Executive Crypto 101: Incentive Re-Design of Finance From Web 2.0 to Web 3.0 via Bitcoin & Ethereum, DeFi, NFTs and Identity.
October 2017, as I packed for a trip to Hawaii, I fielded 3 phone calls.
“I’m retiring at 29.” My mentee said, selling his Ethereum to purchase apartment buildings and living off rental income.
“I’m starting a Hedge Fund.” A 27 year old mentee was leaving her job at Coinbase to start a crypto hedge fund.
“Should I do an ICO?” The third, and most surprising call, was a 63 year old programmer friend of mine asking if he should raise money for his project using an ICO.
“What’s an ICO?” My response marked my entry down the crypto rabbit hole.
In 1999, I was running the #1 mutual fund in the world by riding the internet wave, yet never joined the internet industry that I believed would change the world. Similarly, when I heard about my mentee retiring at 29, I wrote it off as a great trade. Nothing more.
I think of myself as a rational being, but when something comes up 3 times in succession, I stop.
After those 3 calls, I stopped packing, drove to the bookstore. My luggage was more books than clothes. In Hawaii, I went straight to my Airbnb, opened Digital Gold: Bitcoin and the Inside Story of the Misfits and Millionaires Trying to Reinvent Money and next saw my watch at 2am.
Rabbit holes choose you, and never at a convenient time!
My Hawaii trip became a deep dive into everything crypto, setting up wallets, reading books day and night. I barely slept. Any chance I got, I would leave my friends, go back to my room and read.
Still an equity analyst responsible for $500 million, I returned home in early November 2017 and went directly to Silicon Valley. I met everyone I knew who might know something about crypto. My brain was exploding.
Years later, my rabbit hole is still going.
Back to those 3 phone calls in 2017:
Greg Magadini, the “retired” 29-year-old, now in his mid-30s is a co-founder of a multi-million dollar crypto options analytics company Genesis Volatility.
Linda Xie left Coinbase, was named to Forbes 30 Under 30 and runs one of the most exclusive and successful crypto hedge funds in the industry, Scalar Capital.
The 63-year-old software architect continues to build his company without raising money using an ICO, likely staying out of the crosshairs of the SEC.
Today, most people I know are in traditional companies. To them, crypto seems full of contradictions and jargon, the purview of cyberpunks and rebels.
“Olaf Carlson-Wee and Balaji Srinivasan estimate that at a price of $200,000 per Bitcoin, more than half the world’s billionaires will be from cryptocurrency. Whether you think this is a good thing or a bad thing, it means there will be more pro-technology people with access to large amounts of capital in the 2020s.” - Brian Armstrong, Coinbase CEO
This new generation of consumers and investors will change the path of “normal” businesses.
As of October 2021:
$2.63 Trillion is the total value of all cryptocurrencies
$208 Billion of cryptos are “locked” in DeFi pools
$15 Billion has spent on NFTs in 2021
We could get lost in controversial (and important) crypto topics like regulation risks, nefarious uses of bitcoin, environmental impacts of bitcoin mining, and legitimacy of a non-government-backed currency.
Instead, I’ll share my “outsider” equity analyst perspective on how this technology aims to realign incentives and build the foundation for a more decentralized economy.
Illustration by Janis Ozolins
Here are the signposts to codifying incentives to help decentralize economic activity, moving from Web 2.0 to Web 3.0
TRANSACT: Bitcoin and Financial Transactions
AGREE: Ethereum and Smart Contracts
EARN: DeFi and Liquidity Pools
CREATE: NFTs (Non Fungible Tokens) and the Creator Economy
IDENTIFY: Web 3.0, Privacy and Transparency
Given the breadth of the topic, this is an overview, arming you with key terms and a sense of perspective.
In the beginning...the internet was built for decentralization
The internet, originally the ARPANET, was created as a distributed network during the cold war so that if one of our cities came under nuclear attack, we had additional communication routes to use.
Today fault tolerance, i.e. no single point of failure, is a key benefit of distributed systems.
