Investing in Web3’s Querying Layer: Covalent
Written by Scott Canning, CFA
Data Access: Enabling Web3
Web3 represents a first principle reset of how users’ interface with the internet and a paradigm shift from a technology stack that coalesced around a powerful subset of centralized entities borne from widespread digital transformation, towards a fairer user-controlled internet, enabled by decentralized web infrastructure. At LedgerPrime, we are motivated by the disruptive forces unfolding as Web3 emerges into a formal investment theme and our active participation in DeFi provides us with differentiated insights as we deploy early-stage capital to support the protocols building the next-generation internet.
Rapid data access is vital to developing more feature-rich dApps and deriving more generalized insights about opaque decentralized networks. However, absent dedicated indexing and querying protocols, accessing historical smart contract data across multiple blockchains is a complex and time-intensive endeavour. Appreciating this intersection as a clear market opportunity, we expect that data access will become a core, enabling layer of Web3’s propagation, and anticipate significant value creation and capital deployment to support the long-term growth of protocols providing low friction decentralized querying services. Below we discuss one of our investments in the space, Covalent, and how it’s striving to take advantage of this emergent opportunity.
An Overview of Covalent
The Covalent Data Model is designed to normalize and store historical blockchain data behind a unified API that allows more simplified and intuitive querying across a diverse set of Layer 1 blockchains. Currently, the API provides enriched data for Avalanche, Arbitrum, Binance Smart Chain, CasperLabs, Edgeware, Elrond, Ethereum alongside others. It is used by clients to handle diverse use-cases including tax calculations, profit and loss tracking, and granular custodial, exchange, and network analytics. In terms of Covalent’s distribution strategy, the team has pivoted to a bottoms-up approach and is experiencing the benefits of landing and expanding with smaller clientele. Uniquely, the team is also increasingly dealing directly with a new client base — blockchain foundations seeking API integration of their platforms, which has the potential of creating a flywheel effect around Covalent’s emerging two-sided market. The company is actively transitioning the Covalent Database towards a fully decentralized version of itself motivated by the associated benefits of having no single point of failure and a more intrinsic alignment with the ethos of the industry it supports.
This future implementation, formerly known as the Covalent Network, is abstracted into a four-layer architecture as follows:
- Base Layer: the foundational data warehousing layer built upon the engineering experience and technology of the Covalent Database.
- Privacy/Enrichment Layer: the layer tasked with normalizing cross-chain indexing and simplify multi-chain querying. Though largely conceptual today, handling the dedicated demands of private data within the Covalent Network is an opportunistic ambition of the team which the market likely does not yet fully appreciate.
- The DeFi SDK: a software development kit that enables developers to further tailor queries to meet more exacting use-case requirements.
- App Store Layer: a digital storefront, allowing developers to use SDK tooling to build and market Covalent-native applications. Within the internet and software industry, app stores have become coveted market positions, often strongly protected by leading consumer and commercial technology platforms. Thus, we view this layer as alluding to the Covalent team’s future ambition to create organic network effects and as representative of longer-term optionality in the platform.
Importantly, the transition introduces the Covalent Query Token (CQT) to facilitate network transactions and incentivize validators to fulfil queries faithfully or risk slashing. To better understand CQT, we discuss the set of distributed responsibilities spawned to support the protocol’s evolution, how they interface with CQT, and token value accrual below.
The Covalent Data Economy & CQT Value Accrual
The Covalent Network is currently live, running atop the EVM-compatible Moonbeam network, and will transition towards full decentralization through a phased introduction of six key network responsibilities:
Despite each distinct responsibility, a single node has the option to perform all six, and for some nodes there exists an economic incentive to cross-operate. This point deserves further consideration given the importance of data validity to the network’s long-term success and the consequent impact on CQT staking requirements. Most notably, block-specimen producers and indexers are inherently incentivized to collude with PoS block producers and are therefore likely to fulfil both roles:
Due to the Network’s heavy reliance upon staking we anticipate a natural positive feedback effect on the percentage of CQT staked as demand for its querying services grows over time. As a directional read-through for anticipated staked CQT, we would highlight that The Graph’s Indexing nodes and Delegators currently stake 30% of the GRT token supply.
Over the long run, CQT will act as the core utility token of the Covalent Network, used for validator platform access and network security through staking and internal network payments. Distilling down the nuance of the complex interplay, there are three sources whereby long-term value is likely to accrue to CQT in our view:
(1) the balance of supply and demand for blockchain indexing and querying services,
(2) staking lock-up and the associated yield for services provisioned, and
(3) the anticipated value of governing the protocol.
Below we take a deeper look at the most fundamental driver of value accrual — the expected supply and demand dynamics of blockchain querying.
Off-chain Comparables: Appreciating the Opportunity
The connective fabric enabling the past decade’s digital transformation has been partly rooted in the frictionless scalability and adoption of APIs. To appreciate the longer-term prospects of Covalent’s operating model and the demand for querying protocol services more broadly, it is sensible to draw parallels with prominent off-chain API providers — for our purposes, we look at Twilio and Elastic. While these comparables are fundamentally imperfect as they face materially different addressable markets, they can provide directional insight for high-level thematic analysis as we think about the S-curve for indexing and querying business modelled around a unified API.
