Crypto Network Fundamentals

Crypto networks are my catch-all name for everything surrounding an individual cryptocurrency (i.e. the technology, community, developers, etc.)

1) Introducing the Crypto Network

Crypto networks have taken the world by storm. The vast majority of people don’t understand what is happening, and have rushed to describe the phenomenon as a “bubble”. They are partly right; there are some very clear signs of speculative excess in the crypto space. But this is missing the far deeper point. Crypto networks represent a fundamental change in the way society transacts, organizes, and works with each other.

Many of the largest technology companies in the world over the last ten years have been technology platforms. This type of business model typically involves setting up an online exchange for buyers to interact with sellers. The company then acts as the intermediary, and charges a transaction fee.

For example:

• Facebook/Instagram/Twitter: Platforms for users to exchange content amongst each other. Transaction fees come in the form of ads.
• Uber/Lyft: Platforms for users to buy transportation from amateur drivers. Transaction fees come in the form of a commission.
• AirBnB: Platform for users to buy hospitality services from other users. Transaction fees come in the form of a commission.

This type of business model create huge network effects that protect them from competition. These barriers allow these firms to generate large profit margins, and public markets have responded by valuing them at far higher multiples than other business types:

However, there is a fundamental problem with the business model. Platform owners are for-profit companies that can only generate revenue by reducing the utility of the platform to its users (in the form of transaction fees). This creates a severe misalignment of incentives between the platform users and platform owners.

Crypto networks are similar to platform companies. But rather than having a central owner that coordinates activity between users, they are decentralized systems that are coordinated by an underlying blockchain-based crypto asset (i.e. the cryptocurrency). This currency acts as the incentive mechanism to ensure that all stakeholders work towards the success of the network.

This system has a number of advantages. First, it solves the mis-alignment problem by decentralizing ownership among its users. Second, because users have their net worth (and therefore, to a certain extent, their self-worth) tied up in the network, they often have extreme levels of loyalty to its success. This can lead to rapid viral growth as users evangelize others to join. Lastly, because of their unique structure, new types of decentralized business models we can’t even imagine suddenly become possible.

2) Crypto Network Economics

Crypto networks can each be thought of as their own enclosed economy with their own unique incentive systems, governance mechanisms, and monetary policies.

In a real-world economy, we measure economic activity using gross domestic product (GDP). GDP is the sum total of all goods and services produced in an economy. Using the expenditure approach, it is measured by summing the total amount spent by all ultimate or final consumers of products and services. The higher the expenditure (i.e. transaction) volume, the larger the economy.

The process of measuring economic activity is similar for a crypto network. The only difference is that all transactions happening in a crypto network are recorded on a transparent, shared public database (i.e. blockchain).

Transactions are simple to understand — there are buyers provisioning money to sellers in return for a good or service. In traditional economies, the scope of products or service offered is vast. In contrast, the product or service provisioned by crypto networks can be much more narrow in focus, and is highly dependent on the focus of the network.

For example, in the Golem crypto asset network, participants use the GNT cryptocurrency to buy cloud computation resources from each other. This is in contrast to the bitcoin crypto network, where some of the initial ideas were to have every product and service in society offered/denominated in bitcoin (though the network seems to have narrowed its focus to provisioning a store of value outside of state control).

3) The Three Core Forces of Crypto Networks

Economic textbooks teach us that real world economies are driven by three forces: long-term aggregate supply, short-term supply, and short-term aggregate demand.

This is roughly analogous in crypto networks, which we believe are also driven by three core forces. The three main forces that drive crypto network activity are:

1. Long-term Technology Utility Trend (Years)
2. Intermediate-term Ecosystem Growth (Months)
3. Short-term Market Prices (Days)

Each of these forces work in different timeframes and evolve differently as time passes. The technology utility of a crypto network tends to increase in a linear fashion over time, as improving the codebase is a highly manual process typically done by a core team of trusted developers. The ecosystem of a crypto network evolves in an exponential fashion, with a very small initial group of enthusiastic early adopters evangelizing the network to broader society, often in a viral fashion. Finally, market prices fluctuate hour-to-hour based on the emotional sentiment of the investor community.

These three forces are sketched out below:

The following sections will analyze each of these core forces in more detail, showing the factors to consider when evaluating the strength of each.

