Originally published on Jan 3, 2018
This post does not aim to explain what a blockchain or a cryptocurrency is. It offers to show why this technological invention matters for society.
TL;DR The great Naval Ravikant wrote a series of tweets in June 2017, which are a must read for anyone, crypto lover or not. They show the big picture. Here is the transcript.
All I do here is trying to expand this line of thinking as to how and why blockchains can replace existing networks for everything.
1/ I am a member of different networks: the network of male humans; people who speak English and German; people who own a flat; people who live in Austria; people who own Euro and US Dollars; people who work for company X. For the most part, I could be viewed as an intersection of these networks. I can go in and out of these.
2/ Blockchain-based networks (cryptoassets) allow for different slicing of life and society with one big difference: these networks are based on market forces and use tokens as the form of merit (could be money or work). They have no rulers and require no trust. In the crypto world I could be part of the market networks of Bitcoin, Ethereum, Civic, Storj, Golem etc. What does that mean? I am part of a network of people who are their own bank; network of people who own their ID data; network of people who rent out their hard drive space and computing power to others; (at the same time) network of people who look to store files on another person’s hard drive, etc. The intersection of these also defines me in crypto. It turns any product/service we use into a market based network.
3/ These market networks operate with digital tokens, meaning that these services have a market price based on supply and demand. They are created by someone in order to serve a concrete goal (utility, money, computation etc) but, most importantly, have been financed by their users/investors/speculators/founders. They were not created centrally to be forced on top of any particular group of people. They are open source, which means that anyone can see how they are supposed to work and decide whether or not to participate and in what capacity.
4/ If we continue with the analogies, countries could be seen as protocols, companies as dApps (decentralized applications). dApps that do the same thing form “industries”. For example, I live in Austria, which has its own rules of operation — various laws and procedures, which are set by the central government. Companies operate on top and within these rules. Someone started and invested in these companies and now owns them. Others simply use their services. Hard to do both at scale. Moreover, people can not participate monetarily in the success of the underlying “protocol” — the country Austria, they can only experience it by obeying the rules. Protocol, in this sense means the set of rules, by which the citizens live.
5/ Now imagine I decided to create a new country with a simple set of rules laying out what people can and can’t do. It will be digital, so no geographical boundaries. We will allow others to form economic entities on top of it (think dApps) in order to provide specific services. We will introduce a native currency to be used by everyone in this “country” to exchange value or transact. We will put all our plans about “roads”, “rivers”, “mountains”, “laws and regulations” for people to evaluate.
6/ BUT, most importantly, we invite anyone who wants to help us build this “country” to join and put their money/labor to use. They will get part of the native currency and hence will participate in all the economic upside that this country can achieve. When people build specific companies on top of it, the currency holders can decide if they want to be part of those particular networks or not. Think of this as if you can own a piece of the economic output of the country you live in and/or any company that exists and operates in it. Importantly, it can also be a different slicing, say an industry across countries (protocols). So instead of buying shares in Amazon, you can buy a stake in the output of the global e-commerce industry. How? By dividing the total value by a set number of digital tokens, which are used to transact on this network. Whatever activity can be formed as a market network with a native token, probably will be.
7/ Right now, networks which provide a specific utility, say file storage or ID management, have a utility token (Civic or Storj/Filecoin/Sia are good examples). If it is for a revenue/cashflow producing asset — it is called an investment/rent token (there aren’t many of these just yet). The third class are the currencies like Bitcoin, Monero or ZCash. They are networks for storing value and making payments (for now). Ethereum is widely used to host other applications on top of it.
8/ In this context, what is the cryptocurrency market cap? How should we think about it — as the revenues of a company? GDP of a country? Money supply in a country? The currently prevailing wisdom for utility tokens is to value them using the exchange formula MV=PQ. You can read/listen to more about this here or here. The market cap you will see on most websites is the “M” in the formula. What this formula comes down to is akin to Gross Domestic Output (value of all transactions in an economy) divided by the speed at which this monetary base is turning (referred to as velocity). Often, the amount of native tokens is initially fixed or has a known inflation rate so an adequate opinion can be formed about the value of the token under basic assumptions for the size and scale of the network.
