a16z Podcast | Cryptonetworks as Emerging Economies (Done Right?)

with Chris Burniske (@cburniske), Joel Monegro (@jmonegro), Denis Nazarov (@Iiterature), and Jesse Walden (@jessewldn) When designing cryptonetworks -- really, emerging economies -- how do we avoid some of the monetary and fiscal policy failings of "real-world" economies? Like not separating currency and capital, which accelerated and spread economic growth through the former... but also concentrated the latter into the hands of a few? Yet how can we empower users to access capital while also managing risk? If the promise of cryptonetworks is to better align incentives and value capture, then we can't make the same mistakes as we did in traditional economies. We also have the chance to do novel things not possible in the physical world, through software. So this episode of the a16z Podcast -- featuring voices from Placeholder VC and a16z Crypto -- goes deep into the nuances and mechanisms of cryptonetworks, tokens, and decentralized applications at every layer of the "stack". Chris Burniske (who has written a lot about financial modeling-influenced frameworks for analyzing crypto) and Joel Monegro (who has written about "fat protocols", and once managed the Digital Economy Department at the Ministry of Industry and Commerce of the Dominican Republic) of Placeholder VC discuss and debate all of the above -- and more! -- with a16z crypto's Denis Nazarov and Jesse Walden (co-founders of Mediachain, which was acquired by Spotify). Throughout the history of information technology, we've gone from hardware to software, and software to data. So what's next, what's the layer above data? The answer is governance -- which gives more people a way to participate in decision making around a given network -- but the answer for how to implement the best governance isn't so clear. --- The views expressed herein are those of the individual personnel quoted herein. This presentation is provided solely for informational purposes and should not be relied upon when making any investment decision. References to any securities or digital assets are for illustrative purposes only and do not constitute a recommendation to invest in any instrument nor do they constitute an offer to provide investment advisory services. This content should not be relied upon as legal, business, investment or tax advice. You should consult your own advisers as to legal, business, tax and other related matters concerning any investment. Furthermore, this content is not directed at nor intended for use by any investor or prospective investor, and may not under any circumstances be relied upon when making a decision to invest in any fund. Past performance is not indicative of future results. Please see https://a16zcrypto.com/disclosures for additional important information.

Speaker names marked ? are inferred from speaking time and the show’s known hosts — they are not voice-verified.

• 0:00Speaker 00

  The content here is for informational purposes only, should not be taken as legal, business, tax, or investment advice, or be used to evaluate any investment or security, and is not directed at any investors or potential investors in any A16Z fund. For more details, please see A16Z.com/disclosures.

• 0:19Sonal?

  Hi, everyone. Welcome to the A6 and Z Podcast. I'm Sonal. Today, we have another one of our Podcast on the Road episodes with guests from New York City on the topic of crypto, but more broadly, on crypto networks as emerging economies. This conversation goes into the super interesting nuances of structuring these networks to avoid some of the failings we've seen in the monetary and fiscal policies of traditional economies, including debating how to empower users when it comes to risk, but also how to better distribute access in terms of who captures value from networks. We then also discovered different mindsets for the governance of these networks, which are really cryptoeconomic systems, especially as they evolve and grow more mainstream over time.

• 1:02Sonal?

  Joining us to have this conversation, we have two guests, our friends at Placeholder VC. Chris Burniske, who formerly led ARK Invest crypto efforts, has written a lot about financialing, modeling, influence frameworks for analyzing crypto, and co-wrote a book on crypto assets. And Joel Monegro, who before starting Placeholder with Chris, was an analyst at USV, where he helped develop their early blockchain theses. Prior to that, he managed the Dominican Republic's government office in charge of developing the country's national and digital economy technology agenda. I share all that as key context for the conversation that follows. And last but not least, we have two of our partners from A6 and Z Crypto, Jesse Walden and Dennis Nazaroff, formerly co-founders of media chain, which was acquired by Spotify. Jesse and Dennis interview our guests and also add their perspectives in the discussion

• 1:47Sonal?

  and debate. On that note, the content here is for informational purposes only and should not be taken as legal, business, tax, or investment advice, or be used to evaluate any investment or security. It is not directed at any investors or potential investors in any fund. For more details, please also see A6andZCrypto.com/disclosures.

• 2:10Sonal?

  Before the discussion goes into what it takes to design such cryptoeconomic systems at scale, from value capture to risk to governance, they first quickly begin with the fundamental concept of layers in a stack of protocols and decentralized applications. The first voice you'll hear is Joel's, followed by Chris's and then Jesse, and Dennis joins in later.

• 2:31Speaker 02

  You can think about it from an engineering point of view and how different kinds of software are layered on top of each other. You can think about it also from a more social point of view. Layer one is more machine work and layer two is more human work. And as you transition from layer one to layer two, then you end up with lighter weight models because you don't have the capital cost of the machines to actually do the work, to store the files, to mine the transactions. What we see at layer two are more abstract units of work that require human judgment. And there, the cost is harder to model because it's harder to quantify what is the value that goes into performing some unit of work. And that unit of work can be anything from curating content to making a governance decision.

