Web 3: The Breakthrough of Protocol Tokens
Web 3 is all the rage. Cryptocurrencies are seen as wildly fluctuating investments that go through extreme cycles of hype and speculation. What is actually happening under the hood? To provide a proper explanation, we have to look at the history of the internet.
The internet is built on top of protocols like HTTP, SMTP, TCP/IP, etc. These protocols emerged at around the same time the internet was invented. For a couple of decades now, we have been building applications on top of the same few protocols that allow these applications to communicate with each other.
These popular protocols are for email and data transfer. There was no protocol invented for money or value transfer. Why is that a big deal? Because that means banks and financial institutions that store account balances in their own databases need third party services to communicate with each other. If I want to send my friend money from a different bank, the banks have to make sure that the amount added to my friend’s account is the same amount deleted from my account. Without a built-in system to talk to each other, banks have to rely on third parties that charge fees for the services they provide, adding a cost to all users. If banks had a shared protocol to build on top of, they could communicate directly with each other instead of relying on third parties.
This is where low level internet protocols for value transfer come in. But why hasn’t someone made a protocol for money if it was such an obvious solution? Because nobody will work for free. These protocols are technically complicated and require maintenance and improvements. There was no way for the people developing these protocols to directly capture any of the value that these protocols helped generate. Until Bitcoin. When cryptocurrencies emerged, people realized that they could add a financial component to internet protocols. That changes the game because it provides a financial incentive for scientists, researchers, engineers, and developers to come up with better protocols. In a way, these cryptocurrency protocols can be thought of as decentralized companies, with the individual cryptocurrency coins representing shares of the company.
Different protocols can have different properties optimized for different needs, and developers can choose the protocol they want to build on top of. Since protocol tokens need to be purchased in order to use the network, the token will go up in value as more people want to interact with the protocol. The more developers choose to build on a protocol, the more innovation and applications start to emerge on that protocol, causing users to also purchase that token in order to use those applications, which further drives up the price of the token. In other words, these protocols have network effects and positive feedback loops that benefit those holding the token.
Ultimately, the breakthrough of incorporating a financial component into internet protocols is that it creates a bootstrapping mechanism that enables the protocol developers to directly profit from usage and adoption of the network. This incentivizes more entrepreneurs to build protocols and has led to the massive wave of innovation in the blockchain space that we’ve seen over the past couple of years and will likely continue to see as the industry begins to mature.
In a Web 2 business model, there are a few shareholders who benefit from being an early investor in the network. The majority of Web 2 is also built on a model where the network becomes increasingly extractive as it grows: build a “free” service, accumulate enough users, and then start feeding them ads. Many of these businesses are monopolies in their industries. If I have Facebook, I won’t use an application that provides the same utility Facebook provides, but is second-best. To win in Web 2, you have to be THE best.
On the other hand, in this new Web 3 business model, entrepreneurs want other teams to build on top of the protocol they’re using because the success of those applications would drive up the price of the token that they’re holding. It’s a much more collaborative process because businesses are building on top of the same network. In addition to that, whoever holds the token is basically holding a share of the network, meaning the value generated by the network is much more distributed in Web 3 than it is in Web 2. This dynamic allows for a much more equal distribution of wealth in society.
Protocol tokens are not a new idea. One of the earliest mentions of cryptocurrencies and protocols dates back to a 2013 article by Albert Wenger. Some other blog posts I would recommend reading are all from 2016, after the Ethereum mainnet launched and technological thought leaders started to think about all the possibilities of blockchain technology: Fred Ehrsam (co-founder of Coinbase), Fred Wilson, yet another post by Albert Wenger, and the famous Fat Protocols Thesis by Joel Monegro.
This new era of technological innovation is about moving all value transfer and settlement into pure software systems consisting of decentralized peer-to-peer technologies that are not based in any specific geographical location and are not controlled by any one organization. The rise of cryptocurrencies is a global phenomenon and, like many others, I believe it will be one of the greatest wealth transfers in modern human history.
