Fat protocols are not an investment thesis

Searching for investment criteria in the functionality stack

In Fat Protocols, my fellow Brooklynite Joel Monegro insightfully draws parallels between the Internet protocols of the 1990s and the blockchain-based protocols of the 2010s. Early Internet protocols have provided massive value, he explains, but have been “thin” — meaning that monetization has historically occurred in an industrious, “fat” application layer built on the protocol. As scarce digital assets enable decentralized value and information networks, the protocols which they implement are now “fat” — monetizable at the network level using a cryptoeconomics or token — while the application layer is “thin”. Decentralized applications can still be monetized, but are much more focused on interoperability with the underlying data layer.

This view of blockchain networks is an important observation which has had profound implications for the way blockchain investments are structured, also discussed in CoinFund’s piece on blockchain investing. Specifically, it has taken traditional investors a market cycle with Bitcoin startups to realize that private equity of centralized companies is usually the sub-optimal method of investing in decentralized networks. But that was last summer. This summer we have cryptofunds, VC funds that can allocate capital toward token and hedge fund investments (!), SAFTs, smart contract vesting, options for cryptoassets, token-based engagement agreements, and other technology which collectively provides a set of investment tools for exposure to the growth of value networks. When investors take the time to understand and experiment with the complexity of blockchain’s new asset class, its issuance, and its lifecycle, they can make informed decisions about how to best structure investments into it.

The characterization of value networks as fat protocols has helped to underscore the need for these new investing methodologies and to outline a solution: investment for exposure to the network’s cryptoeconomics. However, the issue is that it’s easy to misconstrue the idea of fat protocols as an investment criteria. We now find investors deploying hard filters on “protocol tokens” when evaluating opportunities. I suppose we all wish that TCP/IP was “fat” and we had invested in it in 1992. In my opinion, though, this kind of investment strategy espoused by cryptoinvestors is a misapplication of Joel’s characterization of value networks.

According to some investors, there is an investment thesis based on the idea of fat protocols which goes something like this:

If you invest in an application token, then you are subject to a 95% startup failure rate (or more!) and if you invest in a protocol token you diversify across all applications built on that protocol. It’s better to diversify across protocols than across applications, because protocols are more applicable and capture the value of everything built on top of them. Base protocols will capture more value than everyone else (alas, if only TCP/IP was a fat protocol!). Therefore, invest in protocol tokens, not application tokens.

I claim that, by itself, this thesis is a highly imprecise, subjective, and therefore sub-optimal investment criteria. I also claim that much value generated within decentralized networks will never make it down into the base protocol layers. We should try to get more precise on the interaction and value flows between layers of the functionality stack of network software.

Alice doesn’t know where the protocol ends

When we talk about protocols in a blockchain investing context, we are usually not being very precise at all. A protocol is simply a collection of rules, behaviors, and formats that specify a communication standard between two or more nodes on a network. That’s extraordinarily general, and we can therefore regard a large number of decentralized applications or platforms as protocols in their own right.

Using just technical intuition, it is obvious that every layer of functionality is simultaneously a protocol for the stack above it and an application of the stack below it. TCP/IP is an application of a complicated stack of network hardware while being a protocol for data transfer between computers. HTTP is a protocol for serving structured Web data and an application of TCP/IP. Higher in the stack, dapps like Augur are applications of Ethereum’s protocol as well as data storage protocols like IPFS. Twitter is, after all, a microblogging protocol with thousands of applications built upon its API, including Twitter’s. Finally, James Childs-Maidment’s stateless smart contracts are an application of Ethereum and the protocol serving Leeroy’s centralized UX application. In short, you can draw a protocol-application boundary at any level of abstraction you like along the functionality stack.

The literal property of being a protocol is not that to which protocol fatness refers. Fat protocols refer to value and information networks — open networks that maintain compact ownership of data which they are able to monetize through cryptoeconomics. It is therefore important to understand how value flows through the layers of the functionality stack and how a given layer might capture that value.