Why Crypto Is Eating the Internet — Part 2 of 2
This article is part of a series being written to help venture capitalists (VCs) understand the importance of crypto-assets.
In this two-part article you will learn:
- Part 1: Why the world needs blockchain technology
- Part 2: Why blockchain technology needs crypto
We advise reading and understanding Part 1 before tackling this article.
There is still much confusion and scepticism about the importance of the “crypto component” in blockchain systems. We plan to tackle these issues head-on here by breaking down the innovation in a way that makes it easier for institutional investors to understand.
The structure of this post is as follows:
- The “Blockchain, not Crypto” argument
- Where Blockchains — without Crypto — Fall Short
- Why Crypto Solves this
Disclaimer: This post is not about Bitcoin. The Bitcoin thesis is a separate topic entirely. This post aims to explain the purpose of crypto, beyond Bitcoin.
The “Blockchain, not Crypto” argument
Many flavours of blockchain-computers have evolved over the years and the terminology is often misconstrued. This is easy to do because public and private blockchain-computers have many similarities:
- Both are peer-to-peer networks, where each participant maintains a replica of a shared database (the append-only ledger of digitally signed transactions).
- Both maintain the replicas in sync through a protocol referred to as consensus.
- Both provide certain guarantees on the immutability of the database, even if some participants are faulty or try to be malicious.
So, how are they different?
The sole distinction between public and private blockchain-computers is related to who is allowed to participate in the network, execute the consensus protocol and maintain the shared database.
A public blockchain computing network is completely open, free for anyone to use and free for anyone (with the IT resources) to participate in the consensus protocol. Updates to the code-base or conflict resolutions are managed through democratic procedures involving everyone participating — a key thing which is often overlooked.
For those wishing to take part in the consensus, they are incentivised by earning crypto-asset denominated financial rewards. The prospect of making a profit through these financial rewards is what encourages participants to join the network.
Meanwhile, a private blockchain computing network requires an invitation and must be validated by either the network starter or by a set of rules put in place by the network starter.
When people say “blockchain, not crypto”, they are referring to private blockchains.
Businesses who set up a private blockchain will generally set up a permissioned network. This places restrictions on who is allowed to participate in the network, and only in certain transactions.
Incentives for permissoned members wishing to participate in the consensus protocol involve financial rewards too, however, they are denominated in fiat currency.
The Basis Of The “Blockchain, NOT Crypto” Narrative
The “blockchain not crypto” narrative most certainly has legs.
For starters, most public — crypto-powered — blockchain computers require users to purchase the native crypto-asset on the market. The crypto-assets are required to use the public blockchain-computer and its applications.
The process of buying these digital assets is typically complex and at times burdensome. The volatility also introduces a level of FX risk an application provider or a customer does not want to worry about.
From a technological standpoint, public blockchain computers also have several drawbacks that make them an unattractive computing platform for either start-up founders and/or enterprise businesses.
To expand:
- Scalability problems — Many of the current public blockchain computers are adequate for dealing with simple scalability. However, we believe that in many large-scale use cases, service providers need IT systems that can automatically deal with more demand from gradual or even sudden demand from the users of the service.
- Privacy issues — The business community has a stronger requirement for data privacy than is currently provided by public blockchains. Even though blockchain computers allow users or companies to self-custody their financial assets and private data, their checks & balances and transaction history are open for everyone to see.
- IT integration difficulty — For several decades, enterprises of all sizes have been optimising and transforming their businesses through the use of digital technologies. This has often occurred in waves, resulting in layers upon layers of different systems being tested and implemented. Enterprise infrastructures, therefore, tend to depend on a diverse range of technologies and processes. As such, integrating new technology such as blockchain into a complex system can be very difficult, risky and costly.
- Control — Not having full control of their IT infrastructure raises operational issues for businesses. Public blockchains have been subjected to frequent hard forks. Hard forks are a necessary measure when modifying or upgrading the underlying technology. However, they create a totally separate variant of the original software program. When a public blockchain-computer experiences a hard fork, the applications are meant to continue to operate as usual on the new version of the blockchain computer. When you consider the spider-web like relations between enterprise solutions, a hard fork on a simple user-application could potentially cause critical business failure.