Messages going over the internet are just 0s and 1s being delivered in packets. How do you get it to the right person? How can you ensure only the person it is intended for can open the package?
Enter cryptography, a mathematical discipline that provides algorithmic digital keys.
While it’s said the early internet was fully distributed, it started with 5 main nodes that most traffic passed through. Certain schools like MIT, UCLA, and Stanford had talent that could run them and thus received the first routers (called Imps). As the internet expanded, it became more distributed.
Near-zero marginal costs and network effects centralized the internet.
All this information and people on one network. How to find information? Search. How to find people? Social media. How to buy things? Ecommerce. The place where everyone hanges out will have the most choice and best information, so more people go there. Network effects.
Web 2.0’s incentive structure is the breeding ground for natural monopolies.
Industrial age monopolies killed off competition and raised prices. Their growth would slow.
Paradoxically, due to marginal costs near zero combined with network effects, the largest internet companies grow the fastest. Result: 70% of internet traffic flows through only a handful of websites and data centers.
Crypto asks: Can we program better incentives into software to re-decentralize the internet?
Centralized - Everyone meets on Facebook and Twitter
Decentralized - You meet and transact in small groups, with code moderating.
Distributed - You meet mostly one on one, like a country with only small roads, no freeways.
Distributed can be more democratic but less efficient. Parts of crypto are more distributed than others depending on what you need to accomplish.
Fighting the dual forces of network effects and economics (marginal costs near zero) requires a redesign of incentive structures from the ground up. Incentive alignment is the north star of Web 3.0., the foundation for a more decentralized economy.
1. TRANSACT: Bitcoin and Financial Transactions
Transact: Web 2.0 problem
Like many innovations, Bitcoin was born out of the frustrations with the current system, during the depths of the financial crisis.
Banks and governments self-deal. US Banks created leveraged esoteric instruments that led to the financial crisis and then US taxpayers footed the bill to bail them out, while top executives took home big paychecks. Ukrainian banks “confiscated” 10% of people’s savings accounts (with more than $100K) to bail out the banks. Bitcoin adoption was strong in Ukraine.
While previous digital currencies had been created, Bitcoin had perfect timing and superior technological innovation (blockchain).
Transact: Incentive Innovation
You could remove all friction to doing business with someone you don’t know by programmatically building trust into the system itself.
Blockchain is called a trustless system. Instead of having to trust a central authority (bank or government), you trust the technology, blockchain, which is validated by a network rather than a central authority.
Bitcoin uses mining to incentivize honest verification of transactions among parties who don’t know each other.
Computers around the world compete to guess a random very large prime number: “the answer”. The computer who guesses correctly gets rewarded with Bitcoin. The difficulty of guessing is inversely related to the total computing power, such that the guess times are held constant.
There is a strong economic incentive to be the verifier of transactions (you could make them up).
Bitcoin offsets this by randomizing who gets to validate and making the “cost” to validate equal to computational power. To overtake the system and validate what you want, you’d need to own, or instantaneously add on 51% of the compute power, currently costing $5.5 Billion. Thus there is a natural system of checks and balances that keeps Bitcoin relatively decentralized.
Transact: Web 3.0 Path Forward
Bitcoin allows two people who don’t know (therefore have any reason to trust) each other to transact without the involvement of any central authority like a government or bank.
If you can trust the system, you can send money, buy things, and trade cryptocurrencies, all without knowing the other party, and without relying on a central exchange to moderate the transaction. This has applications for remittances, international letters of credit, and the general ability to transact without any central authority.
Bitcoin was an innovation in incentive management.
Codifying economic incentives by distributing both rewards and authority became the technological and intellectual foundation of the decentralized economy.
2. AGREE: Ethereum and Smart Contracts
Agree: Web 2.0 problem
Lawyers. Need I say more?
We spend over $720 Billion annually on lawyers. While the law is the foundation of civilized society, giving us a way to come to agreements and transact, we litigate many things that simply should have started with a clearer agreement. Worse yet, we litigate as a “cost-effective” way to get out of what we know we previously agreed to.
