Missing out on the tech-market fit

[Note: the views expressed below are solely my own and do not necessarily represent the views of my employer or any organization I advise.]

One oft-repeated claims from venture capitalists, such as Fred Wilson at Union Square Ventures who have gone “all in” with cryptocurrency-specific investments, is that “banks need to give bitcoin a chance.”

The problem with this claim is that it shows a lack of market intelligence.  Over the past 24 months, banks and many other types of financial institutions have worked on more than 200 proof-of-concepts (PoCs) and pilots with dozens of companies big and small.  Most of these experiments were conducted using a fork or clone of a public blockchain or even a cryptocurrency such as bitcoin or ether itself.

In other words banks and other financial institutions have given Bitcoin many chances and probably many more in the future.

But nearly all of the PoCs have been rejected and will continue to be rejected not because banks have a reflexive knee-jerk reaction due to Bitcoin’s perceived stigmas, but because Bitcoin was intentionally not designed to solve problems that banks have.

Typewriters and airplanes

Consider the typewriter analogy.  At one point in the mid-20th century, there were dozens of typewriter manufacturers shipping millions of kit each year.  Yet irrespective of the anachronistic enthusiasm that VCs who like typewriters may have, it is unlikely that banks will acquire large quantities of typewriters in 2016.  Not because banks don’t like typewriters or haven’t given typewriters a chance, but rather, typewriters as they currently exist, do not solve many problems that banks actually have.

As a consequence, there is a visible misalignment between the supply of startups funded by many of the VC firms that advocate cryptocurrency-specific solutions, with the services and solutions actually needed by regulated financial institutions.  For instance, Wilson’s current USV current portfolio consists of several Bitcoin companies whose business models largely depend on:

(1) continued price appreciation of bitcoin; and/or

(2) massive adoption of bitcoin demand itself.

While I certainly do not speak for the financial service industry, over the past year I have spoken to hundreds of directors and managing directors at highly regulated financial institutions.  And by and large, their pain points and problems are not solved by a cryptocurrency.  After all, they already have access to dozens and in many cases, hundreds of different financial instruments and assets.  As a consequence, cryptocurrencies alone do not provide the utility that certain VCs think it does for the financial industry.

For instance, at R3, we have spent over a year sitting down with many disparate financial institutions to find out what their internal problems are, gathering copious amounts of functional and non-functional requirements along the way.   We have done our homework on what various platforms can and cannot do, publishing many of the findings to our members and to the public as well.

In contrast, Satoshi probably did not conduct that type of sector specific due diligence in 2007-2008, the time frame he purportedly worked on Bitcoin.  Or if he did, he didn’t publish it; nor have VCs since.  In point in fact, the original white paper was not an architectural design document to rework back office, post-trade systems for banks.  Rather, it was a design document explaining how pseudonymous participants could try to become their own sovereign banks without the need for using existing institutional or legal infrastructure.

Another salient analogy are heavier-than-air aircraft.  Neither Airbus nor Boeing reuse the same design or materials that the Wright Brothers did in 1903 in order to build planes in 2016.

Instead, these modern aerospace companies build customized, fit-for-purpose vehicles that specialize in certain tasks, conditions and environments — and are often made of materials that didn’t exist 100 years ago.  Consequently, enthusiastic VCs that fund startups which build copies of the Wright Flyer are probably not going to find much market demand outside of museums.

What does this have to do with the world of blockchains?

Public blockchains, such as Bitcoin, were designed for an environment in which unknown and untrusted parties could attempt to interact in an anarchic system.  Bitcoin, through its intentionally expensive mining process, allows it to route around regulated gateways and purposefully eschewed any native method for complying with KYC, AML and other government mandated provenance requirements.

In contrast, banks and other financial institutions must, by law, know who all parties of a transaction are as all interactions are tied back into the traditional legal environment. And if you know who the participants to a transaction are — by connecting legal identities to them — then the tools and processes needed for this compliant environment are completely opposite to the design constraints and threats that cryptocurrencies are built around.

Training wheels and open fields

While a recent Bloomberg op-ed used a false equivalence – equating public and private blockchains as being able to provide the same utility – the bigger flaw with the op-ed was that it described private blockchains as “training wheels” for banks.

Public and private blockchains, as described above, were designed for different discrete purposes.

To use another aerospace example: calling private blockchains as a type of “training wheel” would be like saying that an A380 is a “training wheel” for commercial cargo air fleets that should instead, for some reason, be solely comprised of F-18s.  Both types of planes were built for different purposes, for different environments and with different operational constraints.  Because of tradeoffs, neither plane can do it all and there is no shame in that.

Similarly, the usage of the word “open” is being misused by Mr. Wilson and others.  Public blockchains are not “open” like the internet.  In fact, the internet is an amalgamation of intranets (ISPs) with peering agreements and a patchwork set of governance mandates which typically includes fulfilling some kind of gating and KYC mandate.  Yet despite the fact that the on-ramps and off-ramps of the internet are permission-based, creative inclusion continues to flourish because all participants leverage the utility of an open, shared standard: TCP/IP.  Bitcoin is not TCP/IP, rather, it is one instantiation, one application of what a blockchain can be look like.

Similarly, once a common shared ledger standard and fit-for-purpose platform is created for financial institutions, after the permissioning of users and most importantly — validators — is done, the ecosystem that plugs into it could see the flourishing of innovation including increased financial inclusion due to harmonized and mutualized utilities.  In other words, rather than having to spend $450 million a year to operate a network of miners to create unneeded pseudonymous consensus, financial institutions can and will participate in robust platforms that solve their business cases and simultaneously align with traditional legal requirements.

Conclusion

Cryptocurrencies such as Bitcoin do not and cannot do many of the things that many VCs and vocal enthusiasts claim it can.  For instance, public blockchains weren’t designed to provide definitive legal settlement finality anymore than F-18s were designed for crop dusting.  Bitcoin wasn’t designed to provide the types of utility regulated financial institutions require and changing Bitcoin to be customized for this relatively alien environment, not only breaks its pseudonymous utility but also its anarchic security assumptions.

Instead of haranguing prospective customers for not buying a product they don’t want or need – or attempting to shoehorn everything onto one niche blockchain – why not cultivate and partner with those who build solutions that solve business cases for a known customer base?  Other VC and strategic investment firms familiar with the pain points of financial institutions are now cultivating startups based on market demand, the fruits of their labor will begin to blossom in the coming years.

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