September 26, 2024
Permissionless Capital, Global Consensus and New Markets
INDEX
The startupization of crypto has been happening since 2016-2017. In every cycle, the visibility of crypto has increased, more people have entered the space, and the prospective returns have gradually diminished. By now, everyone has heard of crypto.
As is typical with any emerging industry, the most promising ideas do not require egregious amounts of capital. But after the initial wave of excitement and eye-watering returns, the capital availability increases, and the bar for investable ideas decreases. Everyone can be a founder as long as capital sloshes around.
With $100B of VC capital poured into private crypto markets since 2016, founders have attacked every possible industry with tokens. If the only tool you have is a hammer, you tend to see every problem as a nail, said Abraham Maslow. This torch has now been passed to AI.
From finance and payments to identity, social networks, media and entertainment, gaming, cloud computing, AI, healthcare and science, supply chains, storage, gambling, art, various kinds of physical infrastructure networks, and even satellites in space—crypto has reached everywhere. No stone has been left unturned.
Today, there’s $700B in circulating market capitalization of altcoins (excluding BTC and ETH) and $40B in Coinbase stock. For simplicity, let us assume that investors own 30% of the network and ignore any unvested tokens; in the case of Coinbase, the investors owned around 50% at the time of its direct listing.
This means the liquid value available to VC investors has been around $230B. Of course, this is not perfectly accurate as we’re not accounting for all public companies, not accounting for companies yet to issue their tokens, or investors having sold at different points in the cycle.
But the reality is that most of the $230B (for the $100B invested) has been driven by a few outliers like Solana and Coinbase, ICOs and memecoins where VCs had no exclusive allocations. You do the math and see for yourself that the outliers in crypto matter as much as and perhaps even more than anywhere else.
Unique Properties of Crypto
It should be clear by now that crypto is not a panacea to every world problem. Distributed systems we call blockchains have very unique properties, and these properties have remained largely unchanged since the invention of Ethereum.
Blockchains are underpinned by very strong financial elements to ensure network security, so no one should be surprised that the sustainable use cases would have to lean in that direction too. That’s why some categories of projects produced enduring winners and others have not.
What are those unique properties? While the list is not exhaustive, we think the main ones are:
- Permissionless capital formation, and, by extension, distribution of tokens;
- Global consensus over a distributed ledger of financial assets.
Permissionless capital formation is the most important and universally extendible PMF of crypto. This is why ICOs, in aggregate, were successful. This is why pump.fun created a bull market for the entire Solana ecosystem and earned more money in 8 months than 99% of all crypto projects combined. This is why crypto capital is funding Network States and longevity experiments. The idea space is infinite, and all of the funded assets will live on-chain, guaranteeing provenance to their owners.
Global consensus and distributed ledger enable open, permissionless finance. Founders have already built out all the financial components in DeFi—borrow-lend, savings, trading, payments/stablecoins, and debit cards for spending. From BlackRock to megabanks, VISA and Mastercard, they’re all looking at properties of crypto and DeFi, and finding ways to incorporate that into their business. Perhaps one day bureaucracy could be outsourced to global consensus en masse.
Therefore when we see founders complaining about Ethereum Foundation’s antagonistic approach towards DeFi, we can only question if it’s ready to give up on the second-best PMF crypto has found to date (second only to Bitcoin’s store of value):
While Vitalik will argue that DeFi is ouroboros, a snake eating its own tail, we think it’s entirely the opposite. DeFi is perhaps the only working crypto category that is positive-sum! It creates new capital markets, and it enables people to take on credit and spend it. Credit expansion is the basic force for creating consumption and investment. That’s why the US went off the gold standard and instead of US markets collapsing, they exploded higher for many decades. The whole point for economies is to BE circular so that they can grow. Why DeFi cannot be circular?
Which projects have leveraged the unique properties of crypto most successfully from the bottom of the market in November 2022 to today? Unsurprisingly, they all lean into DeFi or capital formation:
- Solana’s price has increased 15x, and it has always prioritized DeFi. In fact, it was conceived as “Decentralized Nasdaq” from the very beginning;
- Pump.fun earned over $100M in fees for itself, and close to $1B for the ecosystem because it enabled permissionless capital formation for speculative assets;
- Ethena scaled the basis trade to billions of dollars;
- Polymarket has created new markets for people to speculate on;
- And then we have plenty of CeFi businesses like Tether, and Coinbase that provide financial services and have grown their market share significantly.
One of the loudest narratives this year has been the pivot to consumer crypto. We can broadly categorize it into hyper-speculative games (bonding curves, casinos, memes) and digital ownership-oriented products (ala Farcaster, Zora, etc.)
We first wrote about the need for consumer apps at the end of 2022 in Fappening, when it felt to us like the pendulum had swung too much in the direction of infrastructure. Now, it feels like all the attention is on building The Consumer App of crypto, but most often without questioning what unique features that app enables.
Is a mini-game on TON a more enabling and durable consumer app than boring borderless crypto payments? Probably no. This is not to say that mini-games have no role to play, it’s just that they don’t quite leverage the unique properties of crypto because for them high integrity over financial data is not required. The distribution of tokens, the basic principle of crypto capital formation, is what made them interesting in the first place.
