[Block Crafters Research] Value Chain of the Blockchain Industry (Part 1)
Unfolding Who Creates Value Out of Blockchain Industry and How
It has been a while since blockchain technology has grown into a multi-billion-dollar industry. Little is known, however, about who plays what role in the blockchain industry and how these players create value, specifically, how different players in the blockchain industry make money with their decentralized services. The blockchain industry still lacks a clear step-by-step framework to explain how the technology reaches its users, which is cited as the single most important goal of the technology. A report published by the Block Crafters research team aimed to elucidate the value chain in the blockchain industry and summarize its implication regarding the future of the industry.
[You can download the full research report here.]
Blockchain industry still lacks a clear framework to understand how the technology reaches its users — which is cited as a single most important goal of the technology—through certain steps. Lack of universal framework to understand the market leads to a public confusion and, even worse, to a severe information asymmetry between people within the industry and people who are not — which would be not so much different from status quo that the blockchain technology has tried to solve. Thus it paves a way to find an answer to a down-to-earth question such as, ‘How can players in the blockchain industry sustain themselves while claiming to earn less profit than previous services with decentralized services?’
1. Blockchain Industry Segments
As the industrialization of blockchain technology is under its way, it is imperative to define how to segment the industry. Market segmentation provides a scheme for identifying what direction the market will head. Blockchain industry can be broadly categorized into three; Technology Infrastructure, Blockchain Service Market, and Crypto asset Financial Market. Figure 1 above shows brief descriptions of each segment.
2. Value Chain of Blockchain Industry
Why does the value chain in the blockchain industry matter? According to a recent survey, global firms responded that “new business models and value chains” will be the most significant advantage of blockchains over the existing systems. Figure 1 below outlines the journey of a product or a service based on blockchain technology from its conception to its end-users in a value chain. The value chain consists of different parts: Hardware Infrastructure, Blockchain Protocol Development, DApp (Decentralized Applications) Development, and Product Distribution. The core factors, including players, profit factors, and imperative factors of success, are summarized for each step.
2–1. Hardware Infrastructure
(a) Industry Players
Hardware infrastructure is the starting point of this value chain and comprises mainly of two parts: IT/mobile hardware providers and mining hardware manufacturers. Because blockchain networks and services are composed of software, they inherently rely on hardware gadgets to reach users. One noticeable trend is that leading mobile phone manufacturers, including Samsung, Lenovo, and HTC, have unveiled their newest mobile phones with embedded blockchain-based services such as the cryptoasset wallet or private key management. Although these gadgets may not increase the number of users as a convenient gateway to blockchain services, these developments may signal that hardware, and not only software, has started to put a premium on data privacy and security. One of the challenges facing blockchain services is a high barrier to entry due to technological complexity. However, as more hardware gadgets are being released to the market “blockchain-ready,” this may provide a shortcut to mass adoption.
Just like IT/mobile hardware, mining hardware is also an inherent part of the value chain. There are several types of consensus mechanisms that provide a guideline as to what must be done to operate a secure blockchain network. The bitcoin network, the very first blockchain network, is based on the “proof-of-work” (PoW) system. In this system, bitcoin miners must prove their efforts in maintaining the bitcoin network by first solving a math question based on the hash function to earn bitcoins as a reward. Thus, this has encouraged miners to use more computing power to win the competition against other miners. Ever since the bitcoin price rally back in 2017, the cryptoasset mining industry — while most of it mines bitcoins — has experienced explosive growth. CPU, GPU, FPGA, or ASIC are mainly used as mining hardware and are produced by some notable mining hardware companies such as Bitmain, Canaan Creative, and Ebang.
(b) Revenue Model
In many cases, a profit structure of hardware manufacturers is simple — it mostly depends on the sales of hardware. How mining equipment manufacturers make a profit does not seem too different from it. Bitmain, the largest mining hardware manufacturer in the world, filed a prospectus for initial public offering (IPO) in September 2018. The prospectus revealed that Bitmain, with 75% of market share, earned adjusted net profit of 952 million USD during the first half of 2018, with over 35% profit margin. It further showed that there are three other revenue streams in addition to hardware sales, including mining pool service, mining farm service, and proprietary mining, which generated 5.6% of total revenue in 2018. A diversified revenue stream also shows a sign of forward integration within a value chain.
