Crypto Moats

We are in the early stages of designing and deploying cryptocurrencies, and if you believe the Fat Protocol Hypothesis, there are billions of dollars at stake. Naturally, cryptocurrencies and their adherents will seek to defend their positions from challengers. Fundamentally this is a very different game in the crypto space than it is in traditional business because of the open source nature of cryptocurrencies and the ability to fork blockchains. Together, these things mean the cost to compete with cryptocurrencies is extremely low.

In this environment how do cryptocurrencies seek to defend themselves from competition? What are the defensible competitive advantages, or moats, that cryptocurrencies have and can cultivate? These are questions that I seek to answer in this article.

Defensible competitive advantages

Here is a list of moats that give a cryptocurrency a defensible competitive advantage. Please comment on any blind spots I’m missing here.

Superior brand

Cryptocurrencies have reputations just like firms do. The actions they take, the people associated with them, and the language used to describe them are important in shaping users’ preferences. Describing Bitcoin as digital gold has salience to the average person, which has made the narrative stick. In turn, this narrative has driven millions of dollars into Bitcoin. Likewise, Litecoin being the “digital silver” to Bitcoin’s digital gold significantly contributes to its success.

Moreover, teams of developers and de facto leaders of projects are important. Ethereum is inexorably tied to Vitalik Buterin, Zcash is tied to Zooko Wilcox-O’Hearn, Bitcoin Cash to Roger Ver, and Bitconnect is tied to this guy.

These connections color investors’ choices. An investment in Ethereum right now is, in part, a bet on Vitalik and co shepherding Ethereum through its scaling pains. Likewise, how you feel about a particular person might dictate whether you buy the original currency or a forked version. The future of the crypto space is more political than we like to admit.

Lastly, cryptocurrencies are constantly under intense competition and there is pressure to either evolve or die. The ways that cryptocurrencies respond to this competition will give them a reputation. When a new cryptocurrency encroaches on an old one’s territory, what did it do? Was it accommodating and did it extend an open hand for collaboration? Or did it take aggressive action and invite provocation? The old cryptocurrency could fork the desirable parts of the new one, strategically dump its assets, or even buy out any newcomers. In this way, a cryptocurrency’s reputation can act as a moat that keeps new entrants away.

Superior developers

Cryptocurrencies will die or thrive as a result of their developers. Whether they are a cohesive team an initial coin offering brings, acting under the purview of a foundation, or are simply anonymous contributors, these are the people who will drive the future direction and upgrading of their respective cryptocurrencies. In a nascent and fast moving space developers who are able to separate signal from noise and execute are highly desirable. Moreover, a lot of technology in the space will be open sourced. Knowing how to navigate the complex tradeoffs inherent in many of the new technologies in the space, having a clear vision, being able to articulate that and deliver on it are more just as important as the technologies themselves. Due to this developing talent as well as critical thinking and execution ability will demand a premium.

Partially/fully closed source code

Cryptocurrencies might withhold some or all of their code in the future to keep competitors from taking their code. Spencer Noon touches on this in his post The Persistent Forker but developers could put their code in a “black box” that was able to prove the code did not change over time. That way competitors would not be able to fork a working copy of the aforementioned cryptocurrency.

Rightfully Spencer points out this is anathema to a core tenet of cryptocurrency: no trusted third parties. I agree and I think that in the long term this isn’t a tenable position, but I think that people are willing to to accept a “black box” in the short term if a team will credibly commit to open source at a later date. The reason being is that gives teams a chance to entrench their cryptocurrencies through launching a product, driving adoption, and establishing network effects. In turn these should have a positive effect on their expected returns.

An important caveat here, as Spencer points out, is that this wouldn’t be acceptable for stores of value. Part of what makes Bitcoin Bitcoin is that you can have absolute certainty in its properties. A hidden section of the code could introduce centralization, add inflation, etc. A number of ICOs are inadvertently doing this right now. To some degree this reflects how new these platforms are, but I think there will be a reckoning when some teams launch a product and try to keep some/all of their code closed source.

Life span

Nassim Taleb introduces the idea of the Lindy Effect in his book Antifragile. The Lindy Effect states the future life expectancy of non-perishable assets is proportional to their current age. In other words, the longer something has been around the longer we can expect it to stay around.

For cryptocurrencies this is important for a few reasons. The entire industry is still nascent with dozens of new assets emerging daily, all of them intensely fighting for users, developers, and the attention of the community. To survive a meaningful amount of time in this competitive environment is itself valuable and a defensible competitive advantage.

Further to this, the longer an asset has been around the more it has been battle tested for vulnerabilities. Cryptocurrencies are the largest bug bounties ever created. An enterprising hacker could in theory grift off billions of dollars if they were to successfully exploit a vulnerability. So far, the primordial Bitcoin has survived for nearly a decade. In the long view of history that isn’t very much time, but it is worth something when compared to its fledgling month old competitors, especially when you take into account the amount of money that has been at stake for Bitcoin.

What’s more, a cryptocurrency being around for longer allows for norms to be soundly established. Norms are the unwritten rules of society which shape the behavior and expectations of agents within a system. They are often nebulous, hard to define, and even harder to establish. That is why it can be valuable when a cryptocurrency has a track record and clear norms can be identified.

As an example, after a decade the rather unintuitive number of 21 million coins is hard coded into the culture of Bitcoin. Bitcoin’s community is passionate, even religious at times, and any proposal to change the 21 million limit would be vehemently defeated. There is something inherently valuable that comes with that certainty.

