Revolution of ownership – introduction to the business opportunities of Ethereum and decentralized applications
Vilppu Messo
Cryptocurrencies, decentralized finance, bitcoin, blockchain…Most of us are familiar with these buzz words. Still, I hypothesize that many of our readers have a skeptical view towards the blockchain technology. I assume this is because they are traditionally seen as an alternative for the currencies we trust in. This is natural since most of our jobs and entire lives are based on the stability of the money market. However, blockchains are much more than cryptocurrencies. In this article, Vilppu Messo explains how blockchains can be used to build, grow and own companies more efficiently than we are used to in the status quo.
This article aims to provide a useful framework for thinking about the Ethereum blockchain and decentralized applications. The reason Ethereum was chosen for this article is its leading position as a fully programmable blockchain. Ethereum has been live since 2015 and most decentralized applications are currently built on Ethereum.
Introduction to Decentralized Finance (DeFi)
Bitcoin whitepaper was published in 2008. This pioneered new ways to build and maintain databases without a need for central custodial. At the same time, it gave birth to a new kind of currency. The bitcoin blockchain is a specialized solution for storing and transferring monetary value. It’s a simple, but a very effective and secure system. Ethereum blockchain builds on top of this technology. Unlike Bitcoin, Ethereum supports advanced programming languages like Solidity. This means that software applications can be created and run on Ethereum.
Before blockchain, most use cases on the internet have required third parties to manage private databases. Think Facebook for example. Facebook relies on the ability to collect data from its users. It allows Facebook to create specialized and user-friendly applications. The problem is that this kind of data aggregation leads to data monopolies. These companies can use, restrict, and censor the data as they see fit.
With Ethereum and Bitcoin, information is stored using an open and global network of computers, which enables the following things:
Censorship resistance. Open, immutable, rules are hardcoded into the applications.
Owners of an alternative to Twitter, built on Ethereum, can’t suddenly restrict third-party developers or accounts.
Owners of a trading app, built on Ethereum, can’t stop people from trading, even if it meant that they would lose money.
A Global environment without country-specific limitations. Applications can tap into the global economy from day 1.
Applications can launch without dealing with multiple legislations and extensive regulatory costs.
No restrictions for capital flows.
Anyone with an internet connection can participate, which allows a more inclusive system and huge market sizes.
Transparency & composability through a shared data-layer
Everyone can benefit from shared code and data; applications can freely build and innovate on top of each other.
Regulation becomes easier and is mostly built into the system. An investment bank, built on Ethereum, can’t hide activity from its balance sheet.
Anyone can access applications’ financials in real-time, which massively reduces information asymmetry.
A new type of architecture emerges on the internet
Ethereum is a computer infrastructure running on a global network of multiple computers. These computers store the same information and execute the same code. They all hold the same “state”. The data on these computers is stored in consecutive “blocks” of data (hence called a blockchain). To ensure that every computer has the same information at all times, “miners” are paid to make sure the data added is correct.
After the block is added, the data can no longer be changed. Ethereum is entirely open source, which means that all of the code is publicly available. All the information and activity on Ethereum can be viewed at all times.
Ethereum functions like a jurisdiction
The system is technically complex, but the concepts are simple. Ethereum functions like a country or a jurisdiction. Some conceptual similarities include:
Ethereum has a governance system responsible for governance and development.
Currently, a group of developers and different stakeholders are responsible for the implementation of new proposals.
Ethereum has a court of law to achieve compliance.
The law is the common agreement on the stored and executed code and information.
The court of law is analogous to the network of miners. If disagreements arise, the miners decide the outcome. Miners are compensated for their work, and misbehaving is not economically viable.
Ethereum has a vivid ecosystem of different “companies” and their customers.
Traditional companies consist of pen and paper contracts. The operating contracts of decentralized applications built on Ethereum are written in code.
Contracts are deployed to the Ethereum blockchain and shared with the network.
These contracts then execute the underlying logic when the applications are used, like any software application.
4. Ethereum has a national currency, Ether.
Decentralized applications and their customers pay Ether to miners that keep the system functional. As activity increases so do the fees. This is similar to tax payments.
Customers can use Ether to pay for the services provided by decentralized applications or alternatively use it as collateral.
Decentralized applications are conceptually similar to companies – case Compound Finance
Let’s examine Compound Finance, a lending platform, to showcase what kind of decentralized applications are currently built on the Ethereum blockchain. From a business perspective, these applications function like traditional marketplace companies, e.g., Uber or Airbnb.
Traditional marketplace companies vs. decentralized applications
From a technical perspective, Compound Finance platform consists of code like any software application. Building blocks of the code are called “smart contracts”.
