What Is a Protocol in Crypto: a Comprehensive Guide

Published: April 19, 2024 | Last Updated: October 12, 2023

Markos Koemtzopoulos

Markos Koemtzopoulos is the founder and main writer of ElementalCrypto. He has been a lecturer at the University of Nicosia on cryptocurrencies and DeFi and has taught two courses on crypto and blockchain technology.

In this post, I will explain what a protocol is in crypto as if you were a dummy. By the end of this article, you will have an intuitive sense of what a crypto protocol is and understand why they are so important.

What’s a crypto protocol in simple language?

A protocol in crypto is a set of rules and procedures built on top of blockchain technology that govern communication.

Kind of like the recipe for your grandma’s famous meatloaf, but with more math and fewer onions.

“I see. So, it’s like a recipe for digital money?”

Exactly! Think of it as a recipe, but one that’s been encrypted, dissected, and reassembled by a team of computer wizards. This recipe ensures that all transactions and communications on the blockchain – the digital ledger where crypto transactions are recorded – happen smoothly and securely. It’s like a chef’s secret sauce but for money nerds.

“So, it’s just a bunch of rules?”

Yeah kind of, but it’s also more than that. It’s a whole set of instructions that determine how new coins are created, how transactions are verified, and how the network reaches consensus. It’s like a rulebook that keeps everything in check.

“So, it’s like a secret recipe for money, written by modern-day alchemists?”

“You got it, boss! Crypto protocols are the secret sauce that makes digital currencies like Bitcoin and Ethereum tick. They are like the traffic lights of the crypto highway”

I like the explanation of IvanOnTech

A protocol is just a way of communicating …for example, how do the different participating nodes on the Ethereum blockchain communicate with each other? – a protocol describes the way we should communicate with each other.

IvanOnTech

What do crypto people mean when they say protocol?

There are two types of conversations where you might encounter the term protocol.

The first is in a technical discussion or podcast where developers go in-depth about blockchains and their consensus algorithms.

For example, they might use the term as follows:

  1. “The Lightning Network protocol enables faster and cheaper Bitcoin transactions by allowing off-chain micropayments.”
  2. “The proof-of-stake protocol, used by networks like Cardano and Polkadot, requires users to lock up a certain amount of cryptocurrency as collateral to validate transactions and secure the network.”
  3. A blockchain is a digital ledger that uses protocols to ensure it is secured by the computing power of the entire network
  4. “NFT marketplaces often follow the ERC-721 protocol, which standardizes the creation and trading of non-fungible tokens on the Ethereum blockchain.”
  5. “A blockchain is a decentralized network that uses protocols for its virtual machines (nodes) to communicate”

The second way that people use it is to refer to a dApp. This is the way I often use the term on elementalcrypto.com.

In the crypto industry, dApp stands for Decentralized App which is a set of rules, i.e. a protocol, written using smart contracts to automate stuff without the need for a central intermediary. For example,

  1. “This decentralized finance (DeFi) dapp is an open-source project that operates on the Compound protocol, allowing users to earn interest by supplying assets to lending pools.”
  2. “This decentralized exchange utilizes the Uniswap protocol to enable users to trade various tokens without relying on a centralized intermediary.”
  3. “Users can stake their tokens in this dapp, which follows the Tezos protocol, and participate in the network’s governance decisions.”
  4. “Users can lend and borrow assets on this DeFi lending platform dapp, which employs the Aave protocol to manage collateral and interest rates.”

Why have a protocol in the first place?

Think of it like a set of standards. If we all follow the same rules we can make the code and end product work.

  • Protocols form the backbone of the cryptocurrency ecosystem, enabling the seamless transfer of digital assets between participants. They ensure the proper functioning of the network and enable consensus among participants, preventing double-spending, fraud, and manipulation.
  • They also define the rules for creating and distributing new coins or tokens through processes like mining, staking, or airdrops. They establish the supply limits and inflation rates, influencing the monetary policy of a cryptocurrency.
  • Furthermore, protocols play a crucial role in ensuring the security and privacy of transactions. They employ cryptographic techniques to encrypt and authenticate data, protecting it from unauthorized access and tampering.
  • Protocols also facilitate the development of smart contracts. A smart contract is a self-executing piece of code with the terms of a contract agreement directly written into it. These contracts automatically execute actions when predefined conditions are met, eliminating the need for intermediaries. This is how you get dApps we spoke about.

Types of crypto protocols

There are various types of protocol layers utilized by cryptocurrency projects, each serving specific purposes based on the needs of the network or project.