• 3:15Speaker 02

  All of those things are very difficult to put in a spreadsheet model, but we have the aid of the invisible hand in a way that's helping us figure out what human work is worth. I think the infatuation with layer one comes from it being much easier to understand the cost and value relationship between providing a service and consuming a service. It gets harder as you move up the layers. Once you get into the realm of human work is when you start to really imagine the different ways in which crypto can really change the way we do things.

• 3:44Speaker 03

  I think as we go up higher in these layers, we're going to see different incentivization and therefore value capture mechanisms. Layer one, the priority is security, because that's basically our clearing and settlement layer. And so we've really seen Bitcoin prioritize security or Ethereum. And because if we build all these layers on top of an insecure layer one, then we're screwed. And then as we move up the stack, it's less about that machine security, say, and more about how do you incentivize the economic actors to perform the service that you've promised to perform.

• 4:20Speaker 03

  Provide. And the only way that that ends up being a service that the end user uses is either if it's cheaper than existing services that you can get from the centralized model, but on par in terms of user experience, or it's a fundamentally new experience or service, and this is the only place I can get it. There's the access tokens where basically there's demand of what I find interesting about an access token is historically we've thought of tokens as needing to connect the supply side and demand side. An access token really just focuses on the supply side and it can have a fixed supply and there can be scarcity because basically if the supply side needs that token to perform the service

• 4:58Speaker 03

  and performing the service is a profitable activity for them, then there will be a clamoring to get a hold of that token and that drives its own scarcity. And that's slightly easier to model. You can actually use a discounted cash flow model to approximate the value of that token. And you know, the demand side can pay in fiat if they want. And I think we'll increasingly see this where the demand side is going to just pay in whatever asset they want. They don't need to interface with crypto assets from a day to day perspective, but you can still have value in a work token that organizes the supply side and induces a competition around being able to provide that service.

• 5:34Jesse Walden?

  So in the model you described, Chris, we call it the taxi medallion model. What's interesting about it is there's one token that is the right to do the work and the other token, which is the payment token. And so as you said, it's you can do sort of a cash flow analysis on what the work token is going to earn. And this differs from the base layer where, you know, today, most of the layer one blockchains use one token for both rewarding the supply side and for the demand side to consume the service. And I'm curious, what do you guys think the implications of moving to a work token model are? Is there any sort of implications for users and suppliers not being aligned around the same token?

• 6:17Speaker 02

  Well, the thing that's really scary about this trend to create dual token systems where one token gives you access to the supply side or a right to participate in the supply side and another one ends up being the payment token, whether it's another token that is created by the crypto network or something like ETH or any other one, is that you were doing the same thing that we did with the world economy, which is that we separated currency and capital the moment that we moved into a fiat currency model. In modern capitalism, we have two major kind of asset types. We have capital and we have debt, and currencies are really a form of debt at the end of the day. And backtracking a little bit, the reason we separated currency from capital is because the transaction velocity

• 7:00Speaker 02

  of capital is very low, the transaction velocity of a dollar is very high. And so as the economy grows, exchanging gold or land or just a barter system is not going to work. And so we needed currencies to accelerate economic growth. So far, so good. The problem is that capital and currencies respond very differently to economic growth. Capital appreciates together with economic growth and currencies actually depreciate as an economy grows. Inflation is commonly thought of as the printing of new money, but really, a more traditional definition of inflation is increases in prices over time as a result of economic growth. And capital as an asset type appreciates as the economy grows because it is more scarce

• 7:45Speaker 02

  than currency. Currency, we print more of it to keep up with inflation, to keep prices stable, and that's how they end up devaluing over time because we're creating more and more and more. What happens over time then is that actually capital becomes more and more concentrated because its transaction velocity is so low. And the problem with that is that we end up with a lot of people living their lives in currency and very few people living their lives in capital. What part of the promise of crypto networks, at least to me, is that we are able to combine currency and capital into a single asset so that then we don't get this same kind of income inequality or wealth inequality being created as any individual crypto network grows. And the risk of separating the

• 8:27Speaker 02

  This token or the work token from the currency token is that the people who accumulated the access tokens early on, that group becomes increasingly concentrated over time as the economy grows or as the crypto network grows. The value of combining the two, if you have a single token that is both a supply side token and a payment token, in order for the supply side to provide its service, it has to take payment in that token. So the token has to be in the user's hands in order for them to actually consume the service. And so that creates a pressure to sell the work token or sell the capital token as the network grows, because otherwise you're not going to get any customers. Everyone in a crypto network can participate from the value created as opposed to just one segment.

• 9:06Speaker 03

  I definitely agree there's a risk to backtracking a little bit with the ethos of crypto separating the work or the capital and currency. I think one thing, even if we end up in a work token world or taxi medallion world where we've separated capital and currency, again, at least within those networks, the one reassuring thing is that you can't be a passive accumulator of capital. You have to be more active, like you stake the work token and then you have to continue to provide work for the network to continue to collect cash flows.

