What's this all about?
Read on if you:
- Are curious about the theory of cyclical development
- Want to know more about how the changes underway will impact financial services
- Have an interest in learning about the Lightning Network
Robert F. Kennedy once quoted the old Chinese curse “May he live in interesting times” as a way to encapsulate and characterise the turbulence of the 1960s. Had that same reference been made at any time over the last twelve months it would have felt as apposite now as it did back then.
Another feature of the last year has been the apparent emergence of crypto into the mainstream. As we stumbled from COVID to Trump and from Brexit to GameStop, each event seemed to carry with it an associated crypto narrative that naturally accentuated many of the theoretical benefits of Bitcoin and blockchain and of decentralisation in general.
While to many this may seem like another 2017 crypto bubble that will soon burst and fade away, in reality, it is just another phase in a very predictable and recurring virtuous flywheel that connects price to innovation and eventual progress.
The reality: crypto develops in cycles that appear chaotic but have an underlying order
The data analysis that backs up this theory was presented by Chris Dixon of Andreessen Horowitz at the a16z Crypto Startup School in 2020.
“These cycles appear chaotic but have an underlying order, roughly characterized as 1) the price of Bitcoin and other crypto assets goes up, 2) leading to new interest and social media activity, 3) leading to more people getting involved, contributing new ideas and code, 4) leading to projects and startups getting created, 5) leading to product launches that inspire more people, eventually culminating in the next cycle.”
The a16z analysis goes on further to show that there were three previous crypto cycles. The first of these peaked in 2011, the second in 2013 and the last in 2017. It is safe to say we are now firmly in the grip of the fourth cycle and will soon start to see new investment and fresh startup activity right across the crypto sphere.
Crypto innovation: all waves
The result is consistent, long-term growth, driven by a feedback loop between interest and innovation.
Platforms, applications and evolutionary cycles
The computer industry has tended to evolve in cycles that occur approximately every 15 years and have an initial ‘gestation phase’ followed by an exponential ‘growth phase’. The gestation phase for the PC took place in the 1970s before entering its growth phase with the launch of the IBM PC in 1981. This, in turn, led to the gestation phase of the text-based internet of the 1980s, which transitioned to the growth phase with the launch of the Mosaic browser in 1993. The same pattern is observable within the mobile age that really only entered its exponential growth phase with the launch of the iPhone in 2007.
These phases of gestation to growth occur because of the virtuous feedback loop from application to platform. The platform creates interest which results in new applications being built upon it. This in turn makes the platform more valuable allowing it to act upon the feedback from the application users which in turn drives improvement in the platform. This self-reinforcing feedback loop begins to become multiplied by network effect and eventually transitions the new technology from gestation to growth.
Another consistent characteristic of every new wave of technology is that it always starts with what you might call ‘hobbyists’. That is, people who are experimenting with the tech outside of their normal working hours or using it for various esoteric and niche use cases within their field of interest. The early PC, for instance, was really only ever used by actual computer programmers with huge usability gaps to practical everyday use. The early web was only used within specific tracts of academia to exchange very domain-specific text-based information. Each, however, made the jump into the growth phase when second-layer protocols and applications were developed by innovators and entrepreneurs. Word processors and spreadsheets for the PC, search engines and e-commerce stores for the internet and mobile messaging for the mobile.
The similarities between the current state of crypto and the previous eras of the computer industry are striking and obvious, and it feels like we are just a few consumer use cases away from making the transition to the growth phase. These transformational use cases, as well as the underlying second-layer protocols that enable them, are already maturing and many are ready for scale. They are being brought to life by an ever-expanding army of passionate and ideological open source developers who want to play a part in the next iteration of the digital and financial worlds. Just like the early ‘hobbyists’ and ‘cyber punks’ of the PC and internet revolution before them.
Consequences for financial services
What crypto promises for finance is even more transformational than what the web delivered for commerce. Both in terms of the complex financial use cases of decentralised finance (DeFi) as well as the more near-term and less complex use cases of value transfer.
If this disruption follows the same historical pattern as before, it will occur in waves. It will start at the fringes and be initially focused on the lowest-hanging use cases. From that beachhead, the layer two innovations and applications will become more mature, and the disruption will make its way slowly up the value chain to the more complex and structural financial services use cases.
If I was to pick the most obvious low-hanging use case that the decentralised crypto networks will disrupt, it would be remittance. If I was to pick the most obvious layer two innovation that would enable this disruption, it would be the Lightning Network.
