A lot of people face immense confusion over the differences between the different kinds of coins and tokens out there in the crypto space…and for good reason. With the sheer amount of projects out there, it could be incredibly tough for someone, new to the space, to keep up with everything. We have already covered the differences between security tokens and utility tokens. However, in order to get a more intimate knowledge of the cryptospace, it is important to know the differences between application coins and protocol tokens as well.
Understanding Protocol and Protocol Tokens
We all know what app coins/tokens are. These are the coins that fire up various applications and they have existed before the blockchain. An excellent example of this is in-house currencies in online multi-player games. One can use their fiat money to buy tokens in these games which can be used in various ways (to buy in-game armor, skins etc.). However, before blockchain technology, there were no protocol tokens.
To gain an understanding of what protocol tokens are, let’s understand what protocol means. In extremely simple terms, protocols are a set of ideas that govern an ecosystem.
According to wikipedia, “In telecommunication, a communication protocol is a system of rules that allow two or more entities of a communications system to transmit information via any kind of variation of a physical quantity. The protocol defines the rules, syntax, semantics and synchronization of communication and possible error recovery methods. Protocols may be implemented by hardware, software, or a combination of both.”
One of the most well known form of protocol system is the TCP/IP protocol. The internet is a wonderful invention which connects all of us. However, for the internet to work, it needed to define certain rules and protocols, which can help us to seamlessly connect with one another.
As this article puts it, “TCP/IP specifies how data is exchanged over the internet by providing end-to-end communications that identify how it should be broken into packets, addressed, transmitted, routed and received at the destination. TCP/IP requires little central management, and it is designed to make networks reliable, with the ability to recover automatically from the failure of any device on the network.”
The thing is though before the blockchain came about, these protocols were used freely everywhere and researched by good samaritans and non-profit organizations. However, the same doesn’t go true for the applications that are built on top of this protocol. Think of billion-dollar companies like Facebook, Google, Twitter etc. which have been built on these protocols. Since they have integrated economic incentives within them, investors soon found out that it makes much more sense to invest into the applications and get a high return rather than invest in protocols and get little to no returns.
This according to Joel Monegro’s famous analogy created an Internet stack which has “thin” protocols and “fat” applications in terms of how value was distributed.
However, this is where the blockchain came in and completely changed this whole concept on its head because of two reasons.
- Decentralization: Since no single entity owns the blockchain, the barrier to entry is very low. This is why more and more people can come in create application and products on top of the protocols. Plus, as the applications get more attention, it intrinsically increases the value of the underlying protocol as well.
- Cryptographic tokens: More on this in a bit.
Just like that, we had a system which utilized fat protocols and thin applications.
As discussed above, one of the biggest reasons behind the fattening of the protocol layer are cryptographic tokens. Before the blockchain, there was no way to economically incentivize the underlying protocols. These tokens incentivizes the participants to work in the interest of the protocol. The following diagram shows how the internet stack shapes up against the blockchain stack:
As we stand today, companies can now create protocols which will create value for themselves (and for their investors) as long as they retain some of the tokens. In fact, the better the protocol, the more its adoption, the more its perceived value, and hence more the value of the tokens appreciate. This is exactly what has happened with Ethereum.
This change puts the ball squarely in the protocol creator’s court. Earlier the only way that these creators could make money from their protocols was by creating software that implemented on it and then try to sell it for money. However, with the implementation of tokens, these protocol creators can directly monetize the protocols. In fact, as we have said above, as more and more software is created on top of it, it increases the value of the underlying protocol.
Now, what does this type of positive economic incentivization do?
Developers now have a real incentive to create more innovative protocols which brings even more value to the ecosystem. Plus, this is good news for investors as well since they will be able to invest their money in more valuable tokens, which helps the developers make profit as well. On the surface, it looks like a well-oiled machine.
There is another thing that Monegro talks about in his article called the “token feedback loop”. In other words, how do these protocol tokens help increase the protocol’s adoption and hence fattens the protocol part of the value distribution.
The diagram that you see above is what Monegro uses to explain this loop. What happens when the value of the token increases:
- Investors, developers, and other market elements get interested in the project and start investing into and become stakeholders. The influx of value increases the overall market cap of the network.
