What creates sustainable competitive advantages for ethereum projects?


#1

My background is as an investor at a major technology hedge fund that invests in large cap equities like Facebook. Part of what we focus on is business quality, which I define as “the capacity to earn economic returns in a free market despite competition.” We care about this because, in theory, economic returns should be extremely rare in a competitive market. Part of “business quality” is the property of having sustainable competitive advantages (often called a “moat”) that allows for economic profits greater than 0. A simple framework for assessing competitive advantage is testing for the presence of business characteristics that are (i) valuable, (ii) rare, (iii) inimitable and (iv) non-substitutable. In absence of these characteristics, a business should not earn economic returns in a competitive market because excess returns should be eroded by the aggression of competitors or new entrants to the market.

If we want to map our understanding of classical industries onto crypto-assets, we might say that a crypto-project earns economic profits if it grows transaction volumes at a rate faster than the cost of capital plus the rate of coin inflation less degradation in monetary velocity. If such an event occurs, then competitors should enter to compete away these excess profits. In crypto-land, this often means that a new entrant will fork the source code of an existing project and enter as competition. If 10 factories produce a widget, this widget quickly becomes called a “commodity” and the making of that widget should not earn economic profits. Similarly here, if 10 crypto-projects all replicate a similar codebase and functionality, then the functionality becomes a commodity and the growth in transaction volume should rapidly decline, reducing sustainable returns to coinholders. Stated differently, there is no economically relevant distinction between 1 project with a monetary base of 10 and 10 projects with a monetary base of 1; in either case, value has been diluted even if we want to believe that all the projects have a “fixed supply.”

Unfortunately, many of the characteristics of crypto-projects that are valuable are nevertheless not sustainable sources of competitive advantage (which I define as 5-10 years) even though they do create an advantage initially (e.g., the first 3-4 years). For example:

(A) Talent: Currently, talent is a temporary competitive advantage because it is a constrained resource in the ecosystem. As of right now, this is the factor that prevents immediate competition for successful projects. That said, in the long run, talent is never rare, inimitable or non-substitutable for the simple reason that talent tends to diffuse over time in any new technology ecosystem (e.g., knowledge tends to spread to more people over time). For this reason, talent is not a sustainable source of competitive advantage that can make a project endure for the test of time. It is of course useful in assessing young projects that are pre-ICO or in their first 5 years of existence.

(B) Source Code / Technical Ingenuity: Though I agree that a strong code base is a reason why a particular project is valuable in the short run, it is not a source of sustainable competitive advantage, for the simple reason that it is highly imitable (e.g., you can just fork the code). Even if it is true that a genius wrote a particular piece of source code, in theory a lesser genius can fork the code and replicate the identical codebase. When this occurs this is no different than if the original project had massively diluted coins outstanding.

In contrast, there are at least a few things that I think are, in fact, long term sustainable competitive advantages:

(A) Network Effects: Some projects facilitate the creation of 1 or 2 sided networks. An example is Numer.ai which has a network of data scientists that sit on a 1 sided network. Because it is difficult to coordinate people to participate on this platform, this is a sustainable source of competitive advantage. This also I think does occur in open source / decentralized models that have many contributors. For example, Wikipedia has a two sided network of users and writers; if someone attempted to compete with Wikipedia it would be difficult to replicate both sides of this network. With this line of reasoning a crypto-project that created a wikipedia-coin (similar to Steem or Colony but maybe a Wikipedia version) should exhibit similar sustainable competitive advantages if it were able to achieve mass adoption.

(B) Ecosystem: Ethereum has significant competitive advantages over other smart contracting platforms for the simple reason that it has a rich ecosystem that is supportive of new development. It’s easy to learn solidity because there’s tons of resources. There’s a ton of existing projects and people in the community. All of these things make it harder for another entity to compete with Ethereum eventually.

© Scale: For actual blockchains like Bitcoin and Ethereum scale is often advantage because it creates for more security. It is difficult for a new blockchain to compete with these projects over time without a meaningful source of differentiation (e.g., like Monero in the case of Bitcoin) for the simple reason that scale has the effect of producing a more stable and secure blockchain. That said, unless I’m missing something I am not sure why projects built on top of an existing blockchain should necessarily have automatic benefits from scale – i think this mostly applies to core projects like Bitcoin and Ethereum.

With this in mind, can anyone think of other things that true sustainable competitive advantages for crypto-projects, especially those that are being built on top of the ethereum platform? What are the sorts of characteristics that can create enduring competitive advantages despite competition for a period of 5-10 years?


#2

Another thing you should consider for long term value investing is whether the project needs censorship resistance and trustless interactions. If the project doesn’t need these two features then it is at a very distinct and strong disadvantage to a traditional centralized service.

When I say censorship resistance here keep in mind that a project may need censorship resistance from some single party but can look to one or more governments to provide that through existing legal systems. The only time you really need cryptographic censorship resistance is when it is a government or similarly large state actor that is censoring you.

