Blockchain- what's the big deal?
NOVEMBER 14TH, 2017
Upon talking to investors, entrepreneurs and friends/family, I continually see much confusion around what Blockchain technology is. Is it a currency? Is it a store of value, like gold? What's a token? What's the difference between Bitcoin and Ethereum? I find communicating Blockchain's potential as a technology platform helpful to answering these questions. One way to communicate that potential is to compare Blockchain to the Internet. At its core, Blockchain is a protocol technology, similar to TCP/IP, HTTP, SMTP, etc. This previous generation of protocols laid the foundation upon which the Internet, as we know it, was built. Blockchain developers are building an alternative internet- applications built upon Blockchain protocols as opposed to TCP/IP, HTTP, SMTP, etc.
Most of the value created by the Internet was captured at the application layer, largely in the form of data (think Google, Facebook and so on) and clearinghouse trasaction fees (Amazon, Uber, AirBnB, Square, etc.). To use a term introduced by Joel Monegro of USV, in terms of how value is captured, the Internet was composed of "thin" protocols and "fat" applications. Investing in applications produced high returns whereas investing in protocols produced low returns.
The value distribution between protocols and applications is flipped in the blockchain alternative internet. Value is captured at the protocol layer, and only a fraction of value is captured at the applications layer. It's a stack with "fat" protocols and "thin" applications.
We see this dynamic playing out in the valuations of Blockchain protocols and applications today. The Bitcoin network has a $100B market cap, while the largest applications built on the protocol are only worth a few hundred million. Similarly, Ethereum and Bitcoin Cash have a $20-30B respective market caps while applications built on those protocols are worth significantly less, or non-existant (in the case of Bitcoin Cash). Looking at the top ICOs to date in terms of ROI since ICO, the top nine are all protocol layers.
Why is the value capture relationship reversed when comparing Blockchain to the Internet? The relationship is reversed because data is captured at the protocol layer versus the application layer, and much of the underlying application functionality is provided by the protocol layer (clearinghouse functionality, smart contract functionality, etc.). Because applications built upon the Blockchain don't capture user data and don't provide the fundamental functionality, they're essentially just UI. This means very low barriers to entry for new applications, and very low switching costs for users. It is difficult for applications to generate value in such an environment- no data monopolies to monetize, no meaningful functionality that can't be replicated or improved upon. Perhaps rapid scale and marketing spend can create a defensible application, but this remains to be seen.
Another interesting dynamic is that the market cap of the protocol will always grow faster than the combined value of the applications built on top. This is because development at the application layer indicates technology adoption of the Blockchain protocol, which drives further speculation at the protocol layer (for example, look at the appreciation in the price of Bitcoin, as more and more apps are developed on that protocol).
It is also important to note that 'fat protocols' are not the end of the story. Blockchain protocols are very unique in that they can be forked. This means that if you don’t like how a protocol works, you can copy it and create your own iteration. This makes it very easy to create a protocol to suit exactly your needs or just create an identical protocol to avoid problematic updates to the original. No one needs to rely on a generic solution someone else has created. We’ve already seen this begin to happen with the Bitcoin Cash and Ethereum Classic forks. A generic protocol (broad use-case) is unlikely to provide the best possible technology and incentives for every use-case in the long-term, so there is an incentive to compete. Thus, a mature Blockchain stack could look something like this:
While value capture still occurs at the protocol level, value is not aggregated in any one protocol. Instead value is spread across specialized protocols, each performing a specific function in the stack. Thanks to Teemu Paivinen for his work on this topic, and for his charts ;)
Reverting back to the question of 'what is Blockchain?', I hope its clearer now that we are not simply talking about a currency or fintech, but rather a revolutionary new distributed protocol layer upon which an entirely new internet is being built. Thus, the hype. Blockchain has the potential to disrupt every single Internet application that you use today, in a manner that results in users controlling their own data (no massive data breaches at the likes of Equifax) and very low clearinghouse fees (no rent charging middleman like Uber sitting between you and your on-demand ride). This is all very good for consumers and society at large.
