What is Crypto for anyway?
TLDR: My investing framework for web3 - where the technology improves the ability for the market to coordinate, to connect willing buyers and sellers safely, and to align interests.
Matt Ridley's Rational Optimist makes the point that one measure of human progress is the ever increasing specialization of our labor, and diversification of our consumption. We don't all farm, sew clothes, and entertain ourselves – the total allotment of that labor required to produce all our goods and services is broken into ever smaller segments of the population, and each of us contributes to the sum of collective human progress in our own unique, ever narrowing, way.
A result of the increased specialization of labor is better, more affordable products and services for all. We are all better off that JK Rowling could earn a living writing full time rather than dividing her time farming, building housing, bartering, etc and writing. And she is much better off that her writing can reach billions of people rather than only her local community.
This story is about coordination and trust. I didn't plant wheat last spring, because I trust there will be a robust market for bread when I am hungry this fall. The food will arrive at the grocery store, at an affordable price, through an elaborate market mechanism that coordinates the flow of goods through price signals, without any single person, company or government in charge of the operation.
Commerce, markets and governments all help in the coordination and rule setting that allows for this specialization driven progress to continue. Price signals derived from the market help inform whether farmers should plant more wheat, a young student should study computer science or art history (if optimizing for future income), or a retiree should save in a bank or the stock market. Importantly, price signals are decentralized and iterative. They adjust as humans react to their message, increasing or decreasing to rising or falling demand.
In this story of human progress, governments provide an essential role setting ground rules within which the market operates (labor and consumer protections, securities laws, etc), ensuring contracts are followed, and adjudicating when there are disagreements. The market is prone to both excess and extreme outcomes. Government actions help dampen the negative implications, smoothing volatility and establishing constraints on the market backed by the will of the people, as filtered through the political process.
Enter the internet to this multi-millennia story of ever-increasing coordination and trust building. The internet enables significant increases in coordination, in particular through the accumulation of data about consumer demand.
Ben Thompson's Aggregation theory expresses this transition well. The internet has zero distribution costs. Zero marginal costs. It enables a new competitive moat for companies – aggressively aggregate demand, then capitalize on the competitive advantage provided by that scale to extract large, sustained profits. Google, Amazon and Facebook all fit into this description.
In the language of coordination, the aggregation playbook enables a private company to internalize a segment of the coordination game that was previously done by the market. Large companies such as Youtube, Facebook, Amazon are incredibly efficient at aggregating, structuring and analyzing massive amounts of information to coordinate the serving of a valuable advertisement to you. The companies are valuable because of the information they know about you, which can be packaged efficiently to advertisers. Whether you view this as a positive or negative, the trillions of dollars in market value are the result of better coordination through technology.
As it becomes clear a handful of very large tech companies are replacing the market in coordinating prices and economic activity, trust erodes. Consumers, regulators and competitors are rightly skeptical of the consolidated power in these large incumbents. (A similar critique could be made for 'big business' even pre-internet: Bank of America is a large coordination mechanism to aggregate capital from depositors and decide where to productively lend it to borrowers. With 10% of all consumer deposits nationwide, the company has massive information advantage on other borrowers/lenders).
Now, what about crypto?
Right now, the zeitgeist is crypto is either a ponzi scheme with no underlying utility, or a anarchic-libertarian creation built to replace key governmental roles such as contract enforcement and currency regulation. Advocates frequently speak of eliminating the 'middle man', whether that middle man is a bank which takes on liability for holding your cash for a fee, or has cumbersome steps to send or receive funds to protect against fraud and avoid inadvertently supporting illicit activities terrorism, or government regulators, which design rules for the sale of securities to protect from fraud.
For those of us that value the role of government and financial intermediaries in setting rules, protecting from fraud and managing risk, is there still value in crypto? Will there be space for the 'mainstream' consumer, who likes the protections provided by banks and governments, in the web3 economy? I believe so. To find that future, focus on coordination benefits, not middlemen.
The technological innovation of crypto is open architecture – the ability for unaffiliated actors to coordinate together without an umbrella company standing between them (e.g. Bank of America for capital, Google for ads). Crypto is an internet scale coordination mechanism. Widespread adoption will move us away, at least partially, from the centralized model of competition to an open architecture.
Consider Helium. Helium uses a blockchain to create an open network for wireless communication. In the system, individuals spend money to buy a physical hardware unit which enables them to broadcast a signal to provide internet connectivity for objects in their vicinity. The users are paid depending on how much data is goes through their broadcast signal. The blockchain provides trust. It is open source, allowing potential users to see the mechanics for how it will work and how they will be paid. The blockchain coordination mechanism reduces the insurance costs for all, since it does not require a large company to transact with each side of the marketplace.
The users collectively own the network, with voting in governance decisions and rights to the economic benefits of more data going into the system. Yes, this system could be done before blockchain. But it wouldn't have credibility. A central company would have to make promises to individuals to buy the hardware with both sides knowing that the centralized company could later change the terms of the transaction. The coordination costs would be too high if a central network tried to provide credible reassurance to users, and efficient allocation of resources across the network.
Another example is Goldfinch. Goldfinch is a blockchain protocol to enable small business lending. Anyone can buy a token which earns a return when small business borrowers in Mexico, Nigeria, India and other countries pay back their small business loans. The credit decisions are made locally, through incentive aligned local partners, but the global protocol allows for more capital to come into the market.
Small business lending isn't a new business. What is novel is the aggregation tool for new capital to come into this market. The use case here is to allow a small investor in the US to put capital into a system that results in emerging market loans. Again, the coordination costs to enable that process – especially without exorbitant transaction costs for a company – would too high before blockchains.
There is no free lunch - if coordination costs are lowered, where is risk increased? The much-maligned middlemen provide valuable protection for both buyers and sellers. Revisit the Goldfinch example above. Note the loan is outside of the US, not subject to either US consumer protection laws or securities laws. If there is fraud, or even just reckless risk-taking without sufficient disclosure or understanding, there will be losses.
I am not a libertarian anarchistic. Government protection is vital to efficient markets, as even Milton Friedman argued, through rule setting, contract enforcement, and dispute adjudication. The crypto future I envision still relies on state authority, including robust taxation, but it also benefits from the reduced coordination costs on a global scale.
The use cases I am excited for in web3 follow the same pattern of reducing coordination costs between a wide set of autonomous economic actors. International payments between currencies a good example - think about multinational companies that need to manage liquidity across dozens of countries, moving balances around the world into different local currencies.
How big is this market? I don't know. I don't see crypto taking over retail, healthcare, education, consumer goods. Entertainment? Perhaps. Gaming? Seems likely. Social media firms account for well over $1T of US market cap today, and they seem especially vulnerable to improved customer trust and economics from crypto. Much of financial services is a coordination game between those looking to save and those looking to invest capital.
And consider other areas where we need coordination on a global scale, such as climate change, biodiversity preservation, and war prevention. Could a globally trusted coordination mechanism help in those areas? I hope so.
I remain invested in crypto, literally and metaphorically, as a techno-optimist. Going forward, I hope there is less political rhetoric about leaving the state behind, and more focus on how to remove friction - while keeping consumer protections - as the industry matures.
My investing framework: how does this project improve the coordination of information/people/assets to advance the collective project of progress?
Did you like this post? In one click, please let me know