An Institutional Take on the 2019/2020 Digital Asset Market

As of Q4 2019, the ratio approached 1.0 (but still stood slightly above it). Thus, we are seeing that ETH is not (directly) capturing the value of all the assets launched on its platform; instead, value is getting captured in the applications. There are likely to be several reasons for this, but we think one theory summarizes it best: most applications and tokens (e.g., ERC-20, ERC-721, etc.) built and issued atop Ethereum may, in a large sense, be parasitic to Ethereum. ETH token holders, by holding ETH, are paying for the security of all these applications and tokens, via the inflation rate of ETH that is currently given to the miners. Therefore, ETH token holders are being diluted slowly, but the ERC-20, ERC-721 and other application token holders are not. Such token holders that are building and using systems launched on the Ethereum blockchain benefit from the security that comes from the dilution of ETH holders, but do not currently pay for any of it. As these token holders and smart contract developers utilize gas for transaction fees in order to interact with the base Ethereum blockchain, it does drive demand for ETH, but the problem (currently) is it drives demand for just one block, and then those transaction fees go straight to the miners (who are generally the largest sellers in proof-of-work systems).

One could look at this and perhaps attempt to argue the same concept applies to Bitcoin, however a key difference is that bitcoin is an asset powered by a deflationary system with fixed supply, making its value proposition quite different from that of ETH. Thus, it stands to reason that unless something changes, as more applications are built atop Ethereum, in a very narrow sense, this may be dampening the value proposition of ETH given a structural disconnect between value created and value captured. Fortunately, however, the Ethereum community is currently undergoing a process of navigating the network toward a proof-of-stake consensus system, and this transition has the potential to change the token economics to the betterment of ETH. Additionally, as will be discussed in greater detail in the next section, ETH is fueling a software-powered collateral economy, possessing certain store of value traits that may continue to enhance its value proposition over time.

Lastly, it should be noted that the purpose of this section was not to highlight a bullish or bearish case for ETH (it should not be read as such), but rather to observe, and attempt to understand, early signs of network stack value capture in the space (e.g., whether value largely accrues to base layers or application layers). It remains extremely early for digital assets and their accompanying networks, and in the grand scheme of things, very little data exists so far to support any hypotheses or draw any conclusions, including the one we proposed herein. Token economic experiments continue to evolve, and new networks continue to launch, each one possessing a different monetary policy, token distribution mechanism, consensus algorithm and overall value proposition than the rest.

Another trend that we observed this year and think is worth highlighting is a larger migration away from “cryptocurrencies” in an ideological currency (e.g., money/payment and a means of exchange) sense, and toward digital assets for financial applications and economic utility. This takes the shape of several forms: a very popular one is the store of value asset, commonly referred to by many in the space as “digital gold”. Bitcoin leads the industry here, but it is not the only one; other digital assets like Ether, Decred, Zcash, Monero and others exhibit certain store of value traits as well.

Another form is the notion of programmable value; smart contracts enable programmable representations of traditional financial contracts and can be quite powerful in their utility. Many things in the world today (e.g., wills, trusts, escrow agreements, securities, etc.) are legal code that owns money and then has some rules around how that money can move around, with humans then executing those rules. Computers deterministically execute code much more efficiently than humans, and as the DeFi movement is showing us, it is not hard to envision where this can go.

As of Q4 2019, we believe DeFi has enabled three relatively successful cases of emerging product-market fit: stablecoins, lending, and synthetic assets. Other experiments continue to take place — prediction markets, insurance, decentralized exchanges to name a few — but these are largely still in the go-to-market phase and have not yet gained as much traction as the others previously mentioned.

However, there’s another form of economic utility that took the stage this year that we think is beginning to extend beyond the others: software-powered collateral economies. People generally want to hold assets with disinflationary or deflationary supplies, because part of the promise of those supply curves is that they should store value well. Smart contracts enable us to program the characteristics of any asset, thus it is not irrational to assume that it’s only a matter of time until real-world (traditional) collateral assets get digitized and put to economic use on blockchain networks.

The benefit of digital collateral is that it can be liquid and economically productive in its nature while at the same time serving its primary purpose (to collateralize another asset), yet without possessing the risks of traditional rehypothecation. Dan Elitzer wrote a superb piece earlier this year calling this “Superfluid Collateral” drawing the conclusion that if assets can be allocated for multiple purposes simultaneously, with the risks appropriately managed, we should see more liquidity, lower cost of borrowing, and more effective allocation of capital in ways the traditional world may not be able to compete with.

