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Building the Blockchain Economy is hard and unglamorous infrastructure work

By Bernard Lunn.

Bernard Lunn
Bernard Lunn
The phrase “building the Blockchain Economy” gets bandied around a lot today. It can be hype (like “”New Economy” in the Dot Com era). I am sorry if this post contributes to that hype; my objective is exactly the opposite. This post is a shoutout to those doing the hard and unglamorous infrastructure work of building the Blockchain Economy, the equivalent of sewers, roads and trains in the industrial revolution.

This post is an introduction to a weekly series. Building the Blockchain Economy is too big a subject for one post and writing a book on this subject would be like “painting the Forth bridge”. As soon as the book was published it would be out of date; a weekly series is better for rapidly developing stories such as this.

This introduction is a level set. For those deep in the space it might seem elementary. For those deep in one part it offers context. Further posts in the weekly series will go into greater detail on individual parts of the Blockchain Economy.

Any asset can be bought and sold using Blockchain. These assets can include traditional financial assets - currencies, commodities, bonds, equities, derivatives - as well as new cryptocurrencies and non-traditional assets such as Invoices (Receivable or Payable), precious metals, art/antiques, real estate, livestock, food, wine,music rights, other IP rights. You name it, you will be able to trade it. Every single one of those assets has an ecosystem today that needs to adapt fast or be disrupted. Yes, this will be a transfer of wealth/power bigger even than what happened with the Web and Social Media waves. So you can expect a lot of well articulated articles/videos explaining why this change will never happen and why the status quo incumbency will continue to rule. Those articles will gain a lot of credibility from the crashes of many new Blockchain ventures which will lead to cries of “see, I told you this was all rubbish”.

Disclosure: we work as advisers to companies positioning for the Blockchain Economy. If your company wants to work with us, please send an email to julia at dailyfintech dot com to initiate a conversation about our services.

Yes, the New Economy really was a New Economy

During the Dot Com era, “”New Economy” was the phrase used to unlock capital. So the phrase became regarded as hype after the bubble burst, but there really was a New Economy. This is obvious from even a a cursory glance at FANG stocks Facebook Amazon Netflix Google) and all the old economy companies that became roadkill in front of their digital truck.

The Blockchain Economy will go through the same boom, bust, build cycle.

During the build phase, it won’t look anything like what we have today because Bits Don’t Stop at Historical Category Boundaries.

Bits Don’t Stop at Historical Category Boundaries

I will be describing the current categories in the traditional economy and their analogs in the Blockchain Economy. The conventional approach today is to take the same category and add “Crypto” in front of it. For example, a Hedge Fund becomes a Crypto Hedge Fund. This is often a transitional phase, because disruptive technology (aka ”bits of destruction”) blur the boundaries between categories that were historically separate in the analog world. This is particularly true when the historical category is largely a construct of tax legislation (such as how Carried Interest is taxed as Cap Gains not Income). For example a Hedge Fund and a Prop Trader and a Single Family Office might have the same investment objectives, but the difference between them is driven by tax policy.

Technology also changes the revenue model and the name, even if fundamentals are the same. For example, a Syndicate on Angel List does much the same as a VC Fund, except that compensation is based on the Follow/Copy model not the classic 2 and 20 model.

However, even if the revenue models change due to tax policy and technology, the fundamental needs remain the same. So this post will focus on fundamental needs driving the following entity types in the Blockchain Economy:

- Exchanges - Matching and Settlement
- Buy Side Firms
- Sell Side Firms
- Jurisdictions and the race to become the Blockchain/ICO Capital of the World
- Platforms and Protocols that may be fat or thin

This introduction then outlines three major themes:

- Reducing both technical and market risk in early stage funding
- The new Digital ICO Roadshow and New Media replacing MSM
- The “No Collar” Skills needed to build the Blockchain Economy

Exchange - Matching and Settlement

In ye olde stock exchanges, matching was usually separate from settlement. For example, NYSE and NASDAQ do matching/trading (in fractions of a second), but settlement happens (days later) through DTCC; we go from the Ferrari world of trading to the donkey world of settlement. In the Blockchain world there is real time settlement (cash and assets are exchanged concurrently). One entity, usually referred to as an the exchange, does both both matching and settlement. We are seeing 5 types of exchange go after this opportunity:

1. Startups. There are two well established players. One, with FX roots from Switzerland, is Lykke. The other, with Securities roots from USA is tZERO or T0 (currently owned by Overstock). Lykke has an interesting hybrid model - centralised matching (to optimise for liquidity) with decentralised settlement (better for security as there is no central server to hack). tZERO is working on a big ICO on December 18; lots of capital is needed to “take on” Wall Street.
2. Cryptocurrency exchanges. This includes both centralised (GDAX, Bitfinex, Poloniex etc) and decentralised (0x, Bit square, DEX, and many more in development)
3. Traditional Exchanges that own the Settlement provider. They can offer real time settlement. One exchange, which is seizing the opportunity, is Australian Stock Exchange (ASX). Another exchange that could do this but that is not seizing the opportunity, is SIX (Swiss Exchange).
4. Traditional Exchanges that do NOT own the Settlement provider. They can only offer real time settlement in private equity (for example what NASDAQ is doing).
5. OTC Markets from the BB world (BB = Before Blockchain) such as the Interbank Foreign Exchange and Corporate Bond markets. In crypto speak these would be labelled P2P decentralised exchanges.

Our thesis is that all exchanges for all assets will move to a decentralised P2P model. The reason is simple - centralisation is a massive cybersecurity risk, the biggest risk of the digital age. This is an obvious threat to the new cyber exchanges (where the blow ups hit the news cycle almost weekly), but traditional exchanges are not immune (they have invested in more sophisticated defence mechanisms, but this is an expensive arms race with the bad guys).

There is a huge gap between price quote and liquidity. Today we have price quotes on crypto exchanges (aggregated by the cyber data feed vendor, CoinMarketCap) but try transacting in any volume and you will see the difference between price quote and liquidity. The fees and lack of liquidity are a shock if you come from markets like FX, Public Equities or Bonds.

The Exchange that cracks liquidity without the security risk of centralised settlement will win big.

Buy Side Firms (representing the investor)

- Retail via Brokers (Scottrade, eTrade, Charles Schwab etc)
- Retail via Banks (usually via white labelled trading system)
- Hedge Funds
- VC Funds
- Fund of Funds
- Market Makers
- High Frequency Traders (HFT)
- Prop Traders
- Single Family Office (SFO aka “retail on steroids”)
- Multi Family Office MFO (aka Private Banks for the super rich).
- Private Banks (aka low end of MFO to high end of Retail)

Exchanges need to attract all of the above. Investors will be Exchange agnostic (no investor says “I only buy stocks on NASDAQ not NYSE”).

Blockchain will make it a lot easier to trade assets that are not considered financial assets today, through the “tokenization of everything”. This will bring deep and liquid markets in what are today considered non-traditional or exotic assets such as Invoices (Receivable or Payable), precious metals beyond gold and silver, art/antiques, real estate, livestock, food, wine,music and other IP rights. So while the bits of destruction will erode margins as they always do, they will also increase the size of the market. After some period of turbulence, we expect a more digitised and efficient buy side industry to thrive AB (After Blockchain).

Sell Side Firms (representing the issuer)

The sell side lines are blurring between Investment Bankers, Brokers, Merchant Bankers, Incubators and Accelerators. In all cases they do a similar set of functions:

- Filtering so they weed out the issuers who would damage their reputation

- Coaching and Prepping the issuer for a public Offering

- Investor Rolodex for the Offering launch.

The differences are largely driven by Issuer Maturity. Investment Bankers traditionally did mature companies while Incubators and Accelerators traditionally did early stage ventures. The Blockchain disruption impacts this because early stage ventures can get to liquidity quickly (an attribute that we normally associate with late stage). A new breed of sell side firms, the Digital Merchant Bank, is emerging into this opportunity gap. Digital Merchant Banks work at at the early or late stage with a mix of Buy and Sell Side - they invest at Seed or Turnaround stage (aka PreICO round) and then take on a classic Investment Banking type mandate to “take them out” via an ICO.

We put Seed and Turnaround together. Both are hard work and the lines between them will blur. The Blockchain disruption will lead to a lot of troubled legacy companies and stranded assets. These will be turned around by entrepreneurs who bring new technology, not just traditional roll up techniques using leverage, and these entrepreneurs will be helped by the new breed of Digital Merchant Bank. The mantra will be Buy and Build not Buy or Build.

