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Understanding The Relationship Between Coins And The Protocol

Published 13.12.2023

Every protocol of a blockchain network needs coins for its decentralization. BTC coins serve as a reward for miners. ADA coins are directly used for the decentralization of Cardano. Native coins need protocols. Network consensus allows coins to be spent. Protocols can provide additional utilities to coin holders. Let's explain the relationship between native coins and protocols.

Why Does The Protocol Need Coins?

Any open public network must be able to economically incentivize people to provide security and decentralization. Coins are used to reward people who perform services that are in line with the interest of the protocol. This is the main purpose of coins.

From the point of view of the protocol, the basic principle is the following: Do the work I need and get a fair reward from me. Individual protocols differ from each other in various details.

PoW miners have to purchase expensive ASIC hardware and regularly pay costs for the electricity consumed. BTC coins serve as compensation for these costs. Miners sell BTC coins and can continue business. They expect profit. It's a similar principle to gold miners. They sell the mined gold to cover the cost of employee salaries and mining equipment.

Miners provide Bitcoin protocol security and decentralization. A high hash rate is necessary for security. Openness, i.e. the possibility that everyone can participate in the mining process at any time (and get a reward), is necessary for decentralization.

The reward mechanism works differently with Cardano. Consensus participants must purchase ADA coins. They don't need to buy ASIC hardware and pay energy costs. ADA coins represent ownership of the Cardano network. Depending on the amount of ADA coins that a given holder owns, each holder is essentially a proportional owner of Cardano.

ADA coins are necessary to produce blocks. ADA holders can run the pool themselves (the pool produces blocks), or delegate coins to any existing pool in the network. For this activity, ADA holders are entitled to rewards in ADA coins (staking reward).

ADA holders provide network security and decentralization. So the same things as in the case of Bitcoin. They have to hold ADA coins which is a scarce resource (with capped max supply). This ensures that the market value will be non-zero. Each ADA holder decentralizes Cardano similar to Bitcoin miners.

Staking rewards are a direct economic incentive for holding ADA coins. Unlike BTC coins, ADA coins have cash flow.

The higher the number of miners or stakers, the more decentralized the protocol. However, it is necessary to mention that both hash rate and coins can be concentrated in the hands of wealthy entities.

Protocols use coins for rewards. In addition, native coins may have another (secondary) purpose of existence. The scale can be very wide and perceived by people subjectively.

Coins can be used as a store of value, money, governance tokens, utility tokens (fees for using the network), an expensive resource for network decentralization, etc.

The market value of the coins should be high, as their value is directly related to the defense against a 51% attack on the network. However, the protocol cannot influence the market value and must rely on the behavior of people who influence the supply and demand for coins.

It is important to realize that people perceive and use coins for a different purpose than the protocol uses them. It is the people who decide whether some coins will be valuable or not. Furthermore, it is only people who decide how to use the coins.

Coins are just numbers written in a ledger. If you forget the existence of the protocol for a moment, you will find that there is nothing you can do with the coins other than hold them. Coins cannot be spent without a protocol. Without transactions, it is not even possible to get coins.

Coins are given utility by the protocol.

The capabilities and properties of the protocol determine how and what the coins can be used for. In other words, coins need a protocol to exist.

Why Do Coins Need A Protocol?

The utility of the coins themselves is very limited. In the extreme case, the utility is limited only to HODL coins, i.e. people's belief that the market value of the coins will be preserved over time, or even increase.

Protocols increase the utility of coins.

The basic utility that users need to obtain coins and possibly send them to someone else is the ability to create and submit a transaction.

It is obvious that the higher the quality of the transaction network (we are talking about scalability in particular) the more useful it will be for users. In other words, the more useful the coins will be.

The ability to send coins quickly, cheaply, and among a large number of users increases the so-called network effect of the protocol. The more users can use the protocol, the higher its financial and social value will be.

The primary purpose of coins, from the point of view of protocols, is the ability to reward participants. However, coins will (sooner or later) reflect the utility provided by the protocol. The value of the coins will be a reflection of the size of the network effect.

The network effect can be direct and indirect.

People's beliefs, such as religion, are considered an indirect network effect. People don't need to interact much with each other. Nevertheless, a given religion can have significant social significance. In the context of cryptocurrencies, the HODL narrative can be seen as an indirect network effect.

Communication of HODLers takes place on social networks (modern churches), but not so much through the protocol itself.

The direct network effect is based on the ability of users to economically interact with each other. The banking system and social networks are examples of a direct network effect from the Internet world.