8a/ To give a more specific example, I am not using my laptop when I sleep so I may decide to lend out 10 hours of my CPU/GPU’s processing time to a crypto network. Say on the other side is a 3D design studio that wants to render its latest movie faster. They pay me 10 tokens x 10 cents = 1 USD. This forms one transaction on the network. All transactions for the total GDP. Let’s assume there is a fixed number of issued tokens — 1,000,000 tokens. Also, once I get tokens, I sell them at the end of the month for USD and they re-enter the network’s supply to be purchased by the next company that wants something processed. Let’s say every token gets exchanged 10 times a year. If the value of all transactions is, say, 1,000,000 USD, it means that the implied price of the tokens is 10 cents (1mn USD GDP / 10x velocity / 1mn issued tokens = 0.1 USD)
9/ Coming back to the country analogy, imagine there is no central bank and a set amount of Austrian Euros (let’s call them “Schilling token”) exists from the beginning of the creation. We gather together to build the “Austria” protocol and the companies/industries on top of it that provide water, energy, houses, factories, banking, services, entertainment etc. Using the example calculations above, all of the above industries can have one or several companies, each operating their own network tokens — WaterCoin, EnergyCoin, BankCoin etc, all based on market principles. Given that all these have been built on top of the Austria protocol (set of rules), they all will ultimately settle their transactions via the Schilling token. As a result, all of these economic transactions will form the GDP. By knowing how many Schilling tokens have been created initially and by observing how fast these change hands during the year, we can come up with an estimation of the value of the Schilling in USD, EUR, BTC or any other currency. Then we can compare to how much we paid initially and to our expectations. One of the most crucial things to understand here is that the larger the network is and the faster the transactions flow, the higher the velocity of the tokens will be which would result in a decrease of their price, all else equal. Why? Because you need less tokens to support the GDP and the supply would increase, causing the price to decrease and settle around the equilibrium price needed to support the network (of course, this could be much higher than the initial price).
10/ Why should a protocol/network scale and how? You can and will have different kinds of people to participate — from the regular users or a service who wouldn’t even know or care that their activity goes via a specific token, to initial investors/speculators who may be incentivized to hold or not based on their views about the value of the token economy (network), to those keeping the protocol consensus intact (depending on the governance mechanism in place, but more on that later). Protocol creators should think hard about the incentive structures and mechanism design in the protocol. Protocols that allow for more open and scale focused innovation and blockchain funding will likely emerge as the winners. Lots of work and research is going into this space. I have written about this briefly here. In the end, the products and services which offer the best user experience will win.
11/ We know the concept of Comparative advantage from economics text books. Simply, it postulates that a country has a comparative advantage if it can produce a given good/service at a lower opportunity cost vs. other countries. How is this valid for protocols/dApps? If basically means that you can have more than one application network for file storage on the same protocol (Ethereum) or built on different protocols (Ethereum and IPFS) and they will compete for the same users. Ultimately, the one which will gain more market share will be one with the best UX, best technical solution and scalability and best incentives for the parties. Some of these factors depend on the underlying protocol. As good as a file storage network can be, it will be crippled if the underlying protocol can’t scale fast enough in order to process all the needed transactions for this application and others. Same with protocol security, number of developers who work on the protocol, miners etc. People can move from one network to another with ease, especially when the networks utilize the same asset (computer storage or bandwidth for example). The coming development of decentralized token exchanges will enable the flow even more.
