CG

Posted on Jan 16, 2022Read on Mirror.xyz

NFTs Part 1: A Trip to the Past

This is article 1 of a 3 part series on NFTs. The layout of the series is as follows:

  • Part 1: A Trip to the Past: Token Evolution Over Time + Blockchain Conceptual Building Blocks
  • Part 2: An Examination of the Present: Non-Fungibility + Current NFT Use Cases + Influence of Human Mimetics on Markets
  • Part 3: A Vision of the Future: Future NFT Use Cases + A New Era In Human Coordination

“Know from whence you came. If you know from whence you came, there are absolutely no limitations to where you can go.” - James Baldwin


2021 was the year of the Non-Fungible Token (NFT). Over the course of 365 days, the overall market pumped to a tune of $23 billion dollars in volume. OpenSea, the premier NFT trading platform, is now valued at $13 billion. Collins Dictionary chose it as the word of the year.

Yet while the past year has been absolute madness in the JPEG casino, the future is perhaps even crazier. At time of writing on January 15th, OpenSea has nearly surpassed its monthly trading volume record of $3.4 billion from August of ‘21 - in half the time. This is all occurring at the same time that the platform’s user count has gone parabolic. These indicators seem to suggest that the rocket is loaded with plenty of fuel, with more being added as the 2021 US tax season fades into the rear-view.

Such explosive growth in a market tends to shift our focus out into the future. Humans love asking the questions of ‘what is next’ or ‘how big can this get’. Yet while speculating on the future is a societal past-time, we are unequipped to do so without understanding the path we have taken to get to the present.

So rather than centering this discussion around the future of NFTs, let us start with a trip back in time. The secrets of the future are often revealed by the clues of the past, and the story of tokens is no different.

By understanding the historical inflection points that have led us to this point, as well as the conceptual ideas that gave rise to them, we can better understand what NFTs are and thus how they will shape the future. So let us venture into the past, starting by winding the clock back to 2009 and the inception of blockchain technology.

A brief roadmap of the stops we will cover along the way:

  • Bitcoin’s Trillion Dollar Idea
  • Ethereum & the Re-Definition of Tokens
  • Composability as a Superpower
  • Blockchain Assets vs. Blockchain Networks

To finish, we will tie it all together. Let’s begin.


Bitcoin’s Trillion Dollar Idea

Bitcoin was born in the aftermath of the 2008 financial crisis with the promise of creating a decentralized, peer-to-peer payment system by re-orienting trust from away from institutions and people and towards code and computers. To do so required a unique innovation in technology and incentive structure, what we now know as blockchain technology. Yet while the ability to coordinate financial payments in a trustless manner was revolutionary, this was just one of multiple innovations wrapped into the future-altering package. An equally critical component of Satoshi’s creation was the introduction of the concept of “tokens” - digital assets that capture the value of and align incentive structures for the underlying blockchains they represent.

In the case of Bitcoin, the token (lowercase "bitcoin”) exists at the Layer 1 level. “Miners” invest energy into securing the network by solving cryptographic math problems, and are rewarded with the native token of the network. Each block “mined” releases a “block reward”, a pre-determined amount of bitcoin specified by the source code. This token has value ascribed to it by the market, which further incentivizes miners to invest in the network in order to obtain the financial reward. Over time, as miners continue to mine blocks one-on-top of the other, the network becomes more secure as the energy invested into it grows.

Since its inception, the Bitcoin incentive structure has been highly successful from both a security and financial standpoint. In regards to the former, the network has only spent 14 hours and 47 minutes “offline” (ie not creating new blocks) in over 12 years of operation. In the case of the latter, the network has seen the value of its native token skyrocket from an initial price of $0 to over $43,000 per coin at current time of writing. Even in the face of stark opposition from hackers, media, legacy financial institutions, and more, the Bitcoin network continues to plug along.

Yet while Bitcoin has undoubtedly created one of the most powerful incentive mechanisms in history, the conceptual idea of a token that it gave rise to was incomplete. Coordination at the Layer 1 level was highly effective, but bottlenecks began to emerge.

The Bitcoin protocol deeply intertwines the smart contract functionalities with the processing functions of the network, meaning that projects being ‘built on top of’ it had to use the network’s native token, bitcoin, as their methods of value transmission. Such a setup created a lack of flexibility in the developmental environment, limiting possible applications of the Bitcoin network. Yes, a peer-to-peer, trustless payment infrastructure is critically important for human coordination and societal growth. But blockchain technology had the potential to revolutionize more than just the payments industry, and the constraints inherent to Bitcoin’s design put a temporary cap on those possibilities.

