Hello readers,
This week I want to share my thoughts on the big elephant in the room as it pertains to the blockchain ecosystem today: Private/Permissioned Blockchains.
This is a super important subject that I have been grappling with for some time. As the Director of Ecosystem Strategy at Inveniam, it was a critical topic to explore within the growing ecosystem for tokenized private assets (e.g. CRE, private debt, etc). There are second-order consequences involving trading, custody, token standards, data standards, admin/accounting, operations, liquidity silos, decentralization, security, etc. depending on where you build.
Public blockchains offer open, permissionless data structures for the Internet. Open standards and open-source technologies can drive rapid innovation due to a lack of barriers to entry. This concept has catalyzed innovation cycles within information technology going back to the 1960s.
Yet many large institutional players are building on closed, permissioned, *private blockchains* today.
The DeFi Report is an exploration of the emerging web3 tech stack and an ongoing analysis of where value could accrue.
We also provide “analyst as a service” resources for asset managers, family offices, hedge funds, VCs, start-ups, and more. Simply respond to this email if you’re interested in working with us.
Let’s go.
It’s important to step back from time to time. To zoom out. To simply ask, what is a blockchain? And what is it useful for?
At a really primitive level, a blockchain is just a database or a ledger that can keep track of things of value. Some features differ from traditional databases:
Blockchains are append-only, meaning the data cannot be changed once it is included in a block. When you hear someone say that blockchains are “immutable,” this is what they are referring to. “Immutable” = nearly instant, final settlement with transparency and auditability.
Blockchains use cryptography, a form of encryption that increases security, privacy, and data integrity.
Blockchains rely on a distributed network of computers that update and sync to each other in real-time via network consensus, creating an “automatic audit” function, and greater security since there is no single point of attack.
Now, this all seems fine and dandy. We’ve invented a new structure for databases on the internet that can potentially store the “state” of everything that happened for billions of users.
But is this really that big of a deal?
Does it make sense that there is all of this hype around new secure databases or ledgers?
We think the answer is yes. Creating a new data structure that can store the “state” of billions of users on the internet in a neutral, immutable, and secure way is a very, very big deal. This is like building a shared, global accounting system and computing platform for the Internet. Just as internet protocols opened up the flow of information globally, public blockchains can open up the flow of value globally. Not to mention how these new data structures impact Internet native business models.
The internet is flawed because when we built the open-source base layer protocols (e.g. TCP/IP, HTTP, SMTP, etc.), we forgot to build shared, secure, and permissionless databases to go along with them (this is what public blockchains are).
So, naturally, internet users have relied on private businesses to provide the databases. This worked for a while. But over time it creates a problem…
Because the incentives to capture user data have led to data monopolies — where a handful of large companies (Facebook, Google, Amazon, Apple, etc) control vast amounts of user data, and the economic value embedded in that data.
The Internet needs a neutral, trusted, secure, open, permissionless database that can store the state of everything that happens on Internet applications. That’s the problem we are solving for. Therefore, the best use cases for blockchains are when large groups of individuals or entities need to share data but don’t want to trust a single entity to control the data. You can imagine why this would be useful for health records. For voting. For finance. For supply chains. For social media.
We shouldn’t have to trust anyone to provide the database for billions of internet users. This. Is. The. Innovation.
Moving past the problem that we are solving and the fundamental innovation, let’s compare the differences between Public and Private blockchains.
Private blockchains = fancy new *private* databases.
Public blockchains = fancy new *public* databases that can transform the internet.
As a reader of The DeFi Report, you know how much we focus on how *public* blockchains can transform internet native business models — which is a direct result of the change in the data structure. Open data (public blockchains) + New Compute Functionality (smart contracts) + User Controlled Data (via digital wallets) = New Internet Native Business Models.
When users can control data, and private businesses do not control access to user data, business models have to change. Full stop.
But none of that will happen on private/permissioned blockchains. Because the business model looks more like a traditional SaaS company. Users sign up and get an account or license. The license is paid via monthly or annual invoice. In this case, economic value accrues to one company or a handful of companies running the software — and not to a distributed network of individuals who can provide services in a permissionless manner (public blockchains).
There is no wallet. No crypto assets. No self-custody. No DeFi. No NFTs. No user-controlled data. No permissionless access. No interoperability. No transparency. No *outward* distribution of value.
So which one is the real innovation? Private or Public?
We think there are 4 main themes leading to some confusion:
Public blockchains are far from perfect right now. In particular, they are 1) slow, 2) expensive, 3) lack privacy, and 4) have not been blessed by regulators.
These problems are being (slowly) solved via 1) scaling solutions, and 2) zero-knowledge proofs (the ability to prove the validity of data without revealing its contents). Regarding regulation, we do not expect to see regulators in the US bless public blockchains. Rather, we expect to see new rules introduced by Congress, and the regulators will be tasked with enforcing these new rules — a messy process that will take some time.
Despite these problems being solved on public blockchains, their existence today has opened the door for institutions to attempt to co-opt public blockchain technology via private solutions.
“We solved the problem! All we had to do was make it centralized again, removing the fundamental innovation! It’s blockchain, not crypto. Crypto is rife with scams! Trust us!”
Somehow politics, regulators, the incentives of incumbents, and the court of public opinion have created what appears to be a mass delusion.
Because in our opinion, “crypto” is the real innovation. “Crypto” = the native tokens that power and secure public blockchains in a decentralized manner. Therefore, “crypto” is the thing that matters. And “blockchain” without “crypto” is just a fancy new database.