Smart contracts are deterministic computer programs that are deployed to Ethereum computer, which function as a general-purpose computer and executes the code. The contracts can have many different use cases, e.g., act as a risk management tool for the platform. These smart contracts execute logic presented in the protocol’s whitepaper.
Protocol development resembles hardware development
After the smart contracts are in Ethereum’s database, they cannot be changed. The logic for upgrading contracts has to be encoded into the existing contracts or new contracts have to be deployed to make changes. Upgrading the smart contracts is hard and it has development cycles similar to hardware; after you ship your product there is no way to fix or make changes to it.
The contracts’ immutable and globally accessible nature means that any mistakes will be exploited. Technical security is critical and auditing companies give security assessments on the code.
Immutability is also one of the core value propositions of these applications. Once deployed, the applications became part of the open infrastructure. The developers can freely combine & use them to build new applications, without fear of restriction or changes.
It’s possible to determine very specific aspects of the application that can be upgraded through governance. There is no need to trust the company as long as the code can be trusted.
Different assets can be loaned or supplied with Compound
Compound Finance is composed of 18 money markets or liquidity pools. Participants can loan or supply three types of assets. e.g.
Collateral assets like Bitcoin or Ether
Stocks of companies built on Ethereum, e.g., Compound’s governance tokens
Stablecoins like USDC or DAI that keep a constant value of $1
The interest rate for each market depends on supply and demand. The rate follows a formula that is determined in the code. This is analogous to a bank deciding the interest rate, except now the logic is publicly available and the result driven by market forces.
Tokenholders can take part in online governance
Governance tokens, such as COMP (governance token of Compound Finance), resemble shares of traditional companies. These can be listed in on-chain marketplaces such as Uniswap, an event similar to IPO listings in stock exchanges like NYSE. Being a tokenholder gives similar rights and responsibilities as being a shareholder (cashflows & governance). It can be argued that the purpose of both is to maximize the share/tokenholder value.
In the context of tokens, we speak about protocol governance, which is in many ways similar to corporate governance. Tokenholders can propose improvement proposals, such as adding a new lending market for Compound. These proposals are then discussed and voted on by the tokenholders. The logic of how governance is conducted is determined in code.
Furthermore, the largest tokenholders are listed in a similar way to shareholders of public companies. Addresses are shown in an encrypted format. Every interaction can be viewed, but it is hard to identify a specific address.
Compound’s business model is based on interest payments
Compound earns revenue as a fee from the interest payments. Part of the interest is directed to a given asset’s reserve pool. The amount is decided by tokenholders, and it is implemented in code.
Furthermore, the reserve pool protects the supply side from borrower default. The excess can be voted to be distributed to tokenholders as dividends or invested in further development.
This is like traditional companies choosing between investing the cashflows and distributing them to stockholders in dividends or stock buybacks.
Compound protocol revenue. Source: https://www.tokenterminal.com/
Many industries will benefit from decentralized applications
Any idea that can be translated to code can be built on Ethereum with strong value propositions:
Immutability = trust and neutrality
Global scalability = low cost and accessibility
Transparency = audibility and accountability
Composability = interoperability & modularity
Many of the first use cases are related to finance. Over 130 billion dollars in value is already locked in decentralized finance (DeFi) applications on Ethereum. This shows that there is a clear need for the value propositions offered by open blockchains.
Total DeFi Market Capitalization. Source: https://defillama.com/
Traditional Finance vs Decentralized Finance: A large ecosystem of different applications covering the financial system is emerging.
The financial industry is the natural first use case for many reasons:
The current financial system is local, slow, and expensive. The banks control the data, and we trust the banks to handle our money.
Money and traditional financial services are already mostly digital, making the transition easy.
Ethereum’s scalability limits the possible use cases. Only a limited amount of transactions per second is currently possible.
Traditional institutions are faced with the innovator’s dilemma and need to identify how to adapt and use this technology. Ethereum is currently moving to version 2.0, which will improve scalability. Many other blockchains are also under development with different trade-offs.
Conclusion: most protocols will converge to resemble traditional companies
We are in the first stages of building a new economy on the internet. Everything is still constantly changing and evolving, but in the long run, most blockchains and decentralized applications are likely to converge to the framework presented in this article.
After all, blockchains don’t change the fundamentals how businesses work. They just allow better ways to build companies and applications. It’s an opportunity to re-architecture the financial system in a more scalable, resistant & transparent way.
If you are interested to learn more about blockchains & decentralized finance, feel free to contact Vilppu at vilppu@tokenterminal.xyz