• 9:39Jesse Walden?

  So I would argue that that's not entirely true. And that's because in these proof of stake systems, you have the, often have the ability to delegate stake. And so what happens there is a marketplace emerges where there are people sitting on capital and they just point that capital at a worker. So it's very much like taxi medallions work in New York City. They're mostly bought up by hedge funds and the like, and then they hire drivers to go and drive the cars and earn, you know, earn passive income on those medallions. And so I think that does speak to Joel's point, that the separation of these two things does result in a concentration of capital. But I would argue that, you know, the flip side is that the users of the service don't have to take any risk. So, you know, when I get into a taxi cab, I don't have to think about whether Uber

• 10:23Jesse Walden?

  or Lyft are going to have a real big impact on the value of my medallion and, you know, the future utility I'll get out of it. So, you know, humans tend to think in one unit of account because it's just easier to reason about. And, you know, you don't want to be taking risk necessarily when you're buying a coffee and or a pizza and that ends up, you know, going on to be worth millions of dollars. And so there is this sort of simplicity in the taxi medallion versus currency model that I think, you know, it's hard to get away from just because of human nature.

• 10:53Speaker 02

  I argue that risk is good because you can't create value without creating risk. And again, it's that same kind of thinking that led to the world where we are today. It's much simpler to have everyone use dollars because no one has to think about how the markets are moving and how your value is changing over time. Rather, you trust the government, you trust that they're going to maintain a certain monetary policy such that you hope that your $100,000 today is going to maintain a certain degree of purchasing power. The problem with that is that by not allowing people to take risks in a way, then we've cheated them away from capturing some of the upside of the value. And I think it's time to rethink how we think about risk for people more broadly.

• 11:37Speaker 02

  If we prevent people or design systems that make it harder for people to take those risks and participate in the value, then we're going to end up in the same world where we are today, where the value is concentrated amongst those who took the greatest risks. Now, obviously, it can go really badly if you have a whole bunch of risk spread, a whole bunch of people, and then everything comes crashing down, then you have a real problem. So it's not that there isn't value and stability and value and currencies that make it easier for consumers to go about their daily lives. But I also don't think we're heading to a world where you buy your coffee with Bitcoin. I also think that the overall argument of, well, we need to create these systems because otherwise it's too risky and then people are not going to use it. I think it's a little, not patronizing, but it underestimates people's ability

• 12:21Speaker 02

  to make those decisions for themselves.

• 12:23Jesse Walden?

  I remember asking you about, I don't know, three, four years ago, whether it's actually a good idea to make your users investors because there's a cognitive overhead that is associated with that. You're asking your users to be sophisticated about the underlying infrastructure powering their daily experience. And I think increasingly in crypto, we're seeing that, at least... When you have some skin in the game, participants in these networks are willing to go in a little bit deeper and the types of communities that emerge around these projects are just fundamentally different. Like, people have a different relationship with the network. Ethereum participants own the token and therefore have an emotional connection to

• 13:06Jesse Walden?

  the values of the infrastructure and what its goal is and what it aims to achieve.

• 13:10Speaker 02

  To a fault, sometimes.

• 13:11Jesse Walden?

  Yeah, to a fault sometimes. And I think the question is, how scalable is this? Can we scale this model to the entire world? Or is it limited to a subset of users who are sophisticated enough and want to take on that risk? And so, just to push back a little bit on the idea that we will be able to scale this model all the way up. I think the idea of having this work token currency model, it doesn't preclude power users from participating in the network. And through delegation, the owner of that token does not need to necessarily provide the work. So, a power user can invest in the success of the network that they're using, but it's a choice. And so, I think there's flexibility both ways.

• 13:52Jesse Walden?

  On one side, the assumption is that we should give risk to everyone, and that's that optimality. And the other side is, we should let people choose.

• 13:59Speaker 02

  You can argue both sides of the table. And so, what that tells me is, let the people make the choice. But then that becomes a question of, what's the default? So, we've all gone through a signup form where the checkboxes are checked by default or not that opt you into certain things. And we've learned that people tend to stick with the default. And so, I would rather see a world where the default is, we're all participating in the value. Yeah, any citizen can go and open a brokerage account and buy stocks and participate in the market, but most people don't because that's not the default. So, I think one thing that we can do here is actually create a model and train another generation of users to think as users who are staked in the network in a way that we really couldn't before. And the generational aspect, I think, is very important because the other thing that's

• 14:44Speaker 02

  going on here is that the way these assets accrue value is very different to the way that other, or previous kinds of assets accrue value. Previously, in a more traditional world, when we had companies go public, it was a lot of the same. Philosophy of you, you're a customer of Walmart. Walmart goes public, you can buy stock in Walmart. And then every time that you go to Walmart and you're paying with your dollars, you know, there is some value accruing back to you as a shareholder of the company. But in order to properly analyze an equity, you have to go to business school and learn how to do discounted cash flows and how to figure out, you know, how to analyze whether management is doing things correctly and so on. What's different here is that we're dealing with these decentralized networks where if they're properly constructed,

• 15:27Speaker 02

  the value doesn't really necessarily depend on the actions of a management team, but rather on the overall network.