Jurisdictions and the race to become Blockchain/ICO Capital of the World

Jurisdictions lining up to compete as the Blockchain/ICO Capital of the World include:

- UK
- Isle of Man
- Switzerland
- Delaware
- Gibraltar
- Malta
- Singapore
- Hong Kong
- France
- Germany
- Luxembourg
- Brussels
- Dublin
- Dubai
- Oman

I am sure there are more, these are just the ones that come to mind based on recent news/activity. I have omitted all the name-plate offshore centers. The ones listed above all offer access to talent, infrastructure, investors and consumers as well as a regulatory framework. Note that in a digital world, access to consumers/investors is largely a regulatory issue. For example, “passporting” means that an ICO in say Luxembourg has access to the whole EU market. Also in a Blockchain/ICO world investor and consumer are often the same person/entity (which is the most fundamental innovation of crowdfunding, accelerating and derisking the Product Market Fit phase).

All these jurisdictions wrestle with two issues:

- The right balance of accelerator and brake. The Regulators have a tough balancing act. The instinct to press on the accelerator comes from the need to bring high quality Blockchain Economy jobs to their country. Nothing matters more to citizens/voters and so this is top of mind at government level. The instinct to hit the brake pedal is based on a) not getting in the cross hairs of cross border law enforcers for being too lax on KYC b) protecting their own citizen from scammers c) protecting their reputation among investors from being known as a haven of scammers and junk issuers d) giving incumbent financial institutions enough time to adapt to the new world (so the loss of jobs there is not more than the gain from Blockchain Economy jobs).

- The Digital Passport for KYC. When we physically cross borders we use a paper passport, with some machine-readable code if we are citizens of a reasonably modern economy. Some countries - notably Estonia, Switzerland and India are leading the way with Digital ID that make it easy to cross borders on the “digit express”. There is lots of innovation in this area at both the government level (eg Aadhaar in India and SwissID) and the consumer venture level (e.g Civic).

Platforms and Protocols that maybe fat or thin

These are the leading Platforms and Protocols for the Blockchain Economy:

- Bitcoin with Sidechains
- Ethereum
- Colored Coins
- Counterparty
- Inter Ledger Protocol (ILP from Ripple)

I have not included forks and Altcoins that I think will fade into the dustbin of history. These include many of the currently hot Crypto Tokens where the speculation is based on the Fat Protocol Layer thesis that was first expounded by Albert Wenger of Union Square Ventures. Value enablement in the Web/Social era was at the Protocol Layer (everything depended on TCP/IP) but value accretion (return to investors) was captured by application layer companies such as the FANG stocks. I believe it will be the same in the Blockchain era for three reasons:

- There was only one TCP/IP and it was open source and nobody made money directly from TCP/IP. How many protocols will power the Blockchain Economy? How can you extract commercial rent from that protocol while making it ubiquitous? One reason TCP/IP was so successful was that there was no commercial value extraction. Everybody benefited equally from TCP/IP.
- The fat protocol layer thesis points to the massive value creation of Bitcoin and Ethereum, which are fundamentally open source protocols. However I do not buy the idea that we will see many more platforms like Bitcoin and Ethereum. All the supposed Bitcoin killers and Ethereum killers sound like the Facebook killers and Google killers of an earlier era (cue nostalgic “whatever happened to” nerd reminiscing). The analysis behind Bitcoin and Ethereum crushing most Crypto competition will have to wait for a later post in this Building the Blockchain Economy series.
- Many of the current Crypto ventures have been funded through a speculative coin and the volatility of a speculative coin can be fundamentally at odds with an open source protocol value creation model. For example Ripple includes both Inter Ledger Protocol (an open source protocol) and XRP (a speculative coin) and it is unclear whether this combination is 2+2 = 5 or 2+2 = 3.

Reducing both technical and market risk in early stage funding

Lets not forget the point of all this - which is how innovation that improves all our lives gets financed.

We want more real innovation in areas such as transportation, clean energy, a cure for cancer and CO2 extraction. That is what finance is meant to do. Sadly, Wall Street East and West forgot this. Wall Street West (aka Sand Hill Road) stopped funding innovation and simply became a funding stop on route to Wall Street - hugely profitable for them but not much use for funding real innovation.

Investors have shunned early stage because of risk. To change that means reducing both technical and market risk; simply saying that investors should fund real innovation falls on deaf ears.

Technical Risk.

If you invent a cure for cancer (or longer lasting/cheaper/safer batteries or other change-the-world technology), the market is huge and ready. There is lots of technical risk, but there is no market risk.

Professional investors have had a “run, don’t walk” attitude to technical risk. Imagine Vitalik Buterin pitching a Sand Hill Road VC for Ethereum in 2014. Would they have seen a future Bill Gates? Probably not; the first filter of technical risk would have killed the deal. In contrast look at the individuals who bet early on Ether in 2014; they had some ability to assess the technical risk of building a decentralised computer, because they were developers first and investors second.

