While we love being in the weeds of innovation within the crypto market, we recognize the need for broader education about our industry and for us to zoom out and revisit the big picture. Today we’ll skip the jargon and go back to the basics by answering some frequently asked questions. Of course, please feel free to send additional questions our way.
Q: What is the main thesis of crypto?
A: Most simply, it’s that many existing business models can be improved or rebuilt on blockchains.
Q: Why is that better? What’s different about blockchain-based business?
A: The main advantages come down to cutting out middlemen and making things more trustworthy via code and cryptography. When someone talks about decentralization, they generally mean cutting out middlemen or platforms and letting people connect directly to each other, which is often a cheaper and faster way of doing things. Computer code of the blockchain model replaces middlemen and allows peer-to-peer interactions at scale.
Q: Can you give an example?
A: Most people now know bitcoin as a sort of digital gold, but it was designed as a blockchain version of a payment network. Traditionally, banks keep ledgers of what dollars belong to whom; credit card companies keep ledgers of what they owe merchants and what customers owe them; messaging networks help reconcile all the ledgers, and eventually everyone settles.
The Bitcoin network is just a big ledger that uses cryptography and computer code to allow anyone to pay anyone else and settle immediately, instead of having to rely on banks and payment processors and ledgers secured by humans. Another name for blockchain is “distributed ledger technology.”
Long story short, blockchain payment networks like Bitcoin cut out intermediaries and let people securely move value amongst each other without delay and without having to rely on or trust anyone else, and often for a fraction of the traditional cost.
Q: But using bitcoin is complicated, and normal payments work fine, so how is the blockchain version better in practice?
A: It’s true that using a credit card is a better user experience than sending money via blockchain, for now. That’s because the user experience is separated from the clunky plumbing behind the scenes. The cost for that convenient user experience is a few trillion dollars annually in processing fees. Notice the 3.5% credit card fee last time you went out to dinner? The point is that the blockchain alternative to current technology can cut out this trillion-dollar middleman.
Blockchain absolutely needs to be made more user friendly, and there are also technical limitations on network scaling and throughput that are being worked out, which is why the payments “killer app” isn’t yet ready for showtime. This is also why it’s such an exciting time for us to invest—every industry that has expensive middlemen becomes a market for blockchain-enabled tech to improve and disrupt.
Q: Can you give some more examples of what that opportunity set looks like? What are some applications for the technology that are currently being pursued?
A: Blockchain allows peers to connect with and trust each other without an intermediary, so think of anything where there’s a toll to connect with others, and that is a market that will eventually be on chain.
If borrowers and lenders can interact directly without bankers between them, savings rates go up and loan rates go down.
If participants in financial markets can buy and sell assets directly with each other rather than market makers and exchanges, spreads and fees go down.
If musicians can sell music or concert tickets directly to fans, both parties benefit at the expense of Spotify and Ticketmaster.
If drivers and riders can connect directly without Uber, the 30% of fares that goes to Uber can now stay with drivers/riders.
If bettors can face off against each other rather than DraftKings, the ~10% betting fee can shrink.
In all these cases, value accrues to platform contributors and users rather than being appropriated away by companies.
To apply the benefits of blockchain-based apps to today’s banking crisis, we can look at Decentralized Finance (“DeFi”) apps for comparison. Silicon Valley Bank ran into problems when they purchased too many long-term bonds at low interest rates and had to sell those bonds at a loss after rates rose when depositors demanded higher-than expected withdrawals. With “on-chain” finance applications for borrowing and lending such as AAVE, users, investors, and regulators alike can see in real time the deposits, collateral, loans, interest rates, and revenues of the application with full transparency, alleviating risks to all parties or at a minimum allowing participants to best understand the risks they are taking when depositing. Real-time immutable financials as opposed to the quarterly financial statements released by today’s public companies can offer real benefits to all parties.
Q: So how does this come to be, how is it actually being built?
A: Developers can build programs on blockchains just like they might build apps for a smartphone. While Bitcoin was designed as a payments network, Ethereum was designed to be a decentralized global computing platform. It’s a platform just like the Apple App Store, and there are already thousands of apps built on top of it. There are many other blockchains with various features that optimize for different types of applications to use them. The success of bitcoin as a cryptocurrency has led many people to mistakenly believe all crypto tokens are currencies, but the reality is there are many types of crypto with many different use cases, not all of which are strictly payments or financial related, but also gaming, rewards, social media, file storage, etc.
Q: What are some different types of crypto you are referencing?
