A Brief Primer:
Historically, internet and web systems have transmitted information and messages via foundational open protocol layers, such as: TCP/IP (for internet access), HTTP (for web messages and commands), FTP (for file transfer), and SMTP (for email transmission). These open-source protocols function as critically important building blocks and rails upon which centralized high-level applications, such as Google, Facebook, Amazon, and Uber, all reside.
Sitting atop the technology stack, these centralized companies capture and store user data, monopolizing that information, while simultaneously enjoying the majority of economic value accretion. Thus, lower level shared protocols have largely suffered from the “tragedy of the commons,” historically capturing little to no economic value despite their critical role in powering applications. The stagnation in innovation at protocol levels can partially be attributed to these dynamics.
Moreover, many centralized applications have been able to leverage their network effects and walled gardens to wield much power and influence over end-users and services. Operating in such a manner, these information silos and gate-keeping structures remain in stark contrast with the original ethos of the Web as an open platform where everyone can publish.
Finally, the client-server networking architecture these applications reside upon often rely on the competence, trust, and security of their centralized business or government operators. Time and time again these centralized custodians have been exploited, or in some cases, have done the exploiting themselves.
Times They Are a-Changin’:
We believe the arrival of decentralized protocols built on cryptographically bound networks signals a fundamental paradigm shift in technology that will disrupt legacy centralized architectures.
Native and highly programmable digital assets built into the protocol layer will help serve as their “amino-acids”, becoming the essential building blocks for their decentralized bodies. Most importantly, these digital assets enable monetization and value capture at the open protocol level for the first time ever. Individuals can now invest directly in the underlying asset of a protocol, funding innovation within it, while relying on asset performance for returns. In doing so, economic value flow is redirected away from centralized top-layer applications, and moved toward lower layer decentralized protocols.
Joel Monegro does a far better job discussing how blockchain assets enable this value-inversion, so I won’t belabor it. Read about the creation of “Fat Protocols” in his seminal post here.
Blockchain’s Fundamental Achievement:
Blockchains, perhaps, can best be thought of as decentralized (no main authority), distributed (spread across a global network), public (accessible/auditable by anyone), and immutable (unalterable) databases. Blockchain databases maintain a distributed ledger of events (transactions or otherwise) for a particular digital asset class. Bitcoin is just one type of digital asset class: a cryptocurrency.
Blockchains unlock the power of distributed ledger technology through their utilization of two key features: 1) Impartial laws of mathematics and cryptography 2) Powerful game-theoretic incentive structures. These crucial features help drive peer-to-peer (P2P) network consensus and create a unified set of checks and balances against malicious actors.
1) Through impartial laws of math and cryptography, blockchains link timestamped batches of data together in a manner that makes it easy for the majority of the network to spot and reject any attempts of tampering with that data. Being cryptographically and consensus bound, these distributed networks are able to protect and secure network resources without relying on the directional commands of a trusted central authority. In doing so, they achieve self-governance and what Nick Szabo labels as “social scalability”: high levels of coordination with trust minimization.
2) Moreover, powerful economic incentive structures have been embedded into blockchain protocols via the introduction of digital assets that carry some assignable value. Digital assets, at their most basic levels, can be thought of as access keys used to unlock the functionality of the decentralized protocol or application they serve. This is why they are so often referred to as “tokens”. These assets have some functional network utility, are tradeable within a market, and therefore have the ability to demand a price.
Miners or validators, who devote computing or economic resources to audit and maintain the integrity of a distributed ledger, are typically rewarded with issuance of the underlying asset or with transaction fees (or both). As such, it remains in their best economic interest to maintain and validate the ledger in good faith; otherwise, it carries great costs. This is not where the capitalism and money incentives behind digital assets adjourn, however. Since the assets have assignable value, all other remaining network participants (developers, users, and investors) also remain motivated to exhibit desirable, non-hostile behavior. It should come as no coincidence, then, that crypto communities are some of the most galvanized in tech.
Quick Recap & Why This is Important:
To summarize the above more simply: blockchains and distributed ledger technologies remove central points of failure and use greed to drive coordination amongst network participants. In doing so, they become highly fault tolerant against forces that are trying to undermine their consensus. As a result of this, they are able to achieve decentralized governance and end-to-end security while becoming permission-less and highly censorship resistant.
The tremendous merit of these properties is perhaps most evident in the example of Bitcoin’s blockchain. Individuals have flocked to its native asset, BTC, as a borderless and censorship resistant store of value, akin to digital gold. Similarly, the value of these properties can be witnessed with Ethereum, whose blockchain is being used to develop a “world computer” upon which uncensored applications can be built. Developers are utilizing its digital asset, ETH, as computational “gas” to execute contracts and bring to life new decentralized applications.
This is just the tip of the iceberg. Many additional decentralized networks and applications are being experimented with across a wide array of verticals and industries. Since blockchains are controlled by open-source software and comprised of highly programmatic assets, we remain confident they will continue to evolve and fill new use cases.
Potential Impact:
We believe blockchain technology will redefine existing marketplace structures and enable true peer-to-peer (P2P) interactions in which participants are no longer dependent on market-makers or subject to their fees. This has the potential to radically transform existing internet, financial, and social constructs which have low value middle-men in place. By connecting individuals and businesses to one another directly, blockchain technology will give way to true “collaborative consumption” of goods, resources, and services on a much greater scale.
It is important to note, however, that we are not advocates of the “decentralize everything” approach. Many centralized bodies will always have greater structural merits and demonstrable efficiency, cost, and experience advantages over their decentralized counterparts. For example, companies whose number one concerns are privacy and executing intensive serial computations are likely to be better served by centralized databases rather than blockchains. Likewise, Apple is never going to use a truly decentralized approach to manufacture its iPhone. Thus, certain centralized fixtures will always be granted staying power.