- Plus, if the protocol is deemed valuable then it will attract more developers to create applications and products on top of it. If the applications are of good quality, then it will attract even more users and developers to the network which will increase the overall value once again. Think about how cryptokitties brought in so many users to the Ethereum network that it actually clogged up the entire system.
In fact, just to buff up this point, the market cap of the protocol always grows faster than the combined value of the applications built on top of it. This how the protocol layer becomes fatter than the application layer.
Analogy For How App Coins and Protocol Tokens Co-Exist
As you would have probably guessed by now, app coins are the tokens that runs the applications built on top of the protocols. So, if Ethereum is the protocol then Augur is the application built on it and Augur’s tokens REP are the protocol tokens.
Let us give you an example as to how the protocol tokens and app coins co-exist with an analogy.
Suppose we have a blockchain called “Singapore” which has a protocol rule that states “transactions can only be allowed by exchange of currency”. To enable this facilitate this protocol, Singapore has a native currency called Singaporean Dollars or SGD.
Now, there is a mall inside Singapore which has a food court. However, one can only buy food inside the food court by exchanging their SGD for food court tokens from a token counter. Once these tokens have been attained, you can use them to buy anything you want inside the food court.
One thing to keep in mind here.
These tokens are valuable only inside the food court. They are not valuable anywhere else. In this example, the food court is an application that has been built on top of the main protocol i.e. Singapore and the food court tokens are app coins.
As of right now, there is a lot of debate going on around the space as to which layer, application or protocol should development be concentrated on. We are not going to take a side on this debate. However, what we will do, is to present all the arguments on both sides. We hope that you can see the POV from both the sides of the debate and come up with your own opinion.
Backing App Coins
Mason Borda, the CEO of Token Soft, believes that while protocol tokens is good for investors it is bad for business. He believes that focussing on needless protocol development makes the space vulnerable and open to three major risks:
- Technical Risk
- Business Risk
- Execution Risk
One thing that people tend to forget is that the blockchain space is still a relatively young space. There aren’t many extremely educated or experienced developers here, because, there aren’t many blockchain development courses and training programs out there. There are very few developers out there who actually have the expertise to build the necessary abstraction layers for seamless execution. For a developers to build a faultless protocol system, they need to gain experience and expertise, both of which are lacking as of now.
As Mason puts it, “protocol tokens can take over five to ten years for the market cap to reach expectations .” For a business that’s looking to incorporate the blockchain technology, they should keep in mind that it requires significant resources and attention. In fact, most of the times, it requires full concentration and focus of the entire team. More of then than not, really good business ideas are lost because of failure to produce a concrete decentralized protocol.
Finally, even if you have a good business idea in place, finding the team and executing it can be a huge challenge. Because of the sheer lack of developers in the space, it is near impossible to find the right team. Most of the good blockchain developers are already involved with several projects. Most of the time, you will have to invest in the education of your team members and develop your own team.
James Kilroe, the investor at Newtown Partners feels that protocols, as a whole, have evolved and the thesis provided by Joel Monegro is outdated. He says that instead of having a single layer of protocol, projects nowadays have multiple layers of protocol. One of these layers happens to be the application protocol, which Kilroe believes to be the next avenue of real investment.
He gives the example of Civic to show how these different layers work. According to him,
“The ‘processing layer’, either Ethereum or RSK, a file storage layer (perhaps FileCoin in the future), other critical infrastructure layers (such as inter-protocol connectors) and finally the $CVC layer, which governs the crypto-economies surrounding the identity verification economy. All of these layers are protocols in their own right and will make up the identity verification value stack in this case.”
As opposed to the original fat protocol system, the new diagram would look like this:
So, why is it that application protocol has become such a value capture as opposed to the base protocol?
One of the reasons could be the aggregation theory which states, “the value chain for any given consumer market is divided into three parts: suppliers, distributors, and consumers/users. The best way to make outsize profits in any of these markets is to either gain a horizontal monopoly in one of the three parts or to integrate two of the parts such that you have a competitive advantage in delivering a vertical solution.”
