"an entity that lives on the internet and exists autonomously, but also heavily relies on hiring individuals to perform certain tasks that the automaton itself cannot do…"

"Automation at the center, humans at the edges"

The reason “automation at the center” is so important is closely related to Nick Szabo’s concept of social scalability:

Social scalability is the ability of an institution…to overcome shortcomings in human minds and in the motivating or constraining aspects of said institution that limit who or how many can successfully participate.

In 2020-2022, we saw a wave of DAOs that were not this: they were more like co-ops, with humans at the center, and little to no automation. And like most co-ops they failed to coordinate at scale.

Today we are seeing a wave of AI agents doing things onchain, with varying degrees of automation. Many of these agents are tokenized, meaning they have capital at their disposal, and a network of owners—at least some of which are human—at the edges, who have capabilities the models don’t.

The way I’ve been thinking about the emergence of these “agents” onchain is the true beginning of DAOs 2.0, where agents have the potential put the “A” back in DAO.

With AI automating day-to-day objectives, the role of humans can be minimized to focus on providing capital, nudging guidance, long-term planning, and other resources the models do not have at their disposal.

For DAOs 2.0, the question is: what are models uniquely good at today, that can be fully automated, with minimal human intervention?

LLMs are the most obvious example of AI models that are self-sufficient because they can parse human language and take pre-defined actions without any additional human touchpoints. This unlocks text-based, intent marketplaces like Clanker, an agent on Farcaster that uses natural language to enable token launching.

Diffusion models also require very minimal human input. For example, Botto uses a diffusion model to create 20-30k images a week and another model filters out what it knows are “objectively” bad images. This smaller set of “contender” images is presented to the DAO, which chooses the most marketable or “valuable” piece to auction off as NFTs through simple yes/no voting. The role of the humans at the edges is limited to high-value strategic decision-making.  To date, Botto has generated $5M in NFT artwork sales.

What’s an example of something I don’t think current AI models can automate well without significant human touchpoints?

Anything requiring long-term planning, like long-term investing. Long-term investing has a lot of unknown external factors and requires fuzzier data that is difficult to capture or requires significant human labor to wrangle into a digestible format. Compare this with an onchain trading bot — it can use simple deterministic algorithms with information that is readily available to it (e.g., price of an asset) to react to information and execute an immediate strategy.

The broader point is that DAOs 2.0 should track the strengths of AI, and as model capabilities grow, the set of objectives they can accomplish grows, and thus, the size of the DAOs economic influence can grow as many originally hoped. I’m excited by that, and eager to see more breakthroughs in economic activity agents can automate onchain.

Thanks to Daniel Barabander, J.Hackworth, and Kyle Samani for discussion/input.

Crypto is exiting what I would describe as a consolidation phase of the industry that has lasted the better part of the last 2 years. During this consolidation, there’s been a lot of optimization, as opposed to 0-to-1 (net-new) innovation.

You can see this consolidation/optimization across 3 dimensions of crypto:

• Infrastructure
• Use cases
• Secular winners

Optimization: Infrastructure in 2024

Infrastructure has matured and is no longer the bottleneck. This is the result of lots of technical optimization (as opposed to groundbreaking new architectures). These optimizations have set us up for perhaps the first “bull market” where:

• Blockspace is abundant.
• Tooling is mature.
• Transaction fees are near to or actually zero for users.
• Wallet complexity is abstracted.
• Onchain apps can rival web2 consumer experiences.

We are really only about 12-18 months into this chapter of infrastructure abstraction, performance, and reliability. (Ethereum L2s, Solana reliability, and wallet abstraction have only been production-grade for about that long.)

Consolidation: Use Cases and Secular Winners in 2024

Two use cases have hit their stride: speculation and stablecoins.

Both of these use cases have been around, really, from the inception of the industry: Bitcoin (2009) is the original speculative asset in crypto, and stablecoins were one of the first types of token applications (USDT started in 2014). Today, both use cases are coming into their prime—in large part, because of the optimization of infrastructure.

Memecoins are the most distilled form of speculation, and it is now extremely cheap and easy to create and trade them. The same is true of stablecoins. Tooling like Bridge makes issuing and transacting with stablecoins buttery simple.

Downstream of these two use cases, another trend of consolidation is legible: secular winners—which, in many cases, are winners from the recent past—keep winning, and winning bigger. They are blockchains like Solana and Ethereum, wallets like Phantom, DEXs like Uniswap and Raydium. Each of these benefit from the growth in stablecoins and speculation, and they adapt to whichever speculative game is being played on the field (e.g. whether memecoins or NFTs).

Crypto’s Next Phase

With the infrastructure bottleneck fading into the rear-view, there are two other major bottlenecks to nix, both of which have arguably contributed to the consolidation-optimization phase and hindered the industry from more 0-to-1 innovation.

The first bottleneck—an adversarial and uncertain regulatory environment—is (hopefully) on its way out. For the first time, crypto may be on a path to regulatory clarity in the U.S. that enables the industry’s good actors to flourish and flushes out the bad.

