DLT and the Rise of Crypto Moats
Updated: Aug 8, 2018
One of the most innovative and interesting technologies today is distributed ledger technology (DLT). DLT is only in its infancy, and much of the work to create a scalable and robust DLT infrastructure is still being developed.
But what is DLT, really?
DLT is a social scaling tool. We humans have cemented ourselves at the top of the food chain by being able to coordinate large groups in a highly flexible manner. Core to this is our ability to tell stories and for other humans to effectively buy into these stories, enabling us to effectively work at scale.
DLT is simply another story (albeit with programmed rules), designed to help us socially scale in an entirely new way, without the need for central intermediaries and middlemen.
Simply put, DLT uses incentives and cryptography to enable parties anywhere in the world - without any prior relationship - to safely, cheaply and honestly coordinate and transact with one another (at least, this is how it works in theory).
This is the essence of permissionless blockchains such as bitcoin and Ethereum, which allow anyone to join the network.
What’s so special about DLT?
DLTs provide the world with a new design space.
Some argue that this new paradigm is as game-changing as the invention of the modern corporation, which led to the discovery of new lands, the rise of West, and the industrial revolution. This led to the creation of entirely new forms of businesses, which changed the course of history.
Whether or not the same kind of value will be realised with DLTs is yet to be seen. That being said, if you listen to any DLT zealot, they’ll tell you the seeds have been sown and the sprouts are already visible.
So let’s say this is the case, and DLT is indeed poised to disrupt the modern world. What characteristics or attributes would such a system need in order to succeed?
Or in business speak, what kind of moats would ensure a distributed project thrives in a highly competitive and frothy market?
Hang on. What’s a moat?
The concept of moats was heralded by Warren Buffett to describe a sustained competitive advantage.
Key to this is the word ‘sustained’, as the whole idea of a moat is that it is not easily replicated or, even better, impossible to replicate. Any organisation that sustains such an advantage over its competition is rewarded handsomely.
In reality, moats don’t last forever. That’s just the nature of the markets. Something that was successful today won’t necessarily be successful tomorrow. This can happen for a number of reasons, but typically it’s because innovation creates new forms of value, changes customer demand, and thus alters the dynamics of the market(s).
In short, innovation is the ultimate moat-buster.
Before we consider the moats of the crypto era, let’s take a quick look at the moats of yesteryear. Specifically, pre-digital moats and web 2.0 (digital) moats.
A pre-digital company is a company that created a successful business model before the rise of the internet era. Therefore, pre-digital moats are the sustained competitive advantages that don’t rely on digital technologies, such as the internet, cloud computing, AI, etc.
So, what are the competitive advantages of the pre-digital company? Here are the main ones.
Economies of scale
The classic moat, the more you make, the cheaper it becomes to make, allowing you to price out the competition.
There is also a point where you can become too big, and, after reaching a certain level of economies of scale, diseconomies of scale kick in.
This is where things become more expensive as you grow. The goal is top keep the marginal cost of producing something as close to zero as possible.
Proprietary technology or trade secrets
Intellectual property can include anything from novel solutions to hard problems, new inventions, new processes, new techniques and patents. Over time, a company’s IP will evolve and accumulate, bolstering the moat.
Issues can arise when companies culturally lock themselves into their IP and processes, creating a one-trick show pony, which is all well and good until the market moves on to something else.
High switching costs
This occurs when your customers rely heavily on your product or service to create value for their own customers. They become structurally and culturally reliant on your offering, and you become cemented into their value chain as a result.
Your service or product becomes so ingrained that, if your customer were to stop using it, this decision would be very costly as it would dramatically affect their operating model.
An example is the use of specific machinery in a manufacturing supply chain.
The issue is that if they miss opportunities to innovate, so might you.
Brand and customer loyalty
With each positive interaction between your product or service and your customers, your brand advantage gets stronger over time. At the same time, brands are particularly vulnerable to matters of trust, and your brand strength can quickly evaporate if your customers lose trust in you.
There are others, but these are the major competitive advantages of the pre-digital company. As we progressed into the digital economy, the platform on which business was conducted changed from brick and mortar production to digital production powered by the internet.