Enter Ethereum.


Ethereum & The Re-Definition of Tokens

Vitalik Buterin recognized both the beauty and limitations of Bitcoin, and sought to generalize the ideas behind Satoshi’s work to unlock the potential of blockchain technology.

To do so, he introduced the idea of decoupling the smart contract functions of a blockchain from the native processing functions of the base protocol. Such a setup would allow anyone, anywhere, to write smart contracts and build decentralized applications on top of a blockchain network using a standard programming language. He and his team developed the programming language Solidity specifically to enable this functionality, and the Ethereum ecosystem was born on July 30th, 2015.

In creating a new blockchain ‘operating system’, Vitalik and his team took the concept of a token introduced by Bitcoin and flipped it on its head. Whereas the Bitcoin ecosystem operated solely around one protocol token - tokens that orient the incentive structure of the base blockchain layer - Ethereum now enabled the creation of multiple application tokens - tokens that can have any functionality or property, beyond simply serving as an incentive organizer for a Layer 1 blockchain. In the Hotel Cryptofornia analogy, protocol tokens exist at the ground floor whereas application tokens reside on the second floor and above.

ETH unlocks the upward mobility that BTC lacks, enabling infinite possibilities in the process.

At its core, Ethereum’s token landscape is about upward mobility of functionality. Capabilities that were historically native to the base blockchain layer were pushed up the technology stack to the application layer. New platforms can be spun up on top of the Ethereum blockchain thanks to smart contracts, inheriting it’s security in the process, all while expanding the possibilities of what the protocol can accomplish alone.

By taking smart contracts and effectively open sourcing them, Ethereum has created an environment in which builders can build. New platforms, applications, and tokens can now be spun up quickly with a few simple lines of code. In regards to token design, rate of creation has taken a quantum leap forward as smart contract standards like ERC-20 and ERC-721 have emerged. These standards essentially serve as ‘blueprints’ for token construction, allowing creators to design new application layer tokens that will be interoperable (ie able to interact) with other Ethereum based protocols.

So while Bitcoin seeks to be one or two things (digital gold/permissionless financial network), Ethereum seeks to be many. Each, however, is revolutionary in its own right. Bitcoin gave us the foundation upon which to dream, and the technological breakthroughs made by Satoshi and co. cannot be understated. Ethereum followed by using Bitcoin as a launching pad, telling us to dream bigger in the process.

Yet while the technological breakthroughs that each have made are truly astounding, they have merely leveraged simple principles of economics and computer science in order to do so. Concepts such as game theory, Metcalf’s Law, and network effects are integral to understanding the ways in which blockchain networks are constructed. One principle, however, stands above all the rest - composability. Enabled by open-source software design, it is the Arc Reactor that supercharges the crypto ecosystem.


Composability As a Superpower

As a16z’s Chris Dixon describes it, composability is the stacking and pairing together of software components like lego blocks. When software is open-source, each piece of the puzzle - lines of code - can be pulled from pre-existing programs around the web and stitched together to create something unique. Where the macro (the software program) is novel, the micro (lines of code) is familiar. In a space where anyone can read, anyone can write - all it takes is a simple copy and paste.

Blockchains tap into this software superpower due to their fully transparent nature. Whereas Twitter’s API is now closed, the genesis code for Bitcoin, Ethereum and other blockchain networks is freely accessible to anyone, anywhere, at any time. Should I wish to spin up a Bitcoin node, I can simply download the source code to a computer of sufficient processing capabilities and start validating transactions. The same principle applies to Ethereum and other L1 chains. Should you wish to participate in the network, you can.

At its core, composability means that each problem need only be solved once. Should someone in the world find a code-wrapped solution to an issue that I am also facing and decide to open-source it, I can simply borrow their code and use it for my own purposes. Their building blocks can become mine with a simple Control-C, Control-V combination. By creating a developmental environment in which a rising tide lifts all boats, composability shifts the pace of innovation into 6th gear. In a twist on an old proverb, it allows us to go both far and fast together.

