Protocols: The New Asset Class

The software we use today is so user-friendly it can seem like magic at times. People rarely stop to question how the applications they run work.

What are the underlying technologies that allow us to browse the web, send messages, or facetime? How does information flow? Surely whoever invented the piece of software that allows all of this to happen has made a lot of money.

The Internet products we use today are made possible by open source software and various protocols.

This begs the question what is open source software and what is a protocol?

Open source software is developed and maintained by a non-profit organization or foundation. These projects are built and managed by a community that collectively makes decisions. Anyone can look up the code base and contribute to the project. If you’ve ever used an Android phone, you’ve benefited from the development of an open source project called Linux.

A famous quote related to human interactions is “communication is key.” Computers are no different. If computers are to communicate with one another, they need to know how the information will be exchanged and what format it will be in. Standard methods of sending and processing information are used so that computers can properly communicate with one another. These standard methods are called protocols.

Some important protocols are:

TCP (Transmission Control Protocol): This protocol facilitates the timely transmission of information over the Internet. TCP allows information to be transferred in smaller packets that can be sent via different routes and then reassembled once it reaches the final destination. TCP also acts as a safety measure, ensuring that no information is lost in the transmission process.

IP (Internet Protocol): The Internet Protocol provides a method for routing information to the proper address. Every computer has its own unique IP address. The Internet Protocol is in charge of getting information to the correct destination.

HTTP (Hypertext Transfer Protocol): Web pages on the internet are built using a standard method called HTML (Hypertext Markup Language). These web pages are transmitted via HTTP. A related protocol is HTTPS (Hypertext Transfer Protocol over Secure Socket Layer) which allows for transmission in an encrypted form to provide security for sensitive data.

The reality is that the creators of these open source projects and protocols never struck it rich as one may think. Since there was no real economic incentive to create these open protocols at the start of the internet, they were developed by non-profit organizations, academics, and government agencies.

The wealth was captured by those who:

  1. Started a company enabled by the Internet (Amazon)
  2. Invested in a company enabled by the Internet (KPCB’s investment in Amazon)

However, in January 2009 something revolutionary happened. A pseudonymous group or individual known as Satoshi Nakamoto released a white-paper titled: “Bitcoin: A Peer-to-Peer Electronic Cash System.” In it, the author described how this new technology, known as Bitcoin, would allow online payments to be sent directly from one party to another without the need for a financial institution or third party.

In a blog post from December 2013, Chris Dixon explained his excitement for the Bitcoin Protocol:

“One of the interesting things about Bitcoin is the contrast between how it is portrayed in the press and how it is understood by technologists. The press tends to portray Bitcoin as either a speculative bubble or a scheme for supporting criminal activity. In Silicon Valley, by contrast, Bitcoin is generally viewed as a profound technological breakthrough.
The Internet is based on a set of core protocols that specify how information such as text, photos, and code should be transmitted. The designers of the Web built placeholders for a system that moved money, but never successfully completed it. Bitcoin is the first plausible proposal for an economic protocol for the Internet.
This matters for two reasons:
1) It fixes serious problems with existing payment systems that depend on centralized services to verify the validity of transactions. These services are both expensive (roughly a 2.5% tax on all transactions) and prone to failure (Internet payment fraud is rampant).
2) More importantly, Bitcoin is a platform upon which new technologies can be developed. Developers have created some early applications, and speculated about future applications. Some potential applications include: a) micropayments as a replacement for banner ads or subscription fees, b) machine-to-machine payments to reduce spam and denial-of-service attacks, c) a way to offer low-cost financial services to people who, because of financial or political constraints, don’t have them today.”

Bitcoin gave rise to a new way to profit from the invention and potential adoption of a new technology. Investing in protocols. There are three ways one could financially profit from the invention of Bitcoin and the underlying technology called the blockchain. The first two being traditional, while the third being something entirely new:

  1. Start a company that is enabled by the Bitcoin protocol (Coinbase)
  2. Invest in a company built on top of the Bitcoin protocol (Andreesen Horowitz investing in Coinbase)
  3. Invest directly into the protocol (buy bitcoin)

Coinbase, a digital asset exchange and digital wallet company, was founded in June of 2012. Coinbase has gone on to facilitate the exchange of 6 billion dollars worth of digital currency, and has served 6.8 million users in 33 countries.

In that same time period, the price of Bitcoin has increased from ~$5.49 (USD) to ~$1839.23 (USD). That’s an astonishing ~33401% increase in value.

Coindesk Bitcoin Price Index

Starting a Bitcoin enabled company like Coinbase required a set of unique skills and competencies, and not everyone had the opportunity to invest in the company. However, anyone can own a piece of the protocol it’s built on, and gain from the potential adoption of the technology by buying bitcoin.

(Note: Bitcoin with a capital “b” refers to the entire system itself. The cryptocurrency and digital asset you can buy is referred to as bitcoin, with a lowercase “b”)

The belief that value is accruing at the protocol level has given rise to new types of investment vehicles like Polychain Capital, a hedge fund that invests exclusively in cryptocurrencies. Instead of investing in companies building on top of protocols, Polychain Capital invests directly into the protocols. The fund takes equity ownership of protocols instead of taking equity ownership of companies.

When people think of cryptocurrencies, they think of Bitcoin. However, there has been an explosion in protocol development. Some noteworthy projects are:

  • Ethereum: A decentralized platform that allows anyone to write and deploy smart contracts.
  • Golem: A peer to peer marketplace for computation built on the Ethereum protocol.
  • Augur: A decentralized prediction market built on the Ethereum protocol.

This recent introduction of capitalism into protocol development has two benefits:

  1. It provides a new funding model for those building protocols. When Golem had their initial coin offering and launched their token network, they raised $8.6 million in 29 minutes. This allowed them to hire developers, rent out office space, etc. This was traditionally impossible since organization building open protocols were once forced to rely on fundraising and donations.
  2. Individuals and institutions can invest in an entirely new asset class. Investing in protocols allows one to profit from the potential adoption of a new technology. The exciting part is that we’re still in the infancy of this phenomenon and there is lots of opportunity for financial gain and innovation.

The invention of Bitcoin and subsequent protocols has sparked a renaissance in protocol development and has created a new set of investment opportunities. The way we send and receive value, how computation is distributed, and how ownership of a particular asset is determined, are just a few processes that can potentially be reinvented with the new protocols in development today.

The most exciting part, in my opinion, is that everyone can profit from these innovations.

“There is a famous scene in the Matrix where Morpheus asks Neo if he wants to take the blue pill and go back to life as he knows it or take the red pill and see life as it is. Neo takes the red pill and begins a period of exploration about humanity, hierarchy, rules, etc. Bitcoin is a red pill. There will be some bad and awkward moments, but lots of good, useful and powerful things will also ensue.” — Chamath Palihapitiya

This post was inspired by a conversation between Sonal Chokshi, Chris Dixon, and Olaf Carlson-Wee. I highly recommend giving it a listen:

If this article has sparked your interest and you want to take the red pill, I suggest this lengthy but nowhere near exhaustive reading list:

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(Note: This post is merely a reflection of what goes on in my weird little head)🤓