UNDERSTANDING BLOCKCHAIN INNOVATION

Blockchain Coinvestors Letter from London

Vol. 1, No. 5, November 2022 

UNDERSTANDING BLOCKCHAIN INNOVATION

Before diving into this month’s Letter from London, we want to comment on the recent news and events surrounding FTX, Alameda, and FTT.

 

While the exact details remain unclear, we can say that at best FTX was a horrendously managed firm, and at worst a full-fledged fraud. It will take years to unwind and resolve the web of creditor claims and litigation spanning the more than 100 insolvent entities and perhaps as many as 1 million creditors. The psychological blow to the public liquid crypto market writ large is substantial, and the damage to its reputation will take time to repair.

 

Needless to say, there are also second order reputational implications for blockchain as an innovation, although the press coverage continues to confuse crypto trading with blockchain technology, and seldom addresses the seismic shift we are witnessing to digital monies, commodities, and assets – they are not equivalent of course. In fact, right now we are in London at Digital Assets Week with 200 of the world’s largest banks, asset managers, exchanges, and payment companies; these industry insiders continue to lean in and are actively driving toward digital commerce. This is the core of our own investment thesis.

 

Meanwhile, we are saddened by the devastation to FTX’s everyday customers, many of whom used FTX as their entry point to the digital asset ecosystem. Bad actors and bad practices are too common in finance and investing, and we fully support best practices - including appropriate regulation - that always focuses on their elimination. It is time for lawmakers to constructively provide guidance and not simply regulate through enforcement.

 

However, as investors, we are well prepared, and plan to be disciplined and also opportunistic. Most of our funds sit in dry powder and downturns are always good times for the best early stage investors.

We should also remind you that Fund III (Fund of Funds) will hold its final closing this month so please let us know at ir@blockchaincoinvestors.com if you want to participate or raise your current commitment level.

 

* * *

It is in that vein that this month’s Letter from London overviews some of the key innovations we have seen in blockchain recently, with particular focus on scaling blockchains. These innovations demonstrate how we have line of sight to the next phase of digital monies, commodities, and assets.

 

As we overview below, blockchain technology has innovated at a staggering pace in recent years. In particular, we focus on (i) modular blockchains, (ii) scaling solutions, and (iii) the Ethereum Merge. As you will see, the capacity for a decentralized, secure, and scalable financial infrastructure is close upon us. We hope that gives you our same level of optimism in these uncertain times.

 

The Modular Blockchain Thesis

 

A.  The Scalability Trilemma

 

Not all blockchains are made equal. In fact, blockchains vary significantly in their architecture, economic model, and method of validation among many other parameters. However, all blockchains face the “Blockchain Scalability Trilemma”, in that there is an inherent trade-off between decentralization, security, and scalability – in short, blockchains appear to be only able to guarantee two of the three at any given time.

For instance, the Bitcoin blockchain is currently decentralized and secure, but has not achieved scale, as the transactions per second remain low and the cost remain high. Other blockchains, such as Binance Smart Chain, have increased the technical requirements to run a validating node, which has significantly increased the scalability of the chain, and reduced its costs. However, decentralization has been compromised, as the chain only has 21 validating nodes, many of which are run by Binance itself. This compares to Bitcoin which has more than 10,000 validating nodes - a far more decentralized system.

 

One of the reasons we believe in a multi-blockchain future is that we expect fundamental design choices along these three dimensions will make each blockchain fit for specific use-cases but not for all.

 

B.  The Key Functions of Blockchains

 

The next level of architecture necessary to understand are the four key functions of blockchains: execution, settlement, consensus, and data availability.

  • Execution refers to how transactions and state changes are processed. This is the layer that users usually interact with as they sign transactions, deploy smart contracts, and transfer assets.

  • Settlement refers to the layer where blockchain activity is verified and disputes are resolved.

  • The consensus layer provides the ordering and executing of the contents of the blocks by reaching agreement on the validity of the state transitions.

  • Data availability refers to the data required to verify that a state transition is valid.

Bitcoin and Ethereum (in its initial conception) are monolithic blockchains – meaning that they do all their security, data availability, consensus, and execution themselves. However, as you will see below, there is a growing school of thought called the “modular blockchain thesis” which states that by separating the components of a Layer 1 blockchain, we can make significant improvements on individual layers, perhaps breaking away from the constraints of the scalability trilemma.

 

C.  Monolithic vs Modular Blockchains

 

Modular blockchains provide one or more of the functions of a blockchain, but not all four. This blockchain architecture may solve the blockchain scalability trilemma through the principle of separation of concerns. Through a modular execution and data availability layer – in other words a separate chain which handles either data availability or execution, or both – blockchains can scale throughput while at the same time maintaining properties that make the network secure and decentralized. This breaks the correlation between computation and verification cost of transactions while keeping resource requirements low. In short, you may scale without giving up decentralization nor security.

