Part 2 of the 4-part series “How to Think About Investing In Cryptocurrency” starts exploring the economic forces that will drive market segmentation to help us identify the future industry leaders. It’s best to start by asking, what needs to exist? What services does the world need that can best be provided by a public blockchain?

First, let me try to convince you that cryptoccurency isn’t “winner take all”, although some specific niches within the crypto world probably are. Imagine if Uber tried to offer term life insurance? Imagine if Lloyd’s of London tried to sell virtual reality headsets? Imagine if McDonald’s tried to offer a 12-course $400 dinner with wine pairing? Imagine if Nordstrom tried to compete with Walmart with rock bottom pricing?

Some business models are natural fits for particular products. People want to buy their insurance from stable, long-lived, boring companies. And the companies best suited to compete on cutting edge technology offerings are generally smaller, leaner, and have an ethos of “move fast and break things.” IBM is a good example of a huge stable company that appears superficially to be a tech business, but really is a consulting firm that just happens to consult on tech. Similarly, Apple used to be a nimble tech innovator, but is now a consumer brand company, more comparable to something like Coca-Cola. The winning cryptocurrency in a niche will usually not be decided predominantly based on marginal technological differences relative to competitors. Launching a new cryptocurrency that aims to copy a market leader with a slight improvement is kind of like saying I’m going to create a product to compete with the Iphone with a better camera, or that I’m going to launch a competitor to Coca-Cola that tastes the same but with 10% fewer calories. I’m unlikely to get very far because the specs and price are just one small part of their success.

Turning back to cryptocurrency, there’s a critical idea that’s often overlooked: the role of community. In cryptocurrencies, governance is driven by that cryptocurrency’s community (developers, miners/stakers, users, service providers, etc). There’s often a positive feedback loop that makes the community more homogenous over time. Consider Ethereum’s hard fork after the DAO bug was exploited. Many of the community members (holders of ether, miners, developers) who strongly opposed the fork abandoned the ETH chain. Alternatively, people who liked the philosophy that led to the hard fork were attracted to the ETH chain. The result was that the community post-fork was substantially more homogenous than the community pre-fork. The community is often a key feature of a cryptocurrency because it contributes to governance via game theory. While the community can certainly change over time, it needs to be thought of as a core part of how a cryptocurrency functions, almost on par with the scripting language. To put it simply — the community makeup of a cryptocurrency directly influences how that cryptocurrency behaves. Cryptocurrencies are differentiated not only by their code, but also by their communities.

Bitcoin has a community that is mostly committed to stability. To the majority of Bitcoin users and developers, Bitcoin is IBM, it’s Lloyd’s of London. This makes technical innovation at the protocol layer very difficult in Bitcoin, but also lends it a great deal of stability. By “stability”, I don’t mean price stability, but rather protocol stability. If I buy 1 bitcoin today, I can be fairly confident that in 5 years I’ll own pretty much the same thing. In contrast, the Ethereum community has adopted a “move fast and break things” mentality. Ethereum is Uber, it’s Facebook 10 years ago. This community facilitates breakneck technological progress, but increases the risk of bugs, and makes it impossible to know what ownership of 1 ether will mean in 5 years.

We see a similar dichotomy in the protocols themselves. Bitcoin has a very simple scripting language which makes it difficult to build new features, but also relatively easy to avoid devastating bugs. In contrast, Ethereum has a complex Turing complete language which lets it do pretty much anything, but greatly increases the chance of serious error.

I don’t view one of these communities or scripting languages as superior to the other. Rather, each is optimized to fulfill a particular need.

What does the world need?

The world needs “digital gold” — an unseizable store of value, with great liquidity, a high market capitalization, stable protocol, and great security. While it would be nice if the cryptocurrency that filled this niche also had a quick confirmation and low fee, those things are not core to the value proposition, and those factors are unlikely to determine which cryptocurrency dominates this niche. I think this niche is likely “winner take all.”

The world also needs cheap, fast, and private, monetary transmission. Much of the infighting in the Bitcoin community today stems from the growing realization that it might not be possible to optimize a single cryptocurrency for both the “digital gold” and “monetary transmission” niche. For Bitcoin to do both well will probably require a secondary layer like the Lightning Network. Alternatively, the “monetary transmission” niche may be best served by an entirely separate cryptocurrency that may eventually be made interoperable with Bitcoin via parachains. Cryptocurrencies like Monero, Litecoin, Dash, and Zcash are primarily competing for the “monetary transmission” niche. For this niche, security is less important than speed and cost. I don’t need $1 billion worth of security if I’m only paying an $80 restaurant bill. Because there are different levels of security demanded for different transactions, this may not be a “winner take all” niche. I can imagine a scenario where there are 3+ cryptocurrencies providing varying combinations of speed-security-cost-anonymity for monetary transmission. For example, Zcash offers the best anonymity, but relatively slow execution if you’re on a smartphone since the algorithm is so intensive — this might be a welcome tradeoff for some uses, but highly inefficient for others.

The world needs a platform for decentralized applications (dApps). The cryptocurrency to provide that platform has to have a complex and evolving scripting language, and a community that embraces constant innovation (at least for the next few years until the technology is more mature). This is such a new area that I find it impossible to predict if the equilibrium is one dominant platform or multiple competing platforms with different network architectures and communities.

So far I’ve only explained why Bitcoin and Ethereum are the two biggest cryptocurrencies by market capitalization by far. I can’t say if Bitcoin and Ethereum will remain the dominant players in their respective niches forever, but if they get replaced, it will probably be by something that looks very similar to the incumbent in terms of both the code and the community.

What *else* does the world need? That will be the topic for Part 3.

Ari Paul

Written by

Ari Paul

Co-founder and CIO of BlockTower Capital.

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