A: Crypto tokens can represent lots of things, and that’s part of the reason for confusion about what crypto is used for. Bitcoin is generally considered a store of value (having evolved from its original use for payments). Ether, the native token to Ethereum, can be thought of as credits to use the “world computer.” Stablecoins are just US Dollars on-chain to facilitate payments and borrowing and lending. NFTs (nonfungible tokens) are like digital proof of ownership. Perhaps most interestingly from an investment perspective, a token can represent voting rights and claims on revenues of a network, somewhat like a stock. For example, let’s say we build a borrowing/lending app on Ethereum. Token holders might determine what collateral to accept, lending values, borrow rates, etc. They might also decide how much of interest revenue to pay themselves as token holders.
Q: Why is this all done through tokens? Why not issue stock or be a private company rather than issuing a token?
A: If one function of crypto is to connect people without requiring intermediaries, then if a private company owns the blockchain, or if a single person has too much control, that defeats the purpose of decentralization. Issuing a token makes ownership and control completely transparent.
Tokens on a blockchain are also a transparent way to incentivize positive behaviors. For example, users may contribute to the security of blockchain networks in exchange for receiving tokens or fees. From our borrowing/lending example, if the app needs to attract stablecoins to be able to lend in the first place, they may give out tokens to incentivize users to deposit their stablecoins to help bootstrap the project to higher adoption. Tokens can also be locked up for periods of time, or they can be taken out of circulation like a stock buyback.
Tokens are flexible by design. They can be issued or earned for a variety of reasons over any timeframe or based on specific events or milestones. They are a transparent way to account for ownership, governance, and the value of a protocol, and these attributes all contribute to elegant incentive structures for building decentralized apps to be robust, fair, and durable.
Q: This is all theoretically sound and interesting, so is it getting any actual adoption?
A: There’s a very long way to go, but adoption is far greater than the news would suggest. Stablecoins settle more value everyday than PayPal, Square, and Stripe combined. “Bitcoin holders” as a population would be the world’s 3rd largest country. If including just financial services related transactions on Ethereum, it is the 5th largest “fintech” platform on earth. Most of the blockchain apps mentioned before already exist, processing tens or hundreds of billions of dollars in transactions every month despite not yet having great user interfaces. All of this has occurred without any lobbyists or CEOs and despite the many detractors.
Q: Why isn’t crypto already a bigger part of life then? What will it take for the next major wave of adoption?
A: Crypto isn’t already bigger because it’s still early days and the technology and user interfaces are catching up to the theory. Think back to dial-up internet and huge mobile phones from the 90s. They were great technologies that hadn’t yet been made user-friendly enough to permeate our daily lives, but the promise was clear. That’s where blockchain tech is today—the technological advantages are clear, and now builders and engineers must bring it mainstream. The major adoption will happen after usage of crypto technology is abstracted away from user experiences, meaning once the crypto transaction appears no different to the user than a credit card transaction, for example.
Q: How does this all translate to an investment thesis?
A: As blockchains play a greater role in our everyday technologies, they will capture some of the revenues they disintermediate, and the tokens that have claim to those revenues will accrue value. Just as large, centralized tech platforms absorbed power and value over the last several decades, trustworthy peer-to-peer applications that decentralize power and value capture are poised to do the same over the next decade.
Q: How do you invest in it specifically?
A: The underwriting process isn’t all that different from traditional assets, although there are more variables to consider (like ownership structures and dilutive token emissions) and different ways to participate (like “farming” incentive tokens or helping bootstrap liquidity). Some tokens earn fees, and you can observe data about that revenue stream and value it. Some tokens don’t earn fees more like pre-revenue startups, but given their market opportunity and probability of success, you can still underwrite them. Sometimes by simply using a protocol early on or providing stablecoins on a platform, for example, you can earn tokens without buying them.
Q: Some of the terms used in the media and your newsletters are crypto jargon. Can you define what you mean by these terms?
A: Glossary of terms below:
Blockchain: A ledger that tracks all transactions of a digitally native asset (i.e., Bitcoin) between parties in chronological order. The ledger is public and distributed to all network participants and is cryptographically secured in a way that makes the ledger unchangeable without a majority’s consensus.
Bitcoin: As the first blockchain launched in 2009, Bitcoin introduced this new type of decentralized application, allowing anyone to participate in a new type of globally accessible payments network using bitcoin as an online currency. (Bitcoin with a capital “B” references the protocol and payment network, while bitcoin with a lowercase “b” references the currency.)