Web 2.0 (digital) moats
Web 2.0 companies are those that built their business model around the internet. Think Google, Facebook, Amazon, etc.
Here are four competitive advantages of digital moats.
This occurs when the value of your product or service increases in line with the amount of people using it.
There are single-sided and double-sided network effects, as well as data network effects. Network effects are the reason why the big tech platform companies have become so dominant, while traditional pipeline businesses have struggled.
Data sets are extremely valuable (as long as they are unique) and, combined with AI or ML, lead to a virtuous cycle, whereby customers create data.
That data enables the organisation to improve its service offering, which in turn attracts more customers, and so the cycle continues.
What I have just described here are data network effects. The more unique your data set, the deeper your moat and the more this flywheel spins.
Interestingly, in the era of web 2.0, the features of the classic moat (customer lock-in, intellectual property, high switching costs, and brand loyalty) are still very much in place.
Economies of scale also serve to create strong moats, especially when they are combined with network effects, which is what Apple has done with the iPhone and App Store.
In the digital world, you’ll also find that high switching costs are a major factor (in terms of being ingrained into the culture, workflows and typically monolithic IT systems), yet with the rise of APIs and modular architectures, it can also be very easy and cheap to plug in a software product.
Brand reputation is certainly a moat, but it can be lost extremely quickly in the
digital age - think data leaks and leadership scandals. Furthermore, competition is rife, and it all it takes is web browser and a quick Google search for your customer to access a competitor.
Proprietary technology/software or trade secrets
You’ll notice I’ve added software to this moat, because software is eating the world.
Interestingly, though, much of the world’s proprietary software is built on open-source software accessible to all. The economics of this aren’t fair, as many open-source projects are extremely overfunded yet are relied on by some of the biggest companies in the world.
Web 3.0 (crypto) moats
Web 3.0 is the world of decentralisation and transparency powered by DLTs. The first DLT was bitcoin, which came onto the scene in 2009.
The whole premise behind DLTs is to disintermediate and effectively disrupt the moats of web 2.0, specifically relating to the aggregation of data and power.
In the world of DLTs, the moats are once again different.
In the world of web 3.0, network effects will accumulate around the tokens used in the networks.
Tokens can be broken down into different categories and use cases. But key to all of them is the idea of increasing token value. These tokens and their associated value are used to incentivise users of the network to work towards a common goal.
If the token has some useful utility, people (usually developers) will want to build in the ecosystem.
This will create a better experience and attract users to that ecosystem, which in turn increases demand for the token (which is required to participate in the ecosystem), thus attracting more developers as well as investors. This creates a flywheel.
Developers are usually incentivised to build in the ecosystem through the provisioning of tokens. Over time, the utility of the token - and the token’s value - increases, locking in more developers, users and investors.
But it’s not just the token network effects that can create a moat. DLT governance dramatically impacts crypto projects, and good governance in the decentralised world is hard!
Having good governance means all actors are fairly incentivised over a long period of time to build value in the project’s ecosystem.
Good governance is something that continues to evolve over time, ensuring a thriving community and a valuable token. Governance is critical to ensuring the flywheel for the token network effects continues to spin.
What about proprietary software?
Proprietary software is not enough to form a strong moat.
This is because the underlying premise of the crypto world is transparency, decentralisation (in other words, no intermediaries taking a clip) and openness.
This means that all the code for the foundational blockchain projects - like bitcoin, Ethereum, Decred and so on - is open-source, so anyone can fork the code and start their own project with it.
That being said, this isn’t done because it is extremely hard to build token network effects and good governance, which as you know, are crypto moats.
So what does the future hold?
Where things will become interesting is what happens on top of these foundational layers as assets become tokenised, people build new DApps upon these foundational DLT layers, data silos are broken down with the rise of DLT projects like Ocean Protocol (which is a DLT ecosystem for sharing data and associated services), and people are able to prove their identity without handing over any private data.
It’s hard to say, as many of these concepts are unproven, but things point towards a more open, fair and evenly distributed economy and society, where value is shared.
Organisations whose moats embody these attributes will be the most successful.
That being said, humans have a frustrating tendency to aggregate and centralise power and wealth, so will we return to the moats of the digital age, or never leave...?
Only time will tell.