4) Technological Utility

In the long-run, the vast majority of all activity on a crypto network is dependent on the underlying technological utility of its protocol. Technological utility represents the different economically valuable activities that users can perform on the network. A crypto network with high technological utility will see increased activity on its network over time relative to a crypto network with low utility. Similarly, a crypto network that can improve its technological utility faster than other networks will also see more activity on its network.

It is extremely difficult to quantitatively compare technological utility across different crypto networks. Crypto networks are typically open-source software, so one way to gauge utility (albeit crudely) is to measure the amount of development activity on a network’s Github repositories. In this way, crypto networks with more development activity could be used as a rough approximation of technological utility. This is crude as it solely measures development quantity, rather than quality, although it at least does so in an objective and consistent manner.

The chart below shows the cumulative number of “commits” (i.e submitted changes) to the bitcoin codebase over time:

As we can see from the chart, technological utility (as measured by commits) has progressed fairly consistently upward over time for bitcoin as developers continually improved the underlying protocol of the network. While this measure is a crude approximation of true technological utility, the principle holds that in a well-functioning crypto network, the underlying protocol will continually improve over time.

The difficulty of objectively measuring technological utility means that expert subjective assessments of the technology are crucial. This is a highly manual process of diligently reading white papers and testing source code, requiring a deep expertise of cryptography, blockchain engineering, and game theoretic methods.

When analyzing a crypto network’s technological utility, there are three broad factors that determine its value:

i) Flexibility — The types of activities that are enabled on the network

ii) Scalability — The transaction throughput of the network

iii) Security — The security of the network

The most valuable protocols are ones that have the most flexibility in the types of activities they support, have the largest scalability, and are the most secure. Of these three features, flexibility is the most important, followed by security and then scalability. There is often a trade-off between these three characteristics. For example, increasing scalability often comes at the expense of security through increased centralization risk.

The flexibility characteristic is our catchall term for everything that a crypto protocol enables stakeholders to do with the technology. It is vitally important to the network’s success as it determines the scope of different use cases for the underlying currency and the potential audience size. It is also the core factor differentiating the network from competitors. Flexibility is determined by the different types of transactions that are possible on the network.

For example, the Ethereum crypto network has built a distributed computer called the Ethereum Virtual Machine (EVM) into their underlying blockchain. The EVM makes it possible for users to create their own customized transactions (“smart contracts”) that are self-executed by the network. The applications for this technology are endless, creating an enormous amount of end use cases for the technology and the crypto asset (i.e. ether) behind it.

Some of the more common features enabled by crypto protocols:

• Wallets
• Private transactions
• Decentralized exchange
• Side chains
• Smart contracts

Crypto network scalability can be thought of as the potential GDP of the network. We measure economic activity in terms of transaction volume (in both the real-world and crypto network economy), and transaction throughput represents the upper limit on this. It is possible for overall volume to continue increasing after transaction limits have been hit, as average transaction sizes can increase.

This is not sustainable in the long-term though, as the competition to be included in a block leads to increasing transaction fees. As transaction fees increase, wallets become “stranded” in that the transaction fees are greater than the amount in the wallet. For example, if the minimum transaction fee to send bitcoin gets to 0.1 BTC, then any wallet with less than that amount will be unable to spend, effectively becoming frozen. Extrapolate this trend further, and eventually only a select few are even able to use the currency, decreasing community support.

Lastly, the security of the network is also extremely important, and is comprised of two main risk factors. The first risk is related to the underlying technology of the crypto network. The consensus mechanism utilized to secure the blockchain must keep the network secure from malicious attacks and prevent transactions from being “double-spent”.

The second risk is political, and relates to the degree that the network relies on centralization to function. For example, the bitcoin network uses the SHA256 algorithm to secure its proof-of-work (PoW) based blockchain. The problem is that specially designed chips called ASICs can be used to gain a huge computational advantage on other miners, effectively rendering small miners unprofitable. ASICs are expensive, which, when combined with the high electricity costs associated with PoW mining, means that the security of the bitcoin network has become extremely centralized.

Technological Utility Growth

There are three factors that determine how fast the technological utility of the network protocol will grow over time:

i) Governance efficiency — System for development decisions

ii) Active development team — People that are actively paid to work

iii) Developer community — The surrounding open source community

Crypto networks with large, well-funded, high-quality development teams and efficient governance systems will improve their technological utility faster relative to other crypto networks. On average, we believe active development teams are likely to add more value than passive developers as they have direct incentives to work on the protocol.

