Reciprocal’s ICO — Initial Crypto Opinions from a FinTech VC
This post is an adaptation of a speech Michael Steinberg (General Partner at Reciprocal Ventures) delivered on Tuesday, July 25, 2017 to a group of investors and (patient) blockchain entrepreneurs.
As early stage venture investors, it’s pretty hard for us to not be excited about blockchain. The industry is a hotbed of experimentation and revolutionary thinking, and though my colleagues and I see a lot of different opportunities, few appear as groundbreaking as blockchain. Entrepreneurs and developers in the space have blown us away with their intelligence and creativity. They’ve created a new funding market, a new asset class and even proposed a new economic theory.
We believe we are only at the front end of a long cycle of innovation in blockchain and we’re actively searching for opportunities in the industry that fit within our investment framework. Like most venture capitalists, as a starting point, we look for large markets that can be disrupted and blockchain is only one of the areas that we are focused on. But in our view, the size of the addressable market for blockchain applications is potentially several orders of magnitude larger than many other emerging technology markets, which makes it particularly compelling.
Alex Tapscott, the author of Blockchain Revolution summed up the size and scope of blockchain well. He expressed the idea that just as the internet accelerated the exchange of information, blockchain will take it one step further, accelerating the exchange of value. The exchange of value refers to payments, but also to the underlying market structures of many multi-billion dollar verticals: authentication, cloud computing, domain names, and social media, to name a few. Currently, we use Verisign for SSL verification; Amazon, Microsoft and Google for cloud services; GoDaddy for domain names; Facebook and Twitter for both secure login and social media. The goal for many players in the blockchain space is to break these corporate oligopolies.
To do so, blockchain companies are constructing new protocols — protocols are systems of special rules and standards that networks utilize so network participants can understand each other and exchange information. The Internet leverages key protocols for information transfer: TCP/IP and HTTP for sending and receiving data on the Web and SMTP for email. Blockchain protocols are now being developed to enable peer-to-peer transfers of digital assets. Today, we think of digital assets as the things on our smartphones…our pictures, songs and maybe Bitcoin….but we expect to see a wave of new digital assets introduced. We expect to see digital music rights, digital title documents, bills of lading, national currencies and much more. As early evidence of this, Spotify recently acquired a digital music rights blockchain startup. And as Bloomberg reported in June, central banks in Asia and Europe are experimenting with plans to digitize up to 30% of their current floats! The market opportunity for digitized record keeping and exchange is enormous.
But transferring assets, as we all know, requires a lot of trust. And for the last 600 years, we have had a central party, or middleman, at the hub of every transaction! Blockchain seeks to remove that middleman and replace trust in human operated systems with trust in code. The procedures and fees for blockchain transactions are hard coded into the software and the network ensures that the data is properly entered, stored and secured. Blockchains are called decentralized systems because the implementation of the code is not done by a central party — it occurs across the entire network in a coordinated, but distributed way. It’s the type of technological innovation that gets us very excited.
Of course, it’s a valid question whether eliminating a central party from transactions is a great idea. Broadly speaking, intermediaries often serve valuable roles in business; they provide information, access and help with decision making. They frequently perform the vital role of referee, helping to resolve disputes and reversing transactions, when appropriate. Static code and peer-to-peer transactions may not be optimal in some situations.
For almost any new product to succeed, it needs to solve a problem and do so significantly better than existing options. This is a serious challenge, because not everyone sees a problem with centralized providers. Some incumbents, like Google and Amazon, receive very high NPS scores from their customers. These internet giants offer an unparalleled user experience and displacing them will be very challenging! Mainstream adoption of blockchain will be further challenged by the simple fact that many businesses and consumers will not be naturally inclined to participate in a non-intermediated system that places its trust entirely on computer code. Security is a very common concern.
Our own view is that blockchain must still tackle some serious challenges and it’s not a panacea that will work across all segments of the market, but it does offer a tremendous value proposition. The effect of removing the middleman from transactions should dramatically cut costs. Banks, according to Accenture, will save $8-$12 billion on their back office alone! And settlement times will accelerate, reducing the amount of capital required to be held as collateral by financial institutions — thereby boosting the capacity to lend and the return on assets.
Another important, less appreciated promise of blockchain is that the decentralized architecture can potentially make systems more secure. Today, data breaches are common at centralized providers and customer confidence is waning…. they happened at Yahoo, the NSA, even Ashley Madison had one! By distributing customer information across a network, blockchain could eliminate a central point of failure.
It’s important to note that there are different types of blockchains. The most well-known blockchains, Bitcoin and Ethereum, are referred to as public blockchains. They are developed by an open-sourced community and managed by a distributed set of developers that don’t actually work for the parent company. There are also private blockchains which can be developed by open-source communities or by corporations, governments and other entities — and they are managed differently. Private blockchains permission access, so only select parties can read or write the data. They more closely resemble traditional high margin software companies. This public versus private distinction is very important because only public chains can be forked and cloned.
A fork is what happens when a blockchain splits — and moves into two potential paths forward. It’s an existential risk, akin to a civil war within your developer community. A clone is when your code is copied and altered, usually to make a small technical change, like adding a new feature.
Forks and clones are important to think about because they create a dynamic market and enable competition. When Bitcoin was launched in 2009, it was the first and only protocol built on the blockchain. By mid 2015, there were 650 Bitcoin clones. Most Bitcoin clones didn’t generate a substantial, sustainable community, but a handful did quite well, like Litecoin, which currently has a $1.5B market cap. It’s unclear if Litecoin’s growth and devoted following has diluted Bitcoin’s own trajectory. I’d argue that in this case, cloning spurred innovation and it was a net positive for the Crypto community. Recently, Bitcoin announced that it will fork for the first time. It’s a highly contentious split and most would agree it does not appear to be a net positive for Bitcoin. The developer community, along with investors, are understandably nervous about it.
The vulnerabilities introduced by open-source development should be considered alongside the tremendous benefits. Open-source projects have advantages in the diversity and quality of the developer community, as well providing free and open distribution. But it’s worth noting that the IP in open-source projects is not exclusively owned by the company itself and establishing patent rights is difficult. Where would Bill Gates be today if Microsoft had been open-sourced in 1990?
We believe the blockchain industry is still early in its lifecycle and we want to help it flourish. Articulating its potential to financial industry executives and investors is one way we feel we can add value. Having invested in different asset classes over multiple cycles, we have learned many lessons and wish to use that experience to help point out not only the strengths of blockchain, but also some of the bugs and potential issues. We are also seeking to partner with entrepreneurs and support radical innovation by making investments in the space. We are particularly excited about base protocols, middleware and other infrastructure that helps enable scalability and interoperability in the blockchain ecosystem. We look forward to participating in the continued evolution of digital assets and growth in the blockchain community.