Blockchain 101 — Decentralization, Cryptoeconomics and ICOs

My introductory talk at Commit Porto 2018

I was invited by Commit Porto to give an introductory talk about blockchain at their 2018 edition. Below is the video, the slides and the transcript.

Background: Photo by Dmitry Ratushny on Unsplash

Video recording

Slides and transcript

I’d like to start by clarifying what this talk is not about. I’m not about to mindlessly drone on about how some new shitcoin will disrupt disruption. I’m certainly not going to give anyone investment advice.

I’m going to explain why I believe blockchain technology is worth your time, and why I’m devoting myself to it for the years to come. I’ll start by covering the topic of decentralization, why it’s a good thing, and give you my perspective on why blockchain is uniquely positioned to help us go down that road.

I’ll also talk a bit Bitcoin and Ethereum in the context of cryptoeconomics, and wrap up with a short explanation of what ICOs are, and why they’re an exciting new form of financing the future.

When people talk about decentralization, they’re coming mostly from cypherpunk or libertarian perspectives. They talk about censorship resistance. It’s simply beautiful that I can use the Bitcoin network to transfer value to anyone, or that I can use Ethereum to perform arbitrary computations, and that nobody can stop me from doing so.

This perspective is not wrong, and it’s very dear to my heart. But it’s incomplete. It misses a larger point.

Centralized services are inherently insecure, as they grow into hacker honeypots. A fitting analogy for blockchain security is that it’s easier to rob a bank than to rob every single one of its customers. We have to look no further than the current Equifax data breach, which exposed more than 100M people to identity theft and credit card fraud.

Secondly, and perhaps more importantly, the incentives of a centralized platform necessarily benefit the platform’s owner as it grows in size and scope, at the expense of other stakeholders. When these start out, they do everything they can to recruit users and third-party ecosystem participants like application developers. This is because the more users there are on the platform, the more valuable the platform becomes. The same goes for its ecosystem: the more vibrant it is, the more users the platform will be able to attract. As the platform’s adoption grows, so does its power over the very participants which enabled this growth.

Predictably, this power asymmetry quickly turns attraction into extraction, and cooperation into competition.

This chart by Andreesen Horowitz captures these dynamics neatly. Take Twitter as an example. When it started out, it offered a great service for free. It encouraged developers to build on its network, which caused an explosion of third-party apps that helped popularize the service and drive adoption. As it grew in users and power, it started extracting value from users, charging them for the service by introducing ads. It also started phasing out third-party apps, regarding them as competitors for eyeballs. More importantly, only Twitter had a say in the matter.

This is a common path for centralized networks. Developers are becoming wary of building on top of centralized services. Why wouldn’t they?

Users, too, tend to get the short end of the stick. They’re vulnerable to arbitrary decisions by a central authority. Which content and behaviors are allowed? Which features get developed? Which people are admitted and banned? Users are mostly unable to vote except with their feet. But, way too often, they don’t have anywhere else to turn to.

Blockchain technology holds the key to push back against this centralization. It promises to take back the internet from the incumbent juggernauts, and give everyone else a much fairer chance at participation.

It does this because it introduces a new feature into networks: trust. Trust between the users, developers, and other network stakeholders. This trust comes first and foremost from the way the blockchain is cryptographically secured. Additionally, and more interesting still, is how game theory can be used to develop token economies on top of this trust layer, which turn blockchains into incentive machines. This essentially makes it possible for us to trust the network, without having to trust any of its individual participants.

In order to get a better grasp of what is meant by incentive machines, let’s talk about Bitcoin.

The concept of a blockchain, as a cryptographically secured chain of blocks, emerged almost 30 years ago. About a decade ago, an entity named satoshi leveraged this data structure to create Bitcoin: a proof of concept for a fully decentralized currency.

Say that Alice and Bob have an account at the same bank. Because of fractional reserve banking, where banks don’t need to keep everyone’s money at hand, their money is essentially just a number in a database. When Alice transfers €100 to Bob, the bank essentially subtracts 100 from Alice’s number, and adds 100 to Bob’s. Both of them are trusting the bank to do this properly. They have no choice.

Bitcoin proposed to keep these balances differently. Instead of relying on a trusted third party, like a bank, it suggested decentralizing its upkeep to thousands of participants, who would maintain a common ledger. Every participant would keep a copy of every transaction, and help make sure that only valid transactions make it onto the common ledger. This way, there’s no single point of failure. It’s harder to hack thousands of computers than a single one, no matter how secure it is.

The important takeaway is this. The great innovation of Bitcoin wasn’t that it became the first large-scale application to use a blockchain. It’s that it found a way to incentivize these thousands of participants to contribute to the network our of their own self-interest. It did so by creating the very first blockchain token.

The mechanism is simple. In order to participate in the network, you become a miner. To do this, you run this open-source peer-to-peer software that is kind of like a lottery ticket. If you’re lucky, you could be rewarded with newly minted bitcoin.

This mechanism worked. Bitcoin today has thousands of nodes participating in its network. Every additional nodes makes it a bit harder for the network to be compromised, since it makes it increasingly difficult to orchestrate an attack.

Personally, I’m very skeptical of the notion of a single decentralized currency. Currencies with a large user base, like the Euro or the Dollar, tend to be managed by very smart people in response to economic conditions, and I don’t think Bitcoin will quite replace them. It happened to take off, and is now worth upwards of 100 Billion, but that’s not where my focus lies. I don’t care much for the currency use case. I used it as an example because it’s the best known project, and because it’s dead simple to explain.

Let’s move on, and talk about Ethereum, a much more interesting platform.

A few years after Bitcoin came out, Vitalik Buterin, who had tried and failed to convince the bitcoin community that it needed to be upgraded to support more use cases, proposed Ethereum.