Supply side services in digital asset networks are a commonly discussed crypto-native topic. These are services provided by a third party to a decentralized network in exchange for compensation allocated by that network. Examples of supply side services include mining, staking, validation, bonding, curation, dispute resolution, node operation, network routing, and more done to help shape the direction of networks that supply siders are incentivized to participate in.

The lifecycle of a decentralized blockchain network typically comprises three high-level phases: the fundraising period, the bootstrapping period, and the live period. The fundraising period of a network’s lifecycle is simple; when a founder and development team are first starting out, they need to raise money to fund themselves, and typically issue equity or the future rights to the network token via a SAFT (simple agreement for future tokens) structure, or a combination of the two (permitted the incentives must remain aligned). The bootstrapping period is where supply side services come in; in this phase tech-savvy third parties are incentivized to contribute their time and resources (both hardware and software intensive) to a given network because they are promised a token-denominated reward in return for every block they mine or validate. These actors help the network position for a public launch. Finally, in the live period, the network is formally launched with the token generally being fully distributed and publicly trading on exchanges.

In 2019, we observed the continued proliferation of supply side services across various networks, but very little demand side activity to meet them. This suggests we are still largely in the bootstrapping period of many networks’ lifecycles, otherwise commonly referred to as the go-to-market phase. There is a floating hypothesis that it’s easier to bootstrap the supply side of a network than the demand side; that is, getting supply side participants on board is easier than convincing users to start using the outputs of the supply side and generating revenue from them. Our view is that as developer infrastructure continues to mature and activity begins to move “up the stack” toward the application layer, more obvious manifestations of product-market fit are likely to emerge with cleaner and simpler interfaces that will attract high volumes of users in the process.

However, several concerns have been expressed by industry participants, including that most tokens are currently designed in a way that leads to speculation rather than usage. There has been much ideological debate in the industry pertaining to the difference between speculation and investment, and whether buying and holding a particular digital asset signifies utility or speculation (most commonly in the case of bitcoin). Despite this, there are some emerging cases of networks successfully bootstrapping the demand side. DeFi is perhaps the most commonly known example, and while this has been largely confined to Ethereum to date, it will be expanding to other blockchain networks like Cosmos and Tezos via interoperability initiatives in 2020. Other kinds of demand side traction among smaller networks include Helium, where anyone can set up a hotspot, provide wireless coverage, and earn native token rewards that can be redeemed for a fixed unit of bandwidth on the network, and Basic Attention Token, where publishers receive native tokens from advertisers based on the measured attention of users, and users receive native tokens for their participation that they can in turn donate back to publishers or use on the platform in exchange for premium content from the publishers.

This section pertains to a tale nearly as old as time for those that have been involved in digital assets since the industry’s early days: the tale of base layer scalability.

For those unfamiliar with the history of the so-called “Smart Contract Wars”, the tale generally goes like this: in 2017, a single Ethereum application — Cryptokitties — became so popular it clogged the network, slowing all transaction processing nearly to a halt. Recall that the Bitcoin network processes 3–5 transactions per second, and the Ethereum network processes about 15 transactions per second, creating the general view that blockchains are simply not scalable at this point in time (especially when compared to traditional networks like Visa or Mastercard that process thousands of transactions per second). A couple problems emerged from the Cryptokitties frenzy, such as high wait times and high fees because anyone desiring to start a new transaction was placed in this long queue of transactions that were all competing to get placed into the next block on the chain. Furthermore, at its peak, Cryptokitties only had about 14,000 users, which is quite small when compared to traditional networks like Visa or Mastercard. Thus, the notion of base layer (e.g., “layer-1”) scalability competition was born.

While Ethereum leads the space on adoption and moves closer to executing on its scalability initiatives, a plethora (e.g., dozens) of smart contract competitors fundraised in the market throughout 2018 and 2019 in an attempt to dethrone Ethereum. A handful have formally launched their chains and operate in mainnet as of the end of 2019 (Blockstack, Cosmos, Kadena and Algorand are some of the popular ones), while many others remain in testnet or have stalled in development. What’s been particularly interesting to observe is the accelerative pace of innovation — not just technologically, but economically (incentive mechanisms) and socially (community building) as well. Many of these competitive smart contract platforms have undergone extensive technical research and have taken differing approaches to achieving these scalability initiatives, and it remains to be seen how well they perform when their mainnets launch.