Composability as a principle exists at all levels of the crypto ecosystem - it is both cross-chain and inter-chain. In the case of the former, new layer 1 blockchains find inspiration from chains with greater provenance in terms of both code and ideas. Ethereum borrowed heavily from Bitcoin, just as many chains are now borrowing heavily from Ethereum. The same concept applies within the frame of an individual blockchain ecosystem (or ‘stack’). Where Ethereum borrowed from Bitcoin, Ethereum-based projects borrow from both Ethereum and other Ethereum-based projects. It’s composability, all the way down.

In the case of tokens, composability has been perhaps the single largest factor in enabling an exploding economy. When a revolutionary technology such as Ethereum begins to leverage a revolutionary principle like composability, magic happens.

The boom in tokenized assets (platform tokens, DAO tokens, social tokens, NFTs, etc.) within the Ethereum ecosystem has largely come at the application layer thanks to this unique combination. Builders can leverage programmable smart contracts to plug into the Ethereum network, borrow ideas from pre-existing projects, and add their own flavors to create a new recipe.

Composability is the critical cog in the crypto machine, and Ethereum has unlocked it for the masses.


Blockchain Networks vs. Blockchain Assets

As the token landscape pioneered by Ethereum continues to expand, an interesting symbiosis has emerged. Due to network effects, the value of application tokens are highly interdependent on the value of the protocol token they are built on top of. But, from a protocol perspective, as the use cases expand for a particular chain and more things are built on top, value accrues back to that base layer. So as applications become more valuable, so too do their native protocols.

In thinking about the value that these second layer tokens create, it is helpful for us to make a distinction between two unique value propositions of blockchains: blockchains as networks and blockchains as assets. Tokens fall into the latter category, but rely heavily on the first.


Blockchains as Assets

Today, the overwhelming majority of the population participating in the crypto ecosystem is cued into the former proposition - “blockchains as assets”. We have a tendency to think of blockchains in terms of the token in which they are denominated (eg: $BTC, $ETH, $SOL, etc.) rather than in terms of the use cases the chain itself provides.

From a 50,000 foot view, this perspective is entirely understandable. The barrier of entry to understand the technical nuances of blockchains takes significant time and research to scale, while the manner in which tokens are represented on exchanges have a high level of familiarity to us.

When we log onto an exchange (such as Coinbase or Kraken) for the first time, there is a subconscious “aha” moment that occurs. While the fundamentals behind the space are novel, the user experiences (UX) draws strong parallels to the way stocks are currently traded on digital platforms. Human psychology then plays a subtle trick on us, as we instinctively look to draw connections between the new and the old. And since we tend to place stocks explicitly in the “asset” bucket, our first experience purchasing crypto tokens tends to lead to us placing the entire blockchain ecosystem into the same bucket.

This viewpoint on stocks, and thus crypto tokens, has only become more common in recent years with companies such as Robinhood and CashApp rapidly mitigating the friction to investing real dollars. This democratization of finance is a net positive for humanity, but it comes at a cost - as our comfort level grows in purchasing digital assets, so too does our interest in trading them at high speed. When everyone can become an investor, everyone can become a trader.

The desire to trade significantly outweighs the desire to hold for a significant portion of investors today, and skews even more-so towards the former the younger a person’s age. Approached from the lens of human behavior, there are no surprises here. As a species, we have an innate tendency to prefer the short-term over the long-term, to solve the problems of today and neglect those of tomorrow.

Evolutionary history provides some answers as to how this mental model of the world arose. In earlier times, when resources were scarce, optimizing for the short term served us well. We were incentivized as a species to think in terms of the immediate present so that we could maximize the resources around us amidst constant uncertainty. In a world of “survive at all costs”, the cost of survival was frequently in the here and now.

Over time, however, the world has moved drastically from uncertainty towards certainty. Continuous innovation has taken what used to be scarce and made it abundant. While puzzles and questions do still remain, we now know many more things about how the world around us works than we did millennia ago. We live in a much safer society as a result - we no longer need to worry about lions snatching us in our sleep. This reality now enables us to shift our focus away from surviving in the present and towards prospering in the future.

Such drastic changes to society mean that many mental models from the old world no longer apply in the new one. Yet while we may recognize this truth easily, old thought patterns are still hard wired into our behavior. Evolutionary habits are difficult to break, and high time preference overrules low time preference for most - we want things, and we want them now. The ability to buy and trade with limited friction exploits this human psychological tendency, as we now have the perceived ability to create more value in less time. Crypto networks provide a compounding effect on these psychological tendencies, as the friction to moving assets around is compressed to zero.

