Coins and tokens are obviously a vital commodity in cryptocurrency. Along with their significance comes a misconception regarding how the various types of tokens and coins are different from each other; and this misunderstanding is not unwarranted. With a large number of crypto projects that seem to keep growing in size and quantity, it is not uncommon for someone unfamiliar with the field – let alone someone with basic knowledge of it – to get lost in the confusion.
This article will serve as a guide to assist in clearing up any of that confusion.
Security vs. Utility
Before we begin with the titular coins/tokens, we must first take a quick look at security tokens and utility tokens. If we were going by a superficial perspective, these two elements may not seem like they have much to do with the topic of protocol tokens and application coins. They are, in a way, their own entity, but the core of their functions and differing aspects reflect the impending analysis of what makes app coins and protocol tokens unique from each other.
A security token is a portable device that validates an individual’s identity electronically by storing certain pieces of personal information. The owner plugs the security token into a system that gives them access to a networking service.
These kinds of tokens come in various formats; some of which include hardware tokens that contain a chip, USB tokens that can be plugged into USB ports, wireless Bluetooth tokens, or programmable electronic key fobs that can remotely activate devices. An example of this would be gaining access to enter into a vehicle or an apartment building. These tokens are also used as either replacement for or additions to a password to prove the identity of the owner.
A utility token is a digital token that is issued in order to fund the development of the cryptocurrency. It can additionally be utilized to purchase a good or a service that is offered by the issuer of the cryptocurrency. The person who bought this token has paid the issuer of the token money NOW so that the company can then build a product that the buyer of the utility token can redeem LATER for the good or service.
Medium describes utility tokens as a representation of “a unit of account for the network. The bigger the network grows, the more utility in the token, and because the number of tokens is fixed. As the size of the network and transaction volumes within it grows, this will create demand for the tokens.”
While they are not designed to function as investments, that does not necessarily mean that they are incapable of bringing in a profit. They have a specific type of use case inside the project and do not represent a company’s share. If the demand increases, so too do the prices of these tokens and buying ones associated with a project that provides solutions to real problems of users and is regularly being developed and improved may lead to giving great profit in future.
A more comprehensive method to distinguish the two tokens and to see if a digital token can be categorized as ‘security’ is by applying the Howey Test. A token must meet the following requirements (according to Medium):
- There is an investment of money.
- The user expects to profit from the investment.
- The investment of money is in a common enterprise.
- Any profit comes from the efforts of a third-party or promoter.
Applications & Protocols
Now that we have established the basic differences between security tokens and utility tokens, let’s now transition into discussing what differentiates application coins from protocol tokens.
The most elementary description of a conventional coin/token is that they represent a fungible and easy to trade asset or a utility that is commonly found on a blockchain. They fire up a number of applications, an example of this being currencies that can be found in a slew of online multiplayer games. A player can use their fiat money to purchase tokens in these games, which can later be used in numerous ways, including buying in-game armour, skins, weapons, etc. That being said, before the inception of blockchain technology, there were no protocol tokens.
In the simplest terms, a protocol is a set of ideas that collectively govern an ecosystem. It defines the guidelines, syntax, semantics, and synchrony of communication and any potential error recovery methods. Another way to look at protocol is to correlate it to telecommunications, where it is described as a communication custom that works as a system of rules. It allows two or more entities of a communications system to convey information by way of any kind of variation of a physical quantity. Protocols can be implemented by a variety of ways: hardware, software, or a combination of both
One of the more well-known forms of the protocol system is the TCP/IP protocol, which essentially powers the internet and it requires very little central administration. Like with many other systems, it needs to establish certain rules and conventions if it wants to keep the internet working and allow us to continuously – and seamlessly – connect with each other.
For those who are unaware of what the name of this protocol stands for, TCP defines how applications are able to create channels of communication across a network. In addition, it manages the assembly of a message into smaller units of data (known as ‘packets’) before they are transmitted. IP illustrates how to address and escort each packet to make sure that it reaches the proper destination. Every gateway computer on the network closely inspects this IP address to select where exactly the message will be forwarded to.
TechTarget mentions in this article that, “TCP/IP specifies how data is exchanged over the internet by providing end-to-end communications that identify how it should be broken into packets, addressed, transmitted, routed and received at the destination. TCP/IP requires little central management, and it is designed to make networks reliable, with the ability to recover automatically from the failure of any device on the network.”
Before blockchain was launched, these types of protocol were used everywhere without restriction and were researched by organizations and everyday people, though the same cannot be said for the applications that are built on top of this specific protocol. Let’s take billion-dollar companies (Google, Facebook, etc.) for example, which have all been built on these protocols. Since their economic incentives have been integrated into them, investors eventually picked up on the fact that it makes much more sense to invest in the applications and proceed to garner a high return as opposed to investing in protocols and receiving little to no returns.
