Short Convexity

The big problem awaiting token teams

Every team that has fundraised through a token in the last 5 years has signed up for an experiment in fundraising, cash flow generation (or lack thereof), and treasury management. And there’s a big problem they would all be wise to consider.

These teams are almost universally sitting on a huge war chest, consisting of both the funds they raised and their own tokens. Capital is the last thing they are worried about right now — and perhaps with good reason given how much else there is going on.

Because they are so flush with cash, little thought is being given to what their capital and cash flow situation looks like long term. After all, these teams have exited before they started. They got their one real shot get money in the door and now that’s it. Possibly for life.

I’ve talked to a lot of teams about this. The standard answer I receive is that the plan for the project is to continue to hold a nontrivial quantity of the token. As adoption occurs, the token price will go up and the project will have more capital to fund development.

This answer fails to recognize an important and troubling problem that will play out for any project relying on that model. In order to explain this problem, I’ll need to take you to the relatively boring world of bonds. Bear with me.

The straight line is something called duration. The curved line is something called convexity. If you don’t know what I’m saying stick with me — this is going to be way less complicated than any white paper you’ve ever read.

There’s this concept in bond markets called convexity. Each bond has several different properties. Like all loans, a bond will have a maturity and an interest rate. Because bonds are also traded in secondary markets, they also, naturally, have prices. Those prices reflect whether the market thinks the bond has become more or less risky since it was issued.

As a quick example:

  • I take out a loan from you for $100 on which I pay a 10% annual interest rate for 10 years.
  • I then get a big raise at work, causing my credit score to go up.
  • Today, if I were to take out the same loan from you, I would be able to do it at just a 5% interest rate! This new, implied interest rate is what is called the yield.
  • This lower credit risk gets reflected in a higher price for the bond you hold. The bond is now worth about $105.
  • Yield goes down, price goes up.

So there’s this relationship between the yield and the price (and a handful of other factors). The relationship between the price and the yield largely gets captured by the something called the duration of the bond, or the change in dollar value per unit move in the yield. But duration plots a linear relationship between the two — glossing over a very important and more subtle dynamic at play.

Enter convexity. Convexity is the second derivative. While duration is the relationship between yield and price, convexity is the relationship between yield and duration. If a bond has positive convexity, the bond will experience larger and larger price increases as the yield falls. Conversely, as yields rise, the bond will experience smaller and smaller price drops.

Put simply, if you are long convexity, your risky exposure increases as the market moves in your direction and decreases as it move against you (yay!). If you are short convexity, you become less exposed as the market moves favorably and you become more exposed as it moves the wrong direction (uh oh).

One of the number one rules of the bond trading desk is to, all things being equal, always be long convexity. (I learned this the hard way when I once tried to go short one of the most convex bonds out there — the Mexico 100 year bond. The Bank of Japan announced a $1.4 trillion stimulus package a few days later. Talk about rekt.)

Here’s the problem: right now, token projects — despite their talk of antifragility (another word for convexity) — are all short convexity in their overall business models.

Remember: the whole idea is that they will use the vast sums of their own token to fund the project over the long term. Even as their tokens go up in value, they will inevitably have to sell some on the market to actually deploy that capital. They will be less and less exposed as the market moves in their favor.

And what about if things don’t quite go as planned? Projects may find that the most prudent thing to do in a downturn is to sit on their tokens rather than try to sell them into an illiquid and unfavorable market. They may even find themselves supporting the market for their token, buying some back from the open market. They will maintain or gain exposure as the market moves against them.

The takeaway: we need to start thinking about ways for these projects to get long convexity. If you are an investor, especially of the venture capital variety who is playing the long game, this should be all you are thinking about. If you are a founder, you should be considering options for long term, sustainable, and convex funding for your project.

Infrastructure Matters

Transforming Ownership Through Infrastructure

I have written in the past that blockchain technology is all about assets.

More specifically, though, it’s about how we interact with assets. It’s about new ways of custodying property. It’s about transacting digitally, without the involvement of coordinating third parties. Sometimes it’s about being able to do so privately. Achieving any of this is a larger issue than what the assets themselves are capable of. It also has a lot to do with the infrastructure we use.

For example: gold bars. By their very nature, I am able to directly own gold bars. I can store them in my garage, if I want to. But, in order to feel good about this, I need to be able to buy a personal safe, learn how to operate it, and have it installed in my house. If this is not an option, I might just choose to keep them in a safety deposit box at the bank. Just because I can hold onto physical gold myself, does not mean I do. The infrastructure I have access to matters here.

