Building the Internet 3.0 with Cryptonetworks

Overlooked #8

Hi, it’s Alexandre from Idinvest. Today, I’m talking about the cryptonetworks and how they have the potential to be the core primitive of the new web paradigm.

I will start with a brief overview of why cryptonetworks are setting the stage for a new paradigm for the internet. Then, I will discuss the cryptonetwork trends I want to investigate in the coming months.

These domains could be categorized either as key enablers to make the Web 3.0 a reality (proof of stake, capital market infrastructure, stablecoins, original protocols scalability) or potential applications powered by cryptonetworks (finance, gaming, marketplaces, social networks, medias).

Big disclaimer: I’m a crypto neophyte so please be nice and don’t hesitate to give me feedback / resources to dig into on the technical stuffs and on other domains to investigate.

The rise of cryptonetworks is much more than a trend. It’s a new paradigm for the internet. Let’s take a step back and understand why.

NB: If you’re already familiar with cryptocurrencies, I’m sure you already know by heart this section. You can skip it and go directly to the trends I want to explore.

The first era of the internet (1980s-2000s) was built on open protocols (like HTTP for web browsers, DNS for domain names, SMTP for mails) controlled by the internet community. Individuals or businesses were able to build projects and extend their presence on the internet knowing that the rules of the game will never change because these protocols were open source and not controlled by a central authority.

Today, we live in the second era of the internet (mid-2000s-present) which is built on a limited number of platforms like Google, Amazon, Facebook or Apple. The strength of these platforms was to build free to access services with better performance than the capabilities offered by open protocols. As a result, users started to migrate from open services towards these centralized platforms.

What is the key issue with centralized platforms? When a platform is created, it does anything it can to attract stakeholders (users and third parties like developers, businesses and media) to make the platform more valuable. But when the platform reaches a sufficient size or a plateau in terms of usage, to keep growing the platform will have to start extracting value from its users and compete with third parties for their profits.

It’s great for users to have these centralized platforms because they got access to incredible services essentially for free. But when a platform has become dominant, the economic incentives between the platforms and its stakeholders are no longer aligned.

The user experience level is deteriorated to optimize the platform’s monetization (e.g. the evolution of Google Ads to push you advertised results not always relevant). Moreover, all the creators and entrepreneurs started to become dependent to these centralized platforms which have the ability to change the rules without or kick out your project without prior notice (cf. Facebook-Zynga exclusive 5y contract shut down unilaterally by Facebook in 2012). Innovation is slowing down and entrepreneurs are restricting themselves to make sure they remain compliant with the platform (cf. Youtube becoming a uniformed platform).

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So far, the internet story has served both a source of inspiration to realize of much value creation can be unlocked when you built on top of open protocols (Web 1.0) and as a cautionary tale when you place too much trust and power in a small number of players (Web 2.0).

Bitcoin white paper was released in 2008 and has served as the funding block of the Web 3.0 combining open protocols (inspired by the Web 1.0) and cryptographic innovations. This third era of the internet will be decentralized and all stakeholders incentives will remain aligned.

  • On the one hand, cryptonetworks are decentralized using consensus mechanisms between stakeholders to update and maintain the the state of the platform (e.g. proof of work and proof of stake).

  • On the other hand, economic incentives are created to maintain the alignment of interest between all stakeholders thanks to the emission of tokens distributed to all the stakeholders. Everyone is working towards the same goal: increase the size of the network to make the tokens more valuable.

We are still far away from the domination of the third era of the internet. Numerous technical issues must be solved to make cryptonetworks usable by anyone. This is why two product market fit phases could be distinguished (Chris Dixon):

  • "1) product-market fit between the platform and the developers/entrepreneurs who will finish the platform and build out the ecosystem, and

  • 2) product-market fit between the platform/ecosystem and end users."

First, decentralized networks must conquer the heart of entrepreneurs and developers to solve these issues and then build applications for end users. Second, cryptonetworks will have to experience their product market fit with end-users - either businesses or consumers.

Trend #1 - Scaling Decentralized Computing

Building a crypto app as a developer is a pain. Using crypto as a consumer is also a pain. As of today, it's almost an ideological choice to take part into the crypto revolution.

For instance, it took me an entire evening to be able to stack DAI without prior knowledge on how to do it. I had to download Metamask, transfer my ETH from Coinbase to Metamask, convert my ETH in tradable ETH on Maker, convert some of my ETH into DAI on Maker and stack them to earn interests. At each step of the process, you have to pay gas fees and wait for 1-5 minutes.

In their original design, BTC and ETH are struggling to scale with regards to (i) number of instructions per second, (ii) cost per instruction and (iii) latency per finality.

Numerous projects are tackling these issues. Some are building layer 0 (under all blockchains) or layer 2 solutions (over a specific blockchain). Others are building new protocols no longer based on proof of work like BTC and ETH but based on proof of stake.

