Evaluating Crypto Currencies
The Devil Isn’t In The White Paper
Bitcoin is the technological version of Roger Bannister’s four minute mile. Before Bannister no human had ever run a mile in under four minutes. Four years after Bannister set the mark, twenty others had accomplished the same feat. Before Bitcoin some thought that the Byzantine Generals Problem was impossible to solve. No one believed that anonymous strangers could come to a consensus without getting a trusted third party involved in the process. Today however, there are plenty of technologies that do just that. All of these technologies are based at least in part on Bitcoin’s breakthrough.
Taking a dive into the waters of Bitcoin’s technicalities is both a rewarding and time consuming endeavor. Bitcoin is a breakthrough, but understanding its many nuances requires time and effort. This intense focus on technology has caused many to fall into the trap of over evaluating the importance of the technology while discounting the other aspects of Bitcoin. A mainstream belief is that Bitcoin isn’t the real solution at all. The real solution is the technology behind Bitcoin, the blockchain! The blockchain is the fantastic, new, and modular thing that we will use to solve problems in every field.
Real estate titles are too hard to keep track of? Just sprinkle a little blockchain on them. Electronic voting can be easily manipulated? Slap some blockchain on that. What about company ownership? Let’s hit that with a double dose of blockchain. Just like that all of our problems are solved!
Pulling Back The Curtain
The only thing wrong with this line of thinking is that it isn’t accurate. Bitcoin is akin to a living organism. It works not only because of technology, but also because of a well designed incentive structure that encourages people to act in specific ways. There is a human element to Bitcoin. As Satoshi states in the introduction of the Bitcoin White Paper,
The system is secure as long as honest nodes collectively control more CPU power than any cooperating group of attacker nodes.
Said differently, the technology is infallible, unless the majority of people using it are bad guys. In that case it doesn’t work. We can’t promise with 100% certainty that this technology will always function properly. It functions only when a certain set of conditions (an honest majority) are valid. This is distinctly different from technologies such as GNU/Linux, which do not rely on their users moral character and can be reliably used by anyone at any time. Blockchains are not plug and play.
This makes for an interesting situation because the majority is measured on a sliding scale. Two people are a majority in a system of three users. Fifty-one people are a majority in a system of one hundred users. The more users there are, the harder it will be for a group of bad actors to gain a majority. In Bitcoin more users equals more security. This means that public blockchains like Bitcoin depend on technology AND network effects to function.
Competing with Facebook
To illustrate this point and its ramifications let’s pose the following hypothetical.
Could we create a company capable of competing with Facebook if Mark Zuckerberg were to give us access to all of Facebook’s intellectual property?
We would be starting with some of the best technology out there. Assuming we had some money for hardware and personnel, we would have everything we needed to run a top of the line social network. The only thing we wouldn’t have is a user.
This is a problem. The entire point of a social network is to connect people with other people. Our network wouldn’t be valuable if people weren’t using it. So how could we get users?
One way would be to come up with some innovation that was better than anything Facebook was doing. Say we came up with a way of improving the chat feature by 15%. Would a significant number of users migrate to our social network because of this slight improvement? The answer is likely no. It’s a hassle to create a new account, build out a profile, and learn a new interface. Switching isn’t really worth the effort unless the benefit is significant.
So how much better would our innovation need to be to attract users? It’s hard to say for sure, but it’s safe to say that our innovation would need to be something considerably better than anything Facebook was doing.
Let’s say we somehow do come up with an innovation that begins to pull users away from Facebook. What will happen when we began to attract a significant number of users to our platform? Will Facebook sit and watch passively? Not likely. In fact it’s very likely that Facebook will attempt to create their own version of whatever it is we came up with. There are many examples of them doing this in the past. The kicker is that we need to be good enough to get people to leave (take some action). Facebook only has to be good enough to get people to stay (take no action).
Having valuable technology alone is not enough. Facebook derives a tremendous amount of value from its massive network of users. The value of this network is enough to compete with better technology. Every new user makes Facebook’s network more valuable and duplicating this type of network is very difficult.
Winning by being better is hard to do, but winning users by being different is possible.
Back to Blocks
Blockchains like Bitcoin are faced with the same chicken and egg situation. They must initially attract users to networks that aren’t very useful, due to a lack of users, and also suffer from low security due to a lack of users. As our Facebook example highlights, it is very difficult to do this solely with “better” technology. Bitcoin is significantly better than anything before it, but it also benefited from the first mover advantage. It had no real competition. This isn’t the case for new blockchains.
The fact that new blockchains must compete with existing networks is rarely discussed in today’s crazed ICO environment. The value of network effects and the difficulty in acquiring them is heavily discounted while the value of underlying technology, which in many cases doesn’t exist, is hyped to astronomical proportions. This creates a feeding frenzy where investors flush money away chasing “better” technologies when they should be looking for technologies that are significantly different from the competition.
Ethereum is a perfect example. Ethereum did not try to be significantly better than Bitcoin. Ethereum tried to be, and is, significantly different. This is clearly seen in the opening paragraph of the Ethereum white paper.
“What Ethereum intends to provide is a blockchain with a built-in fully fledged Turing-complete programming language that can be used to create “contracts” that can be used to encode arbitrary state transition functions, allowing users to create any of the systems described above, as well as many others that we have not yet imagined, simply by writing up the logic in a few lines of code.”
Ethereum did not try to build another peer-to-peer electronic cash technology with faster transaction speeds (Litecoin). They built something that was significantly different from Bitcoin and something that was very difficult for Bitcoin to duplicate.
A network with no users has no value, regardless of how great the technology is. It may become valuable in the future, but the future is very uncertain. Technology is critical and new innovations are happening every day, yet technology is only one part of the story. The devil is in the details and not all of the details are in the white paper.
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Author’s Note: This article was written in July 2017 with the assumption that independent public blockchains are in direct competition with one another. There are various proposals for new technologies, such as the Lightning Network, that might alter this dynamic in the future. These technologies could make it possible for several different public blockchains to seamlessly interact. If this technology is ever implemented it might shift the dynamic between blockchains from competition to cooperation. In this scenario some of the assumptions made in this article may no longer hold true.