Blockchain applications investment thesis
Emerging from the protocol rabbit hole
The consensus crypto investment thesis that dominated the discourse in 2017 and 2018 was the fat protocol thesis[1]. Essentially the fat protocol thesis states that, contrary to prior generations of the Internet, most value in decentralized systems will be captured at the protocol and not the application level. Unfortunately, many also interpreted this to mean that investing in crypto, or Web 3.0 was somehow fundamentally different from all prior investing. It was not just a new thesis, it was a new paradigm.
With investment focusing on the protocol level a corollary thesis was that the development of applications, and investment into applications, was structurally constrained by the deficiencies in the infrastructure layers — including problems of scalability, interoperability and lack of established standards. This narrative only began to change recently after a post by Dani Grant and Nick Grossman of USV[2], arguing that in fact application and infrastructure protocol development are far more symbiotic.
The protocol thesis shortfall
Our position is far more emphatic. We propose that blockchain, or Web 3.0 applications present a far more appealing investment thesis than has been recognized and one which is not very different from established technology investment. Furthermore, on the flip-side, the protocol investment thesis that has driven much of the infrastructure investment continues to suffer from unresolved deficiencies and inconsistencies which have been wilfully overlooked but acutely need to be addressed by its proponents and practitioners.
Perhaps the biggest shortfall is that the basis of protocol token value and thus valuation remains unresolved. As we noted in the midst of the ICO boom[3], this was a thesis that gathered billions of dollars of committed investment capital, but with no generally accepted framework for analysing and valuing tokens as investments. Now, despite the 70–80%+ collapse in the price of most tokens, core proponents are still not in a position to argue how much cheaper in relation to any underlying value metric these assets have become.
There is an emerging recognition that the correlation between the price of a token and its actual or expected network utility is certainly not straightforward, might not be very strong[4] and might not even be positive. But even this viewpoint is far from generally accepted.
Much of token investing in practice was conflated with trading based on technical analysis. While anything with volatility may be traded, and the trading may even appear meaningful, what got lost is that something has volatility does not mean that it has value. In the midst of the bear market the value question has now become pressing — and a robust answer is probably necessary for the market to recover.
The case for applications
Applications sit at the top of the blockchain protocol stack (already a stack of significant complexity). Applications rely on the infrastructure of underlying protocol layers which form infrastructure, and conversely build value into the stack.
Applications are typically the customer facing layer of the stack; they encapsulate the value proposition for the customer. The value proposition of an infrastructure protocol may be greater, if it is shared or accessed by multiple applications. But in so far as the protocol does not represent a client facing application, the protocol value proposition is inherently dependent on the value of the applications on top.
Some applications may be structured as protocols (e.g. Augur), but most applications a) do not need or support a decentralized token logic; and b) focusing on the protocol engineering detracts attention from maximizing customer utility, including care for components such as the UI or UX. The choice of monetization logic has significant consequences for service design, and the focus on tokens has arguably suboptimized many value propositions to customers[5].
The value of a smart-contract platform, such as Ethereum, is dependent on the volume of smart contracts being transacted. But smart contracts do not exist in the abstract. Instead, they relate to specific use cases and need to interface with a number of real-world parties related to the use case (including those that verify identity, or contract state or provide for adjudication). The ventures that apply smart-contracts to specific use cases are application layer businesses; the state engine that enable the smart contracts is an infrastructure protocol.
The scalability of application layer ventures may not match the scalability of the underlying protocols. But again, the value of the latter is fully dependent on the success of the former. Furthermore, the ability of application business to build economic moats may be higher than that of the underlying protocols. That is the network effects and switching costs that a customer-facing enterprise is able to engineer through resolving specificity may be significantly superior to those of the underlying smart contract platform, which is likely to focus on universality.
From an investment perspective, investing in the primary layer of value capture is attractive, even if the protocol value proposition may be more scalable. It is attractive because of the visibility of the value proposition, and because the direct customer interface allows dynamic shaping of the value proposition. It allows for the creation of maximum contextual value.
