Retrospective Study: Detailed Explanation of Layer 1 Cycle Rotation Theory

Author: ChainLinkGod

Original Title: 《The Layer-1 Chain Rotation Thesis: A Retrospective Analysis》

Compiled by: Guo Qianwen, Chain Catcher

"The bull market optimizes narratives, while the bear market optimizes fundamentals." Although this statement is overly simplistic, it can still serve as a foundational logic to explain how participants think and react in different market environments. This is true for most financial markets, but this principle is even clearer in the cryptocurrency market, where the speed and acceleration of operations are 100 times that of any other existing or historical market.

2022 was clearly a bear market, not only because most crypto tokens fell 80-90% from their historical highs, but also because market participants shifted their attention from hype-driven Ponzi schemes to sustainable income and sound economics, creating a demand for using cryptocurrencies to solve real-world problems. In a bear market, the free flow of capital stagnates, and the question of "why are we building all this again" quietly resurfaces.

While the cycles of bull market narratives and bear market fundamentals are not new—this is true for cryptocurrencies as well as any other financial market—it is worth exploring what actually happened during past bull market booms. In this article, I will discuss how I view the reflexivity of the capital rotation game (which can be simply understood as the theory of reflexivity in the market, where market trends and investor psychological expectations influence each other) and the nearly unsustainable growth strategies adopted by blockchain projects in 2021.

Mismatch of Blockchain Bandwidth Supply/Demand

It is clear that one of the major issues facing the cryptocurrency industry is the scalability of blockchains, which may hinder the future development of cryptocurrencies. "The monetary internet shouldn't cost 5 cents for every transaction," Vitalik still affirms this point. A throughput of 15 transactions per second and transaction fees of several dollars are clearly unsuitable for the vast majority of people.

Although this issue has appeared in various forms over the years, it first emerged when the Ethereum community criticized the Bitcoin community for high transaction fees, but later the script flipped. After the summer of DeFi in 2020, we entered early 2021, and Ethereum became increasingly difficult for the general public to use, with issues of network congestion and high fees becoming clear.

The above tweet perfectly summarizes the key views and anxieties many had about Ethereum during 2021. Due to price reasons, they were forced to exit, believing that the Ethereum community did not care about them but was more concerned with ideals surrounding decentralization, self-verification, and monetary premium. People's reference points differ; some might say this is "disconnected from reality," while others might say it is "different priorities."

In an ideal world, scaling a blockchain would simply mean increasing block size and reducing the time interval between blocks. Here’s how Musk passionately articulated the expansion plan to reduce transaction fees on the Dogecoin blockchain by 100 times.

Make the blockchain faster, crank the parameters up to 11, who knew it could be so simple! Of course, this is not the case in reality. Such an approach would lead to centralization, as running a full node requires higher hardware specifications, breaking the security model of the blockchain. Maintaining the properties that keep the blockchain operational while also scaling is a significant challenge.

How Ethereum Previously Met Retail Demand

Ethereum's scalability plans have changed over time. In 2021, plans for sharding and Plasma were removed, and Rollup became the main focus to meet the demand for block space while maintaining Ethereum's decentralization. Rollup blockchains separate execution from consensus and data availability, allowing existing L1 blockchains like Ethereum to settle more transaction volume without increasing the hardware requirements for running a full node.

However, the speculation about how long it would take for Rollup to be formally released and reach scale is almost completely inconsistent with the existing challenges. This mismatch of information regarding timelines exists within the Rollup development teams and the entire Ethereum community (including you). In fact, in 2021, Rollup was not ready to meet the demands of retail investors. Even by 2022, Rollup was still not fully prepared to meet the demand that comes with global scale.

But this explanation is too nuanced; retail investors do not care. Decentralization? Full node hardware requirements? Years of scaling plans? Retail investors in 2021 just wanted faster and cheaper transactions so they could continue to easily bet on speculative tokens. Failing to meet this very real market demand at the time would mean leaving a lot of money on the table. Would these users simply stop using the blockchain and wait for Ethereum's scaling? Of course not; in the meantime, their needs would just have to be met elsewhere.

