The Next Era of Digital Disruption - Part 2

Public Blockchains: Part II

(Any views expressed in the below are the personal views of the author and should not form the basis for making investment decisions, nor be construed as a recommendation or advice to engage in investment transactions.)

This week I’m sharing part II of how I have come to think about the current era of digital disruption that we are in. Part I can be found here in case you missed it. The tl;dr of part I is that Digital Assets or blockchain based technology is the continuation of several decades-long secular technological trends: i) faster and cheaper compute power, ii) the digitization of information, and iii) network economies. In part II, below, I make the case that Digital Assets have catalyzed three revolutions: a) The Savings Revolution: the dematerialization of physical stores of value via bitcoin and the Bitcoin blockchain, b) The Financial Revolution: the dematerialization of traditional financial services via decentralized finance (“deFi”) and smart contracts being built on blockchains like Ethereum , and c) The Digital Network Revolution: the dematerialization of centralized, corporate-owned platforms via interoperable, user-owned decentralized platforms.

What is a blockchain?

To understand what a blockchain is we must first understand the problem it solves. For years, to transfer anything valuable we have depended upon third party intermediaries to act as a medium between us and the party we want to exchange value with. Why? Simply put, trust. Intermediaries prevent the need for us to place trust in another party. The presence of a third-party to establish trust is not necessarily a bad thing. However, intermediaries often create inefficiencies, add cost, and create a single point of failure, each of which can be undesirable. Blockchain technology seeks to solve the problem of trust between parties and remove the need for central intermediaries.

A blockchain is a virtual computer that sits on top of a network of decentralized computers (miners / validators) that can make commitments. The commitments of a blockchain are \ programmable computer code that is accessible to everyone. For the first time, a computer system can run autonomously, self-governed by its own code, instead of by people, so does not rely on the “trustworthiness” of individual participants, organizations, or governments. Trust is generated from the consensus process itself rather than centralized parties. Autonomous computers can be relied on and trusted in ways that human-governed computers can’t.

Public Blockchains Revolutionize Savings, Financial Services, and Digital Networks

Public Blockchains have spawned three separate revolutions: i) a savings revolution, ii) a financial revolution, and iii) a digital network revolution.

1)       The Savings Revolution: the dematerialization of physical stores of value via bitcoin and the Bitcoin blockchain

2)       The Financial Revolution: the dematerialization of traditional financial services via decentralized finance (“deFi”) and smart contracts being built on blockchains like Ethereum

3)       The Digital Network Revolution: the dematerialization of centralized, corporate-owned platforms via interoperable, user-owned decentralized platforms, known as Web3

It is beyond the scope of this piece to go into depth on each of these revolutions. However, the intent is to introduce them and contextualize the scope and magnitude of their potential impact.

The Savings Revolution

Bitcoin, with a capital “B”, is an internet wide distributed ledger, or blockchain that records the ownership of all bitcoin (lowercase "b"). bitcoin is a Digital Asset that is exchanged between two parties with no pre-existing trust. bitcoin the asset moves across the Bitcoin network with each movement permanently recorded on the Bitcoin blockchain. It is outside of the scope of this paper to provide a detailed explanation of bitcoin. What is important to know about bitcoin is that it is a digital bearer instrument that is dematerializing traditional stores of value.  

Arguably, the greatest characteristic of bitcoin is its scarcity. Not only is bitcoin scarce, but unlike gold, it is provably finite. There will only ever be 21 million bitcoins. In contrast, we do not know how much gold exists in the crust of the earth. The quantity of any fiat currency, physical property, or credit instrument, in theory is unlimited and at the whims of individuals or countries that have the power to increase the respective supply. The provably finite nature is a result of the monetary rules being written in code and enforced by a decentralized network of individual computers. It is incredibly hard to change the Bitcoin code and all network participants are incentivized to abide by the monetary rules of the code (i.e., if you are an owner of or participant in the network there is no incentive to increase the supply as it would dilute your ownership of the network). No other asset in the world possesses an immutable monetary policy on the level of bitcoin. There is ~$264T of traditional store of value assets (gold, collectible art, government bonds, cars, collectibles, and real estate). Bitcoin, just as the digital networks that preceded it, will dematerialize these analog stores of value, likely resulting in the best savings mechanism the world has ever seen.

The Financial Revolution

Decentralized finance (“DeFi) is an ecosystem that leverages blockchain technology and smart contracts to provide cheaper, faster, and more equal access to financial services. A smart contract is computer code comprised of rules and conditions under which a good or a service should be transferred. A good mental model for smart contracts is to think of them as vending machines. A vending machine is an analog contract. The user agrees to deposit cash under the implicit promise that the vending machine will deliver the selected good and dispense the change from the purchase, if necessary. The vending machine is a contract with bearer: anybody with money can participate in an exchange with the vendor. Vending machines are "dumb" contracts. Smart contracts allow for programmatic transfer of value. For example, on the Ethereum blockchain I can use computer code to programmatically send you $5 ETH (the Ethereum blockchain currency, like bitcoin on the Bitcoin blockchain) if the date is November 28th, 2021 and your balance is less than $10 ETH. The contract will only execute if the two outlined conditions are met. This is as it completely bypasses the intermediary. Without Ethereum we need an intermediary (bank, venmo, paypal) and we are unable to program conditions for the automatic execution of our agreement. This example may seem trivial; however, the market for digital financial services, or decentralized finance is an 140bn+ market.[1] The amount of value being transacted in DeFi would place the Ethereum blockchain as the 20th largest bank in the world by market cap.