Performant infrastructure and regulatory clarity are two tailwinds that have the industry poised for a shift as it relates to the last and most important bottleneck: talent.

Since 2022, there has been a bottleneck of net-new talent entering crypto. This is understandable given the negative headlines and personal risk founders take on in an uncertain regulatory environment. The problem is that downstream of new talent are net-new ideas.

I think that trend will reverse next year, in a two-step process:

1. First, the secular winners of the consolidation phase will keep winning, and win bigger than anyone expected. Polymarket did that this election cycle, and there will be more to come. This will be the result of more mainstream onchain adoption—both consumer and institutional. Startup companies will go public. More projects will launch tokens. The result may be a reset of expectations on crypto’s impact. This is the first step to inspiring a new generation of builders to learn about crypto, which is what gets us to the next leg up…
   
2. A new cohort of entrepreneurs will come in and take it from first principles, unburdened by the baggage of legacy infrastructure and ideas. With clear rules of the road, it will be newly possible to run experiments around building products with ownership as a keystone of new user experiences.

Crypto will continue to be volatile, but with new rules of the road, new talent, and new ideas, our hope is that in the next five years, we will know definitively whether crypto has more to offer than speculation and stablecoins—andwhether ownership will be a keystone of new products and networks that grow faster through economic alignment with users. Validation through breakout applications is the path to less volatility over the long run. I’m personally excited to see that through. I think the years to come are our window.

One caveat: the thing that worries me most is that we’ll have another fast, boom/bust price cycle before we get out of consolidation-optimization mode and into innovation mode. If that happens, it may slow things down, but the next five years is still the window.

Powerful technologies are rarely used as intended by their creators or the early-adopter scenes. See bitcoin, the “peer-to-peer electronic cash system” vs. Bitcoin, the ETF; or USDC.

As the original values of smart contract blockchains mingle with mainstream market values, it's likely that the next ten years will pull in a different direction.

Many of the growing use-cases of smart contract platforms—fiat stablecoins/RWAs, open finance, many depin networks—are neither decentralized, permissionless, nor censorship resistant, but simply use the decentralization of the underlying blockchain for their openness, interoperability and settlement.  Applications are also increasingly abstracting L1 cryptocurrencies, which historically have been viewed as censorship-resistant “internet money,” causing many to rethink the value proposition of the largest coins, including the base assets of next generation chains.

For early-adopters, this can be difficult to reconcile. It's not what many in the scene showed up for. Does that mean it's over?

I don’t think so. But it's probably the end of the beginning.

In meeting the market on its values, crypto is commercializing.  Commercialization, especially that of open/permissionless software, is the form-factor that takes good ideas to their largest possible audience, and thereby makes the most impact on the world.

And commercialization often comes with compromises. The opportunity is to shape the nature of those compromises, and thereby, the outcome of that commercial impact. To do that, you have to drop ideological dogma, adapt to the game on the field, compete, and try to steer things in the direction you want them to go.

For example, a compromise on decentralization for scale (whether by way of rollups or integrated architectures) can better serve use cases that are putting wallets in people’s hands today. If that works, the next opportunity is to improve decentralization–and then, to teach many more thumbs to learn new things that skew towards the original ideology.

This is personal for me. I care a lot about the original ideology; it was the hook that brought me here. That said, I care much more about impact. I learned this lesson in a different creative scene. I went to university in Montréal, which had an unusually productive culture scene at that time (Arcade Fire, Tiga, A-Trak, Chromeo, Grimes, Vice, American Apparel, etc.) Things emerging from this local scene were also quickly global, transported and mixing with other hipster scenes via the internet, especially music blogs of 2004-2012 (Hype Machine, anyone?)

Fairly quickly, that scenius mixed with the mainstream market. The way that played out was principally by way of corny artists and brands taking the essence of sound and culture, dropping the nuance and packaging it up to retail in a way that was popular, but vapid. Meanwhile, a handful of artists and creative people who pioneered that original scene persevered and became pop culture fixtures. To do that, they typically had to compromise just enough between the original movement and something that was palpable to the masses. That mix of determination and pragmatism was admirable, because it has the most reach, and thereby, the most impact in taking culture one step forward at the largest possible scale.

So if you’re feeling like the values that got you into crypto are getting diluted by the mainstream market–I hear that, but try to see it in a different light—because in terms of impact, the commercialization of crypto likely means the real opportunity is just getting started.

I’ll try to write more specifically with examples of what that opportunity might look like. I scratched  the surface of this in my post yesterday on “only with crypto” / “better with crypto" but there's more to say.

Better with crypto: open finance (RWAs/fiat stablecons), prediction markets, international payments, most depin, tokenized equity, etc.  

“Only with crypto” has been facing headwinds (apart from SoV) while "better with crypto” has been gaining steam.

Will this change? If so, how?  

Maybe the flip happens when there are better distribution channels, as pioneered by better with crypto use-cases, more regulatory clarity, and of course, the key ingredient: time for those two things to mature.  

