Finding Networks

Photo by Zheng Wei Lim on Unsplash

As we wrote last week, Coinbase’s listing on the NASDAQ would mark a watershed moment in crypto’s journey into the mainstream. Indeed, their direct listing came to pass, with its first shares traded at around $381/share, a strong premium to the $250/share “reference price” set by NASDAQ the eve of its listing, valuing the company in the open market at north of US$100bn.

Of course, Wall Street’s welcome party for all new joiners only lasts that long – Coinbase now joins the ranks of the great companies which, great as they are, remain subject to the vagaries of the market. Whether Coinbase brings crypto to Wall Street, or Wall Street to crypto – only time will tell. But when it comes to Main Street, that listing was the biggest advertisement Coinbase could put up.

It’s often said that the fanfare around stock listings is as much of a celebration of the company’s achievements as they are a big exercise in brand-building. The deluge of questions we were asked this week, especially from people who have historically never even been involved with markets, much less crypto, suggests that Coinbase succeeded greatly in the latter as well, both for itself and for crypto in general: What is Coinbase? What does it do? Why is it different from something like Binance? Is it a wallet? Isn’t Bitcoin illegal? What can I do with cryptos? Is it safe? What is this Dogecoin thing? Is it like Bitcoin? Is it all a joke? Is it a bubble?

The list goes on.

We’ve watched with keen eyes the evolution of crypto from its beginnings as a fringe “project” to circumvent traditional banks till the present, in its early days of mainstream adoption. Our views on the space have been consistent: of the innumerable masses of crypto projects in existence, the vast majority will likely find themselves zero-ed. There may be the occasional anomaly of a joke gone viral (Dogecoin at all-time highs, valued more than Ford motor – imagine that) but we wouldn’t count on that as a base case of any kind.

Among the survivors, however, will be such specimens of technological brilliance that they could literally change the world.

Working out what will and will not survive is the challenge of this new era, as the lines between crypto, Wall Street and Main Street blur. We don’t profess to have the secrets of working out what the hundred-bagger opportunities look like – there is so much potential variety in crypto applications (just consider how different DeFi and a project like Helium are) that we can scarcely capture that variety in a single descriptor.

What makes one crypto project more viable than another? How do we identify the potential zeroes and avoid them like the plague?

What we do know is that the yardstick for what may or may not succeed is going to look quite different from traditional instruments.

Network effects

Arguably, the biggest effect of distributed shareholders’ equity is its ability to coordinate: a large number of shareholders are now incentivised to support the success of a certain company, since they are promised and to some degree assured of their ability to share in the upside of the business.

Together with the other owners of the business, perhaps they, too, shall prosper. Back in 2009, this paper by Jaakko Aspara at the Helsinki School of Economics and NYU found that “for a large proportion of individuals, becoming a stockowner of a company leads to positive, increased motivation to exhibit brand loyalty towards the company, in terms of his/her personal purchases of the company’s products. Second, the analysis shows how stock ownership often leads to increased motivation to engage in other brand-supporting behaviors, such as positive word-of-mouth.”

At the same time, the cost of showing one’s loyalty to a specific company is rising – not so much in terms of absolute dollar amounts, since the introduction of fractional shares makes it easier for small investors to participate even when the share prices are high, but in terms of the disproportionately small amount of influence and involvement one gets from paying to be a minority shareholder. Is there even a point in owning 0.03 shares of Amazon?

Public backlash against the behaviour of some of the world’s largest (and most well-owned, directly or indirectly) companies has led to governance becoming a major issue, as founders and management increasingly seek to maintain control and voting rights. Dual share class issuances, in which management and founders own shares that command multiple-times the voting power, have come under fire – even facing calls for them to be banned.

For the company, it makes very little sense to build networks of loyal customers or promoters by way of equity distributions either. Give away too little and it wouldn’t even move the dial; give away too much and the company’s equity gets diluted, and the founders’ share of future upside is whittled away, diminishing incentives to build.

Equity has a very specific significance – ownership and control at the highest levels, but of a specific company entity. It also serves a very specific set of beneficiaries: the shareholders.

As we wrote in our paper The Theory of Nachas, the relationship between shareholders and everyone else (suppliers, customers and the general public) is adversarial: it is zero-sum. Network effects are built to accrue value only to shareholders – hence a telecommunications company owns all its towers, a gas utility owns all its pipes and an e-commerce giant owns all its logistics infrastructure.

