Finding Genius

by Kunal Mehta

  Protocols Powered by Tokens

  “Blockchains are a new invention that allows meritorious participants in an open network to govern without a ruler and without money. As society gives you money for giving society what it wants, blockchains give you coins for giving the network what it wants. Blockchains combine the openness of democracy and the Internet with the merit of markets. To a blockchain, merit can mean security, computation, prediction, attention, bandwidth, power, storage, distribution, content…”

  Naval Ravikant, AngelList

  Tokens account for units of value built on top of a protocol. Tokens are the powerful incentivizing force which allow protocols to coordinate trusted economic activity on the web. They help bootstrap network effects by first providing financial liquidity for future network value. This then attracts early adopters to contribute specific work, data, and capital for the network (in exchange for tokens.) Lastly, as the supply side becomes more robust, the demand-side participants can buy and sometimes pay via token for the network’s services. Bitcoin is the most basic example of a token — Bitcoin is the native token for the Bitcoin blockchain, which is a protocol for financial transactions. Bitcoins derive their value based on the future expected value of the protocol, priced on the market. Miners do work for the Bitcoin blockchain by recording transactions on an immutable ledger; for this work, they are rewarded in Bitcoins. Way before the Bitcoin blockchain became useful for real-world adoption, the supply-side of miners became very robust due to this ability to capture and get liquidity for future protocol value. Projects are experimenting with a variety of other token models, which derive their value from different aspects of protocols — for example, Work tokens, Currency tokens, Non-Fungible tokens, Security tokens, Discount tokens, Stablecoins, DAO tokens, etc. The economics behind these are fundamentally different, and it is perhaps simpler to think of them as potential business models on top of protocols. There can also be more than one token per protocol, and they can also be layered on top of one another as basic economic building blocks for a new digitally-native value chain.

  Protocols vs. Institutions

  “One of the areas of blockchain innovation I am most excited about is building open, permissionless, and decentralized technology infrastructure. The three areas that seem most obvious to me for decentralized infrastructure are compute (code execution), storage (storing files, etc.), and bandwidth (network infrastructure).”

  Fred Wilson, USV

  If you reduce the role of an institution or a protocol down to the very core, the aim is to get a bunch of people and machines to work together towards a common goal; usually that’s the production of some sort of good or service. It then stands to reason that whichever entity can do this cheaper will have an advantage over the other and grow, while the other shrinks (adapted version of Coase’s Theorem for those fluent in economic theory.) Well-designed tokens allow crypto protocols to coordinate people and machines more cheaply than institutions by cutting out middlemen, simplifying contracts, and reducing political friction.

  We haven’t yet seen the line drawn between where companies end and protocols begin, but bolstered by tokens, protocols have a lot of room to grow and can be expected to take significant share from current companies. One hypothesis is that the future of the web could be composed of a few widely-used crypto protocols responsible for much of the transactional, low-value tasks in addition to thousands of highly specialized institutions focusing on user experiences. For example, institutions win when the market depends on physical goods — real estate, e-commerce, services, etc. — as the touch points with meatspace usually cannot be perfectly governed by a digital protocol. Institutions also win when control/design and subjectivity are required, in products such as gaming experiences, wallets, and arbitration. On the flip side, protocols win when the market is self-contained and digitized, as the economic logic within games. They also win when consistency and censorship resistance are important, allowing developers to build on them without having to worry about the rules being changed arbitrarily. Lastly, protocols win when coordinating a very large number of workers across discrete, measurable markets, such as a market for global compute power.

  Where Adoption Starts

  “Crypto-powered governance markets will solve the tragedy of the commons and drive future abundance at the same level of scale as the stock market and the corporation. In a pervasively connected world, it will be more global and democratized than what we’ve seen before.”

  Mike Maples, Floodgate

  How exactly does the value erosion happen from Web 2.0 to Web 3.0? And where will the wedges be created in the existing web businesses, dominated by giants? One potential answer to this is wherever there are digital market failures in our society today.

  In economic terms, a market failure is any time the free market fails to allocate resources efficiently, usually requiring government intervention. There are a few types of market failures, but let’s focus specifically on the tragedy of the commons. The commons refers to a pool of scarce resources, shared by all, but not governed by any, so it’s often exploited and depleted. The only solutions proposed by economic theory are privatization — letting an enterprise govern it, or nationalization — letting governments govern it. Well-known examples of tragedy of the commons include global warming, depletion of our natural resources, and a lack of funding for public schools.

  This was until economist Elinor Ostrom proposed a solution which won her the Nobel Prize in 2009. She observed that many communities have successfully governed the commons by adhering to a set of rules. These rules are largely encoded into the fabric of trust built within the small communities she studied; she never thought them to be socially scalable to our large, modern societies… until crypto protocols came along.

  For the first time, the rules for governing a common resource can be encoded and enforced digitally, within crypto protocols, without the need for an enterprise or a government. If we can account for the resource and enforce rules around its consumption digitally, Ostrom’s findings can extend beyond the small communities where this already works in practice.