Similarly: bitcoin. I can custody bitcoin myself, directly, by holding my own private keys on a piece of hardware or even a piece of paper. Many owners of bitcoin choose to do this. Many others choose to entrust their private keys to an exchange or another third party. Again, the infrastructure matters.

I have said before that, in order for a new asset to be defensible against its legacy counterparts, it must enable a new form of ownership, value transfer, or coordination. My ability to reasonably custody and transfer assets in these new ways is as much dependent on the available infrastructure as it is on the assets themselves.

This is not a new lesson. In fact, we have already once seen a prolonged period of blockchain hype around financial infrastructure (as opposed to assets). 

The difficulty in devising and designing new asset classes was a key lesson that emerged out of the altcoin craze in 2013 and 2014. Altcoins were all about the creation of new assets, but the infrastructure getting built around these assets was largely centralized. Mt. Gox was the exchange of choice (for a brief time anyway). Coinbase emerged as the major retail platform for buying, selling, and holding. LocalBitcoins served as a real life on-ramp. The assets were new, and the companies and brands were largely new, but the infrastructure looked old.

The market spent the following two years focused on building decentralized experiences around legacy assets. The concept of the permissioned blockchain was born. Say what you will about permissioned blockchains, this shift in focus was a logical move by a market that realized creating value with no legal structures or strong cultural forces around it was no easy task.

Keep the old, legacy assets, but build decentralized infrastructure. What if we could custody equities without relying on rent-seeking intermediaries? What if we could track diamonds as they moved through the world without needing a single, central database? And (*whispers*) what if we could tradesyndicated loans in such a way that they did not take weeks to move through the antiquated plumbing of the financial system?

Out of the altcoin wreckage, 2015 saw an awakening to the fact that infrastructure is a critical component of the promise of blockchain technology. While it looks very different this time around, a similar realization is emerging from the token mania of the last year. 2018 is witnessing the pendulum again swing back to innovation in infrastructure.

There is perhaps no better example of rearchitecting infrastructure around assets than the innovation currently happening with decentralized exchange.In the first few weeks of the year, 0x has already achieved more than $10 million worth of transactions in a single day.

Self-custody also looks poised to make huge strides. Private key management by individuals and institutions alike has long been a critical UX issueLedger’s fundraising round should position it to bring hardware wallets even more mainstream. Radar Relay’s integration with Ledger takes the market a long way in terms of balancing usability, access to liquidity, and secure self-custodyMobileCoin’s use of SGX and remote attestation, while perhaps not the ideal cypherpunk solution to key management, also marks an important experiment in private key custody.

The important progress being made on payment channels also belongs in this category of infrastructure. With the mainnet finish line in sight, 2018 looks to be the year Lightning goes fully live.

Blockchain technology has never just been about the issuance of new assets. It’s about how we can custody, trade, transact, and secure value in new waysThis year, look to infrastructure projects to deliver the real transformation.

Killer Assets, Not Apps

Make Something People Want

The question of the killer app of blockchain technology is a popular topic.

Some of the answers have already presented themselves — and they have come in the form of assets, not applications.

I have written in the past about the history of blockchain innovation. I outlined three waves of experimentation since the creation of bitcoin:altcoins, permissioned blockchains, and tokens. Several insights can be drawn from these waves. These phases of innovation and exploration have a common theme: the search for killer blockchain apps has all along been a search for assets. Product-market fit in blockchain technology has always been about the digital (or digitizable) assets.

The search for assets began with fundamentally new assets in the form of altcoins. Permissioned blockchain technology attempted to apply the new technology to pre-existing asset classes. The tokens that have been center-stage for the last 9 months have represented a shift back to exploration of new forms of value.

Inventing new assets is no easy feat. Wall Street has been attempting it for decades — with varying levels of success and disaster (and sometimes both).

Financial engineering can mean many things, but amongst those definitions is the practice of inventing new financial instruments. These structures and vehicles allow people — usually professional investors and traders — to allocate capital and manage exposure in new ways. Credit default swaps, collateralized debt obligations, and convertibles are examples of these. Sometimes these instruments allow consumers to invest or borrow in new ways. ETFs and mortgage-backed securities fall into this category.

For a new asset to be defensible against its legacy counterparts, it must enable a new form of ownership, value transfer, or coordination. CDOs and ETFs were enabled by repackaging existing instruments and agreements. Cryptocurrencies and tokens are different. They invent entirely new assets through innovations in technology, as well as law and market structure.

There are three types of assets built on blockchain technology that, today, can count themselves as defensible against their legacy counterparts.

