A framework to analyze blockchain protocols and applications - Part 2
My approach to analyzing blockchain projects
In part 2 of my framework, I list out additional areas of analysis and key questions associated with it:
Token Distribution & Governance
A bad token distribution model has the potential to derail a protocol by dis-incentivizing community engagement.
How are tokens being distributed to users, validators/miners, developers, investors and the founding team? Is there concentrated ownership of tokens? Is there a cap on token supply? What is the supply schedule of tokens?
Is there a deflation/inflation mechanism?
What is the incentive to hold the token?
What is the vesting schedule of tokens held by insiders and early investors?
What is the utility of a token? Are there multiple types of tokens within the protocol and what is the purpose of each?
Understanding the token distribution model and its impact on deflation/inflation is an important factor. Premines and existing allocations should be reviewed to get a picture of the distribution of token holders. A ’fair’ distribution of tokens is becoming increasingly important to blockchain projects and is crucial to get an active community.
Here’s an article by Vitalik Buterin on token sale models.
The velocity problem and the mechanisms implemented to address it are important in evaluating the value accrual mechanism of a token.
What are the incentive structures around staking? What is the lock up period, minimum amount required to stake, slashing rules, etc. (There’s a lot more to consider on this)
How is token liquidity being managed? Are there liquidity pools on DEXs and is the token listed on trusted crypto exchanges?
How are transaction fees on the protocol determined? Who can become a validator or miner and what are the minimum requirements to become one? How are validators or miners rewarded?
Here’s an insightful post I found on twitter from Mike’s Cryptosystems Manifesto:
A token must work as a necessary element of a self-sustaining system which is a public utility.
A token is a necessary element of a system if the use of any other in its place would damage the system’s normal functioning.
A system is self-sustaining if it would continue to function normally in the indefinite absence of its creators.
A system is a public utility if it is permissionless, rent-free, and does something useful.
(I’ve not yet confirmed the author of the manifesto; I found it here)
What is the governance model and decision-making process for the project? This is key to surviving and recovering from attacks on the network and is important to building a community that is actively engaged.
Governance and decision-making processes are critical, especially when there is an adverse event such as a hack or network interruption. Two examples that highlight the importance of this is how the decision making process was executed when a DAO on Ethereum was hacked and the other was when Solana was facing resource exhaustion and had to restart. In these scenarios, having a clear and efficient decision-making process is vital to implementing an effective solution with minimum interruption.
What is the role of the core team in governance decisions?
Good governance + good decision-making process + fair and properly incentivized token distribution = engaged community = protocol success
Competition
Porter’s 5 forces is a very useful framework to evaluate competitive dynamics, especially the threat of new entrants and substitutes within an industry. This framework has been used in evaluating traditional industries and might not be apt for blockchain protocols, but I believe the concepts in the framework are useful in thinking about blockchain protocols and applications.
In the world of blockchain, forking makes it easy to a copy a protocol, elevating the threat of new entrants. E.g., Sushiswap is a fork of Uniswap.
How can the protocol defend against forking? Has the team formulated a defensive strategy to minimize the impact of forking and vampire attacks?
Identifying the inherent value of a protocol that cannot be forked away is a crucial competitive edge.
Is the team aware of competitors and their strategy? Has the team created a competitive strategy?
What is the switching cost for users to switch to a competitor’s product?
Cost of switching to a substitute is assumed to be minimal for blockchain applications unlike most other industries and products. Imagine the cost of switching a large global organization from AWS to Azure; such astronomical costs of switching to a competitor are not always a major concern for end users of a blockchain product; not yet anyway.
Interoperability between protocols elevates the threat of competitors.
Therefore, it is paramount to ensure that a protocol has the right governance and decision-making process that is considered fair and effective by the community. This is closely related to the edge that a protocol has.
The Edge
What is the competitive edge (key points of differentiation) that the protocol or product provides?
Is there a compelling use case associated with the protocol or application that taps into a large untapped market that can support multiple players?
How is it going to be defended in a rapidly evolving industry?
Are there important partnerships that have been established with private or public institutions? Will these partnerships really benefit the project, or will it become a distraction?
In the world of investing, identifying and understanding your edge is an important element of long-term success. I believe the same question should be asked of blockchain protocols. Identifying the real edge of a protocol could be a challenging task. More challenging is attempting to quantify it and determining what it takes to maintain that edge over the long term. Does it need to evolve, especially since we’re in a nascent domain that’s rapidly innovating? Almost always, not evolving and adapting is the guaranteed path to failure.
In summary, knowing the tangible and intangible competitive edge of a protocol will be important in evaluating immunity to forks and defending against new entrants and alternatives.
What is the probability distribution of long-term outcomes?
A key question I ask myself is whether I can imagine the evolution of a protocol over the next ten or twenty years in terms of a probability weighted range of outcomes.
Does the product roadmap provide sufficient insight into what the future looks like? Can the protocol support high compound growth rates of user and development activity for the foreseeable future i.e., is it capable of scaling? Is the community excited about the future or is there frustration brewing? If it’s hard to paint a picture of the future, then there’s a high probability that the network might not exist in ten years.
How will the market structure and competitive dynamics between competitors evolve over the next twenty years?
I believe there’s room for an oligopoly of layer 1 and layer 2 protocols to exist because [1] No single protocol will be a good fit for all blockchain use cases [2] This implies that it will not be a winner-take-all market structure. I believe that the core philosophy of decentralization and the influence of cypherpunk principles within the blockchain community will prevent a winner-take-all market structure, especially for layer 1 protocols.
Blockchain Applications (dApps):
When evaluating blockchain applications, in addition to evaluating the factors above, additional dimensions for analysis are:
Product Design
Is the product well designed – does the user interface/user experience (UI/UX) have the power to excite customers and make them want to tell others about the product?
Is the technical design and implementation robust and can it scale to support exponential growth? What is the benefit of utilizing blockchain technology? Does the product benefit from network effects?
Are there early adopters and if so, what feedback have they provided?
Has the team created a comprehensive product strategy to acquire users?
Does the team have a product roadmap that is achievable and exciting to end users?
There are other variables to consider but the crux of the product analysis is in determining whether the product will get traction and stickiness with end users.
Total Addressable Market (TAM):
I consider TAM to be an important metric for long term investment decisions. Without a large addressable market, it becomes difficult to sustain growth in a highly competitive market environment.
Does the team understand market structure and competitive dynamics within the application space?
Metrics to evaluate growth in users and user activity are the vital stats on the product and need constant monitoring.
In conclusion, I’d like to mention an element in the decision process that should not be completely ignored. All of us get the benefit of millions of years of human evolution and inbuilt awareness of our environment distilled into a singular force – the ‘gut feel’. A lot of investors incorporate this knowingly or unknowingly as quantifiable or intangible factors in their investment process. I believe it’s well advised to not ignore it but to develop a philosophy and process that taps into it. It takes practice and awareness to successfully incorporate it.
Hope this was useful. I will post updates to this framework as I learn more in my explorations of Crypto.