Online, the stakes are even worse, with Facebook, Google, and Twitter using the power of their platform (via their “Terms of Service”) to decide the truth.
Jack Butcher was running his multi-million dollar design agency, Visualize Value, creating art for the Academy Awards and other top brands. His marketing is 100% on Twitter, and one day Twitter shut down all his accounts. While this “error” was corrected because he knew someone at Twitter, not everyone is so lucky.
In 2015, the 21-year-old Canadian Vitalik Buterin put contracts in code (creating the Ethereum blockchain) and leveraged the lessons of the incentive system Bitcoin developed.
Agree: Incentive Innovation
Imagine escrow without the escrow company, putting the agreement terms and money inside a vault that automatically releases the money when the terms are met. That’s Ethereum smart contracts.
Ethereum smart contracts put our agreements in a software program. These smart contracts are validated on the Ethereum blockchain, thus you have two layers of incentives: keeping the blockchain secure so you can trust the contracts that reside there and the programming inside each smart contract.
The Ethereum blockchain is secured using mining, just like bitcoin, but it is moving to secure itself using a different incentive system, called staking. You put up, “stake” money you can lose if others witness you cheating the system. This is more complicated in practice, but far less environmentally harmful than mining.
The second layer of incentives is built into each individual smart contract.
With a well-written smart contract, you reduce the friction of coming back later and bickering or trying to renegotiate.
Say I want my house painted. We agree on the outcome and select the third party to validate the work (they are part of the smart contract). We put the $500 for the paint job plus $20 for the validator, in the smart contract. The painter finishes the job, the third-party validator verifies the job is done, and the smart contract then pays the painter and validator.
This is two-layer incentive innovation: the validation of transactions, ie the existence of the smart contract and later the completion of the smart contract, is done on the Ethereum blockchain. Layer 2 is that each smart contract contains code, agreements, and money that aligns incentives to complete the contract.
Agree: Web 3.0 Path Forward
With smart contracts, we could conceivably move towards a society with less litigation, less friction, and smoother execution of agreements.
Enter human error...aka where’s my $50,000,000?
In 2016, there was a Decentralized Autonomous Organization (DAO), created using an Ethereum smart contract to invest based on the voting of members. A programmer instructed the smart contract to send them all the money, $50 million. This wasn’t hacking.
The code worked fine, it just didn’t work as intended.
The DAO “blunder” provided valuable lessons. The industry’s improved smart contracts became the foundation of Decentralized Finance (DeFi), which has $100 billion “locked up” by 2021.
Early smart contract successes and failures provided fast feedback loops on human incentive experimentation, yielding the next generation of innovations: combining decentralized transactions and agreements to create DeFi.
3. EARN: DeFi and Liquidity Pools
Earn: Web 2.0 problem
The problem with centralized exchanges is incentive misalignment.
Fidelity, Schwab, and Robinhood are optimizing for their own profits, not yours.
In early 2021, individual investors correctly predicted a rise in certain “meme” stocks like Gamestop and AMC Theaters. Individuals bought stock options en masse to bet against hedge funds that were “short” the same stocks.
Hedge fund Citadel pays Robinhood to route more than half their customer orders to them.
Citadel makes money executing the orders and earning a spread. But Citadel was also short those meme stocks. Robinhood claims they had liquidity issues, but it was also not lost on them that their largest client was being hurt when those stocks rose.
Robinhood shut down options trading for several of these high-flying “meme” stocks, ending the rise in the stocks which allowed Citadel to exit their short positions at better prices.
While it may be that Robinhood had to restrict trading for liquidity issues and that Citadel was an unintended beneficiary, the question remains:
Should a company be able to toss you out of your trade any time your profits conflict with theirs?
Earn: Incentive Innovation
Soon after bitcoin decentralized transactions, the crypto industry focused on removing centralized entities with misaligned incentives from every financial agreement (i.e. transactions plus smart contracts).
Enter DeFi.