• 15:33Denis Nazarov?

  Yeah, you know, we were talking about the consumer perspective and them being a shareholder. And that's one side of the argument. The other is from the developer and people who are actually building these protocols.

• 15:44Speaker 03

  So I want to take a step back because we've been saying user, network, participant, those kinds of things. And I think that it really depends on which network participant we're referring to. So early on in a network where it's mostly the supply side, right? Because the supply side has to come on board to actually provision the asset. And presumably the supply side is going to be a much more sophisticated person, at least in their understanding of the network than the demand side. At least as we scale out over the long term, I think that's an assumption we can make. And so that supply side can tolerate that earlier risk because presumably they're more sophisticated and so that all makes sense.

• 16:26Speaker 03

  Where I think we start to encounter more problems, especially if crypto goes mainstream, we will have, you know, hundreds of millions, billions of end users on the demand side. And I think it's a stretch to ask the demand side to be an expert in the network. The supply side, this is different from our current equity environment. If you set aside stock-based comp, traditionally, an employee at a company doesn't necessarily have exposure to the upside of that company. Stock-based comp has changed that a lot, but that employee mostly gets paid in fiat currency, which goes back to Joel's point of, you know, they don't get to participate in the capital appreciation as much as the management and the concentrated owners of capital. So for me, that's a big improvement.

• 17:11Speaker 03

  Early on, demand siders, they'll be early adopters. But I think as this space grows, we will abstract a lot of that complexity away from them. And the demand side will just pay in whatever they want to pay. Be they in Kenya, be they in the US, be they in Korea. You pay for the service with whatever currency you want. That ends up getting converted and the the supply side will get paid in the native asset of the network through whatever it may be. But the key is that the supply side gets access to that risk and that capital appreciation. For me, for me.

• 17:42Jesse Walden?

  So I think an interesting sort of avenue to go down here is is to again, come back to this idea of the different layers in the stack and how it may be different at each of them. So at the base layer, it makes a lot of sense for there to be sort of one currency. Or, you know, because because you do really want to align the incentives of the supply side and the users. Because it's this very general substrate upon which, you know, like all all kinds of more complex applications can be built. But this, because it's very general, you want there to be this sort of network effect that everyone is everyone converges on the values and the goal of this general substrate. As you get further up the stack and you build more complex applications, something like a stablecoin, for example,

• 18:25Jesse Walden?

  requires sort of more specialization in terms of the type of work that's being done. And this is to Joel's point earlier, that it's it's more human work. And more specialization generally means more expertise. And so, once you get into to those types of applications, I think it becomes a little bit harder for everyday users to be sophisticated about the work that's going on behind the scenes. People probably don't need to understand how Ethereum computers, you know, determine consensus. But I think I think the difference is that in order for a stablecoin to work, it it's a much more, you know, complicated system and it has parameters that need to be tuned. And they probably need to be tuned by experts.

• 19:05Jesse Walden?

  Whereas computation is deterministic, it's sort of a binary outcome, right or wrong, and it can be verified by computers. And so I would argue that the the base layer of the system being more general lends itself to this sort of single token model a little bit better. But as you move further up the stack, I think you do want this separation between sort of the management and the users, because it requires expertise.

• 19:27Speaker 03

  And that brings us to governance.

• 19:28Jesse Walden?

  Right.

• 19:29Denis Nazarov?

  And maybe an analogy is the base layer is sort of like A country, it's like you're a citizen of America. You get to vote and participate in elections and to decide kind of policy. Taxation policy is the substrate for all economic activity built on top of America. And then there's more specific corporations inside of America. And they have their own governance practices. They have their own equity and then participating in them is much more specialized. But you have this broad substrate that everyone else builds on top of with different governance parameters.

• 20:02Speaker 02

  So I like to think of, or we like to think of crypto networks as emerging economies. And what's interesting about that is that if you compare a crypto network to a country, you start to see a number of similarities. There's a currency that's exchanged between buyers and sellers. There's, if you think of the executive team or the executive branches, the core development team, and you think of the blockchain as the court or the legislative system where all the rules go there. And then you have the supply side, which are the miners or the producers. And you have the demand side, which are the users who are consuming the service. That starts to look a lot like a small economy. And then what's cool about that is that you can use this model to think through whether a crypto network is properly constructed or not.

• 20:47Speaker 02

  So for example, things that we've learned over time that we like to see in physical economies, like low degrees of corruption and sound monetary policies and fiscal policies and a rich supply side and an active demand side. It ends up getting us into the topic of governance because one of the things that can determine the success of a national economy or not is how that economy is governed. There's a broader conversation about where is the value of governance in crypto networks? And governance is a difficult topic because it is so broad. But I'll bring it even further back to the history of information technology. In the 50s and 60s, that era was based around the hardware. How quickly you could iterate on hardware and how quickly could you get computers in the market?