Since private blockchains are controlled by a small group of permissoned members, they can easily be adapted to solve some of these technological issues, better aligning themselves with the needs of entrepreneurs and enterprise businesses.
As a bonus, there would be no need to touch volatile crypto-assets.
So, surely this settles it… It’s “blockchain, not crypto”, right?
Where Blockchains — without Crypto — fall short
In Part 1, we talked about how blockchain has given birth to a new computing platform. Unlike any other computing platform we’ve had before, the blockchain computer enables everyone in the world to:
- Trust the integrity of the computer thanks to data transparency and open-source code. {TRANSPARENCY}
- Trust the security of the computer thanks to no central points of failure and mathematically-guaranteed consensus. {SECURITY}
- Trust the rule-makers of the computer thanks to community-driven decision making. {GOVERNANCE}
These three drivers form the basis of a concept we introduced, called the Trust Tripod.
Why a Tripod?
The three drivers of trust are like three legs of a tripod. Interestingly, a tripod manages stability even if there is a difference in the length of the three legs. However, in the absence of a leg, the tripod is completely unstable and it collapses. In this situation, losing faith in either transparency, security or governance will result in the breakdown of trust.
Trust is at the very core of blockchain computing systems. Without trust, there is no point using a blockchain computing platform over a substitute like AWS. Purely from an economic standpoint, it would simply make more sense to use a centrally managed computer and database.
To understand where blockchain computers (without crypto) fall short, we must investigate and dissect the three drivers of trust individually:
(1) Transparency
As the name suggests, public blockchains are inherently open and public — visible for anyone in the world to inspect. You can never question the truthfulness of the data or source-code.
However, the “openness” of the data residing within private blockchain systems is controversial. Typically, visibility of the data or code is restricted to those that have permissioned access to the network.
The integrity of the system, therefore, is only maintained with full confidence and assurance for those that have granted access.
As these networks try to scale, they will need to allow more and more businesses as well as consumers to access the system. Businesses will not share their data or run their business logic on IT infrastructure that they know other businesses and potential competitors are seeing. It is this concern about threats from the competition that ignites the breakdown of trust.
A way to overcome this obstacle is for each and every business to attain access and full visibility. Access control, however, adds complexity and time-consuming onboarding processes. A workaround solution — coined “public permissioned” — is being explored by the likes of R3 and others, however, they sacrifice the privacy many enterprises desire.
(2) Security
Code and data managed by the blockchain-computer are distributed across peer-to-peer networks that are continually updated and kept in sync. Because they aren’t contained in a central location, blockchains do not have a single point of failure and cannot be changed from a single computer.
A hacker would need to hack the majority of the entire blockchain computing network to get control. So, the greater the number of computers with the power to validate transactions and computations, the more tamper-resistant and secure the blockchain-computer is.
In this case, the question becomes: how big does a blockchain computing network have to be before becoming sufficiently secure?
Private networks compensate by recruiting several companies to form a consortium responsible for taking part in the consensus protocol.
Similar to public blockchains, consortium members are incentivised through financial rewards (collected through fees paid by the users of the blockchain-computer). However, unlike public blockchains, these rewards are denominated in fiat currency such as the Dollar or Euro. These rewards offer consortium members the incentive to dedicate their IT infrastructure to the protocol. A good example of such a system is the Facebook-led private blockchain endeavour, Libra, which comprises of ~20 permissioned members.
The rate of growth of concerted efforts like Libra and others is limited by complex IT due diligence processes and security assessments.
Will Libra be more secure than a public blockchain computing platform like Ethereum where there are thousands of nodes running the consensus protocol?
Most definitely not.
Is it secure “enough” to store our valuable financial assets?
With the added layers of enterprise-grade cybersecurity software as well as common deposit insurance, it’s probable.
(3) Governance
Governance is at the crux of the problem with private blockchains.
Unlike “transparency” or “security” which can to some degree be worked around, the “governance” component can never establish trust at macro-scale.
For example, when you are dealing with tens of thousands of small-to-medium-sized businesses, private blockchains will likely ease access control. However, it is likely that new members will not benefit from the privileges offered to the early permissoned members. These less-privileged members will, therefore, hold fewer responsibilities and voting power.
No matter how large or how small the network is, private blockchains centralise the power into the hands of several consortia members.