This would be some version of “better with crypto” use cases putting wallets in users hands, while their “thumbs learn” to do the “only with crypto” things.  On the other hand, many of the “better with crypto” use-cases are notable in that they are often not meaningfully decentralized—they simply rely on the decentralization of the underlying blockchain as a back-end for its openness, interoperability, and settlement.

If blockchains turn out to be back-end plumbing, its likely that users won't see the underlying metal, and the learned behaviors involved with “only with crypto” use cases will be more distant or abstracted.  

One way to look at this is through Chris Dixon's Strong and weak technologies framework, where “only with crypto” is strong tech and “better with crypto” is weak tech:  

Strong technologies often develop according to the Perez/Gartner hype cycle…During the trough of disillusionment, entrepreneurs and others who invested in strong technologies sometimes lose faith and switch their focus to weak technologies, because the weak technologies appear nearer to mainstream adoption… That said, weak forms of technology can be successful…Weak technologies adapt to the world as it currently exists… Strong technologies adapt the world to themselves.

Im optimistic, but curious: what will be the catalysts for "only with crypto" to make a comeback?

Discussion on Twitter / Farcaster

I see two convergent paths to get there:

1/ “sign everything”
2/ decentralized social

“Sign everything”

Fred Wilson wrote a post with this title where he asks, “What do we do about this world we are living in where content can be created by machines and ascribed to us?” His answer: “sign everything.” In a world increasingly awash in synthetic media, verifying authenticity and provenance is going to be increasingly important. It’s also a new path to monetization.

There are two shapes this can take:

• Sign on publishing: Platforms like Zora and Paragraph/Mirror give creators tools to publish familiar media formats (JPG, TXT, GIF, MP4, etc) onchain. By doing so, creators gain new paths to monetize and ways to archive their work. Fred wrote about exactly this recently too (link below).
  
• Sign on creation: Increasingly we are seeing hardware devices that sign data on creation. You can see this in crypto-native marketplaces like Hivemapper and Dimo, where map imagery and car data is signed at creation, on device. Initiatives like C2PA.org are creating standards to have digital media signed on capture on devices like phones and cameras.
  

Decentralized social

A parallel path to make crypto the port of entry of all media is through decentralized social. Here there are a couple paths that start from different places, but arrive at the same result.

• Familiar social form factors
  Protocols like Farcaster and Lens start with a familiar format where underlying content units, akin to tweets, are signed. The presence of wallets and signatures makes users’ identity, money, and data composable to third party devs, who are proliferating an ecosystem of mini-apps (Frames) and clients (e.g. Kiosk, Nook). This rapid experimentation can hopefully unlock new experiences that grow to rival the scale of web2 social, but with all the media onchain by default.
• Asset-first social
  Another form of decentralized social is asset first. I think the right way to look at a platform like Pump.fun is as a social network built around onchain media assets: memes (aka “memecoins”). These products lean into the scarcity of onchain assets to create net-new social experiences that are unfamiliar to non-crypto natives, but are becoming increasingly mainstream.

So multiple paths are converging at crypto becoming the port of entry for all media. This is one of the things I’m most excited to see accelerate and invest in at Variant.

Network: networks are stateful, singleton, canonical – where the presence of those properties create network effects. Stateful networks have traditionally been closed. Examples: Facebook, Twitter. That's because a company has been required to maintain the state, and there’s a cost to doing that. Crypto changes that because it's now possible to incentivize independent parties to maintain state, because we can incentivize them with tokens!  That's what blockchains do, and they are the obvious example of open, stateful networks. Their state is singleton (due to global consensus) and canonical (due to social consensus.) On top of blockchains, we can build stateful networks at the application layer too. Networks can be formed around the state in a singleton smart contract, or an application-specific rollup. An example is Uniswap, whose state is liquidity in a marketplace (tokens that are deposited to Uniswap’s smart contracts.) That state has network effects because the more state (liquidity) the better the pricing for exchange.

What is the point of this framework?
Building (and monetizing) open source libraries is a tested and true strategy, but crypto presents a new opportunity—to build open, stateful networks. In my opinion, that's the exciting opportunity and where the most value creation will be. If you’re setting out to build something in crypto, ask yourself: is it a library or an open, stateful network? We need both, but the max interestingness and value creation is probably in the new thing: open, stateful networks.

In Wilson’s Fees for the Good of the DAO, he argues that protocol DAOs should seek to only take fees where it makes the protocol stronger.  I've started referring to these kinds of fees as "productive fees."

One example Wilson cited is a hypothetical: what if Uniswap charged a fee to flash LPs that hop in-and-out to provide liquidity for a single transaction. The motivation: 1) earn the protocol revenue 2) make the protocol stronger by advantaging long-term LPs who make Uniswap a good place to trade. I'm not sure of the merit of this specific idea, but taken at face value, I think it illustrates the idea of "productive fees" well.