Protocols play a critical role in both public and private blockchains.

Some common types of protocols include:

  • Transaction Protocols: Focusing on secure and efficient transaction processing
  • Consensus Protocols: Establishing agreement and preventing fraud or malicious activities
  • Privacy Protocols: Ensuring the confidentiality and anonymity of transactions and user data
  • Interoperability Protocols: Facilitating communication and value transfer between different blockchains
  • Address Generation: Enabling the creation of unique addresses for receiving and sending cryptocurrencies
  • Smart Contracts: Self-executing agreements with predefined conditions
  • Governance Mechanisms: Involving participants in decision-making processes

Benefits and limitations of crypto protocols

Benefits:

  • Decentralization: Reduces reliance on central authorities and enables peer-to-peer transactions
  • Security: Provides strong encryption, preventing unauthorized access and tampering
  • Transparency: Allows participants to view and verify transactions on the blockchain
  • Trust: Establishes trust without the need for intermediaries
  • Innovation: Enables the development of new features and functionalities within the crypto ecosystem

Limitations

  • Scalability: Some protocols struggle to handle a high volume of transactions, leading to network congestion
  • Complexity: Understanding and implementing protocols can be challenging for newcomers to the crypto space
  • Energy Consumption: Proof-of-Work based protocols often require significant computational power and energy
  • Interoperability: Different protocols may have difficulties communicating and exchanging value

Sample crypto protocols

#1. Bitcoin protocol

The Bitcoin blockchain protocol governs how the Bitcoin blockchain network works.

Check out What is Bitcoin for a good explainer.

For example, it details how a network of computers can collaborate to verify transactions on a distributed ledger without the need for a central authority to coordinate and lays out how it proof-of-work consensus mechanism works.

It also defines how newly issued coins and transaction fees can be used to reward developers called miners for verifying and adding new blocks.

#2. Ethereum Protocol

The Ethereum Network is the second most popular blockchain platform.

Its protocol defines how the Ethereum blockchain works.

Ethereum also has rules that govern its smart contract functionality, its ERC-20 token creation, and its proof of stake consensus protocol.

Ethereum’s native cryptocurrency ETH is also governed by a protocol that defines its supply and inflation.

#3. DeFi protocols

DeFi protocols are essentially apps that operate on top of blockchains.

Most of them are built on top of Ethereum but many other blockchains are catching up including the Bitcoin Network itself.

Open-source protocols on blockchains such as Ethereum become the building blocks for third parties to create their own new protocols.

Internet protocols vs. crypto protocols

Protocols are not unique to crypto.

The most famous internet protocols are TCP/IP which governs how computers connect to the internet and SMPT which governs email messaging.

For both of these, there were alternative protocols but these are the ones that stuck.

While crypto is decentralized for anyone to participate in, the first set of protocols were developed by Satoshi Nakamoto, the person or group behind the first cryptocurrency and public blockchain aka Bitcoin.

FAQs

What is the difference between a protocol and a coin?

Think of a protocol in crypto as the recipe for baking a cake, with all the detailed instructions and ingredients. It tells you how to mix things, the temperature to set the oven, and so on. Now, the coin, that's like the delicious cake that comes out of following the protocol's recipe – it's what you actually get and can enjoy. The protocol is the chef's secret, and the coin is the tasty dessert on your plate!

Is ethereum a protocol?

Yes, Ethereum is both a protocol and a platform. The Ethereum protocol specifies the rules and procedures that govern the Ethereum blockchain network. It outlines how transactions are validated, how smart contracts operate, and how the network reaches consensus. Ethereum also serves as a platform where developers can build decentralized applications (dapps) using its protocol. So, Ethereum is not just a cryptocurrency (Ether or ETH), but it's also the underlying protocol and ecosystem for creating and running various blockchain-based applications.

Is a blockchain a protocol?

Yeah pretty much. By definition a blockchain is like a protocol or a rulebook for recording and managing data in a way that ensures transparency, immutability, and trust among its users. Different blockchain networks may have variations in their protocols, but at the core, a blockchain is a protocol that governs how the technology operates.

What is the largest crypto protocol?

Technically Bitcoin is the largest protocol in terms of market capitalization. But if you are referring to dApps then Lido has the highest TVL (Total Value Locked) followed by MakerDAO and Uniswap

Up next

Why Is Cryptocurrency Worth Anything? Unknown Secrets

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Markos Koemtzopoulos is the founder and main writer of ElementalCrypto. He has been a lecturer at the University of Nicosia on cryptocurrencies and DeFi and has taught two courses on crypto and blockchain technology.

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