DeFi, Decentralized Finance, is a term first coined in an August 2018 Telegram chat between Ethereum developers and entrepreneurs including Inje Yeo of Set Protocol, Blake Henderson of 0x, and Brendan Forster of Dharma. Can we create a way for people to trade and earn without a central exchange?
Some early solutions like 0X (“Zero-Ex”) allowed people to trade amongst themselves “peer to peer”, but found matching buyers and sellers challenging.
The solution, today’s DeFi, was combining earlier technologies:
Bitcoin for decentralized validation
Ethereum for financial agreements in smart contracts and
DAOs: Decentralized Autonomous Organizations, an automated organization inside computer code that executes what the code says, not what any outsider says.
The New York Stock exchange had individuals responsible for “making a market” i.e. providing liquidity, in one or more stocks, matching buyers and sellers, and being the buyer or seller if one side didn’t arrive. This created a “liquid” market, where whenever you come to trade, you can get the trade done because there is always a counterparty ready to trade (the market maker).
Using smart contracts, DeFi created Automated Market Makers (AMMs) where you can trade, lend, borrow various cryptocurrencies with the ‘authority’ being the software code.
People wanting to lend, borrow and earn on specific cryptocurrencies come together and enter the same smart contract, creating liquidity. This is called a Liquidity Pool (LP).
Entering these pools involves putting or “locking” a specific cryptocurrency into a smart contract, (like putting money into a CD for 3 months in order to earn a higher interest rate).
Total Value Locked (TVL), is the size of the pool, i.e. the amount of money locked in the smart contract for the time specified. See DeFi Pulse for a list.
The DeFi industry figured out how to use incentives coded in smart contracts to draw liquidity in, without having an arbitrary centralized authority.
Earn: Web 3.0 Path Forward
Even though it has nearly $100 billion total value locked, DeFi is very young, even by crypto standards, with liquidity pools coming into their own in 2020.
Liquidity Pools answered the question: how can we use incentives to create liquidity without a central authority?
Finance is a huge industry, touching nearly every facet of our lives.
DeFi asks: can we improve financial systems by optimizing and codifying incentives instead of having institutions in the middle?
4. CREATE: NFTs and the Creator Economy
Create: Web 2.0 problem
The internet allows for effortless one-to-one and one-to-many communications, so why are record companies, agents, and book publishers still taking such huge chunks of artists’ pay?
Worse, why do these same institutions control artists' interactions with fans, how their IP is used, and even their future artistic direction.
With Web 2.0, massive companies like Netflix and Amazon are creating mega studios and mega agencies, with even more scale and leverage.
Create: Incentive Innovation
NFTs. How did this happen? One minute people are copying and sharing online art for free and the next minute similar PDFs are being sold for $20 million.
Unlike dollars and bitcoins which are fungible, i.e. one is the same as the next, Non-Fungible Tokens (NFTs) are each tied to a unique asset, like a piece of digital (online) art or physical art.
In 2017, one of the original NFTs, Crypto Kitties, was created by a video game software team. People were breeding digital cats. The high-end (first-generation foundational digital cats) went for hundreds of thousands of dollars.
Why now? OpenSea and other platforms developed technology to allow you to create (“mint”) NFTs without needing a gaming software team.
With artists easily able to create a token tied to their art, the possibilities are endless: royalty streams without record labels or agents, transparency into what you can get paid, peeling off various earning streams from art, with different owners, selling some, keeping some, etc.
NFTs allow unique incentive structures to be created for every situation.
Create: Web 3.0 Path Forward
Imagine every unique asset having a digital token that specifies custom owners’ rights.
Once you digitize ownership, entirely new worlds open up. You can sell future earnings streams of an artist’s project. A company could take part of its IP and codify how it can be used.
An artist could directly release music to fans and choose the incentive structure. It’s happening now.
The artist could keep or sell all their IP, keep or sell royalty streams, and more. Right now, artists are selling their IP, and entrepreneurs like Jack Butcher purchase the art plus the IP in an NFT, then create and sell merchandise with those images.
