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a16z Crypto Entrepreneurship Class: How does the blockchain capture value?

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How to build the defensibility of blockchain projects?

Original title: "a16z Crypto Entrepreneurship Course: How does the blockchain capture value?" "

Original Source: Chain Catcher

At the beginning of 2020, the well-known venture capital organization a16z held the An online video course called "Crypto Startup School" that covers the basics of encryption technology and what you need to know about building a crypto company.

In order to help entrepreneurs in the domestic encryption market obtain more methodologies, Chain Catcher has translated the series of courses and made deletions that do not affect the original intention. The speaker of this article is Allie Yehia, an investment partner at a16z, who has been engaged in cross-research on computer security, computer networks and distributed systems at Stanford University. It mainly introduces the core business model of cryptocurrencies and how to obtain them in a sustainable way in an equilibrium state. value.

Blockchain is a kind of computer in a sense, and participants gather together through consensus algorithms to form a computer-like environment for developers. stuff, and the applications we'll be discussing run on these types of computers are quite different from those typically written by traditional computing paradigms.

< p>Let's analyze from the bottom layer first. The blockchain first needs computing hardware. This is the hardware layer called layer 0, which includes miners, validators, and a peer-to-peer network protocol. A consensus is reached on the state of the network, such as how much cryptocurrency a participant owns, and once all participants can agree on the state, they must be able to verifiably perform calculations on top of that state and use game theory to ensure that the network is Correct, this is where the computation layer at layer 1.5 resides.

It is worth noting that the layer 1 consensus layer and layer 1.5 computing layer are bundled together in almost every blockchain system, Therefore, these two layers are often collectively referred to as layer 1. Layer 0, layer 1, and layer 1.5 combine to form a complete blockchain computer. Developers can actually deploy the programs they write and let the computers run these programs. Each layer faces various challenges. challenges, but several startups are already tackling challenges at each level.

For example at the hardware layer, the main challenge is often to provide computing resources to ensure bandwidth and connectivity between the various nodes in the network, and to manage and manipulate large amounts of data center. Layers above the consensus layer need to ensure that there is only one version of the true computer state at any point in time, and that no one will subvert the fact that everyone agrees on the key challenges of layer 1.5 to ensure that computations are performed correctly, and that no Humans can surreptitiously perform calculations to steal cryptocurrency.

The above three levels provide users with blockchain computers, and on top of this is the second layer of smart contracts, which are all things on the blockchain basic building facilities.

Then there is a layer 3 user interface, which actually consists of code that runs on e.g. a mobile phone or a web browser, including wallets, exchanges, etc. A product for you to interact with smart contracts, which ultimately becomes a bridge between the protocol world and the human world.

Layers 0 and 3 are the peripherals of the crypto world, and their business models look more like traditional ones, in a way that doesn’t Maximize revenue in ways that are confusing to users.

Layers 1 and 2 need to be focused on, and layer 1.5, the computing layer, doesn't really need to be talked about, because it tends to be bundled with the consensus layer. The reason to focus on these two layers is because they are ultimately the aggregation points, and most of the value in the blockchain stack is ultimately captured by them.

One thing that is really striking now is that the business models of both layers ultimately follow the same is an example of a multilateral platform. What are multilateral platforms? My favorite definition is that a multi-sided platform is a common ground that creates value by enabling multiple actors in a network to interact directly.

As a concrete example, a bazaar is a type of multilateral platform, as it enables merchants to interact directly with villagers who want to buy goods.

The ride-hailing app Lyft is also an example, the driver interacts with the Lyft app, and the Lyft app interacts with the writer on the other side of the operating system, Windows, Typical examples of multi-sided platforms such as iOS connect developers with users using these applications.

So, I think that a multi-sided platform is the core template for providing value creation and value capture in the crypto world, and the key is that it applies to both layer 1 and layer 2. The core business model of Layer 1 is the most important business model in the crypto world because it enables all crypto applications. Bitcoin pioneered the incentive structure in 2008, and then widely popularized by Ethereum making it fully programmable.

Going a little deeper into how this model works, I tend to call it the layer 1 "flywheel", which starts with the founding team, which may A vision of an agreement will be proposed, and then with the help of the core development team and external investors, they will be able to build the agreement and endow the initial token value, thereby incentivizing verifiers to provide computing resources and hardware, and endowing the security of the platform function.