• 21:29Speaker 02

  And IBM won that war because they were able to design custom computers for custom use cases faster than anybody else. That business started breaking down in the 70s and 80s following the introduction of the microprocessor, which consolidated. A whole bunch of those circuits into a single part that was widely available. And that created two things. At first, it unbundled the hardware industry and we went from effectively one computer manufacturer to dozens of PC manufacturers and so on. But then what happened is that value moved one layer up to the software layer. And so we have Microsoft and the PC software boom of the seventies and eighties. We saw that get built on top of the microprocessor standard or platform. Fast forward to the end of the eighties and into the nineties.

• 22:13Speaker 02

  And we went from having dozens of independent software ventures to having Microsoft consolidating that entire ecosystem and building its business on the basis of proprietary software and proprietary distribution of that software. And what happened in the nineties is we got two things. We got the internet and we got Linux, which was free software and free distribution. And so that directly challenged Microsoft. And so we got into the web era where the value moved again one layer up to data, which is where we live today. We have the big tech companies of today, Google, Apple, Facebook, Amazon, and so on. Their main asset, their main capital asset is all the data that they've been able to accrue over time as people have used their service.

• 22:56Speaker 02

  So we've been in this stage for about 20 years now. And right on schedule, we get the arrival of a new open technology, which are blockchains that directly challenge the proprietary data business model, just as the internet and Linux challenged the proprietary software and distribution business model. It gets into a question of, okay, if we see this pattern of value moving one layer up, one layer up, one layer up, and we've gone from hardware to software and from software to data, and now data's free, what's above data? What's the layer that exists at a higher level? And to us, that's governance, because it becomes a question of how do we manage? How do we control? How do we manipulate the data? And how do we agree on a single source of truth, which is the whole thinking behind designing these consensus systems?

• 23:39Speaker 02

  The crypto networks, at the end of the day, are systems that we designed to arrive at a shared understanding of what is the right data to observe in a world where all the data's open. And ultimately, that is a governance system.

• 23:51Denis Nazarov?

  With that model, do you think the base layer, the computational substrate, does that become a commodity? How do you think about the value of the base layer and how governance of the base layer relates to the governance of the applications on top of it?

• 24:05Speaker 03

  I think we need to be careful of thinking of it statically because just as Joel just went through, there's this evolution of value capture that we saw with information technology. And I think we will see an evolution of value capture within crypto, where value will start to move up the protocol stack. Right now, we're focused a lot on developer protocols because we believe it's the developer era of crypto. And that's, those are the most valuable people and developer attention is the most valuable resource, I would argue, within crypto right now. And we may have this period of value accrual in developer-facing networks, which then may become commoditized and shift up to more consumer-facing protocols. But it's more that there's this evolution.

• 24:50Denis Nazarov?

  So how do you justify that more concretely? Like, for example, two transactions can use the same amount of gas. They could use the same amount of the computational resource of Ethereum, but their economic value can be drastically different. I mean, that brings a question of, there's sort of this tragedy of the commons problem that one user of the protocol derives way more value from this underlying substrate than another. We can compare the foundational layer of a blockchain smart contract platform and decentralized applications being built on top of it to general cloud computing infrastructure, you know, such as Azure or Google Cloud or Amazon AWS and all the applications, all the super valuable kind of unicorn applications built on top of it.

• 25:31Denis Nazarov?

  They all utilize this commodity layer and kind of pay for computation at the level of the resource. But the value they derive from the cloud platform is immensely higher. Hence, their market caps combined are much higher than the cloud platforms underneath them.

• 25:46Speaker 03

  So I don't think every Layer 1 protocol will capture a ton of value. I think most of them will get commoditized. And the ones that don't will be the ones that become these stores of value for these really important settlement protocols within the space. But I think that, you know, as we move up past that, we could see these middleware protocols actually have more scale than the underlying smart contract protocols. Start now with the developer, in the future with the consumer, but still largely in the protocol layer. And I mean, we're talking about a multi-decadal evolution here, but an evolution nonetheless.

• 26:18Speaker 02

  I have a different way of thinking about value, which is through the lens of cost. And this goes back to Econ 101. One of the first things they teach you is marginal benefit equals marginal cost at equilibrium. And Bringing that into the discussion of where does value accrue, then you can then extend that and okay, value will accrue to where there is the highest cost. And it doesn't really matter where in the layer that is. It matters more, what is the kind of service that's being provided and what is the cost of that service? And then the other dimension is scale. I think people sometimes confuse commodity with valueless. You can have something that is a complete commodity like milk and still get enormous amounts of scale that permit value to accrue at that layer regardless.

• 27:03Speaker 02

  As you move up the different layers or you start thinking about where does value accrue in different places, just bringing back the whole governance umbrella, making a decision, you know, what's the value of a decision? Well, it might be in precisely where they're implementing it in the governance over the standard and over the protocol over time, where perhaps over time, as the protocol becomes more important and the standard becomes more widespread, then the value or the cost of making a protocol decision increases over time because it affects a greater number of people. And so that's, that's one way in which you can kind of use the lens of cost to kind of chase down where value might accrue in different services or across an ecosystem.