Recapping the investment proposition
The fundamental economic or investment attraction of decentralized systems is twofold. Firstly, these systems are potentially very good at resolving coordination costs in a novel way[6]; economic development in the past decade has clearly demonstrated that resolving coordination costs is significantly more valuable than resolving production costs (which most of the world still focuses on). Secondly, eliminating centralized intermediaries leads to a new distribution of economic value, which is likely to benefit new emerging actors.
In this second respect there remains a valid question that even if disintermediation of centralized structures leads to a new distribution of economic value, it is not all obvious where the value accrues to, and where, if anywhere, will there be potential to exercise value capture.
This is a key point, as it is the principle of value capture that has been most diverted with the focus on the fat protocol thesis and the enthusiasm for protocol tokens.
To cut to the bone of the current thesis, the proposition has been that by introducing the protocol token as the unit of exchange, unit of account and store of value in a micro-economic system, the aggregate monetary value of the tokens (M) is equal to the value of the economic activity in the system (P*Q) divided by the frequency (V) that the tokens change hands. Therefore, it is suggested that M = PQ/V.
This approach is highly dependent on the assumed monetary velocity (V), which in a transaction network not only may be high, but it is economically rational to expect it to be very high. If V is a very large number then monetary capitalization becomes a small fraction of economic activity. On the other hand, if the system is engineered (artificially or otherwise) to lead to a low monetary velocity, it is likely to lead to lower economic activity in the system (a lower Q).
Furthermore, can the system sustainably price in its unit of account, or will pricing be set in an external currency? Or what of the latent inflationary effects (debasing the value proposition) from any token stores held in a monetization reserve?
With the market diving down the token rabbit-hole, there has been a fundamentally false consensus assumption that decentralized economic structures need to have value capture structured around native tokens. Given our fundamental proposition that value is created by improved resolution of coordination costs and further disintermediating of transaction and information intermediaries, there is no inherent linkage that this must be monetized through protocols and/or tokens. Belief in that linkage is an ideological thesis which has cost significant numbers of investors significant amounts of money.
Capturing the investment proposition
Applications sitting at the top of the stack have a significantly simpler value proposition. Application value is based on utility to users modulated by the ability of the application to monetize this. The investment thesis becomes one of estimating the utility value, the number of addressable users, and the monetization ability of the application. Again, the utility is not fully independent of the monetization mechanism, and certainly the latter impacts the evolution of the former.
Nevertheless, the essential point is that applications in decentralized systems can, or often should, deploy value capture that is not so different from traditional models; the method of value capture impacts the value proposition and should primarily be set so that it does not impair it. And, as with many things, if excess complexity is distilled away the underlying focus can remain on the economic value being created as a function of decentralization.
Certain investment principles remain
A commercial organization should have an earnings logic to it, and this logic needs to be structured in a manner that allows the deploying of capital for the deployment of the organization. A protocol is not equivalent to an organization and deploying a protocol is not equivalent to deploying an organization. Protocols are limited by the states they are able to cover. There is a common (false) assumption in the crypto community of protocols and contracts being complete (“code is law”). In practice potential states are generally infinite, contracts are always incomplete, and circumstances will arise that were not accounted for in the protocol algorithm.
Applications, even decentralized ones, are typically developed by a core team of founders, which seeks to incentivize itself and extract value in fungible form. As a precondition of investor participation we believe there are certain fundamental requirements or principles:
1. to be economically aligned with the interests of founding teams, and in a position to keep team members accountable;
2. to have appropriate rights related to ownership, disclosure and governance;
3. to have parity with other investors, as well as customary minority protections.
Historically these principles have been well codified into an instrument that is generally called equity. One of the prospects of the new technology is that these same principles can be recoded into a tokenized security (aka. security token), that would be more customizable, cheaper to implement and with higher inherent liquidity.
The tokenizing of assets promises new opportunities for significant financial engineering, including new capital fractioning, new structuring of cash flows and liabilities, new liens on assets and higher transparency and liquidity for all the components. This potential is thoroughly disruptive to the existing financial industry and set to radically improve access to financial services. But it does not follow that the rules, regulations and investor protections that have been established over time should not apply to the new instruments or the new players[7].
