The recent increase in popularity of alternative funding methods enabled by blockchain technology — what has been dubbed “ICO mania” in the media — makes it possible for individuals with limited capital to access the previously walled garden of investment vehicles that potentially offer venture capital-like returns. Many rightfully warn that the market is overheated and that the current approaches to token funding are still very limited, but at this point, token sales need to be acknowledged as a disruptive force in venture capital and finance. But the huge quantity of new projects, with multiple token sales every single week, and the incredible pace of innovation in the sector make it extremely hard not to be completely overwhelmed.
There are many helpful evaluation tools meant as an overview of aspects to consider before investing in a given project/token (here is a crowd-sourced due diligence framework and here you’ll find Chris Burniske’s valuation framework). However, before diving into the nitty-gritty details, the huge inflow of projects needs to be filtered according to concrete investment hypotheses. An investment hypothesis is a set of predictions about the future, based on certain assumptions, with the goal of generating returns by investing in opportunities that are aligned with them. They are useful to prime your awareness to notice interesting investment opportunities when you come across them and to help you build a more focused portfolio with good reasons behind your investments, giving you the confidence to HODL through tough times. I am assuming a high-risk, long-term, technology focused investment approach similar to venture capital for the purpose of this post.
One approach is to look at the fundamentals as a starting point: What innovations does the technology enable?
As Andreas Antonopoulos phrased it aptly, if you can replace “blockchain” with “database” and the brochure still reads the same, that’s not a good sign. Instead, it is more interesting if the core value proposition of the project is derived directly from the innovative properties of blockchains.
This post reflects on a few key areas of innovation in the cryptocurrency space that could lead to different investment hypotheses and illustrates with examples of current projects. We are going to look at the different innovative capabilities of blockchains and smart contracts one by one, and see how they can lead to different speculations about the future. Most of these innovations are only applicable in a very limited manner as of now but the exercise is to think about how the future might look like if current limitations can be overcome.
Please note that strategic considerations alone won’t make a project succeed, but other factors such as timing, team, and execution are often crucial in the end (there is no way around due diligence). These are my own speculative reflections that are not intended as investment advice. It is meant as an input from an innovation-based, strategic perspective that may help you in designing your own hypotheses about the space and to make more confident investment decisions. It can also be read as an introduction to cryptoland and as an optimistic outlook into what might come out of this space in the future.
Capabilities of blockchains:
Blockchains are distributed ledgers that enable the exchange of value between parties that neither know nor trust each other. They reliably track the state of these interactions while maintaining consistency across the database and providing guarantees of informational security. For example, most blockchains guarantee that no single party can secretly make changes to the shared ledger, that information stored in it stays there permanently, and that everybody follows the same rules. The interesting properties and capabilities of blockchains are what leads to their disruptive potential. Because they often overlap and rely on each other, the categorizations made are not clear-cut and certainly not exhaustive. We are mostly talking about public blockchains, because the most powerful characteristics are directly derived from the openness of these systems and therefore usually don’t hold for permissioned (corporate or syndicated) blockchains.
Decentralization and Disintermediation
Until now, a successful VC investment hypothesis has been to invest in centralized networks, because the only way to enable many actors to engage on a single platform in the current client-server architecture of the web is to have a centralized facilitator in control of the platform. This powerful intermediary can then impose transaction costs or otherwise extract a large part of the value created on the platform (e.g. user data).
The combination of cryptography and economic incentives makes it possible for the first time to build complex networks of collaboration and interaction without the need for a trusted third party.
If the same functionalities as in existing platforms (wherever many parties interact and some sort of value is created) can be realized with a decentralized architecture, the cost of using the network could be reduced drastically by bypassing this central intermediary. And if the current solution is free (e.g.: social media), users could even be payed to use it (e.g. Steemit) — this has been called better-than-free models.
In addition to the reduced cost, some even expect an increase in the quality of such platforms: Because there is often no need to “monetize” in the token economy and because users (as token holders) have a say (not only investors), the user experience could potentially be superior (no annoying ads, pop-ups, sponsored content).
An investor who finds this line of thought convincing would systematically look for blockchain based systems that provide the same or superior functionalities without a middleman. So, for payment use-cases, examples would be Bitcoin, Litecoin, Dash and other classical cryptocurrencies. Some ventures trying to bring the benefits of decentralization to to peer-to-peer lending are ETHlend, Ripio, and Bloom. Projects such as OpenANX, Airswap and 0x are attempting to build decentralized exchanges. In social sphere we also have Leeroy, Indorse and Akasha. Basic Attention Token and AdEx attempt to revamp the advertisement industry. For e-commerce, there’s Open Bazaar. Even the cloud is being disintermediated with Golem and SONM for computing, and Filecoin, Storj and Sia for storage. Another approach would be to invest in ecosystems that aim to be a factory of decentralized markets such as District0x.
