Blockchain Layer 1 is the operating system for the decentralized Internet. Although this layer is technically complex, the winner is not necessarily the technically best software. In the PC era the winner was a program that was initially called QDOS (which later became MS-DOS) that stood for Quick & Dirty Operating System and there were social networks that were technically better than Facebook. What matters is adoption/network effects. Technically the software just has to be good enough – which is actually a pretty high bar at the Protocol Layer of the Blockchain Economy.
This is Part 1/Chapter 4 of The Blockchain Economy. This serialised book is a practical guidebook for investors, entrepreneurs and employees who want to learn how to prosper during the transition to an economy where value exchange is permissionless and disintermediated. For the index please go here.
The 3 layers of Blockchain Economy Infrastructure, seen from top to bottom are:
- Layer 3: Blockchain Finance Market Infrastructure. This was covered in Chapter 2. This level is familiar to those coming from Legacy Finance. Above this level will be financial services used by individuals and businesses.
- Layer 2: Middle Layer Services. This was covered in Chapter 3. These services are used by Layer 3 and use Layer 1.
- Layer 1: Protocol. This is covered in this Chapter 4. This is the base layer. We have made this chapter accessible to non-technical people (no code samples!)
The boundaries between Layers 1 & 2 are fairly fluid. In both cases, the users/customers are developers; developers are building for developers. However there is some debate about what functions should go into the two layers and some of the work that is happening at Layer 2 will impact how we use Layer 1 and vice versa.
If you operate at Layer 3 you need to understand how Layers 1 & 2 work.
This Chapter covers:
– Function 1: Internode Communications.
– Function 2: Consensus
– Function 3: Virtual Machine Management
– The fat protocol thesis
– The bitcoin maximalist thesis
– How platforms may evolve into “horses for courses”.
Blockchain works because people/companies dedicate compute resources to being “nodes” on the network that perform tasks which in aggregate deliver a useful service. The nodes are “peers” on the network; thus it is a Peer To Peer (P2P) network. The most basic task of a Layer 1 platform is communications between these nodes, so that in aggregate they deliver value. For example, Ethereum has the DEVP2P library at this layer. This basic layer is needed in all P2P network systems and is relatively easy compared to the other functions because Blockchain is not the first P2P network, so the solutions have been tested before (eg in Voice Over IP or VOIP networks such as Skype).
The Consensus function is native to Blockchain. Before Bitcoin, nobody had ever built a decentralised consensus method at scale.
Blockchain is a decentralized data structure/ledger that uses a method of getting to consensus on who did what when that does not rely upon a centralized intermediary. The Blockchain Consensus generates the order that blocks are created (aka the blockchain) and validates blocks created by other nodes in the network. The latter function is done by specialist nodes called miners.
The most proven consensus method is Proof Of Work (POW) that is used by Bitcoin, Ethereum (today) and, with modifications, by many other cryptocurrencies.
There are many things wrong with Proof Of Work. It is slow and consumes too much electricity and mining power consolidation can lead to centralisation via the back door.
The search for more efficient consensus methods has led to a number of alternatives that tend to be labelled Proof of X (where X can be activity, burn, authority, elapsed time etc). There are two reasons why these alternative consensus methods struggle to get mainstream acceptance:
- people are cautious when it comes to money. So they tend to use the methods that have a long proven track record. Today that means Proof Of Work.
- platforms find it hard to convert their ecosystem to a new consensus method. The miners who use the original consensus method may be economically disadvantaged in the transition to the new consensus method. The case study to watch here will be the Ethereum transition from Proof Of Work to Proof Of Stake in the Casper upgrade/hard fork.
Virtual Machine Management
Blockchain platforms are the next generation of operating systems. All earlier operating systems ran on a single computer such as a mainframe or a PC. For the first time we are getting operating systems designed to run on a network. So a third key job of a Blockchain platform is managing this network of machines (each of which also has its local operating system).
There are two types of Virtual Machine Management systems:
- Turing-complete, represented by Ethereum.
- Turing-incomplete, represented by Bitcoin.
Turing-complete is named after Alan Turing and now refers to a system that can run any program (irrespective of the language), given enough time and memory.
Theoretically, Turing-complete is better. The practical nuance comes from considering the line “given enough time and memory.” In practice, time and memory are constrained. So in practice a simpler Turing-incomplete system might be better.
The market may blur the boundaries. For example Rootstock offers a way to build functionally rich smart contracts on the Bitcoin blockchain, so you are not constrained by Bitcoin Script. Whether something is Turing-complete or not may be debated by developers, but for practical purposes the question is “does the platform enable me to build the functionality that our application needs?”
The Fat Protocol thesis.