  1. Store of Value coins enable direct yet digital ownership in a way that neither physical gold nor digital bank accounts can.
  2. Privacy coins achieve the above, while also adding features of increased anonymity and obfuscation.
  3. Cash coins that optimize for throughput, latency, low/predictable fees, and transaction finality achieve disintermediated yet digital transactions — an accomplishment that neither physical cash nor PayPal can promise.

This is not intended to be an exhaustive list of coins that can fall in these categories — just a sample.


The question of the killer apps of blockchain technology always comes back to the assets involved. The startup adage that says to make something people want applies as much to cryptocurrencies and tokens as it does to any other new product or innovation. So far, it seems like by and large what people want is to be able to speculate and gamble.

But as I’ve said beforespeculation is not itself a use case. So look past the price pumps and instead, seek out assets that enable something that was previously impossible.

The Power of Pseudonymity

Open to Interpretation

September 15, 2008 marked the height of turmoil for financial markets. The Dow plummeted 500 points. Oil dropped below $100 per barrel for the first time in a year. And Lehman Brothers, the 4th largest investment bank in the world, filed for Chapter 11 Bankruptcy Protection.

While hell broke loose on Wall Street, a shadowy character under the guise of a pseudonym posted to an internet message board. Though largely unnoticed by the mainstream at the time, this post, and the mystery of the persona behind it, would go on to become the stuff of internet legend.

I am talking about @dril. @dril (also known as ‘wint’) is the pseudonymous Twitter account that uncannily parodies everyone you’ve ever considered unfollowing on the internet. Firmly in the realm of the absurd, bordering on the unintelligible, @dril’s humor has reached cult status and has created an internet subculture unto itself: Weird Twitter.

What’s most incredible to me, however, is not the popularity of @dril (over 850,000 followers). Most astounding is that @dril has managed to remain masked.

Cursory research indicates that there has not been much serious attempt to reveal @dril’s identity. Whether consciously or not, @dril’s fans must know that the humor of their favorite Twitter account would be eroded if they knew who was behind it. So they don’t want to know. @dril’s tweets can mean anything to anyone in his (her? their?) audience. Pseudonymity allows the consumer to impose their own meaning, independent of the intent of the author or creator.

A few weeks after @dril’s initial post, another pseudonymous figure who would go on to attain cult-status emerged on a different forum.

The last day of October 2008 was a Friday. Traders, beaten from the last several sleepless weeks, went home that night hoping they would still have a job come Monday. It was the worst month on record for Wall Street. Three days earlier, the consumer confidence index had printed an all-time low.

That day, Satoshi Nakamoto posted a paper to the Cryptography Mailing List. The Bitcoin Whitepaper.

The breakthroughs of the Bitcoin Whitepaper need no retelling here. For the first time, thanks to Satoshi’s design, fully peer-to-peer electronic cash was possible.

The Bitcoin Whitepaper, without doubt, represented a technological leap forward. But, interestingly, many of the components of the protocol had been around for years by the time it was released.

The new combination of these various pieces is cited as the real differentiator and innovation of bitcoin. While (pretty much) all the pieces were there in 1998, it took ten years to assemble them correctly.

Or perhaps that was not really the hard part. Maybe Satoshi put those pieces together back in 1998 — and then spent ten years figuring out where, when, and how to successfully release the idea.

After all, in order for this new model to work, in order for this system to truly be decentralized, it could not have a long term figurehead. Trust in the technology (or lack thereof) needed to be based on objective assessment, not based on an individual or organization backing it. Trust in the asset, likewise, needed to respect the fact that value is a social construct. By publishing under a pseudonym, Satoshi Nakamoto enabled consumers to make their own judgments of the technology and determine the value of the asset independent from its creator.

Just as with @dril’s humor, pseudonymity allowed individuals to impose their own meaning on Satoshi’s creation. Incredibly, almost a decade later, Satoshi has also remained masked.

In order to pull this off, Satoshi needed to ensure that his identity would not be uncovered even when under scrutiny from the likes of journalists, security experts, and government agencies. This would have demanded consideration of not only technical problems of operational security, but would also have entailed composing his code and the language of the whitepaper such that semantics would not allow him (her? them?) to be traced. Discussing ideas related to bitcoin with family, friends, colleagues was to be scrupulously avoided, as was posting anything online that could possibly link his pseudonym to his real-world identity.

(For an example of how not to do this, one need look no further than one of the first major commercial adopters of bitcoin, Dread Pirate Roberts.)