Distributed trust and open access
As we saw, blockchains enable participants to interact with each other without having to go through a centralized platform. However, the central authority in the current system is not only needed to provide communication channels, but also crucially, to provide trust. In decentralized systems, trust is generated through transparency, cryptographic guarantees and proper incentives. Because every participant has access to the ledger, everybody can check for themselves that everything worked as it was supposed to. The cryptography used to secure funds and track data (mainly private/public keys and hash functions) provides mathematical guarantees for the security and integrity of the data. And proper incentives provide the basis for trust in the behavior of other actors, because most people like to make money. The combination enables participants who neither know nor trust each other to transact nevertheless without a third party establishing trust. This central attribute of blockchains is often called “trustless” (although the term has been criticized as misleading, since trust is still required, but based on cryptoeconomics instead of authority).
Because of this, distributed ledgers are a good protection against middlemen likely to abuse their power or malicious parties that want to tamper with the data or bring down the system and can be applied to things like voting, tracking ownership in public registries and even provably fair games such as lotteries and casinos. The fact that data is always time-stamped when included in the chain yields further use-cases like copyright and proof of intellectual property.
Another major benefit is the radically open nature blockchain based systems: Currently, people need to ask a gatekeeper for permission to use most services by tying their identity to an account and accepting terms and conditions. In order to make a bank transfer, I need permission (a bank account) from the bank, based on the permission from a bunch of other entities from governments to credit rating agencies. Not with (most) blockchains — create a new address and off you go. This is obviously big news for financial inclusion of regions with lacking infrastructure or individuals without documents. Another advantage is that blockchains are inherently global and not only accessible by everyone, but also from everywhere (with internet access).
There are tons of candidates for investments that make use of these characteristics: Horizon State is an example for voting and Edgeless for a provably fair casino. It has been argued that prediction markets at scale may finally be possible because of them, Gnosis and Augur being the most prominent examples. Use-cases around preserving and validating digital assets are being built by Factom, Tierion, and Po.et. Some of the most prominent ventures aiming to bank the unbanked are Stellar and Humaniq (while OmiseGo wants to unbank the banked).
Transparency — privacy
Another notable feature of blockchains is that they can fall anywhere on the dimension transparency — privacy. Most blockchains as of now offer transparency over all transactions stored on the ledger, disclosing sending and receiving addresses as well as the content of transactions. Privacy is conserved to a large extent by letting anyone create as many addresses as they want (so they are not directly tied to one’s identity, although it is possible to infer it through correlation in certain circumstances). However, there are others that guarantee total privacy, disclosing neither sender/receiver addresses nor their content. Not only is privacy needed for business transactions, but necessary for fungibility, which is in turn needed for all “currency” use-cases (if every coin has a certain history attached to it, not all coins have the same value any more). Some currencies provide privacy solutions through mixers and ring signatures (obfuscation through the use of one time addresses) or zk-snarks. The latter is an astonishing feat of cryptography that makes the apparent contradiction of public audibility and total privacy possible: It can be mathematically proven that a transaction (or code, for that matter) was executed correctly without disclosing any of its content. This is incredibly useful for a vast array of applications from strategic business transactions to voting. While some argue that blockchains may yield a practical implementation of the right to privacy, others worry that especially privacy focused currencies could be a catalyst for all sorts of criminal activity. Although very interesting and relevant, these are difficult moral and legal controversies that would clearly exceed the scope here.
On the other end of the spectrum, the transparency and audibility aspects of blockchain can be leveraged as well to make opaque processes such as supply chains more transparent (although these use-cases often need to rely on trusted information inputs such as sensors, which limit their effect for now) or achieve audibility per default if things like accounting.
For use cases where only a specific entity (a person, an organization, or a smart contract) should be able to perform a transaction or own a given asset, identity is needed. However, the concept of identity is ambiguous and, depending on the context, can mean many different things. While some blockchain operating systems try to bake identity right into their product, most projects in this space are focused on creating an identity protocol or a data locker that can be used across multiple applications (with the idea of keeping sensitive data in the control of the user), but differ strongly on the concrete implementation. The applicability of blockchain to identity in the first place is contested by many: Recurring arguments are that to establish identity — an off-chain property — one would have to rely on an trusted party anyway and that a permanent ledger of identity could have potential for abuse. Others argue that identity as we know it is not needed any more in openly accessible systems, but will be fragmented into context specific attributes.
