Opinions and analyses

12 February 2018

A Thematic Approach to Blockchain Investing

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Anybody (especially me) trying to break down blockchain investing into a rubric of any kind would be treading on thin ice; this is a complex ecosystem and that is rapidly evolving and I do not think anybody has a complete and well-informed view at once. But this post reflects my current thinking and I am constantly meeting amazing entrepreneurs, technologists, and visionaries that help me evolve my view frequently.

Anybody (especially me) trying to break down blockchain investing into a rubric of any kind would be treading on thin ice; this is a complex ecosystem and that is rapidly evolving and I do not think anybody has complete and well-informed view at once. But this post reflects my current thinking and I am constantly meeting amazing entrepreneurs, technologists, and visionaries that help me evolve my view frequently.

Applications

The top layer in my framework is the most familiar to technology investors since traditional startup investing screens apply pretty well here: teams, product, market, and business-model. The first two cannot be generalized, but the last two can.

Market focus tends to usually be one of three that we know well:

  • Enterprise: moving transactional or operational functions of the enterprise to the blockchain, both for internal and external processes, primarily via private or hybrid (permissioned) blockchains. There are some examples in Financial Services and Government here
  • Consumer: almost anything that can be consumed by an individual (musicvideosgamblingland titlesbanking, and to nobody’s surprise, “escort services” too) has now been put on a blockchain
  • Infrastructure: tends to apply equally to both enterprises and consumers, by providing infrastructure used by either/both (storageidentitypayments, etc.)

Business models are a harder aspect of approaching opportunities because in this domain, they are usually untested and radical in their approach. All blockchain apps (should) try to be decentralized and trustless (hence generally called dapps for decentralized apps). That in and of itself is not what defines “disruptive” but the kind of impact they create is. This can usually be classified as one of three.

  • Transformative: are they rewiring an existing use-case or ecosystem? rewriting the rules perhaps? I have seen a number of sharing economy transformation ideas (Uber?) on the blockchain where key impediments are no longer meaningful: “are suppliers employees or contractors” or “platform commissions are a drag”.
  • Creative: are they doing what was previously not possible? Imagine a lender in negative-interest rate countries like Japan lending to a someone in a high-interest rate country like India (cross-border lending), or a network of bots that transact with each other while still maintaining the security and immutability of every transaction (Botchain).
  • Destructive: there exist rent collecting monopolies and oligopolies at the center of many global transaction flows and these are being assailed by blockchain startups: card associations like Mastercard/Visa (Ripple), remittance gateways like SWIFT (Circle), credit bureaus (Bloom), etc.

There are many considerations tied to the business model:

  • how does the token economy work? how is the initial pool of tokens being allocated?
  • why will the value of tokens go up (if indeed that is how value is returned to investors)?
  • why would miners/minters bother with creating blocks for this dapp instead of others.

This takes some serious spreadsheet work beyond meeting the team and working through the higher level business model questions.

Protocols

As much as popular attention is focused on Bitcoin it is best to think of this cryptocurrency as an application that stores value running on top of the Bitcoin protocol. But the original blockchain protocol did not meet the needs of other applications that needed to exchange more than a single stored value for data. New protocols emerged to meet those needs. As applications get more sophisticated, the need for evolution of protocols increases and this creates some of most exciting investment opportunities at this time.

Perhaps the best known evolutionary protocol value creation to date was the genesis of Ethereum (see Smart Contracts below) but there have been a number of other new protocols created like TenderMintRipple, and HyperLedger (a larger compilation here).

Consensus: The process by which new blocks are added to a blockchain requires all participants to agree on a consensus protocol. While Bitcoin introduced the concept of “proof of work” and others like Ethereum have adopted it as well — the technique has been criticized for being wasteful of resources and for constrained transaction throughputs ( ~7 per second for BTC and ~20 per second for ETH ). Even after blocks are created, the changes to the ledger need to propagate and the blockchain needs to reorganize which can take a while (on the order of hours) — leading to unreasonably delayed settlements in transactions. These shortcomings (and others) are being addressed by some exciting new protocols.

Heritage: While Bitcoin itself has evolved into a couple of variants, the limitations of storing only a piece of data (value) led others to build new protocols which also support so called “smart contracts”: the storage of blocks of code on the blockchain which can execute themselves (securely) when associated data meets certain conditions. Unlike previous generations of computing protocols like HTTP and SMTP that merely transmitted data from point to point, these new protocols also carry chunks of software associated with the data being transmitted and are hence called “fat”. A lot of the excitement around Ethereum is based on smart contracts.

But another significant contribution from the Ethereum community has been the ERC20 specification which standardizes the way smart contracts are implemented. Most new protocols are compliant with this specification which allows applications to interoperate and for developers to gain generic skills that translate well from application to application. At its most basic level, ERC20 allows exchanges and wallets to work with any of these new applications that adhere to the standard.

Trust: Blockchain purists value “trustless” networks — the absense of a trusted third party to facilitate transactions” which is made possible by technologically establishing trust. Protocols are evolving to establish technological trust at three levels:

  • Cryptographic Identities and Verification: all aspects of the blockchain use robust cryptographic techniques to verify identities, secure and authenticate messages, create and validate new blocks, and hence confirm transactions (rendering them immutable)
  • Sofware Code: Most block-chain software is available as open source which enhances trust in the protocol via peer review and verification; and when a protocol is hacked, it evolves towards a secure version of itself
  • Counterparty Contracts: Protocols implement self-fulfilling contracts with payments placed in “escrow”, so any counterparties to a transaction can be assured that value will be exchanged for a service/product as expected

Permission: Early blockchains evolved to be “public” — anybody could join them. Over time use cases evolved (especially within enterprises) to limit access to some blockchains, which gave rise to so called “private” blockchains. Protocols have since then evolved to be “permissioned” — that is anybody with the right credentials can join the network, which is a hybrid between private and public chains.

There is a lot of movement and evolution currently underway in the protocol layer. One of the strengths of the blockchain community is its ability to police itself; several new proposed protocols have been exposed for having security and logical vulnerabilities. The same community also fosters fervent debateabout proposed changes to protocols.

All the protocol debates can create friction, but I believe at this point in time, this is where most value is being created in the ecosystem, and informed investors can probably find the next Ethereum.

Infrastructure

Some of us love the picks-and-shovels aspect of any new technology boom. And there is enough of that around the blockchain as well. In addition to the tech giants playing in this space (see Retail Investors section above), several startups are coming up with specialized versions of technology to make development, deployment, monitoring and monetization of block chains easier. Couple of examples:

  • Adjoint for RAD tools targeted at the financial services sector. Their open source framework called Uplink allows companies in the sector to build blockchain apps with minimal lines of code — as a lot of business logic and smart contract primitives are built in
  • Antpool is a mining IaaS platform that has custom hardware and the protocol stack to support the mining of multiple cryptocurrencies. I foresee similar platforms to support mining of application tokens as that market stabilizes

Each of us will have to figure out what part of the stack we are most comfortable investing in, and when. And we all have to do the work we usually do (find the opportunities, apply the usual rigor), but then we also have to map them against a fast evolving frame-of-reference.

 

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