But Satoshi was not only solving for how to keep his identity private. He was also solving for how to make sure the idea would end up in the right hands, would be implemented, and would gain adoption.

He had to craft a go-to-market strategy that would take care of itself, once set in motion. He had to figure out in what format to release the idea (whitepaper), in what forum (the Cryptography Mailing List), and at what time of day so that it would be picked up by the right people. He had to find a name to release it under, such that it would not be traced back to him or anyone else. A name that would be neutral. A name that would invoke trust.

But perhaps most of all, he had to consider the broader societal circumstances under which to release it. He must have waited patiently for a time when the world was doubting the structures that had held the global financial system in a precarious balance. Maybe he woke up that morning of September 15, when Lehman filed, and thought to himself: this is it. Maybe he spent the next six weeks getting organized.

The message Satoshi embedded in the bitcoin genesis block, the headline of the Times that day, is a pointer to this consideration. And was also a masterstroke of marketing. “Chancellor on brink of second bailout for banks.”

Banksy, the subversive, pseudonymous artist has said: “if you want to say something and have people listen then you have to wear a mask.”

It certainly seems to help with the listening. It also helps with the longevity. Only when separated from their creators can concepts, humor, inventions, and content be fully open to interpretation.

This is why bitcoin is so many different things to different people. This is why forks happen and why, with every forking debate, there is a vocal faction asking the question “What would Satoshi do?”

But this inefficiency is also one of the main value propositions of bitcoin. It does not have a leader who can answer that question, who can decide on forks, and who can steer the community or consumer. So the purpose of the network and the value of the asset remain uncorrupted by intent. Often cited as a problem, this may in fact be the feature that will ensure Bitcoin’s staying power.

A Brief History of Blockchains

In Search of Assets

If the recent run up in crypto markets is to be sustained, some of its products will need to start delivering real end-user utility. As we go into 2018, the biggest question facing blockchain technology is that of product-market fit, or more specifically, whether these products have utility beyond speculation.

Bitcoin, the original blockchain-based product, has arguably achieved this: acting as disintermediated, digital gold. But the market is currently pricing in a bet that many more products will deliver value.

In order to understand where the industry is going, and where fundamental value might lie, it is helpful to consider the short history of crypto innovation. The market has experimented with blockchain technology in three waves: altcoins, permissioned chains, and tokens.

In examining this progression, it becomes clear that the search for product-market fit in blockchain has always been about a search for assets.


The first trend of experimentation saw the creation of altcoins in 2013 and 2014. Most of these altcoins were technically very similar to bitcoin, with a few tweaks, maybe a new feature, and some fresh branding.

Some of these altcoin protocols have survived and thrived over the last 4 years, while others have failed. Those that have gained and retained value have found product-market fit in two ways: either the asset has met an economic need or the protocol has met a technological demand.

Like bitcoin before them, the assets that have met a real economic need have done so by enabling a form of ownership or transaction that was not previously possible. Zcash and Monero, which both implement privacy as a feature of transactions, are good examples of this.

Other altcoin projects that have endured have done so because of they meet technological demands of developers and innovators. They have served as testing grounds (Litecoin) or they have become platforms for building (Ethereum).

The altcoin boom was explicit in what it was creating: new protocols, platforms, and, most fundamentally, assets.

Permissioned Blockchains

In 2015 and 2016, as many altcoins lost momentum, the second wave of blockchain innovation took off. Rather than generating new assets, this wave focused on assets that already existed.

One lesson from the altcoin boom was that creating a new asset is hard. Not technologically, but economically. How do you endow a new asset with value? Value is a social construct. For an asset to have value, the only rule is that people must perceive the asset to have value.

In traditional finance, perception of value usually comes from the backing of institutions and legal constructs. So this second wave of blockchain innovation says, “let’s apply the blockchain innovation to the assets we already have.” Assets that already exist should not face the perception-of-value problem.

But as soon as you represent an asset in a new format, the nature of it changes — and so does the perception of its value. It is not as simple as creating a digital asset and saying it represents the US dollar. (Although, Tether seems to have achieved this, but we will leave discussion of that for another time.)

This point is intuitive but is so fundamental that it is worth spelling out. In order for an asset to represent an actual dollar, the Federal Reserve would have to be the issuer and declare that it is backed by the full faith and credit of the US government. Legal structures would have to be created around this asset to make people comfortable with the idea that the digital version was equivalent to the dollar in their pocket. Even then, there might be a spread between the value of the two, as there is between on- and off-shore versions of currencies.

This concept of porting existing assets into new formats is at the heart of what permissioned blockchain technology attempts. Operating within a closed environment helps get us part of the way there.

