Crypto Tokens and the Coming Age of Protocol Innovation (2016)

HTTP as the underlying protocol of the web allows for decentralized publishing. Anyone can operate a web server and publish their own content. And anybody with a web browser can access that content (subject to governments and ISPs imposing limitations). But as a stateless protocol, HTTP needs a data layer for any application functionality, which until recently was provided by companies such as Google (search), Facebook and Twitter (social), Amazon and eBay (commerce). Because we didn’t know how to maintain state in a decentralized fashion it was the data layer that was driving the centralization of the web that we have observed.

The potential for blockchain technology to provide an organizationally decentralized alternative for maintaining state is beginning to be be reasonably well understood. I first wrote about this possibility on the USV blog in 2013 and a year later here on Continuations, clarifying why bitcoin represents such a foundational innovation. Organizationally decentralized but logically centralized state will allow for the creation of protocols that can undermine the power of the centralized incumbents. At USV we have invested in a number of companies that are active in this area, including Blockstack, Mediachain and OB1.

Historically many key protocols, such as TCP/IP and HTTP, have come from researchers. Subsequent iterations of these protocols were often handled by nonprofit organization that tried to wrangle with more or less success the various commercial interests that sprang up around this protocols (the companies that were making and selling software and hardware based on them). The more money was involved the harder this became.

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).

A for profit company can now create a new protocol and create value for itself (and its investors) by retaining some of the tokens. If the protocol becomes widely used, the value of the tokens will increase. For instance, think of a decentralized storage service (a la Amazon’s S3). Anyone can implement the storage protocol in whatever language they want to as long as they meet the protocol spec. They can then get paid in the relevant storage tokens. The original creator of the protocol will make money to the extent that it is adopted and to the degree they have retained some of the tokens (so they can sell them at a higher price later on). This is not hypothetical as there are a variety of such protocols out there, including Storj, SIA and Filecoin.

I can’t emphasize enough how radical a change this is to the past. Historically the only way to make money from a protocol was to create software that implemented it and then try to sell this software (or more recently to host it). Since the creation of this software (e.g. web server/browser) is a separate act many of the researchers who have created some of the most successful protocols in use today have had little direct financial gain. With tokens, however, the creators of a protocol can “monetize” it directly and will in fact benefit more as others build businesses on top of that protocol.

Given this new incentive I expect a lot of resources to be devoted to protocol innovation. That would be great as we have many missing protocols to make a decentralized data world work well. There is also a natural rate limit on how much of the wealth can be retained. Because the protocol is public (by definition) if a creator tries to retain too many tokens there is an incentive for everyone else to replicate the protocol with a new token none of which is retained.

More generally, the evolution of these protocols will be governed by the decision of those who have adopted it to adopt a future version. This has the potential to provide a much more democratic process for changing protocols over time then the historic committee process. Just how democratic it will be depends on a lot of factors starting with how concentrated the group of protocol operators is. We are just at the beginning of this world and are in the process of learning a ton (for instance from the recent hard fork of Ethereum where there is an attempt to maintain the old chain as well).

There are also questions as to how these tokens will be treated by existing regulators such as the SEC. I am hoping they will see them as tokens to a global fair and not as securities. The need to comply with regional securities laws would likely kill the amazing potential that tokens have for protocol innovation. We are just at the beginning of this. I am excited about where it can go!