Ethereum: Taking the Bitcoin ledger a step further, Ethereum introduced the idea of becoming a decentralized global computer anyone can build applications for using “smart contracts.” Think of Ethereum blockchain as an Operating System such as Apple’s iOS, where developers can create new applications and any person can access them globally. Within and across these new borrowing, lending, trading, or gaming applications, all transactions settle to the digital ledger called Ethereum. To use these applications, users pay Validators in ETH tokens to allow their transactions to take up space in the ledger. The Validators, which anybody can be by “staking” their ETH, are incentivized to prove transactions are legitimate or not as the process and ledger are transparent to all, and good actors receive those payments in ETH from all valid transactions added to the ledger (see Proof of Stake below).
Stablecoins: Stablecoins are tokens meant to be pegged 1-to-1 to a fiat currency such as US Dollars, removing price volatility against currencies like bitcoin or ETH. Most stablecoins are backed by cash or equivalent securities like US Treasuries in a bank’s custody account, allowing users to create or redeem 1 Stablecoin for $1 at any time. Potentially a “killer app” of blockchain, this allows dollars to freely move around the blockchain 24/7/365, with nearly instant settlement times and often cheaper costs. Ever need to send a wire on a Saturday? Wait until Monday!
DeFi: Decentralized Finance is the term typically used for blockchain-based applications focused on financial applications for borrowing, lending, and/or trading.
Tokens: Tokens are digital assets issued directly onto a blockchain, so the full issuance, distribution, and holding history are stored on the ledger. Tokens can serve many purposes or no purpose at all, can be issued by anyone with an internet connection, and are immediately transferable to anyone participating on the blockchain where they were issued (most today are issued on Ethereum). Tokens can be used as native currency or represent fiat currency (stablecoins). They can represent physical assets or be issued as art or be used for many other use cases. This is what makes the space wildly confusing for many new to it, as there is no single definition or use case, but a Cambrian explosion of new applications and business models (scams included!).
Proof-of-Work or “Mining”: The Bitcoin network, with no central authority stating which transactions are valid or fraudulent, incentivizes the decentralized network participants with newly issued bitcoins when they successfully add valid transactions to the ledger. This process is called “Proof-of-Work” mining. Anyone can attempt to be a miner, in a race to validate the next “block” of transactions and add it to the historical “chain.” This race requires costly computing power as more and more miners join the network, which in turn provides immense security as everyone within the network now has immense financial incentives to keep the ledger running and fraud-proof.
Proof-of-Stake: The Bitcoin network has been criticized for the significant amount of energy required to maintain the network with its Proof-of-Work consensus process. Proof-of-Stake consensus, to which Ethereum migrated in 2022, requires significantly less energy. Rather than race to validate transactions, Validators “stake” or post an asset as collateral for the right to validate transactions in a block, and are randomly selected to do so, earning all the transaction fees within that block of transactions. If the network consensus reveals inappropriate behavior such as including fraudulent transactions, the badly behaving Validator’s collateral can be slashed and redistributed amongst other Validators. This incentive structure aligns the incentives of Validators, who want to earn fees, with users, who want accurate validation.
Layer 1 and 2: A “Layer 1” is a blockchain such as Bitcoin and Ethereum. Given the consensus mechanisms described above (Proof of Work or Stake), transaction times may be slower than a network such as Visa or Mastercard if massive amounts of transactions clog the network. “Layer 2” blockchains are meant to offer scale and reduced transaction costs, and eventually settle transactions down to the “Layer 1” they are built on top of. One example of this model is the Layer 2 Arbitrum built atop the Ethereum network.
Non-Fungible Tokens (NFTs): If I owe you $5, you don’t care which $5 bill I hand you, assuming it’s not ripped in half. If I owe you a Picasso or a house, the specific painting I hand you or the specific home I transfer you matters. Dollars are fungible, as are bitcoins, but original art and homes are not. A Non-Fungible Token is a one-of-one type of digital token, issued on a blockchain, with provable digital creation and ownership. This application of the blockchain technology has flourished within the art community, where proving provenance was historically difficult, and reach was limited, and it has applications from gaming to real world assets to memberships to earning Starbucks rewards.
Past performance is not indicative of future results. This communication does not constitute an offer to sell or solicitation of an offer to buy the Interests in any jurisdiction where, or to any person to whom, it is unlawful to make such offer or solicitation in such jurisdiction. This communication is being provided solely as a high-level overview and is not intended to be relied on for the terms of any offering. Motus Capital Management has or may hold a financial interest in the assets mentioned. Full disclosures can be found here.