Let’s say there is a digital asset that is intended to represent a US dollar. Now let’s say that the only users of this digital asset — Alice, Bob, and Carol — exist within an enclosed system. If Alice, Bob, and Carol all come to consensus that this asset is equivalent to a US dollar, then they might be able to create a functioning market for transactions amongst just themselves. This is what every blockchain consortium is attempting to achieve with stocks, bonds, and syndicated loans.

The persistent problem with permissioned blockchain technology is the on- and off-ramps. How do you cash in and out of the system? A friend of minehas coined this the Porsche problem: I might have all of these cryptodollars that Alice gave me, but if I can’t go buy a Porsche with them, what good have they really done me? Maybe I can redeem them with Alice for US dollars, but then the asset is really just a claim on Alice. A claim that is redeemable for an underlying asset, as anyone who lived through 2008 can tell you, is never the same as owning the underlying asset itself.

This second wave of blockchain experimentation also tries to move physical assets onto a blockchain. This has been applied to everything from shoes, to homes, to diamonds, to pork bellies, to art. One illuminating point here is that the world has a major tracking problem. Maintaining a record of the existence and ownership and authenticity of physical goods, it turns out, is something we are very bad at.

Unfortunately, a blockchain won’t help you with this. This is a last mile problem. You can, perhaps, track digital deeds or titles on a blockchain. The real difficulty, however, lies in linking those deeds and titles to the physical good. The issue that arises in tracking provenance and ownership is not a matter of the database not being good enough. It’s a matter of having good data that actually represents the assets.

Reformatting existing assets onto a blockchain, it turns out, is just as challenging as creating new assets. Valuing digitized assets poses many of the same problems as valuing digital assets.


Which brings us to the third wave of blockchain experimentation. The market has returned to a trend of creating new assets, this time rebranded as tokens. Tokens are new natively digital assets that creators attempt to imbue with value.

Tokens differ from altcoins in that their value attempts to be derived in more traditional ways. They might, for example, represent a claim on returns of a project or set of ventures. (In traditional finance, this would be called a share or an LP interest, but never mind that.) Blockchain Capital’s token and the Ethereum DAO are obvious examples here.

Tokens might also represent an asset to be used in an application. File storage is an intuitive example. Various applications offering a decentralized version of DropBox have come to market in the last several months. The file storing system runs as a market, where users can purchase storage from each other. App-specific tokens are the medium of exchange for these markets.

This type of design begs the question, why not use bitcoin? Or ether, the asset that is native to the platform some of these apps are built upon? Just because it is a decentralized marketplace does not mean that it needs its own peer-to-peer currency: AirBnB and Uber did not need BnBCoin or UberCoin to bootstrap their networks and become successful.

Admittedly, using in-app tokens as a medium of exchange helps to solve the token’s perception-of-value problem by making it redeemable for an actual good or service.

So the token’s problem gets solved… But the token does not solve a problem for the application or the user. Indeed, it most likely harms user experience. Are people willing to use specified assets for different goods or experiences? After all, I probably want to buy my Porsche with US dollars, not with PorscheCoin.

These examples, wherein tokens act as securities or app-specific money, are the most straightforward paradigms emerging. In fact, many tokens being pitched to the market today do not fall squarely in either category — meaning the perception of their value remains pure ideology. It has become a trend for entrepreneurs to find a way to wrap their app in a token in order to fundraise. Really, however, these entrepreneurs are encumbering their business models, corrupting their cap tables, and creating a user experience of their app rife with friction. Only the tokens that can justify their existence as independent assets will have staying power.

How to Price Hard Forks

Can Bitcoin Markets Add and Subtract?

I find it fitting that the winner of the Nobel Prize in Economics for 2017, bitcoin’s annus mirabilis, is Richard Thaler. Thaler is known for his work on irrationality and the role of psychology in determining market movements.

In 2001, as the market approached the nadir of the dot-com bubble, Thaler co-authored a paper that asked the question: Can the Market Add and Subtract? The question certainly feels applicable to cryptocurrency markets. Nowhere is this more evident than in considering the bitcoin fork that occurred in August.

In this 2001 paper, Thaler and his coauthor Owen Lamont explore inefficiencies in the pricing of technology stocks. The basic idea that they explore is that when companies are split, the broken-up units should, in aggregate, be priced on par with the company pre-split. But that does not always happen.

