What’s the Skinny on Fat Protocols?
In August 2016, a member of the investment team over at Union Square Ventures (USV), Joel Monegro, proposed the idea of “Fat Protocols.” The thesis holds that blockchain technologies will be valued more on the protocol level rather than the application level. This is in stark distinction to how value was created with the current model of the Internet in which technology companies captured and built businesses around user data.
Monegro’s proposal made waves when it was first published. It was the first time anyone had succinctly captured why blockchains and their tokens even mattered. This was three years ago, however. Much has changed in the space, as well as the theses on where investors should focus their attention.
Venture Capital as a Market Oracle
Venture capitalists and hedge funds have an interesting perspective on how markets operate. They serve these markets well by spotting inefficiencies and making important bets on their conclusions. Sometimes, they describe their thinking process to the larger public. This is in part why keeping a close eye on where these firms are placing their bets is so important.
If the thesis makes sense and earns followers returns, this thesis is then trotted out like a prize-winning racehorse. So was the case with Monegro’s writeup. In fact, the post is still critical reading for incoming crypto investors. It is based on the idea that a) blockchain technology will be as revolutionary as the Internet b) and also that blockchain technology’s value proposition is nearly the opposite of the Internet’s.
It should be noted that both of these propositions are under further interpretation at current. We’ll dig into that later on.
Monegro’s definition of a protocol revolves around infrastructure including SMTP, HTTP, and TCP/IP. These three items are the nuts and bolts of our Internet experience. At the time, these protocols weren’t the best. There were many better alternatives which were both faster and more efficient. But it worked and enough people had already begun using these standards that switching made little sense. Even Google didn’t dare rearrange SMTP, for instance, when they were developing Gmail.
The open-source nature of the early Internet standards also meant that developers weren’t going to become rich fiddling with them. Outside of building a reputation within early chatrooms and research departments, there was no Jeff Bezos-like figure who profited from HTTP the protocol. The real money was found in the businesses built on top of these protocols.
Monegro wrote the following on the subject:
“The Internet stack, in terms of how value is distributed, is composed of ‘thin’ protocols and ‘fat’ applications. As the market developed, we learned that investing in applications produced high returns whereas investing directly in protocol technologies generally produced low returns.”
The massive technology conglomerates of today are all built using the same Internet standards. And yet, the data they have aggregated from users flying around on the public rails of the Internet is private and siloed. Google, Amazon, and Facebook have built extensive moats around this data and now charge clients to access it. These clients make up advertisers and startups eager for information. An up-and-coming artificial intelligence (AI) company, for example, desperately needs huge swaths of data to merely test the functionality of their algorithms. As a side note, this gives Google a huge advantage in the AI business.
The business models springing up around public blockchains is markedly different. Instead of data being blocked off and sold to the highest bidder, this data, in the form of transactions, is publicly available. Anyone can view operations on the Bitcoin or Ethereum network. And yet, despite the low barrier to access, this is where all the value lies.
Exchanges that allow users to trade bitcoin and ether, Ethereum’s native token, all have direct access to the underlying protocol. Binance and Bitmex, two direct competitors, both operate their businesses on shared access to the same, free data. Adding a token to this model further adjusts the business model.
More Incentives to BUIDL
Blockchain-based networks create tokens that users can hold or use within the network. Despite best promises though, most tokens are still used for speculation. But this isn’t really a problem.
Offering developers, entrepreneurs, and users monetary value for using a particular network may incentivize further utility by even more people. As more and more people join the network by buying the relevant token, the price of that token goes up. It follows too that as a network develops more features, this will inspire more users, which will also be reflected in the price. Developers, who are likely token holders, can thus indirectly profit by improving the network with desirous components.
From this one can understand tokenization as a means to fund development. Traditionally, open-source development inevitably runs into a corporate buy out as hobbyists working for free will only get so far. Consider how Microsoft bought GitHub in June 2018.
Technically, such a buy out could happen in the world of crypto, but if the majority of users disagree, then they will simply fork the protocol away from incoming stakeholders. This organizational model thus appears far more democratic than the models of large Internet companies.
Much of this is still true, but much of this, especially three years later, has drastically changed. In 2016, when Monegro drew this argument out, there was little discussion about side-chains and off-chain applications. It should also be noted that at the time of writing the scalability issues of 2017 were still on the horizon. He may have also underestimated how crypto exchanges have become very profitable businesses, but aren’t protocols.
So, let’s break down some of the portions of the Fat Protocol thesis that are now under revision.
If one were to follow the Fat Protocol thesis stringently, one would end up with a handful of different tokens from various blockchain-based networks. These networks may have been relatively successful with lots of developer activity, like Ethereum. Others could have been entire flops. In the end, Monegro’s thesis appears more like a shotgun investment which attempts to hit as many “protocols” as possible.
This has immediate drawbacks. The first, of course, is that investment in projects who may not be working at the protocol level but nonetheless offer value to a community, are overlooked. This can be disheartening even for the most militant of followers.
Orthodox protocol investment misses many of the derivative projects focused on solving real problems backed by network effects.
A network like Algorand, for instance, enjoyed a massive valuation because of a reported 1,000 transactions per second with its blockchain. Unfortunately, they lack the same activity, developer and user, as Ethereum or Bitcoin. Algorand lacks the network effects of the top blockchains despite its clear advantages. This scenario has played out multiple times with other blockchain projects. Each time, the longevity and brand name of Ethereum and Bitcoin have always won out.
Despite these alternative solutions, Bitcoin and Ethereum developers continue to work on scaling their networks. Why? Because solving the scaling problem for both blockchains means that all bitcoin and ether holdings will also enjoy a serious price hike.
Ultimately, the reward for solving problems within a network that already enjoys massive uptake, high-activity, and a broader distribution of tokens is much greater than starting over with a completely new protocol. This is key, not just for venture capitalists, but for all members of the cryptosphere.
The Fat Protocol thesis may provide an introductory framework for how to think about crypto networks, but as the technology steams full speed ahead, a more nuanced vision becomes necessary.