A well-scalable protocol has a higher chance of gaining a strong market share than a less scalable one. A more scalable network is more useful. Scalability is not bound necessarily only to the protocol (L1), but to the entire ecosystem (L2s). However, the scalability of L2s is always dependent to some extent on the scalability of L1.

The image below shows two protocols that have different scalability. Scalability has a direct impact on the growth of the network effect.

Instead of scalability, you can imagine any other feature that users can perceive. For example, decentralization, security, DeFi, or also an indirect network effect, i.e. belief in the growth of the market capitalization of the project.

The social and financial importance of the protocol, i.e. its network effect, is a mix of different properties. Not only the technical side is important, but also the Lindy effect, adoption, partnerships, etc. However, this topic is not related to the mutual relationship of coins and protocols, so we will not cover it.

A protocol's only utility is not necessarily just a transactional network. Cardano is a smart contract platform. The utilities of the Cardano protocol are higher than, for example, in the case of Bitcoin, which represents the first generation of blockchain.

The higher utility of the Cardano protocol affects the utility and demand for native ADA coins. Why? Because users can do more things with ADA coins.

Other native tokens can be minted on Cardano. In addition, Cardano allows third parties to build and deploy applications. These applications add extra utility on top of the transaction network.

On the Cardano network, it is possible to create NFTs or users can send each other tokenized assets, such as dollars. In addition, it is possible to create various applications that can replicate financial services. For example, exchanges or lending protocols.

ADA holders can hold (and stake) coins, but they can also do many other things. If the protocol tools are useful for someone, the coins are also more useful. The protocol's utilities increase its network effect and demand for coins.

The native coins (ADA and BTC) of the protocols serve as utility tokens, i.e. they are necessary for paying fees for using the protocol. Fees represent the income of the protocol.

If interest in using the Cardano network grows, the demand for ADA coins necessarily grows, as users must pay for use with ADA coins.

ADA coins are the natural currency in the Cardano ecosystem. As the utility of the protocol increases, the value of ADA coins naturally increases.

It is important to note that users use coins through the protocol. In other words, the blockchain wallet interacts with the protocol. The protocol provides utility to coins.

Let's demonstrate it with an example. ADA coins can be used as collateral.

The algorithmic overcollateralized stablecoin Djed is one example of the use of ADA as collateral. ADA coins are used as an expensive digital resource for minting DJED stablecoins. The Djed protocol tries to stabilize the value of DJED tokens to match the value of USD.

Note that the demand for DJED increases the number of locked ADA coins in the Djed protocol. The Djed protocol is a utility that increases the demand for ADA coins.

Users can use the stablecoin DJED, which increases the utility of the ecosystem (financial stability is useful in a decentralized world) and, thus the utility of the Cardano protocol.

I believe there is a positive correlation between utility and value. What is more useful is naturally more valuable.

People decide what is useful to them and what they want to use. Just keeping coins in your wallet can be useful. However, if in addition to holding the coins, it is also possible to use them, that is an extra utility that adds value.

Protocols (L1s) are not necessarily the ones that provide extra utility to coins. Coins can be used in second layers (L2s), in DeFi, or even in centralized services. Holding native coins on a centralized exchange can be seen as a utility (speculation on growth in value).

Sending BTC through PayPal can also be seen as a utility (although it is not in line with the principles of decentralization and self-custody).

The crypto industry is reaching a stage where it is even possible to use coins or minted tokens of one protocol in another protocol. For example, it is possible to use BTC coins in the Ethereum and Cardano ecosystems.

The utility of BTC coins can be increased through other blockchains. Think for yourself if the large number of BTC coins locked in the Cardano ecosystem can affect the market value of ADA coins.

Conclusion

In the article, I only focused on the direct relationship between the protocol and the coins. However, the topic is more complex and nuanced. I will give an example. Do people perceive decentralization as a utility? Although decentralization is a key feature of the blockchain industry, people do not perceive this feature when using the protocol. What they perceive is scalability. So is decentralization important? From my point of view, yes, because centralization gradually leads to abuse of power. Power can be abused by a team, dominant pool operators, or dominant miners (stakers). However, the potential risk may never materialize. Continuing this consideration would be for another article.

It is important to understand that a blockchain without native coins cannot be decentralized because if there is nothing to be used for rewarding participants, there must be some centralized form of management. Protocols directly affect the utility of coins with their properties and capabilities. More useful has the potential to be more valuable. Both holding and using coins can be valuable to users. More options for the user logically increase the value.

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