Last October, Catalonia again demonstrated its history of separatism through a unilateral independence referendum. In the days preceding the vote, Spanish law enforcement seized Internet domains related to the referendum, effectively blocking the Catalan public from accessing voting information.
Independent of politics, Internet censorship raises difficult questions about our modern freedoms as increasingly digital citizens. Ultimately, the Catalan government leveraged the peer-to-peer network behind Juan Benet’s InterPlanetary File System (IPFS) to overcome Spanish censorship and distribute voting station information with the public.
In the wake of the recent market correction, I’ve found myself thinking about what makes for a strong, resilient crypto investment thesis. While reading content published by crypto thought leaders, protocol was a word I commonly saw used to defend investment decisions.
Protocol: A collection of rules, behaviors, and formats that specify a communication standard between two or more nodes on a network.
IPFS is based on distributed, cryptographically-secure databases — a concept that Satoshi Nakamoto introduced to the world as part of the original bitcoin protocol. Developers have since iterated upon this original protocol to create countless alternative coins and blockchains, including Ethereum: upon which IPFS and its sibling FileCoin are built.
Put simply, every decentralized application (and coin) lives on top of a protocol, which dictates some rules for how it’ll work under the hood.
Value Chains: Internet vs. Blockchain Protocols
Protocols (in general) exist in layers, stacked on top of each other. Think of a single layer as an abstraction for the protocols below it, and as a base for the applications above it. Using the Internet as an example, IP is responsible for determining the address to send data to, while TCP ensures that data packets are securely sent to that address.
Union Square Ventures’ Joel Monegro made a critical observation about traditional Internet protocols like TCP/IP: that the amount of value captured is thin at the protocol layer and fat at the application layer. On the Internet, protocols simply exist to route and transmit user data generated by powerful apps that live on top, like Google, Facebook, Uber, etc. — who accordingly capture the bulk of the value created in the overall system.
That’s inverted with blockchains.
Value is mostly concentrated at the protocol level, because that’s where all of the important, meaningful data about users lives. Decentralized consumer applications simply provide a platform through which users can interface with the underlying wealth of blockchain / ledger data. That’s why it’s (relatively) easy to switch exchanges — it’s simply modifying your interactions with the same underlying network. With increased usage of decentralized apps, the more value that underlying protocols (like Ethereum) capture.
Infrastructure On Top of Protocols
Today, we’re seeing multiple protocols in crypto competing amongst each other to be the base layer for decentralized consumer applications across multiple market segments.
One school of thought for investing is to make bets across protocols and segments, since eventually, the most effective, scalable protocol for a segment should win and create value for everyone. An alternative opinion, that I personally think makes more sense, was proposed on this a16z podcast. It’s something like this:
For blockchain to really take off, there needs to be concrete consumer applications that leverage decentralization not just for decentralization’s sake, but to deliver a truly better product. How can we enable these consumer apps in the future, at scale? The answer is to invest in infrastructure based on the blockchain that provides applications with a functional middle layer to build on top of, instead of simply relying on a single underlying protocol.
One clear indication that we still require infrastructure investment was when the CryptoKitties project wound up nearly swamping Ethereum late last year. There is not yet a blockchain that can handle the throughput requirements of most real world applications. Now there are important efforts underway both to build on existing chains, such as the Lightning Network for Bitcoin and Plasma for Ethereum, as well as to extend the capabilities of existing base chains such as Ethereum through protocol upgrades…
— Albert Wenger, Union Square Ventures
Basically, scalable consumer applications need resources that the base protocol itself can’t always be expected to provide. By adding additional layers of infrastructure for scalability, data processing, storage, etc., investments in infrastructure will generate value by increasing the throughput of existing protocols.
Hosts of the a16z podcast even argued how when once powerful infrastructure is in place, developers could build actually efficient P2P versions of centralized marketplace platforms like Uber and Etsy.
Soros’ Theory of Reflexivity & The Future
Elad Gil has suggested that cryptocurrencies are reflexive— assets that become increasingly valuable as others agree that it is valuable. Reflexivity is part of George Soros’ mental model to think about market bubbles.
“Every bubble has two components: an underlying trend that prevails in reality and a misconception relating to that trend. When a positive feedback develops between the trend and the misconception, a boom-bust process is set in motion.”
From this perspective, crypto’s rise in market value can be attributed to a virtuous cycle. Mass blockchain optimism increased prices, which funded development and new proposals around the technology, which in turn continued to feed the hype (and gains). The recent correction can then be attributed to how “market expectations become so removed from reality that people are forced to recognize that a misconception is involved” (Soros).
In a nascent space like crypto, it’s tough to identify for certain at this stage what the misconceptions are, and what is the underlying reality. What seems more obvious, though, is that better infrastructure is a necessary step for more scalable decentralized apps.
Even in the last couple weeks, we’re seeing major investments designed around better infrastructure for the future:
- Microsoft helping build protocols that live atop public blockchains to achieve digital identity solutions.
- a16z’s $60mm investment in DFINITY Stiftung, a “decentralized cloud computing” platform, compatible with Ethereum smart contracts.
- Union Square Ventures’ investment in Algorand, a brand new protocol that was designed for scalability from the ground up.
Thinking about protocols and layers in context helps me think more critically about blockchain’s future as a whole, and hopefully you as a reader will feel similarly.
Thanks for making it to the end, and I’d love to hear your candid thoughts.