The modular blockchain thesis emerged due to the scalability limitations of the Ethereum blockchain. Consequently, ‘layer 2’ solutions are now being utilized to separate the execution layer while continuing to use the Ethereum chain, or ‘layer 1’ chain, for consensus, data availability, and settlement.

Why is this the case? Simply put, monolithic blockchains may be limited in their design. Consider scalability for instance. This is the ability of a blockchain to handle increasing volume. There are two ways to improve scalability. You can increase the block size, and therefore the overall capacity that can be managed. However, larger block sizes increase the hardware requirements of running a full node, and as we noted above you must consequently sacrifice decentralization. Alternatively, you can move execution ‘off-chain’, shifting the burden away from the main network. Below, we outline the two emerging scaling solutions – deemed layer 2 scaling – which take execution off of the main layer 1 chain.

 

Scaling Solutions

 

A.  Rollups: Optimistic vs Zero-Knowledge

 

As mentioned earlier, separating the components of a blockchain can yield great results, and one way to achieve this is through bundling transactions into batches, or ‘rollups,’ to be executed off of the main chain. Rollups come in various forms, but at their simplest, rollups only handle execution while relying on a different (the ‘main’) chain for security, consensus, and data availability. In other words, they work by moving transaction processing off the base/main chain while ensuring storage of transaction data on the original chain, thereby facilitating security from the layer 1 network. Validators manage the data and submit the collections of highly compressed transaction data to the main chain.

 

Two of the most common and exciting innovations in blockchain technology are optimistic rollups and zero-knowledge rollups. Zero-knowledge (or ‘ZK’) rollups batch and process transactions as compressed blocks back onto the base/main chain, utilizing cryptographic proofs to prove transaction validity. Optimistic rollups do the same, but by assuming that all transactions are valid ‘optimistically’ then providing rewards for fraud checks within a subsequent time period.

While we won’t go deep into the technical differences, the table above provides a thorough overview of the differences between ZK and optimistic rollups. Both types of rollups have made incredible technical gains in the past year. Some notable optimistic rollups include Optimism and Arbitrum while notable ZK rollups include StarkWare and zkSync (Matter Labs).

 

B.  The Future of Blockchains

 

We should also point out there is a new breed of Layer 1 blockchains with no execution layers, solely focused on providing data availability for other chains. These blockchains have their own consensus protocols for data and on their own are useless, but when leveraged by other execution chains (such as the rollups mentioned above), can be incredibly valuable. For instance, Celestia is aiming to offer both consensus and data availability to projects that handle settlement, and especially execution layers. Thus, potential users of Celestia include rollups, as they are designed to achieve scalability by managing the execution of transactions on a separate chain.

 

How about Ethereum? While most transactions today still occur on the Ethereum main chain, the Ethereum roadmap now anticipates most transactions will ultimately occur on layer-2 rollups, like optimistic or ZK rollups. The rollups in turn are relieved of the responsibility of consensus and data availability, which will still occur on Ethereum. Hence, while Ethereum started as a monolithic chain, it now can be considered a modular blockchain utilizing the scaling solutions noted above.

 

The Ethereum Merge

 

Finally, we turn to the much written about Ethereum Merge, which while not directly connected to the modular blockchain thesis, was a significant part of Ethereum’s roadmap and an important development for the industry. After many years in the making, the ETH Merge was finally completed this year on September 6th. To put it into laymen’s terms, a complex software protocol and body of code was fully upgraded, while in operation, with no outages or apparent issues. An equivalent analogy would be Microsoft attempting to upgrade all of its software on the fly and doing it without issues for users and developers.

 

But what exactly was the Merge?

 

A.  Proof-of-Work vs Proof-of-Stake

 

Let’s start with the basics. The beauty of a public, permissionless blockchain like Ethereum or Bitcoin is that there is no central authority or gatekeeper. But by logical extension this also means that there is no single source to validate transactions. For any blockchain based cryptocurrency to work as a payment system, there needs to be a way for transactions to be validated and for the famous ‘double spend’ conundrum to be accounted for. This is where the proof-of-work and proof-of-stake consensus mechanisms/models come into the picture.

 

In proof-of-work, thousands of server farms across the world are dedicated to solving mathematical problems to verify transactions on the network. We needn’t get into the minute details of block headers and hashing, but what you need to know is that in proof-of-work ‘miners’ use computational power to solve complex math problems to verify transactions on the network. The miner that solves the problem first validates the block of transactions and is rewarded accordingly (with the block reward and transaction fees). However, this requires a huge amount of computing power and, thus, electricity. While the issue is complex and we will revisit on another day, the vast quantity of electrical consumption has negative impacts on the environment in most contexts.

