In my last two posts, which you can find here, I discussed the history and benefits of cloud (aka centralized) computing. In my next few posts, I’m going to shift to the other side of the spectrum and explore distributed computing through blockchain technology. Blockchain is a relatively complicated technology that is rapidly evolving so I thought it would be helpful to split this discussion into a three part series. The first will discuss the history of decentralized computing, the second will provide an overview of how the technology works (with posts on protocols, Dapps, and ICOs), and the third will detail a few of the most exciting opportunities in the space. Hopefully you find them interesting!
As I’ve mentioned in prior posts, I think that it’s helpful to understand the history of innovative technologies as it is difficult to understand where a technology is heading without understanding how it has developed up to this point. Therefore, this post is dedicated to understanding the history of blockchain and, more broadly, the crypto ecosystem.
So where should we start? The most logical place to start would be with the coin that inspired the movement.
In 2008, Satoshi Nakamoto released a paper titled “Bitcoin: A Peer-to-Peer Electronic Cash System”. What’s interesting is that Satoshi has remained anonymous to date. Nobody knows if Satoshi is a person or a group of people. Nobody knows where he/she/they are from. However, the paper that Satoshi wrote has sparked a bit of a revolution. The paper outlined a peer-to-peer payments system that did not need verification by a central authority. The underlying technology was the blockchain. At a high level, bitcoin’s blockchain was the first peer-to-peer payment network to truly facilitate trust between anonymous parties and solve the “double spend” problem. The double spend problem stems from the fact that digital assets are easily replicated so there’s a chance that somebody could try to copy that digital asset and use it twice. The double spend problem is the reason that we have historically needed trusted third parties to confirm that the digital assets we are exchanging (currency, property, etc.) have not already been spent elsewhere. Bitcoin’s protocol (which sits on top of the TCP / IP stack, similar to the HTTP protocol that fueled the growth of the modern internet), solved this problem through a combination of a few technologies, including advanced encryption, distributed ledgers, proof of work validation and integrated blocks. I’ve purposefully refrained from describing the technology in detail here because this post is designed to focus more on the history. However, please stay tuned for my next post if you want a better description of how the underlying technology works. The point is that Satoshi’s paper established the theory behind blockchain and laid the groundwork for future development.
In 2009, the first bitcoin was mined. Ironically, the code referenced a newspaper article that was published on the same day describing the bailout of a large British bank, a reference to the crumbling global financial infrastructure. The first bitcoin transaction quickly followed when Satoshi sent a bitcoin to Hal Finney. There are many rumors that Hal Finney is Satoshi Nakamoto; however, he has repeatedly denied those.
As with most new technologies, bitcoin took a while to pick up steam. It’s user base started with a small group of devoted followers. It wasn’t until 2010 that bitcoin was first used to make a transaction. That transaction will forever be infamous. On May 22, 2010, Laszlo Hanyecz purchased a pizza for 10,000 bitcoins. At the time, that probably seemed like a good deal for Laszlo as bitcoin was worth next to nothing. However, at bitcoin’s high of $19,783.06 in 2017, that pizza would have been worth $197.83 million… Hopefully it was tasty!
At that time there weren’t many businesses that would accept bitcoin as compensation so its use as a legitimate medium of exchange was limited. So how did bitcoin gain in popularity if there weren’t any legitimate use cases? Unfortunately, one area where bitcoin’s anonymous and decentralized nature was highly valuable was for illegal transactions. The early growth of bitcoin between 2010 and 2015 was through an online dark-web marketplace called the Silk Road. It was used to purchase everything and anything imaginable, including a significant amount of drugs. While it’s disappointing that bitcoin’s initial use case was to facilitate the transaction of such harmful goods, the growth that was fueled by these illegal transactions brought the technology to the attention of governments and investors worldwide. It’s likely that the technology would still remain largely undiscovered without this.
Bitcoin has experienced some crazy price fluctuations over time, particularly in 2017, when speculators fully embraced the crypto market. Bitcoin broke $1000 per coin for the first time in November 2013, $5000 per coin in October 2017, $10,000 per coin in November 2017 and ultimately made it as high as $19,783 before stabilizing down in the $6,000 to $10,000 range.