Wilson's second post, The Case for Value Capture at the Periphery, makes the case for value capture at the application layer:

Clearly DAOs are exciting and probably needed for many things, but I think that many parties taking fees at the periphery, and the core team working to make this highly viable, is under discussed. It strikes me that the dynamic of many productive and profitable teams wanting to see the core keep working might be more generative than many people trying to vote their way to a share of one giant pot.

Products create a lot of value for their end users, and as Wilson argues, it is healthy for protocols to have an ecosystem of sustainable applications building on top and driving protocol usage.

The most practical way for this to happen is for those products to be able to sustain themselves through a free market enterprise. This seems plain as day, but it is something I’ve actually diminished in previous writings suggesting that DAOs seek to commoditize their complements (the products building on top) by subsidizing their development.

Commoditizing a complementary product in order to bootstrap a protocol is a good playbook at the outset. The most succesful DeFi protocols like Uniswap and Compound gave away their products for free, to help kick off the network effects of the underlying protocol. But this model can't last without protocol subsidies to fund the product. I've come around to the view that mid to long term, this approach is suboptimal because it is too bureaucratic.

Instead, an optimal equilibrium may be 1) protocols sustain themselves through "productive fees" that make the the protocol better, faster, stronger such that products want to build on top, and 2) product teams charge "extractive fees" that capture the value they create for end-users.

Tying this thread to another, I think there's an argument that the more products built on top of a protocol, the more likely protocol DAOs will be able to charge "productive fees." Lets use Uniswap as an example, which has a rich ecosystem of apps on top driving demand to the protocol, many of which do extract their own fee (e.g. Metamask,) In aggregate, that demand helps keep Uniswap's monopoly on supply in tact, as there are strong network effects to LPing where the demand is routed. Today, Uniswap has a simple fee switch, which may actually diminish the supply-side network effect. But if Uniswap were to update its tokeneconomic model as described in the hypothetical model above, it could help reinforce a strong moat on supply and keep the flywheel between products and protocol spinning.

You can contrast this with protocols that have a a single or more power-lawed product ecosystem. An example is OpenSea (product) vs. Seaport (protocol.) In this example, and others like it, value accrues to the company building the product.

I wrote a thread last week, comparing this market dynamic to that of  NFT collectors who value creator royalties. The tl;dr: even if you are a product team who values decentralization, if you control the bulk of value flow, the market will make it hard to justify that value flowing to a DAO instead of the company creating it.

I was discussing all this with Peter Watts from Reservoir, and he raised a great point, that perhaps one additional consideration for protocol value is the degree to which the protocol can successfully monopolize supply.

As I wrote above, if demand is distributed at the product level, but supply is monopolized due to network effects (e.g. Uniswap) you may be in the sweetspot for protocol value.  However, if supply is able to easily multitenant AND there is fierce competition for demand at the product level, you may end up in a race to the bottom in both product and protocol, as is increasingly the case in NFT marketplaces. The former seems more likely with peer-to-contract markets, and the latter more likely in peer-to-peer markets.

Of course, reality isn't so theoretical, and if you aggregate lots of users, or lots of developers, there's likely a way to step into the flow. But its an interesting thought.

What didn't I think of? What did this prompt you to think of?
Please jump in on Twitter or Farcaster.

"Crypto" has its roots in two camps with strong overlap:  money-crypto and the more political “sovereign individual” crypto—the nexus of which is decentralized assets and protocols, finance and autonomy. It follows that “crypto” commonly refers to decentralized assets/protocols, whereas “Web3” broadly espouses decentralization of consumer products, a more egalitarian and expansive strand that builds on the origins of the former.

When I talk about my work, I always say I work in crypto, though I still think the term “Web3” is useful, and will serve a lasting purpose.  That said, I think the underlying argument, that Web3 has caused some indirection, has merit worth exploring further:

It is the case that building consumer products tends to benefit from centralization. In making the case for progressive decentralization, I argued for centralized product development at the outset, which benefits from rapid iteration and singular vision. A more recent supplement on the topic argued that this can be pursued so long as future decentralization is worked into the initial planning and vision. But what resonated about the tweet is that it was misguided to think that everything— especially well-known Web 2.0 apps—would be better off decentralized as DAOs.

I’ve argued that assets (tokens) can and should be products—NFTs being a prime example—and I continue to think there is ample room for tokens and DAOs to be fun and transformative consumer experiences. But I’ve also refocused on a specific line in the original thesis penned for Variant, that “ownership will be a keystone of new user experiences.”

Next generation consumer products may be built around making users into owners, but it doesn’t follow that the platforms facilitating access to new ownership experiences will all be owned like co-ops, by their users. While the latter is newly possible, the realization of users as owners may be barbelled: at the fat head, for critical infrastructure that depends on decentralization for its core value proposition suchas Ethereum or Uniswap. And on the other side, the long-tail of networks that wouldn’t exist any other way—NFT and DAOs formed around them, online investment clubs, trade guilds, etc. In the middle, we may find companies that broker access to both ends.