• 27:44Speaker 03

  I think one helpful analogy with the, the governance space and value accrual from the perspective of cost, if you look at, for example, the United States, right? The United States has a fixed supply of one president, but the cost of being that president has grown over time as the network of the United States has also grown over time. And this is actually where I think fixed supply works in a governance token setting. If you have a fixed supply of that asset, but the cost and value of governing that network is going up, then so too should the cost per token of that asset. And so that's, that's a useful analogy for thinking through it.

• 28:23Denis Nazarov?

  And just thinking about America being a substrate for businesses built on top of it, the incentives there is that corporations that exist within America are taxed to fund that substrate, better infrastructure, you know, all kinds of services. And but, you know, to my earlier point, that there is no kind of economic relationship in the same way that there is in America between Ethereum, for example, and the applications built on top of it. You could imagine that there's some way in protocol to say it's an upgrade to ERC 20 standard, that, you know, 10% of the tokens every quarter.

• 28:58Speaker 02

  It's a tax that goes to fund the base chain. And maybe this is a way to solve the, you know, the problem of how do we fund innovation of the base chain?

• 29:07Speaker 03

  Right, right.

• 29:08Speaker 02

  I'm curious what you think of that.

• 29:09Speaker 03

  I think, you know, traditionally taxation is one of the mechanisms through which a currency can bootstrap value, right? And this goes back, for example, to the Shartelis theory, that the government has to spend the currency first and get it into circulation and then collect taxation. And so that kickstarts the economic flywheel. People are experimenting with different forms of taxation in the space. And really, a transaction fee is a form of tax. But we haven't seen direct taxation to fund core developers beyond the inflationary model, right? And that's really kind of taxation through seniorage or dilution. For example, there's Zcash or Decred or some of these networks that are working with this idea of,

• 29:52Speaker 03

  okay, part of the monetary policy, we're going to mint out over time and Decred allocates 10% of each Coinbase reward to the developer pool, which will be allocated through governance and the community's decisions around it.

• 30:05Speaker 02

  That's effectively a 10% tax. And same with Zcash, it's a 20, 30% tax. And because it's of the income, right? If you think of every time a new block is produced, that's income that's going to the miners. But 10% of that is coming back to development.

• 30:18Speaker 03

  It's an implicit, as opposed to an explicit, tax that then funds the network.

• 30:22Speaker 02

  You know, if you start thinking about governance first through the lens of this idea of taxation, you can think of your kind of analogy of we have a fixed supply of one precedent and then we can figure out how much it's cost to run for precedent over time and figure out, you know, what's the cost of that governance model. But there's something that we can observe more concretely, which is just a tax rate over time in world economies. And we have seen tax rates as a proportion of GDP increase over time as GDP increases because the cost of governing the economy grows together with the growth of the economy. And so how we can translate that into crypto networks is thinking through what is the cost of governing a crypto network and the cost of maintaining an economic system over time?

• 31:04Speaker 02

  And how does that change as that network grows or contracts over time?

• 31:08Jesse Walden?

  So again, we keep coming back to this conversation around different layers in the stack. And we did a whole podcast on this about how the emergence of base layer crypto networks are like cities in that there's a bunch of people that have a vested interest in the infrastructure upon which they're building and they're pulling it in different directions. But there's actually, at the birth of a lot of cities, there's not this like formal process for coordinating that. It just, you know, consensus emerges to this very rough process. A lot of these ideas around rough consensus and running code are from Venkatesh Rao's post on Breaking Smart, which we've referenced a number of times on the podcast and we keep coming back to. We also talked about sort of the emergence of internet standards.

• 31:48Jesse Walden?

  And specifically, the Internet Engineering Task Force was this loose group of academics and engineers that were working on base layer internet protocols. And they had this very formal policy to not have voting, but instead sort of weekly coordinated consensus mechanism whereby people argued their points with strong opinions. It was a sort of a robust and sort of scientific approach. And the best ideas were converged upon. So it's this idea that a rough consensus emerges from, one, strong opinions weekly held, to running code and in order to form those opinions. And that's very much the governance model of Bitcoin and Ethereum today. Other projects are taking a different approach with formal on-chain governance. I think our view is that the more general the network in terms of the service that it's providing,

• 32:33Jesse Walden?

  the more it lends itself to this process of rough consensus. And if you go all the way down the stack down to IP protocol, it's this very general protocol. It's completely unopinionated about the packets that it's moving from A to B. And the rough consensus process work there, it's very lightweight and easy to integrate. I would make the argument that general computation platform would lend itself to that same process because you wanted to do this very general thing and a thing that is very deterministic. It doesn't require human subjectivity to validate. Then, as you go further up the stack, there are applications built on top of the substrate. And as Dennis made earlier, it's like the businesses built on top of America.

• 33:16Jesse Walden?

  They, each of them are providing different services. They have, they require different expertise in order to provide those services. And I would make the argument that at that layer in the stack, governance does become important. The expertise requires specialization and these applications need to be more dynamic and responsive to their users versus general computation, which over time, you know, Should hopefully remain fairly consistent such that these applications can feel like they can build on top without the rules changing on them.