As bitcoin grew in value and notoriety, other cryptocurrencies began to pop up. Notably, Namecoin was created in April 2011 to decentralize DNS (with the goal of eliminating internet censorship), Litecoin was released in October 2011 (with the same purpose as bitcoin but a slightly different technical implementation), and Peercoin was launched in 2012 (again, with the same purpose as bitcoin but without the token cap). While there have been a significant number of different coins created over the years, none have been as important as Ethereum. However, before we get into Ethereum, we’re going to take a brief look at the creation of cryptocurrency exchanges as these were essential to the growth of the technology. Without these exchanges, users would not have been able to exchange coins for fiat currency or make cross-chain transactions.
In order to actually acquire and sell bitcoins, users needed an exchange that would take their fiat currency and trade it for cryptocurrency. The first to do this was Mt. Gox. Mt. Gox was founded in 2006 by a programmer named Jeb McCaleb. I know what you’re thinking: how was it founded in 2006 if bitcoin wasn’t even around until 2009…? This is possible because Mt. Gox was originally founded for a completely different purpose. It was originally founded for fans of the game Magic. The name was literally an acronym that stood for “Magic: The Gathering Online eXchange”.
Mt. Gox was the original crypto exchange; as such, it had a significant first mover advantage and processed the large majority of trades in the early days. Unfortunately, it also experienced several major issues. In 2011, it was hacked for the first time, resulting in a loss of over 2500 bitcoins. While the hack did not diminish the exchange’s popularity (it still accounted for over 70% of trading value), Mt. Gox continued to experience a number of challenges behind the scenes. In 2013, it was sued by a former business partner and investigated by the SEC. In addition to that, it was unknowingly the victim of an ongoing hack that may have begun as early as 2011 and wasn’t discovered until February 2014. After identifying the hack, Mt. Gox temporarily shut down its operations. However, it quickly realized that hackers had stolen 744 thousand bitcoins from its customers and an additional 100 thousand that were owned by Mt. Gox. This hack rendered Mt. Gox insolvent and led to its bankruptcy on February 28, 2014.
Following the bankruptcy of Mt. Gox, there have been a significant number of exchanges that have popped up to fill the void (including MF Global, Bitstamp, Bitpanda, Luno, XEC.io, Kraken, Binance, Bittrex, Gemini, GDAX, Kucoin, Changelly, CoinMama, Cryptopia, Bitfinex and Poloniex to name a few…). I’ll provide a brief history of three of the most popular exchanges; however, this history will not be comprehensive and I recommend you look into the names above if you want the full background. Also, one last disclaimer before we dive in: the exchange landscape is rapidly changing and will likely look drastically different in a few years.
Coinbase / GDAX:
The Coinbase story starts in June 2012 when the company was founded by Brian Armstrong and Fred Ehrsam. A few months later, the team applied for, and was accepted into, the Y Combinator incubator class of 2012. During the program, Coinbase created a viable product and began offering consumers three important features: a cryptocurrency wallet to store their coins, a merchant platform that allowed businesses to accept Bitcoin as payment and an exchange service to trade cryptocurrencies for fiat currencies. The following spring, in May 2013, Coinbase received its first venture capital investment when Union Square, Ribbit Capital, SV Angel and Funders Club invested in a Series A round. This represented Union Square’s first blockchain investment, a space where they are now highly active.
Following this initial investment, Coinbase rapidly scaled its platform. In 2014, it reached 1 million users, added a number of businesses to its merchant platform (including Overstock.com, Dish, Dell and Expedia) and added several payment processors (Stripe, Braintree and PayPal). As Mt. Gox collapsed in 2014, Coinbase shifted its focus to improving its security. This led to two major decisions. The first was to take clients’ private keys offline and store them in secure physical vaults. The second was to begin to engage with regulators and integrate the platform with traditional financial institutions. These steps positioned the platform as a “safe” crypto exchange, leading to strong adoption among traders. Additionally, this led to a massive $75 million fundraising round from DFJ, the NYSE, USAA and several other banks.
As interest in crypto grew, Coinbase decided that it needed to add an offering for more sophisticated traders. This offering has gone by several names over the past few years. It was launched in January 2015 under the name of “Coinbase Exchange”. In May 2016, Coinbase changed the offering’s name to Global Digital Asset Exchange (“GDAX”) to clarify the difference between Coinbase and the new trading platform,. However, this still didn’t satisfy the Coinbase team so they renamed it “Coinbase Pro” in 2017. This brings us to present day, where Coinbase remains a leading crypto exchange and offers a variety of services to merchants and consumers.