Weighed against Variant’s mission to build a more equitable internet, I take a glass half full view of this: even if users don’t own the product interface for the next major consumer social product, its still the case that for the first time, users will have the chance to own a piece of the internet: their content, their identity, and their on-chain data. This is a forcing function for platforms to be more aligned with users, economically and otherwise, because ownership empowers users to participate in market activity more directly and vote with their feet. That is the glass half full take. Half empty is that it would be better if everyone could earn equity-like upside in every product and service they use – in other words, for user ownership to extend to the product level. The other half empty take is that because platforms have network effects, the utility of user ownership of underlying crypto assets can still be eroded, as we’ve seen unfold recently as NFT marketplaces enact whitelists and blacklists regarding where NFTs can trade.

To get to the extreme realization of user ownership of consumer interface products, there’s no question in my mind that it must be done through progressive decentralization, where ownership is intrinsic to the product flywheel and user experience. It could be that the time-scale to progressively decentralize these types of applications is much longer than folks in the “web3” camp would have hoped—wherein it makes sense to decentralize unstable elements of otherwise mature and stable products, like, for example, content moderation for a scaled social network.

To tie this up: long live crypto and long live Web3. They both need our chants, because its definitely the case that 10 years from now, just as today, nobody will use the name of the technology or its epoch number to describe what they do on the internet.

Web3 is a set of expectations, about what the internet can and should be: native money, assets, ownable identity and media, transparency, automation, control, privacy, new institutions and more meritocratic and equitable outcomes.

Web 2.0 was not a revolution against what came before, but an expansion of it —  a realization of new markets and networks, enabled by using the technology the way it wanted to be used. In time, that is what Web3 will come to be known as too.

But crypto networks do adhere to a sustainable business model, and it’s one that will be quickly familiar to those who understand the dynamics behind valuable Web 2.0 marketplaces. Like marketplace companies, crypto projects seek to create defensibility via network effects that allow for fee streams and make users reluctant to switch to a competing service.

What makes crypto unique is its potential to expand on that familiar framework. The principal innovation of crypto networks is their ability to grow network effects by enabling users to share in the value they create.

Network Effects, Switching Costs, and Defensibility

Misconceptions around crypto and value capture are understandable. Open source code has enabled trillions of dollars to be generated by software companies that use it, but the communities that develop that code typically haven’t had a means to capture much of the value directly.

That’s because there is a major difference between open source code libraries, which can be easily copied, and networks that form around running open source code as a service. An open source library is an empty blueprint. It’s dead code, until it’s run as an instance and is filled with data, users or both, forming a network or service.

Many internet platforms are built using open source libraries, which are run by companies as an instance or service. With each new database entry, or user, the service becomes more valuable to each individual user, generating a network effect. This creates an inherent cost for users switching to a new, competing service. These switching costs make it harder for competitors to break through, creating defensibility. Imagine a clone of Facebook with no friends, or a clone of Uber with no drivers. It’s why big platforms get bigger while competitors get stuck.

Once defensibility is established through network effects, switching costs become the basis for fees that companies can begin to charge users, advertisers or both. This model is viable so long as the fee is below the switching cost of moving to an alternative.

Why Forking Does Not Eliminate Switching Costs

Like Web 2.0 platforms, a well-designed crypto network is a live, running service, and it too can be the basis of strong network effects that create switching costs. Given that crypto networks rely on open source code, it’s true that they can be more easily copied (or forked). But while replication of code may be free, the social cost of coordinating all network participants to move to an empty room is non-zero. Add to that the trust and familiarity that come with brand, lindy effect, and smart contract integrations, and you have a recipe for entrenching an existing service, building its network effects, and generating switching costs.

Bitcoin’s network effect derives from more people considering it a store of value, which in turn, incentivizes miners to secure the network. Ethereum’s network effect derives from developers who deploy apps — each becomes a building block that other devs can compose into higher order services, driving increased usage, and demand for ETH.

At the application layer, Uniswap, an automated token exchange, becomes more useful with each new user because additional liquidity in the marketplace results in better prices on trades. Compound, a money-market protocol for lending and borrowing, offers more competitive interest rates on loans as lending liquidity increases.

In every case, a fork of the original network will initially be technically equivalent but functionally inferior to the canonical instance. A fork of Compound would offer worse interest rates due to lower liquidity. A fork of Uniswap would have inferior pricing for the same reason. A fork of Bitcoin is less likely to be viewed as a store of value or medium of exchange and thus less likely to capture value.

This is the same basic principle of defensibility in traditional Web 2.0 platforms: attract users, build network effects, and increase defensibility through switching costs. That switching cost forms the basis for margin extraction, usually in the form of a fee:

So long as a service remains minimally extractive — charging a fee that is lower than the costs to switch — its model is viable.

So what’s new in crypto isn’t the business model. It’s who benefits from it.

The Differentiator: Crypto’s Value Distribution Capability

Crypto tokens are an innovation akin to that of data packets. We can now move bits of value in the way we move bits of information: using an open standard, in very granular transmissions, instantly, to anyone, anywhere in the world. This means that valuable crypto services now have the unique opportunity to redistribute that value directly to the users who generate it.