Governance efficiency is difficult to quantify. There’s the same balance between decentralization and decision-making speed prevalent in country political systems. Decentralization is a benefit as it prevents the leaders of the network from acting in their own personal best interests over the best interests of the network. On the other hand, too much decentralization can lead to “leaderless” networks with no ability to agree on even simple changes to the protocol.

Crypto networks that build on-chain governance systems that incentivize stakeholders to quickly come to consensus on network decisions will likely outperform networks that have little formal governance systems. Typically, these types of networks utilize an on-chain voting system (in which the number of votes is equal to the amount of each user’s tokens) to come to consensus on which network upgrades to implement.

For example, in the Dash crypto network, 10% of miner revenue is allocated to a special fund controlled by master nodes (users that own 1000 DASH and run a special service nodes). The network then utilizes a decentralized governance and budgeting system in which users can submit proposals to help the network, and which the master nodes can then vote on.

Looking at a screenshot of this system below, we can see that a user named “Hando” submitted a proposal to run a Dash marketing campaign in Estonia. The user requested 21 DASH ($25k) of the monthly budget of 6,651 DASH (~$8 million). As this user brings more users to the Dash network, the value of the DASH currency increases, increasing the monthly budget and allowing for even more marketing campaigns and development proposals to be funded.

The active development team will be the most important factor driving the technological utility of the platform. Key factors to look at are each team member’s past experience, the size of the team, and the amount of funding they have secured.

Lastly, the surrounding open source community around a crypto network can dramatically accelerate the technology’s utility as it enables far more human capital to help develop it. Crypto networks that have open source codebases and position themselves ideologically with the OSS ethos will attract more of this human capital, and accelerate faster. This was huge problem for the Ripple crypto network when it first started, as they belatedly made their code open source, attracting widespread developer criticism and leading to a 75% decrease in the price.

5) Ecosystem Growth

The economic activity of a crypto network is determined by the size of its underlying community, because at the end of the day, the technology is useless if there is no one using it. The size of the community is what separates crypto networks from each other. Anybody can go clone the source code of bitcoin and launch their own copycat version, but no one will ascribe any value to that crypto asset if there isn’t a community backing it.

Crypto networks have the same economics as any technology platform, in that the utility of the network grows exponentially as more users join. This is similar to Metcalfe’s law, which states that the value of a communications network is proportional to the square of the number of connected users of the system:

Source

Crypto networks function in a similar fashion, because as the user base of a network grows, the number of economic links between users increases exponentially.

The ecosystem of the network is comprised of four main communities, each of which are incentivized by different factors and add value in unique ways:

i) User community — Incentivized by utility & ownership stake.
Core users generate the bulk of real economic activity and incentivize other communities to join.

ii) Developer community — Incentivized by utility & reputation.
Developers build directly on the underlying technology or additional applications surrounding the network, increasing its technological utility and facilitating broader network adoption.

iii) Mining community — Incentivized by short-term mining profit.
Miners maintain the network’s technology, ensuring security and transaction throughput.

iv) Investor community — Incentivized by short-term price returns.
Investors don’t generate real network economic activity, but do provide liquidity, funding, and incentivize others to join. They can also transition to becoming long-term core users.

Each of these four communities is crucial to the success of a crypto network. Depending on the degree of centralization and the lifecycle phase the crypto network, some communities may be more important to the success of the network than others.

For example, in a highly centralized crypto network like Ripple, investor communities are less important to the network’s success. This is because the currency is backed by a well-funded company that is able to support development efforts irrespective of the market price. The opposite would be true for an extremely immature crypto network (such as an ICO), as the size of the investor community determines the amount of funding they receive and the size of their initial user base.

There are also three sub-communities that aren’t necessarily involved in every crypto network but can play a crucial role and/or provide valuable support functions:

i) Exchange support — Incentivized by trading volume.
Increases network adoption and liquidity for the asset (see price of Bitcoin Cash when it was added to Coinbase).

ii) Business support — Incentivized by # of users / technological flexibility.
Can significantly increase network economic activity and network adoption.

iii) Regulator support — Incentivized by consumer/investor protection.
Potential to impact adoption of network both positively or negatively.

iv) Venture capital support — Incentivized by short-term profit.

