Principles of Value in Blockchain Technology
22nd October 2021
In this blog I outline the core principles of value that have held true over 5 years and throughout the recent trends
I’ve been in the space since 2015, and I usually write an end-of-year summary of developments, but blockchain technology and applications are evolving at such a pace at the moment, that I think there’s no point waiting until the end of the year.
Below is a diagram that I’ve used many times in webinars and conferences. These core principles of value in blockchain were true 5 years ago, and they’re still true today, and they’re one explanation as to why we’ve seen some of the recent developments such as NFTs and DeFi.
The diagram illustrates where I see the added value of blockchain technology. The 10% on the left refers to the use of blockchain technology to improve business processes, the next 60% is when master asset-ownership records are held on-chain, and finally 30% of the value and efficiency gains come with digital (tokenised) money. If all three are combined then we reach what I like to call “Blockchain Nirvana”, with decentralised, atomic, trustless, autonomous, rules-based delivery vs payment. You can send an asset somewhere, and you can be certain that a transaction will be completed and you will receive your portion of the deal based on pre-defined terms without requiring or relying on any third parties or escrow services.
Over the last 5 years, I’ve seen the following primary trends:
- Prior to 2015, we had Bitcoin and numerous forks/variations of Bitcoin. These revealed the wonders of the distributed ledger, but their usage and potential were primarily limited to payments (see 30% on the right of the diagram).
- In 2015 Ethereum was born, and with it fully programmable smart contracts. These captured the imagination of many in the finance and technology industries (including ourselves). The smart contracts were originally designed to enforce rules regarding asset movement.
- One of the real innovations of Ethereum was the ability to create custom tokens on top. In the diagram, this is the 60% and involves using the blockchain to represent different asset types, both physical and digital. For this to work, the blockchain must act as the master registry of this asset. If the blockchain record doesn’t represent ownership, and the token transfer doesn’t represent a final change of ownership (e.g. there is a legal registry outside the blockchain that holds the true master record), then the value of the blockchain is completely undermined. If this is the case, and the blockchain does represent the master ownership records of the assets, then we have the potential to get to 100% of the value. We’ll have real asset ownership records (60%), tokenised payment (30%), and smart contract based escrow and rules (10%). This is where the real efficiencies come together.
- In the years 2015-2018, we saw a plethora of enterprises exploring blockchain technology and announcing initiatives, either alone or in industry consortia. These initiatives were almost exclusively focused on overlaying their existing business processes onto blockchain technology (instead of standard centralised databases) to reduce reconciliation with their counterparts and dependencies on intermediaries. For example, insurance companies relying on claims data they share with each other as a group, or companies in a supply chain sharing provenance data. The blockchain networks were typically closed (private), and small (average network size 1.5 nodes). It’s not that there isn’t value in these experiments or use cases. There is, but in most cases a similar solution could be implemented without blockchain and the practical benefit may be negligible, hence we’ve indicated in the diagram that this is only 10% of the potential value. The two key points that are missing are that the blockchain is not really a master ownership record in these solutions, and they aren’t really decentralised, hence they aren’t really set up to get the maximum security and efficiency gains. Conversely, the industry hype projected that they would gain 100% of the benefits of the technology, and this meant that expectations of value and advantages were high and misaligned.
- 2017-2018 saw a cryptocurrency boom with the advent of the funding of projects through the issuance of new tokens (ICO). The vast majority of projects that were funded at the time were nonsense, scams, or just didn’t have the technology, innovation or team to deliver on their marketing promises (a small number projects in this category are still with us, and some are very highly valued in the crypto markets). A small group of projects that were funded in this manner at that time did, however, provide some incredible innovations in technology, cryptography and financial models.
- 2019 was quiet. Many of the enterprise experiments were not demonstrating the value that companies were expecting, given the hype, and similarly, an incredible number of cryptocurrency projects had been funded and were not even close to delivering meaningful value. Meanwhile the small number of cryptocurrency projects that were genuinely innovating and had been sufficiently funded quietly continued building.
- In 2020 something very interesting happened. Those projects that had been funded and were building genuine innovation began to launch and gain traction, and as the pandemic set in, more people found themselves at home, on their screens, with more time on their hands, and the interest in cryptocurrencies grew.
- By 2021 we witnessed the emergence of two very fast growing phenomena. NFT’s for digital art and collectibles, and decentralised finance (DeFi) for swaps and yield. Projects like Uniswap, MakerDAO and Aave for DeFi and OpenSea and Nifty Gateway for NFT’s began processing and holding 10’s billions of dollars in value. NFT’s are digital assets with master records of ownership on the blockchain (the 60% in the diagram above), and the global trading and liquidity that they bring to the assets is the real value. On chain swaps for NFT’s combine digital assets with payments (60%+30%), and if this is combined with smart contract business rules such as automatic artist royalties, then we’re getting close to 100%. The same is true for DeFi. DeFi uses tokens as collateral to provide swaps and loans in other tokens. As the master ownership records of digital tokens are of course on-chain, and DeFi business rules are encoded in smart contracts, we have our 100% value, based on the model above.
- Most of this innovation, activity and liquidity happened on Ethereum. The cost of transacting on Ethereum became very high, and the throughput and time to confirm very slow, to the point where application developers and traders started looking for alternatives. Two categories of alternatives were available: “layer 2” solutions which attached themselves to Ethereum (such as Polygon and Optimism), and other “layer 1” blockchain networks such as Polkadot, Solana, Cardano, Flow and a host of others. Ethereum 2 is also on the way with a controversial sharded architecture. Solana in particular gained traction for NFT’s, and Polygon took much of the DeFi liquidity. Having built most of our applications on Ethereum (public and private), we found ourselves increasingly building applications on the Algorand blockchain. Algorand comes with a really impressive team with some great, scalable, low cost technology, and this enabled us to design, develop and deploy scalable solutions for our clients that deliver and work well today. We’ve even been selected by Algorand to build a bridge to Ethereum to introduce more liquidity into the network.
- As with the ICO phenomenon of 2017, the NFT and DeFi activity is accompanied by much hype, questionable projects and even fraud. However, as with the ICO period, foundations are being built and meaningful innovation and infrastructure are taking hold. In the case of NFT’s we’re witnessing meaningful adoption across the art world including by the most traditional institutions, see: NFTs: A digital fad, or a transformational technology?. In DeFi we’re seeing the early “logo bricks” of an alternative, mainly autonomous, fully digital, potentially super efficient and low cost, open financial system. Is DeFi the “Netflix” of the “Blockbuster” banking world?
- In 2020-2021 we’ve also seen the interesting rise of stablecoins. I’m not referring to Diem (by Facebook) which is yet to launch, but rather to Circle and USDC. It is looking likely that the regulators will seek to regulate stablecoin issuers and their reserves, see: As regulators circle above, how should the DeFi industry respond?. This will take much of the risk out of the market. The emergence of regulated stablecoins will make it easier for businesses and enterprises to transact on these platforms, and brings with it the (30%) value proposition. Retail CBDC’s are really a central government, rather than commercial stablecoin. It will be up to each government to decide on governance, issuance and collateral structures for its currency.
- Enterprises have been watching all of this from the side, either looking to bring DeFi yields to their customers, in the case of banks, or to capitalise on NFT growth using their brands and audiences.
Will NFT’s continue to rise? Will DeFi become more sophisticated? How will the regulators react? Will stablecoins mature and become more widely accepted or will central banks push their own? This space has never been boring.