Wendy Xiao Schadeck is a venture investor at Northzone, based in New York City. She has been following the blockchain space closely, focusing on the behavioral perspective.

In this opinion piece, Schadeck outlines her thesis on how the blockchain market is evolving, and where she believes assumptions should be challenged so as to further the tech’s development.

In light of the fascination with decentralized blockchains (now termed “crypto”) in recent months, I’ve been spending a lot of time trying to counterbalance the hype with critical perspectives on the technology’s future.

I am not building a bear case per se, but rather looking for opposing viewpoints in order to practice quantum thinking on the topic, which in my opinion, is absolutely critical to being a successful investor in this space.

So far, there are several types of blockchain skeptics I’ve observed.

The spectrum ranges from those suffering from incumbent biases to those sitting in the trough of disillusionment to others who have spent real time understanding the recent developments but came out negative because of their experiences or beliefs. There are also fervent disagreements between the different blockchain communities that raise key questions.

The issues I’ve been looking for in the midst of all of this are not technical in nature because, in my opinion, those challenges will be solved over time, especially given the massive amount of talent this space has been able to attract and will continue to attract. I have also not focused on external factors such as regulatory risk, though they are huge concerns. I believe that signals shown so far suggest regulators are very savvy and are careful to enact new regulation.

If you’ve been following the space for some time, you’ve probably observed that opinions about decentralized blockchain are pretty binary. The reason for this is that the biggest risks faced by projects in this space are existential. There isn’t a full continuum of outcomes that are easily understood or widely acknowledged.

Either you’re a believer or you aren’t, and a lot of it hinges on your views on the issues below. I have also searched for answers to these questions, but so far I have found no clear answers except for further experimentation and a natural evolution of the ecosystem.

Therefore, it makes sense to think of these as basic assumptions that the entire space has been built upon:

1. Mass user adoption

The first line of defense for many critics is the argument that blockchain technologies can only replicate use cases that centralized systems already achieve, and that because of this, there is no reason for the average user to switch.

While I believe that during this first phase of adoption we will see these skeuomorphic use cases, I also think we haven’t begun to understand yet what blockchain technologies can enable. The most powerful use cases for the internet didn’t evolve until many years after initial adoption. However, we still have to prove adoption in the skeuomorphic period, and I think my hypothesis around adoption by investment addresses that.

The gist of it is that instead of fishing for a future application solving a future consumer pain point, we should observe how bitcoin, ethereum and the hundreds of other tokens on the market today have been achieved adoption through a similar pattern:

Initial investment due to speculation or alignment of beliefs-> Emotional commitment to the growth of the network -> Adoption -> Advocacy (and further investment on technologies built on top).

The value prop to adopters of new technology used to be limited to only having their user pain points addressed in a better way (and whatever coolness factor comes with telling their friends about it first), which is why, as VCs, we are so used to only looking for user value proposition in the traditional sense, driven by slick onboarding funnels, library completeness, etc.

The bar is much higher compared to existing solutions, thus it is true that most blockchain use cases don’t deliver a differentiated value prop on those dimensions.

However, in the decentralized world, adopters of new blockchain technologies can actually make money while the network is growing by earning or investing in tokens. This psychology is unexplored territory and taps into highly motivating human forces such as greed.

However, if this hypothesis makes any sense, then we have to also assume that early adopters will not turn off later adopters (network gets too expensive/volatile to use from speculation), and that investors will ultimately become users, which brings us to our next big blockchain assumption:

2. Tokens should be entangled

Tokens have two roles – serving as both a ticket to a network’s services and a vehicle for investing in a network. This means token prices are much more volatile, and that lowers its utility as a transfer of value because the price of the exchanged good or service can fluctuate quickly in a short time-span.

This effect is described well in this article authored by Marcin Rudolf:

“Consider the following: Do you invest in a car factory by buying a lot of cars for a price much above market value? If this idea sounds weird to you check again what are you buying when you invest in app tokens. You get a right to use a network – it’s like [getting] vouchers for cars instead of shares in a car production business. Do you really need those years of access to global super computer? Do you really need to make millions of transactions over the ethereum network? Probably not so you will realize your investment by dumping your tokens on secondary market. In that case, however, you should ask yourself what happens to your car factory if you first massively drive up product price by hoarding cars it produces and then dump them on secondary market?”

This creates conflicts of interest between token investors, who want the prices to go up, and spenders who want the prices to remain stable.

Assuming investors are spenders as to my earlier point, token entanglement then disincentives participants to use their tokens in exchange for the goods and services provided by the network, which makes the network useless and also the token.

