The Fat Protocols thesis has become one of the most axiomatic principles in the blockchain space. Published in an article by Joel Menegro, fat protocols refers to a market dynamic in the blockchain space in which the bulk of the market value gravitates towards tier 1 protocols. This dynamic contrasts with other technology trends in which the value is mostly captured by the application tier.
When Monegro published the fat protocol article, the world of blockchain could be safety divided between tier 1 protocols such as Ethereum, Stellar or NEO and the new universe of application/utility tokens. Not surprisingly, the fat protocol thesis is mostly focused on the utility token model. Since then, the market has experienced a rapid interest in the tokenization of financial and alternative assets which has come be known as security tokens. From the market perspective, security tokens challenge many of the principles that we took from granted in the utility token space and the fat protocols thesis is not the exception. In my opinion, many of the ideas behind the concept of fat protocols simply don’t apply in the universe of security tokens.
Investment vs. Utility
There are many definitions of security tokens and how they differ from more traditional utility token models. The common denominators across all those definitions is that security tokens represent an investment vehicle whose sole purpose is to capture monetary value over time. In that context, investors will buy security tokens to achieve a return in the form of dividends, price appreciation or other value creation models.
Analyzing security tokens from that perspective helps us understand a fundamental difference in the form value is created in this world compared to traditional utility tokens. While the value of utility tokens is mostly driven by the characteristics of the underlying decentralized network and protocols, security tokens achieve value following principles of financial markets. Therefore, when comes to security tokens, fat protocols are simply not that fat 😊
Security Tokens in Three Levels
To understand how value is created in the security token space, it might help to segment that space into three fundamental tiers. In the first tier we can place traditional blockchain protocols such as Ethereum, Stellar, EOS or NEO that enable the fundamental building blocks of decentralized applications. Other utility protocols such as FileCoin or Oraclize or 0x can also be placed at this level. This layer absolutely follows the fat protocol dynamic and the core value is accumulated by the lower parts of the stack.
On top of tier 1 protocols we can place the new wave of tokenization platforms. These stacks are the producers of security tokens based on different models such as tokenizing alternative assets or financial products. In this tier we can place platforms such as PolyMath, Securitize, Harbor Dharma Protocols and others. As security tokens growth this layer is likely to become more relevant and start taking some of the value from the tier 1 protocols.
Finally, the third layer are products built around security tokens themselves. From derivative models to passive investment vehicles, a large percentage of the products in financial markets can be emulated in the security tokens space. This space is simply not constrained by the network and computational resources of the underlying protocols. New mathematical and investment models can be constantly assembled using different security tokens in a circle with no limits in terms of value creation. If you think about it, the overall market value of financial derivatives is over a QUADRILLION dollars surpassing all economies and stock markets in the world. Security tokens are just opening the door to a new world of financial models built on top of tokenized products. This layer of the security token ecosystem simply defies all the principles of the security token thesis.
So how would the security token space evolve over time? Nobody knows for sure but here is an interesting thesis. I think that, over time, the value is going to be shifting from the tier 1 protocols to the tokenization platforms to the security token products and ultimately the bulk of the value accumulates in that third tier. I know that idea might seem controversial to many but it follows many of the historical patterns in financial markets. The following figure illustrates this evolution.