The example of Palm and 3Com is the most well known and is fairly intuitive. Palm (remember Palm Pilots!?) was owned by a company called 3Com. In 2000, 3Com sold some of its stake in Palm to the public in an IPO (this is called a carve-out). 3Com also announced its intention to eventually spin off the rest of Palm to 3Com shareholders at a rate of 1.5 Palm shares for every 3Com share they owned. In other words, everyone who owned 1 share of 3Com would wake up the morning of the spin off with not only 1 share of 3Com but also 1.5 shares of Palm.

Intuitively, the following inequality should therefore have been true on the day of the carve out:

Price 3Com > Price Palm x 1.5

This is assuming that there is some fundamental value to 3Com in addition to its stake in Palm. Since equity cannot be priced negatively (and really rarely trades at zero), this is reasonable.

But this is not how it went down.

In the words of Lamont and Thaler:

“The day before the Palm IPO, 3Com closed at $104.13 per share. After the first day of trading, Palm closed at $95.06 a share, implying that the price of 3Com should have jumped to at least $145 (using the precise ratio of 1.525). Instead, 3Com fell to $81.81. The stub value of 3Com (the implied value of 3Com’s non-Palm assets and businesses) was minus $63. In other words, the stock market was saying that the value of 3Com’s non-Palm business was minus 22 billion dollars!”

The IPO was widely publicized, so it’s unlikely that there was an informational inefficiency at play. Thaler and Lamont explore the possibility that the overpriced stock was merely too expensive to short for arbitrage to make economic sense — but as they note, this does not explain why there werebuyers of the overpriced stockThis mispricing lasted for weeks, despite it being publicized in the media.

What does all of this have to do with cryptocurrency and hard forks?

The closest parallel to a hard fork in existing financial markets is a stock spin off. In both cases, a pre-announced event occurs wherein the owner of a single asset ends up not only with the initial asset but also an additional asset.

Last August, the bitcoin network experienced a major fork, testing the rationality of the crypto market. The results were unsurprising (the market is irrational), but noteworthy nonetheless. This fork resulted in owners of bitcoin not only possessing the original, but also a new asset called Bitcoin Cash.

The equality that should intuitively have held true for the Bitcoin Cash fork, then, is the following:

Price BTCPreFork ≈ Price BTCPostFork + Price BCH

Just before the fork actually occurred, the price of bitcoin should have roughly reflected the price of the two resulting assets. There are some explanations for why the price might have deviated: there may be some discount in the price to reflect the risks of the impending fork or the possibility that the fork would not actually occur. But broadly, the immediate pre-fork price of bitcoin should have been about equivalent to the collective prices of post-fork bitcoin and the newly created Bitcoin Cash.

This is not about whether forks are accretive. Whether you support cash, or gold, or classic, or core — undeniably a fork results in the existence of two assets with some value. Efficient market hypothesis would say that the collective value should approximate the value of the single parent asset just prior to the event.

But this is not what happened. Bitcoin barely moved on the day of the fork. Yet Bitcoin Cash closed the day with a market cap of over $6 billion. This $6 billion in value emerged from one moment to the next… at the moment that the fork occurred. Even assuming the market viewed the event as accretive, it was foreseeable for hours, days, weeks, before it happened. Why was none of this priced in?

The only thing to do is return to Thaler:

“To explain that, one needs investors who are (in our specific case) irrational, woefully uninformed, or endowed with very strange preferences.”


Thanks to another UChicago affiliate, John Loeber, for providing feedback and to Shelley Pearson for bringing the Palm / 3Com example to my attention.

The Riot Act

What’s in a blockchain?

Last Friday, a stock called Riot Blockchain gained nearly 50%.

The former biotech company pivoted in October to “Blockchain.” Since then, the share price has risen from $5 to over $20. 

Upon learning this, I went to Riot’s website to see what exactly they are doing with blockchain technology. I suggest you check out their site. I mean, this place has everything: a bitcoin and ether price feed, an animation of a gold coin bearing the Ethereum logo, and a proclamation that they are disrupting the future of transactions.

The first line of their About section betrays what is, of course, really happening here: “Riot Blockchain Inc is a first mover on the NASDAQ focused on blockchain technology.”

Their main value prop is that they are a publicly traded company that has said the word blockchain. Wall Street players have to date largely been unable to invest directly in crypto. Hungry for the action, they seem to be piling into this stock as a vehicle for some of that coveted blockchain exposure.

It’s right there on the third slide of their recent investor presentation: “What’s in a name?”