The goal of DeFi is to replace technical bottlenecks and intermediaries with open-source code to transform legacy financial products (borrowing, lending, trading, and market making) into trustless and transparent protocols that run without intermediaries. Relative to Bitcoin, the DeFi asset class is in its infancy. However, the trend and long-term outcome will be similar to the digital revolution – DeFi will dematerialize brick and mortar financial institutions and expand access to financial products globally.

The Digital Network Revolution

Blockchain technology has ushered in a new era of the internet and digital networks, or Web 3. Web 1 (roughly 1990-2005) was about open protocols that were decentralized and community governed. Most of the value was captured by users and builders. Web 2 (roughly 2005-2020) was about siloed, centralized services run by corporations, largely on mobile devices, where most of the value accrued to a handful of companies like Google, Apple, Amazon, and Facebook. Web 3 combines the decentralized, community-governed ethos of Web 1 with the advanced, modern functionality of Web 2. Web 3 leverages Digital Assets to better align network incentives such that the builders and the users can capture majority, if not all, of the value that is created.  

Web 3 is in stark opposition to Web 2, where the business model is centralized and the monetization model, selling ads, comes at the expense of user privacy and is not shared between the user and the contributors of the platform. Early on Web2 platforms do everything they can to recruit users and 3rd-party complements like creators, developers, and businesses. However, at scale and over time, the centralization and monetization incentives of Web 2 create rent seeking behavior and stifles innovation. At scale Web 2 platforms drive growth via extracting data from users and competing with complements (creators, developers, etc), at the expense of users and third parties that build on their platform. In short, the goals of the users and creators diverge from the goals of the platform.

In Web3 ownership and control are decentralized. Digital Assets are used to give the users and the builders of the platform ownership and property rights to what is being built. Today, NFTs or non-fungible tokens are the best example of the power of Web 3. NFTs give users the ability to own objects, which can be art, photos, code, music, text, game objects, credentials, governance rights, access passes, etc. Web 3 will dematerialize corporate owned digital platforms and create an internet of interoperable, user owned platforms.

The “so what?”

The three public blockchain revolutions have attracted the attention, creativity, and capital of the general population, developers / creators, and venture capitalists, respectively. The convergence of public attention, bright technical minds, and capital contribute to the flourishing of Digital Assets’. As awareness increases, more talent is attracted into the industry, which attracts capital, which results in the creation of innovative products and services that increase the utility and general awareness of the technology and in turn attracts additional talent and capital that continue to perpetuate the cycle. The feedback loop and growth of the ecosystem is not new. A similar phenomenon occurred, or arguably is still occurring, during the adoption and development of the internet. The early days of the internet are a great mental model for the current state of the Digital Asset ecosystem. No one knows where the confluence of talent, capital, and technological progress is going to take us, but it is likely to be profound and lead to increased abundance for humanity.

Who did what this week?

Stripe goes web3

Stripe announced this month that it will now support crypto businesses and be able to help with exchanges, fiat on-ramps, wallets, pay-ins, payouts and NFT marketplaces. John Collison, Stripe’s CEO, also mentioned that Stripe will aim to give customers tools and APIs for the purchase and storage of crypto and provide KYC compliance workflow, identity verification and fraud prevention. This is a massive shift from the payment giant’s attitude on crypto prior when it ended Bitcoin support in 2018, and now it is thinking of supporting users to buy 135+ cryptocurrencies with fiat currencies spanning 180 countries.

Goldman Sachs announces milestone OTC crypto trade

Another event that signaled momentum in institutional adoption of cryptocurrency is Goldman’s announcement that it traded a bitcoin-linked instrument called a non-deliverable option with crypto merchant bank Galaxy Digital. This effectively makes Goldman the first major U.S bank to trade crypto over the counter. The trade is a step up from the exchange-based CME Group bitcoin products the firm traded last year. 

ExxonMobil is piloting an on-site crypto mining program powered by excess natural gas from oil wells in North Dakota. A pilot program launched in January 2021 and expanded in July. Link

Qualcomm is launching a $100 million investment fund to support companies building out the metaverse using AR, MR, or VR. AR/VR chips represent 17% of the company's $10.7 billion chip revenue. Link. 

A recent Goldman Sachs survey of 172 clients showed that 60% expect to increase their digital asset holdings in the next 1-2 years with 32% responding they expected to "significantly increase" their crypto holdings. 51% reported already having exposure to crypto, compared to 40% from the previous year. 14% expressed interest in DeFi tokens and 9% were interested in NFTs. Link. 

Treasury Secretary Janet Yellen cautiously acknowledged the benefits of crypto and blockchain tech, saying that "innovation in the payment system can be a healthy thing". She also suggested that Bitcoin and digital assets are not a fad, and that "crypto has obviously grown by leaps and bounds". Yellen has long been a crypto skeptic. CNBC Interview

Florida Governor Ron DeSantis said Florida would accept Bitcoin for state taxes. Link. 

Payments giant Visa has launched an incubator program. to support small businesses who are building with NFTs, commenting that "NFTs represent a new form of e-commerce".

Notable Deal Activity

• Cross River Bank, a "crypto-first" banking company, raised $620 million from Andreessen Horowitz, Eldridge Industries and others.

• Crypto exchange Blockchain.com raised an undisclosed sum at a $14 billion valuation from Lightspeed and others.

• Salad, a compute-sharing network operator planning to support web3 ecosystems, raised $17 million from Left Lane Capital, Origin Ventures and others.