Understanding Monetary Premiums in Programmable Value Networks

By: Dan Zuller

I’ve been thinking about the state of programmable value networks a lot lately, and in particular, Ethereum. From the distance, it appears there are many “contenders” competing to be the “win all be all” smart contract leader; on the public side we have Ethereum, EOS, Tezos, Zilliqa, Cardano et al., not to mention the newly launched Cosmos, and on the private (pre-launch) side, we have DFINITY, Coda, Near, Polkadot, Oasis, Kadena, Thunder et al. The purpose of this post is not to analyze each of these networks with respect to the other and assign probabilities to the likelihood of a particular network “winning” (I don’t even think there will be one “winner”) but rather to focus on one item in particular that I believe is an imperative component to a given network’s ability to achieve large scale success with programmable value: the monetary premium.

The monetary premium herein simply refers to an asset’s information insensitivity and its ability to withstand the test of time; for an asset to be used in transactions, users must not worry about its future value, and must be comfortable with its economic history. Censorship resistance, security, a predictable (and stable) monetary policy and an otherwise justifiable and sustainable value proposition are also key in order to enable social scalability.

But how exactly does social scalability work? We know monetary assets must have a large backing of physical capital in order for the value proposition(s) therein to be justifiable and sustainable. But physical capital doesn’t just appear out of thin air; social capital is also needed.

Social capital, or cultural capital as some refer to it, refers to the networks of relationships among people who live and work in a particular society. It includes things such as interpersonal relationships, a shared sense of identity, a shared understanding, shared norms, shared values, trust, cooperation, and reciprocity.

So what then, is the relationship between physical capital and social capital?

Does physical capital lead to social capital, or does social capital lead to physical capital? Or is the relationship between the two circular?

A society of people may not want to socially back a perceived monetary asset if there wasn’t substantial physical capital behind it. However, as we have learned in the past, especially with bitcoin, cryptonetworks can start off as early ideas with very few supporters that are able to attract physical capital over time. This suggests social capital initially attracts physical capital; however, to continue scaling, physical capital needs to attract more social capital over time, which in turn needs to continue to attract more physical capital. This suggests that the relationship between social capital and physical capital, particularly in the case of cryptonetworks, is circular. The more people that believe the story, the more people subscribe to said story; the more people subscribe to said story, the more frequently the story gets told, and the cycle repeats.

Recall that blockchains create financial incentives whereby a community is catalyzed to pull together to provision a decentralized digital good or service, and then remunerate for either the contribution of that digital good or service, or pay for a specific digital good or service on a network. Generally there are three primary actors involved in cryptonetworks: developers (builders), workers (supply side) and investors (demand side). Placeholder views this somewhat similarly, with miners replacing workers and users replacing developers. One class of these network actors is not necessarily more important than the others. Rather, the right combination of these actors, and their aligned coordination of behavior toward a common goal, is necessary for a network to create and capture value, illustrated below by the gold star.

Investors inject physical capital into decentralized cryptonetworks with the expectation of earning a future return on that invested capital. Somewhat similarly, workers bootstrap decentralized cryptonetworks by provisioning various forms of supply-side services in a non-Byzantine fashion, with the expectation of compensation via network rewards (i.e., returns) for their invested labor. Thus, both investors and workers have aligned incentives in that they want to invest both their physical capital and labor into networks that offer attractive monetization benefits. What then, of the developers?

Developers are part of the lifeblood of cryptonetworks, and are needed for social capital to develop. Without developers, a network will be unmaintained, and its future security questionable. It should be clarified that developers do not directly secure the cryptonetworks they build upon; that is done by the transaction validators (referred to as workers above). Each network has a different security mechanism, with some arguably more secure than others, but that analysis is for a different post. Point is, developers are needed to maintain, upgrade and help govern the cryptonetworks they socially back. Proper financial incentives are powerful, but social incentives and connectivity are arguably just as powerful.

If developers migrate away from a given cryptonetwork for any particular reason, investors and workers will have a challenging time assigning value to their physical capital and labor. Their physical capital needs social capital for value creation, and the economic design they subscribe to facilitates the value capture. Thus, a network’s ability to earn a monetary premium, depends, to an arguably large degree, on the strength of its developer base. If developers abandon one network in order to build on another, whether due to improved UI/UX, computational efficiencies or simply a better perceived community and sense of belonging, the original network’s monetary premium should not be expected to hold its value over time if that developer base is not adequately replenished with equal or greater caliber. The monetary premium speculated upon by the investors and workers becomes nothing other than an illusion in this case.

So, how does this relate to Ethereum and the other programmable value contenders?

There has been much controversy around Ethereum’s 1.x and 2.0 roadmap, execution plan, and timing. While DeFi/Open Finance enthusiasts holler that over 2% of the ETH supply is locked up in MakerDAO smart contacts and that ETH is being used in other DeFi/Open Finance applications (Dharma, Uniswap, etc.), signaling a bullish trend that ETH is emerging as a global store of value and digital reserve asset, it is important to remember that ERC20 tokens are portable and can be moved over to other networks if so desired. Thus, eyes should remain on developer activity.

According to Electric Capital’s March 2019 Dev Report, Ethereum has demonstrated extremely strong and consistent active developer growth over the last year with the highest number of core and total developers among the most valuable public projects, including Bitcoin. Thus, despite a choppy and uncertain roadmap and arguably high execution risk, the Ethereum network’s developer activity has continued to surge, suggesting an extremely large social capital base.

If these trends stay intact, Ethereum may be on the path to earning a sustainable (and justified) monetary premium as time goes on and more and more physical capital is attracted. That is not to say, however, that Ethereum doesn’t have a fair amount of challenges ahead of it. The arguably high execution risk inherent in the ETH 2.0 roadmap should not be taken lightly, and the need for a predictable and stable monetary policy, coupled with censorship resistance, is necessary to attract that additional physical capital. But the present state of the network’s social capital seems to suggest these trends may be pointing in the right direction.

We should also remind ourselves that the private programmable value networks such as DFINITY, Near, Polkadot et al. have yet to launch. Will these projects cause developers to leave Ethereum if they are “better technologies”? Can those other programmable value networks also accrue monetary premiums of equal or greater magnitude? The possibilities of those things happening in the future may look extremely unlikely from today’s lens, but such possibilities arguably have non-zero probabilities nonetheless.

Another thing to keep in mind is we should not discount the fact Ethereum has a tremendous regulatory advantage over soon-to-launch programmable networks, considering it is not a security. Nonetheless, when these projects hit mainnet, and are fully live and operational, eyes should remain on Ethereum developer activity; up until now, these developers may not have had many attractive options of where to build, given the somewhat limited (live and operational) mainnet competition. The real test may be yet to come. However, as noted earlier, the Ethereum community’s interpersonal relationships, shared sense of identity, shared understanding, shared norms, shared values, trust, cooperation, and reciprocity are all “sticky” factors that may produce substantial friction against the possibility of migration. In other words, the story has been told.

Grateful thanks to Spencer Noon for his help and thoughtful feedback with this post.

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Disclosure: I personally hold positions in ETH and BTC, and indirectly through Vision Hill may hold some of the other assets discussed in this post. The content provided herein is of my own opinion and should not be considered investment advice, and is not a recommendation of, or an offer to sell or solicitation of an offer to buy, any particular security, strategy, or investment product. I have not received and will not be receiving any compensation as a result of this publication.