These sub-communities aren’t necessary, but can accelerate the adoption of a crypto network. For example, a crypto network’s asset price will often increase significantly when it gains entry onto a major exchange, as it opens the asset up to an entirely new pool of investors and users.

Business support can accelerate adoption as well, as they can drive significant new economic activity onto the network and bring new users. For example, Apple recently approved Dash as an official digital currency, allowing it to be integrated into any iOS application on the Apple Store. This opens the currency up to a number of different use cases, increasing the economic activity of the network.

Regulator support can cut both ways. On the positive side, regulators can erect regulatory barriers protecting a network from competition. For example, the Chinese government’s hardline stance on ICOs could mean that they will only allow pre-approved projects in the future. This would benefit the Chinese founded NEO network over North American based rivals like Ethereum.

On the other hand, regulators can erect barriers to adoption and other obstacles if they deem a network to be fraudulent. This could be a significant risk factor in the future for privacy-focused coins, as regulators will have no way of monitoring transactions that take place on them.

In short, the ecosystem of the crypto network looks like the graph below, with the core technology in the middle, and core communities and sub-communities surrounding it.

6) Short-Term Market Cycles

Over the long-term, crypto asset prices should revert to their intrinsic network value. As mentioned earlier, this value is determined by the size of the network ecosystem, which itself is mostly determined by the core technological utility of the network.

In the short-term, prices of crypto assets fluctuate in a volatile manner. These fluctuations are highly chaotic, and many investors would be better served by simply ignoring these gyrations and focusing on the long-term fundamentals of the network. However, humans trade markets, meaning that prices often reflect certain predictable behavioural patterns.

Academics have extensively studied these patterns over the years in the traditional financial markets, and there is an abundance of research on return anomalies that can’t be explained by risk. We have found some evidence in our own studies that these patterns also exist in the crypto markets. This is key as we can utilize these patterns to better understand the short-term pricing dynamics of a crypto asset and potentially time them. In particular, there are three patterns to look for:

i) Post-news announcement drift: Asset returns tend to drift in the direction of news flow (1–30 days). Positive news flow for a crypto asset tends to lead to subsequent outperformance, and vice versa for negative news. This is due to the fact that information tends to diffuse slowly across the market, meaning that it takes time for market participants to price in news. This is particularly prevalent in the crypto space as news sources are highly fragmented, and crypto asset developer teams are not bound by securities laws to disclose material information broadly.

A great recent example of this is the IOTA crypto network, which announced a partnership with Microsoft on November 28th. The price drifted sideways for a couple of days as the news diffused through the market, before quadrupling in price as hype grew around the partnership.

ii) Intermediate-term price momentum: Asset returns tend be autocorrelated in the intermediate-term (3–12 months). Crypto assets that have outperformed over the last six months tend to continue outperforming in the future. In traditional financial markets, the momentum anomaly is often ascribed to cognitive biases and the existence of irrational “noise traders” that use price returns as an indicator of fundamental quality.

In a perfectly efficient stock market and assuming no changes to fundamental value, it would make no sense that the stocks that go up in price the most would continue outperforming in the future. Because if stock price goes up and fundamental value stays flat, then expected returns mathematically have to decline.

This is not necessarily true with crypto assets, because investors that buy into crypto assets often end up becoming end users themselves. This increases the size of the community and thus increases the crypto network’s fundamental value. Price momentum therefore becomes a self-fulfilling prophecy, as price increases lead to a larger user community, which then justifies the higher valuation. Essentially, crypto asset networks are reflexive.

iii) Short-term mean reversion: Asset returns tend to be mean reverting in the short-term (1–30 days). Crypto assets that have risen in price the most over the last month tend to underperform other assets the following month. This is especially true when the high short-term returns were due to a liquidity shock event rather than actual news flow.

Combining these three general patterns implies that investors should buy into long-term upward-trending crypto assets that have recently fallen in price but have just released some positive news.

7) Conclusion

Crypto networks are a radically new system for humans to coordinate and create economic value. Because they decentralize ownership to their users, they create incredibly high levels of loyalty among their community. Investors looking to evaluate crypto networks on their investment potential should focus on the technological utility of the protocol, the size and veracity of the surrounding community, and the short-term pricing dynamics of the crypto asset.