‘Dogecoins’, Applications, and Protocols, Oh My!
1. Only Protocols
2. Think Vending Machine
3. Protocols are Polygamous
4. Metcalfe’s Law
5. Zipf’s Law
This is a short explanation about the valuation difference between ‘Dogecoins’, applications (apps), and protocols. There are a lot of initial coin offerings (ICO)’s happening right now, and I’ve had quite a few friends and strangers alike reach out to me asking how they should think about investing in this space.
** Disclaimer, by ‘Dogecoin’ I am not referring to the actual Dogecoin — I am referring to the idea of a novelty coin that does not serve investment purposes.
I don’t like ‘Dogecoins’, and I don’t like applications — I only like protocols. Why?
Because if you are an investor, you are hunting for 1000x returns (the next Google) and the protocol layer is where to find them; not in the application or ‘Dogecoin’ layer's, most of which don’t make any sense.
A lot of people are asking…
How should I invest in these coins?
How do you know which ones are worth considering?
The first and most important thing to understand when hearing about a new coin is finding out which of these three coin types are they:
A ‘Dogecoin’, an application, or a protocol.
What is a ’Dogecoin’?
These coins are simply not worth your time. These are people who are making a movie, or doing something that’s not related to some kind of scalable technology; because of this, I avoid these type’s of coins at all costs.
What’s the difference between a protocol and an application, and why is one potentially so much more valuable than the other?
A protocol can be thought of as the infrastructure anyone can plug into, e.g. Electric/Energy grid, whereas an application is like a light bulb — the light bulb plugs into the infrastructure. While the application can be valuable, all of the applications built on top of the protocol, are never more valuable than the protocol.
HTTP is the protocol used to distribute information on the internet. All of the websites (applications), i.e Facebook, Amazon, Google built on top of HTTP, are never more valuable than HTTP itself.
All of the light bulbs in existence are not as valuable as the electrical infrastructure they plug into. Applications have to plug into protocols to get the resource that they need, protocols are the resource.
Think Vending Machine
If you are going to invest in or build a new technology in the digital currency economy, why choose a protocol instead of an application?
The short answer is, money.
If you were going to work for an hour, and could either make $10 or $100, which one would you do?
I'm of the opinion the amount of work required to release a coin for an application, and a coin for a protocol is roughly equivalent — however, the return potential for a protocol is much higher than for an application.
This is because protocols have the ability to both save and make money at scale — and for some protocols, at levels that haven’t been seen before.
Here’s an easy way to think about it. Think vending machine.
What is a blockchain protocol?
You can think of blockchain protocols as vending machines for a specific digital service. The suppliers can be anyone on the internet, anyone can connect and contribute a resource, whether that’s their CPU, GPU, storage, memory, information etc. and this vending machine only accepts coins specific to that blockchain.
Why do protocols save money?
Protocols save money because they have insane economies of scale. Since anyone connected to the internet can provide the supply side of the vending machine, you’re always going to get the highest possible quality return of the digital service that you’re looking for.
To bet on a technology I have to be able to say, with this protocol I can see a lot of people plugging into the platform because it’s easier for them to use it, then the existing services available to them. The more people that plug into the protocol, the more valuable the platform becomes.
If it’s axiomatic that you need the the electrical grid to use the light bulb, then it’s also axiomatic that the number of people who can plug into an application is much smaller than the number of people who can plug into the utility grid.
Now what about the other side…
How do these vending machines make money, and capture value?
Each vending machine has it’s own specific coin for that particular vending machine. As these vending machines increase in demand and become more popular, people who want to use that vending machine need that protocol specific coin.
Because these coins are scarce and therefore are either deflationary (no inflation), or have modest inflation which is governed by code and math instead of people; the code and math ensures these coin's remain reliably scarce. As a result, they increase in value as their demand increases.
By creating a popular vending machine for a specific digital service and having a scarce protocol specific coin, as the popularity for your protocol increases, this variable directly increases the value of your coin/investment.
Think about this in terms of internet search engines. If time is money, then attention is currency. If you are using Google instead of Yahoo’s search engine, then you are paying Google with the currency of your attention, which in turn creates traffic, which in turn attracts advertisers, etc.
** A note of missed opportunity, remember when Yahoo turned down the opportunity to buy Google.
Protocols are Polyamorous
What is the main difference between an application and a protocol?
Protocols have polyamorous relationships with their users, meaning the coins can be used by any application (on the vending machine) platform. Whereas applications, are mostly monogamous relationships, meaning the coins are primarily used inside of a specific application.
Protocols should recognize three major things:
1. The Big Picture
- Do they understand the major components within a given industry?
- Do they know how to start off in a market with a notable scaling problem?
- Does this technology have the potential to eat some major aspect of human nature?
- Are they capturing involvement from top developers in the industry with a proven track record of bringing previous products to market?