The company pays for everything – as a result it owns everything and is entitled to the profits it can extract. Paying for everything, however, is a luxury few can afford.

Likewise, until customers happen to become shareholders (and pay for the luxury of doing so, rather than being able to say, earn rewards through consumption – shares instead of loyalty stamps, perhaps?), they transact on an arms-length basis with the company. They pay, a good or service is provided, maybe they tell their friends that it’s good but by and large it’s a matter of chance rather than there being an explicit incentive to spread the love for their favourite company.

Bootstrapping scale

We wrote in our piece on Helium how token economics enables bootstrapping on a scale beyond anything any capital instrument has been able to do in the past. Part of the magic perhaps comes from not having to “give away” company equity, part of the magic also comes from giving away a token that essentially becomes a “payment of future revenues in kind” that allows investors and tokenholders to bridge the gap between “now” and the “future”, aligning interests in order to build a network.

But while writing a derivative instrument on a specific part of a company’s capital structure or income statement makes for interesting accounting (and does form part of the capabilities of a crypto-enabled token system), the key inequality that needs to be satisfied for a flywheel network to blossom is that which alchemists have sought through the millennia: turning lead into gold, making a product that is significantly larger than the sum of its parts.

Essentially, 1+1 >>>> 2.

And that’s where we believe the line will be drawn between the wannabe crypto projects and the true successes. Anything can be bootstrapped with an initial giveaway of some freebies, but for the value of the “freebies” (in this case tokens) to NOT crater to zero, the expectation of future value of the token being given out must be larger than its current value.

Evaluating the viability of future networks takes on a whole new form of fundamental analysis. It entails a much bigger question than simply “economies of scale” – economies of scale typically present themselves in the form of cost reductions: buy a lot or produce a lot, and supplies and raw materials can be procured for a greatly reduced cost.

These principles of cost reduction and cost as a barrier to entry apply to the traditional company: since the shareholders have to stump up the capital on their initial investment, they need to know how high that barrier of minimum efficient scale is that might defend them from incoming competition.

Just as economies of scale represent the dominance of supply-side microeconomics in decision making, network economics represent the rise of demand-side microeconomics. Whereas in microeconomics, “demand” is this exogenous factor that simply appears as a function of “utility”, looking at industries, product user groups and markets as self-sustaining networks that generate their own demand and feed on themselves to grow becomes an intriguing exercise.

Therefore, the question one must ask when attempting to evaluate any project which claims to build a network is simply: “What’s the benefit of this product or service being networked?”

And then things come into perspective. A network of nodes that transfer data? Hell yeah, the more the merrier; A distributed network of lenders and borrowers? Definitely could work. A network of solar panel installations? Not so sure – perhaps it is a case of the more generation, the better, but does more generation lead to demand for more generation? Not so clear. A network of dentists? You get the point.

For all of the above, there’s a “coin”. Are all of them buys just because they leverage token economics? Certainly not.

There’s scale and there’s Scale

As far as truisms go, more is definitely more when it comes to business – whether in a traditional corporate structure or something with more esoteric economics. While we’re of the view that token economic structures represent a new form of business model, we’re not one of those demagogues who claim that EVERYTHING needs to be tokenised.

Token economics are not the “one ring to rule them all” – sometimes they work, other times they’re no better, if not inferior to, classical debt/equity capital structures. It all depends on the nature of the industry, good and service in question.

Scale can be attained in many ways, but as case studies like Helium demonstrate, there are certain kinds of scale which traditional equity – distributed as they may be – will never be able to garner on a sensible budget. The likes of Amazon, Netflix, Facebook, Google and Microsoft are champions in their respective spaces, with capital pools built over decades of hard work, sprinkled with some good luck along the way – and we stand in awe of what they have achieved.

Can upstarts with creative approaches to incentive design and capital, taking advantage of this new asset class for which Coinbase has provided the best advertising, launch a credible assault on incumbents? And should we be backing them with hard-earned capital?

We are always brimming with enthusiasm for the potential that crypto token economics can bring to the world of investing. But it would be unwise to forget that old trading floor saying: to the man with a hammer, everything looks like a nail.

Likewise, it should not be the case that to the crypto enthusiast, forgetting the lessons of 2017, everything that ends with “-coin” is “only up”.