History tells us that self-elected officials typically do a poor job at representing the interests of everyone. They always find a loophole that they economically benefit from.
The Heart of the Governance Problem
To understand the reason behind the irreparable governance problem we have to look beyond the confines of “blockchain”. We have to look deep into our model of capitalism.
Let’s break it down:
For every business in the world, they tend to bring together three groups of people.
- Capital providers — those that provide the financial capital to start the business. They are shareholders in the company.
- Supply siders — those that provide the human or machine capital that ultimately creates a good or service. These can include employees or independent resource providers, such as Uber drivers.
- Demand siders — those that purchase the goods or services to fulfil their needs. They are the customers.
Each of these groups has their own interests that do not align. Shareholders want to maximise profit, supply siders want to maximise their income and demand siders want the lowest price.
Thus, demand and supply work opposite to each other.
In the end, the point where demand and supply intersect each other and are equal on that point the price is fixed and is called “equilibrium price”.
In competitive markets — whereby demand siders or supply siders are free to move to a competitor or a different marketplace platform should they disagree on the price — this inter-relationship works very well. It is what makes capitalism a highly effective model for productivity and growth.
But…
Things start to get ugly when a company starts to monopolise.
Once a company attains considerable market share, they no longer experience significant threats from competition. Neither demand siders or supply siders have a viable opportunity to move to an alternative solution that can offer the same quality of service that the monopoly can, due to the economic moats they have.
Because the three groups are each motivated by their own interests, monopolisation of the firm shifts the balance of power to the shareholders, who are incentivised by value extraction. We, therefore, hold witness to prices being pushed unjustly away from their natural equilibrium point to the detriment of either the supply siders, the demand siders or both.
Monopolisation in markets that we consider public utilities, like marketplaces, can be damaging to both innovation and society in general. Internet or banking services fall into this category. As touched upon in our last post, taking excessive amounts of value out of the economy and placing it in the pockets of shareholders exacerbates inequality.
How does this relate to private blockchains?
As private blockchain participants grow beyond the confines of their permissioned members their interests will become more and more misaligned with the users.
Blockchain computers aim to be foundational technological infrastructure for everyone, used as a globally accessible repository for property rights, financial assets, personal data, etc.
They will only become truly valuable if everyone opts into the same system. For us to get to that stage, it will mean competitors at the core base layer of the blockchain computing stack will be few and far between. “Monopolisation”, as we know it today, is inevitable.
New technology, same economic model.
In the context of private blockchain computing platforms, monopolisation destroys trust due to:
- Excessive value extraction and competition — since blockchain computers are platforms on which applications are built, application developers must trust the governors to not shut down their application due to, for example, a conflict of commercial interest. Besides, as the private blockchain monopolises, there is always the risk of the governors changing the rules of the game in a bid to maximise financial returns for the small group of “permissioned” members (plutocracy).
- Unlawful censorship — With the internet companies of today, we’ve only had a mere taste of censorship. Once our valuable assets become digitised and recorded on blockchains, censorship will become significantly more profound. Private blockchains, for example, may become powerful tools for corporations or governments to push their political agendas by giving them the power to easily seize an individual’s assets unlawfully, or shut off their access to the economy. This type of power in the hands of a small group of people (who do not represent everyone) is concerning and takes us a step closer to the Orwellian future we fear.
Why Crypto solves this.
Crypto-powered systems reshape the economic model of internet-based businesses, to one that aims to establish and maintain trust amongst all its users from new to old, regardless of the size of its economic moats.
New Technology, new Economic model.
Similar to a traditional business, we have the same three groups of people: capital providers, supply siders and demand siders.
However, unlike the private blockchain monopoly, the crypto-powered blockchain computer allows us to create a system that maintains trust among all three parties as it scales and attains significant market share. As a result, the balance of power no longer swings towards the capital providers (shareholders).
Therefore, supply siders and demand siders no longer need to fear:
- Unjust price premiums and unfair wealth distribution.
- Competition threats from the platform operators.
- Unlawful censorship from unelected entities trying to push hidden commercial or political agendas.
The end result becomes a system that everyone can truly trust globally. It doesn’t matter whether you’re China or the USA, the computer will keep a record of your assets as well as run application logic without discrimination. Always.
How does it work?