I think “Riot” is not the part of your name people are paying attention to…

The importance of names in publicly traded stocks is well documented. Psychologists Adam Alter and Danny Oppenheimer studied this phenomenon in newly IPOed stocks from 1990 to 2004. They found that stocks with easy-to-pronounce names fared significantly better in early days of trading than others. If you can boost your stock price just by having a catchy ticker symbol, imagine what adding the word “blockchain” can do for you in 2017.

To be fair, Riot has put some money where its mouth is. It has acquired stakes in a handful of blockchain-oriented startups and has also entered an agreement to purchase mining hardware. This hodgepodge of “strategic” investments strikes me as a strange approach for a public company executing a pivot. It looks more like a haphazard attempt to quickly gain exposure to this whole blockchain thing. Of course, they could have just bought some bitcoin.

The company has said in its recent press releases that it “leverages its expertise and network to build and support blockchain technology companies.”

Expertise and network, eh?

Who are these people? I read their 2016 annual report so you don’t have to. That’s where this whole thing gets really weird.

The report does not even attempt to construct a coherent narrative for the meandering course that the business has charted in the years since it was founded in 2000.

The company began its life as a veterinary venture. In 2004, it acquired an exclusive license agreement for products related to cattle reproductive health and animal pregnancy testing. It has since sublicensed this IP to a French animal health company.

Around 2012, the company changed course into diagnostics. It spent several years attempting to obtain approvals from the FDA for a blood test that would be used to rule out the possibility of appendicitis in (human) patients. It failed.

In September 2016, just 14 months ago, the company made another acquisition: this time the target was a company that was building something called Enhanced Surface Plasmon Resonance technology. I don’t know what this product is, but I can tell you that working on it for a little over a year is unlikely to endow you with expertise in blockchain technology.

One theme that has been consistent for the company over the years is management’s inability to deliver results. No matter the market, industry, or product, the company’s financials have been perennially abysmal. As of December 31, 2016, the company had an accumulated deficit of almost $110 million. They achieved $9,000 in sales last year. There is no “k” missing from the end of that number. Nine thousand dollars. You don’t need to know accounting to know that this is not good.

I have to admire management’s honesty about all their misguided decisions, though. In their 2016 annual report, one of the first things they said regarding their biotech strategy was: “It will be difficult for us to establish a market position… We believe that most of our competitors have significantly greater financial, manufacturing, marketing and product development resources than we do.” Pretty self-reflective for a venture that has taken so many wrong turns. It’s unclear, however, why they think their market position “in blockchain” is any better.

There’s something about saying the word blockchain that is currently causing normally thoughtful, intelligent people to lose their heads.

FOMO is a big part of this, but it’s not the only dynamic at play. There is also a Fear Of Missing Something. What I am talking about is a form of gaslighting that has gripped the market. People right now will hear about a token or a company or a pivot and they might think to themselves, “this whole pitch doesn’t make a lot of sense to me.” But then they look at the price of bitcoin, read some jargon-filled whitepapers, and shrug and go, “well I must just be missing something here.”

To these people I say: you are not missing something. You don’t need to understand blockchain technology to be able to spot bad business models or poor management teams. Keep your wits about you in this market.

After all, would this company by any other name look like quite so cheap?

Thanks to my mom for first pointing out to me the crazy rally in this stock. And then for listening to me complain about it for the better part of Thanksgiving weekend.

Top-Down Demand

Fat Products

Yesterday, I wrote about the layers of blockchain technology.

Products, platforms, and protocols. Assets, tools, and rules.

I noted that there are all kinds of dependencies among products, platforms, and protocols, resulting in every layer of the stack being built at once. Good products rely on secure, friendly platforms. Secure platforms depend on sound, scalable protocols. Protocols hinge upon an asset that, itself, serves as a product.

The flow of dependencies among these layers is circular, but the flow of demand through these layers looks different.

Demand flows from the top-down. End users demand products. Products are built by developers. Developers demand platforms. Platforms are created by engineers. Engineers depend on protocols. 

This is significant because demand drives value.

One of the most influential pieces on valuing blockchain technology is Joel Monegro’s note on fat protocols. The idea is that, in blockchain ecosystems, value accrues at the protocol layer as opposed to the application layer.

This is a helpful framework for understanding how protocol technology can be funded and monetized, but it is important to note that protocols are not intrinsically valuable. A protocol is only as good as its products.

Sustaining the astronomic rise in the price of bitcoin this year will depend on it continuing to gain adoption as a product: as a store of value, a means of diversification, and (maybe someday) a form of payment. Maintaining the colossal increase in the price of ether will similarly hinge upon tokens, Ethereum’s products, finding genuine demand among end users.

