We often get asked why crypto assets are necessary to invest in projects based on blockchain technology. In this article, we explain why crypto assets are an essential part of blockchain technology.
What is the most basic function of a blockchain?
Blockchain technology is used to maximize trust around a given dataset. Maximizing trust is achieved by ensuring that a specific set of rules (i.e. immutability, privacy, format, etc.) governing that data are followed at all costs. The flaw with traditional databases (which come in all shapes and forms – i.e. a bank keeping a ledger of its customers balances), is that those are controlled by trusted third parties, which are costly and lead to security holes.
Broadly speaking, what are the different types of blockchains?
Blockchains are either permissioned or permissionless: either participant need to be granted access, or the blockchain is accessible to everyone.
Building further onto the prior question, trust around a dataset is maximized in permissionless blockchains where the integrity of the dataset is secured by a large number of participants (i.e. decentralized) and the rules/codebase auditable by the public.
Why do blockchain projects issue crypto-assets?
In order for participants to secure (i.e. dedicate resources – like capital, computing power, and energy – to ensure the set of rules/protocol is followed) permissionless blockchain projects, there needs to be an incentive mechanism. With blockchain technology, this incentive mechanism comes in the form of crypto assets. (i.e. the Bitcoin blockchain pays those that secure and support it – the “miners” – in Bitcoin)
In addition to compensating for the use of resources in securing the network, crypto assets are often designed so that the holders benefit from the success of the blockchain. Indeed, as the main function of blockchain is scaling trust through decentralized governance rather than through the reputation of centralized institutions, it is important that the network is truly decentralized. This can be done by giving crypto-asset holders the right to use the blockchain, participate in providing services and earn revenue, or govern the blockchain.
Since issuing equity is always inherently linked with a centralized entity (the company) it falls short to achieve those decentralized attributes.
Why are crypto-assets (as opposed to fiat) the ideal incentivization mechanism for a blockchain?
Blockchains thrive when they have many participants in multiple jurisdictions. The more the miners and users are distributed, the more secure the network is. Hence, blockchain projects try to make it as easy as possible to participate in the network, which can be as simple as having a computer and an internet connection.
Conventional compensation methods, such as fiat and equity, introduce a significant amount of friction as they are not designed to bootstrap a decentralized network.
• capital controls prevent distribution and hinder broad participation,
• fiat transfers and remittances suffer from high friction costs and prohibitive time lags,
• no additional utility at the network level
Crypto assets enable incentivization while keeping participation barriers low since they can be assigned and traded by computers freely and quickly.
Are crypto assets the only way to invest in a blockchain project?
While some blockchain projects are funded by equity and the issuance of crypto assets, most blockchain projects only enable investing through crypto assets to ensure the crypto assets represent the value (i.e. tied to the service provided on the blockchain) captured by the blockchain.
Note that not all crypto assets are optimally designed to capture that value, and careful due diligence is required to ensure the crypto asset is investable. (we will write a follow-up article that covers this topic)
Additionally, most of the infrastructure (i.e. exchanges, custodians, market makers, data providers, regulatory technology, etc.) being built to enable blockchains to reach their full potential is typically investable through equity, which is still the investment focus at Tioga Capital Partners.