12/ A crucial difference and advantage of decentralized networks is the concept of forking, i.e. the opportunity to take the existing state, users and history of any open source protocol or application and to replicate it with the goal to make it different/better. Unlike with traditional companies where in order to change something, you need to form a new company and start from scratch with development, product, funding and marketing, forking allows for much faster innovation. As a simple example, imagine the recipe for Coca Cola was open source and everybody could copy it. Most people still drink it because it has the brand loyalty and history. Forking would mean that someone comes, takes the recipe, changes a few things and claims it is better. Ok, that has been tried before even without knowing the exact ingredients or process. In crypto world, you take the whole existing Coke business with its factories, customers, brand and inventory. You copy/paste with a few changes, call it BetterCoke and give everyone who has a bottle of regular Coke one bottle of the new one for free to try out. If you are a shop and have 50 bottles, you get 50 of the new. Then you wait and see what people would prefer with the hope that they will like BetterCoke more and will switch or at least have the new one as well. If nobody likes it, it would quickly die out. Now imagine that anyone can do that and more than once. It allows for the rapid testing and innovation cycles of different models and services. Anything which is harmful to the user, costs more or is less efficient would likely be forked away over time. This puts all kinds of middleman businesses in grave danger unless they can lock in their high value added somehow. But even then, it will probably be a matter of time for a decentralized version to attack any centralized service. The beauty of decentralized networks is that all the data is out there on the public blockchain, ready for anyone to leverage it. This will almost always be better than a corresponding centralized data warehouse.
13/ Who sets the rules in blockchain protocols and how? This is another major difference vs. traditional thinking. In a country, the rules (laws) are set by a government and can be changed over time. With protocols, once the rules are set and the protocol has gained acceptance, it is very hard to change anything. This is why forking has been a major tool for people who wanted different rules for Bitcoin. There are rules as to how major features in the protocol can be changed, but they usually require a vast majority of its users to agree, which proves to be difficult. This is especially true for protocols where a larger number of individual developers are contributing. There are other protocols where the creators have more power vis-a-vis the decisions, because more users believe that whatever they decide is for the best. All of this will be put to the test in the future as these consensus mechanisms evolve and new governance models are tested. What is important here is to understand that the creators of a protocol are like founding fathers of a country. They set the initial rules and the tone of the development and then invite others who share their vision. We have had a few governance models in human history which we have tried because it is really hard to change one. From communism to democracy, authoritarian to libertarian regimes, very few have stuck around and we have 195 sovereign states globally! In crypto world, we will have the opportunity to try out many more models over time and find the one that work for each individual network (a protocol-user-fit). In the physical world, people are often stuck with whatever government comes to power. In crypto, you can fork bad governance away much more easily or you can force changes in a truly decentralized way. This is a big deal.
14/ OK, this is all digital. What about real assets like my house, a factory, a copper mine or a share in a company. These assets are already in the hands of the capital owners. Well, tokens are coming for those too. The tokenization of real assets is still mute as they are regulated, but this may be a major theme into 2018 in the crypto world. Why? Because tokens allow these assets to became programmable. You would be able to make ownership, financing and investing in them a lot more flexible via tokens. It will allow for a similar level of innovation as with native crypto assets. Tokenize a flat, have banks compete what part to finance, sell part to investors, swap tokens in your flat for tokens in a copper mine somewhere else via a decentralized exchange. You get the point. It will take time, but we’ll get there.
15/ All of the above relates to public crypto networks. The blockchain technology can very well be used internally within companies and governments. A number of them are already testing it for various things. Both public and private blockchains will co-exist as both are needed. Public ones to provide the decentralized alternative to governments and big corporations. And private chains in order to try and compete effectively with public ones and regain control. I believe this will be the ultimate test of the current society vs. a new one. I expect that eventually a mix of the two will settle, with heavy battles in between.
16/ Our digital life has already blurred the borders and boundaries of today’s societal and geographical constraints. With the advent of the new decentralized networks, the potential reclassification in society and a resulting change in its structures seems one step closer. No idea whether this is good or bad, but I am certain it is coming.