Bitcoin can’t do much else than value transfers. Ethereum, on the other hand, was to be a world computer, a platform for arbitrary computation and storage, on top of which distributed applications could be built. The building blocks for these applications are now called smart contracts. They are turing-complete pieces of code, stored on the blockchain, that network participants can deploy and interact with.

Since Ethereum would support arbitrary computation and storage, and since every node would have to run said computation and store said storage in order to participate, running an Ethereum node could get expensive. In order to keep costs under control, Ethereum introduced the concept of gas: a network fee, which increases with the complexity of the computation and the size of storage.

This gas is paid in ether, a cryptocurrency native to Ethereum. Ether is more correctly denominated an “utility token”. It’s called that way because its whole purpose is to pay for network utility. Having to pay gas in ether incentivizes network users to place only as much strain on the network as necessary, and penalizes poorly constructed code and excessive storage. It also helps prevent denial of service attacks.

Ethereum rewards its network participants in a similar way to Bitcoin. It incentivizes them to run Ethereum software to validate transactions, and it rewards them with newly minted Ether as well.

Bitcoin and Ethereum are relatively simple examples of how the emerging field of cryptoeconomics works. As Vitalik himself puts it, cryptoeconomics is about using economic incentives to reward participants who further the system’s objectives, and penalize participants who harm the system’s objectives.

Ethereum has been instrumental to the recent explosion of the blockchain space. On top of it, a whole new class of decentralized applications are being built. People are experimenting with self-sovereign identity systems, voting, insurance contracts, supply chain tracking and financing, and much more.

The simple cryptoeconomic mechanics that Bitcoin and Ethereum pioneered are serving as an inspiration for a new class of solutions. Prediction markets help tap into humanity’s collective knowledge in order to help see the future, while incentivizing participants to remain honest. Token curated registries introduce a mechanism to guarantee reliable curation of lists. Social networks are using cryptoeconomics to get over the cold start problem. Dating apps are using token design to reduce spam and increase the quality of matches. And much more.

I’d like to take a quick detour to talk about another use case for blockchain tech which I believe is really easy to understand: digital scarcity.

Digital scarcity is obviously implied when we speak of cryptocurrencies. After all, if there were infinite bitcoins, their value would drop to zero. A currency only has value if there’s a limited amount of it.

There are contexts other than currency in which scarcity plays a vital role. Fine art is a well understood case study on scarcity.

Why would I buy an original Picasso? It’s not because it looks better than a copy. It’s because I get to say I’m the one who owns it. Bragging rights have long been a reliable driver of economic activity.

Scarcity has been absent from the digital world. After all, information wants to be free, as it should. Creation and curation should be rewarded, but I don’t believe there should be barriers to consumption.

Digital artists have a hard time monetizing their work. Why would I pay you for a gif, if anyone else can copy it and get it for free? So they resort to platforms like Patreon, where content lovers gather to reward content creators. All a digital artist can do is ask their Instagram followers to go to Patreon and sponsor them. Which is amazing. I love Patreon, and I’m a contributor myself. But I think this model is incomplete, because it amounts to little more than charity.

Blockchain technology offers an alternative which is modeled on good old bragging rights. Instead of asking for donations, digital artists could sell the ownership of an original. This ownership is a permanent blockchain record, and serves as an inviolable proof that I am the person who owns the original. No matter how many times it is copied.

This isn’t the stuff of dreams, it’s already being built. Platforms like Azelo can even guarantee that the artist will always be paid a fee for every subsequent sale. I’m excited for what this could mean for the future of digital art.

Let’s wrap up this talk with a short note on ICO, or token sales. ICO means Initial Coin Offering. It is a pun on IPO, or initial public offering, which is what happens when a company gets quoted on the stock market, and sells stock to the public for the first time.

ICOs are an innovative fundraising mechanism. What gets sold isn’t necessarily a share in a company, but rather tokens, which constitute a share in a network.

In order to understand how they work, let’s go back to Ethereum. In order to fund the development of their network, Ethereum conducted an ICO. They sold ether, their network token, in exchange for Bitcoin, part of which they converted to cash to fund their operations.

So far this is easy to grasp: having money to build things is good. But why would anyone participate in this? In short, for the same reason they would buy shares of a company’s stock.

People buy shares because they hope the company will go up in value, and so will their share. A share is a slice of a company’s metaphorical pie, and so when the pie grows in size so will each individual slice.

The mechanics with ICOs are slightly different, even though the general principle remains the same. For example, with Ethereum, the expectation is that, as the value of the network increases, more people want to use it. In order to use it, they need to buy ether to pay for gas. Because the amount of ether is limited, more demand for ether exerts an upward pressure on its price, as per the law of supply and demand. As such, buying tokens in an ICO, or in general at an early stage of the network, could yield great returns as the network and consequently those tokens appreciate in value.

Unfortunately, the ICO space has been rife with scams and bullshit. Even when there are honest intentions, people misunderstand the scope of applicable law and handwavily dismiss their legal responsibilities by calling the space “unregulated”. This is not true, and it’s a dangerous belief to hold. Raising money, and selling things in general, has a pretty tight legal grip. While it’s fair to complain that the law doesn’t address cryptocurrencies in particular, ICO issuers still have to abide by the spirit of capital markets and consumer protection regulations.

Time for a little shameless plug! Regulatory compliance is what my company Fractal does. We help companies conduct their ICOs in a globally compliant manner, respecting KYC, AML and capital markets regulations for almost any jurisdiction worldwide. Talk to us if you’re planning an ICO. Or if you’re a great developer looking to get into crypto.

Planning an ICO? At Fractal, we offer a hassle-free, user-friendly launchpad solution combined with a comprehensive customer identification service (KYC/AML) to successfully deploy your token launch with ease.