  • In the proof of work system, to add a block to the blockchain you have to compute the proof of work on top of the chain and then anyone will verify and validate your proof of work. The beauty of the system is that there is no central authority. It's a decentralized mechanism preventing anyone to control the overall blockchain. But the problem is that it requires every participant to compute an expensive and time consuming proof of work.

  • On the contrary, with the proof of stake validation is intrinsic to the system and no longer extrinsic to the system. Validation is based on a vote in which every toke holder will vote. As a result, the cost in participating in consensus comes down dramatically because there is no longer a need to verify it through computation.

Moreover, compared to the PC and the Web stacks, there is a strong uncertainty regarding what the middle platform layer will look like when the blockchain ecosystem will be mature. Three options can be distinguished:

  • The primitive layer becomes the platform layer. Applications will be built over ETH or BTC directly.

  • Multiple composable protocols will form the platform layer and will be combined to build applications. For instance, some DeFi applications like Multis or Instadapp are built on “money legos” combining many different protocols (ETH, Compound, Maker, Uniswap). It’s great for developers which want to build end users applications with a suite of financial services without having to build them in-house.

  • A unique player will build a the platform layer for cryptonetworks. Alchemy (Pantera and Coinbase) has the ambition to build a developer platform dedicated to blockchains.

Trend #2 - Scaling Decentralized Storage

It's crucial to build a decentralized layer of storage to make possible the decentralized world promoted by cryptonetworks. Numerous decentralized applications will not be able to work on a centralized storage layer.

The economics of this decentralized storage are different compared to centralized cloud providers.

  • The value proposition is not economic because a decentralized cloud network is way less efficient in terms of economics of scale compared to a centralized cloud network.

  • The value proposition is to avoid a central authority. You will accept pay a premium to access these decentralized infrastructure because trust will be at the core of your usage.

Filecoin is an advanced decentralized storage project. Filecoin has been on the Testnet since Dec. 2019 and is planning to be released on the Mainet in Mar. 2020. It has raised $252m with prominent investors like USV, Sequoia, Digital Currency Group and YC. I

Filecoin is a decentralized market for storage based on blockchain. It allows users to buy and sell unused storage on an open market. When you put your unused storage to work, you get rewarded in Filecoin that you can use to buy data storage space for yourself or convert it to other crypto-currencies or FIAT.

Source: a16z

Trend #3 - Establishing a Trusted Governance

The opposition previously mentioned between proof of work and proof of stake is also implying two different models of governance to approve the transactions but also to make changes to the protocol.

Cryptonetwork protocols are still in their early days and governance will be enhanced iterations after iterations.

Trend #4 - The Crypto Capital Market Infrastructure

We are still in the process of building the right financial infrastructure inspired by traditional financial markets but suited for cryptocurrencies. It's a pre-requisite for crypto to become mainstream and be used by traditional financial players, tech companies and even States.

Interestingly, an increasing number of financial professionals are leaving their old-fashioned jobs to work on building the crypto capital market infrastructure. Some of them even have the ambition to bring back the innovations they are implementing in the crypto world to more traditional asset classes (bond, equity etc.).

Source: Etienne Brunet

Trend #5 - Bringing Stability to the Crypto Market with Stablecoins

Volatility is a key issue for cryptocurrencies. It prevents them from being used in our day to day lives beyond speculative usages. Stablecoins are cryptocurrencies pegging their value to another currency or to a basket of other currencies (could be either crypto or fiat currencies).

Three categories of stable coins have emerged in the past few years:

  • Algorithmic stablecoins: a digital coin is pegged to a traditional currency (1 coin = 1 dollar) and an open source algorithm will maintain the equilibrium between supply and demand to make sure that the exchange rate is maintained. In practice, this model is hard to maintain when the traditional currency value is decreasing sharply and quickly.

  • Fiat-backed stablecoins: the digital coin is collateralized with traditional currency and a centralized platform make sure that the exchange rate is maintained over time. In this set up, you are dependent from the stablecoin operator and no product innovations can be build on top of the coin because it's only pegged to fiat currencies.

  • Crypto-backed stablecoins: it’s an hybrid model between the two previous categories as people will purchase the stable-coin with other cryptos that they have and these other cryptos will be placed in a reserve that will get diversified overtime. Product innovation is possible in this set-up. Additional stability mechanisms are set up by crypto backed stablecoins like over collateralization of reserve, transaction fees into the reserve, mining rewards going to bolster the reserve etc.

As of today, stablecoins are mainly used as a parking vehicle for crypto investors seeking stability in the volatile crypto market and avoiding the conversion of their cryptocurrencies into fiat.

But in the medium term, interesting financial applications could be based on stablecoins especially the ones that are crypto-backed and completely independent from fiat currencies.

