2023 Outlook: In which scenarios will on-chain applications for one billion users explode?

In July 2018, Dr. Xiao Feng, Vice Chairman of Wanxiang Holdings, mentioned that "the blockchain industry could see companies at the level of 5 trillion dollars." At that time, the total market capitalization of the entire cryptocurrency market was only over 200 billion dollars, which dropped to 100 billion after a year of decline. From the highest point of 830 billion dollars in January 2018 to the lowest point of 100 billion in December, the cryptocurrency market fell by 88%, which is 50 times away from Dr. Xiao Feng's prediction of a 5 trillion market cap.

At that time, most people were confused about the future of the cryptocurrency industry. Although DApps on Ethereum had begun to take shape, almost no one could predict that in July 2020, the DeFi craze would ignite the summer of the crypto world, shifting the narrative of the entire industry from underlying infrastructure to applications that generate real value.

In this cycle we experienced, the application layer and protocol layer began a large-scale explosion: DeFi protocols created value, discussions of "fat protocols" and "fat applications" came into view; public chains prioritized ecosystem development, improved the developer ecosystem, and established ecosystem funds; NFTs like CryptoPunk and BAYC successfully broke out of their niches. In November 2021, BTC reached 69,000 USD, and the total market value of the entire crypto market reached 3 trillion USD, less than a double away from 5 trillion. The number of global crypto users reached 100 million.

Despite the decline that began after November 2021, as the industry continues to clean up, we believe the bottom of the bear market has presented itself, and 2023 is an important moment of transition. Rather than focusing on timing, we should consider: which sectors will give rise to trillion-dollar applications when global crypto users reach 1 billion and 15% of humanity enters Web3? How should these applications develop in the next cycle? We will analyze multiple sectors such as DeFi and gaming, exploring how to position ourselves in 2023.

Application or Infrastructure?

We believe that the next cycle is very likely to witness an explosion at the application layer, similar to the development path of the internet. When physical devices and hardware are difficult to popularize, developers focus on building infrastructure. Once a large number of users are ready to flood into the internet, industry giants become monopolistic application developers. The Web3 path is the same; after exploring through multiple cycles, the "application" discourse power gradually increases. After applications capture users, building public chains suitable for their own users has become a feasible path, with Binance building BSC and Polygon gaining a leading position in infrastructure through acquisitions being a great example.

Developers have realized that infrastructure serves applications, and mastering user and traffic entry points equates to mastering the discourse power of Web3. Therefore, in the next cycle, although the infrastructure has not yet been able to support a billion-level users, for application developers, this is the dawn of seizing the "high ground."

DeFi

The future exploration of DeFi may focus on two aspects: first, attracting centralized financial institution clients within the industry, and second, attracting unbanked users from outside the industry, namely users from the third world. The collapse of Luna in 2022 triggered a chain reaction of collapses, including Three Arrows Capital, FTX, DCG, and others, leading many users to question Crypto. However, we observed that the trading volume on DEX rapidly doubled within a few days after the FTX collapse, transforming the panic towards centralized institutions into trust in decentralized financial protocols.

This is one of the next narratives of DeFi, which is to replace existing centralized financial institutions. In 2020, due to incentives such as trading mining and liquidity mining, the trading volume of DEX at one point accounted for 15% of CEX. After two rounds of declines, there are no longer rich mining incentives, but the trading volume of DEX has risen again to about 15%, in line with the development curve of emerging technologies. After the bubble burst, more and more people began to use DEX as a daily trading venue, replacing the functions of CEX.

Of course, CEX still occupies the vast majority of the market share, and DEX has a lot of room for growth. This is only the share of spot trading volume; if we look at derivatives, the proportion is less than 2%. The trading volume and fees from derivatives are the main profits for many centralized exchanges, and DeFi has even more room for growth here. To achieve the same trading experience for derivatives as CEX, current decentralized derivatives exchanges are far from sufficient. Although excellent products like GMX have emerged, their response speed, high concurrency processing capability, depth, and convenience are all far inferior to those of centralized exchanges. This means that most users at this stage will not choose to trade futures, options, and other derivatives on DEX. This is a problem that the next cycle of DeFi needs to solve, and it may also lead to significant growth to capture the current CEX users in the industry. This requires exploration in multiple areas, such as L2 scaling solutions, cross-chain asset solutions, account privacy protection, and new liquidity solutions.

Another direction for DeFi development is how to grow in low-financialized third world countries and acquire users with low barriers to entry. Just as China has bypassed credit cards to directly expand mobile payments, DeFi may also help third world countries skip the steps of establishing bank accounts, using credit cards, and relying on third-party payments, allowing them to directly use digital currency for everyday transactions. Currently, some shops in countries in Africa and South America have begun to accept BTC payments, because even though BTC is highly volatile, their local fiat currency is even more volatile, and due to the lack of trustworthy banks, they do not have the habit of saving in banks. DeFi can assist them in establishing a new financial order in places without centralized trust. To realize such a vision, it is necessary to rely on technological iterations to further lower barriers, such as the development of AA wallets and smart contract wallets, and to establish a purely on-chain credit mechanism, while also considering how to localize and promote, educate users, and build localized communities.