 

In the proof-of-stake model, miners are not solving complex math problems on large server networks, but rather the validators are selected out of a pool of those who ‘stake’ ETH in a smart contract. Staking is jargon for taking Ethereum you have and committing it to the network. An algorithm then selects a validator based on the amount of ETH they have staked. Thus, the more a validator stakes, the more likely they are to be chosen as the validator of a specific block. Once you are selected and validate the transaction, you are rewarded with newly minted ETH. Consequently, if you are found to be a bad actor, your staked ETH can be ‘slashed’ or taken by the network. This process incentivizes participants in the network to remain good actors.

 

B.  The Merge

 

In short, the ‘Merge’ was a long-awaited plan to transition the Ethereum blockchain away from the proof-of-work consensus mechanism to a proof-of-stake consensus mechanism. The term merge comes from the fact that the Ethereum community was running a side chain to test proof-of-stake and the transition of the main chain to proof-of-stake occurred when these two chains were ‘merged’.

 

With the ETH merge now complete, there are several purported benefits to the network. The first of which is a reduction in energy use. It is estimated that under the proof-of-work model, a single ETH transaction was consuming as much energy as a US household does in a week. However, with a shift to proof-of-stake, the ETH network will use 99% less energy. Beyond just lower energy usage, post-Merge Ethereum will also now generate a yield (currently approximately 4% to 6% annually) to those staking Ethereum. By giving staking yields on Ethereum, the network theoretically grows more secure because the system rewards honest validators whilst punishing dishonest validators.

 

The View from London: Our Key Takeaways

 

We’ve summarized some of the most important themes in blockchain innovation at this time; however, for us the key question is what does this mean for our investment thesis and strategy. Here are some of our key takeaways:

 

A.  Blockchains on Precipice of Achieving Necessary Scale

 

Global commerce will digitalize, this much is inevitable. Just as information was digitalized with the advent of the internet in the early 90s, the overwhelming tailwind is for monies, commodities, and assets to travel on natively digital rails. When the Bitcoin blockchain completed its first block in January 2009, the technological infrastructure for a digital financial system became a technological inevitability. Yet, blockchains hitherto have remained in their initial phases, and consequently have been unable to achieve necessary scale without sacrificing important tenants of decentralization and security.

 

Prior to the merge and the modular thesis, the Ethereum blockchain was able to execute about 20 transactions per second and Bitcoin about 3-4. This compares to PayPal at 193 t/s and Visa at 1,667 t/s.  Yet, at the same time, Ethereum was already settling more value than Visa; Ethereum settled $11.6tn in 2021, surpassing that of Visa at $10.4tn.

 

With the vast strides made in the modularization of blockchains and corresponding leveling up of scalable rollups, we can also now see, for the first time, line-of-site to blockchains that are fast and efficient, and that which can underpin a global financial system. 

 

B.  Rightly or Wrongly, the Ethereum Merge Removes a Key Hurdle for Mainstream Adoption

 

While we don’t necessarily agree with every critic of proof-of-work blockchains, we cannot deny that ESG concerns will sit front and center in every large institution’s financial decision-making in the years to come. Exploring the impact of proof-of-work on the energy grid is complex and nuanced and hence we will leave that topic for a future report. However, by switching to proof-of-stake, Ethereum has side stepped what was one of the most common arguments heard against blockchain based systems. Quite simply, Ethereum now will use little energy and hence should assuage both large institutions and everyday consumers who were previously concerned about the carbon footprint of this protocol.

 

C.  Rapid Innovation Continues through a Bear Market

 

Despite the drawdown in both traditional equities and public liquid token prices, innovation in the early stage of blockchain remains robust. As we’ve noted before, the world’s largest institutions are leaning heavily into the space as the inevitability of digital monies, commodities, and assets becomes clear. The Merge represented one of the greatest technological transitions carried out via open source, public software to date. Great projects are finding funding and rolling out product rapidly. It is a cliché - for a reason - that during downturns builders build and early stage venture investors benefit.

 

For those watching closely, there’s a lot to be excited about.

Thank you for reading.