The discussion of these characteristics could lead to very different investment decisions: Investors who believe that privacy will be an ever more important concern in the future might turn to privacy focused coins such as Monero, Zcash, Dash or even a VPN-like systems such as Mysterium or Orchid Protocol. The recent integration of zero knowledge proofs into Ethereum make it an even more interesting investment from this point of view. On the side of transparency and audibility, applications like Balanc3 might be interesting for accounting, or Ambrosus and Modum for supply chain. Individuals who think that identity is an interesting use-case should look into Blockstack, Uport, Val:ID, and Civic.
The power of smart contracts
Smart contracts leverage the properties of blockchains to create contracts that trigger certain transactions once predefined conditions are met and can be used to create decentralized applications. Nick Szabo, who coined the term, proposed the analogy of a vending machine. Because smart contracts are not owned by any single entity, they enable what has been called relational software, which has exciting implications on the possibilities of collaboration. USV’s controversial (challenged by Jake Brukhman here) “fat protocols” hypothesis recommends to invest in general operating systems such as Ethereum, Neo, Qtum, EOS, Cardano etc. that leverage the properties of blockchains to provide these smart contract functionalities and are at the basic level of the emerging tech stack. This has the benefit that whatever specific application will win in the end, it will likely be built on top of one of these systems. Again, as of now, there are numerous unresolved issues from how to include data external to the blockchain (oracles) to the relationship to the different national legal systems (Oracelize and ChainLink are working on this), but the goal is to imagine what might be possible in the future .
Automation, DAOs and distributed collaboration
Simple applications of smart contracts, such as transferring ownership of some asset as soon as payment arrives or some other conditions are met, seem moderately useful. It gets more interesting, however, the more elaborate vending machines we imagine — in theory, an entire business could be managed entirely by smart contracts. This is the idea behind DAOs (not “the” DAO), decentralized autonomous organizations. Not only could these organizations do the same at a fraction of (transaction) costs, but also in collaborative structures never seen before. Because they would also enjoy the properties of immutability, auditability and would operate in a disintermediated way, this seems like an incredibly powerful mix that has led some entrepreneurs to proclaim the death of the firm and the age of unstoppable organizations.
So what kind of novel organizational structures could be possible? First of all, these organizations can be distributed around the globe without the need for even an office (as we are already seeing with a lot of projects in the space) and its participants aligned more directly with the success of the project (for example wage payments in tokens with a lock-up period). Decisions can also be taken in a distributed manner: An easy application would be the use of muli-sig to make certain transactions. However, there are ideas emerging about how to leverage blockchain to make decisions more inclusive, democratic, transparent and simply better such as liquid democracy. It gets even freakier with the idea of futarchy, which basically applies prediction markets to decision making to improve its outcome by means of proper incentives for individuals with valuable knowledge — it forces people to literally put their money where their mouth is.
Another possible implication concerns the boundaries of collaboration: Because the boundaries of distributed organizations are blurry and participation is often permission-less, anyone can contribute and, if the system is properly designed, gets compensated according to the value provided to the network. These radically open systems are built on a foundation of decentralized trust that, again, stems from the properties of blockchains described above. If the right cryptography is added to the mix, systems can be designed that even allow competitors to collaborate without disclosing any data that would harm their competitive position. Such a scenario is only possible because neither of the different competitors are in control of the data or the contracts that govern the collaboration and they can all verify what will happen under which conditions.
A great use-case for automation of transactions is making the energy grid smarter (see Grid+ or Power ledger). Fascinating projects who are focused on building blockchain native organizations are Aragon and Colony. If you are interested in liquid democracy, check out democracy.earth. Examples of interesting attempts towards collaboration on sensitive data are Numer.ai, Enigma and Ocean Protocol.
Tokenization & Programmable Money
Another very powerful application of Smart Contracts is the creation of a variety of new financial/legal instruments on top of existing blockchains, generically referred to as tokens. Tokens can represent whatever the use case demands — it’s programmable value.
As Nick Tomaino explains, there are many kinds of tokens who derive their value from different rights, for example, usage tokens grant the right to use a digital service whereas work tokens represent the right to contribute. Voting rights and rights to proceeds are also possible, but likely fall under regulations. Many projects are also trying to tokenize traditional assets to allow their integration into smart contracts or to make them more liquid or divisible. However, the relation of the on-chain representation of the asset (the token) and the asset itself is problematic, since current solutions need to rely on a trusted intermediary.
