3 Economic Rules Every Crypto Start Up Must Obey

There are a ton of people infusing cryptocurrency and blockchain into traditional businesses and asset classes claiming to have some revolutionary breakthrough when, in fact, the business value proposition is nothing more than, well, bananas.

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We see a lot of crypto start-up ideas that go something like this: "We'd like to put bananas on the block chain and trade them with utility tokens. It will revolutionize produce sales globally. Our pre-money valuation for the seed round is 2 trillion dollars." I've taken some editorial license here, but you get the idea. There's a ton of people infusing cryptocurrency and blockchain into traditional businesses and asset classes claiming to have some revolutionary breakthrough when, in fact, the business value proposition is nothing more than, well, bananas.

I thought I'd take the time to put down some basic "cryptonomic" rules to help would-be, block chain titans evaluate if their idea is gold or goop. It all begins with Ronald Coase at the University of Chicago, Laureate for the 1991 Nobel Memorial Prize in Economic Sciences (yes, it does have a cool sounding official name).

In 1937 (yeah, it takes that long to win the Nobel prize), Coase wrote a paper called the Nature of the Firm that revealed the fact that transaction costs are almost always material and do shape economic transactions. For example, if it takes too many clicks of the mouse to buy something online (a non-monetary transaction cost of your time), you'll just go buy something on another website. Transaction costs, while not always monetary, affect our willingness to buy, sell, and engage in a market.

Why does this matter to crypto? Because what crypto and blockchain do, precisely, is reduce transaction costs for certain economic activities. For example, bitcoin makes it possible to transfer money between parties without fees, or oversight from your bank, government, etc. That transaction cost can be high (prison) if you're a drug trafficker or engaging in some other illicit activity. That is why so much illegal activity is transacted using virtual currencies. They lower the transaction cost of the exchange sufficiently to justify the risk of volatility inherent in virtual currencies. I'm not advocating using virtual currency for illegal activity, I'm just saying that it happens for well-understood economic reason.

Overall, bitcoin is probably the lowest transaction cost method to transfer "money" securely to anyone, anywhere, for any reason, and at any time.

This leads us to crypto start up rule #1 - the use of crypto or blockchain must lower transaction costs for the economic activity it underwrites.

If you're not actually making it easier to transact an economic activity using your business plan, then you're not creating consumer surplusabove traditional market activities and no one will adopt your platform after the initial hype wears off.

The second rule of crypto start ups is due to a government body that was created as an indirect result of Ronald Coase and his pioneering work on transaction costs: the Securities and Exchange Commission (SEC). Some asset transactions require government oversight to even the playing field in public market transactions. This is because asymmetric information (when one party has inside information about the value of something) leads to fraudsters dumpling worthless assets on less-knowledgeable persons. If this insider trading was allowed, it would impose a major transaction cost on public markets from a fundamental lack of trust between two parties in any asset exchange.

To remedy this, the SEC regulates certain asset classes that are publicly traded to ensure that all information provided from insiders with non-public information about an asset, and have control over that asset, share that information with all market participants simultaneously and do not manipulate markets to their advantage. If you try to create an asset for public trade, and then benefit from trading it with inside information, you will go to jail.

This is rule #2: Don't go to prison. Sounds simple, but for some crypto folks, this is a difficult idea to master. If you intend to create an exchange for your crypto tokens where they can be held, bought and sold, then you're business should be regulated by the SEC and you need to hire a regulatory attorney who specializes in crypto assets and make sure that you're idea is lawful with appropriate disclosures and oversight. This isn't cheap to do, but going to prison is definitely more expensive.

Hmm, does that mean prison is a transaction cost of criminal activity? You bet it is!

Now, on to rule number three.

Blockchain is a secure way to share information, plain and simple. If you want to use it for a business purpose, then by so doing it needs to be a transaction where securely sharing information on the blockchain lowers transaction costs sufficiently to act as an incentive to increase underlying economic activity . For example, putting banana information on the blockchain doesn't really help a person buying them at their local Target store get better information in a manner that is more convenient than the sign at the store; however, securely transmitting point of agricultural origin data may be helpful to Target if they have to certify to their shoppers that the banana is organic and their sign is accurate.

To simplify, rule number three is that blockchain should only be used when it lowers transaction costs to securely share and maintain information critical to the underlying economic exchange.

Now, if you're a crypto entrepreneur, you still have to abide by the basic rules of good startups (link shamelessly inserted if you missed it before). So don't think that if you do merely these three things, you're going to be the next Winklevoss twins and the living is easy. Getting any startup off the ground is still a knife fight in an alley with Andre the Giant and he has a gun (as we often say at Sputnik ATX). These are just economic realities that any crypto start-up will ultimately have to face, so better to know up front and assess if your idea has merit before you push your life savings into the next banana-crypto debacle.

In summary:

  • Rule 1: The use of crypto or blockchain must lower transaction costs for the economic activity it underwrites.
  • Rule 2: Don't go to prison, hire a regulatory attorney and obey the law.
  • Rule 3: Blockchain should only be used when it lowers transaction costs to securely share and maintain information critical to the underlying economic exchange.

Now go out and make Ronald Coase proud: start lowering those transaction costs crypto entrepreneurs!

By: Joe Merrill, Partner at Sputnik ATX.

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