etc.)
How much money a protocol earns from fees and otherwise is one of the most critical aspects of analysing it and creating a (discounted cash flow) valuation model for it. Additionally, similar to assessing a traditional business, a crypto protocol’s financial ratios can also be assessed, like the Price-to-Sales (P/S) and Price-to-Earnings (P/E) ratios.
Some important questions to consider around the governance model are:
How decentralised is the protocol? How do they plan on decentralising? Suffice it to say, this is one of the most critical answers to find, and greatly affects the security and construct of the protocol.
Is governance on-chain/off-chain/hybrid? If governance is on-chain, it’s better for transparency purposes. However, it is cumbersome and unscalable to have all governance discussions happen on-chain, and some sort of hybrid model between on and off-chain may be better.
How is the Discord organised? An organised Discord with a good onboarding process for new members provides the highest chance of long-term community growth and success.
How do you propose improvements to the protocol? Do you have to hold a certain amount of the token? What is the impact on decentralisation, and do they plan to change it?
What are the voting mechanisms used and what are the benefits and drawbacks? Some examples of voting mechanisms are in this great breakdown by Accelerated Capital.
What sort of governance tooling is used (e.g., Snapshot/Tally), and is it scalable? Are there any user experience issues, or any sort of problems that inhibit voter participation?
To assess a lot of these, you’ll have to comb through the project’s Discord, GitHub, Notion, or Medium.
These are different on-chain and off-chain indicators that help track the growth of a network. The faster these metrics increase the better.
# Social Media Followers
Discord Channel Activity
# Medium Followers
It may not be straightforward to get all this data, especially around active developers, but other data can potentially be obtained from some of the sources mentioned already – CoinMarketCap, CoinGecko, Token Terminal, and Dune Analytics.
Resources / Tools
Below is a non-exhaustive list of tools we’ve compiled. A lot of the metrics mentioned above can be found here:
Closing Thoughts ⌛
We hope this article helps you start your own journey of independent research. It is merely a framework and should just be looked at as a starting point. Our goal is to get you started on your journey and give you the basic understanding and resources to enable you to critically analyse a crypto protocol and separate the real from the hype.
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