Joel Monégro, a writer for Union Square Ventures, created an analogy that demonstrates the difference between the internet and blockchain. He says that, “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.”
Around here, however, is where blockchain came into the picture and proceeded to completely change this whole concept, primarily due to two key reasons:
- Decentralization. Because no single entity controls the chain, the barrier to entry is incredibly low. This is the reason as to why more people can come in to create applications and products on top of the protocols. Moreover, as the applications continue to garner more attention, it naturally increases the value pertaining to the underlying protocol as well.
- Cryptographic tokens. This will be further explained in a bit.
With that, we suddenly had a system that employs both ‘fat’ protocols and ‘thin’ application.
As has been previously stated, one of the biggest reasons behind the fattening of the protocol layer are things called ‘cryptographic tokens.’ Before the “era” of
Nowadays, companies, are able to construct protocols that will create value for both themselves and their investors, so long as they preserve some of the tokens. As a matter of fact, the more exceptional the protocol, the more it is embraced, the more its perceived value is, and thus the appreciation of the tokens’ value grows.
All this is what later happened with Ethereum.
Before the change, the creators could only make a profit off of their protocols by creating software that has been enforced on it and then try to sell it for money. Now, with the implementation of tokens, the creators of these protocols can directly monetize the protocols, and with the increasing number of software being created on top of it, the value of the underlying protocol expands.
By now you might be wondering what this type of incentivization does. Well, developers now have a genuine sense of motivation to create more innovative protocols that will, in turn, bring in even more value to the ecosystem. In addition, this is beneficial for investors since they will have the ability to invest their money into more valuable tokens, which also allows the developers to make a profit.
Monégro touches on this, entitling the concept the “token feedback loop,” which describes how these protocol tokens are an asset to the increase of the protocol’s adoption.
“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.”
Undoubtedly, application coins are the tokens that run the application built on top of the protocols, so if Ethereum is the protocol, then that means that Augur is the application built on top of it. Furthermore, Augur’s tokens (REP) function as the tokens of the protocol. With that said, it only makes sense to provide an analogy of sorts that explains how exactly the protocol tokens and the app coins co-exist with one another.
How they co-exist
Let’s imagine that we have a blockchain called “Canada” and it has a protocol rule that states “transactions are allowed only by the exchange of currency.” Let’s add to this by establishing Canada’s native currency as being known as Canadian Dollars or CAD.
There is a market inside Canada, however, the catch to this is that the only way for a person to purchase food from here is by exchanging their CAD for market tokens from a token counter. Once these tokens have been obtained, then you are permitted to buy anything you want from the market. It is important to keep in mind here that these tokens are only worth value inside the market and aren’t as useful anywhere else, if at all.
In the context of this analogy, the market is an application that was built on top of the main protocol (i.e. Canada) and the market tokens are app coins.
Currently, there is apparently a lot of dispute surrounding what is going on regarding which layer – the application or the protocol – should be given the most concentration in relation to its development. We are not going to pick a side, but what we are going to do is highlight the arguments stemming from both sides of the debate.
Supporting the Coins
The CEO of Token Soft, Mason Borda, is of the belief that while protocol tokens benefit investors, it is ultimately bad for business. He claims that by focusing on protocol development, this makes the space vulnerable and susceptible to three types of major attacks:
- Technical Risk: Because blockchain technology is a space that is still in its infancy, there are not many experienced or educated developers (contrary to popular belief) due to the lack of blockchain development courses and training programs. There is a small number of developers who are actually experienced in the construction of necessary abstraction layers for smooth execution. For a group of developers to build a protocol system without any faults, they need to gain experience and knowledge; both factors that are currently in short supply.
- Business Risk: Borda states that protocol tokens can typically take from five to ten years for the market cap to reach the expectations. For any business that might be looking to incorporate blockchain into their operation, they should keep in mind that it will require a significant amount of resources, as well as lots of attention. A good chunk of the time, it needs the dedicated concentration of the entire team. More often than not, business ideas with great potential are lost because of the collapse of the generation of decentralized protocol.
- Execution Risk: Even if you manage to have a good business plan in place, appointing the team and executing it can be a huge challenge, especially considering the lack of developers in the space. A good portion of the competent blockchain developers are involved with a number of projects most of the time and you will usually have to invest in the education of the members of the team and develop your own crew.
James Kilroe, a Newton Partners investor, believes that protocols have all in all evolved and that Monégro’s thesis can be considered outdated, stating that rather than having a single layer of protocol, projects commonly have multiple layers. One of these layers is actually the application protocol, which is what Kilroe believes to be the next logical path of investment.