Kraken was founded about a year after Coinbase. It was launched by Jesse Powell in 2013. As legend goes, Jesse had visited the Mt. Gox headquarters to offer assistance following the first major hack. During this visit, he recognized how poorly the organization was run and created Kraken as an alternative in case the exchange ultimately failed. Not a bad prediction…
Kraken initially offered trading between bitcoin, litecoin and euros, enabling it to grow in a slightly different geographic market than Coinbase. Over time, the exchange has gained in popularity by maintaining a consistent focus on security and continuously expanding its crypto offering. Kraken now offers 18 cryptocurrencies (notably, it added Dogecoin in April 2014 and Ether in August 2015) and allows investors to trade in both EUR and USD.
There are a few interesting things to note about Kraken. First, Kraken has built one of the largest crypto exchanges in the world; however, it has raised a relatively limited amount of external funds. While Coinbase has raised over $225 million in venture funding according to Crunchbase, Kraken has only raised $11.5 million to date. That’s a big difference. Second, Kraken places enormous emphasis on security, which is demonstrated by the regular audit that it conducts and the various features it offers to help customers mitigate risk. Third, it has gotten in a number of spats with US regulators because it believed that the regulations they proposed stifled innovation while doing nothing to improve security. If you’d like to read more on these, I’d recommend checking out this article written by James Holmes in Bitcoin Magazine.
The last exchange I want to highlight is currently number one in trading volume: Binance. Surprisingly, the history of Binance is very short. While Coinbase was the first bitcoin unicorn, Binance was definitely the fastest. The company was founded by Changpeng Zhao in 2017. Mr. Zhao had previously founded Fusion Systems in 2005, which built high frequency trading systems for brokers.
To fully appreciate the company’s unprecedented growth, it might be helpful to walk through its timeline. Binance published its white paper in June 2017, completed its ICO ten days later (which generated $100 million in a few minutes), became a top ten crypto exchange by volume 42 days after inception, broke into the top three just 143 days after inception and topped the charts shortly thereafter. It now has almost $1 billion of daily trading volume and has raised capital from the likes of Sequoia and IDG.
While this growth is quite impressive, I need to throw in one caveat. Binance has been accused of falsely inflating its trading volume. Nobody has proven that the claim has merit but its worth noting.
As I said, this is not a full history but gives the background of a few of the most popular exchanges. It’ll be interesting to watch the competitive dynamics of these over the next few years.
Now that we have a general understanding of crypto exchanges, let’s rewind a little bit and discuss the creation of what has become the second largest cryptocurrency by market cap: Ethereum.
Ethereum & Smart Contracts
As I mentioned before, the second most important development in crypto was probably the invention of Ethereum. Ethereum was founded by Vitalik Buterin. Buterin became a bitcoin programmer in 2011 (when he was 17 years old) and soon after founded Bitcoin Magazine. In 2013, he became unhappy with bitcoin’s limitations. Notably, he believed the cryptocurrency could be much more than purely a peer-to-peer payments protocol. He argued that bitcoin needed a scripting language that allowed users to trade more than just cryptocurrency. When the bitcoin community disagreed with this approach, he decided to raise capital to create his own cryptocurrency. In 2014, Buterin crowdfunded $18 million through a crowdsale on the Bitcoin network, which funded the initial development of the Ethereum network.
On July 30, 2015, Ethereum rolled out Ethereum Frontier, which was a bare bones platform that allowed users to trade Ether (Ethereum’s cryptocurrency), mine Ether, and create smart contracts through Ethereum’s Turing complete scripting language. You may have just skimmed past the last part of that sentence but its worth re-reading because the ability to create smart contracts was a HUGE development in blockchain’s history. Smart contracts make blockchain technology much more useful for end-users.
It’s hard to understand why this is so important without walking through an example so I’m going to briefly describe an example written by Blockgeeks. Imagine for a second that you want to rent an apartment from me. To do so, I’m going to send you an electronic key and we’re going to create a smart contract via the Ethereum blockchain. The contract says that you will be automatically reimbursed if the key does not arrive on time (the funds will be automatically released by the blockchain). The contract also says that you need to send me a rental agreement and valid form of identification. If the key, rental agreement and valid ID all arrive on time, then the blockchain will (i) allow the key to open the door and (ii) release the funds to me on the rental date. These previously agreed upon rules can be coded into the Ethereum blockchain, ensuring that both parties hold up their end of the bargain. While this is a somewhat obscure example, it demonstrates the if-then logic that can be incorporated into smart contracts, which reduces the need for third parties to create and enforce legal contracts. This logic can be applied to automate contracts across a wide range of industries and functions. For example, think supply chain agreements, health record management, real estate contracts, and even voting in local or national elections. One particularly interesting use case of a smart contract is the initial coin offering (“ICO”), which we’ll discuss next.