This variety of token structures makes it a lot harder to take investment decisions because in addition to all the other parameters, the viability of the token design and the drivers of the token value need to be analyzed carefully. It is paramount to understand that tokens have properties that may resemble currencies, product licenses/APIs, or securities to a varying degree, and that they may also exhibit novel characteristics, such as increased liquidity and fungibility, or their ability to interact with other smart contracts.
The most prominent use-case for tokens to date is fundraising and the exuberant amounts raised via token sales have been making headlines lately. Interesting about token sales is not only that a whole new class of investors (retail investors) can participate and that transaction costs for fundraising are significantly reduced, but that tokenization can be used to fund public goods and open source protocols that up until now weren’t able to “monetize” (this basically corrects a market failure by distributing property rights).
There are many projects that focus on tokenizing traditional assets, for example LA token (others focus on specific industries such as real estate or fine art) or Digix that tokenizes gold. Bancor and their “smart tokens” aim for the long tail of currency and offer a user-friendly way of providing continued liquidity to tokens that are not heavily traded (through mechanisms similar to fractional reserve banking). It also makes sense to look into projects aspiring to be a catalyst for token sales, such as Cofound.it and Neufund (tokenizes startup equity).
Other approach following the line of thought of programmable money would be to look at the needs of the financial industry: One often mentioned case is Bitcoin as a replacement for gold in its function as an independent store of value and hedge against market risks. Bitcoin, almost entirely uncorrelated with other assets, has similar characteristics than gold like proven scarcity, international acceptance and resistance to change and even offers improvements over gold, such as increased ease of storage, access, transfer, verification, and the independence from banking and market infrastructures. The only real issue is Bitcoin’s volatility, which has been decreasing, however. A much needed financial instrument for the crypto space are stablecoins, that is to say, tokens that have minimal volatility and can be used in other applications. Maker’s stablecoin in the making is called Dai and aims to have a volatility comparable to major currency pairs like EUR/USD in the crypto world.
Network ownership effects
Network effects, the increase in utility for existing users when new users join, are at the core of many of the most successful business models such as Facebook or Amazon. The merger of users and investors basically puts these effects on steroids, leading to what has been called network ownership effects: In addition to the increase in utility, existing users (and owners) also profit from an increase in the value of ownership of the service when new users join. Imagine how users of (early) Facebook might act differently if every one of them would also hold Facebook shares. They would be way more engaged and involved in the platform and would promote it to the point of signing their grandmothers up because they have direct financial incentives to do so as well as a strong sense of ownership and identification. As we could observe with Bitcoin (and other projects), a user base can turn almost fanatical, support the project as dedicated marketers and developers, and start positive feedback loops that may lead to the dream of many entrepreneurs: organic hyper-growth.
This is especially powerful in the beginning, where traditional platforms struggle with a chicken-and-egg-problem of onboarding new users to increase the utility of the platform: Network ownership effects can be leveraged to basically kickstart network effects and solve the “cold start problem”.
As mentioned above, this also solves classical agency problems of management theory (assuming that token holders are involved in the decision making process) and may even remove the need to “monetize” through annoying ads.
We have seen that the properties of blockchains enable countless applications wherever there is middlemen to be removed or data to be liberated or secured.
The best projects create ecosystems that align incentives of diverse stakeholders through a shared currency whose value is tied to the success of the platform, distributing the value back to those who are creating it. In general, blockchain-based business models seem to have a number of unfair advantages: Drastically reduced transaction costs, a higher degree of trust through transparency and audibility, empowerment of users through data ownership and low entry barriers as well as crazy scaling speeds fueled by network ownership effects.
Even though it seems quite certain that a lot of innovation will be happening, it is extremely difficult to imagine where all of this is going and to pick winners — this is why proper due diligence and diversification are paramount when investing in cryptocurrencies. Probably the highest risk is execution, making the ability and credibility of the team a critical factor to consider. Timing is another crucial factor (because of the inherent liquidity of tokens), and it makes most sense to enrich one’s different investment hypotheses with tentative timelines for adoption. Also, the opportunity costs of just holding major coins like Bitcoin are huge, so it is recommended to only invest very selectively in projects that are not only aligned with your hypotheses for the space but also passed a thorough due diligence. At last, obviously never invest more than you can afford to lose and expect some major corrections along the road: as they say, everybody is a genius in a bull market.
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Disclosure: I hold Bitcoin, Ether and many of the tokens mentioned