Nov 08, 2019 10:59 AM | Rin Huang
For the past several years, I have been working at an Asia-based blockchain venture capital firm. While everyone has his or her own investment logic, these are my personal thoughts on how to evaluate blockchain projects. Generally speaking, investment in the blockchain industry targets projects in three categories:
Ecosystem services — This includes media, centralized exchanges (including derivatives), wallets, brokers, mining pools and asset-management services.
Services for companies — This includes blockchain-related technical services for institutions, such as consortium chains, regulatory technology and data analysis.
Native blockchain projects — This includes public chains, protocol layers, etc.
Let’s talk about how to assess projects in each of these sectors in more detail.
The success of ecosystem service projects generally depends on the project having active users. For both media outlets and exchanges, the competition is fierce, and it can be difficult to distinguish oneself. Founders who lack solid resources, extensive background or outstanding operational ability may find it difficult to make an impact with investors.
Exchanges for derivatives and brokers may have more potential. Crypto derivatives are still in their early stages, and compared with the traditional financial industry, crypto derivative platforms and brokers tend to have more space in the market to compete. The ability to design financial products is a key skill that investors look for here.
An interesting sub-section of this sector is wallet services. Wallets are shifting in new directions like asset management platforms (such as finance management, lending, DEX, etc.) and dAPP platforms (such as gaming).
Although the top wallets have a first-mover advantage, there are two reasons why new wallet projects still have a shot. The first has to do with new main chains. Whenever a new top-level public chain appears, it may come with a batch of wallets to attract users. Wallets also have room to grow because there are still plenty of users that have never had cryptocurrency.
In my opinion, today's wallets have a tendency toward oversimplification, including mobile cold wallets, wallets that can be logged into with traditional social media accounts (with private key segmentation and storage technology behind), and card wallets without private keys.
Compared to other types of projects, ecosystem services tend to have clear business models and close access to capital flows, and they face fewer technical barriers. That’s why they seem to develop faster.
Finally, let's take a look at asset-management services (including custody), which are relatively special. With a focus on fund and investment management, this subsector is generally divided into institutions/influential customers (B to B/B to major C), and popular platforms (B to B/B to C). These companies either directly raise funds from investors in the market, cooperate with popular platforms and provide asset management services for users, or provide internal management systems for organizations with additional services of custody and asset management.
The latter two approaches will be more attractive to investment institutions. The most common practices are quantitative staking platforms and the combination of management systems plus integrated hosting services. There is a lot of competition in this area, so winners will likely need solid credibility endorsements such as licenses, well-known investors, support from key opinion leaders and past performance.
This category is similar to enterprise services in the traditional investment sector. Success mainly depends on teams' business development, product understanding, and technical experience. The common business model is charging regular project fees or service fees. In China, where I am based, the government’s recent support for blockchain technology could accelerate the development of this sector, as there may soon be more enterprises in need of blockchain-related technical services.
Still, these kinds of businesses struggle to attract Chinese investors. There are a few reasons why. Projects in this sector mainly focus on infrastructural data services and the technical market, so the overall market size is more limited compared to other sectors. In the field of traditional enterprise services, the valuation of domestic projects is basically one-tenth that of overseas projects. Chinese enterprise services still lack a mature level of professionalization and refinement. So for the moment, overseas projects are worthier of attention in this sector.
With blockchain gaining more popularity, domestic leading companies or traditional big data companies may deepen their deployment in this area, which means that there may be much less space for emerging small companies.
For these reasons, I don’t see great opportunities in this category. In some areas, however, China offers possibilities. When it comes to data analysis and monitoring projects, the US market is relatively established, leaving few openings for newcomers. But in other regional markets, especially in China’s domestic market, there are still chances due to the specificity of language and regulatory distinctness.
Native blockchain projects tend to focus on an “impossible trinity” of decentralization, security, and efficiency. At this stage, what really brings profits are trustlessness features, i.e. enabling users to trust algorithms instead of institutions or individuals. Bitcoin and Ethereum’s trustlessness has helped them achieve real-world implementation and application. But trustlessness hasn’t always been the focus of blockchain projects, and trustlessness is often more difficult to achieve than efficiency or security.
This sector can be further divided into three underlying layers: public chain, protocol, and application.
The Public Chain Layer
We have already seen various public chain projects in the market aimed at solving the "impossible trinity." But few of them make real progress. Therefore, it may be better for projects without cutting-edge technology or outstanding operational ability to stay away from this area. A blockchain key opinion leader with a strong technical background, on the other hand, might have an advantage here.