NFTs allow each asset to have it’s own incentive structure, building one to one relationships with buyers at scale.
5. IDENTIFY: Web 3.0 Privacy and Transparency.
Identify: Web 2.0 problem
Identity is the final piece of a decentralized economy. You want to do business with people who are not criminals AND respect their privacy.
Internet 1.0, you were anonymous. You could say who you were, but you might not be truthful. The early internet was the purview of quite a few criminal activities.
Why would we need to know someone’s identity in Web 3.0, a trustless system?
When we're buying, agreeing, earning, creating, there are times where you want to share a piece of your identity. You want to authenticate your art. You want to authenticate yourself. And there are other times where you want to keep your privacy.
The answer is not Web 2.0 where Facebook or Google verifies you, and you're putting your identity in the hands of some company who can arbitrarily decide to “cancel” you.
Identify: Incentive Innovation
Self-sovereign identity: you know your own identity best and should control it.
Combining who you are (biometrics) with what you know (prove it by unlocking cryptographic keys) is a powerful combination to both protect your privacy and verify your identity.
The holy grail of identity management is privacy AND transparency, not either-or.
Simple example: I'm going to a bar and the bouncer says, "I need to see your ID." Does he really need my home address, weight, full age, eye color? All he needs to know is that I'm over 21.
In Crypto, with a zero-knowledge proof (i.e. the proof shares no info), my being able to unlock a combo means I’m over 21. All he sees is me unlocking the combo, preserving my privacy.
And yet, there are times when we want to know who we are dealing with, or worse, regulators need to chase down bad guys.
A fully anonymous internet is dangerous. Sharding to the rescue! Like shards of glass, sharding keeps pieces of identity separate, where no one piece would identify and link to a person and you can combine them later in response to a valid inquiry.
In this world, you could have a DeFi wallet company who is unaware of their customers’ identity, thus customers enjoy 100% privacy, yet is compliant with AML (Anti-Money Laundering) and KYC (Know Your Customer) regulations through their ability to reconstruct identities from multiple shards of information.
Identify: Web 3.0 Path Forward
With identity technologies simultaneously providing privacy and transparency, and control resting with the individual, incentives align for a safer Web 3.0, with minimal friction to doing business together.
Self-sovereign identity, bringing control of identity back to the individual it belongs to, is the antithesis of Web 2.0 where large companies verify or cancel you.
With a Self-sovereign identity, you are back in control. With Web 3.0, you can choose to interact with the parts of the economy where the incentive structure works for you.
Are we there yet?
We’ve gone on the journey from Web 2.0 to Web 3.0, through Bitcoin (transact), Ethereum (agree), Defi (earn), NFTs (create), and Identity. Have we arrived? Is this Web 3.0? Probably not.
The pace of innovation is extreme.
The industry will continue to improve incentive structures, allowing more of the economy to be codified and decentralized. At the same time, Web 2.0 companies continue to grow and increase their power. So as much as we move towards Web 3.0, gravitational and economic forces pull us to rely more on Web 2.0.
And my personal crypto story?
I have remained a dabbler. I’m an investor in a fund, have owned individual cryptos, have advised several companies, and briefly worked in the industry. I consider myself more of an equity analyst observing one of the greatest incentive experiments of all time.
Epilogue: Why do we call these tokens and not shares?
The Oxford Dictionary defines Cryptography as “the art of writing or solving codes.”
These codes allow only the sender and intended recipient of a message to view its contents, like the ones used in wars. Cryptography has existed for thousands of years.
In modern cryptography, data is encrypted using a secret key, and then both the encoded message and secret key are sent to the recipient for decryption. Tokens contain the key to open the secret.
The bitcoin network used cryptography to create a secure way to transact with someone without knowing them, and the tokens used to validate and transact on that network are also called bitcoins. Ethereum is a network and a token, and other ERC-20 compliant tokens can be validated and moved from one person to another on the Ethereum network.
Tokens are casually referred to like a share of stock, but that’s inaccurate as they don’t represent equity ownership, but rather a participation in a cryptographic network.