Retail Investors Massively Shift to Cheaper New Opportunities

Scaling Ethereum is like changing the engines of a 747 mid-flight, with a passenger load equivalent to that of a medium-sized country and a capital value comparable to a medium-sized American bank. But what if we don't need to scale Ethereum at all, and we don't need to care about "maintaining decentralization"? That would certainly simplify things. All of Ethereum's code is open source, most DeFi primitives have already been established, and people are bidding on all these essentially worthless governance tokens…

Thus, the "Layer1 Cycle Theory" was born. It is very simple: fork Ethereum's code, make blocks larger and faster (thanks to Elon), fork all the core DeFi dApps, pay people to use it. This way, you get a cutting-edge next-generation blockchain that is cheaper and faster than Ethereum. If the timing is right, you will witness capital flooding in, along with all the speculation that comes with hypergrowth.

This approach is so simple and effective that it keeps being repeated. Whenever a new deployment that makes money appears, retail investors, opportunistic capital, and other market participants eagerly rotate onto the new chain to earn "money falling from the sky." Each chain typically has some hidden new tricks, usually different narratives or subtle technical improvements, but fundamentally, the same theory is at play.

In the frenzy of a cryptocurrency bull market, this situation is a win-win for all participants. Core blockchain developers can guide the adoption of the chain (and profit in the process), retail investors can interact with DeFi applications again (and profit in the process), and opportunistic capital can get their assets working (and profit in the process). If everyone is making money and there are no losers, it sounds unsustainable, and it indeed is. The Layer1 Cycle Theory is an extreme example of the hyper-reflexivity of cryptocurrencies. Anything that has an up must have a down.

12 Simple Steps to Join the Layer1 Chain Cycle

To understand how this blockchain growth strategy works and why it is effective, let’s take a look at the steps involved. If we were still in a bull market, this explanation could serve as a playbook, but now, in hindsight, it makes sense to consider these steps.

1. Launch (Fork) a New Blockchain and Create a Token

The first step is the most obvious: fork the Go implementation of the Ethereum protocol (called Geth). Geth is not only free open-source software but has also been strengthened through years of production use and extensive testing. Since a low-cost development team has already built the core technology foundation for you, why do unnecessary work?

Naturally, the new deployment of Geth requires a native coin that users can use to pay transaction fees and support block producers through block rewards. A native coin is also needed to fund the eventual "money printer" that attracts users and pays the core development team that worked hard to fork Geth.

Therefore, you cannot just fork Geth; you need to launch a token sale to supply the initial native coin to yourself (for free), venture capitalists (at a price 100 times lower than the public sale), and perhaps some users (the remaining portion). Regulators are generally busy sending moral signals of "investor protection," exposing legitimate projects, and hardly paying attention to you.

To reiterate, forking free open-source software or initiating a token sale is not inherently problematic, but these are merely necessary steps to join the L1 chain rotation cycle, which may accelerate the development of the blockchain and allow you, your investors, retail investors, and everyone else to make money in the process.

2. Promote Your "Unique" Speed and Cost Advantages

After forking Geth, there is almost no need to keep the block size and block time parameters consistent with the Ethereum mainnet. After all, the purpose of this new chain is to be cheaper and faster than Ethereum. After thanking Musk for his wisdom on the infinite scalability of blockchains, you can also adopt some other clever marketing tricks.

When the new blockchain launches, the blocks and state trees are empty. This means transaction costs are nearly zero (sub-cent), and they will be included in the next block on-chain (confirmed within seconds). You should use comparison charts to show the differences between your new chain and Ethereum, proving to people that only "masochists" would continue using Ethereum.

Don't worry about the demand for block space eventually exceeding supply (at which point the fee market for transactions will kick in), or uncontrolled "state bloat" eventually making the chain unoperable (due to increasingly severe disk I/O bottlenecks). These are problems that will arise in the future, but for now, from a technical perspective, your blockchain is faster and cheaper than Ethereum.

Similarly, since the blocks and state trees are empty, the hardware requirements for running a full node will be very low, even lower than Ethereum. Over time, as blocks fill up and the state tree grows faster than Ethereum, this situation will naturally change, but in the meantime, you can claim that you have solved the scalability problem without sacrificing decentralization and self-verification.

Naturally, some people will try to point out that you are taking shortcuts to increase throughput, but they can easily be dismissed as "maximalists," or simply ignored, as they are clearly NGMI (not gonna make it) commentators. If that doesn't work, then some more advanced tactics will be needed. At this point, marketing becomes more like psychological manipulation, the "gaslighting effect," and Twitter becomes the main battlefield.

