Fat Protocols —— Placeholder

Translator: Evelyn｜W3.Hitchhiker

Note: See the follow-up article in 2020: Thin Applications

Here’s one way to think about the difference between the Internet and blockchain. The previous generation of shared protocols (TCP/IP, HTTP, SMTP, etc.) generated immeasurable value, but much of it was captured and reintegrated at the application layer, primarily in the form of data (think Google, Facebook, etc.). In terms of how value is distributed, the Internet stack is made up of “thin” protocols and “fat” applications. As the market has evolved, we’ve learned that investing in applications produces high returns, while investing directly in protocol technology generally produces low returns.

In the blockchain application stack, this relationship between protocols and applications is reversed. You can see that value is mostly concentrated in the shared protocol layer, while only a small portion of value is distributed in the application layer. This is a stack with "fat" protocols and "thin" applications.

We see this very clearly in two major blockchain networks, Bitcoin and Ethereum. The Bitcoin network has a $10 billion market cap, but the largest companies built on it are worth only a few hundred million dollars at most, and most are probably overvalued by "business fundamental" standards. Similarly, Ethereum has a $1 billion market cap even before it has any real breakthrough applications in its own ecosystem, a year after its public launch.

There are two things about most blockchain-based protocols that cause this to happen: the first is a shared data layer, and the second is the introduction of cryptographic “access” tokens that have some speculative value.

I wrote about the shared data layer about a year ago. While the article has since gathered dust, the main point remains: by replicating and storing user data across an open and decentralized network, rather than individual applications controlling access to disparate silos of information, we lower the barrier to entry for new participants and create a more vibrant and competitive ecosystem of products and services in it. To give a concrete example, imagine how easy it is to switch from Poloniex to GDAX or any of the dozens of cryptocurrency exchanges, or vice versa, in large part because they all have equal and free access to the underlying data and blockchain transactions. Here you have several competing, non-cooperative services that interoperate with each other because they have built their services on top of the same open protocol. This forces the market to find ways to reduce costs, build better products, and invent exciting new products to succeed.

But an open network and a shared data layer alone are not enough to drive application adoption. The second component — protocol tokens[1] — fill this gap by providing access to the services provided by the network (transactions in Bitcoin, computational power in Ethereum, file storage in Sia and Storj, etc.).

Albert and Fred wrote this post last week after we had many discussions at USV about investing in blockchain-based networks. Albert looks at protocol tokens from the perspective of incentivizing innovation in open protocols, as a way to fund R&D (via crowdfunding), create value for shareholders (via token appreciation), or both.

Albert’s article will help you understand how tokens incentivize protocol development. Here, I will focus on how tokens incentivize protocol adoption and how they influence value distribution through what I call the token feedback loop.

As a token appreciates in value, it attracts the attention of early speculators, developers, and entrepreneurs. They become stakeholders in the protocol itself and make a financial investment in its success. Then, some of these early adopters, perhaps partially funded by the initial profits, build products and services around the protocol, recognizing that the success of the protocol will further increase the value of their tokens. Then, some of these become successful, bringing new users to the network, and perhaps some venture capital and other types of investors among them. These successes further increase the value of the token, attracting the attention of more entrepreneurs, which in turn leads to more applications, and so on.

There are two things I want to point out about this feedback loop. The first is how much of the initial growth is driven by speculation. Since most tokens are programmed to be scarce, as interest in the protocol grows, so does the price per token, creating growth in the market cap of the network. Sometimes, interest grows much faster than the supply of tokens, which can lead to frothy appreciation.

Deliberately fraudulent schemes aside, this is a good thing. Speculation is often a driver of technology adoption [2]. Both sides of irrational speculation (booms and busts) are highly beneficial to technological innovation. Booms attract financial capital through early profits, some of which is reinvested in innovation (how many Ethereum investors are reinvesting their Bitcoin profits, or DAO investors’ Ethereum profits?), while busts can actually support long-term adoption of new technologies because prices are depressed and stakeholders outside of price hope to pick up the slack by promoting and creating value around them (just look at how many Bitcoin companies today were started by early adopters after the 2013 crash).

The second aspect worth pointing out is what happens at the end of the cycle. When applications start to emerge and show early signs of success (whether measured by increased usage or by attention (or capital) from financial investors), two things happen in the market for the protocol’s token: new users are attracted to the protocol, increasing demand for tokens (because you need them to access the service — see Albert’s analogy of tickets at a trade show), while existing investors continue to hold their tokens in anticipation of future price increases, further limiting supply. This combination forces prices to rise (assuming there is enough scarcity in the new token creation), and the protocol’s increased market capitalization attracts new entrepreneurs and new investors, and the cycle continues.

The significance of this dynamic lies in how it distributes value along the stack: the market cap of a protocol always grows faster than the combined value of the applications built on it, because success at the application layer drives further speculation at the protocol layer. Moreover, the increased value at the protocol layer also attracts and incentivizes competition at the application layer. Coupled with the fact that a shared data layer greatly reduces the barrier to entry, the end result is a vibrant and competitive application ecosystem that distributes a lot of value to a wide group of shareholders. This is how a tokenized protocol becomes "fat" and its applications become "thin".

This is a huge shift. The combination of shared open source data and incentives prevents a “winner take all” market, changes the rules of the game at the application layer, and creates a whole new category of companies with fundamentally different business models at the protocol layer. Many of the established rules about building businesses and investing in innovation don’t apply to this new model, so today we may have more questions than answers. But we are quickly learning the ins and outs of this market through research across our blockchain portfolio, and in typical USV fashion, we will continue to share that knowledge as we go.

[1] Also known as App Coins, a term coined by Naval in 2014 – pun intended.

[2] Edward Chancellor has written an exhaustive and fascinating history of financial speculation and its place in society (you’ll be in awe of how similar today’s cryptocurrency speculation is to previous financial booms!), and Carlota Perez has described the important role of bubbles in the development of new technologies by attracting financial capital for research and development.