• 33:44Denis Nazarov?

  To add to that, there's really many factors that go into kind of governance decision processes that are informal. So I think that like one factor is the original roadmap of the project. Does this change fit within the original vision kind of outlined by both the founders and the community? So like in Bitcoin, there is a promise of 21 million Bitcoins. That is very important to it. Also, there's figureheads. Vitalik, for example, has very strong opinions. While people trust him, he is one of many voices in the community. And I think it's not dictatorial. He proposes changes and there's a debate and a conversation.

• 34:18Jesse Walden?

  So at the base layer today, in a platform like Ethereum, Ethereum is both the medium of exchange and the reward for the supply side of the network. And importantly, the governance process is this process of rough consensus where there is no default setting for upgrading the network. And this is sort of an important connection to draw because the users of the network have an active interest in how the network evolves. And so they are incentivized to participate in this process of rough consensus. Whereas an application built on top of Ethereum, that layer in the stack, the expertise required may necessitate that the management of this organization, whether it's a central company or loosely affiliated group of people all over the world, that those

• 35:01Jesse Walden?

  stakeholders have that expertise in order to make those decisions. And so I think this is a really critical difference. The base layer is very general. Users wanted to do this one thing and do it well, compute things in a deterministic way. But as you get further up the stack, it becomes a lot harder to reason about those mechanics.

• 35:17Speaker 02

  I've started to use the term power tokens instead of governance tokens to refer to tokens that represent the power to change the rules or change the makeup of a crypto network or at least one vote to change the rules of the crypto network. And one way that I like to describe it is that cryptoeconomics are the rules of the game and governance is the power to change the rules of the game. And my belief is that as the game becomes more valuable, then the power to change the rules becomes more valuable as well. And so that's the umbrella that I like to use to think through what's the value of power? What's the value of changing the rules of the game?

• 35:54Denis Nazarov?

  If power tokens were the only means of making decisions, it's sort of a very heavy-handed, specific tool that if manipulated incorrectly, it will lead to negative outcomes. But this more informal process through hard forks, you also, in addition to having checks and balances, where, as you mentioned earlier, there are different classes of participants, the miners, the developers, the users, sort of different bodies of the government, that developers propose the code. It has to be agreed upon by the miners to implement it. So it's a more multifaceted, multi-stakeholder operation as opposed to who owns the tokens gets to. And the other problem is it creates a default. So if the network automatically upgrades into some specific version of the code,

• 36:39Denis Nazarov?

  the catastrophic scenarios are much worse because everyone opts into a default. Whereas in this more weak consensus model, everyone has to agree in a broader way.

• 36:49Speaker 02

  I have a twist on rough consensus in running code, which is cryptic economic consensus in running code. And my take on it is, rough consensus works well when you're small and when the number of stakeholders is fairly small. When the IETF was working through these protocol iterations, you didn't have to find consensus amongst a very large group of people in terms of who is really affected by these decisions. Today, it's a completely different kind of dynamic where the underlying protocols have remained fairly stagnant and all of the innovation in terms of use cases has happened above where governance is a lot more fluid in the sense that each individual application can construct its environment or its system in the way they prefer. But bringing these ideas back to crypto, there's another model that I like to think about,

• 37:34Speaker 02

  which is on-chain governance, off-chain diplomacy. So by off-chain diplomacy, I mean every time that a core developer team meets with each other to make a decision or a user or an application of that protocol wants to lobby for a change, really the human process by which we arrive at proposals and ultimately decisions. You still have meetings between people debating and arriving at decisions and proposing different ideas. All sorts of issues can emerge, right? You can have concentration in the power token that enables It's a small group of people to really control the network. But you can have the same kind of dynamic today with rough consensus. If you don't have a formal process that allows everyone that they can participate in that process, you can end up with a clique that effectively governs the network

• 38:18Speaker 02

  through their own rough consensus and cuts out everyone else. Let's make sure everyone in the network has a fundamental right to participate in that governance process. And let's have mechanisms for people to get together and have sophisticated discussions about how decisions were made. But let's make them convince the community and convince the network that that is the right thing to do.

• 38:38Speaker 03

  I think also if you don't have formal governance mechanisms and clarity around it, you devolve into governance by defection. And we saw that with Bitcoin. We're not necessarily arguing for complicated governance. We're arguing for rules and transparency such that the network participants all understand not only what the rules are, but how the rules are changed.

• 39:02Jesse Walden?

  Yeah, I guess where we might diverge a bit is that we are arguing that the more general the service of a crypto network, the more it should be ossified. So again, coming back to this, IP is ossified, Bitcoin has ossified. Maybe a general computation substrate is better ossified because it lends itself to the trust that the developers building on top need in order to feel comfortable building there. However, those applications that developers build, because they're complex and dynamic and interfacing with end users, need to be able to change. And in order for them to do so, a formal governance process is probably necessary. The default is to take whatever the coin holders vote upon and upgrade the system.