Find and own a slogan, such as "Consensus is the bottleneck; scalability is not an engineering problem," "Decentralization is the cost of destroying all copies," or directly label those who do not align with you as "pathetic," "their scale is not scale." Throwing out a phrase like "the future is multi-chain" is also a good strategy.

Congratulations, you have successfully solved the scalability problem of the blockchain without making any sacrifices; that is your advantage. Furthermore, you have launched and distributed tokens, and you now have a community composed of economically incentivized token holders who will mimic your narrative and defend your blockchain at all costs against FUDsters (those spreading fear, uncertainty, and doubt). Also, don't forget to regularly point out how expensive Ethereum's fees are.

3. Fork and Deploy Core DeFi Modules

By this point, you may have developed a niche community, but so far, there is nothing to do on your new blockchain. Retail investors want applications where they can speculate on tokens, and there is demand for key DeFi modules like non-custodial exchanges, money markets, over-collateralized stablecoins, and derivatives platforms. Looking back at Ethereum, you will find that it has a free, open-source, and ever-growing ecosystem of smart contracts that can be easily forked and deployed on the new chain.

However, it does not look like an ecosystem if the core blockchain development team deploys their forked dApps on their forked blockchain, so you will want to get other teams to deploy these dApps, which can be easily achieved in two ways. The first is to distribute grants to opportunistic developers who have innovative ideas to create "[ABC] chain's [XYZ] dApp."

To be fair, forking and improving open-source protocols does push the boundaries of possibility and has a positive impact on the industry. But many times, their ideas are simply to fork an established protocol, deploy it on the new chain, and market it as something entirely new with a different brand.

The second method is more subtle but usually has lower time and financial costs. Fork these dApps yourself and hire a development team to impersonate the founders and maintainers. If you can't find developers to play this role, then play it yourself but use a pseudonym so no one will know.

The end result and goal are the same—mimicking the Ethereum ecosystem, but on your blockchain, with new dApp tokens so that retail investors can speculate. This will lead people to think, "If this new dApp token reaches [x]% of its counterpart's market cap on Ethereum…"

4. Ensure Dependencies Are Controllable, Sell Bridges to Users

The benefit of forking Geth is that your blockchain runs EVM, which means all the tools built around Ethereum and Solidity smart contracts will work the same way. Importantly, this means Metamask (which your target audience has already downloaded) will work just like it does on Ethereum, requiring only an additional RPC connection. The developer community can also use Hardhat, Truffle, and all other necessary development tools to create new dApps on your chain.

However, it is also crucial to ensure that your other dependencies are controllable. You need a block explorer, either by forking an existing chain or paying Etherscan to clone it. You need to provide oracles for the DeFi applications you forked, which means contacting Chainlink. You need to provide liquidity and fiat conversion channels for your token, which means working with exchanges to list it. You want this experience to be like Ethereum (but cheaper and faster).

Finally, you need to get people to bridge from the existing ecosystem (like Ethereum) to your new chain. A walled garden is no fun for people and greatly limits your growth potential. Therefore, you need to create a cross-chain token bridge managed by a small number of trusted validators with multi-signature. Using a cross-chain bridge well may not be easy, as over the past year alone, over $1 billion worth of cryptocurrencies have been stolen from bridges.

To join the Layer1 rotation cycle, you must take on the risk of deploying a cross-chain bridge. Once deployed, be sure to inform users that you are selling them a bridge—and it is the most seamless and secure bridge they have ever seen.

5. Launch the "Money Printer" and Start the Growth Cycle

By this point, you have created (forked) a new blockchain, and you have successfully convinced some community members to believe and/or echo your claim that "this blockchain is faster and cheaper than Ethereum." But why would users switch from other "faster and cheaper than Ethereum" alt-L1 blockchains they are using to your chain? Your blockchain may have less liquidity, users, appeal, and attention than existing solutions.

The answer is simple: for money.

This step is a key component of the Layer1 Cycle Theory. Deploy, promote, and market large-scale token subsidy programs where users can earn rewards just by deploying their capital into your blockchain's dApp ecosystem—often referred to as yield farming. These token subsidies can be the on-chain native coin (of which you minted a portion for distribution) and/or governance tokens deployed by the dApp itself.