Crypto Creates New Markets
Now that we’ve established that crypto is great at capital formation and facilitating financial transactions, where does this take us? New Markets.
Despite having no sea access unlike Genoa and Venice, Florence became a trade superpower in Medieval Europe, largely thanks to its innovations in banking and financial instruments. The golden Florin, minted in Florence, quickly became the dominant trade coinage of the Western world.
The superpower of crypto has always been finding a price for assets that otherwise wouldn’t be priced. In other words, creating markets, where markets did not exist before; or, at the very least, significantly improving the transactional experience by bringing abundant liquidity where it’s lacking. Crypto is a coordination tool for transacting in opaque and nascent areas, which require high degrees of specialization, and which are burdened with bureaucracy and multiple layers of middlemen.
A few examples: Kettle is building a marketplace for tokenized watches, with Kettle’s team hustling in the NY Diamond District, doing the authentication, vaulting, and logistics of watches. Baxus solves a similar problem for collectible spirits, with their team doing authentication and running a central vault with controlled humidity, temperature, etc. Both of them would eventually unbundle Sotheby’s. There is highly specialized work being done in the physical world, while the crypto element (coordination of payments) allows addressing the cold start problem much sooner. We will see that both the physical world, and the crypto side, reinforce each other’s progress. Onchain and offchain components are synergetic, in that they both benefit from more transactional volume
Crypto can make people care about things they did not know existed. Uniswap made people care about ERC20 tokens, and Opensea made people care about NFTs.
A fresh example we like is SkyTrade which allows landowners to sell, or lease, rights to airspace above their property. The air rights are tokenized in the form of NFT and then auctioned off to real estate developers and drone delivery companies like Walmart, Amazon, or other specialized air transportation companies in the future.
Most real estate owners have no idea that a) they own airspace, and b) that it’s valuable to someone. Crypto, being the hottest ball of money, can prove it very quickly.
The Market for DePIN
Another area with strong transactional features of a marketplace is DePIN, or decentralized physical infrastructure. The supply side usually leverages latent or idle physical hardware, hence it’s the easier part of the two-sided marketplace to start. The demand side is unproven—we can only deduce that it exists based on demand for similar centralized services.
At its core, DePIN is a marketplace for transacting services. Alas, we haven’t had enough demand and transactional value yet to say that it has found PMF.
One of the main value propositions of DePIN is a transfer of infrastructure investment and maintenance to a decentralized network. The costs of doing that for centralized entities have been ramping up, with capex growth exceeding growth in revenue. Higher spending implies more expensive services for consumers. And, the better the network coverage, the more spending it requires too, as last-mile costs increase exponentially in the rural areas. Without price discrimination, someone ends up subsidizing the service.
Source: DePIN's Imperfect Present & Promising Future: A Deep Dive by Compound
Another factor is network resilience, where the electric grid in the US is a good example. Consider that even the electric grid is not a single, monolithic network. There is no single company responsible for its maintenance. Instead, it’s composed of many different utility companies (both privately and municipality-owned), and overseen by federal and state regulatory bodies. The grid is already fragmented, precisely for the reasons of resilience. And, it can be fragmented further, as long as it achieves the goals of affordability and resilience while earning the required cost of capital for whoever invests in and runs that infrastructure.
Why is DePIN effective at overcoming the upfront costs of hardware? Because capital formation allows projects to deploy and distribute tokens into the hands of hardware operators very quickly.
Granted, a token is not enough. But it’s enough to get it to 100 users on the supply side who truly care about it to see if the demand side and revenue exist. If so, the unit economics improve with the increasing demand and network coverage, and reliance on token incentives diminishes. Ultimately, all sustainable crypto marketplaces will compete on a) price, and b) reliability and/or customer service, with revenue being the single most important metric.
Again, crypto’s role is to help marketplaces, and, by extension, DePIN too, reach escape velocity sooner rather than later through coordination of resources and payments.
Create the Markets People Want to Trade In
Having invested in crypto across several cycles, we have come to realize that ideation in crypto is bounded by the same unique properties that crypto enables. We discussed them above.
The permissionless nature of crypto capital is both a blessing and a curse. The design space for crypto startups seems infinite until you realize these ideas must have a strong and explicit financial element.
To us, the answer seems rather clear—find assets and markets that people want to trade before they know it. They will always sound controversial—whether it’s Helium in the last cycle (and Uniswap even earlier), or SkyTrade today. But that’s how you know you’re onto something worth exploring.
Alas, not every type of asset will be traded. We saw time and time again that users don’t value their data, privacy, or their in-game swords. Marketplaces for “ownership” and egalitarian compensation schemes for content creators have not worked. Enough time has passed in crypto for some areas to be invalidated, and for great businesses to be built in others. In every cycle, the explicit financial elements of crypto have been proven stronger than ever before.
Crypto does not fix economically unsound ideas; instead, it doubles down on the features of capitalism as we already know it. More money, more trading, more upside, and faster. Crypto is propelling us further along a path we’ve known and walked since the late Medieval Ages when capitalism began to take shape.
Build new markets and find new assets, and your application will live long and prosper on blockchains where economic security is paid for. This is crypto’s most optimistic future.