Now imagine a Biotech or Cleantech venture with a massive market but lots of technical risk. Biotech or Cleantech scientists who can assess that technical risk can use ICO mechanisms to vote with their wallets by buying in early. Those scientists will be the technical smart money voting on Technical Risk. Professional investors will follow that technical smart money.

Market Risk.

Most ventures funded by VC have close to zero technical risk. Look at ventures such as Facebook, Twitter, Uber and AirBnB; the early technology was trivial. Then as VC funds grew in size they also shunned market risk. They wanted to invest after Product Market Fit, letting founders, friends and families and the occasional Angel take that market risk. That outsourcing of market risk caused the innovation funnel to dry up and made entrepreneurs jump on the ICO train..

The ICO model reduces market risk, because the early visionary users are also investors.

Again Ethereum is a useful case study. Ethereum’s early visionary users/investors also built the early DAPPs; they had the tech chops to do so, as well as the financial motivation because they owned some ETH. In contrast, in some 2017 ICOs, the early investors are speculators who don’t use the product. They speculate based on some hype in a YouTube video; these ventures will probably fail. A promising sign is when, like Ethereum, the early investors also build stuff with the new technology coming from the ICO; that is when passion, expertise and capital are aligned.

The new Digital ICO Roadshow and New Media MSM

Ye olde IPO roadshow included:

- Lots of meatspace work, travelling from city to city to pitch to rooms full of investors.
- Very expensive PR firms to get your venture onto network TV - your 30 second interview slot on CNBC or Bloomberg TV was critical.

The long hot summer of ICO of 2017 changed all that and almost made one hanker for ye olde world. The long hot summer of ICO was when you could issue a White Paper, pay some YouTube vloggers, raise hundreds of millions of dollars in hours, use that money to “paint the tape” to make it look like a success and maybe deliver a product (most token buyers are still waiting for a product).

The democratisation of media via blogging and vlogging is a good thing - MSM needed the competition and it offers the opportunity to create a new road show format with:

- some face to face interaction with those who will influence other investors (effectively the Sell Side but with more credibility in the cyber space than the current Sell Side).

- Mostly digital road show via forums that allow both video distribution and Q&A.

The No Collar Skills needed to build the Blockchain Economy

I call it No Collar because Blue Collar obviously does not fit, but neither does White Collar, which tends to mean Organisation Man working in big companies. Yet by using the word Collar I do want to associate with hard work - often unglamorous behind the scenes work.

No Collar workers building the Blockchain Economy (wearing a uniform that is more jeans and T shirt than suit and tie) need familiarity with 5 complex functional domains:

1. Technology. All of this is driven by technology, you need to understand how Blockchain (and SMAC and AI) work to even start doing any work in this space.
2. Law. The concept of a Smart Contract is simple enough to understand, but beyond the conceptual level you will need to understand a bit about how the law and contracts actually work and how they intersect with regulation.
3. Finance. You cannot change how Wall Street works unless you have some understanding of how Wall Street actually works today.
4. Startups. Most innovation today comes from Startups, so you need an understanding of how Startups work (from MVP to PMF to Scale).
5. Accounting. Accounting is the language of business, pretty much the same across the globe. A profit and loss statement is the same in Asia, Europe and America (differences of GAAP vs IFRS is a nuance). So you need some understanding of Accounting.

This is where generalists score over specialists. When change is slow, you hire specialists in each domain. When change is very rapid, which it is as we enter the Blockchain Economy, consulting lots of specialists becomes confusing.

I have seen decision-makers get very confused as they get advice from specialists in each of those 5 functional domains:

1. Technology. You should do A.
2. Law. You should do B.
3. Finance. You should do C.
4. Startups. You should do D.
5. Accounting. You should do E.

Is your head spinning? Should you do A or B or C or D or E?

Commercial break. This is the kind of cross-functional advisory work that we do at Daily Fintech Advisers.

Bernard Lunn
Founding Partner, Daily Fintech Advisers

Bernard Lunn is a serial entrepreneur, senior executive, adviser and a strategic dealmaker. He worked in Fintech before it was called that with startups, growth stage and turnaround ventures (incl. Misys, Temenos, IMS, ITRS). He has lived and worked in America, India, UK & Switzerland and is adept at cross border deals.

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Mercredi 29 Novembre 2017