The Second Wave of Blockchain Innovation

The last months have included intense discussion on the feasibility and desirability of various economic forms of Blockchain innovation, including the ominous title of an article in Techcrunch, “A Bitcoin Battle is Brewing.” Although they contain many of the same principles that made Bitcoin successful, other digital assets have often been criticized and dismissed as “speculative.” However, recent usages of cryptoledger systems (c.f. “appcoins,” cryptoequity, smart contracts) often include substantial technological innovation and can be used to solve long standing problems both in investment and corporate governance.

History

In the mid-90s Nick Szabo, the inventor of smart contracts, noted the many fascinating things that could be done with programmable money. Another one of his best ideas, “Bit gold,” was later implemented as Bitcoin, a distributed network with unique incentivization mechanism for growth. It included a rudimentary scripting language that allowed you to send a unit, a “coin,” to another participant in the network. This was enough for it to rise in value from mere pennies to a high of over $1,000.

In 2013 J.R. Willet drafted “Second Bitcoin Whitepaper” and proposed that the Bitcoin blockchain be extended with more advanced smart contract capability, encoded via metadata. His proposed way to finance the development of this new functionality was to create a new type of token that gave access to these advanced features. This was called the “Master” coin.

J.R. sold $600,000 worth of Mastercoins for Bitcoins in the first ever “crowdsale” in the summer of 2013. By the end of that calendar year, they had appreciated 74x in value. Investors rejoiced. But not all was well in the world of Mastercoin. Instead of full-time developers crunching away in hope of some future event, founders weren’t working full time and most people were employed via “bounties.” All of the best developers interested in the idea were quietly drifting away from the project. These notably included Vitalik Buterin and Adam Krellenstein, both of whom would attempt to solve the same problem in their own way.

In early 2014, Adam Krellenstein, a self taught programmer, created a re-implementation of the Mastercoin idea from scratch. Like Mastercoin, it contained an implementation of certain smart contract ideas, primarily implementations of existing financial tools. This included asset issuance, asset trading, dividends, and betting. It was released as Counterparty and approximately $1.5mm worth of Bitcoin were transferred into this new system.

Around the same time, Vitalik Buterin developed the first proof of concept of Ethereum, an abstraction of the same idea. Instead of programming the specific desired features of smart contracts, Vitalik proposed creating a toolkit that allows anyone to program their own smart contract. While theoretically possible to implement in a similar context on the Bitcoin blockchain, Vitalik believed that there were many other aspects of Blockchain architecture that could be improved, including file storage, clearing times, and proofing against special hardware. Vitalik initiated his own crowdsale to finance this blockchain, which gathered approximately $15mm worth of Bitcoins.

As numerous other projects followed a similar model for funding in 2014, including Counterparty, Maidsafe, Storj, Supernet, Gems, and SWARM, there was a precipitous decline in the value of the progenitor. Mastercoins returned from a peak of almost 100 times return on investment to a price close to the original sale.

This left many with open questions. Might all of these “coins” simply be a large pump and dump? Or was there some tangible lasting value?

Economics of Blockchain Innovation

Students of Warren Buffet and Charlie Munger know that one of the most important aspects of economic development is examining the incentive structures and seeing if they are appropriately aligned for long-term growth. Unfortunately this remains relatively unexplored among the current phase of Blockchain innovation even among the technologically astute.

There are currently a number of incentive structures surrounding blockchain technology and open source software:

(1) Contribute open source code and make money via services (i.e. Peter Todd’s consulting)
(2) Create a new close source software project based on the Bitcoin blockchain with a privately held speculative unit (i.e. legal equity in Coinbase)
(3) Create an new technology set plugged into the Bitcoin blockchain with a privately held speculative unit (i.e. legal equity in Blockstream/Sidechains)
(4) Create an entirely new unit with inherent utility on a new blockchain (BTC in Bitcoin, XRP in Ripple, ETH in Ethereum)
(5) Create an entirely new unit with inherent utility on the Bitcoin blockchain (MSC in Mastercoin, XCP in Counterparty)

For a long time, the primary model of open source software development has been in category one. The software itself is free. Hosting and other services around it are not. People can also build high value applications on top of the open source code, but these are usually closed source. This is the model that Ruby on Rails and other web frameworks have used fairly successfully as Joel Dietz has previously written.