(c) Key Factor
The driving forces for the growth and success of the hardware infrastructure industry rely heavily on buyers’ demand. In the case of IT/mobile hardware, not many users have found adequate reasoning to choose gadgets with embedded blockchain services thus far. The industry is shortly expected to focus more on its compatibility with blockchain services or cryptoasset management rather than on launching new models to target blockchain users specifically.
Likewise, demand for mining hardware is a primary interest for IT/mobile hardware manufacturers. The market, however, is affected by increasingly complex dynamics that surround the industry. The demand for mining hardware is primarily affected by the price of the target cryptoasset. Along with cryptoasset price increases, the overall demand for mining has also increased since 2017. This has also indicated demand for mining hardware depends on cryptoasset prices. Furthermore, in the case of bitcoin, a halving happens when a block reward is cut in half every four years. Because bitcoin is designed with a limited number, mining rewards will be down to 0.78125 bitcoin per block in 2036, and the mining process will come to an end in 2140. It is also worth noting that many post-bitcoin blockchain networks have adopted PoS (Proof-of-Stake), DPoS (Delegated Proof-of-Stake), or other consensus mechanisms that do not require computing power competitions between miners or generate other possible impacts on the sustainability of mining industry.
2–2. Blockchain Protocol Development
(a) Industry Players
The next step is to develop the blockchain network platform. Often called the “protocol,” blockchain network platforms provide an operating system on which applications can be developed. The activeness or market dominance of a blockchain protocol can be gauged through the transaction volume within its DApps. In 2019, one market report showed that the EOS, Ethereum, TRON, and Steem were the top four blockchain platforms with the highest transaction volume in DApps, as shown in Figure 5. The market share of the blockchain protocol industry based on a total transaction volume in DApps is more fragmented than that of the mobile OS market. Even though the majority of DApps present in the market were built on the Ethereum network, the report showed that almost half of Ethereum-based DApps were inactive and so were its users.
One distinct aspect of the blockchain protocol market is that its protocol providers and operators are inherently separate players within the same market. While blockchain protocol providers design and build blockchain platform, protocol operators process transactions and maintain a secure network as miners, consensus nodes, or other network participants. When operators successfully process transactions and connect a new blockchain to a chain, they are given a certain percentage of the total transaction amount as a reward — an essential process of minting new cryptocurrency. A transaction fee earned by network operators thus can be viewed as seigniorage, the difference between the face value of newly created coins, which is quite volatile in case of cryptocurrency, and production costs.
Consensus mechanisms are evolving away from PoW but toward other mechanisms with designated “supernodes” that can oversee network operation, which indicates that the relationship between protocol providers and operators is becoming closer to a partnership. While PoW mechanisms allow any network participant to compete to process transactions, the operators selected under PoS or DPoS mechanisms are more dependent on the level of trust and reputation of the candidates. Although most selection processes go through a vote of network users, being listed and promoted as a trustworthy candidate for the operation node necessitates interactions with protocol providers. In the case of the private blockchain adopted by Calibra, a subsidiary of Facebook, a platform provider designates who gets to participate and operate the Libra network, which is an example of a typical case of a permissioned blockchain protocol. These candidates also often must agree on a token vesting contract to prevent conflicts of interest.
(b) Revenue Model
At first glance, it seems that the blockchain platform does not need a long-term, sustainable profit structure as it operates in the hands of network operators who earn profits through rewards. However, when it comes to protocol providers, a stable profit structure is necessary to cover the costs of network management, providing client services, and technical updates. Additionally, fundraising can now cost upwards of millions of dollars due to rising regulatory hurdles. For instance, BlockStack, a public blockchain protocol that enables convenient DApp development that has been authorized to launch security token offering (STO) by SEC, revealed that it had spent over 2 million dollars to get approval for its offering. Although users pay a transaction fee on the network, most of the fee goes to the people who handle the transaction validation process, which in most cases, are the network operators and not the providers. To cover operating costs, many of these foundations have relied on so-called “donations” from its users or burned the reserve portion of cryptoassets they have issued while maintaining its volume or value through the token economy.