• 39:45Jesse Walden?

  And so I think one of the assumptions is that the token holders participating in the vote and prior to that participating in the diplomacy are experts and have the best interests of their users in mind. Their interests are hopefully aligned with their end users.

• 40:00Speaker 03

  And they pay for it if they mess up through dilution.

• 40:04Jesse Walden?

  Right, that's right. And so the incentives are tightly coupled so that the experts make decisions for the benefit of their users and for the benefit of themselves. And you end up with this very dynamic system where the end users don't necessarily need to think about the complexity of the underlying mechanic of the thing. And importantly, there's explicit enforceability over one canonical group of contracts that control the system. And so the output of the governance process doesn't require, for example,

• 40:31Jesse Walden?

  End users or other participants in the network to download new software and run it.

• 40:36Denis Nazarov?

  The analogy of a blockchain is like we're traveling down a highway. And then we decide that we want to like take, take a turn, one of two turns into two different futures. You know, and that will be upgrading miners upgrade their software to a new fork version. What forks are in protocols is different than forks are on base layers. Like you can't fork in the case of a stablecoin because it has all this collateral. You can't fork the collateral because you, your DAP doesn't control that. You know, you are using the existing platform's collateral. So the upgrade process has to be different. In the governance debate, there's nuance in like what it means to upgrade a DAP that's running on Tower Proko and the protocol itself.

• 41:16Speaker 02

  You brought up the example of a computation network. It's a very well-defined kind of service. You know, a computer runs the code and the code has an output. If you focus on something more controversial like how value is distributed, then all of a sudden you find that the governance is really important.

• 41:30Denis Nazarov?

  But I'd also argue that power token voting excludes the needs of miners and the needs of users.

• 41:38Speaker 02

  That depends on how you design it. If you think of power as a source of value, then you want to make sure that that power is evenly distributed amongst the participants of the network. Otherwise you end up again where we are in the modern economy today with very few people with a lot of power and most people with not that much power.

• 41:53Jesse Walden?

  So just one, one thing I wanted to add is that one of the problems with thinking about on-chain governance as a sort of a way for users to actively participate in the evolution of a network is that in practice, if we look at the real world and how governance systems work, there's, there's actually very low participation. And this is because, you know, as an individual user, an individual voter, my one vote, my, my little say doesn't have all that much influence on its own. And so there's this apathy about participation. And so a assumption is that when we talk about users affecting or risking together and participating in governance is that they have some sort of emotional stake in the outcome of governance processes.

• 42:34Jesse Walden?

  And that may be the case in very niche applications where users, you know, feel a strong affinity to the application they're using. If I don't have a strong connection to participating in voting, maybe I'd be more likely to sell my vote to someone who does. And the result of that is the same risk that Joel described earlier, where the capital and the currency become disaggregated. And this could undermine on-chain governance processes. It's important to note that on-chain governance is really hard for a number of reasons. In the context of blockchains, it's very difficult to know who the participants are. You can be hundreds of people just by generating multiple keys. And so when you have this system that is synonymous, it's difficult to enforce

• 43:17Jesse Walden?

  behavior patterns that lead to good governance, say in shareholder governance, where shareholders are bound by fiduciary law. There's a great post by a researcher at Cornell, who we recently had on the podcast, named Phil Diane, and he went deep down the rabbit hole into different attacks that you could launch.

• 43:33Speaker 02

  The rise of dark DAOs?

• 43:34Jesse Walden?

  Yeah, the post dives in deep, and our podcast does as well, on different attacks that you can launch to bribe participants in on-chain governance schemes.

• 43:43Speaker 02

  I think a lot of arguments against on-chain governance are primitive in their thinking around how is that governance applied. One common element of a lot of the counter-arguments is the assumption that governance power is linear, and one token equals one vote. Whereas in crypto networks, we have the opportunity to design much more intricate systems with much more intricate rules. And so, yes, you can replicate yourself across 1,000 different addresses. Well, you can make it such that your governance power is amplified if you have all your tokens in one wallet. And so you can make it actually more powerful to basically voluntarily disclose, still within this synonymous system, how much of the token you have, because you get more power by aggregating your assets together. And you can change

• 44:27Speaker 02

  how that, the shape of that curve, depending on the context. You can also do things like look at the age of an address. One thing that we learned actually from a non-crypto company that was in the online community abuse space is that the length an account has been open is the greatest determinant of whether it's a troll or not. And so you can use things like the lifespan of an account, or of a wallet, or the tokens that it received. And you can even make distinctions around whether the tokens in that wallet were purchased from an exchange, or were received directly through mining. And you can factor all of those things into how you design, let's call it, your governance curve.

• 45:02Jesse Walden?

  Right. And maybe those are all examples of on-chain reputation that's sort of native to the system.

• 45:07Speaker 02

  Exactly.

• 45:08Jesse Walden?

  So yeah, thank you guys very much for coming on. It's been awesome sort of recapping the space and how it's evolved over the last few years and super excited to see how our thesis play out over the years going forward. Well, thanks for having us. Thank you, everyone.