For example, if you disagree with Twitter’s censorship rules, you can simply create a competing product that doesn’t have them or has different censorship rules, no need for a blockchain. On the other hand, governments around the world have been known to heavily censor trade (drugs, guns, etc.), prostitution, pornography, gambling, prediction markets, and currencies. Because of this, using a blockchain is a good solution to the problem as it allows you to take the teeth out of government censorship attempts via decentralization.


#3

Not helping you here, but rather adding to the burden.

Blockchain projects are usually open source and distributed. That means, if a service can be implemented that is very cheap to use, it may effectively out-compete similar services where the creators try to make a profit. A service that is almost free (except for transaction fees) is very hard to compete with.

Suppose the Ethereum platform eventually is a total success on scalability and user-friendliness. In that case, I believe any business of today that can be implemented on Ethereum, will be, provided that the reduced costs are good enough or that it provides some real benefit compared to the currently existing services. I would go so far as to claim that it is ultimately one of the goals; to disrupt existing business cases.

One possible business case that can still function in this environment, is using donations. That is, the development team uses donations to pay for the costs. However, that would leave no space for investment agencies.

This all ends up with the Network effect as the only effective mechanism to control a monopoly. You mention the ecosystem as one of the things on your list. This is really just another aspect of the Network effect. The more projects there are on the Ethereum blockchain, the more will they provide advantages to each other.


#4

Responding to Micah: I agree. In the framework above, proving a “X needs / truly benefits from blockchain” is necessary to prove that a project is (i) valuable and, more importantly, that (ii) the value is non-substitutable with a non-blockchain solution. I agree that censorship resistant products are a critical use case where blockchain usually has unique advantages from both a business and, of course, social good standpoint. Projects that have a large addressable market that benefits from censorship should command higher valuations, because its more likely that they have a viable value proposition.

That said, even in cases where it is true that “X needs / truly benefits from blockchain”, my point above is simply that in many of these cases there will be multiple competitors in the long-run because being the incumbent does not have an ability to generate a sustainable marketplace advantage from scale or access to truly unique resources. The concern is that, if this is true, most non-core blockchain or currency-related projects should not be able to earn any excess returns over time. This is not the end of the world (most projects in the normal world outside of blockchain are unable to do this), but it does mean you have to make different assumptions in assessing projects (e.g., most people assume blockchain projects are winner-take-all markets, but if this argument is true then this cannot be the case, because most market categories in blockchain do not have meaningful returns to scale).


#5

I would add external barriers of entry. On the business side, in the past exchanges listed coins themselves, today they demand a fee. On the regulatory side ICOs are increasingly restricted or even banned (eg. China). Crypto ads are getting banned making it harder for new entrants to compete.

Decentralization also provides absolution of responsibility due to a true lack of control over users and their data, both socially and legally. It’s always technically possible to delete, edit and filter user submitted content on a centralized service. Socially many people take the stance that not censoring what they consider to be unacceptable content is equivalent to agreeing with it, or even just transacting with someone considered evil. Legally it means having to conform to eg. DMCA.

Not a perfect analogy, but something like a difference between having a vending machine that sells printers and offering a printing service.


#6

@griggah I agree with you. The vast majority of “blockchain” projects should not have any value or should have incredibly limited value. I can count on one hand the number of blockchain projects I have seen that actually make sense as a blockchain project and a business.


#7

@MicahZoltu I agree with you. To be clear, I think many projects will undoubtedly create immense social value, especially in cases where expression has been censored etc. That said, I agree they may not create value for token holders in many cases. Curious though, what are the cases that you think make sense? Maybe it makes sense to discuss those as a case study to see whether we can reason to abstract principles for what, in the abstract, allows for sustained value creation via tokenization. The community I think benefits from discussion of this issue because the standard rules of business only partly apply to blockchain.


#8

@nootropicat that’s a great point and a timely one. complying with regulation doesn’t scale and regulation usually benefits the incumbent. it requires a human / soft element that is annoying and can’t be written in software. in my view though, compliance helps consolidate value into fewer hands in a way that actually helps the few that get past the hurdle make a bit more money. except in the cases where avoiding regulation is the express goal (e.g., censorship resistance for internet in China etc.) strict focus on regulation is a good strategy.


#9

Augur, because governments around the world have a long history of censoring prediction markets.

Maker, because governments around the world have a long history of censoring alternative currencies (same argument for many crypto-currencies).

Both of these projects also benefit from network effects (business value to first mover) and the token serves a clear purpose of risk transference (maker) or behavior incentivization (Augur) that can’t be achieved with an off-protocol token.

One crypto currency also can fit this bill (Bitcoin at the moment). However, Bitcoin has shown an inability to adapt that will eventually overpower it’s first mover network effect advantages, thus many altcoins are competing to take bitcoins place as a medium of exchange/store-of-value once it collapses from its stagnation.


