Crypto Protocols are a new way of providing services. They provide services autonomously without the need to rely on any person or company. This makes them more efficient, scalable, and fair than alternative options. Crypto Protocols are the most important innovations in the last 200 years.
They are also deeply misunderstood.
The thinking models of companies are being incorrectly applied to protocols. And more recently, the ill-defined term “DAO” is being incorrectly applied to crypto protocols with tokenized governance.
This article explains why crypto protocols are unlike both companies and DAOs and why understanding this difference is crucial.
The desire to use familiar company concepts like “revenue” and “expenses” is widespread when discussing crypto protocols. These terms can be helpful and work as mental shortcuts but they lead to incorrectly viewing protocols as business and ignoring what makes protocols unique.
Properly designed protocols are pieces of software that operate autonomously on blockchains. What makes them unique is that they do not need revenue to operate and scale. They cannot “go out of business”, they do not have expenses, and they do not have employees.
Yet these terms are often used when discussing protocols. Part of this is because protocols may have expenses associated with using them. For example, making a trade on Uniswap requires someone to pay a trading fee, however, that trading fee is not revenue to the protocol. Similarly, protocols may pay people to use them but that does not mean the protocol itself has expenses. A liquidity provider on Uniswap is paid trading fees by the protocol but those trading fees are not expenses of the protocol.
Some protocols may have a form of value capture built into them, but unless explicitly designated, they should not be equated with fees or revenue. For example, the Compound protocol retains a small percentage of interest paid but this is not a fee or revenue. The purpose of the retained tokens is to provide more value to the user. The retained tokens act as an insurance fund for the protocol and also improve liquidity at times of high utilization. This is very different from an extractive fee or revenue in the sense of a company.
Similarly, in the V3 PoolTogether protocol the concept of the “reserve” retained a portion of yield. This was not a fee or revenue. This was a mechanism to strengthen the protocol by making prizes larger than the underlying yield generated.
In theory, it might be possible for protocols to arbitrarily extract value and take a fee in a way a traditional business would. That could be considered “revenue” but this is problematic for several reasons.
The first is that it goes against the raison d'être of crypto protocols and decentralized finance in particular. The whole point is to remove rent seeking centralized intermediaries. The promise of decentralized finance is to replace profit seeking banks with autonomous code and thereby offer more efficient and cost effective solutions. A protocol with arbitrary fees is still better in many ways than an off-chain bank but it undercuts a primary value.
The second problem is that extracting fees and putting them under the control of something (presumably governance token holders) can potentially have complicated tax, regulatory, and legal implications.
The third problem is fee extraction will stifle protocol growth. By definition, a fee being taken out of the protocol and set aside for future arbitrary uses is extracting value away from the protocol. To reiterate the earlier point, if there is any value being retained by the protocol, it should be done for the purpose of strengthening the protocol.
To summarize, crypto protocols are unlike companies because they don’t have revenue, expenses, employees, and they can’t go out of business. They are similar in that they provide a service to users of the protocol. They do so far more efficiently than companies because they operate autonomously according to unchangeable rules.
An additional point of confusion is the emergence of a popular but ill-defined term “DAO”. In popular understanding, DAOs have come to essentially mean a joint bank account with token voting. DAOs have proved to be a very useful tool to collect and allocate capital (think of Constitution DAO or Nouns DAO). However, they differ from protocols in two key ways.
The first is that DAOs have carte blanche control over any assets. This is in stark contrast to protocols that enshrine immutable rules and enable token holders to have a limited ability to adjust those rules. For example, POOL token holders have no ability to influence or access deposits into the PoolTogether protocol.
The second is that DAOs are a generic template to coordinate around a goal, whereas protocols already exist to provide a specific service in an autonomous way.
Protocols with tokenized governance and DAOs sometimes share one similarity – decision making via token voting. However, this similarity should not lead to confusion around the key differences.
The distinction is important. Calling a crypto protocol a “DAO” makes it sound like a human centric organization, much more similar to a company. It ignores the very things that make protocols revolutionary – their ability to operate without humans according to immutable rules. DAOs have humans at the center, protocols have humans on the edges.
Companies, DAOs, and crypto protocols are each world changing innovations of their own. Crypto protocols have the most novel attributes and therefore it’s essential to use language and thinking models that reflect these. If what makes crypto protocols special is ignored, it’s possible their unique attributes will not be leveraged.
This post helps define what crypto protocols are not. Future posts will go into details on what they are. My hope is this article helps builders, policymakers, and users better understand crypto protocols.