The second model is the typical business model. In this, the structure of legal equity binds both investors and developers to a future value that may not be realized for several years. This typically creates a group of a few people who are highly committed to a particular outcome, but may naturally come into odds. Historically there is also no way to incentivize any of the parties beyond employees and investors that may also have a vested interest in the platform (i.e. power users).

The third model, by which I primarily refer to Sidechains, is still inchoate. In the Sidechains whitepaper it proposes demurrage as a method for incentivizing sidechain development. This seems to promote exactly the opposite set of incentives than what you would want. Effectively this means that assets on the main chain hold their value, while assets on a sidechain gradually decrease in value, while the difference is basically given away to miners. Also, the Sidechains project has no publicly stated business model, which is also a fairly significant concern. Any potential revenue on a service-based business will never be enough for the venture capitalists to get their necessary return, which basically forces them to either create a closed source product or otherwise leverage their position to “gate keep” and charge some sort of toll on network usage.

The fourth model, though strongly disliked by many, is ironically closest to Bitcoin itself. It states fundamentally that there can be a speculative unit with attached technological innovation that is acquired, and by which the speculators will benefit as both utility and network grows. The somewhat unique feature of Ethereum and a few other related projects (e.g. DarkCoin) is that unlike earlier “altcoins,” these new projects do have significant additional utility that is not found on the Bitcoin Blockchain.

Since all such projects extend the core Bitcoin technology with this additional utility, this effectively makes them competitors to the Bitcoin blockchain. Although early adopters and venture capitalist backers of Bitcoin had the hope that the network effects of Bitcoin would make it something like the TCP/IP protocal of internet money, it is entirely possible that some other competitor will surpass it. I suspect that whether or not this is the case will depend highly on whether or not anyone can make comparable utility and innovation compatible with Bitcoin.

This leads to a fifth model that was perhaps under-appreciated until Ethereum came along. This is the possibility that a metacoin, so called because it works via inserting metadata into Bitcoin transactions, could provide much of the increased utility provided via a smart contracting layer without creating its own blockchain.

Both four and five have very similar economic incentive structures. First of all, they are open to all participants and immediately liquid. Because of this it means that they naturally engage much more quickly a wider audience who are also incentivized to spread the word about that network. But, because of the immediate liquidity, there is no necessary long-term engagement. This affects both the development side and investing, and also means that there a fairly strong incentive to drive up the short time value for a project and exit at the peak. This likely results in a greater amount of capital, greater number of participants, with less depth. While potentially appropriate to the Facebook age, it is typically the case that startups require a few number of very intensely committed people due to the often intensely competitive nature of development, the occasional crisises that test resolve of key participants, and the general need for deferred compensation.

An additional problem is that none of these projects have evolved business models independent of the appreciation of their new asset class. All effectively depend on driving up the price by increasing the underlying utility of the unit and size of their related network, something that, while feasible, remains a questionable choice for anything that expects to be around in 5–10 years. Also, it is quite possible that price appreciation in such an asset is limited relative to the benefits traditionally associated with equity (i.e. 1000x returns on a successful software exit from an early investment). Since venture capital is generally structured as taking high rewards for high risk, projects with capped rewards impossible for them to undertake from an investment perspective.

Another very significant drawback is that even where economic incentives maybe aligned, there are basically no accountability structures due to the basically non-existant legal framework for entities receiving this sort of funding. In this case, Counterparty decided not to take funds whatsoever, whereas Ethereum structured their legal documentation to explicitly state that they were promising nothing in return whatsoever.

As Vitalik recently noted, Ethereum also has a problem of having a dual purpose “product” offering and an “investment” offering, something Swarm founder Joel Dietz called misaligned incentives in an early piece on economics of Ethereum. It is problems like these that have probably caused two out of three Counterparty founders to begin working for a private corporation (Overstock), presumably with some additional equity-based incentivization in addition to the base counterparty unit. In this case, the Counterparty ecosystem now has participants both in categories (4) and (2), with potential conflicts of interest between the participants in area (2), but also the possibility for larger ecosystem growth presuming that those conflicts can adequately be mediated.

So far we have only discussed the advantages and disadvantages of existing economic incentive structures. What about the future? What other possibilities can we expect to emerge?