Many interpretations of fat protocol theory also confuse infrastructure for applications. An investment in bitcoin, the reasoning goes, has fared better than an investment in, say, Coinbase. But Coinbase is not an application of the Bitcoin protocol. Coinbase is a web application that provides infrastructure for the bitcoin product. Like protocols and platforms, infrastructure is only as valuable as the products it serves.

Fat protocol theory glosses over the top-down dynamic of demand. If a protocol accrues value — and keeps it — it is only because its products are delivering value.

Products, Platforms, and Protocols

The Blockchain Technology Stack

A couple weeks ago, I mentioned the moat of jargon around crypto. Even among those who have been working on this technology for years, there is often dispute over preferred terminology. Indeed, the word “crypto” is itself a point of contention. It’s little wonder there is so much confusion.

Whether you are new to the space or deep down the rabbit hole, it’s worth having a framework for where different technologies fit into the ecosystem.

Blockchain technologies break down into three categories: products, platforms, and protocols.

  1. Products serve end users
  2. Platforms serve product developers
  3. Protocols serve platform & product developers

Products sit at the top of the stack and are what end users interact with. These are often standalone assets: cryptocurrencies and tokens. Sometimes these assets serve a function within larger products called smart contracts or decentralized applications (dapps). Tokens are generally built by developers on top of a platform.

Platforms are a kind of middleware. Platforms facilitate the creation of products (in this case, tokens) and are usually associated with things like IDEs, high level languages, compilers, and other tools. These platforms, along with the products built on top of them, abide by conventions and procedures defined in their respective protocols.

Protocols are the set of rules that govern the network. Blockchain protocols usually include rules about consensus, transaction validation, and network participation. Protocols are often dependent on economic incentives — which generally means the protocol hinges upon an asset.

Circularly, this protocol-level asset can also serve as the protocol’s native product (no platform required!)

Bitcoin is a good example of this. Bitcoin (capital B) refers to the protocol. The protocol hinges upon a native asset: bitcoin (lowercase b). This native asset is also what gets used as the end product: it is the user’s means of payment, store of value, and (let’s be honest) vehicle for speculation. Note that Bitcoin does not really offer a platform. It’s not very friendly for developers trying to build new products on top of it.

Ethereum, on the other hand, exists at all three layers. It is a protocol, providing base-level rules. It is a platform, enabling developers to build new products on the system. And, because its protocol also has a native asset, it is also a product (in the form of ether).

Bitcoin and ether are cryptocurrencies, not tokens. A cryptocurrency is an asset that serves an economic purpose at the protocol layer and exists as an end product itself. Other examples include zcash and tezzies.

Tokens, meanwhile, are assets that function solely at the product level. Tokens are built on a platform and are not a core component of the underlying blockchain protocol. They may, however, be a core component of a smart contract or a decentralized application. Examples of decentralized applications include Augur and Brave, which implement the REPutation Token and the Basic Attention Token respectively. Both examples are built on the Ethereum platform and leverage the Ethereum protocol.

There are lots of layers to blockchain technology — all of which are being built at once. There are circularities to and dependencies among these layers. Having a framework of terminology helps in reasoning about where value lies, where investment is being made, and what is left to be worked on.

Of Blockchains and Brokers

A Note on Intermediaries

A couple of days ago, I wrote that blockchains are basically only good for cutting intermediaries out of transactions.

The idea of disintermediation gets thrown around a lot in this world. But when you talk about disintermediation, you have to be specific about where you are removing a third party.

Transactions can be broken down into three levels:

  1. Execution
  2. Clearing
  3. Settlement

Execution occurs when counterparties are coordinated and agree to a transaction. This is usually done through a broker or exchange.

Clearing refers to the official recording of the transaction by each party involved, along with whatever reconciliation needs to happen amongst them. Clearing can be done through a central clearinghouse that manages all of the transactions in a market. It can also be done bilaterally, directly between the two counterparties.

Settlement happens when the trade or transaction is considered complete. This is when the funds actually show up in the account.

Blockchain technology today only provides solutions for disintermediation at the clearing and settlement layers.

This is important to recognize because oftentimes, value extraction occurs at the execution layer. Middlemen often take tolls for coordinating buyer and seller or managing market liquidity, not for updating books and records. If you want to disintermediate the execution level of a transaction, a blockchain cannot help you. At least not yet… Innovation in decentralized exchange may eventually get us there.

But until then, we will still need brokers, exchanges, and other liquidity providers. Which is why, with its explosion of new assets to be traded and moved, blockchain technology has created more intermediaries than it has destroyed.