As DeFi develops into the next cycle, achieving explosive growth in the two scenarios mentioned above may be difficult to rely solely on a single protocol and liquidity solution. To a greater extent, it requires the development of multiple underlying infrastructures within the industry. This demands that investors and developers not only focus on the solutions provided by the protocols themselves but also pay more attention to the construction of the underlying facilities.

X to Earn

In 2021, Axie Infinity brought Play to Earn into the public eye. The ERC721 solution, combined with a cost-effective pet battle game and a Ponzi token economic design, had a huge impact, becoming a national game in several Southeast Asian countries. At the beginning of 2022, the explosive popularity of StepN expanded the Earn boundaries to "X", thanks to refined numerical design and a strong anti-cheat system. Subsequently, various X to Earn projects flooded in, but most of them were very similar, merely replacing "shoes" with various NFTs, or changing running to eating, sleeping, and other daily activities, essentially not deviating from the framework created by StepN. After the collapse of StepN, many discussions arose in the market regarding token economics: What are the pros and cons of Ponzi token economic design? How does the NFT reservoir change the original economic model? How do multi-chain output tokens balance the conflicting interests of new and old players? Can any scenario that requires user incentives incorporate a similar design?

The Ponzi scheme has accompanied the crypto world for many years, and its definition can be broad or narrow. Looking back at the development of the crypto world over the years, we can cite some well-known examples. The essence of many token economies is actually Ponzi, but if we define it that way before a collapse, we may face verbal attacks from the community; correspondingly, after the collapse, what we need to do is not to completely deny it, but to review and reflect, considering the explorations it made in the historical development of token economies. The failure of Fcoin has become a historical dust, but its contribution of "trading is mining" laid the foundation for the "liquidity mining" boom of DeFi Summer two years later.

So when discussing X to Earn, we are not trying to define a Ponzi scheme, but rather to discuss how token economics and user behavior should be bundled in future Web3 applications. For decentralized applications or protocols, there are generally three types of token schemes in the market:

1. Governance tokens: Primarily based on voting rights, whether voting directly according to the amount held or obtaining voting rights through time-weighted staking. Token holders cannot directly receive project revenues; they must monetize the ecological resources brought by governance rights or rely on future dividend expectations.

2. Dividend-type tokens: also known as security tokens, these tokens use project revenues for dividends or buybacks, directly providing benefits to token holders.

3. Staking Tokens: Holding tokens can increase future output, or output can be obtained based on the proportion of the staking share, or based on the holding amount of other tokens ( or NFTs ) within the ecosystem to obtain the output of this token. We believe that models like X to earn, which require holding NFTs and accompanying in-app behaviors to earn token output, belong to this category of variants.

Unlike the previous cycle, this cycle has seen most projects, except for some strong compliance projects, starting to integrate multiple types of tokens, rather than solely using a specific functional token or employing a dual-token system, which consists of a governance token + a dividend/staking token. Compared to the first two types, staking tokens place greater emphasis on future output, which requires more refined supply and demand numerical design. The supply and demand of tokens directly affect token prices; staking tokens, due to their larger output, inevitably require a larger demand. If governance rights and profit distribution rights cannot stimulate significant token demand in the short term, and the native demand within the application also fails to reach the expected scale, then using native tokens as incentives becomes a more Ponzi-like design that becomes the final choice. This is why many X to earn projects have to adopt the Ponzi model, and it is also a pressing issue that needs to be addressed in the next cycle. The key to the Ponzi model lies in whether pseudo-demand can stimulate true demand, and whether it can achieve a soft landing amid an ever-lengthening payback period and continuously decreasing returns.

We believe that X to Earn emphasizes X rather than Earn. Earn can help projects with cold starts, expanding user base early on, and addressing the "customer acquisition" step in the growth model. However, projects should not treat Earn as the only focus; instead, they should quickly transition the Ponzi model to a soft landing after completing the cold start, diminishing the interests of early users. This is because "X" is the key to the project's sustainable operation, and the application itself should generate more user demand. User "retention" should rely on user behavior within the application, rather than acquiring more tokens. "Positive externalities" is a term many developers have recently mentioned, emphasizing how a project can attract external increments to ensure internal revenue generation, making external demand greater than the internal ( token ) supply. Lowering user thresholds and attracting traffic from outside the community is the consensus for the next cycle and is also the necessary path for the transition from Web2 to Web3.

In the next cycle, Ponzi schemes will still exist, and there will surely be some that will shine brightly and cause a huge market impact during the crash (, just as the collapse of Luna had a significant impact on the South Korean economy ). What you need to remember is:

1. There is never anything "too big to fail".
2. What can achieve you often can easily lead to your downfall.

Games and the Metaverse

Axie Infinity has led the Play to Earn trend, but this is not all there is to gaming. According to the 2022 financing data disclosed by Planet Daily, "GameFi has been prevalent throughout 2022, with a total financing amount of $5.189 billion," accounting for the largest share among all types of financing, and this figure does not include the "metaverse" category. Similarly, in our own fund's primary market project database, gaming projects account for about 20% of the total project count with 796 projects, second only to DeFi.

This is partly due to the investment boom in the "metaverse" sparked by Facebook's rebranding to Meta, and partly due to the organic combination of NFT and gaming in Axie Infinity. The synergy of these two aspects has made investors flock to gaming, and they are bound to invest in the next big breakout.