Designed correctly, an effective distribution of a fee stream can further entrench network effects by giving users a direct economic incentive to contribute, generating more defensibility, which in turn, reinforces the viability of the fee stream in the first place. This is a virtuous loop that has the potential to result in sustainable, user-owned networks that grow in size and defensibility because of their cooperative economic model.

Crypto networks like Bitcoin and Ethereum are the very first community-owned-and-operated platforms at scale. But given the right tools, many more founders may be able to leverage this new stack as a tool to distribute economic value, build network effects and generate value for themselves, investors, and their user communities.

By making economic collaboration with users a primary feature of the product experience, founders may be able to unlock networks that are bigger, more competitive, and more defensible, while simultaneously enabling more innovation — all thanks to crypto’s open source foundation.

This post was originally published on a16z.com

The views expressed herein are those of the individual personnel quoted herein and are not the views of AHCM or its affiliates. This presentation is provided solely for informational purposes and should not be relied upon when making any investment decision. References to any securities or digital assets are for illustrative purposes only and do not constitute a recommendation to invest in any instrument nor do they constitute an offer to provide investment advisory services.

This content should not be relied upon as legal, business, investment or tax advice. You should consult your own advisers as to legal, business, tax and other related matters concerning any investment. Furthermore, this content is not directed at nor intended for use by any investor or prospective investor, and may not under any circumstances be relied upon when making a decision to invest in any fund.

Past performance is not indicative of future results. Charts and graphs provided herein are for informational purposes only and should not be relied upon when making any investment decision. Please see https://a16z.com/disclosures  for additional important information.

This made Bitcoin's early narrative not only anti-establishment, but also intertwined with individual economic empowerment.  Outsiders benefited from BTC's first major price gains in 2011, a time when economic inequality advanced rapidly & the Occupy Movement was birthed.

This dovetailed with "software eating the world" or the story of computers playing a greater role in people's lives  Bitcoin offers a way to benefit from the rise of computers— to participate in history, even if only superficially (without having to master computer science.)

Then came the stories of how investors got rich simply by being on the cutting edge of "what's next."  This is the lure of VC and startups in general, and it is reinforced by repetition of founder and early investor glory stories.

With Bitcoin, anyone could participate in cutting edge wealth creation, even if you don't understand how it works. Remember the guy who sold a pizza for BTC who's now a billionaire?  Participation by Regular Joes multiplies the repetition of glory stories on the cutting edge.

Then there is the narrative of BTC as membership in a global, autonomous economy, free of the perennial problems of  government incompetence and corruption. Both technically and psychologically, Bitcoin offers an escape hatch from increasing distrust in traditional institutions.

One other that I'll add is the narrative around fixed supply: the sacred 21M.  The fixed supply narrative is reinforced by the "money printer go brrrr" narrative. And also by the recurring halvening (the pre-scheduled decrease in the supply that can be mined into circulation)

In general, economic narratives have a number of variables that determine their success and impact:  Speed is one. Narratives can permeate culture and impact economies quickly or slowly, but what matters is the rate of contagion vs. the rate of recovery (debunking the narrative)

Scale is also a variable.   Major economic events can be tipped by small ripples in popular discourse, each of which form a constellation of intertwined narratives that make waves over time.  Bitcoin is a good example of the constellation effect.

There are many more variables, and tons of good examples in the book.   My takeaway is that predicting economic events can depend heavily on the epidemiology of narratives. Viral stories matter. Duh.

A complementary read is @ystrickler's recent book "This Could Be Our Future" which details how the narrative of "Financial Maximization" took hold and has accelerated since the 1970s.  He also offers a framework for building new economic narratives to improve our future.

This is a difficult challenge because much of what it takes to build a successful product at the outset — product leadership, rapid iteration, a managed go-to-market — complicates the path to community ownership and regulatory compliance, which guarantee long-term health.

I’ve talked to a number of crypto founders working to resolve this tension. Here I’ll propose a three-step process that may serve as a guide for how to do it, by way of progressive decentralization — a process in which founding teams relinquish control by degrees, over time. Doing so step-by-step allows teams to focus and creates a path toward regulatory compliance, including issuing tokens that hopefully will not run afoul of securities regulations.

Keep in mind that this process is intended for certain crypto startups building applications on smart contract platforms. It’s less useful for blockchain computing platforms themselves, which require sufficient decentralization from inception in order to be useful.

Given the still-uncertain regulatory framework around community-owned networks, the final stages of this playbook are only pointing toward potential solutions rather than identifying proven winning strategies. Think of it as a possible path.

The Three Components of Crypto Success

First, I’ll posit that any successful application running on a blockchain computer will feature these three components:

1. Product/market fit
2. Community participation
3. Sufficient decentralization (community ownership)

The need for product/market fit is obvious. Without a product people want, there are no users, no business, and it will be difficult to sustain a community for long. Community participation and decentralized control are less applicable to traditional startups, but are crucial for crypto startups. Why are they so important?