Once the functionality exists, then there is an incentive for third-party developers to build useful applications that actually provide utility to the end user, and the end result Instead, a community began to form, strengthening the protocol and the original idea behind it.

The stronger our vision for the protocol around this "flywheel" is that the more tokens are valued in the wider market, the more Validators provide greater incentives for security and functionality, thereby encouraging developers to build more applications, which in turn creates more utility for end users.

A protocol itself is a common ground that enables direct interaction between all participants. The protocol is a multi-sided platform that happens to have five different parties, the founding team, investors, miners/validators, developers, and end users, and since everyone can rely on the protocol to create enforceable rules, they Ability to interact directly and trust each other.

There's a lot of nuance to how it ends up actually capturing the value, and that's a hard question we have to face because you can even ask why it captures For what it's worth, this inevitably became a competitive landscape, and made this "flywheel" begin its open source journey.

So it's a question of how to defend against competition, and it's also an obvious paradox, which I call the value capture paradox. At its core, because all the code in the stack is open source, if the model works, anyone can simply copy it and commoditize any value captured by the inner mechanisms over time.

Here we need to define the defense capability, which refers to the ability of an enterprise to maintain a positive rate of return for a period of time, or refers to a network that will not Disappear due to competition from other players in the ecosystem, or a project that creates a moat around its core value.

Historically, almost all value capture has relied on three things. One, this is a company that has some kind of secret that can be used to build something that no one else can build, and two, that this company has some kind of intellectual property that helps it get a license or a fee right or something like that , which is enforced by some legal jurisdictions; and third, the company has ownership control over certain resources that others do not. Through this kind of thing, a company finally has a defensive capability, but these things do not exist in the blockchain industry, all code is open source, every technical insight is open and available to the entire ecosystem.

This is the problem of the first layer of defense. As another thought experiment, if you are a loyal user of Lyft or uber, and these companies announced that they would make all their technical code public, imagine the impact and whether you will continue to use it. I bet Lyft would be less affected than other platforms because if someone were to copy the technology and create a clone, there wouldn't be a driver for you to serve on the clone server, so you wouldn't Easily switch between uses.

Another important factor is the network effect, which is defined as the phenomenon that the value of a network to new users tends to increase as the number of existing users increases. It has been around since the beginning of the telecommunications industry. A telephone network is worthless if it has only one user, because it has no users to call. If there are already two users in the network, the new user can call two people, and the value of the network is improved.

The more people in the network, the more valuable the network is to the next marginal user. This rule also applies to social networks and even monetary systems, because accepting The more people there are in any form of currency, the more value the currency provides and the more willing new users will be to trade or hold it.

The previous cases are all unilateral network effects, and there is another network effect called cross-sided network effects. Also in the case of Lyft, the number of drivers also affects the availability of the platform to riders, with each additional driver joining the platform, the usability of the platform is stronger for riders, not drivers. The same thing applies to the iOS operating system, the more developers on one side of the platform, the more useful it will be to users on the other side.

Back to the topic, on Each connection of the graph is an example of a cross-edge network effect, e.g. the more financial capital enters the ecosystem through external investors, the more attractive the network is to miners and validators because there are larger tokens Value incentivizes them to provide the same productive capital, whereby the network becomes more useful to users.

However, the functions provided by the blockchain network are different from other paradigms (such as operating systems such as IOS) because Applications on the network are able to interact with each other, which is the concept that smart contracts can be combined with each other.

For a smart contract, it can seamlessly and directly connect to other smart contracts that have been deployed on the platform, thus creating Same unilateral network effects. Developers will want to build their projects on blockchains that already have the most important projects in the ecosystem, such projects include Maker, Compound, Uniswap, etc., and most of them are currently located in Ethereum.

Similarly, there is also a unilateral network effect on the user side. Users will hope that all their friends are on this platform, and all interesting events happen on this platform.

In addition to network effects, economies of scale can also create defensibility, as miners and validators build tools and provide services specifically for a certain blockchain network , the network can benefit from economies of scale as each component of the network is integrated into the ecosystem, the utility application is integrated into the user interface, and the token value is embedded in a non-obvious way, It is difficult for external developers to replicate the entire ecosystem built around token value by replicating the technology.

A blockchain network can gain defensibility from the set of protocols, which often leads to a winner-take-all situation where the winning network ultimately creates an irresistible Gravity forces developers and users to join the winning network instead of entering a new network, just because the network effect is so strong.