We expect many more smart contract competitors operating privately as of Q4 2019 (whether in development or testnet) to launch their mainnets in 2020. Thus, we hold the view that, given the incoming magnitude of publicly observable experimentations throughout 2020, we are likely approaching the late innings of Smart Contract Wars. If a smart contract platform does not launch in 2020, it is likely to become disadvantageously positioned relative to the rest of the landscape as it relates to capturing substantial developer mindshare and future users and creating defensible network effects.

One of the biggest complaints pertaining to the digital asset industry is that crypto/blockchain is a solution looking for a problem to solve. This view is generally based upon the various metrics that indicate little user traction to date (relative to common applications built on top of existing internet infrastructure — e.g., the App store) and the fact that crypto is still not mainstream. Even the notion of “product-market fit” (“PMF”) is not well defined in certain crypto circles and often becomes rhetorical in nature. Is a global store of value PMF? Is speculation PMF? Is democratizing access to investments and capital/early stage markets PMF? Is the idea of a token structure as an improvement to the joint stock corporation (and thus a new way of capital formation and incentive structuring/sharing) PMF? Are dApps with users an example of PMF? Is decentralized banking PMF?

Contrary to the above, we don’t think human and financial capital would have continued pouring into the digital asset space in such great magnitude over the last several years if there wasn’t a focus on solving at least one very clear problem. The questionable sustainability of modern monetary theory is one clear problem, and Ray Dalio of Bridgerwater Associates has been quite vocal about it. Big Tech centralization is another. There are also growing global concerns related to data privacy and identity. And let’s not forget cybersecurity. The list goes on.

Yet, it remains early for crypto/blockchain and the potential of the asset class. There are no mainstream solutions yet, and the publicly traded, venture-like nature of the asset class doesn’t help much either for those looking at prices for validation of signs of immediate traction.

We are at the tip of the iceberg as it relates to products and applications blockchain technology enables. Just as it was difficult to conceive of ideas like mobile app businesses or SaaS-based business models in the early days of the internet, similarly it is difficult even for those in the digital asset space full-time to conceive of the possibilities the technology enables. The demand side is not an overnight switch nor is it binary — it’s not likely it will just, all of a sudden, turn on as a result of one or two specific things. It is neither necessary nor desirable that everybody embrace digital assets all at once.

Rather, crypto is more likely to have a trickle and flood effect in various forms and through various interactions by all different kinds of people — but driven by quality products offering solutions and convenience. We are already seeing the trickles (see Takeaway №8), but as of the end of 2019, we are just not there yet. Developers are still finding their footing with blockchain technology, and the right infrastructure is still being built.

Our team has also programmed and deployed different types of smart contracts on Ethereum — and can confirm firsthand that the technology is still clunky despite its tremendous potential. On the whole, we are still largely in the go-to-market phase; mainstream users will come with manifestations of PMF. As more time and attention gets spent on diagnosing problems and working on the applications, protocols and primitives to solve them, the industry will begin to achieve its full potential.

But these things can’t be rushed.

Nonetheless, Facebook’s Libra and Twitter’s Bluesky initiative confirm that as an industry we are heading in the right direction.

Libra was announced earlier this year with the ambitious goal to introduce billions of new users to the world of digital coins — especially those that have little or no access to legacy financial infrastructure. While it is unfortunate that Facebook’s problems with trust and privacy became large obstacles for Libra to overcome, it elucidated just how dangerous Big Tech centralization is becoming. In just a few short weeks, Libra, bitcoin, digital assets and “cryptocurrency” were discussed on every major news outlet and in every major publication, as well as in Congress, in the Federal Reserve, and by the President of the United States on Twitter. This elevated level of mainstream awareness around digital assets has not been generated since the 2017 initial coin offering frenzy.

Additionally, Jack Dorsey’s recent announcement of Twitter funding an open protocol for social media through a project called Bluesky was another major step forward for the industry. Twitter is a Big Tech club member managing greater than 100 million active users each day. The fact that the company’s founder and CEO — who also happens to be a long-term advocate and supporter of bitcoin — is spearheading a worldwide decentralization initiative is simply breathtaking.

We, therefore, end this section with a takeaway from Ori Brafman’s and Rod Beckstrom’s book The Starfish and the Spider that explores the notion of decentralization and leaderless organizations:

Over time, industries swing from being decentralized to being centralized to being decentralized to being centralized again. In the swing toward decentralization, open “starfish” (decentralized) systems are inevitably created when institutions or industries become over-centralized. Therefore, in many respects, the phenomena are not in themselves new, but what is new is our society’s understanding and recognition of them, and how they apply to our current business environment.