During the Centralised Internet Economy, the big money was made at the application layer, through services that delivered value to end users – think Amazon, Google, Facebook, Netflix etc. They used a “thin” protocol layer (eg TCP/IP and HTML). The Fat Protocol thesis is that this will be reversed in the Blockchain Economy; we will have a Fat Protocol layer (where most of the value creation will happen) and a Thin Application layer (where not much money will be made).
For example, we can look at both Bitcoin and Ethereum as Protocols. In both cases, far more money has been made buying and selling BTC and ETH than creating applications that sit on top of those protocols.
If you buy both the Fat Protocol thesis and the Bitcoin Maximalist thesis (see next section), there is s ridiculously simple way to make money in the Blockchain Economy which is just to buy and hold BTC.
You could take a slightly more complex portfolio with say 80% BTC and 20% ETH. That does not need any expensive intermediaries, just a simple way to buy, store and sell those Tokens.
It is as if you could have “bought a stake in the Internet” around 1994.
If you are inclined to invest in platforms other than Bitcoin and Ethererum, you need to take one of these two approaches:
- Very high risk/return. If you invest in a platform that beats Bitcoin and Ethereum, you can make very high returns – not 10x or 100x but 1,000x. The problem is that network effects means that risk that you get it wrong is equally high. The numbers are stark.
- Horses for courses. This is the thesis outlined at the end of this Chapter that there will be a number of platforms for different purposes. This means a lower risk/return profile.
The bitcoin maximalist thesis
There are 3 reasons to be an economic Bitcoin Maximalist.
- 1. Brand and network effects. Step outside the cryptoverse for a moment. Do you have any trouble explaining Bitcoin? Try explaining Ethereum. Try explaining hundreds of Altcoins. Are yo uilding a crypto product/service? Building for Bitcoin or Ethereum is a no-brainer. Which Altcoin do you invest your R&D budget into?
- 2. Copy that. Sidechains will allow entrepreneurs to copy many feature of an Altcoin. For example, if you like Smart Contracts, you can use Rootstock on the Bitcoin Blockchain. Innovation in other technologies may take away an Altcoin’s advantage; for example see this Chapter for the impact of TOR on privacy centric Altcoins. Altcoins as a sandbox for experiments is a “good thing” as donation to the community. As an investment thesis it is less compelling.
- 3. Flight to safety from both directions. Coming from Fiat, Bitcoin is crash protection bet in the aftermath of Fiat money printing. Coming from Altcoins, Bitcoin is safe haven while still believing in Crypto. If you made millions in an ICO, where do you put your stash?
Note that this is different from being a moral Bitcoin Maximalist (which says Bitcoin is better for the world). An economic Bitcoin Maximalist simply says that Bitcoin will be better than Altcoins as an investment.
How platforms may evolve into “horses for courses”.
In a world dominated by network effects, there is still room for niche players. For example in the social media era, Facebook was the huge winner but Twitter, WhatsApp and LinkedIn prospered by offering something that Facebook did not excel at (such as Interest Graph for Twitter, mobile for WhatsApps and work for LinkedIn). The same may happen in the Blockchain era. We may have multiple niche horses for courses platforms.
These niches include Blockchain Platforms optimised for:
- Enterprise. A permissioned Blockchain that provides a distributed ledger for multiple enterprises can use a more efficient Consensus Protocol because the number of entities that need to agree that Consensus Protocol is limited.
- Internet Of Things (IOT). This one of two other big disruptive waves coming at the same time (AI is the other one). IOT and Blockchain go together like horse and cart because both have a decentralised architecture.
- Dark Web. You could use TOR and transaction obfuscation tools with a more open network such as Bitcoin but if hiding your identity is job number one, you may want to use a Blockchain Platform coin built specifically for that purpose.
There is some technology innovation that is making this horses for courses niche platform scenario more likely:
- Blockstack browser. So you can browse across platforms as easily as we browse across websites today.
- Atomic Swaps. So you can easily exchange one coin for another.
- New Virtual Machines. One example is WebAssembly (WASM) which has credibility because it comes from W3C and is licensed using Apache. WASM was not built for Blockchain but is a decentralised virtual machine management system. Some other contenders in this category include RChain, TrueBit and EILE
- Inter Ledger Communications. This is like the Internode Communications with in a single Platform but working across platforms. The leading example today is the Inter Ledger Protocol (ILP) from Stellar.
What all of these new technologies have in common is that they all work cross platform.
Bernard Lunn is the CEO of Daily Fintech and provides advisory services to companies involved with Fintech (reach out to julia at daily fintech dot com to discuss his services).
Get fresh daily insights from an amazing team of Fintech thought leaders around the world. Ride the Fintech wave by reading us daily in your email (along with more than 23k industry leaders).