  Crypto protocols will have a harder time managing the physical commons because rules like access rights are harder to enforce in the physical space without some sort of central party intervention (e.g. clean air, oceans, schools, roads, etc.) However, applied to the digital commons where all the value can now be traced and tracked for the first time, real-world adoption begins to look more near term. However, the idea of a valuable digital commons is still somewhat new to us because digital scarcity is new. What makes this really big is that any scarce resource can be thought of as the commons and managed by crypto protocols if producers and consumers are willing to produce into and consume from the “collective pot.” The problem with this line of thinking has always been the corrupted incentives of the central party required to manage the allocations back to society.

  Again, crypto protocols solve this problem — far better in fact than even the most uncorrupt central authority, because protocols can deliver services at monopoly efficiency while maintaining perfectly competitive prices. This means that any time a protocol or an enterprise is competing to deliver a service, a protocol can deliver it more cheaply by making it a commodity. The usefulness of this economic model extends thus beyond the commons and into other types of market failures such as monopolies or oligopolies. It is perhaps a useful framework for thinking about how to economically break up the Web 2.0 giants discussed earlier.

  Time will tell the extent of adoption and how many of our resources we’ll be able to manage as commons. However, aligning our incentives with the collective using crypto protocols is powerful because it is how our society works today, but not how our businesses work. Our incentive structures fail in the face of increasing human connectivity because they fail to capture the growing impact of our actions on our networks and vice versa. In the future, our decisions’ impact on others will perhaps be greater than on ourselv
es, so continuing to operate in single player mode in a multiplayer world is not only wrong but dangerous.

  Technology vs. Human Protocols

  “One of the challenges of this sector which I think is not getting enough attention is this: what is the cost to society of not trusting?”

  Dan Ariely, Economist

  In this industry, we tend to overemphasize the role of technology and underplay the other forces driving the growth of the digital economy. The crypto world promotes “trustless” as an ideal, which is not surprising given that the Bitcoin whitepaper deems the elimination of the need to trust (specifically in a third party) as a core value proposition of Bitcoin. It would be foolish to pretend it’s possible to completely remove trust from the equation and propose instead that blockchain technologies should be used to enable more trust between counterparties. While cryptonetworks are technology protocols, trust is a human protocol. The former is more scalable across a large, anonymous population, but the latter is more powerful as it is far more adaptive and multi-dimensional. The two need each other to scale.

  Trust is essential for growing the economy. In the absence of trust, even with technology, many value-creating transactions wouldn’t happen. A simple example is this: I am selling a t-shirt online to you. However, you don’t trust that I will send it to you after you send me payment, and I don’t trust you enough to send you the shirt before you pay; therefore, this transaction never takes place and the market for t-shirts was not established. Then comes along an e-commerce platform to facilitate this trust by holding funds in escrow until verification of receipt and promising to take recourse on both seller and buyer if either misbehaves. So, we make the transaction, but the platform takes a cut for establishing the market. However, all participants have to trust the platform will do the right thing, and they suck significant value out of the ecosystem. Now, cryptonetworks come along and allow us to program the verification of receipt and escrow into the smart contract such that we can transact without the need for trust in a third party. The elegant technological solution can help establish many new markets and even allow certain economies to leapfrog financial systems where there hasn’t been a credible third party to establish societal trust.

  The idea is that participants in blockchain networks so fully trust the technology that they implicitly trust the entire network. This could be thought of as an evolution of trust in the most ideal case. However, in reality, especially at this stage of the technology’s development, we cannot expect the code to fully account for all edge cases, and this is what’s worrying. Abiding too strictly to the trustless ideal allows network participants to offload personal (or community) responsibility for unethical behavior because it is supposedly “programmed into the code.” This type of “code is law” thinking puts us in a position where everyone is expected to be cold-hearted and uber rational, and exploitation is the norm. As such, the trust and ethics governing the edge cases dissolve altogether. Countless incentives play such a major role in governing our behavior today, and we can’t possibly account for them all by top-down design. There are always unforeseen edge cases, and they can’t always be predicted and must be resolved over experimentation and trust.

  However, what’s optimistic is that the virtuous (or trusted) participant always has a competitive advantage in the market; they are likely to attract more transactions because dealing with lack of trust can be costly and complex. A few virtuous actors can anchor a market because others will try to mimic them in order to also win business. There have been tons of studies done on reputation games in economic literature — the gist is if we enable a transparent reputation system over time, all players have an incentive to behave, virtuous or not.

  Technology’s impact on society is so greatly influenced by how we choose to adopt it, and some of the decisions we make right now are fundamental to how and how much crypto will change society in the future. As this technology prepares for the mass market, it will be key to build more trust into these networks: trust that we all will act with integrity where lines are blurry, and code is broken. This will actually speed up adoption.