In the earlier days of bitcoin, people spent bitcoin because no one believed bitcoin was real. Now, stories of the “$5 million pizza” make token investors incredibly weary of spending their tokens.

If we model out when investors become spenders, it is when value of services that can be bought with a token becomes more than the expected future value of the token you’re holding. This will happen when token price stabilizes, and supply equals demand.

However, by that point, will there be enough development done on the network for the token to have significant utility value? If yes, then prices for using the network services will be compared to prices for doing things the centralized way.

If not, we will probably have a trough of disillusionment period during which many people sell their tokens and the true “hodlers” form the bottom. Which projects survive this period depend on both the speed of development and how many true “hodlers” exist in the network.

While most projects are not at a stage where the network can even deliver any meaningful utility value, several recent consumer-facing projects (Brave, Kik, etc.) will encounter this problem before others.

If they’re able to build incentives into the product and make people spend (maybe in order to earn?), then that will be an important proof point. Also, if the end user is a machine rather than a human (in the case of pure infrastructure tokens), then the problem is less evident.

There are also a number of projects working on “stablecoins,” which from my limited understanding are kind of like collateralized FX swaps, but the usefulness of these will be limited in times of extreme volatility because they require huge amounts of capital to work.

3. ICOs incentivize good projects

I’ve been very pessimistic about ICOs as a funding mechanism (at least in its current form) because incentives for the founding team are so misaligned with the project’s investors and community, and even the most prudent founding teams will have trouble allocating hundreds of millions of dollars efficiently at a pre-product stage.

History has not shown that large amounts of funding at very early stages of a project leads to successful outcomes. A more ideal distribution mechanism might be more of a helicopter drop and liquidity via decentralized exchanges or a phased, proof-point based model of token sale.

Albert Wenger wrote a good blog post on this recently where he urges projects to set up internal mechanisms for post-ICO governance. Ethereum creator Vitalik Buterin also wrote a blog post earlier this summer illustrating issues with single round ICOs.

Right now, it certainly feels like a race to build the largest arsenal via ICOs before clear regulatory guidance, and it is the most rational thing to do given the short term incentives, but arguably, similar to dot-com days, it might not bode positively for these projects’ ability to build value for its community long run without stronger governance mechanisms.

This is also a symptom of current market conditions and should naturally self-correct when the hype dies down and investors become more critical. I am optimistic that when capital becomes scarce again, it just takes one responsible project to establish the norm, and the rest will have to follow suit because the market should negatively select against any project that doesn’t.

4. Governance paradox

This is often the most commonly cited core issue for decentralized blockchain networks. How do blockchain networks define the rules? If they can trust a central party to define the rules, then there is no need for a blockchain in the first place.

Oxford professor Vili Lehdonvirta authored a piece on this in 2016 which explains the concept really well:

“Blockchain technologies cannot escape the problem of governance. Whether they recognize it or not, they face the same governance issues as conventional third-party enforcers. You can use technologies to potentially enhance the processes of governance (eg. transparency, online deliberation, e-voting), but you can’t engineer away governance as such. All this leads me to wonder how revolutionary blockchain technologies really are. If you still rely on a Board of Directors or similar body to make it work, how much has economic organization really changed? And this leads me to my final point, a provocation: once you address the problem of governance, you no longer need blockchain; you can just as well use conventional technology that assumes a trusted central party to enforce the rules, because you’re already trusting somebody (or some organization/process) to make the rules.”

The bitcoins scaling debate is the most well-known manifestation of this issue, and some have looked to forks as a way to define governance by means of natural selection of blockchain networks.

However, Vili argues that competition via forking does not solve the problem because strong network effects prevent competition. Building accountability into the nodes might be another solution (for example, like R3), which might limit the use case to centralized protocols or a decentralized protocol managed by a central party. These types of blockchain networks are less economically transformative.

Ultimately, more sophisticated governance mechanisms should evolve, built by others way smarter on this topic than I am. There are giant pools of knowledge in sociology, behavioral economics, etc. that are still largely untapped by those building cryptoeconomic designs, and this is where I am spending my time these days — making these connections. I am a believer that this will not be done through technology alone; our governance processes will have to evolve significantly in order for the technology to work. I would even go as far to say that blockchain technologies allow societies to rapidly prototype human coordination processes that have historically taken centuries to develop.

Many thanks to those who helped contribute ideas to this article either directly or via conversations (in person and on Twitter): @jessewldn, @iiterature, @petkanics, @bradusv, @jmonegro, @pjparson, @julianmoncadaNY, @arbedout, @pete_rizzo_, @pt, @aweissman, @kevinsullivan36, @arthurB, and many others…

Wendy posts regularly about blockchain on her Twitter and on Medium.

Danger image via Shutterstock