In a bull market, retail participants will speculate on anything that is changing, and the tokens used for subsidy rewards will inevitably have a value greater than zero, even on the first day, which is enough to kickstart a positive feedback loop. Be sure to give the subsidy program a catchy name, focus on the growth achievements of the project, the growth of the ecosystem, and ensure it is good growth. Welcome to the world of "money printing" where profits flow like water.

6. "Fundamentals" Increase, Enjoy TVL Growth

When adopting token subsidies, the "yields" offered by dApps on your blockchain will appear quite enticing. Loan rates in money markets will be higher, returns for providing liquidity in DEXs will be higher, and the ROI for depositing tokens into a contract that does nothing will also be higher. As long as the "money printer" continues to distribute tokens and people are willing to buy these tokens, the "yields" will keep flowing. However, most people do not question the actual source of the yields, and even for those who do, it does not matter because the "yield" will still exist.

The "yields" from the growing token subsidy program will attract retail and opportunistic capital, who will deploy assets into your blockchain ecosystem through cross-chain bridges. This capital deployment from yield chasers will lead to an increase in the total value locked (TVL) of your blockchain and dApps, a key metric that signals to users and speculators that your blockchain is growing healthily. The "fundamentals" of your blockchain are increasing, and TVL can prove it.

7. Promote TVL Growth as a Success

Naturally, this growth in TVL will be exciting, and now is the time to promote your success. Multi-channel marketing campaigns, tweets, and sponsored media articles are the fuel needed to accelerate this positive feedback loop. You won’t be alone, as your core development team (also acting as marketers), venture capitalists, token holders, dApp development teams, and influencers will all promote the amazing growth of the new chain.

There is no need to stop at TVL; as users chase subsidized yields, a whole host of metrics will rise. Active address counts, daily transaction numbers, protocol revenue, market capitalization, and almost all metrics benefiting from subsidized yields can be used for promotion to prove that your chain is full of potential.

However, do not emphasize one metric—how much money has been spent on token subsidies or the resulting inflation rate. This large number is impressive for the initial announcement. But after deployment, the focus should be on promoting yields, TVL, and growth. Your goal is to stir up emotions of FOMO (fear of missing out) and WAGMI (we are gonna make it)—"If you haven't deployed your capital into this new chain and speculated on these hot new tokens, sorry my friend, you missed out."

8. Witness Speculation Accelerate

At this stage, things really start to accelerate. Retail investors will see this marketing blitz on social media timelines and feel they must get involved, especially since the opportunity cost is zero. The impressive and growing TVL and other growth metrics will be so eye-catching that they cannot be ignored. As a result, retail investors will feel that the value of these tokens is underestimated and begin to speculate, driving up their value. The inflation rate of the tokens, the insufficient value capture, or unsustainable economics are all irrelevant; after all, TVL is growing, and that is a good thing.

Token speculators often not only defend their investments but also actively promote them, further accelerating the cycle through word-of-mouth marketing. These individuals pursuing high-risk ventures become addicted to this, but as the value of their portfolios rises, they feel their views are being validated.

Anyone shouting that this cycle is merely unsustainable hype is just someone who missed out and did not make money like everyone else, spouting nonsense. The market has spoken; these worthless governance tokens are actually very valuable because their prices are rising. Forget about any circular logic; just look at the growth of TVL.

9. Cycle Accelerates, Yields and TVL Rise

The flywheel of the Layer1 Cycle Theory is now spinning at full speed. The prices of tokens used for subsidizing yields appreciate due to market speculation, which in turn increases the subsidies provided to users. These increased yields attract more capital into your dApp ecosystem, further boosting growth metrics like TVL. You can promote these growth metrics again on social media, leading to more token speculation, which brings more yields, more TVL… and the cycle accelerates.

This positive feedback loop effect is at the core of the L1 chain cycle rotation theory.

Speculation on the fundamentals of the blockchain ecosystem suddenly makes the fundamentals look better. Can you see where this might start to go wrong?

10. Reality Check

At some point, the underlying blockchain reaches its breaking point. Blocks start to fill up, leading to increased transaction fees and longer confirmation times. This is precisely the problem your chain should solve. Fortunately, you can simply increase the block size to address this issue. But this increases the hardware requirements for running a full node, which is unsustainable because eventually, disk I/O will become saturated, even for the most powerful servers—adding nodes cannot keep up with the chain's top.