Ultimately, tokens become the form of currency that coordinates all economic activity within the network, and the store of value and medium of exchange upon which all participants in the network rely.

Now briefly summarize the business model and value capture mechanism of layer 1. This layer is a multilateral platform, and its defense capability comes from being a common foundation , can support 5 different types of participants to interact and trust each other.

Tier 1 is unique in that it is owned and controlled by a broad and representative community and programs operating at this tier also have a Sovereignty, once deployed by the Creator, operates autonomously without interference from anyone, including the people who wrote the code in the first place, the people who control the physical machines that actually execute the logic.

Let's talk about layer 2 next. Smart contract-based applications are also a multi-sided platform, because smart contracts enable people to trust each other to interact with each other in ways that were not possible in the past due to sovereignty issues, so they can establish consensus through mandatory rules.

Looking at a few more specific examples, Maker is one of the most important projects in the Ethereum network and a multilateral platform with five types of participants. Maker is a lending platform with lenders on the supply side and borrowers on the demand side, and Maker is also producing a cryptocurrency called DAI, which has its own set of use cases.

The platform also has so-called keepers, who are the guardians of the network and ensure the financial health of the network. Finally there are holders of the Maker governance token MKR, which is both a mechanism for ensuring the soundness of all parameters of the system and enabling risks to be properly managed, so they have a governance function and are a medium for financial capital to enter the network.

Another case is Uniswap, which is also a smart contract running on Ethereum, and it is also a three-sided market, in addition to buyers, sellers and liquidity Providers, who need to transfer in and lock assets so that buyers and sellers can match each other, and they have a different set of incentives, which are transaction fees.

Compound is a decentralized lending market, any lender can lend encrypted assets, and then smart contracts can lend some of these assets to The borrower, in exchange for interest payments on that loan.

Like Maker, there is also a keeper in the Compound market to maintain network security, to ensure that those loans with unsatisfactory risk factors are liquidated in a timely manner, so as to keep the entire system in good condition . At the same time, governance token holders will ultimately provide governance and thus provide management rights over the system. It's also a way for financial capital to get into the system.

Further analysis of Compound, On the one hand, after making a deposit to the network smart contract, the lender can also get a claim token in return, which can be used to redeem the deposit if they want to withdraw money. Borrowers, on the other hand, can borrow against this capital from a pool of capital managed by the contract by first providing some collateral to the contract, and then the borrower withdraws the loan as it pays interest on the loan. Most of the interest is paid to the depositors who initially parked the asset in the contract, and a portion of the interest is returned to governance token holders.

This is the template for a layer 2 business model. We can see this in various examples where there is a demand side and a supply side, the supply side provides a service, the demand side pays for that service, and part of the fee is paid in an automatic fashion by governance token holders .

This also involves how to build defense capabilities. The smart contract is completely open source and anyone can easily copy it. Given that governance token holders charge users a fee, it is likely that someone will copy the project code and remove the fee or reduce it.

But what prevents this from happening, which brings up the question of layer 2 defensibility, and the answer to network effects. Different projects in layer 2 tend to have different types of network effects, and this is because there is a lot of room for design, and only projects that take network effects into account can benefit from it.

Taking Compound as an example, there is a virtuous feedback loop between lenders and borrowers, because as transaction activity aggregates on Compound smart contracts, The total amount of assets increased, resulting in better and more stable interest rates for both parties, so all participants in the market generally have a better experience. This virtuous feedback loop makes Compound a more useful platform for participation .

Looking at the chart above, it can be seen that while the internal assets of the Compound protocol are increasing, the cost and user risk are decreasing, so the defense capability of the project is increasing, which makes the protocol more effective for the next generation. A new user is more valuable.

If we accept the premise that the usefulness of a smart contract increases with the capital inside the protocol, then it is necessary to do several Thinking exercise, that is, how the defense capability of the protocol is affected by the following three factors, namely the distribution of protocol assets among different smart contracts, the distribution of protocol assets among different users, and the loss rate of protocol assets.

In fact, layer 2 smart contracts themselves are also multilateral platforms, so they can gain defenses from the network effects built into their mechanisms, and also through Layer 1 also gains defensive capabilities by integrating the surrounding ecosystem.

The final conclusion is that the multi-sided platform is the core business model of the encryption network, and the defense capability is ultimately provided by the network effect.