Blockchain Infrastructure Thesis 2.0 — From a Corporate to a Micro Crypto “Hedge Fund”
Table of Contents:
- Introduction: (Generalized) Mining as a Corporate
- Infrastructure Provider Perspective & Incentives
- Investor Perspective & Proof-of-Stake
- Network Perspective & Enterprise Right-to-Play
- So… why T-Systems and telcos again?
- Summary & Outlook
1. Introduction: (Generalized) Mining as a Corporate
In July 2020, our team at T-Systems MMS, subsidiary of Deutsche Telekom (Europe’s largest telco, parent of T-Mobile) has started providing an IT service to a public blockchain network. Despite IT service provisioning being pretty much our daily business, this time it is slightly different. There is no direct customer per se, as well as our revenue takes the form of a crypto-asset. In a specific case of Chainlink, $LINK token this is paid to us for providing real-world data like asset prices, making it available for various decentralized applications built on top of Ethereum, mostly in the area of Decentralized Finance (DeFi).
The concept of a blockchain native service provisioning is sometimes referred to as “Generalized Mining” or blockchain infrastructure provisioning. In broader terms it means taking on a certain role in a given blockchain network and performing a certain task in exchange for a reward in form of a native digital asset of that network. Examples include being a validator, miner, transcoder, witness, node operator, curator, providing liquidity and so on. Each of these differ from network to network.
T-Systems is thus the first major corporate in the world to engage in such type of blockchain infrastructure provisioning while (more importantly) also monetizing it via the respective crypto-asset of the network, all in a regulated and fully compliant way. With this, we have turned ourselves into a mini “hedge fund” of sorts.
The goal of this post is two-fold. Firstly, it is an attempt to take an in-depth look at the concept of blockchain infrastructure from both the investor, as well as corporate standpoint. And secondly, perhaps of more interest to the seasoned validators and yield farmers, argue why I believe in convergence between IT and finance when it comes to staking and generalized mining and why I can’t stop talking about it.
Intro to Blockchain Infrastructure
The term infrastructure is perhaps even more abstract and high-level than the term blockchain itself. For one to give an elevator pitch for this and convince a large entity to look into generalized mining opportunities is not an easy task, as, not surprisingly, I have found out multiple times. It helps to break down the concept by looking at it from different perspectives, of which there are three main ones — infrastructure/tech, financial/economical and a business/strategic. I will cover these one-by-one below.
Disclaimer: all opinions expressed in this post are my personal opinions which might not be fully representative of the opinions of my employer.
2. Infrastructure Provider Perspective & Incentives
This is the starting point of understanding what blockchain infrastructure looks like, the forms it can take as well as why blockchains are referred to as incentive machines.
● The world of many chains. There are various blockchain networks out there. Most of these exists to fulfill a certain role and to provide a certain use/value to its participants and users, for example:
- Bitcoin — to provide a secure, censorship-resistant, global, etc. payment network or a store-of-value (SoV) asset like digital gold. Jury is still out on the “true” goal of Bitcoin (if there is a single one at all)
- Ethereum — to create a Turing-complete Virtual Machine (EVM) which allows to run immutable, censorship-resistant applications on top of it to allow for composable and open innovation in e.g. finance and economic coordination among others.
- Chainlink — to bring real world data on-chain in an (economically) secure way
- ..the list of protocols, L2 and dapps with their own tokenomics can go on and on.
● Decentralization is key. Blockchains value decentralization (for multiple reasons which are out of scope here). It’s achieved by having a relatively large number of nodes (infrastructure providers) who run and contribute work and perform services for these networks. These nodes perform various supply-side services needed for the network to achieve its goal (e.g. Bitcoin miners incur real world costs to ensure the security of the network, Livepeer Transcoders are transcoding videos, etc.). Some networks might also have means to incentivize the infrastructure/stake decentralization (e.g. Polkadot).
● Participants are rational. As no rational actor would provide infrastructure by operating a node or providing supply side services like storage or liquidity for free, there needs to be an economic incentive to do so.
● Carrot and Stick. Blockchains, or in some cases dApps themselves, address bootstrapping the infrastructure and supply-side services by having a native digital asset — a token, which rewards a certain type of behavior, service or infrastructure provisioning which are defined by the protocol itself. “Good” behavior -> reward (inflationary and/or service fee), “Bad” behavior -> opportunity cost, or in the worst case slashing (loss of a fixed % of stake/collateral).