The answer is that community participation and control results in limited platform risk — the risk that the rules of a platform will change against the will of its users. Web 2.0 platforms have demonstrated the potential for this kind of misalignment, for example by killing innovative app ecosystems built on their APIs, or by profiting at the expense of users’ privacy or wellbeing. In contrast, user-owned networks can benefit from a cooperative economic model that helps ensure crypto services remain better aligned with their users, even as they scale.

Another important reason for achieving decentralized community control is regulatory compliance. Crypto tokens that facilitate economic alignment can be deemed securities under the Howey Test, a regulatory framework used by the SEC. Managing a distribution of securities to a large community of users can be challenging and expensive for a startup to manage — even Airbnb and Uber haven’t figured out how to do it. But analysis of recent SEC commentary and enforcement actions suggests that true decentralization may enable a startup’s token to transmute from a security to a non-security if the team is able to sufficiently decentralize operations, eliminating information asymmetry or dependency on the efforts of the founding team to create value. One key test for whether an investment might be deemed a security is whether investors are relying on the efforts of others with the expectation of profits.

As Scott Kupor, managing partner at Andreessen Horowitz, has previously written: “In the pre-network stage, tokens will generally be characterized as securities in light of the ‘reliance on the efforts of others’ prong of the Howey Test. However, post-network launch — provided that the network is sufficiently decentralized — the nature of the token can change from security to non-security, owing to the fact that the holder of the token is no longer relying on the efforts of others.”

So, with these reasons for decentralization in mind, let’s walk through a framework for tackling it as a process, with the goal of building a sustainable, compliant and community-owned product.

Objective 1: Product/Market Fit

The earliest stage of building a crypto application requires all the ingredients of a normal startup: a great team, lean development, tight execution, and quick learning. During this phase, the only thing that matters is product/market fit. To move fast toward finding it, it’s important to avoid design by committee (or community!) A product needs opinionated leadership to test hypotheses and update assumptions quickly. In practice, this could mean admin privileges on smart contracts, which allow for rapid iteration and product management — including upgrades, shutdown, or quick parameter setting.

At this stage, there should be no pretense of decentralization — a core team is driving all product decisions by necessity, in the interest of finding product/market fit. Launching a token at this stage is not advisable because it could trip compliance wires. Dependence on the core team’s efforts is one way a token might be deemed a security under the Howey Test, and thinking about this is a distraction from product development.

The idea of a core team controlling all aspects of a project may ruffle the feathers of some early users, but founders shouldn’t be wary of this. If users are complaining about the control you’ve got, that’s actually a good problem to have! It means someone cares about what you’ve built. That said, it’s important to communicate clearly about where control exists. Faking autonomy is a quick way to undermine trust, whereas transparency is a way to build it.

Objective 2: Community Participation

At early signs of product traction — a growing user base, developer ecosystem and network effects — it’s time to start devoting more cycles to fostering harmony between passive users, more-active contributors and the core team.

To start, founders might invest more heavily in best practices for running the product like an open source project: invest in good documentation; develop openly; offer bounties, grants or other incentives for third-party development; hire community leaders to help steward open development; and introduce rough consensus on decision making.

Going further, it may make sense to start eliminating platform risk through imposed technical constraints. For example, in Compound v2.2, upgrades take effect 48 hours after they are pushed, allowing time for users to exit the protocol, or review and voice dissent. Urbit practices “Kelvin versioning,” in which version numbers count downwards to 0, at which point no more updates are to be made.

For the core team, relinquishing control comes with an opportunity to begin transferring responsibility to the community. But as you go about engaging community members, it’s important to revisit incentives. Why will community members contribute to the product on an ongoing basis?

Incentives (Fees)

An economic incentive is one way to engender community contribution. But where do the economics come from? A pragmatic and familiar business model for crypto services is a fee-per-call, similar to an API micro-service like Twilio or Stripe. Distributing this fee stream to active contributors can align the community around the project’s success.

That said, fees don’t always make sense at the outset of a project. Given that crypto services are open source, it may be better to introduce fees only once there are strong network effects, resulting in defensibility through switching costs.

Uniswap, a decentralized exchange, is an example of how a crypto application with a fee can be protected by the power of its network effects. In Uniswap, the more users that contribute liquidity to an exchange pair, the better the pricing for traders. In order to provide the same pricing in a fee-free fork, you’d need to coordinate all the liquidity providers and third-party services integrated with the original to start using said fork. The cost of coordinating all that is a switching cost. While such switching costs are lower in crypto where data is open, they still do exist. In crypto, however, protocols must remain minimally extractive (in other words, they cover relevant costs rather than seek to maximize profit) in order to incentivize community contribution.

Distribution (Tokens)

Tokens are an instrument for effectively distributing the fundamental value of a project, including a fee stream. While token distribution can incent participation and help build defensibility, it’s important to consider how to construct a distribution that is both fair and effective.