Mitchell Mechigian, Partner

London

ABOUT BLOCKCHAIN COINVESTORS

 

Launched in 2014, our vision is that digital monies, commodities and assets are inevitable and all of the world’s financial infrastructure must be upgraded. Our mission is to provide broad coverage of the emerging unicorns and fastest growth blockchain companies and crypto projects. Our investment strategy is now in its 9th year and has to date invested in more than 40 pure play blockchain venture funds in the Americas, Asia and Europe; and in a combined portfolio of 400+ blockchain and crypto projects including approximately 60% of all blockchain unicorns. Our funds rank in the top decile amongst all funds in their respective categories on both Pitchbook and Preqin. Headquartered in San Francisco with a presence in Grand Cayman, London, New York, Zug and Zurich, the alternative investment management firm was co-founded by Alison Davis and Matthew Le Merle.

FUND PERFORMANCE

 

Blockchain Coinvestors Fund III (Fund of Funds) was created to provide diverse coverage of the best blockchain pure play venture funds in the Americas, Asia, and Europe. Blockchain Coinvestors Funds I and II have already experienced significant appreciation. Fund I Net TVPI is 4.82x with an IRR of 67%. Fund II shows equally impressive early results with Net TVPI of 1.42x and an IRR of 42%. Almost all of our fund investments are performing as top quartile against the Cambridge Associates Venture Benchmark.

BLOCKCHAIN COINVESTORS FUNDS

Blockchain Coinvestors’ goals are to provide broad coverage of the emerging unicorns and fastest growth blockchain companies and to capture superior returns from investing in the leading blockchain venture partnerships. Our funds are open to investors that meet the Qualified Client definition with a minimum subscription level of $250,000 at the discretion of the Manager. 

 

  • Blockchain Coinvestors Fund III (Fund of Funds) was created to provide diverse coverage of the best blockchain pure play venture funds in the Americas, Asia, and Europe. Blockchain Coinvestors Funds I and II have already experienced significant appreciation. Fund I Net TVPI is 4.82x with an IRR of 67%. Fund II shows equally impressive early results with Net TVPI of 1.42x and an IRR of 42%. Almost all of our fund investments are performing as top quartile against the Cambridge Associates Venture Benchmark.

  • Blockchain Coinvestors Fund IV (Early Stage Token) provides direct access to promising private stage token projects accessing our relationships with many of the world’s leading blockchain investors. We leverage asymmetrical information from our 40+ VC Funds to pick the most attractive opportunities. This is a continuation of the direct token investing strategy of the Fund Manager that has included private stage investments in Acala, Filecoin, NEAR, Polkadot, Structure, and others.

  • Blockchain Coinvestors VI (Mid Stage Growth) provides direct exposure to the emerging category leaders in the blockchain and crypto ecosystem. The fund leverages our unique sustainable competitive advantage (USCA) in blockchain, web3, and fintech to create a concentrated portfolio of between 20 and 30 investments with attractive return profiles and visible paths to liquidity. The fund assesses the more than 400 blockchain and crypto projects in which we are direct and indirect investors and employs a robust investment framework to select investment opportunities into the leading mid stage growth rounds - typically Series B, C and D. This is a continuation of the mid stage investing strategy of the Fund Manager that has included investments in Bitwise, Brex, InfiniteWorld, Securitize, Uphold, Wyre, and others.

Please visit the Blockchain Coinvestors website to learn more about our offerings. You can also reach our Investor Relations team directly at ir@blockchaincoinvestors.com.

BLOCKCHAIN COINVESTORS SWISS

We are excited to announce that Blockchain Coinvestors Funds are now available through Swiss certificates for those of our non-US investors who prefer this approach. The underlying fund is the same, however, our Zurich based team at Blockchain Coinvestors Swiss, who will introduce in future weeks, can provide detailed information regarding this investment option. Email us at mlemerle@blockchaincoinvestors.com to learn more.

BLOCKCHAIN COINVESTORS ANGELLIST SYNDICATE

Continuing the theme of the democratization of investing, we have a rapidly growing Blockchain Coinvestors syndicate on AngelList providing access to selected coinvestments. Please join us and our partner Lou Kerner on AngelList.

Click here to receive the insightful weekly crypto newsletter and webinar invitations from our Blockchain Coinvestors partner Lou Kerner.

REGISTER NOW FOR UPCOMING WEBINARS AND CALLS

 

Our investment team hosts regular webinars and calls to help educate our community about the Fifth Era, fintech, blockchain and crypto. We discuss important trends, tailwinds and investment themes including what we have learned and how we are using our knowledge to inform our own investment thesis and actions. Below is a list of upcoming webinars for which you can register by clicking the links:

 

Meet the Blockchain Unicorns - Year-End 2022

- December 5th, 7:00am PT
- December 5th, 12:00pm PT

 

2022 Year-End Wrap Up

- December 19th, 7:00am PT
- December 19th, 12:00pm PT

 

Recordings of past webinars and calls can be found at www.blockchaincoinvestors.com/webinars.

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