#10

@griggah These are some of the things that make me think that maybe blockchain technology is fundamentally at odds with the goals of a business.

Businesses seem to like control. They keep their software closed-source. They take out patents to protect key innovations. They lobby for laws that protect their rights to do business and even try impose licenses on others to do so.

Blockchain technology on the other hand seems to have the opposite goal. It is like a corporation that automatically hires and pays anyone. That keeps its code open source simply because it serves a “common good”… and obviously its anti-regulation because technically speaking everyone benefits from more people adopting and sharing it… at least that’s the idea.

What I find hard to resolve is all the contradictions between these two extremes. Businesses trying to profit from blockchain technology… To do so, they end up crippling it. They make it less open, more tedious to use, and harder to participate in. Which makes me wonder if that’s necessary then does any of the economics behind this technology make sense?

Should all blockchain projects just rely on donations to be logically consistent with their benefits and goals, or are my thoughts here too black and white? Cryptosocialism? :joy: I don’t know that much about economics but there are definitely some smart people here who do. Very good thoughts OP


#11

@Uptrenda there are some projects, like Augur and Maker, that require some asset that can be minted by the system to have a certain value in order for the system to be properly secured against economically motivated attackers. They achieve this by rewarding the holders of that asset in the form of some kind of revenue (e.g., via fees for platform usage).

Now the question is, how do we initially distribute this asset to those most interested in holding it. The most efficient solution is to have each actor interested in receiving hose future dividends bid on the asset, thus began the infamous ICO process. You could achieve the same level of security in the system via an airdrop, but by doing an ICO, you fund development while also efficiently distributing the asset.


#12

@griggah great post! Have been thinking abt this as well.

One idea: because there’s a realtime, trustless record of all activity within a crypto-project (the blockchain), it takes considerable off-chain signal for an individual to decide to move to a lower activity competitor. Not a sustainable moat, but something that I think will lead to crypto-projects having more inertia than their centralized, trusted counterparts.


#13

@lsankar4033 yeah I agree. This is sustainable to the extent that there are real barriers to developing the right expertise and being able to signal that expertise. Google, Baidu, Amazon and a few others have all the best AI engineers in the world, for example. Though there is no “barrier” to writing AI software, having all the engineers with the right signals and right actual skills has become a real barrier in the AI market. The same could be true here for blockchain potentially for quite some time. In a certain way, this is a soft network effect (the best people want to work with the best people and it is genuinely difficult to coordinate and incentivize the best people for a decentralized project). This is part of the barrier for creating a new Wikipedia for example. In theory, you could create a clone of all the articles and this is legal I think, but you wouldn’t have the network of Wikipedia contributors here.


#14

wonder if it’s possible to quantify this soft inertia for a given time window, i.e. based on:

  • number of participants
  • transaction volume
  • some parameterization of how likely a participant is to act in accordance with past behavior

#15

What I find hard to ignore about using economic value to improve security in distributed systems is how do you account for irrational markets? It seems clear to me that the vast majority of assets are over-valued. So how does the system stay secure even in the face of obvious market manipulation?

If some ridiculous scandal were to happen tomorrow to the Ethereum foundation for example, the price of Ether could crash causing a mass exit of hash power to a chain that was more profitable. Overtime this would allow a smaller miner to DoS the Ethereum chain or double-spend their own coins even if all other usage remained the same. Here the chain would be DoSed due to adjusting hash rates down and the resulting slow block times in-between. In a sense miners could “strike” by relying on slow block rates to force users to pay them higher fees, right?

It seems to me that so much of the “cryptoeconomic” security assumptions behind blockchains is based on an illusion of crowd psychology that’s outside anyone’s hand to control and I don’t know how realistic it is to rely on that as the basis for future security. Do you think these are issues for blockchain technology and would partially stable coins help alleviate this problem?

Edit: This is all a good discussion, by the way. These are the key elephants in the room for blockchain projects and there needs to be a good answer to these questions.


#16

I see talent/expertise as a sustainable advantage. Things are moving at an ever-increasing speed, so it’s harder and harder to catch and keep up. There are more and more people in the ecosystem, but the top experts won’t really change over time.


#17

@balazs I can see that. Traditional investors often talk about an “experience curve” for classic manufacturing industries. The idea is that the ability to learn new techniques to reduce the cost of making widgets is a function of your volume each year (eg, practice makes perfect). Something similar could be true here for quite awhile: the top experts are doing more and more and as a result they just end up having an ever growing edge over everyone else in the field in terms of understanding. I see something similar in my current field as a public markets investor - the expertise needed is given to only a few people and then once you enter the field you are given a set of experiences that would be difficult for an outsider to replicate; the very high barriers to entering the field means that the few in the field end up making a lot of money.