● Generalized Mining. Bitcoin network mints BTC for the “good” service miners provide — securing the network with their hash power and electricity to enable Bitcoin to fulfill its goal. Chainlink and DeFi applications which are using it pay out LINK for reliable real-world data provision. Filecoin rewards users who contribute storage to the network and so on… Providing supply-side services is also sometimes referred to as Generalized Mining (more about it here). This is seen in both PoW and PoS, with governance tokens, Layer 2 applications, AMMs and so on. Each of these requires a different form of infrastructure.
● Incentive Machines. This turns these networks into a sort of autonomous incentive machines (not a company, but a set of various entities performing certain roles coordinated by the network economics), often also characterized as “commons” or public goods, like the city park or a river where there is fish, which you can catch if you perform a set of actions. River = blockchain network; fish = digital assets; fishing stick = validator/node; laws of physics and fishing stick requirements = blockchain code and protocol economics.
● Running a validator is not too “blockchainy”. The blockchain part of running a validator (designing the “fishing stick”) is to understand the rules of the game (protocol economics), and define the architecture and service provisioning requirements accordingly. Majority of things one needs to optimize for are rather traditional infrastructure operation and security. This provides more traditional tech companies, possibly without an extensive blockchain track record, with a right to play in this industry.
3. Investor Perspective & Proof-of-Stake
● Proof-of-Work was first. Most of the “newer” blockchains are predominantly Proof-of-Stake (PoS) based, Ethereum will start to shift to PoS by end of this year as well as the most Layer2s are PoS-based as well. This is a huge topic in itself, but the way to summarize is this. In Proof-of-Work, the simplified F(revenue) = f(your hash power / total hash power in the system) –> a function of how much power your machines have relative to the combined power of all machines in the network. If one controls 1% of a PoW network’s hash power, one can expect to get around 1% of all rewards.
● Rise of Proof-of-Stake. With PoS it is similar, but instead of hashing power and electricity costs, we are talking about share of tokens which are staked with a given node compared to overall token supply: F(revenue) = f(your staked tokens / total staked tokens in the system) -> if your validator node secures 1% of all staked tokens, you will get about 1% of all rewards.
● Inflationary rewards. Staking means that any token holder can get a % “return” (like a dividend or bank deposit rate) on his tokens (e.g. 10% per year) if he stakes (or locks-up, like with a bank deposit) the tokens with the validators they trust. Staking, unlike a bank deposit though, is oftentimes non-custodial. In detail, staking returns mostly consist of inflation and some form of a network fee and are meant (among other things) to avoid dilution.
● Earning staking “yields”. These 10% are created by the network to incentivize nodes/validators to provide the service to the network (bootstrap the supply-siders). Not everyone can/wants to provide the service so the way to participate in these yields by a token holder is to stake with a validator, so the way to get exposure to those % is to delegate the tokens to a trusted infrastructure provider.
● Staking as a form of “elections”. Staking one’s tokens with a validator can also be thought about as an election, where citizens elect a representative to represent their interests in parliament (blockchain network) and perform the services (validation) on their behalf. The validator is actually the one who enables those 10% to be created, but has to be secure and reliable not to lose the tokens of its stakers (voters) who trusted him. Election analogy also holds well in the context of on-chain governance, where validators vote on proposals with the votes (stake) which is backing their node.
● Validator as a Bank. Another way one can think of a PoS validator being a bit like a bank, enabling its customers to earn % on their non-custodial “deposits”, while having to stay very secure and perform certain services correctly not to lose its clients funds due to slashing and maximize yields by e.g. avoiding downtime.
● Most will need to care about staking. As the nature of digital assets is increasingly becoming PoS, any token holder is incentivized to stake with a validator (or operate one himself). As larger financial institutions are starting to offer digital asset custody, they will need to operate validators to enable customers to receive respective yields.
● Convergence of Finance and Tech. As the software is eating the world, a lot of the services banks have historically provided are now the core business of tech companies. The nature of custody is changing from an underground vault holding gold or cash into a hardware- or software-based HSM. The nature of yield and interest rates (esp. in our current zero-interest world) is slowly shifting towards staking, generalized mining and DeFi-native business models like yield farming.
● Further split amplified. What further facilitates this convergence between financial and IT services, is that the yield generating strategies on PoS networks (e.g. transcoding videos on Livepeer, feeding data to smart contracts on Chainlink, providing storage on Filecoin or zero-knowledge proof computing on Coda) and thus providing yield exposure to investors is not a core business of a bank anymore, but rather the one of an IT company.