I’ve found Ernst & Young to have clear eyes about what’s going on here. Their head of Blockchain, Paul Brody, has indicated in interviews that they turn down consulting gigs with anyone that is building on private blockchains. To me, this is the right thing to do. Because the future will not be built on private chains. But lots of consultants don’t care. They just want the contract. And so they’ll steer clients in the wrong direction, without explaining to them that private blockchains:
Are data silos
Are not interoperable
Lack shared standards (there is a reason why we have a standard for railroad design, highway systems, telecom systems, and one suite of internet protocols)
Are not decentralized
Lack developer talent
Are less secure
Lack the innovation driven by the composability of open-source computer code
Are not designed to connect to billions of users globally
If you are interested in learning more about E&Ys stance on the Private vs Public blockchain debate, you can check that out here, here, and here.
It’s common to see folks such as Jamie Dimon or Warren Buffet openly disparage public blockchain networks (crypto). Yet, if asked about the technology more broadly, they’ll say stuff like “The underlying technology is sound. It produces efficiencies. Lowers costs. We’re rolling it out across several business lines.”
This shouldn’t be surprising, since people like Jamie Dimon have to protect the interest of their companies. He wants to talk about JPM Coin. Not Bitcoin.
Since public blockchains are not ready for primetime just yet, it could make sense for financial institutions to use private chains as “playgrounds” or “sandboxes” today. This gives them an idea of the benefits, use cases, and how they could implement new business processes utilizing blockchain.
In this case, the best practice would be to use a private fork of Ethereum to set up a private network for testing. This way, once the Ethereum mainnet is ready for prime time, these firms will already be utilizing the shared standards of the EVM system and can more seamlessly connect to the open, permissionless, global marketplace on Ethereum.
Our thesis is that the future of finance will play out on *public* blockchains, for all of the reasons we’ve stated in this report.
In particular, we think large financial institutions will eventually offer financial services to their customers by leveraging open-source protocols built on public blockchains. In this case, the institutions will not own the protocols or the blockchains. But they can still own the relationship with their customers and the access points to these services. Could a large institution such as JP Morgan launch a DeFi Protocol on Ethereum or Solana? This is certainly possible. And we’ll note that JP Morgan did some testing on Ethereum/Polygon, Uniswap, and Aave last year. It’s plausible that JPM could even launch something like this in conjunction with other large banks. In this case, the protocol would be open-source, and a token would allow anyone to own the protocol and vote on future development. Anyone would be able to provide services. And you would get security, interoperability, user-controlled data, new business models, etc. This could be strategic, but a lack of clarity from regulators makes it impossible today. Instead, we see “blockchain consortiums” via permissioned blockchains — putting these firms in “no man’s land.”
The challenge of all of this comes back to timing. It turns out that laying down the infrastructure for a new data structure for the Internet is really hard. We think the gestation period of public blockchains will persist for another 2-5 years. However, we will continue to see breakthroughs related to scalability and privacy that will give us brief glimpses into where we are heading. Lindy effects take time. Trust takes time.
With that said, we’ve seen past technologies go through similar drawn-out gestation periods that include periods of “disillusionment,” before rising from the ashes. As the saying goes: gradually…. then suddenly. This cannot happen until regulatory clarity is achieved. *Europe just passed new regulations — which we’ll cover in an upcoming report.
Ultimately, we think that *private/permissioned* blockchains will follow a similar path that we saw with *intranets* in the 90s. There were many concerns with the “openness” of the internet back in the 90s. Large companies were concerned about liability. And many thought that they could build their own version of the internet. Rather than create their own version of shared databases for the internet, we think private chains could serve as fancy proprietary databases in niche use cases. For example, private companies can use private chains when the data does not need to be shared in a permissionless, immutable, and trusted manner amongst a large group of individuals or entities.
In some cases, human behavior is at the core of the defensive posture of incumbents. We should not be surprised that many large institutions are reluctant to disrupt themselves. We’ve seen it over and over and over throughout history. Blockbuster could have purchased Netflix for $50 million back in 2000. Instead, they installed candy aisles in their stores.
“This dot com hysteria is completely overblown.” — John Antioco, CEO
Sound familiar?
I’ll leave you with this:
“The financial sector favors permissioned chains today. The financial sector says too many costs are associated with privacy, scalability, and security. So that’s where they are today. But I’m not sure that’s where they’ll be in 5-10 years.”
- Gary Gensler, November 2018 while teaching at MIT (42:30 mark)
Thanks for reading.
This issue of The DeFi Report is brought to you by Glassnode, the leading crypto platform for on-chain analytics and insights. As a reader of The DeFi Report, enjoy a 10% discount on any license tier by clicking here.
If you got some value from the report, please like the post, and share it with your friends, family, and co-workers so that more people can learn about DeFi and Web3.
This small gesture means a lot and helps us grow the community.
Take a report.
And stay curious.
Individuals have unique circumstances, goals, and risk tolerances, so you should consult a certified investment professional and/or do your own diligence before making investment decisions. The author is not an investment professional and may hold positions in the assets covered. Certified professionals can provide individualized investment advice tailored to your unique situation. This research report is for general educational purposes only, is not individualized, and as such should not be construed as investment advice. The content contained in the report is derived from both publicly available information as well as proprietary data sources. All information presented and sources are believed to be reliable as of the date first published. Any opinions expressed in the report are based on the information cited herein as of the date of the publication. Although The DeFi Report and the author believe the information presented is substantially accurate in all material respects and does not omit to state material facts necessary to make the statements herein not misleading, all information and materials in the report are provided on an “as is” and “as available” basis, without warranty or condition of any kind either expressed or implied.