Trend #6 - Decentralized Finance (DeFi)

DeFi aims at using the crypto decentralized structure to power financial applications without the need of a trusted third party like a bank. Intermediaries are adding frictions and are driving costs upwards. DeFi aims at bypassing them. Moreover, DeFi is a solution to offer financial services to the 1.1bn people unbanked worldwide who have access to a mobile device.

DeFi protocols like Maker are emerging in the credit and lending space. Maker has released a stablecoin called DAI pegged to the value of the dollar. People can then borrow or lend DAI without the need of third party and with more attractive financial terms (higher interest rates when you lend and lower cost when you borrow). Every loan is collateralized on-chain through ETH representing at least 150% of the initial loan to prevent major ETH value shifts.

Decentralized exchanges are also emerging to compete with centralized platforms like Binance and Coinbase allowing P2P trading without any centralized intermediary. The promised benefits are numerous: minimize hacks, preserve the privacy of users, operate without the risk of a central failure etc.

Source: DeFi Pulse

DeFi platforms have recently passed the threshold of $1bn hold in value (in 2.5 years) according to DeFi Pulse data. MakerDAO accounts for almost 60% of the value locked but other projects are soaring like Synthetix and Compound Finance. This threshold is good signal to drive attention from users, entrepreneurs and investors.

Trend #7 - Social Networks and Medias

Medias and social networks are broken. Incentives are no longer aligned between the readers / users and the platforms as the platforms will maximize their revenues from advertising at the expense of the readers / users. Content quality is decreasing in medias, relationships are no longer meaningful on social networks.

Cryptocurrencies change the economics for users. Early users earn tokens and as the network grew in popularity these users were rewarded fostering a better alignment of interests between the platform and its users. Users participate in the economic upside of network and are rewarded for the time invested in building the product & the network.

Monetization will no longer be based on advertising but on memberships with strong incentives to be active in the community (e.g. your membership is free this month if you refer 5 people to the platform).

This set up also solves potential governance issues as the platform will be governed by the community of token holders and not an obscure product manager deciding on his own to implement functionalities.

Trend #8 - The Next Generation of Marketplaces

Blockchain has the power to replace all existing marketplaces by cutting the middle man and offering better unit economics to all the stakeholders. Traditional marketplaces are super hard to kickstart. Solving the chicken and egg issue is a nightmare.

Once the marketplace is getting traction thanks to early users either in the supply side or the demand side, these users are never rewarded. Most of the returns created by the marketplace are captured by founders and investors. Other stakeholders are left on the floor. For instance, the first Uber drivers were detrimental to the success of the company but none of them were rewarded. Same for the firs hosts on Airbnb.

Blockchain has the power to (i) solve the chicken and egg problem of marketplaces (cf. the below graph from a16z), (ii) make sure that the value creation is better shared between all stakeholders.

Source: a16z

Trend #9 - Gaming based on NFT

Crypto will become mainstream thanks to consumer finance and… gaming. Games using blockchain are using Non Fungible Tokens (NFT) under the ETH token standard ERC721. These tokens are different than traditional ERC20 because they are unique and indivisible.

On the contrary, a fungible asset is an asset that can be exchanged with a similar asset without the possibility to find any difference between the two assets. Gold is a fungible asset. A Van Gogh painting is a non fungible asset.

Three waves can be distinguished in the adoption of NFT by games:

  • 1st wave: companies providing collectible digital goods like the old fashioned Panini cards. You can buy them and store them but you cannot do a lot of things with them. Crytpokitties is the most famous example. The hype was hype but the gaming experience was relatively poor - quite similar to Tamagochis.

  • 2nd wave: companies using NFT to build games which are increasingly complex. In these projects, it's crucial that the tokens add value to the users and is not only a way to replace a digital currency.

  • 3rd wave: all NFT-based games will be connected. Gameplays and items from different games will be combined into unique and custom-made experience. Like in Minecraft, modes and possibilities will be almost infinite. Interoperability will be at the core of the experience.

Source: Non Fungible

Following the explosion of NFT at the end of 2017 and beginning of 2018 driven by Cryptokitties, the NFT growth has slowed down in 2019 with only a 17% growth in the market capitalization ($210m) and a 3% in the number of users (113k).

Trend #10 - The Tokenisation of Everything

Beyond gaming, NFT have the potential to tokenize every asset - digital or physical.

  • Digital assets: financial instruments will be the first digital assets to be tokenized beyond gaming (bonds, stocks, equity investments etc.) but other digital assets will follow suit like legal contracts.

  • Physical assets: tokenize digital assets could allow you to fragment them and sell them into pieces (artworks, sneakers) but also to build financial products secured by physical assets (asset backed lending, insurance for your goods).

Philosophy

Concepts Explanations

Trends & Predictions


Feel free to send me any feedback on this issue or on this newsletter at ade@idinvest.com. If you find this issue interesting do not hesitate to share it with your friends. See you next week! 👋