However, for the blockchain world, the definition could be reworded something like this,“the economy for any given decentralised vertical is divided into three parts: base protocols, application protocols, and consumers/users. The best way to capture outsized value in any vertical is to either gain a horizontal monopoly in one of the three parts or to integrate two of the parts such that you have a competitive advantage in delivering a vertical solution.”
Ok, so what does that mean?
For a protocol to dominate the crypto space, one of two things need to happen:
- Either they have to dominate one horizontal layer
- Or they have two aggregated the two layers of protocol into one.
Let’s explore both of these options:
#1 Dominate one horizontal layer
How likely is it for the protocol layer of project to dominate the entire space? Let’s take the example of Ethereum.
- Ethereum miners make money via transaction fees, however, Ethereum is working on various scaling solutions to cut back on transaction fees.
- Since most of the projects, including Ethereum, are open source code, it enables the door for forking and creating more specialized form of the cryptocurrency for more niched use cases. Think of how Litecoin forked from the Bitcoin protocol. This greatly dilutes the value of the actual base protocol.
- Finally, interoperability is just round the corner thanks to projects like Cosmos, AION etc. These will also lead to reduced fees overall.
Hence, it is overall really difficult for a project to simply dominate one layer.
#2 Aggregating Two Layers into One
The idea is to aggregate the application protocol and the base protocol and encapsulate in a way that users use the protocol without even knowing that it exists. This is a high level abstraction that most decentralized projects are aiming for. As Dr. Gavin Wood puts it, Ethereum’s ultimate goal is to completely disappear in the background.
The reason why this is desirable is because it is significantly easier for application protocols to get users than a base protocol. If this is done properly, then you can see why the application protocol becomes the real value trap instead of the simple base protocol.
Backing Protocol Tokens
Will Warren, the CEO of 0x Protocol, on the other hand, believes that “the current culture surrounding token sales has created incentives that do not align with these beneficial practices.”
According to him, the token sales are incentivizing developers to create value around specific application(dApps) rather than the protocol as a whole. This is the reason why the cryptoverse is littered with app coins which serve no other purpose but to be used in crowd sales and for following regulatory guidelines.
The problem with focussing on APP coins rather than protocol coins is that it is specific to the dApp’s smart contract. On the other hand, shared protocols provide standardizations which promotes the overall growth of the entire space. As Warren puts it, these coins are the “ antithesis of standardization: many custom and incompatible contracts with varying levels of quality and security, all implementing the same functionality. What do end users get out of it? A larger attack surface, multiple configuration processes, app coins and learning curves to deal with.”
So, while shared protocols can grow the entire network in a synergistic way, app coins can fragment the users into different cabals which makes the overall system highly inefficient. To understand how that will work, let’s look into something called Metcalfe’s Law.
Metcalfe’s Law is a theory of network effect. According to Wikipedia, “Metcalfe’s law states the effect of a telecommunications network is proportional to the square of the number of connected users of the system (n^2).”
It was formulated by Bob Metcalfe, the inventor of Ethernet and co-founder of 3Com.
Image Credit: Andrew Chen
If we were to equate this to the blockchain network then Metcalfe’s Law states V ∝ N² where V is the overall value of a network while N is the total number of nodes within that network.
Now, suppose for argument’s sake imagine that we have three sets of nodes, N1, N2, and N3. These sets are part of two networks. One network utilizes a shared protocol while the other network has three apps which uses their own specific protocol. How do you think the Metcalfe’s law graph is going to turn out in these two cases?
Something like this:
The first network, which uses three Dapps with their own protocols and as you can see, instead of working in tandem with each other, the nodes are individually doing their own thing. As a result, following Metcalfe’s law, the overall value comes out to be N1^2+N2^2+N3^2.
On the other hand, the second network which utilizes a shared protocol, has the Dapps working in tandem. So, the overall value of the network comes out to be (N1+N2+N3)^2.
(N1+N2+N3)^2 > N1^2+N2^2+N3^2
This is why, the overall value of the second network is higher than the first network.
We hope that we have made the difference between protocol tokens and app coins clear to you. We have presented to you both sides of the debate. Protocol tokens drives the overall value of the protocol system while the app coins fuels the applications that are running on top of the said protocol. Where do you think the overall ecosystem needs to put their focus on?