Nonetheless, there are many centralized & human mediated systems which do derive superfluous value from rent-seeking middleman. Verticals we see most primed for erosion from the introduction of autonomous, trustless, and decentralized technology solutions include:
- Banking & Payments
- Governance
- Insurance
- Security
- Supply Chain Management
- Real Estate
- Internet Service Providers
- Online Gaming & Gambling
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- Publishing
- Social Networks
- Search
- Data Storage
- Exchange Operators
- Identity Management
- Digital Art & Collectibles
- Many More…
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We believe the level of disruption will be proportionate to the cost, redundancy, and complexity of involvement in the existing system of intermediation. As it stands, financial services seem to be leading the way in blockchain applicability, primarily since they currently have the most commercial use cases.
That said, blockchain technology and crypto assets have yet to truly spread virally across the globe. Scalability bottlenecks and ease use have largely prevented mainstream adoption, at least for now. Web3.0’s technology stack is still in its most nascent stages and a tremendous amount of work is likely necessary in building out the decentralized infrastructure for a decentralized age. But, with much work comes much opportunity.
Construction Underway:
We believe the greatest initial opportunity exists for the companies attempting to build this new Web’s infrastructure (i.e. scalable computation, data storage layers, data distribution and messaging layers, inter-protocol connectors, off-chain and cross-chain tools, open & interoperable APIs, etc.) to drive greater utility for builders and ease mainstream adoption for users. Only until developer tool needs are met, and the appropriate infrastructural components of these enhanced software and web service stacks are built out, will we see a true blossoming of end user applications on higher-level decentralized systems. In the medium-term, however, it may be possible for certain application protocols to take a hybrid approach and leverage existing infrastructure to achieve interim functionality, while waiting for the decentralized ecosystem to become more robust.
Although the reversal of centralized structures will surely require time, and much trial and error, the strategic layering of monetary incentives into open-source protocols and applications can dramatically increase their rates of development. As evidenced in Bitcoin and Ethereum, this newly redirected value flow supercharges all network participants (developers, users, service providers, and investors) and creates positive virtuous loops: price increases lead to more user adoption, greater demand for the asset, more customers, greater developer interest, and more innovation (and vice versa). These properties can significantly accelerate network effects, adoption rates, and intrinsic growth for successful projects.
Further, given the open-source nature of decentralized protocols, developers who are looking to make necessary protocol improvements are granted unfettered access to their shared data layers. They can either make evolutionary improvements directly to the existing chain, or they have the ability to copy the codebase and “fork” the modifications onto an entirely separate chain. In the latter case, the market is left to decide which chain is more valuable and better serves its needs; in theory, the strongest version of the two should prevail. While this poses some issues, we generally believe its iterative openness and the healthy competition it creates will speed up rates of innovation.
Equally important to note, the introduction of initial offerings of digital assets, often called ICOs, has created a new means to fund the development and operating expenses required to host a decentralized network as a service. This highly disruptive fundraising method circumvents many requirements from traditional equity raises. In doing so, it provides teams greater access to global pools of retail capital beyond the restrictive and dilutive ones offered by VCs and institutional investors. This crowdsourced capital isn’t just coming from investors, but also from users and developers who will help grow and build that network. It should be cautioned, however, that this current model may be subject to many regulatory sanctions as the SEC has yet to issue a definitive ruling on it. Additionally, these investments are extremely high risk and have been susceptible to price manipulation and other fraudulent trading practices.
Value Opportunities:
Given the value inversion digital assets create from the application layer to the base protocol layer, many investors chose to remain myopically focused at the very base layers of the decentralized technology stack. Piggybacking off Joel Monegro’s notion of “Fat Protocols”, they speculate that this is where the lion’s share of value will be captured since the remaining stack of applications will have to be built on top of it.
We remain in partial agreement with this thesis and recognize that a few protocols are well positioned to be winner take most; However, we also maintain that tremendous value opportunities can extend more vertically in the decentralized stack, reaching both mid-tier protocol and application levels. We see tremendous value in decentralized applications that are creating consumer onramps and drive further utilization of protocols beneath them. After all, as Jake Brukhman sensibly points out, “every layered protocol is simply just an application for the stack beneath it”.
Under this premise, we think it’s a wise requirement for investors to judge the merits of a digital asset by evaluating its touchpoints and interactions within the stack, as well as its potential relationship with the end-user. The best positioned digital assets will be the ones that derive value through high degrees of functionality and usage (not to be confused with velocity) within their respective ecosystems. Good questions to ask are: Does the decentralized protocol uniquely enable specific end-user needs and desires better than a centralized equivalent? And, is a digital asset necessitated for the protocol’s functionality?
Correspondingly, we caution against investors solely placing bets on protocol monoliths. Most will struggle to survive. Moreover, we caution against investing in projects whose protocols and applications cannot demonstrate a real need for a token or the censorship resistance and premissionlessness a blockchain provides. Unfortunately, many existing projects fall into this category – but not all.
Conclusion:
We’ve begun to enter into an exciting digital age — one where more market participants are demanding privacy, censorship resistance, security, and direct sovereignty over their own financial and digital resources. We are seeing a slow shift in the public zeitgeist around cryptographically bound networks’ ability to deliver on decentralized market needs, as well as the legitimacy of the new digital asset class they have created.
Similar to how the internet’s influence reached well beyond the technical fields of computer communications, we believe blockchains and distributed ledger technologies will eventually scale their way into the larger labyrinth of economic, social, and organizational structures.
While truly transformative use cases may still be some ways off, we remain excited to evaluate the possibilities now, and invest in the digital assets that can make them a reality.