● Becoming a mini crypto “hedge fund”. As financial services and IT services converge, many IT service companies participating in Web3 will be sliding into becoming financial players like VCs, hedge funds and potentially become banks. As the product of the service is a crypto-asset, it automatically means getting exposure to the respective token. We ourselves have now turned into a form of a “hedge fund” where we need to think about hedging in order to ensure the long term sustainability of the business cases we are operating as well as conducting fundamental analysis of the networks we are looking at.
● Getting a better price than some VCs. By running validators, IT infrastructure teams are able to acquire/earn tokens at a lower cost basis than what some VCs might have paid in private rounds... which is great to say the least and what demonstrates the power of the space in terms of democratizing investment and the power of tokens as a means of enabling digital economies. This is often true with regards to generalized mining opportunities.
● Network Lifecycle Investing. The concept of infrastructure providers participating in individual network (crypto)economies goes even further if we consider this as a part of Network Lifecycle Investing, a term coined by Jake Brukhman. He talks about networks going through a typical lifecycle, through which the token and investment character changes. In the beginning, investing in these networks is VC-like (investments are mostly illiquid), later as the network goes live and the supply-side kicks in, there is a need to match the supply- and demand-sider to bootstrap these networks with good infra. In the later stages, as networks mature and further applications are built higher in the stack, tokens start to resemble public assets (trading like large caps). From an enterprise perspective, investing takes a form of time and sunk costs of developing a service for a specific blockchain in addition to potentially having to directly acquire the minimum stake required to run a node. Corporates and large software integration houses become more relevant towards the end of lifecycle in which they (aside from bootstrapping the network in stage 2) can develop/integrate use-cases on top of these networks and help to bring those to their existing customer base.
4. Network Perspective — Role of enterprises in Web3 infrastructure provisioning
● Blockchain thesis of a woke enterprise. Public blockchains will likely become the base layer technology for moving value around (from financial products to fiat money aka CBDC) and cross-company collaboration (so-called message bus). These also enable a new set of business models in various industries, starting with finance (DeFi) which is arguably the first to gain traction.
● Limited enterprise right-to-play on (d)application level. Blockchains often disintermediate centralized actors which puts more traditional companies in a tough position. There is limited right to play for enterprises in areas like DeFi on the application level, whereas when we talk infrastructure provisioning, there is indeed a place for those as argued below. Running a Chainlink node and providing reliable data on-chain is an example of being able to monetize DeFi usage and growth from infrastructure perspective.
● Tokens and token economics matter. One way to look at a new technology according to Peter Thiel, is that it has to be 10x better than the next alternative in order to overcome all sorts of frictions and adoption hurdles. I believe that the 10x improvement in blockchains lies in their digital asset component and the economies enabled by these. Distributed ledgers and smart contracts alone, used without a digital asset and economies around these, are not enough to create value to justify the usage of blockchain as base technology. That does not stop however a lot of corporates to be using them to track food produce (and here I’m not talking YAM, SUSHI, PICKLE etc.)… but that a whole another topic.
● Being a validator node is the most important role. Validators are the core infrastructure pieces of blockchains, they effectively “run” and do all the heavy-lifting for Ethereum 2.0, Polkadot, Cosmos, etc. are incentivized to do so via block rewards/subsidy and are also getting the share of economic activity on top via transaction fees (if running Web2 infrastructure like data centers would entitle for a share of value transacted on the internet application level).
● Top-down demand. Getting reliable infrastructure providers on board is one of the largest challenges new networks face (a single or just a few infrastructure providers = not a blockchain). Bootstrapping the supply side is as crucial for the long-term project success as the demand side, especially with exponential growth in the number of new networks and a lack of professional infra providers.
● Bottom-up demand. There is large demand for professional infra providers (e.g. validators) from network stakeholders like funds, custodians, token holders, exchanges and very soon banks. These normally lack the expertise to make their tokens productive and participate in these networks (in the end: building up an own validator). Most don’t want to bother and it’s not their core business (e.g. feeding weather data on-chain is not a bank’s core business, as discussed above).