Many ICOs and airdrops were suboptimal in that they invited unengaged communities and regulatory scrutiny. Crypto applications that focus on product/market fit have an opportunity to do better, by distributing tokens to an already active user base.

To start, teams might test a distribution with a managed and permissioned group of community members. A number of teams have elected to do this by allocating a slice of future tokens to early “power” contributors, for example through testnet programs where independent community members can register to participate in operating a node. A promissory and managed token distribution to users that contribute valuable work can help eliminate community dependency on the effort of founding teams.

Next, teams need to plan how remaining tokens will be distributed to participants, both fairly for past contributions, and effectively as a future incentive for ongoing participation. The distribution design needs to consider the core team that built the product, as well as the users that make it useful. Getting this right is hard, and will always be specific to the application in question, but some common questions to think through are:

• What percentage of tokens should be allocated to the initial team and cap table?
• How will you reward different types of contributors to the product or service, historically and in the future?
• How will technology leadership be rewarded going forward?

Answering these requires analysis of community behavior, modeling of rational outcomes and workshopping proposals with community members.

Objective 3: Sufficient Decentralization

If you’re a crypto founder and are ready for this stage, that means you have achieved early product/market fit, built a robust community capable of successfully maintaining the application, and mapped out a model that properly incentivizes sustainable operations.

Now for the last and final step on the journey to sufficient decentralization: a widespread token distribution.

In practice, I imagine teams will “exit to the community” by airdropping tokens to users and contributors based on the plan mapped out in the prior objective. This would happen the moment a smart contract is triggered to mint and distribute tokens. Optimally, once this function is triggered a number of things will have happened:

• The core team will have ceded majority ownership of the application (fees and control) and mitigated platform risk by ensuring the product is community-owned and operated.
• The token may have transmuted to a non-security, given that the service is now sufficiently decentralized — that is, independent of the efforts of a single entity that might have asymmetric information.
• The company is sustainable, having retained enough tokens to benefit from fees and growth.
• User-owners realize increasing returns to scale, as the cooperative economics of the service allow for better alignment and growing value (as defined by users rather than shareholders.)

The spirit of this objective is to mark a specific moment where a crypto product company completes its journey from traditional product team to sustainable community-owned-and-operated network. (Conducting a token distribution always requires careful legal review, and there is little precedent for what I’m describing, so please consult a lawyer first!)

How to Avoid Getting Stuck

A lot of teams have gotten stuck by tackling these objectives in the wrong order, “faking” decentralization, or by trying to do everything at once.

For instance, app teams that pursue community ownership first (starting with a wide token distribution) risk engendering a community of speculators, rather than real users. Without a working product, ownership is worthless, and the community won’t stick. Many teams that have done this are unable to back into product/market fit, and as a result have a hard time kickstarting meaningful community participation.

Another sequencing risk is jumping straight from early signs of product/market fit to decentralized community ownership (skipping objective 2, community participation.) Failing to formalize real community participation can land projects in an uncanny valley of decentralization theater. A symptom of being caught here is an apathetic community with low participation rates, and a heavy dependency on founding teams. In this situation, formalizing control (e.g. through delegation) may be a better path to building trust, whereas hiding under the pretense of decentralization is a quick way to undermine it.

Another way to get stuck is to aim to do all three things at once. Lack of focus is the death of most startups, and the same is true for crypto applications. Each of these objectives overlap and needs to be considered holistically, as part of an idea maze, but execution needs to be sequenced and prioritized, not attempted at once.

Finally, it’s worth noting that even if you do the steps in order, once you flip the switch to full community ownership, you’re in fairly uncharted territory in terms of governing the application. Scaling effective community decision-making is challenging, but if internet communities can accomplish feats like Wikipedia, I’m optimistic that experimentation and skin-in-the-game (via valuable ownership) can lead to cooperative decision-making at unprecedented scale.

So far, we have yet to see a crypto application execute each of the objectives sequentially, but the most promising project teams I’ve spoken with have been navigating their way through this playbook. Through those conversations, I’ve come to believe that progressive decentralization offers teams the most auspicious path to finding product/market fit, financial sustainability, a participatory community and regulatory compliance — in that order.

This post was originally published on a16z.com

The views expressed herein are those of the individual personnel quoted herein and are not the views of AHCM or its affiliates. This presentation is provided solely for informational purposes and should not be relied upon when making any investment decision. References to any securities or digital assets are for illustrative purposes only and do not constitute a recommendation to invest in any instrument nor do they constitute an offer to provide investment advisory services.

This content should not be relied upon as legal, business, investment or tax advice. You should consult your own advisers as to legal, business, tax and other related matters concerning any investment. Furthermore, this content is not directed at nor intended for use by any investor or prospective investor, and may not under any circumstances be relied upon when making a decision to invest in any fund.

Past performance is not indicative of future results. Charts and graphs provided herein are for informational purposes only and should not be relied upon when making any investment decision. Please see https://a16z.com/disclosures  for additional important information.