Initial Coin Offerings
An ICO is a special kind of fundraising that is specific to cryptocurrencies. In an ICO, a predetermined quantity of crypto “tokens” or “coins” are sold to investors / speculators. Typically these investors and speculators buy into the ICO using bitcoin or ethereum. The capital raised from the ICO is typically used to fund the development of the network.
Purchasers are willing to give this capital to the developers because they either want to use the application following its development or because they believe the price of the token / coin will significantly increase once the network is established. The idea being that, similar to a company, there is often a cap on the total number of tokens that can be created by the network. Therefore, if users are required to buy the token to use the network, then the price of the token should increase as the value of the network increases. As an example, Filecoin was created to decentralize file storage. To store a file using the filecoin protocol, users must first buy filecoin. If the user base scales from 100 to 1 million and the number of filecoins stays the same then the value per filecoin must go up. Whether or not this logic will prove to be true over the long-term is a debate that warrants its own blog post but that should give you a basic idea of what an ICO is and why people participate in them.
So how did they come into existence? Many people believe that the first ICO was Mastercoin. In 2013, J.R. Willet published the Mastercoin white paper, which stated that Mastercoin was intended to sit between the bitcoin network and the application layer. In the paper, he posited that it did not make economic sense to create a completely new blockchain. He believed that it made more sense to simply build applications on top of the existing networks (aka bitcoin) and wanted Mastercoin to be the link between the two. In the paper, he also outlined a way of crowdfunding on the blockchain, which would later be known as an ICO. Mastercoin went on to successfully raise $500,000 worth of Bitcoin in August 2013.
While Mastercoin proved that it was possible to complete an ICO using Bitcoin, there were clear technical limitations; most notably, it’s scripting language was not Turing-complete (can you see where this is going?). Ethereum was created to solve those issues. Ethereum’s full scripting language allowed users to create smart contracts and fully decentralized applications where they could “create their own arbitrary rules for ownership, transactions and state transitions”. In addition to the scripting language, Ethereum provided several other features that improved the ICO process; notably, it allowed users to lock coins until the result of the transaction. This allowed users to put coins in an escrow of sorts until the full amount of the ICO is crowdfunded. These differences made Ethereum an ideal platform for ICOs.
The release of Ethereum Frontier in June 2015 facilitated early growth of the ICO market. The first successful ICO was held when Augur raised over $5 million on August 17, 2015 (only eighteen days after Ethereum Frontier was released!). While there was a substantial increase in ICOs in late 2015 and early 2016, the true growth of the fundraising method did not occur until Ethereum upgraded the network through the release of Ethereum Homestead in March 2016. Homestead increased transaction speeds, allowed for protocol revisions and simplified the development process. This lowered the technical barrier to entry, enabling developers without a highly technical background to use the network.
The growth of ICOs was stunted in mid-2016 when the DAO was hacked (which we’ll discuss in detail below). However, ICO volume bounced back quickly and 2017 became known as the “year of the ICO”. Statistica reported that ICOs raised a total of over $4 billion in 2017, which is an unprecedented amount of capital. To put that in perspective, they also reported that VCs deployed a total of $709 million in the blockchain space, indicating that ICOs raised 5.7x as much capital (to be clear, this is just referencing VC investment in blockchain: total VC investment was over $70 billion). This trend has continued in 2018 and some people have begun to claim that ICOs have the potential to disrupt traditional IPO processes.
Needless to say, the ICO fundraising method has exploded and doesn’t show any sign of slowing down. For readers that want a more detailed description of the history of ICOs, Ivona Skultetyova gives a great overview of the history here.
Decentralized Autonomous Organizations
What the heck is a DAO?