  What Web 3.0 Means for Entrepreneurship

  Decentralization is a core value of the early crypto ecosystem, and fundamentally that means resetting the web’s rules of engagement such that competition increases naturally and that economies of scale don’t form because of unfair advantages. That lays the groundwork for cheaper tech infrastructure, upon which other entrepreneurs can easily build. For example, several projects are looking to build cheaper global payment rails, including Facebook’s project Libra. A few others are looking to commoditize file storage, cloud computing, and networking. Most importantly, Web 3.0 companies are looking to commoditize data, which breaks down the biggest moats of Web 2.0. This should dramatically lower the cost of starting an Internet company in the next phase of the web, even more than the existing platforms (AWS/Shopify/Google/Facebook) already have.

  “Web 2.0 developers treat data as “the new oil” — a scarce resource to be acquired and exploited. Web 3.0 developers now see that hoarding user data is a liability, and that giving users control reduces the cost, complexity and risk of managing that data while also enabling more powerful online experiences. It also directly challenges the Web 2.0 business model of “user as product” forcing the dominant incumbents to either forgo current revenue and market power or allow Web 3.0 developers free reign to pioneer new business models based on giving users access to and agency over their data.”

  Brad Burnham, Union Square Ventures and Placeholder Capital

  Another big feature of this era of the web is composability — the ability for developers to combine pieces of innovation like building blocks to create something that is very complex with relative ease. Since these pieces are all permissionless, there are no central dependencies nor central points of value extraction. The decentralized finance (DeFi) movement, which includes lending protocols, prediction markets, decentralized exchanges, and a whole host of other tools, is a great example of this. Using different DeFi protocols as building blocks, entrepreneurs can create, test, and launch complex financial derivatives in weeks as opposed to years.

  “A traditional business is generally best positioned setting up shop in a location with existing residents, utilities, law, security, and a vibrant market economy. Similarly, developers benefit from building on top of shared resources such as an existing user base, data, security, and running code…. Composability is important because it allows developers to do more with less, which in turn, can lead to more rapid and compounding innovation.”

  Jesse Walden, a16z

  The organizations that win in this paradigm are probably also different too, as protocols are in their essence collaborative, and their incentive mechanisms are decentralized. This means a different approach to leadership is required to manage a different type of organization. The incentives structure between a company and a protocol are vastly different; the community around a protocol is perhaps as important as the technology itself. Whereas entrepreneurs scaling equity organizations need to be able to scale pyramidally, ruling by dictatorship, protocol entrepreneurs need to lead by inspiration, influence, and incentive design, often taking themselves out of the story line in the long run (e.g. Satoshi Nakamoto.)

  Ultimately Web 3.0 infrastructures create a whole new basis of competition for startups, where competitive advantage is still undefined. It allows startups to attack the tech giants right where it hurts by commoditizing their moats and leavening the playing field. When developers can easily pick and choose the cheapest infrastructure stack, plugged into specific user data they don’t have to create or own, they can build more powerful custom user experiences and business models.

  “Information technology evolves in multi-decade cycles of expansion, consolidation and decentralization. Periods of expansion follow the introduction of a new open platform that reduces the production costs of technology as it becomes a shared standard. As producti
on costs fall, new firms come to market leveraging the standard to compete with established incumbents, pushing down prices and margins, and decentralizing existing market powers. The price drop attracts new users, increasing the overall size of the market and creating new opportunities for mass consumer applications.”

  Joel Monegro, Placeholder Capital

  NITYA RAJENDRAN

  TRIBECA VENTURE PARTNERS

  The 2008 financial crisis wreaked havoc across the global economy and transformed the financial services industry so that it was ripe for disruption. Following the crisis, new laws and regulations emerged, forcing incumbents to look inward; at the same time, it also created immense opportunity for upstarts to enter the industry. After the financial crisis, millennials developed a deep-seated distrust for large financial institutions, a sentiment that was exacerbated by their overwhelming student debt. On the technology side, machine learning and artificial intelligence powered algorithms for more efficient financial platforms. Since 2008, the $1.8 trillion financial services industry has gone through monumental shifts and even over a decade later, continues to be upended by upstarts across insurance, personal and business loans, financial advisory, investments, and other financial sectors that power the global economy.

  Intricate, complex, and difficult to navigate, financial services is an industry in which an aspiring founder requires deep insider insight to gain a competitive edge. Nitya Rajendran, an investor at Tribeca Venture Partners, develops her investment perspective for a fund that has previously invested in companies such as CommonBond, AppNexus, and ShopKeep. A former investment banker who worked on mergers and acquisitions at Lazard, Nitya understands the business fundamentals and metrics that drive businesses forward and make them more valuable over time. In her assessment, many innovative fintech startups have emerged in the last decade and while incumbents have faced their fair share of challenges over the past decade, some have evolved to keep pace with the digital revolution and have rebranded themselves either through partnerships or high marketing spend. As Nitya reveals, ‘there is a massive opportunity for financial institutions to invest in or partner with startups so that they can reinforce each other, help each other thrive, and help provide more financial tools and access to more customers in innovative ways.’