● Trust matters. The more people/companies trust that validator’s infrastructure is secure and reliable, the more stake in the network the validator can attract, allowing it to perform more services (validation, data provision, zk proof computation, transcoding, etc.) in the network and thus earn more. Most institutional players/investors don’t have a choice but to go with third parties. Trust is also more important than the price for institutional investors, which is mostly not the case with retail. And as Mike Novogratz like to say, the institutional “herd is coming” (and is partially there already, seen mostly with traditional banks working on crypto-custody).
● The right timing (esp. in Germany and US). BaFin (German SEC) has passed a law since January 2020 regulating digital asset custody and thus giving green light for institutional adoption of tokens. With 40+ applications for the license, most if not all of these will offer PoS assets to their customers and thus will have to think about staking (as 70%+ of token holders of the larger PoS protocols stake). Similar development can now be seen in US.
● De-risking blockchain activities. Infrastructure provisioning for Layer 1s is sort of a use-case agnostic blockchain bet. No one really knows what the killer use-case of crypto will be (just like early days of the internet) and with an infrastructure-first approach, one does not bet on a single use-case but rather on the success and network effects of a given protocol… and a bit of speculation, which is unlikely to go away. The already infamous Fat Protocol Thesis is yet to be validated…
● Not just public blockchains. Blockchain infrastructure models are possible not just in public blockchain settings, but in private/permissioned ones as well. There is a market for providing Node-aaS for Corda, Hyperledger, etc, however this market is harder to quantify and value due to the absence of on-chain incentives and respective digital assets.
● Web3 infrastructure market is growing. PoS validators are currently securing $32+ billion in assets, generating up to $500 million in rewards per year for respective network participants. This is growing fast.
● Finding the right staker audience. There is large competition in the retail staking space with the race-to-zero in terms of fees having persisted throughout 2018–2020. Differentiation can be achieved through value added services like dashboards, open-source contributions, staking derivatives and so on (more on this here) or targeting less fee-sensitive institutional markets, as seen with e.g. Coinbase fees of around 25%. Enterprises, at least in the early days of staking industry professionalization, should go towards the institutional markets, being able to enjoy higher margins there.
● Scalable business model. Operating a validator or providing Web3 infrastructure is a way for more traditional players like enterprises to move away from headcount-driven business models. Furthermore there are certain economies of scale to be enjoyed when offering infrastructure across multiple protocols or especially within one protocol standard (Cosmos/Polkadot universes).
5. So… why T-Systems and telcos again?
● Core business and (arguably) our duty. Telcos have historically provided public network infrastructure. With telephones (letting people communicate) it took the form of phone lines. With Web2 (internet of information) it took the form of optic cables and data centers. With Web3 (internet of value) it takes the form of nodes, validators, witnesses, etc. Telcos no longer can monopolize the space (and even if they could, they shouldn’t), but they will be able to play a role in this space. We see providing secure public network infrastructure as our core business and the next logical step as we have been operating enterprise mission-critical systems for the last decades.
● Size matters. “Dealing with corporate, think as a corporate” as they say in Germany. As the space is maturing and newer (sometimes more traditional and heavily regulated) institutions enter, the requirements for infrastructure and Staking-aaS providers also increase. This includes but is not limited to their size, jurisdiction, SLAs, own cloud, being able to negotiate slashing insurance with insurers, etc. I believe a company like Deutsche Telekom might have the means to support overall industry professionalization especially when it comes to onboarding traditional financial players like banks.
● Value for protocols. Enterprises and integration houses due to their corporate network and ongoing projects are able to support the protocols with implementing and integration beyond the crypto space, which we have to admit is still rather walled off from the outside world (“no-coiners” and “normies”). I see bringing institutionals to the network and building use-cases as the later stage of the network lifecycle investing.
● Open T Cloud. One of the concerns being discussed is the cloud centralization in the hands of AWS, Azure, Google, etc. as when all nodes will be run using these, the decentralization on the node level would be an illusion. By having an own public cloud (Open Telekom Cloud), we can contribute to further decentralization on the cloud level. This is especially relevant for protocols with correlated availability slashing (e.g. Substrate-based chains).
● “Dude where is my customer?” With providing service to a decentralized network, and getting a share of economic activity on top one does not rely on a customer as there essentially is none in traditional sense. The network economics are normally public, describing the service the network needs and the potential reward it is able to generate. It is up to the company to decide whether it wants to participate in it or not. As you might imagine here we have very funny discussions with certain departments as the blockchain has no postal index or legal form to send a contract to…
6. Summary & Outlook
Companies or individuals participating in crypto-networks are often financially incentivized for these to succeed. What these entities could do in order to participate and facilitate that success differs from the profile of the entity (retail, VC, corporate) and the timing of where a given network is in its lifecycle.
