Blockchain Moats

Warren Buffett popularized the idea of an economic moat – the ability to maintain competitive advantages over competitors and build long-term defensibility.

Web 2.0 companies built moats around centralization and taking fees on centralized data. Blockchain moats are important to understand as they follow a different set of rules because of decentralization and a shared data layer.

The biggest leverage for decentralized projects is to align incentives across all stakeholders. For the first time in history, we have decentralized communities that can exceed the impact of centralized organizations.

I first started thinking through moats from my experience building Skillshare, which is a website to stream 20K+ online classes. We had to take strategic bets that would both differentiate us from our competitors, and allow us to win in the long-run.

Since Skillshare is a marketplace, we benefitted from two-sided network effects. As we added more classes, it would bring more users, which would bring in more teachers, and vice versa. This flywheel got stronger as we got bigger.

Eventually, we started to also focus on data network effects. As more users used the product, our algorithms and recommendations got stronger, creating a better product experience. This ultimately led to us building a strong brand.

These three factors: network effects, data, and brand make up our moat and ultimately how we believe we will win in the long run.

Similarly, other web 2.0 tech companies focused on data network effects. The more data your product creates, the better your algorithms, and the better the overall product experience. By owning as much data on each user, you can target better ads (e.g. Facebook), create better recommendation algorithms (e.g. Spotify), or build an entire ecosystem of apps (e.g. Apple).

But when code is open-sourced and data is shared and decentralized, how does a blockchain project win in the long-run? Multicoin Capital highlights this in “Good Artists Copy, Great Artists Steal.”

“The logical conclusion is that the key to long-term, sustained success is go-to-market strategy and execution, and that technology and product are almost irrelevant.”

If technology, product and data were important components pre-blockchain, what are the most important factors today? Obviously, creating barriers to entry, high switching costs, and aligning incentives are important. These are table stakes.

We believe the following strategies will allow blockchain projects, protocols, and companies to build a long-term competitive advantage and moat. (This is not an exhaustive list but we tried to limit it to five for this article.)

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Network Effects

According to NFX, 70% of value in tech is driven by network effects. The concept of a network effect is pretty simple: the network becomes more valuable as more people use it.

“It turns out that having a network effect is the single most predictable attribute of the highest value technology companies — other than perhaps “having a great CEO.”” – NFX

There are many different types of network effects, including marketplace, platform (two-sided), and data network effects.

For crypto-networks, there are protocol network effects (declaring the communication standard), token network effects (aligning incentives to accelerate both the growth of the network and token appreciation), monetary network effects (positive feedback loops between liquidity and value), and security network effects (highest hash rate equals the highest security), resulting in the Lindy Effect.

“A Protocol Network Effect arises when a communications or computational standard is declared and all nodes and node creators can plug into the network using that protocol.”

Once a protocol has been adopted, it is extremely difficult to replace. As more and more participants use this declared standard, it also becomes extremely defensible. For example, Ethereum has ERC20, ERC721, among many other standards. Therefore, the most effective route of getting wider adoption is by building a developer community who adopts your protocol standards.

One of my favorite examples is 0x, which is an open, permissionless protocol allowing for ERC20 tokens to be traded on the Ethereum blockchain. Rather than building a decentralized exchange on top of their own protocol, 0x focuses on developer adoption. As more decentralized exchanges use 0x, the shared liquidity pool gets stronger, which is a reinforcing flywheel that gets more powerful as 0x scales. Today, 0x has the following projects building on top of their protocol: These network effects contribute to the creation of monopolistic, winner-take-all (or winner-take-most) dynamics.

Ecosystem

“The ecosystem is a network effect of products/services that a company offers that generate synergies that allow them to dominate a market and move into other adjacent markets.” – Wiley Jones and Niraj Pant

Everything starts with the community. This community can adopt new protocol standards and build a new ecosystem. Or, the community can sell tokens to push the price down, which limits network effects. Therefore, it’s vital to build a strong culture around your community that is transparent.

Once standards are adopted, and a community grows, an ecosystem gets built out. Ecosystems are important because it lowers the barrier of entry while allowing for a robust set of apps. Couple this with a shared data layer and it’s hard to leave an ecosystem that isn’t fully built out.

The difference between Ethereum (open blockchain) and Hashgraph (private blockchain) is the ecosystem that builds around it. For example, if one were to integrate a security token as an ERC-20 token then it would also have access to the entire ecosystem:

Rather than building out each infrastructure, a new company could plug in immediately. This further locks-in users to the protocol and strengthens network effects.

Most users don’t care which protocol is being used. But it’s important to attract both entrepreneurs and developers to build apps to give users a great experience.

Governance

Governance is a system for managing and implementing changes to protocols. With the right governance mechanisms, anything is possible. For example, Decred creates a system of check and balances between all of the participants in the network: users, miners, and developers.

“Decred’s killer feature is good governance, and with good governance, you can have any feature you want.” – Placeholder

Most projects start off centralized with reliance on the founding team. But as a project scales, it shifts to the community as it becomes more and more decentralized.

Participants are given voice through community governance, both “on chain” (via the protocol) and “off chain” (via the social structures around the protocol).

These communities and protocols evolve under collaboration, consensus, and coordination. When there’s contention or disagreement, participants can exit by selling their tokens or forking the protocol. When a fork happens, it’s not just forking the code, it’s forking the community.

Governance is the key to keeping a community in-tact and is what gives a token value. The benefit of the blockchain is that its trustless but the challenge is in  cooperation. In the end, it’s all about coordinating people towards the same goal. 

Compliance

There is a reason that Coinbase is one of the most successful companies within the space – nearly 20% of Coinbase employees work in the compliance group.

Coinbase is the most compliant in the eyes of regulators. This creates a significant advantage as it’s a huge barrier to entry. It’s very costly and time-consuming to be regulatory complaint. Coinbase has created trust through compliance, which also has an added benefit of building a strong brand.

This week, Square was approved for a BitLicense, which allows them to serve customers in the state of New York. They are only one of seven companies that have been approved. The other companies include Circle, Ripple, Coinbase, bitFlyer, Xapo, and Genesis Global Trading.

Brand

By developing a trusted brand and reputation in an otherwise murky space, Coinbase has become the de facto way to access digital currencies.

The brand that you build is important because it invokes trust, recognition, and leadership in a category. Building a trusted brand is a hard thing to build and very hard to displace. But, it can quickly evaporate if your customers lose trust.

For example, Quantstamp was under fire for taking fiat and ETH, instead of their native token. The community believes that the team has been undermining the value of the token it used to raise millions. It’ll be a long road for Quantstamp to rebuild the trust that was lost. It’s possible but won’t be easy.

A strong brand can help accelerate (or decelerate) network effects by bringing more participants into the ecosystem.

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The moat that you create is only as big as many people that you ultimately reach. Once a project hits critical mass, it becomes much easier to recruit developers, partners, and investors.

However, it’s not enough to just have one of these strategies to build a moat. It’s the combination of the interlocking pieces that creates long-term defensibility. For example, having a  strong transparent brand helps build trust within the community, which allows them to be properly governed, which allows changes to the protocol that accelerates both growth of the network and token. By building an end-to-end solution, it’ll be extremely hard for other competitors to replicate these interlocking pieces.

The teams and organizations that can excel at all these areas will build long-lasting organizations, networks, and communities that will propel the space.

Thanks to Linda Xie (Scalar Capital), Paul Veradittakit (Pantera Capital), and Felix Feng (Set Protocol) for reading early drafts of this article and providing thoughtful feedback.