Understanding the fat protocol thesis

In August 2016 Joel Monegro (then at USV) wrote about value capture for blockchain vs web protocols. It gave folks a mental model of how to value blockchain protocol tokens.

According to this thesis, applications built on top of web protocols captured more value than the protocol, but when it comes to blockchain protocols, value capture shifts from applications directly to the protocol. Here is a nice picture explaining the difference

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.

Joel Monegro, Fat Protocol thesis post.

What Joel rightly points at in the paragraph above, is that the few applications built to service these protocols are valued at a small fraction to the underlying protocol ( as calculated by the price of the token times the number of existing tokens ).

Breaking down this thesis into its core assumptions

  • It is easy to shift between applications as they provide a commoditized service because the underlying protocol has a shared data layer and provides a lot of utility.
  • The price of the token, along with an open network and a shared data layer, incentivizes protocol adoption, and affects value distribution via the token feedback loop.

He also points out the following

  • When a token appreciates in value, it draws the attention of early speculators, developers, and entrepreneurs.
  •  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

From the state of affairs in 2016, these statements are prescient. From what was happening then and we have seen transpire in the following years, they are a bit naive.


What has happened since

We have seen two types of businesses have been built, one is an on-chain product ( truly an application built on top of the protocol ) and the second are off-chain businesses built to serve the needs of people using the protocol.

On-Chain applications have opted to go the app coin route with each application capturing more of the value it creates and lending less of it to the underlying token.

For example –

Aragon, an application built on ethereum has its own App coin called ANT which one needs, in order to access it. One would expect the need for aragon tokens increases the need for ethereum tokens, increasing their value.

Two things stop this from happening

  1. The need for Aragon tokens is miniscule compared to the network.
  2. Speculation on the price of Aragon tokens opposes the outflow of value from Aragon to Ethereum

Off-Chain applications (i.e. businesses) cater to speculators as they are by far the biggest audience. This decouples the need to build applications that accrue value to the network.

For example – An Identity application built on top of Bitcoin or Ethereum that does not use its own app coin, adds value to the protocol. However, building a credit facility to service speculators who ultimately exit to fiat, does not accrue value to the protocol. For sure they create value, but most of it goes towards making the market more efficient and liquid rather than accruing to the base protocol.

The token feedback loop gets broken down into two

The two core assumptions of fat protocol thesis have been broken

  1. the token feedback loop did not complete. Price action has brought in speculators and developers/entrepreneurs are building mainly for speculators and not others because there are very few of them.
  2. applications have found ways to capture value by either creating app coins or providing services that make switching between them harder.

Expected Token feedback loop

Actual Token feedback loop


Reversed Causality

Fat protocol thesis is the first approximation of a venture captial model to blockchain entities. But it reverses causality

From Albert Wenger’s Crypto tokens and the coming age of protocols

Now, however, we have a new way of providing incentives for the creation of protocols and for governing their evolution. I am talking about cryptographic tokens. You can think of these like the tokens you might buy at a fair to get on a ride: different operators can have their own rides and set their own price in terms of tokens. You only need to buy tokens once (in exchange for fiat currency) and then can use them throughout the fair. With blockchains we now have a way of issuing and redeeming these tokens digitally (the underlying blockchain can be Bitcoin or Ethereum or possibly its own as in the case of Steemit).

Albert Wenger, Crypto Tokens and the coming age of protocols

Both Albert and Joel make an assumption that the fair ground has rides that are available for people to use.

What actually happened was, tickets were sold to an empty field with a promise of rides being built in the future.

This caused speculators to rush in and people built tools to take advantage of this price action.The few rides that got built haven’t seen people using them because of the lower hanging fruit of speculation.

We can see causality being broken if we use the core assumptions of the fat protocol thesis to model tech startups (you can say that the thesis does not apply here, but it makes sense to compare what it says)

Applying fat protocols to tech startups, you could conclude that because venture capitalists speculate on tech startups, it attracts entrepreneurs and builders of such startups, causing the startup ecosystem to gain value.

Now we see the core issue with this thesis, builders and entrpreneurs accrue vaue to the ecosystem, their capital needs are not a driver of value. If these business have no outside capital sources, then that argument has more footing.

What this framing also suggests is speculative investments are the main source of capital for block chain tokens and not utility because, if there was utility people would pay for it. The fact that their payment has to be in kind(buying tokens) does not add value to the enterprise but just fetches a higher price for the tokens.

What it leaves out

  • The sheer number of base protocols that emerged, often with no appreciable difference, spread out the value capture.
  • The radical importance of Governance of these protocols. Similar teams building similar applications on similar protocols have huge disparities in value created/captured. Example a #defi application on ethereum vs similar applications built on other protocols.
  • Disproportionate ownership (read hoarding) of network and app tokens by teams building applications, causes further value silos.
  • The importance of forks, and the effect forking has on network value.

A thesis is a mental model – Like all theses, the fat protocol thesis was a way to look at the current state of affairs and model what might happen in the future. It provided folks who wanted a guide to making decisions, a model. Nothing more, nothing less.

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