The final piece of blockchain’s history that I want to discuss is the Decentralized Autonomous Organization (“DAO”), which is an extreme case of decentralization made possible by Ethereum’s smart contracts. As the name states, DAOs seek to disrupt the traditional top-down org structure by decentralizing organizations through code written into smart contracts. The idea is that a DAO can raise money through an ICO. Once the entity is established, the entirety of the decision-making process is run through a number of smart contracts that require consensus from the token holders. Due to their decentralized nature, DAOs are not capable of creating a product so they rely on contracting out the large majority of these services. The process of identifying and employing contractors is done through proposals. A token-holder can propose a contract to build a product or complete a service. After the proposal is submitted, all of the token holders debate and vote on the proposal. If the proposal is accepted, then the smart contract is executed. Upon the sale of the good or service, revenue accrues to the DAO. The token-holders can then decide whether to use that revenue to support growth or distribute it to the token holders (similar to a dividend).
That probably sounds like an unnecessarily complicated way to run a business so the question is: what’s the benefit? Evangelists tout that this structure is a huge step forward because it eliminates the principal-agent problem. The principal-agent problem occurs when one person (“the agent”) makes decisions on behalf of another person or entity (“the principal”) and does not proportionately take on the risk of those decisions. The classic example is a public company with a traditional top-down organizational structure. In this case, the CEO often takes on much more risk than the owners (shareholders) want him to because he is poised to benefit from the upside and will not experience as much of the downside if his risky decisions do not pay off. DAOs seek to mitigate this by democratizing management and requiring consensus for each decision.
The history of DAOs is very short as there are few that have been successful to date. Most people consider bitcoin to be the first DAO as it has a “pre-programmed set of rules, functions autonomously, and is coordinated through a distributed consensus protocol”. However, more sophisticated DAOs were made possible by Ethereum’s scripting language. The first DAO to be created through Ethereum smart contracts was Digix Global. Digix sought to tokenize gold using Ethereum. The idea was that Digix would store physical gold in a safe house in Singapore. 1 DGX would represent 1 gram of physical gold. After Digix Global fully built out the platform, the governance was then run by the DigixDAO, which traded under the DGD token. Therefore, any fees accumulated from owning or transacting DGX accrue to DGD token holders. Digix held its ICO on 3/30/16 and is still in operation today.
Another notable DAO is Bitshares. Bitshares is a decentralized cryptocurrency exchange. This differs significantly from the other centralized crypto exchanges (such as Coinbase, Kraken, Bittrex, etc.) as it allows holders of BTS to vote on the strategic direction of the exchange. The decentralized model is said to provide several advantages, including security and anonymity.
Unfortunately, the history of DAOs would be incomplete without talking about the rise and fall of “The DAO” (the story is described in more detail here if you’re interested). The DAO was developed by the Slock.it team in 2016. The idea was for the DAO to act like a venture fund, where community members would submit proposals for potential projects and the token holders would decide whether or not to fund it. After announcing the idea and developing the code, the next step was to raise capital. The DAO ultimately raised approximately 12.7 million ether, which were worth approximately $150 million at the time.
Unfortunately, the DAO’s code had a slight flaw, which was exploited by a hacker in June 2016. This demonstrated one of the downsides of a DAO model: every decision requires consensus…including changes to the code base. The DAO could not patch up the bug in time and the hacker ultimately stole 3.6 million ether. Another issue that this hack exposed was that, while the Ethereum blockchain is secure, apps that are built on top of it can be hacked. Prospective token purchasers need to be wary of this potential issue.
Luckily, the hacker did not get away with the Ether. The funds were subject to a 28 day holding period and Ethereum was able to complete a hard fork in the interim. Following the hack, multiple exchanges de-listed DAO, which began its downward spiral. One year following the hack, in July 2017, the SEC ruled that tokens offered by the DAO were securities and subject to federal securities law. This was the final nail in the coffin for the DAO and served as an important lesson for future decentralized organizations.
While many have proclaimed DAOs to be the “future of work”, the jury is still out on whether this is a legitimate model.
That wraps up my post on the history of blockchain. Hopefully you found it interesting! My next few posts will explain how the technology works and discuss a few areas of innovation in the space. If you enjoyed this post and would like future posts sent directly to your email, please subscribe to my distribution list or reach out to me at email@example.com.
Also, if you have an interest in venture capital and want to read more VC-related content, please follow my publication “All Things Venture Capital” on twitter. Please also reach out if you are interested in adding to the publication! My goal is to continue to add high quality content (articles, podcasts, videos, etc.) from aspiring and current venture capitalists that want to share their perspective. Thanks for reading!