According to him, “For example, Civic has multiple layers. The ‘processing layer’, either Ethereum or RSK, a file storage layer (perhaps FileCoin in the future), other critical infrastructure layers (such as inter-protocol connectors) and finally the $CVC layer, which governs the crypto-economies surrounding the identity verification economy. All of these layers are protocols in their own right and will make up the identity verification value stack in this case.”
The reason why that application protocol has become a magnet for value can be tied to Ben Thompson’s ‘Aggregation Theory,’ which states that, “…the value chain for any given consumer market is divided into three parts: suppliers, distributors, and consumers/users. The best way to make outsize profits in any of these markets is to either gain a horizontal monopoly in one of the three parts or to integrate two of the parts such that you have a competitive advantage in delivering a vertical solution.”
What this means is that in order for a protocol to dictate the crypto space, one of these two things must happen:
- They have to dominate one horizontal layer
- They have to accumulate the two layers of the protocol into one
Let’s take a closer look at both of these options:
- Dominating one layer
To better explain this point, we will use Ethereum as an example.
- Ethereum miners make a profit via transaction fees, though Ethereum is working on scaling solutions to cut back on these fees.
- Because most of the projects (including Ethereum) are open source code, it facilitates the door for forking and generating more specialized forms of cryptocurrency for more niche cases. Think of it like how Litecoin forked from the Bitcoin protocol; this dilutes the value of the base protocol considerably.
- Interoperability is on the horizon because of projects like AION, Cosmos, and others. These will also result in reduced fees.
Generally speaking, it is difficult for a project to dominate just one layer.
- Accumulating two layers into one
The basic idea is aggregating the application protocol and the base protocol, thus epitomizing a way that users can utilize the protocol without the knowledge of its existence. This is a high-level form of abstraction that most decentralized projects, including Ethereum, are aiming for.
This is considered to be preferable on account of it being a lot easier for application protocols to get users than a base protocol. If done properly, it is clear to see why the application protocol becomes more of a value capture.
Supporting the Tokens
Will Warren, the co-founder of Ox Protocol, believes that, “…the current culture surrounding token sales has created incentives that do not align with these beneficial practices. This is because token sales are being used to drive network effects around specific applications (dApps) rather than the common building blocks (protocols) that make applications possible.” This is the primary reason as to why the crypto space is full of app coins that serve no purpose other than to be used in crowd sales and for obeying regulatory guidelines.
The issue with focusing on app coins instead of protocol coins is that it is specific to the DApp’s smart contract. However, shared protocols offer standardizations that promote the space’s overall growth. Warren says that these particular coins “…are directly coupled into a dApp’s system of smart contracts are the antithesis of standardization: many custom and incompatible contracts with varying levels of quality and security, all implementing the same functionality. What do end users get out of it? A larger attack surface, multiple configuration processes, app coins and learning curves to deal with.”
While shared protocols can expand the entirety of the network, app coins can fragment the users into differing schemes that will make the system highly inefficient. To better explain this, let’s go over something called ‘Metcalfe’s Law.’
What this self-proclaimed “law” means is it is a theory of network effect and is typically defined as being a concept used in computer networks and telecommunications to showcase the value of a network.
Below is a diagram made by Andrew Chen:
In his own words, Chen explains the most basic principles of this law, especially when connected to math, as, “…basically the idea is that if every new node in the network connects with every pre-existing node, then as you gain nodes, you non-linearly increase the number of connections that everyone has with everyone else.”
To tie this in with blockchain network, Metcalfe’s Law states V ∝ N² where V is labelled as the overall value of a network, whereas N is the total number of nodes within the network.
Let’s say, for the sake of argument, that we have three node sets: N1, N2, and N3. These sets are part of two networks, with one network utilizing a joint protocol while the other network consists of three apps that employ their own specific protocol. In terms of these two cases, Metcalfe’s Law will turn out as something like this:
- The first network, which harnesses the use of three DApps with their own protocols and evidently, rather than working alongside each other, the nodes are individually carrying out their own actions. Therefore, the result that comes from following Metcalfe’s Law is that the value comes out to be N1^2 + N2^2 + N3^2.
- However, the second network that makes use of a shared protocol has the DApps working in tandem. Because of this, the overall value of the network will come out to be (N1 + N2 + N3)^2.
- So, when it comes down to it, (N1 + N2 + N3)^2 > N1^2 + N2^2 + N3^2.
For this reason, it is why the predominant value of the second network is higher when compared to the first network.
Having presented both sides of the protocol vs. application debate and supplied an extensive explanation that further illustrates the difference between the two, it is clear that this is a lot to take in. Like other systems associated with cryptocurrency, there are multiple layers, each being more complex than the last. Hopefully, this guide will have shed some light on the subject and made the distinctness much more understandable.