The Protocol Layer
I personally believe that there are still many opportunities on the protocol layer (existing projects include open finance and Web 3). Protocol-layer projects focus on problems like identity verification, oracle services, privacy and DeFi. Most of the existing projects on the protocol layer serve only as a supplementary feature for specific applications. When a business model is written into a smart contract, the value of trustless mechanisms is seldom taken into consideration. What's more, few teams have been focusing on the perfection of the overall ecosystem in their respective business models.
My personal suggestion is that entrepreneurs should pay more attention to the perfection of the protocol layer. Instead of sticking to traditional thinking, deconstruct the original business model to create a new one, improving the trustless mechanisms of the protocols via technical and economic means. Moreover, protocols should not be limited to certain scenarios, but instead focus on versatility.
For example, lending protocols are not necessarily exclusively useful for lending platforms. Due to the nature of blockchain-based tokens, lending protocols can be used for any case that involves tokens and demand for lending. Take games, for example. Entrepreneurs can try to build a bottom-up blockchain protocol ecosystem rather than a top-down Internet product.
Of course, the business model of protocol layer projects has always been a controversial issue. As far as the status quo is concerned, there are four trends:
Products-as-a-Carrier: The protocol layer tend to accumulate active users and gain profits via a carrier. The most common practice is wallets. In this case, active users can be used as a tool to attract funds and business cooperation, while profits come from transaction fees and transfer channels. But I don't think this will be beneficial in the long term, as it can harm net neutrality.
Staking Tokens: This is a common practice at this stage – participating in a protocol by staking tokens and receiving some profits in return. However, the idea of staking is only a short-term step if the project itself lacks long-term stability.
Reflection of Portfolio Value: Tokens of protocol-layer projects represent the commissions of each portfolio. A problem for most of the protocol-layer tokens is that there is no need for them to exist, as public chain tokens can solve a variety of problems such as transactions and payment. Therefore, a new token mechanism appeared. The same protocol could be used on two different public chains by using the public chains’ tokens. The protocol token represents the total value of these public chains’ tokens.
Let's take staking protocols as an example. While users stake on different main chains, each protocol involved will take a certain percentage of revenues as commission, such as XTZ tokens for Tezos and ATOM tokens for Cosmos. This sum will then form a value pool. Tokens of protocols represent the shares of every portfolio. The more often a protocol is used, the higher the value of its portfolio and the price of the corresponding token.
Governing Mechanism: This is a relatively advanced way to use tokens. Holding tokens means owning the right to govern protocols. This usually applies to more mature protocols. That is to say, both the protocol itself and its community operation have reached a comparatively high level. Unfortunately, at this stage, few projects have reached that level.
In fact, the design of various token mechanisms has a common problem: the failure to form a closed loop. In most cases, we are just acquiring tokens rather than using them in the ecosystem. A common practice is trading tokens in the secondary market. This failure causes the unsustainability and instability of token value.
The Application Layer
The implementation of application-layer projects has always been a hot issue. My opinion is that what hinders these projects most is the imperfection of the protocol layer. At present, most applications prefer to build a product based on internet logic, creating some closed-source protocols in this process (part of the protocols for forks may be open source). To tell the truth, it is impossible for these products to surpass centralized projects. When the protocol layer becomes more well established in the future, application-layer projects can consider the combination of different protocols to satisfy the demands in different application scenarios.
Zooming out, the degree of success of all these projects will depend on mass adoption of blockchain technology. I don't think mass adoption will be feasible before the realization of real IoT network. This is because blockchain itself is actually a more machine-friendly technology. Nowadays, one of the major causes of failure of most trustless mechanisms is the overcomplicated game between human beings. Trustlessness would become much easier if most of our behavior was conducted through machines, while our behavioral data also being stored by machines.
With the rise of 5G, IoT is also forthcoming. That will be the era of worldwide Internet connection. More interactions will be machine-to-machine than person-to-person. In this process, there will be a large number of machines (5G can support millions of machines per square kilometer), which could become oracles and distributed nodes for blockchain networks. Data on people’s behavior can be collected by machines, and this data can become virtual assets that are used for commercial purposes as the ownership of data could be determined and tracked by blockchain technology. These carriers, coupled with proper encryption and communication technologies, may eventually bring about the time when blockchain can play a major role.
When that happens, many blockchain startups will finally have their moment.
Note: Fenbushi is an investor in LongHash.
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