Issue #4: Decoding Tokens - The Engine Behind Blockchain Protocols
How Blockchain protocols reverse the design mechanism with internet protocols
This is a follow-up to the previous write-up about various blockchains and how you can fundamentally value them. If you haven’t read the previous article, I highly recommend you to read that (link to the previous article attached here) and then start reading this. This write-up is mostly about understanding what protocols are, the difference between internet protocols and blockchain protocols, and how we are seeing a radical shift between the two, where the latter is well on its path to change the world.
In August of 2016, Union Square Ventures’ Joel Monegro dropped arguably the most
famous crypto thesis called ‘The Fat Protocol’ Thesis.
The Fat Protocol thesis suggested that value in blockchains would accrue at the base protocol layer, instead of at the application layer. This was the opposite of what happened with the internet - Google and Facebook became worth trillions, while protocols like TCP/IP accrued little to no value.
Let’s understand how.
Internet protocols are the base layers that allow us to talk to each other seamlessly. These protocols created colossal value over the previous decades which paved way for all the modern applications used by us today like Facebook, Instagram, Gmail, Amazon, etc but most of the value got captured by the applications built on top of these protocols with almost little to no value capture at the base protocol layer.
The original Internet protocols defined how data is delivered, but not how it's stored. This lead to the centralization of data.
HTTP is an underlying protocol that allows the exchange of data on the internet. Using the above protocol, anyone can set up a webserver to publish information whereas anyone with a web browser could consume the information.
Some more examples of internet protocols are SMTP (used for the exchange of email used by companies such as Gmail, Hotmail, Outlook), DNS (gives a humanly readable identity to the IP address of various web servers/browsers used by us and serves as the web directory), and many more like TCP/IP, etc.
Most of these protocols were stateless machines in which each particular communication was handled as an independent event, unrelated to other similar communications. Thus it required companies to add data layers on top of it. This led to the centralization of data stored on closed servers.
Referencing the above diagram, Joel Monegro said ‘Lion’s share of value was captured higher in the stack and that’s where most of the innovation happened. This is what made the internet protocols thin and the applications fat’.
More importantly, these protocols were designed by researchers, and further iterations were done by non-profit organizations. The only way to make money from these protocols was to create a layer of software that implemented it and then further sell it. Since this required one to build an application separately like a Webserver/Browser, many of the creators of these protocols have had little to no financial gain.
Thus, over the last decades, we have learned that investing in internet protocols generated small returns whereas investing in internet applications generated larger returns.
On the other hand, the rise of Bitcoin, Ethereum, and other Layer 1 blockchains as underlying protocols have given birth to a completely new era of protocols where the lion’s share of value is captured at the protocol layer and the applications built on the top captured thinner value.
As further value got concentrated at the application layer, it further increased the value of the protocol itself.
This completely inversed the mechanism of value capture in relation to internet protocols.
Let’s look at a few examples.
The Bitcoin all time high market cap sits at 1.2 Trillion$ whereas the value of applications built on top of Bitcoin like Lightening Network (used to execute low value Bitcoin transactions and used by El Salvador as a proprietary acceptance network), even after 13 years of Bitcoins existence remains a small single-digit fraction of Bitcoin.
Similarly, the all-time high Ethereum market cap sits at 571Billion $ whereas the largest application built on top of Ethereum is Uniswap which has a fully diluted valuation of 22billion $ despite the fact that Ethereum has a much more vibrant and competitive ecosystem which forces developers to innovate and challenge the status quo.
As the above diagram suggests and In Joel Monegro’s words, ‘Value capture in blockchain happens at the protocol layer. This is what makes the blockchain protocols fat and the applications thin’
There are two components that make it possible for blockchain protocols to capture higher value than the applications -
1. Shared data layer
2. Tokenization of protocol
The fundamental concept of a shared data layer is that the database is stored across thousands of computers worldwide by various node providers (node providers are people who host the blockchain database on their local machines) instead of being stored on centralized servers. The public and open-source nature of the database reduces the barrier to entry for new players and creates a competitive and vibrant ecosystem for developers who are building on top of it.
The second component which is a radical change to how blockchain protocols monetize is through tokenization. Tokens allow people to have the right incentives to innovate at the protocol level. Tokenization allows creators to launch a token with the creation of the protocol and retain some of these tokens. This allows the protocol team to -
a) fund for research and development
b) retain value for themselves and shareholders (through appreciation of the token)
These tokens generally act as access pass for anyone to use the base protocol. As the protocol gets widely adopted, the value of the tokens naturally appreciates in value.
This creates a positive loop that further strengthens the ecosystem and makes it bigger, as we have seen with Ethereum.
As the token initially appreciates in value, it attracts early adopters and speculators who eventually become shareholders in the base protocol which further pushes them to attract talent and build applications in anticipation of the growth of the underlying token. As they become successful, they attract more users and VC’s which in turn attract more entrepreneurs and applications and turn the process into a movement.
Although there is a lot of speculation at the initial level, the speculation in itself further fuels the growth of the network and turns it into a widespread movement.
Also, since most of the tokens are generally scarce in nature, growth in interest increases further speculation in the underlying network which generally leads to a bubble-style growth, and the protocols grow much faster than the total combined value of all the applications combined.
This is what makes the blockchain protocols fat and the applications thin.
No wonder, we have seen a new generation of self-made millionaires and billionaires who invested in the blockchain protocols in the nascent days and are now using most of their profit to further push innovation in the base protocol.
For reference, look at the table below to learn about the wealth generated by Bitcoin holders. Balaji has an amazing article on ‘The Billionaire Flippening’ where he writes about how and when the number of newly made billionaires through Bitcoin will be more than the number of non crypto billionaires that exist today.
Referenced from -
1. https://www.usv.com/writing/2013/10/bitcoin-as-protocol/
2. https://joel.mn/
3. https://en.m.wikipedia.org/wiki/Technological_Revolutions_and_Financial_Capital
4.https://future.a16z.com/a-taxonomy-of-tokens-distinctions-with-a-difference/
5.https://balajis.com/the-billionaire-flippening/
6. https://www.usv.com/writing/2016/08/fat-protocols/
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Awesome Average Poor
See you soon,
Abhishek Anand.