I believe there to be synergies between participating in several stages like for example the initial one (e.g. VC-style investing) followed by participating in network bootstrapping and becoming a supply-sider with e.g. the stake acquired from an investment round.
The direction of our future growth would be defined by both vertical as well horizontal scaling. Horizontal scaling means expanding support for newer networks and protocols. Vertical scaling would involve deeper participation in other stages of the lifecycle (by e.g. developing more into a fund and deep-diving into hedging and optimization strategies), as well complimentary business models facilitating overall industry adoption like e.g. custody services.
I’m extremely excited to see where this space goes, how DeFi would interface and compete with traditional finance and I’m very excited about all the crazy generalized mining and validation opportunities we might participate in and how these translate into us becoming investors and stakeholders in these new decentralized economies. Being in the front seat watching traditional finance starting and struggling to understand and participate in these opportunities and open-source software eating finance is exciting.
TLDR: Blockchain infrastructure, its security, quality and decentralization are extremely important to build up and bootstrap decentralized networks and their economies. Blockchains are incentive machines, each with its own token economy. This opens up to multiple ways how various entities (VCs, custodians, banks, enterprises, retail investors) can participate in these networks in exchange for yield. The industry around providing blockchain infrastructure is growing rapidly with big checks as well as some big name entries. Traditional financial institutions while entering the crypto space (e.g. to provide custody) would find it hard to keep their ground as a lot of IT services provided by various start-ups and now enterprises compete with their ability to generate yield for their investors. Large companies might have a right to play in this space due to their resources and experience from non-blockchain domains. These can also participate in the finals stages of the network lifecycle investing and potentially help scale these networks. An ultimate Web3 infrastructure powerhouse would be a fund + IT service company + (traditional player), potentially as a partnership or as single entity.
About the author
Gleb Dudka is an analyst and Staking-aaS product owner at Blockchain Solutions Center of T-Systems (Deutsche Telekom, Europe’s largest telco). Here I focus on blockchain infrastructure provisioning and bootstrapping public blockchain networks as the first enterprise player in this space (offering Staking-as-a-Service, operating validators and engaging in Generalized Mining on public Proof-of-Stake networks). “The guy who brought crypto-assets to Deutsche Telekom” according to our treasury.
I am passionate about investing in decentralized networks through my work as well as personally. I believe in convergence of traditional finance, DeFi and IT services as one of the most exciting trends in blockchain in coming few years. I’m also supporting StakingRewards as an editor/analyst. Semi-retired yield farmer. I love to model network economics and business models for their infrastructure provisioning.
Find more about my work at www.glebdudka.com
Here are some resources about generalized mining and Web3 infrastructure provisioning for anyone willing to go deeper into the rabbit hole:
- “Generalized Mining, An Introduction & Primer by Jake Brukhman, CEO of CoinFund”, must-watch intro to the concept of Generalized Mining
- “How Proof-Of-Stake (PoS) Blockchains Work (An Introduction)” with Luke Youngblood (Coinbase Custody). Also the whole Trustless 2020 Validator Conference is a must-watch!
- “Approaches To Validator Architecture & Security: Trust Model & Slashing Basics” with Luke Youngblood (Coinbase Custody)
- “Game of Stakes Panel Discussion: Cosmos Validators Talk Strategy and Takeaways”. This gives an interesting view into daily business of validator operations and the concept of incentivized testnet, which started with Cosmos Game of Stakes.
- “Blockchain Infrastructure Thesis” — the first version of this infra thesis of why should enterprises provide infrastructure and stay on the infrastructure level, having been disappointed in most of the enterprise blockchain use-cases.
- Staking Ecosystem Case Study — an extensive staking and validator industry research we at StakingRewards conducted, having interviewed 16 validators and 200+ token holders.
- “Network Lifecycle Investing” — a great podast with Jake Brukhman from Coinfund about the concept of blockchain network lifecycles and its impact on Coinfund’s investment strategy.
- “50 Shades of Staking: Part III. Validator — a Bank, Mining Pool, VC, or Exchange?” — my post “from back then” about the value creation of a Cosmos validator and similarities between Web3 infrastructure providers and VCs, banks, exchanges, mining pools and custodians.