What is the Lightning Network?
As a financial technology, the Bitcoin network has many near-perfect qualities but transaction speed and scalability are not among them. It’s not a design flaw however, it’s a feature. The Bitcoin network is in fact ‘slow’ by way of purposeful design. It is slow for technical reasons such as IBD (Initial Block Download) and block propagation that helps ensure the security of the decentralised network. It is also slow for monetary theory reasons. Satoshi programmed the protocol such that blocks could never be mined more quickly than every ten minutes which provides for perfect price inelasticity of demand (i.e. price cannot drive up production and thus inflation), a quality even gold cannot match.
Therefore, Bitcoin the network has an inherent scalability issue – an issue which is virtually intractable on the base layer due to the complexities of distributed consensus. The network is amazing at a multitude of things but not at facilitating many of the day-to-day use cases required to move it into the mainstream. For as long as this problem persists, Bitcoin will remain a brilliant store of value but will struggle to become a medium of exchange.
So while blockchains are the base layer for the decentralised internet, the Lightning Network is a layer two protocol. A HTTP-like application protocol for the Bitcoin stack that solves the speed and scalability issue of Bitcoin while also enabling application innovation to potentially address common use cases such as using bitcoin for small on-the-go transactions or remittances.
If it is to disrupt the remittance world however it will need a killer app.
Strike is a Bitcoin-native neo-bank built directly on top of the Bitcoin and Lightning networks utilising traditional onramps like ACH and SEPA. The thesis behind Strike is that the Bitcoin and Lightning networks combined can be the most efficient global monetary network ever built. While there can be a multitude of use cases for Strike, the most obvious in the near-term is remittance.
The annual pre-COVID global remittance market was estimated to be worth approximately three-quarters of a trillion US dollars. The aggregated effect on the economies of the countries receiving these payments is enormous. In Haiti, for example, approximately 20 percent of its entire economy comes through remittance payments from overseas diaspora supporting families back home. Existing networks for this remittance can be highly inefficient with intermediaries taking as much as 10 percent of each payment in fees. It’s a market and set of use cases that have long been considered ripe for disruption.
Strike is interoperable with the Bitcoin and Lightning networks so it has on- and off-ramps into local currency anywhere there is Bitcoin ATMs or where Strike has a traditional banking relationship. This gives Strike users free and instant international money transfers anywhere in the world, 24 hours a day and at zero marginal cost. In theory, at least, it’s an enormous threat to an entire section of the globe’s legacy financial system.
Strike may succeed or it may fail but it feels inevitable that some version of Strike will succeed in utilising the Bitcoin and Lightning networks to completely upend the legacy remittance networks and perhaps even all legacy monetary networks.
I say this because all existing monetary networks are closed networks and not interoperable with each other. For example, a PayPal user cannot send money to a TransferWise user. Much like a Facebook user cannot directly communicate with a Twitter user.
The upshot of this is that the pace and extent of innovation within a closed network is limited by the collective brainpower of the engineers and designers within the company that controls that network. Within an open network, however, the possibilities are endless and it can be scaled and innovated upon by anyone with an internet connection. Each new node and application adds to the network effect making it ultimately impossible for the closed networks to compete against them. The experience of India’s UPI (Unified Payments Interface) also lends weight to this argument.
The case study of Strike and the remittance industry is interesting in and of itself, but even more interesting when viewed as a microcosm of what is happening within the broader blockchain revolution.
While the decentralisation of the internet’s architecture may be ideological for some, it also happens to be a very powerful mechanism to harness and enable permissionless innovation. The result is an enormous design space opened up by the inherent trust between users, developers, entrepreneurs and investors that is enshrined within the base layer of each blockchain by cryptographic and game theoretic guarantees.
The flywheel momentum and network effect this encoded trust generates are then magnified into a near-unstoppable force by the inbuilt economic mechanism for incentives native to these decentralised networks in the form of cryptocurrencies.
With so much negative sentiment right now around privacy, data sovereignty and the monopolistic powers that are centralised within the closed networks of GAFA, it feels like the ‘decentralised internet’ may be an idea whose time has come.
While the current media attention remains focused on the price of Bitcoin the asset, we know from experience that the real story lies within the global, open-source developer communities that are building the layer two protocols and applications of the crypto revolution. Just out of sight of the mainstream media attention, this is where the next version of the internet is being built.
Interesting times to live in for all citizens of the internet, even more so for those of us in financial services.