cryptocurrency investing

Protocol investing is a guiding strategy that investors might find useful when starting to build a cryptocurrency portfolio.

The concept strips away the need to frantically follow the latest crypto news and instead focuses on the foundational forces driving a crypto’s creation and development.

Update 2023: I originally wrote this post back in 2017. Since then, the crypto space has grown, matured, and become way bigger in terms of overall investment and utility.

Also, since this post was originally created, people have revisited the fat protocol theory. Be sure to check out these posts by others to see how this idea has stood up to the test of time.

Revisiting the Fat Protocol Thesis
Cracks in the Fat Protocol Theory

According to the Fat Protocol Thesis, investors should focus on understanding and buying positions in the underlying blockchain protocol, or the network, rather than the applications built on top of the blockchain.

Protocol investing is somewhat counter to what we hear about cryptocurrencies — that mainstream acceptance is just one killer app away.

Following that logic, of course it would make sense to obtain early positions in what could become the yellow brick road to the future economy.

And while that might be true — that there will be one (or a handful) of killer apps that become super valuable and really change cryptocurrency use and adoption — owning positions of the underlying protocol will still allow investors to capture some of that value, and capture the value created in other parts of the network as it develops.

Think of protocol investing for the crypto world as traditional value investing that is so revered (and profitable).

Fat protocol theory, digital assets, and the inverted value chain

I found a post on the Union Square Ventures blog, a New York City-based venture capital firm, about protocol investing that I think is really instructive.

The post explains how investing in blockchain protocols is different than investing in internet companies.

There is not much value derived from the protocols that govern the internet, like HTTP or SMTP. Instead, much of the internet’s value comes from the applications that make use of those protocols.

Fittingly, investors line up to get behind the next hot app, like Snapchat, while there is little capital (or even interest) flowing towards the internet’s underlying technology.

In other words, or in the words of the blog’s author, Joel Monegro, the internet has fat applications and thin protocols, while blockchain has fat protocols and thin applications.

Unpacking this further, there are some very real technical reasons why blockchain protocols are fat when compared to their applications.

It’s actually the whole reason why blockchains are useful in the first place.

Protocols fed by data and tokens

On the internet, user data is siloed inside of individual apps — like Google or Facebook, for instance — making the apps valuable, but also making it difficult to neatly move from one app to another.

Blockchain is different because of its shared data layer. Rather than give all of his or her data to an application, like on the internet, blockchain user data is stored on the network and accessed by applications.

This creates an easier on-ramp for new blockchain-based companies and projects to build products and services, but it also means that the underlying protocol has greater value than any one app.

“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,” writes Monegro.

Another important distinction between the internet and blockchain protocols — and which leads us back to our point about the value of protocol investing — is that blockchain values are fueled by cryptocurrencies.

A blockchain protocol’s value increases as the token’s associated with the network increase. As more applications are built on top of that blockchain, more value is returned to the protocol, which in turn attracts more developers and investors.

It’s a massive feedback loop, and it is all powered by the underlying protocol.

Anyway, it’s something to think about when building a cryptocurrency investment portfolio.

While protocol investing doesn’t completely rule out chasing new cryptos or looking for the next killer app, it does take into account the long view and is something worth considering.

As always, please let me know what you think.

Fat protocols and protocol investing