First, we start by completely eliminating “shares” or “equity”, which typically represent company ownership and a claim to the company’s proportional earnings.
Instead, we introduce a digitally native crypto-asset; we will use the term token interchangeably.
This token is not the same as shares or equity in a business.
Instead, it is an asset that all three players (capital providers, supply siders and demand siders) must hold or transact with to play their respected role.
To expand:
- Demand Siders: when making a transaction or computation on the computer, the demand-siders must pay fees denominated in the token. Therefore, for demand side participants, the token is a consumable asset, like a commodity. Demand-siders will purchase a specific amount of token to fulfil their needs. For example, you typically fill your car with petrol instead of buying several barrels of oil.
- Supply Siders: The supply-siders must deposit tokens in escrow before being allowed to earn their income, which is also denominated in the token. Therefore, for supply-siders, the token is a productive asset, like a bond or — more accurately — a taxi medallion. By locking a fixed amount of token to be able to participate in the market, supply-siders are rewarded with a yield perfectly proportional to the “work” they do (this yield originates from the fees paid by demand siders).
- Capital Providers: The capital providers must purchase and hold the token if they want to support the project, with the future expectation that the number of users will grow on both the demand and supply side leading to a subsequent increase in the token’s value. Therefore, the token is a speculative asset, like venture equity.
What bonds all these players together is the value of the token. The value comes from deflationary pressure.
Assuming that the token economics are designed properly, deflationary pressure arises from one or more of the four leading factors:
- Staking (like a lock-up) — supply siders must “stake” (place in smart contract escrow) their tokens in order to be allowed to do “work” or offer their goods/services. The more supply siders, the more tokens are purchased in order to be staked. This reduces the total supply of tokens available on the market, making it more scarce.
- Token burning (like a buyback) — The token economic system can be designed to capture a small percentage of the fees paid by demand-siders and programmatically “burn” them. By permanently removing tokens from the supply, the token becomes more scarce.
- Governance (like voting rights) — A token in most crypto-powered systems represent a Vote. Power is a scarce asset. As these systems grow and become critical pieces of technological infrastructure, voting power becomes more valuable. Therefore, more individuals and businesses will be inclined to hold the tokens to ensure their voice is heard, reducing the supply of tokens available on the market.
- Store of value/medium-of-exchange narrative — Money is a belief system. Security guarantees thanks to blockchain, token scarcity and increasing token liquidity results in growing belief in the token’s “soundness”. Soundness translates into a store-of-value price premium. We see the token behind a public blockchain-computer as something similar to silver in the physical world. Silver has more utility versus gold (bitcoin) but less of a store of value premium due to its stock-to-flow model.
What is particularly interesting about the token model is the change in behaviour. Typically, capital providers, demand siders and supply siders have a very separate set of incentives.
However, with the introduction of the token model, we start to see interests beginning to better align and even overlap with one and other. It is not necessarily due to individual changes in customer behaviour, but more due to the fact that the token-project itself attracts participants that genuinely wish to play multiple roles in the system.
Let’s take the overlapping interests of capital providers and supply siders as one example:
“Cashflow is all you should care about.” — Bill Ackman, CEO of Pershing Square Capital Management
Bill Ackman is right. As an investor seeking a consistent return on capital, cash flow is of utmost importance. However, in token-powered systems (assuming we are at a stage of post-product market fit), investors cannot sit back and make a yield by just holding and hoping. For investors to attain the yield they desire, they must in one way or another contribute to the network as a supply-side participant and therefore add real value, making the service better for the demand side. Yes, you read that correctly, add real value! Not extract!
Not all investors will want to participate though. Some may simply hold the token seeking speculative capital-like gains. However, a ceiling will always be reached in terms of growth. At that point, non-value adding capital providers will no longer see value holding the token unless they contribute as supply siders to earn a yield. Therefore, as these token-powered systems reach mass adoption stage, value extractive participants slowly but surely exit the system.
The end result is a crypto-powered system becoming entirely community-owned (supply and demand siders only). The overlap between capital providers, supply siders and demand siders will become so profound it will be difficult to distinguish them from one and other.
We are actually seeing signs of this happening today.
For example, many crypto funds are emerging and are now calling themselves “network participation funds”. On top of the early-stage speculative investments they are making in projects, they are also actively supporting the project by acting as active supply-side participants through running validator notes in return for yield.
