Applying DLT to the Real World

Distributed Ledger Technology (DLT) is regarded to hold great promise in revolutionising the way in which entire industries operate. However, this has not materialized yet. Why is this the case? The obvious answer is that we are still at the early stages of development, where most projects fail amidst the large amount of trial and error from entrepreneurs. However, the very few that succeed may re-define their respective industries and even dominate them, similar to what has happened in previous technology market cycles, for example with Facebook and Google.1 In this note, we outline a framework of the key characteristics that DLT projects should have in order to maximise their chances of success.

Focus on the Outcome

The technology should be in the background, rather than at the forefront. Consumers and businesses do not care about how outcomes are achieved, for example whether through a traditional digital infrastructure or a DLT. What matters for them is whether the outcomes are significantly different and, in particular, better for them. An early indication of whether founders have understood this is whether the relevant white paper emphasizes the outcomes and the added value of the project, rather than the technology (and associated jargon) on which it is built.

Compatibility with Existing Processes

Projects should be compatible with existing behaviors, processes and systems. A DLT project cannot exist in a vacuum, separated from what is happening in the marketplace, or base its success on an implicit assumption that the status quo will be changed by everyone else, just to adapt to its own revolutionary technology. The usual constraints matter, as with any other new project, and they should be taken into account when evaluating the probability of success. For example, a blockchain project on trade finance should articulate very clearly how it deals with the constraints of the existing paper-based system, instead of assuming that everything is already digitized.

Recognition of Economic Incentives

The most successful projects recognise that their platforms are complete economic systems. The white paper should articulate how incentives work in their economy and how they can leverage them in order to serve their aims. The Bitcoin blockchain is a poignant example. Its aim is to transfer value digitally, without using a central authority. To do that, it needs miners who maintain, update and safeguard the ledger. But these miners need to be incentivised to do this work properly, which is achieved through the Proof-of-Work protocol. It is important to emphasise that most of the technology necessary for the Bitcoin was already there. The brilliance of the white paper was to put several different tools together and build a self-sufficient economic system. In a similar fashion, a successful DLT project should be more about designing incentives and an economy, rather than discovering new technology.

Building Network Effects

Another dimension that is very important, but often overlooked, is the way in which DLT projects aim to build and maintain their networks.

How do network effects materialise?

Network effects refer to the economic phenomenon that the value of the network increases for its members as more members sign up. Initially, the value of a network is zero, hence every additional member confers a positive externality on all existing members, without receiving any substantial benefit for himself. If this positive externality is not internalized, there will be fewer incentives for new members to sign up, leading to an under-developed network. One way of internalizing these externalities is by providing immediate value to small groups, who join together within a network. We can call these local network effects. For example, a small group of friends joining Facebook together can immediately enjoy some of the benefits of the network, such as sharing videos and communicating with each other, without having to first wait for the larger network to expand. Another way is focusing initially on a specific type of members. For example, launching a platform that connects patients, doctors, insurance and drug companies from the outset may be too difficult. These groups will eventually benefit from a large network that connects everyone, however at the beginning it may make sense to focus on the value delivered to one or two groups, so that they can benefit from the local network effects. For instance, when Facebook launched, it only allowed University students to join.

Another way of internalizing the positive externality of joining a network is through tokens. Early adopters can earn tokens, whose value grows together with the size and value of the network. Such a prospect can incentivise participation and lead to bigger networks faster. Although these tokens can be easily programmed in a DLT project, there should also be a lot of thought on how exactly they are designed and what incentives they promote, because they can easily lead to speculation and stifle, instead of promote, a sustainable network growth.

How are network effects maintained?

An important part of building and maintaining a network concerns how participants behave after the network has grown in size and value. Will the created surplus be distributed among participants and creators, according to the initial terms? Or will a powerful member try to unilaterally change the terms, in order to re-distribute the surplus? As we explain in this report, this is the “hold-up” problem. After members have joined the network and invested significant amounts of effort, time and resources, they could be held-up by a powerful member and be forced to accept new terms, because joining a different network would result in incurring significant costs.

DLT provides the technological tools to implement a decentralised network, such that there is not one member that controls all of the information. However, technology alone cannot solve all problems and particular attention should be placed on how the project designs incentives, so that continuous cooperation among members is ensured. For example, suppose that two parties create a decentralised network, where party A shares all of its business-critical information with party B. After the information-sharing by party A has been done, can party B still implement a hold-up, by creating a new network with different terms and declaring that it will only cooperate with party A on that network? This is a danger that cannot be solved by technology, only by proper economic design. If a DLT project has not properly designed its network, so that all members benefit from continuous cooperation, new members may be reluctant to join in the first place. For example, a Bitcoin miner has the incentive to continuously participate in the network, because the value of his mining rewards will go down if the network does not do well.

Clear Case for Decentralisation

Decentralisation serves the purpose of removing a trusted intermediary who oversees all transactions, maintains the network and gathers all relevant information. In some cases, a trusted intermediary is needed for a project, whereas in others it is not. A project should always describe clearly why a trusted intermediary is not needed in this particular application and therefore it needs to implement a DLT. In most cases, things are not black and white and there are trade-offs that need to be considered.

An Eye on Technological Constraints

The aims of the DLT project should respect the technological constraints. At the moment, there are computational and bandwidth bounds for DLTs, so applications and use cases should be as simple as possible. Bitcoin is such an example. Because the size of the database is relatively small and the programming language is simple, it can run across a wide variety of machines. Implementing Facebook using DLT however, would be impossible with the current technology, as the updating needs to occur every second, involving different formats such as video, photos and text. This understandably results in the production of an enormous database.

Conclusion

DLT may be successfully applied in a plethora of industries and business cases that involve multiple stakeholders, who may find it difficult to trust each other or a central intermediary. Its distributed nature, together with the strong cryptographic techniques that it implements, provides multiple benefits related to the treatment of various kinds of data – but most importantly, it makes them safer, more available, transparent, and immutable. However, DLT is not a panacea for all conceivable projects. When judging the probability of success, the focus should be on the design and the outcomes of the project, not the particular technology that it uses. Is the project compatible with existing behaviors, processes and systems? Does it take into account the relevant economic incentives and respect the current technological constraints? How does it generate and maintain the network effects that are necessary in order to create a sustainable network? For instance, tokens should be used in a way that promotes growth, not lead to speculation. Finally, how does it leverage the main competitive advantages of DLT, which are decentralisation and a trustless environment? These are the key issues that comprise a framework for analysing a project’s chances of success.

Footnotes

1 See An Introduction to the Distributed Ledger Technology for more on previous technology market cycles: hardware (1950-1970), software (1970-1990) and networks (1990-2010). Expansion is first typically driven by open standards and decreasing costs. Then there is a phase of consolidation, where winners build proprietary systems on top of these open standards, stifling competition. Finally, there is decentralisation through the development of open source alternatives, in order to escape the platforms of incumbent firms and their high fees. DLT is still at the early stages of expansion, where open standards are being developed in order to decrease costs.

Disclaimer

The material provided in this article is being provided for general informational purposes. Aaro Capital Limited does not provide, and does not hold itself out as providing, investment advice and the information provided in this article should not be relied upon or form the basis of any investment decision nor for the potential suitability of any particular investment. The figures shown in this article refer to the past or are provided as examples only. Past performance is not reliable indicator of future results.

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