Unlike private blockchain platforms, developers of public blockchain platforms cannot claim exclusive copyright or control over the platform. Many public blockchain platforms are registered as not-for-profit enterprises or foundations, which is ironic in terms of profit models but fits the basic idea of blockchains. Then how would blockchain platform providers, not operators, make a profit from their product? Two revenue models can be applied to blockchain protocols: charging a percentage of transaction fees, and B2B business models. First, the initial designs of the blockchain network allow only “anonymous and random” miners to claim a full transaction fee. However, as blockchain protocols evolve, there have been variations in such designs. New platforms have adopted a consensus mechanism, including PoS or DPoS, with network operators designated by platform providers. This entails a “contractual relationship” between platform providers and operators and allows room for the negotiation of transactional fee distributions. Under these types of mechanisms platform providers may claim parts of the transaction fees processed by network operators, of which the amount would be much smaller than in the revenue models with a centralized network.
The other stream of revenue may come from conventional open source software business models. Generating profits with such models within a public blockchain platform may go against our expectations; however, note that these revenue models should be strictly separated from the operation of decentralized networks. Although anyone can have access to a public blockchain platform, primary users of such platforms are DApp developers and other enterprise clients. In terms of business models, open source platforms are like blockchain platforms. Open source platforms have become a de facto standard for software business models and have proven that a lack of proprietary source code does not necessarily equal “no profit.” Profit-making does not go against the spirit of openness and blockchain platforms are following in this path. Figure 6 describes eight different types of business models for open source software and its applicability to blockchain platforms.
Among these eight models, ones that may apply to a public blockchain platform as a business are (1) support sellers, (4) accessories, and (8) service enablers. Support sellers and accessories models are based on paid client services, such as education, training, and custom development. Service enablers is a model in which users are charged with an initiation fee within the platform. The blockchain platform NEO is an example of such a model. NEO charges a fixed transaction cost for deploying a smart contract on its blockchain and for registering a digital asset.
Two other models, (5) brand licensing and (7) software franchising, may be viable depending on whether public blockchain platform providers can monetize its brand name. This topic entails a further discussion on regulatory understanding of technology or its interpretations. Additionally, the key to monetizing public blockchain platforms lies in a separation of a blockchain’s brand identity from the decentralized network operation. Note that such models can be implemented only to the extent that the monetization of the brand name or supporting client services does not tamper with the decentralized process of the network. Altering the essence of a public blockchain platform — a resistance to centralized authority — while making a profit should be avoided. The other three types of business models are (2) loss leader, (3) hardware add-ons, and (6) sell it, free it, which were not marked as “applicable” to blockchain platforms due to a lack of other commercial products and proprietary rights to the platform held by its providers.
(c) Key Factor
What determines the growth and profitability of a blockchain platform provider is three-fold: the user base of the platform, the network effect, and the network value. First, because a blockchain’s primary revenue model will rely on B2B models, a platform provider should offer a “developer-friendly” environment with scalability and interoperability to attract a broad and active user base. Such an environment will invite active user involvement, which leads to a larger supply of derivative products and services, which in turn draws more end users paying for transaction fees and thus creating a virtuous circle. A broader user base would boost the network effect and its value, a phenomenon whereby an increased number of users leads to an improvement of services/product value.
In terms of blockchain protocol operators, one of the strongest motivators is the value of the reward they can earn. Because compensation is given in cryptocurrency issued by a protocol, cryptocurrency prices can heavily influence the participation of protocol operators and its price is related to the network effect of the blockchain protocol. Additionally, key factors include the efficiency and security of a consensus mechanism and the network stability. When there is distrust towards consensus mechanisms, this may yield an assumption that the distribution of operation rewards does not apply fairly to every participant, which discourages public participation in network operations.
- Read part 2 of this article (Click Here)
*Disclaimer: The contents provided on this report do not contain any investment advice, financial advice, trading advice or any other sort of advice. This report is intended for informative purpose only. Neither author or Block Crafters does not accept any liability for the actions or decisions of third parties made as a consequence of the contents in this report. This report may not be sold without the written consent of Block Crafters. The opinions expressed in this article are those of the author and do not necessarily reflect the official position of Block Crafters.