As a result, not only are they financially contributing by providing start-up capital in return for tokens that may or may not increase in value, but they are also actively improving the overall health of the project that increases its chance of success and capturing yield as a bonus.
Addressing the Elephant in the Room
In 2017/18 we saw many projects create tokens to raise capital based on a whitepaper hypothesis.
Most projects raising money through an initial coin offering (ICO) did not have a product with a token model ready for demand siders or supply siders to use. The only possible purchasers of the token were the speculators (capital providers).
As we have described, the token model only works effectively when in the hands of the target market participants. By distributing the majority of tokens (and therefore power) to speculators, many projects pretty much destroyed any chance of success from inception.
Although ICOs and whitepaper scams have thankfully tapered off, we are witnessing certain projects contradict the purpose of the Token Model in new ways.
For example, one feature that is being abused is staking, where the staking rewards distributed originate entirely from new token issuance (inflationary pressure).
Do not mistake us, we certainly believe that when done correctly, offering staking yields pre-product launch can be an effective and ingenious way to bootstrap the “financial utility” of the token. However, there is a fine line. Many projects abuse this feature today by giving speculators enormous yields in return for not really adding any value as a supply side contributor.
As a result, the probability of the project succeeding begins to breakdown. Too many tokens in the hands of a small group of speculators is done at the cost of empowering the users. With the inability to achieve “oneness” with the users, there is no real point having a token model. What we end up with is a system like the old one where users no longer trust the platform as it acts in the best interest of the capital providers. Plutocracy.
Now, not all apples are bad in crypto today. We are still in the early stages of this industry where the “perfect” token economic design is being figured out. I believe we are seeing best practices beginning to emerge, successfully establishing real user growth.
Thanks to all code and data being open-source, plutocracy will always be averted through natural competitive forces. “Forking” allows competitors to easily create a copy of the code and data. Therefore, should a developer believe that a crypto-powered application is unjustly benefiting speculators, the developer can copy the application and make tweaks to the source code and/or data. The switching cost for users from the old to the new application is considerably lower in the crypto world versus the traditional.
So, if crypto really is our future, then what does it look like?
I envision (and bear witness to today) a future where will see the token model extend beyond the computing layer to climb higher up the stack since many network-based services have unruly leaders and technological inefficiencies.
We’ll see the banking and financial services industry get replaced by decentralised financial protocols (DeFi applications) and internet monopolies get replaced by decentralised internet protocols (web 3.0 applications).
The shift to fully token models will be gradual, where some applications will run with a traditional for-profit business behind them making all the key decisions. However, due to the open-source nature of the beast, a community-governed and, therefore, a crypto-powered network will inevitably win.
So, what about enterprise needs?
As we mentioned earlier, public blockchains — from a technological standpoint — do not align with the needs of many enterprises or governments.
Eventually, public blockchain technology will evolve to the point where all of the enterprise needs (e.g. privacy, scalability, integration, etc.) will comfortably be fulfilled. Therefore, we believe that in the long term all enterprise applications and cross-company business logic will run on public — privacy-preserving — blockchain computing networks.
In the near-to-mid term, however, we envision hybrid (public and private) blockchain ecosystems forming. This is where private blockchain computers that are tailored to the need of the corporate world will leverage the crypto-powered public blockchain computer for its trust properties (with some sacrifices of course).
“Anchoring” is a term used where private blockchains periodically flush hash values to the crypto-powered public blockchain. In doing so, outsiders can be assured that the data residing on the private chain is not being tampered with. As a result, the private blockchain can maintain privacy of the data and not be forced to expose the data to middlemen.
Therefore, as a short-term solution, it is likely we will see asset issuance and transaction settlements happening on the crypto-powered public blockchain and application logic happening on a more centrally managed private blockchain architecture.
Conclusion
The “blockchain, not crypto” argument has merit to it, however, it fails to take into account the real innovation with blockchain. The economic innovation.
The economic innovation that allows us to build globally accessible technology without trust ever being compromised.
Private blockchains are open to exploitation, the same exploitation we witness in the normal economy in the form of value extraction and censorship. The new economic model proposed by crypto-powered systems aims to better align the interests of all participants in the market around a single common asset.