But don't worry; these are just "growing pains," and every blockchain like yours will encounter these issues at some point. It turns out that the scalability problem of blockchains is quite nuanced and difficult to solve—this has always been the case, but now you need to persuade your audience because they may question whether you have truly solved all the problems. It’s time to find a pivot.

11. Continue the Cycle Through Narrative Pivoting

So far, this cycle has been profitable, and it would be a shame if it just ended like this. But you don’t have to, because now you have an interoperable blockchain that is not a single chain but a sidechain ecosystem, with these chains interconnected through a central hub chain.

However, you cannot call them sidechains because that carries a negative connotation of poor network security. The name doesn’t really matter; the key is that you are solving the scalability problem through horizontal expansion. The security and decentralization levels of these new chains will not be the same as the first chain, but so far, that does not matter on the road to success.

What you are trying to expand is not necessarily transactions per second but the flywheel effect. A new sidechain means a new token for people to speculate on, a new dApp that can be subsidized with tokens, and a new blockchain with empty blocks and states that can be filled. Eventually, these sidechains will become congested, just like the deployment of the first blockchain, but fortunately, you have already solved this problem. You can simply launch another sidechain.

12. (Once Again) Shift to Cheaper New Opportunities

The theory of interoperable blockchains is very good, but by this point, the secret has been revealed. For many reasons, sellers will outnumber buyers. The game of musical chairs is over; people have left the stage, and the flywheel begins to reverse itself. As the prices of tokens used for subsidizing yields fall, the yields also start to decline, leading people to withdraw their funds, either to place them in other blockchain ecosystems for more yields or simply because they are unwilling to take on more risk as returns continue to diminish.

This leads to significant fundamental metrics like TVL declining, making subsidy tokens no longer look like attractive investments. As the "fundamentals" change, token speculators become more bearish and start to sell. This leads to further declines in yields, more capital leaving… and this cycle accelerates.

The unfolding of the reverse L1 flywheel

This does not mean your blockchain and its ecosystem are dead; rather, most opportunistic capital and retail investors are leaving to seek broader opportunities. The remaining users believe they can benefit from your ecosystem, are satisfied with the existing benefits, or have simply become community members. Tokens will never truly go to zero, even in high inflation periods, so subsidies will always have some meaning and can support the ecosystem.

But initially, what led to sellers outnumbering buyers? Most commonly, it is a shiny new blockchain that can offer better yields, lower transaction fees, faster transaction speeds, and/or a better overall narrative. This blockchain may encounter the same problems as your blockchain, but that doesn’t matter; the fact remains that they are faster and cheaper than your blockchain, and they will let users know.

Thus, the rotation cycle continues.

Conclusion and Key Takeaways

The cryptocurrency market of 2021 was largely defined by the JPEG NFT craze and the Layer1 Cycle Theory. When capital flows freely, projects gain attention to compete, and nothing attracts the eyes of capital holders more than the opportunity to profit, whether through investment-grade tokenized JPEGs that can be sold at higher prices or through subsidized DeFi yields on forked blockchains.

While this article may seem filled with a pessimistic view of alt-L1 blockchains, the growth strategies I described above are simple logical pathways, as this approach has received positive returns from the market in terms of attention and capital allocation. It is clear that not every blockchain besides Ethereum is a blatant, profit-driven, non-original fork; after all, many blockchains have genuine merits and unique value propositions that can drive the industry forward. This article is not aimed at any specific blockchain ecosystem but rather emphasizes that the crypto industry as a whole should not only passively accept but actively support capital games.

I am interested in crypto technology because it offers a viable path to executing protocols on a trusted neutral settlement layer, rebuilding trust between distrustful entities, visible to all and tamper-proof. I am not interested in cryptocurrencies because we can fabricate yields out of thin air in various ways, creating "financial weapons" that destroy retail capital, stemming from a disdain for assets with high reflexivity and high speculation. This is simply a problem of a systematically poor incentive structure that no single project or entity can solve, but it is at least worth paying attention to and analyzing.

Given the current market conditions, the Layer1 cycle rotation theory strategy is no longer as effective as it once was. People expect growth narratives to align with sound economics and real defensibility. I hope that when the next bull market cycle arrives (whenever that may be), we have learned lessons from the unsustainable capital rotation game. But to be honest, this is the cryptocurrency market after all, so I have my own expectations as well.