Complexity in the context of the stack
A Web 2.0 platform (e.g. AirBnB) performs significant economic disintermediation, most notably separating asset ownership from asset use and resolving scarcity through restructuring access. However, platforms themselves are highly centralized systems, that provide an extensive and often complex stack of services that underpin the core application, and which typically include proprietary elements (think Google Play)
In a decentralized system the same services need to be replicated and the current expectation is that the stack will be made up of a number of independent but open layers, each named a protocol, and each interfacing with adjacent layers[8].
Assuming that these layers remain open and retain interoperability is inherently linked to assumption that their primary means of attempted value capture will likely be via a native protocol token. This of course involves all of the previously discussed complexities of tokenomics.
On the other hand, we see that applications that reference a clear value proposition to users may deploy more traditional monetization mechanisms. It is not necessary that this would lead them to compromise on openness, or interoperability. However, it is worth acknowledging the dilemma that value maximization for networks (applying Metcalfe’s law) often incentivizes to limit openness at a certain point of growth — limiting interoperability can allow for rent seeking and for limiting churn[9].
From an investment standpoint we do not (yet) recognize this as a problem. However, it is an inherent dynamic that may disrupt and limit the growth of the overall system.
The blockchain / crypto technology stack
End notes
Economic decentralization and applications that leverage decentralization is not exclusively, or even primarily a consumer focused field. On the contrary, the benefits in an enterprise context are often just as significant and potentially easier to determine. In the enterprise context however, it becomes generally necessary to interface the new decentralized economics with existing real-world structures.
This is natural given the need of most enterprises to search for evolutionary solutions, rather than disruptive change. The corollary of course is that enterprises which focus on protecting their legacy structures leave open the opportunity for startups to re-think and revolutionize the value proposition to customers. From the standpoint of committing investment capital, both the evolutionary and revolutionary approach present interesting and valid opportunities, though with very different risk profiles.
Engineering for both approaches requires appreciating complexity, and allowing that the systems that handle that complexity are likely to include also non-digital and centralized intermediaries.
Luckily the blockchain and crypto world is adapting. There now seems to be a new breed of realism both on the side of entrepreneurs building applications, as well as investors assessing such ventures. At the same time, the US$15bn (+/-) of capital that has been raised in protocol investments is continuing to fund substantial technology and infrastructure development.
From an investment standpoint, the core thesis of value creation remains sound. To make it work, there just needs to be a renewed focus on the fundamentals: the value proposition, the utility to users, the monetization and established terms of investment. A pull back from the infatuation with fat protocols, and processing the ICO hangover it induced, is a part of the process which will make the ensuing investment market all the more promising[10].
[1] See http://www.usv.com/blog/fat-protocols
[2] See https://www.usv.com/blog/the-myth-of-the-infrastructure-phase
[3] See https://medium.com/@sasuristimaki/tokenomics-the-shortfall-of-the-protocol-investment-thesis-4abee5c2c850
[4] See https://www.coindesk.com/gas-aint-gold-why-ethers-price-could-tank-even-if-ethereum-succeeds?utm_campaign=Satoshi%26Co%20Daily%20Crypto%20Newsletter&utm_medium=email&utm_source=Revue%20newsletter
[5] To illustrate the importance of choice of monetization method, social media would likely be structured very differently given subscription rather than advertising based monetization.
[6] Whilst this is an observable fact, the underlying modelling would certainly warrant more research. Our hypothesis is that a significant part of this is due to the decentralized information structure itself.
[7] See https://medium.com/@sasuristimaki/understanding-token-regulation-in-context-and-why-dual-token-structures-may-become-standard-f6814ce704a8
[8] Some refer to this as the thin protocol thesis.
[9] Limiting openness is not exclusively related to applications, but the incentive structure for infrastructure layer services is different and may defer the incentives to close off interfaces.
[10] Final thanks and credits to Joonas Järvinen of Prasos Asset Management for key comments and contributions. All views and errors however are solely the author’s.
