Here’s one way to think about the differences between the Internet +and the Blockchain. The previous generation of shared protocols (TCP/IP, + HTTP, SMTP, etc.) produced immeasurable amounts of value, but most of +it got captured and re-aggregated on top at the applications layer, +largely in the form of data (think Google, Facebook and so on). 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.
+ +This relationship between protocols and applications is reversed in +the blockchain application stack. Value concentrates at the shared +protocol layer and only a fraction of that value is distributed along at + the applications layer. It’s a stack with “fat” protocols and “thin” +applications.
+We see this very clearly in the two dominant blockchain networks, +Bitcoin and Ethereum. The Bitcoin network has a $10B market cap yet the +largest companies built on top are worth a few hundred million at best, +and most are probably overvalued by “business fundamentals” standards. +Similarly, Ethereum has a $1B market cap even before the emergence of a +real breakout application on top and only a year after its public +release.
+ +There are two things about most blockchain-based protocols that cause + this to happen: the first is the shared data layer, and the second is +the introduction cryptographic “access” token with some speculative +value.
+I wrote about the shared data layer about a year ago. + Though the post has gathered some dust since, the main point remains: +by replicating and storing user data across an open and decentralized +network rather than individual applications controlling access to +disparate silos of information, we reduce the barriers to entry for new +players and create a more vibrant and competitive ecosystem of products +and services on top. As a concrete example, consider how easy it is to +switch from Poloniex to GDAX, + or to any of the dozens of cryptocurrency exchanges out there, and +vice-versa in large part because they all have equal and free access to +the underlying data, blockchain transactions. Here you have several +competing, non-cooperating services which are interoperable with each +other by virtue of building their services on top of the same open +protocols. This forces the market to find ways to reduce costs, build +better products, and invent radical new ones to succeed.
+But an open network and a shared data layer alone are not not enough +of an incentive to promote adoption. The second component, the protocol +token[1] which is used to access the service provided by the network +(transactions in the case of Bitcoin, computing power in the case of +Ethereum, file storage in the case of Sia and Storj, and so on) fills +that gap.
+Albert and Fred wrote about this last week after we had a number discussions at USV about investing in blockchain-based networks. Albert looked at protocol tokens from the point of view of incentivizing open protocol innovation, + as a way of funding research and development (via crowdsales), creating + value for shareholders (via token value appreciation), or both.
+Albert’s post will help you understand how tokens incentivize +protocol development. Here, I’m going focus on how tokens incentivize +protocol adoption and how they affect value distribution via what I will + call the token feedback loop.
+ +When a token appreciates in value, it draws the attention of early +speculators, developers and entrepreneurs. They become stakeholders in +the protocol itself and are financially invested in its success. Then +some of these early adopters, perhaps financed in part by the profits of + getting in at the start, build products and services around the +protocol, recognizing that its success would further increase the value +of their tokens. Then some of these become successful and bring in new +users to the network and perhaps VCs and other kinds of investors. This +further increases the value of the tokens, which draws more attention +from more entrepreneurs, which leads to more applications, and so +on.
+There are two things I want to point out about this feedback loop. +First is how much of the initial growth is driven by speculation. +Because most tokens are programmed to be scarce, as interest in the +protocol grows so does the price per token and thus the market cap of +the network. Sometimes interest grows a lot faster than the supply of +tokens and it leads to bubble-style appreciation.
+With the exception of deliberately fraudulent schemes, this is a good + thing. Speculation is often the engine of technological adoption [2]. +Both aspects of irrational speculation — the boom and the bust — can be +very beneficial to technological innovation. The boom attracts financial + capital through early profits, some of which are reinvested in +innovation (how many of Ethereum’s investors were re-investing their +Bitcoin profits, or DAO investors their Ethereum profits?), and the bust + can actually support the adoption long-term adoption of the new +technology as prices depress and out-of-the-money stakeholders look to +be made whole by promoting and creating value around it (just look at +how many of today’s Bitcoin companies were started by early adopters +after the crash of 2013).
+The second aspect worth pointing out is what happens towards the end +of the loop. When applications begin to emerge and show early signs of +success (whether measured by increased usage or by the attention (or +capital) paid by financial investors), two things happen in the market +for a protocol’s token: new users are drawn to the protocol, increasing +demand for tokens (since you need them to access the service — see +Albert’s analogy of tickets in a fair), and existing investors hold onto + their tokens anticipating future price increases, further constraining +supply. The combination forces up the price (assuming sufficient +scarcity in new token creation), the newly-increased market cap of the +protocol attracts new entrepreneurs and new investors, and the loop +repeats itself.
+What’s significant about this dynamic is the effect it has on how value is distributed along the stack: the market cap of the protocol always grows + faster than the combined value of the applications built on top, since +the success of the application layer drives further speculation at the +protocol layer. And again, increasing value at the protocol +layer attracts and incentivises competition at the application layer. +Together with a shared data layer, which dramatically lowers the +barriers to entry, the end result is a vibrant and competitive ecosystem + of applications and the bulk value distributed to a widespread pool of +shareholders. This is how tokenized protocols become “fat” and its +applications “thin”.
+This is a big shift. The combination of shared open data with an +incentive system that prevents “winner-take-all” markets changes the +game at the application layer and creates an entire new category of +companies with fundamentally different business models at the protocol +layer. Many of the established rules about building businesses and +investing in innovation don’t apply to this new model and today we +probably have more questions than answers. But we’re quickly learning +the ins and outs of this market through our blockchain portfolio and in +typical USV fashion we’re going to share that knowledge as we go along.
+[1] Also known as App Coins, as coined – pun intended – by Naval in 2014
+[2] Edward Chancellor + writes a thorough and entertaining history of financial speculation and + its place in society (you’ll be in awe by how similar cryptocurrency +speculation today is to prior bursts of financial exuberance!) and Carlota Perez + describes the important role of bubbles in the development of new +technologies by attracting financial capital to research and +development.
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