Why Protocol Investing is a Unique Opportunity

By tying the use of the underlying protocol to ownership of a unit of bitcoin, bitcoin’s creator(s) had, for the first time, effectively unitised or fractionalised a protocol — in our opinion this forever changed the way in which value will be attributed between technology protocols and their native apps

Some of the greatest innovations over the last 50 years have been created by those who have little or no economic ownership in them. The creators of open source assets or open standards that have changed all our lives, remodelling communications, work and connectivity in such a way that it is now hard for these creations to be “unimagined”. Disruptive innovation like TCP/IP, the protocol underlying almost all internet connectivity today, or Post Office Protocol (POP), which drives a significant portion of all email traffic, WiFi, Bluetooth, and many others. Technology protocols developed by some of the greatest technology minds, provided at no cost to become the underlying infrastructure to the innovation that has reshaped the world. The productivity and efficiency gains that these protocols have driven through the broader global economy is immense along with a complete re-engineering of social and business interaction.

To put the disruption in perspective, we need look no further than the internet's growth, in 2017 it is estimated there were:

  • Over 3.74 billion internet users;
  • Approximately 1.24 billion websites;
  • In excess of 98 trillion emails sent; and
  • Retail sales in excess of $2 trillion.

Source: Hosting Facts

Whilst the gains from these protocols to the world economy have been staggering, the gains to their creators and maintainers generally have not. Reputations have been built but economic gains have generally accrued to those that have innovated “on-top” of these layers. The entrepreneurs and companies building websites, apps and consumer devices, such as mobile phones. Most of the greatest modern-day fortunes have been built on the shoulders of these protocol creators.

In our opinion this changed profoundly in early-2009 with bitcoin’s launch which will forever change the way in which value will be attributed between technology protocols and their native apps.

Whilst bitcoin's development, by an unpaid, and unknown lead developer(s) in collaboration with other notable technologists and cypherpunks is not completely dissimilar to many major protocols before it, the incentivisation structure built within it, which has driven a large part of its growth, is.

What is bitcoin's incentivisation structure?

For each bitcoin block produced, which in simplistic terms is a batch of transactions between network users, the validator of those transactions, known as the miner, receives a reward of newly minted bitcoins in return for the computational power, hardware and energy they have contributed to the network to validate that block. This reward began at 50 bitcoins per block at network launch with significant amounts of these block rewards paid to the protocol’s creator and collaborators as they maintained the fledgling network with early mining support. Block rewards have been halving since launch, at intervals calculated by a predetermined formula, to the point where they are now 12.5 bitcoin per block. Through this mechanism those that contribute to the network’s development and maintenance are rewarded by the network itself.

To create demand and subsequent value for these coins that are rewarded to miners, to use the underlying bitcoin blockchain, a coin, or a small fraction of one, is needed both as a transaction fee and as a "place-holder" of sorts on the blockchain itself. By tying the use of the protocol to ownership of a unit of bitcoin, bitcoin’s creator had, for the first time, effectively unitised or fractionalised a protocol. This created a value feedback loop which is responsible for bitcoin's growth.

The more demand there is to use the protocol for the development of apps or as a store of wealth, the more value those coins have, the more value the block rewards have and the more incentive created to attract new mining resources to the network and increase its robustness and reinforce its overall attractiveness to users.

This built a path for those that develop and maintain an open source protocol to be financially rewarded directly by that protocol with the value of the unit of reward directly tied to the protocol’s success. These contributors to the network are effectively “employed” by a decentralised piece of open-source code. They place their trust, and their decision to invest in infrastructure, in mathematically driven code. They have no traditional employment contract or services agreement, they invest and provide “work” purely on the trust they have in the mathematical code. In this way a truly borderless workplace is also created where a bitcoin miner in Iceland can contribute work as efficiently as their peer in San Francisco — all that is needed is a willingness to invest in hardware, energy, internet access and trust in the mathematics driving the network.

The Emergence of a New Asset Class

This incentive model is not without risk and where there is risk, financial or insurance markets almost always develop that allow it to be managed.

As work contributions to the network are only rewarded by effectively “in-kind” payments, the recipients of these payments have looked for an avenue to monetise them, or a portion of them, to cover hardware costs, taxes and other expenses that can largely, at the moment at least, only be paid with fiat money. The demand to make these in-kind payments fungible with fiat running and investment costs drove the need for a secondary market for these coins allowing miners to derisk, if they wanted to, but as a by product also creating a valuation mechanism for the protocol the coins are tied to.

Are these investors playing a role in the protocols development? Not directly but their capital is effectively closing the incentive loop by providing a monetisation avenue for those providing their resources and skills to the network.

The Bitcoin Value Loop

Source: DACM

A market for these coins (and with subsequent assets, tokens) arose relatively shortly after bitcoin's genesis and has now grown into a highly liquid, sophisticated, global, 24x7 trading environment and created a new asset class for investors and regulators to consider.

This asset class is completely new in almost every aspect — its structure, its claims, or lack thereof on any traditional concept of cashflow, its immutability and lack of any centralised controller or issuer and its global fungibility. Yet in this open, largely unregulated market, this asset has prospered and demonstrated incredible financial gains.

In our opinion this is because for the first time, bitcoin made underlying protocol infrastructure an investible asset. For the first time an investor could gain exposure to a technology protocol’s growth as opposed to trying to pick the winning app or apps that will utilise it — a significant divergence from the opportunities available through the internet’s initial growth phase:

Blockchain —Ability to Access Protocol-layer Assets

Source: DACM

If successful, the scale of assets like bitcoin, and other that’s have followed like ethereum — given their potential underpinnings of whole new global market places or economies — could be significant. Its interesting to try and fathom the worth of TCP/IP or POP if there were only 21 million “units” or “shares“ in them and these were required for usage — they would almost certainly have valuations well in excess of the largest corporations today.

Whether they would have succeeded if they were not “free” is also a question worth pondering but they also lacked an incentive mechanism that bitcoin has, through the ability to directly invest in it or earn rewards from it, that continues to attract some of the smartest technology minds globally to bitcoin’s development.

We find it incredibly exciting to see how a truly innovative incentive system has driven a truly innovative asset class and secondary investment market. As the long-term price growth in some of these assets demonstrates, the potential for them to generate significant, global, technology infrastructure in the future is also exciting investors. With this opportunity comes risk. The volatility in the sector reflects the difficulty in valuing a completely new asset class. With time, historical datasets and experience will be built and expertise developed that will refine the approach to valuation but for now, at least, the access to this new asset class and the ability to have economic exposure to the protocol layer of such disruptive technology is, we believe, a truly exciting opportunity.