- (A) Again, because this is critically important in most cases.
3. Game Theory
- Are there any perverse incentives inside the system?
- Does the system make sense?
- Does the vending machine make sense for the suppliers and demanders, the two sides of the market who are going to be using this digital service?
- What is the potential market cap if blank happens at blank level?
Because protocols are more open than applications, they have the potential for much larger and faster network effects.
This is an extremely important factor…
By identifying particular network effects before they happen, you position yourself in the best chance to ride the critical mass crossover outlined by Robert Metcalfe in Metcalfe’s Law. The first person (protocol) to pass this point effectively wins a monopoly.
I look for leading indicators, and patterns associated within certain economic metrics. The theoretical basis for network economic effects is known as Metcalfe’s Law, first articulated in the early 1980s by Robert Metcalfe, the inventor of the Ethernet.
Metcalfe’s Law states the first protocol to clearly get to this critical mass crossover point generally secures a monopoly. They start to develop supermajority, and it becomes very hard for second place to catch up with them.
Supermajority is the point where the distance/gap between first and second place is always expanding, and first place is always becoming more dominant to the point that second place can never catch up.
E.g. Many cite this effectively explains the phenomenon that happened between Facebook and MySpace.
When thinking about Metcalfe’s Law and applying it to ICO’s we are specifically looking at network effect, and monopoly. There is this magical point in network effect where you reach critical mass crossover. After this point is reached, for each new person that joins, the value of the network increases more than the cost of the next new user.
This is the major advantage that protocols have and the reason why they have this potential for 1000x or greater returns because once you pass that point as a protocol, you might have locked up a forever monopoly — the network effects become so strong you have this potential for superdominance.
Although Metcalfe’s Law’s mathematics are correct and certainly gives us a good barometer for valuing networks, this been refuted quite convincingly as a complete method of evaluating changing dynamtics in within network effects after the release of “A Refutation of Metcalfe’s Law and a Better Estimate for the Value of Networks and Network Interconnection” Andrew Odlyzko and Benjamin Tilly’s essay in 2005 and again with Bob Briscoe’s more widely cited article on IEEE Spectrum in 2006.
Their candidate for modeling value?
What is Zipf’s law?
Zipf’s Law /zif/ is an empirical law formulated using mathematical statistics. The law is named after linguist George Kingsley Zipf, who first proposed it in 1949. Zipf’s Law states that given a large sample of words used, the frequency of any word is inversely proportional to its rank in the frequency table.
It is, in essence, an empirical description of hierarchical distribution of resources (i.e., the rich get richer…)
What it really means, is that by looking around society you would find that everything is distributed in an zipfian way, which implies, that picking any data set which involves some interaction in terms of credits (upvotes, likes, shares, coins, protocols, views… basically anything) can be approximated with Zipfian distribution.
What is Zipfian distribution?
In layman terms, it denotes that out of 100% of the data set, 20% overpowers completely the other 80% in a group.
One of every four words you say or write is probably one of these: “the,” “be,” “to,” “of,” “and,” “a,” “in,” “that,” “have,” and “I.”
Those ten words, listed in order of frequency, comprise around 25% of the recorded English language, according to an ambitious project at Oxford University .
Reddit Karma: The above graph posted in this subreddit shows beautifully about how the entire karma system (karma resonates to upvote button) follows the core Zipf’s Law. The top 20% of the total users on the Reddit website have as many as 80% of the karma ever submitted since it has been launched.
Zipf’s law is everywhere and fundamental to how universe really works, as described and illustrated beautifully here in this YouTube video by Vsauce.
Zipf discovered the law through the observation of the frequency of words in the English language, however, the law also holds for randomly generated “languages,” such as protocols…
The law states that, “given some corpus of natural language utterances, the frequency of any word is inversely proportional to its rank in the frequency table. Thus, the most frequent word will occur approximately twice as often as the second most frequent word, three times as often as the third most frequent word, etc.”
… you are three times more likely to have heard of Bitcoin than Stratis, and two times more likely to have heard of Bitcoin than Ethereum.
An example of the difference in valuation between Metcalfe’s law (n2) and Zipf’s law (n log (n)) is illustrated in that same 2006 IEEE article:
Imagine a network of 100,000 members that we know brings in $1 million. We have to know this starting point in advance — none of the laws can help here, as they tell us only about growth. So if the network doubles its membership to 200,000, Metcalfe’s Law says its value grows by (200,0002/100,0002) times, quadrupling to $4 million, whereas the n log (n) law says its value grows by 200,000 log (200,000)/100,000 log (100,000) times to only $2.1 million.”
By diving more into these metrics and better understanding the dynamics of the network effects involved, we can clearly see why investing in a protocol is so much more valuable than both applications and ‘Dogecoins’.