Something that is unfolding in real time is the response to the failure of Parity’s smart contract. In the case of large scale failures, like the DAO hack or the lockup of nearly half a billion dollars in Parity’s case, it is tempting to execute a bail out and reverse the events that transpired. But with each time this is done a norm is increasingly solidified that if enough money is at stake immutability can be swept away to recover that money. Depending on how important you believe immutability is, that can be value adding or value destroying.

A last example and a cautionary message, there is a very real chance that some technologies might break in the future. Zcash uses a technology called zk-SNARKS, which are new and relatively unproven. One participant in the Zcash ceremony highlighted this in the quote below:

The cryptography behind Zcash is both highly experimental, and relatively weak. Fact is, if zk-SNARKS turned out to be totally broken, unlike more mainstream crypto, it just wouldn’t be all that surprising:

The important thing to take away here isn’t that zk-SNARKS are useless and likely to break, it’s that we have less certainty about them because they are so new.

Network effects

eBay is a useful service precisely because so many buyers and sellers gather there. Likewise, cryptocurrencies are useful insofar as they aggregate many different parties on one platform. The value of this aggregation is proportional to how many parties it brings to the table. This relationship is called Metcalfe’s law, which in its most simple form states the that the value of a network is equal to the number of nodes squared.

Indeed, Metcalfe’s law is often cited as a way of valuing the price of Bitcoin, Ethereum, etc. Out of all moats this is the most important one. Network effects take a long time to establish and are very difficult to erode once established. The creator of Metcalfe’s law, Robert Metcalfe, understood this and when he founded his telecommunications company 3COM he persuaded DEC, Intel, and Xerox to adopt Ethernet as a standard protocol. As Ethernet captured more and more market share competing protocols withered away. A range of Ethernet compatible products emerged which compounded the value of Ethernet and decreased the value of its competitors. Ethernet’s network became so entrenched that it is still nearly ubiquitous today.

The same process could happen with cryptocurrencies. A dreadfully simple statement: a medium of exchange (MoE) is valuable in so far as it can be exchanged for things. Due to this, the first broadly used Stablecoin won’t be adopted because it has the least volatility or is cleverly designed (though some degree of these are prerequisites). It will be because of widespread merchant adoption.

Another example of network effects at play would be 0x, a protocol for decentralized exchange of ERC20 tokens in a permissionless and open way. By using the 0x protocol you can seamlessly exchange tokens with other dApps, exchanges, etc that are using the 0x protocol. There are clear network effects at play here. Fragmented patches of liquidity are connected together to create one pool. The shared benefit that each party gains from using this protocol grows as more adopt it. It is still early days for decentralized exchanges but 0x already has an impressive list of adopters, including 16 dApps and 14 relayers.

What remains to be seen is how sticky developers are to particular networks. Ethereum has a huge head start but there are aggressive actions being taken by other cryptocurrencies to steal from its developer base. If they can successfully erode Ethereum’s position it would be a huge deal and decrease Ethereum’s value significantly. Also on the horizon are the effects of interoperability, a topic too large to broach here, but here are two articles I recommend.

Tony Sheng’s Doubts about interoperable smart contracts

Kyle Salamani’s Smart Contract Network Fallacy

Good governance

What good governance entails is so elusive at this stage that I almost didn’t include this. Fred Ehrsam opens his article Blockchain Governance: Programming Our Future with the following quote:

As with organisms, the most successful blockchains will be those that can best adapt to their environments. Assuming these systems need to evolve to survive, initial design is important, but over a long enough timeline, the mechanisms for change are most important.

It is important that blockchains adapt as the world changes, innovations get diffused, and consumers change their preferences. Even stores of value, like Bitcoin, occasionally need to change. The mechanisms for bringing about that change are important. What’s difficult is that there isn’t one set of mechanisms that should govern all blockchains. Even if we drill down to a specific use case, like a prediction market or stablecoin for example, there isn’t a single best mechanism that fits any particular use case either. Instead, we need to think critically about each use case, what its value proposition is, and what the appropriate mechanisms to match that value proposition should be.

In the infancy stages of developing their blockchains it is appropriate for a centralized team to control a project entirely. After these teams roll out main nets and as their blockchain networks grow, it will be a serious challenge for many teams to establish robust governance mechanisms. I fully expect that many won’t want to relax the iron grip they have on their networks. More than just that, robust governance also means fostering a diverse community of stakeholders and figuring out of what the best ways to establish consensus between them are. A lot of this has to come organically, which is precisely why it will be difficult for teams to facilitate this process.

Lastly, I think it is worth touching on the rents that are extracted from a platform as this is a form of governance. If rents, in the form of fees or excessively large token allocations, are too high then a fork is likely. I say too high because I think that there is an appropriate level to justify developers staying onboard. An example of this in action is Zcash (ZEC) and ZClassic (ZCL). ZEC has something called the “founder’s reward,” whereby 10% of all ZEC minted is gradually distributed to the founders, investors, employees, and advisors of the Zcash Company. These folks are largely responsible for driving the development of Zcash, yet calls quickly came to do away with this “genius tax.”

With this Zclassic was born; it was a fork of Zcash that was identical in all ways except two: it lacked the founder’s reward and slow start Zcash had. Put another way, a competitor created nearly the same currency except it removed a rent seeking mechanism. Despite this, Zcash has always dominated Zclassic in terms of marketcap and almost always in terms of ROI as well. The market seems to think that the founder’s reward is justified for now at least.

Rents need to be priced such that the marginal benefit of continuing development by the rent-seekers is greater than the cost of the rents. High rents may be sustainable for a time period in order to incentivize developers, but after a certain point their cost will exceed their marginal benefit. Moreover, competition in cryptocurrencies doesn’t have to be inherently different from competition in other industries. High profits (rents) in an industry (cryptocurrency) invite competition (forks/new protocols) which in turn lowers the average margin (rent).

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