June 4, 2021
Traditional asset allocators look at crypto markets as a ct scan of a pathology they’ve seen before: prices are soaring, retail is manic, individuals are leaving their jobs to become day traders, and their shoe-shiners are giving them advice on which shitcoins will 10x this year.1 With opportunism similar to that of the .com bubble, companies are appending “blockchain” and “decentralization” to their enterprise offerings, seizing the VC valuations and market premia that go along with such epaulettes. Reminiscent of the apocryphal Dutch Tulip bubble, retail investors are mortgaging real-world assets to parlay proceeds into digital tokens. The grifters who exploited the 2017 ICO boom bankrupted early adopters and scared off legacy investors. Even today, onlookers often cannot identify any fundamental utility to many of the protocols appreciating in value.
The skepticism is logical: most protocols (and their concomitant tokens) will not find product-market fit. The offerings address too small a market, or are too early for the world, are vaporware, or flagrantly admit to having no utility. Just as a high tide raises all boats, “when the tide goes out you discover who's been swimming naked.” (Warren Buffett) A more secular bear market will thin out the ranks and make evident which development teams are delivering genuine solutions. But for returns to be distributed via Pareto is not at all unique. Roughly 80% of the total market cap is generated by 20% of the legacy public companies after all. 2 Like in any market, over the long run, only those networks that solve real problems cheaply for real people and businesses in the real world will endure.
Crypto has thus far been mainly a speculative retail phenomenon, failing broadly to address enterprise problems. The Bitcoin network does gold’s job better than gold and Ethereum offers a composable base layer that will automate the digital contracts that underpin commerce. To me, these are clearly solving problems for companies (MicroStrategy), investors (Paul Tudor), developers, and users. However, like the mythical inn-keeper Procrustes, crypto is guilty of jamming a [decentralized] peg into every problem’s hole. This unfortunate mutation, in combination with the speculative mania, has obfuscated the fundamental strengths that blockchains and cryptography will bring (to the enterprise world).
Blockchains are simply data structures with sets of rules that incentivize repeated cooperation between many agents. Through trustless and tamper-proof ledgers, millions of agents can refer to a single source of truth and reason about it accordingly. To lessen the need for trust is to evolve and upgrade the scale at which humans can build things together.
Historically, humans have had to rely on trust that a service or good would be repaid in the future. Individuals would develop reputations and use these as social currency to transact repeatedly with other estimable individuals intra or inter-tribe. Tit-for-tat, or equitable exchange, was a dominant strategy within the constraints of the game. This was not altruistic at all, but patently selfish, as foregoing opportunism in a finite game enabled a greater return for all players over an infinite one.3 Specialization and the subsequent trade of goods and services make everyone better off. Societies were constructed through implicit and explicit arrangements (contracts) between individuals and eventually between individuals and enterprises. A company’s brand became a proxy for its reputation—it’s capacity for trustworthiness. Hence why banks always own the most prestigious real estate in town.
Often people ask me what problem crypto-economic systems are actually solving. And further, why are the trust-based agreements between consumers and corporations not enough? Humans have repeatedly coalesced around corporations to pursue goals for many hundreds of years. Corporations are efficient mechanisms for routing capital to incentivized employees who deliver solutions and thus value to customers. So why fix it if it ain’t broke? In my opinion, the fundamental flaws of this arrangement lie in two places:
A) Misaligned Interests: the interests of owners (management, employees (?), equity & debt holders) and customers are often misaligned and occasionally opposed (e.g. insurance)
B) Taleb’s Turkey: when the going is good, contracts fueled by trust work great. When a crisis hits, the temptation for a counter-party to renege grows. (e.g. Robinhood + GameStop)
Misaligned interests are due to misaligned incentives and these incentives can make duplicity very profitable. Companies will document history in a way that diverges from reality to preserve their bottom line. We can look to the staffing ranks and budgets of insurance claims departments for evidence of this dynamic. To the extent that blockchains can more robustly incentivize service providers and service consumers to act in alignment, they are an improvement. Decentralized protocols can buoy good-faith contributions from a vast network of nodes via Pigouvian4 incentives (rewards and slashes). Every node can refer to a single, indelible recording of history making it obvious which other nodes are acting in bad faith. Nodes acting in bad faith are punished monetarily (slashed), thus reducing such behavior on the network. Slashing not only reduces opportunism in a single episode, but also tarnishes the node’s social reputation, which limits its future earning power on the network. Now whether decentralized protocols are cooperative with or competitive with existing corporate solutions remains to be seen. The outcome will not be deterministic but rather influenced by the providence of CEOs and CTOs. The tide has shifted towards a system with better inherent incentives and corporations will be forced to integrate smart contracts into their business lines.
Taleb’s Turkey is a turkey who’s fat and happy until a tail risk, say Thanksgiving, materializes. Robinhood will serve customers nobly until a market event that does not serve its interests arises. It might then unilaterally shut down one side of the market for certain securities. A disaster insurer will collect premiums and serve businesses nobly until a two-sigma pandemic strikes. It might then fight tooth and nail to clarify what force majeure means. The occasions on which parties violate contracts built on trust are disproportionately concentrated in the tail. Blockchains can execute digital contracts parametrically, or automatically, eliminating counter-party risk and guaranteeing an unprecedented degree of reliability. If the conditions codified in the smart contract are verified, the contract releases value. That’s it. To reliably deliver value with certainty, independent of human manipulation, is to provide consumers with a quality of experience that contemporary commercial contracts cannot match. The irresistible appeal of mostly trustless and consistent value exchange to consumers will become obvious to enterprises.
Just as early emailers coerced their less progressive counter-parties into SMTP for data transmission, the vanguard of enterprises using smart contracts will usher in a new standard for commerce. For a deeper dive into the specific blockchain verticals that will help catalyze enterprise adoption and bridge the gap between wall and main streets, please stay tuned. Next week we will explore how Oracles are key infrastructural layers undergirding this bridge, and thus a sound bet when commerce moves on chain.
James Carse: Finite and Infinite Games, Matt Ridley: The Origins of Virtue