The first “composite” offering has been proposed by Reddit. This is to take an existing equity offering and distribute the benefits downwards to community users via cryptocurrency. This is an incredible opportunity, because it illustrates one of the key benefits of this ‘open’ incentivization model, it actually directly compensates the community members who contribute to network growth.

The other model is Swarm itself, which, due to legal complexities, was deliberately vague about specific utility at the outset of its fundraising period, and instead described more generally the various categories of benefits that could be applied via these technologies (perk distribution, membership, privileged product access, financial rewards).

This was sometimes described as sort of crypto social-contract with the intention of providing as much value as possible to its users as the legal infrastructure was developed in order to do so. Much of this increased value depended on ability to structure agreements via smart contracts, which was a technology that did not even exist in any usable form until one week ago.

The right incentives

It is probably well that we return to Warren Buffet at the end of this, since what we are attempting to do is create the correct incentive structures in place for long-term project success. It is undoubtedly the case that while some projects are helped by the long-term focus of typical investments, the fact that this does not include community participation is a much larger problem that inhibits the success of startups that that have any sort of community involvement.

Bitcoin always contained a very unusual method of incentivizing the growth of its network. Early participants got very substantial rewards. Late participants get considerably less, sometimes nothing. Because this was such a substantial feature of the network’s growth, it has often been called “speculative.” Similarly, these new models of seeding networks have been criticized as overly “speculative.”

“Speculation” in this case is equally a feature in equity-based investment (i.e. the venture capital industry) and other markets, like trading. The difference is that in markets that are immediately liquid speculation is often performed with a short-term time horizon instead of a longer term time-horizon. This increases immediate liquidity, ostensibly benefiting founders in increasing the amount of funds raised. This also introduces a volatile element as stakeholders can join and exit very fluidly. In this case, more funding is not always better, particularly if there is pressure to deliver under an unrealistic timeline. This will cause people to over-hype projects and to prefer marketing to product development.

The 1.0 method of investment also has its flaws. Due to the quirks of the U.S. legal system, equity is only available to people above a certain net worth. This means that there will necessarily be a gap between the investors in a company (who ultimately have legal control), and the users of the product who also have a vested stake in the project. These differences can be especially stark in cases where the community is particularly important. .

The current evolving method of blockchain startup fundraising contains a bit of both elements. At the moment, there are two distinct models. There is the crowdsale model, in which the community is immediately engaged and there may be a near merge of financial supporter and user interests. This model at the moment depends almost entirely on high trust in the founding team, but is evolving other methods of trust.

The second is the ‘giveback’ model. This is what Reddit is doing in “giving back” equity to people from a legal entity to their users via a currency. This is probably ultimately less significant but more secure.

Evolution of Governance

One clear benefit of the equity-based fundraising model is that it comes with an established system of governance. This includes who controls the funds and when and what to do in cases offounder disagreement. When funds are received there are also standard, enforceable contracts in place. Consequently, there is some form of accountability for the people who receive the funds. Although there have been some tweaks on this recently with multisig wallet reception or storage, this area is still quite underdeveloped. The somewhat standard model, initially advocated for by David Johnston in his discussion of decentralized applications is to create a decentralized application that is open source and governed by a non-profit. This non-profit uses a fairly standard method to shape the future of the organization. This was the Mastercoin solution and it also has been adopted by Ethereum in some fashion. Counterparty initially relied on high trust between core team members (Adam, Robby, Evan) and now is transitioning to this same model, except explicitly including industry partners and using proof of stake voting for a community member seat.

Some of the more general possibilities of emendations to standard governance were described in the distributed governance whitepaper (https://github.com/fractastical/distributed-governance/blob/master/whitepaper.md) in early 2014. In particular, it proposed something similar to what Counterparty is now adopting and which Swarm also plans to adopt once its legal structure is more clearly established.

Although these are in an early state, they all illustrate the potential future what is sometimes called the DAO, or Decentralized Autonomous Organization. Most simply, this means that the corporate structure and associated rights are programmed and determined via computer logic, with legal templates as a secondary rather than primary feature.

This is the problem Swarm was created to solve.

Thanks to Adam Krellenstein, Vitalik Buterin, Two Bit Idiot, Jordan Greenhall, William Mougayar and Tak Lo for feedback.

more at www.swarm.fund