Twilio, a publicly-traded company that reported $1.76 billion in 2020 revenue and is estimated to grow north of 30% per annum over the next few years, offers their communication-platform-as-a-service through a suite of cloud-based APIs, allowing software developers to seamlessly embed communication features (e.g., voice, SMS, email) into their mobile and web-based applications. While Twilio’s APIs support a more much robust set of enterprise-grade use-cases relative to Covalent’s, commonalities exist that are worth exploring to appreciate the potential of simplified API-based querying within the context of blockchain ecosystems.
In the same way that Twilio allows a developer to easily integrate existing multi-protocol communication infrastructure (e.g., global telecommunications networks) directly into an application, Covalent allows developers to effortlessly hook their Web3 applications into relevant blockchain networks to provide sensitive and mission-critical on-chain data analytics to enterprise and retail users. Accordingly, a read-through of API-based models like Twilio’s is that their core offerings often find relatively domain-agnostic use-cases as a value from feature-rich APIs can be derived in similar ways across many end-markets, naturally diversifying their respective revenue bases and ultimately expanding their addressable markets. Although Twilio’s customer base exists within the realm of Web2 and mobile, the company serves a spectrum of industries that ranges from financial services and retail to healthcare and hospitality. Therefore, while Covalent’s customer base largely lives in Web3 and is most levered to DeFi today, we anticipate a broadening out of verticals relying upon their unified, enriched data API service as Web3 itself grows and diversifies.
Elastic, a public cloud-based application software company that posted $609 million in 2020 revenue and is expected to grow nearly 30% next year is another noteworthy business to consider as we build our framework to better understand the optionality and potential of blockchain-specific querying protocols. Elastic’s core product Elasticsearch quickly indexes a company’s raw data from disparate systems including databases, e-mail, and web-based applications, enriches that data and provides a queryable API allowing users to conduct complex searches across their enterprises to draw near real-time insights. In a similar fashion, Covalent’s private blockchain querying feature enables customers to query private, firewalled blockchains, enabling enterprises to derive meaningful network insights from complex smart contract code and transactions.
Of particular interest to Covalent with respect to the success of API-based models is that they regularly experience phenomenal economies of scale as incremental API calls carry almost no additional cost. Furthermore, as API customers experience first-hand the value delivered to their own clients, and software applications grow operationally reliant upon the embedded API calls over time, the revenue base naturally becomes stickier, leading to revenue with greater visibility and lower volatility, and creates opportunities to cross-sell innovative features.
On-chain Comparables: Understanding the Competitive Environment
The Graph in which LedgerPrime is an investor is considered a competitor, and Chainlink, a potential competitor. Beyond these two protocols, investors should be mindful of substitute querying services including Google’s BigQuery, Dune Analytics, and Etherscan, as well as a new generation of decentralized oracle protocols, namely Pyth and API3.
The Graph is a decentralized protocol that services queries primarily for Ethereum, EVM-compatible JSON RPC API chains (e.g., Polygon and Binance Smart Chain), and IPFS. Furthermore, The Graph has been actively integrating EVM Layer 1 implementations and laid out intentions to add Solana, NEAR, and Polkadot in the near future. Aside from the scope of data being offered, the two projects differ in terms of performance with respect to the relative lift and time required to conduct a single query workload. The two protocols currently serve differentiated end-users ranging from enterprise clients to on-chain applications like Synthetix, Decentraland, and Uniswap.
On the other end of the competitive spectrum, Chainlink operates as a decentralized oracle built on top of Ethereum whose primary service is delivering asset price feeds from off-chain sources on-chain, and counts leading DeFi protocols, including Aave, Synthetix, yearn, Celsius as customers. Notably, Covalent also distributes price feeds to customers, with the company providing over 30 thousand price feeds for cryptocurrency and fiat pairs; however, their feeds are not all delivered to on-chain destinations in the same dedicated way as Chainlink. With those distinctions in mind, Chainlink represents the current standard and first mover of the decentralized price oracles and offers the following product suite beyond pure price feeds: verifiable random functions (to provide verifiable randomness for protocols, including games like Aavegotchi and PoolTogether), proof of reserves (enabling on-demand audits for TUSD, PAX), and external adapters (allowing API connectedness for Arbol and Everpedia). While oracles do not represent direct on-chain comparables to querying protocols today, evolutions in ecosystems, as well as the former’s reputation for delivering mission-critical information on-chain, has the potential to induce product drift and service overlap in the long run.
While we anticipate that the competitive environment for querying and data delivery services will remain moderately intense for the foreseeable future, these networks are inherently complex to stand up and we do not anticipate a winner take all scenario as it only increases the risks of centralization for smart contract and blockchain developers. In line with that view, we think that the supply of querying services will find a natural balance with demand over the long run.
Our Thesis For Covalent
The basis for our decision was that the broader macro-economic assumption at play is that data will be a crucial component of Web3.0 and existing ventures have not yet tapped into it sufficiently. Specialist networks that offer clear, concise API end-points to support builders have been seeing traction.
Development Team & Marketing
Founded by Ganesh Swami and Levi Aul, Covalent’s CEO and CTO, respectively, the Covalent team currently consists of 30 individuals with deep experience in applying database infrastructure to manage and make sense of complex data sets.
** Disclosures
- Please note that LedgerPrime is an investor in Covalent and The Graph.
- The author owns shares of Twilio.
CFA® and Chartered Financial Analyst® are registered trademarks owned by CFA Institute.