The lower the friction and the higher the perceived opportunity in the here and now, the more we are incentivized to operate from the perspectives of traders - whether in the stock or crypto markets. Participating from such a viewpoint primes us to think in terms of hard dollars and cents. That is, to think in terms of assets.

But in the crypto ecosystem, tokenized assets are only half of the equation. They are the casino through which real-time economic experiments are being run, yet there is much more to the story. In reality, blockchains assets are built off of blockchain networks. And without the latter, the former has no grounds upon which to stand.


Blockchains As Networks

While we have a societal tendency to gravitate to tokenized crypto-assets, this is akin to looking at the trees sprouting from the ground and neglecting the fact that they draw their energy from below the surface. From this perspective, crypto tokens are the things that we see - like trunks reaching for the sky or flowers blooming each spring. Crypto networks, on the other hand, are the things that we do not see - the underlying soil and roots that allow for the beauty above the surface to take hold.

Blockchain assets are what we see, blockchain networks are what we do not.

From a high level technical perspective, blockchain networks are the results of code and nodes. The code is the software of the network, providing the rules upon which it runs, while nodes are the hardware - individual computers around the world operating under the same rules and leveraging energy to solve computationally intensive cryptographic equations.

Blockchain nodes are fractal representations of the macro network. In the same way that you can deconstruct a snowflake into identical sub-components that are representative of the larger whole, blockchain networks can be parsed into individual yet identical computers around the globe. This clever design to the technology begets a direct relationship between the micro components and the macro network. The more micro components - nodes - that are spun up around the globe, the more the macro network benefits in terms of both resiliency and reach.

Blockchains are thus networks of networks, relying on the same underlying principles that have enabled the Internet to become a driving force of society.

These networks provide the scaffolding upon which new things can be built. In the case of Bitcoin, the network infrastructure enables new standards for legacy financial concepts such as payments, clearance, and settlements. In the case of Ethereum, the network enables expansion on the ideas of Bitcoin by pushing blockchain capabilities up the technology stack to the application layer. The fact that Ethereum applications tokens are enabled by Ethereum thus means that they cannot exist without Ethereum. So while Layer 2 platforms and products expand the capacities of Layer 1 chains, each relies on the core value proposition that is blockchains as networks.

Without Layer 1, there is no Layer 2.


Tying It All Together

As we have seen, its is quite easy for us to miss the fact that there is an entire ecosystem of principles and technology underneath the surface that enable the tokens listed on exchanges to exist in the first place.

And while the concept of a token was introduced by Bitcoin in 2009, it has been continually re-defined in the decade-plus since. Since the creation of Ethereum and the decoupling of tokens from native base chains, the token economy has exploded. Yet while that explosion is beautiful in the possibilities it enables, it also comes with its fair share of risks. However, by teasing out the underlying principles that have enabled this crypto ‘Big Bang’, we can start to gain an understanding of where positive value will accrue in the ecosystem - and which traps in the ground we need avoid.

Take composability, for example. Where the principle allows for the compounding of ideas to build new ones, it also enables blatant plagiarism. The friction of copying and pasting will always be significantly lower when compared to the process of creating something new, and that truth has implications for human behavior. If we face reality and recognize that our species likes to optimize for routes requiring the least amount of energy, it should be no surprise that many will forgo steps of additive value and instead seek opportunities for quick cash grabs. The amount of non-innovative, derivative NFT projects flooding the market at current time of writing are exhibit A of this phenomenon.

Yet while pessimism tends to reign supreme to optimism (many have been on the wrong side of this equation throughout the course of history), the beauty of crypto’s foundational principles is that they enable a future of abundance and scarcity at the same time. The result is something of a scarcity paradox - while there is no fundamental cap on the amount of new platforms, NFTs, or tokens that can be launched, there is without question a ceiling to the number of projects that will create something truly novel. These innovations will bring an inordinate amount of value to the world when compared to their peers, similar to what Bitcoin and Ethereum have done for blockchain technology as a whole.

So while the quantity of available possibilities from this point in time is inherently not scarce, the number of truly future altering ones is. This is the reality of a composable future - the formula for historic innovations will not just be of the form Ctrl C + Ctrl V, but rather Ctrl C + Ctrl V + something else.

Copy + Create. The future hinges on the full equation, not just the first variable.

The future will thus be a result of experimentation in combination, of both technology and ideas. Blockchain networks and blockchain assets will continue their intricate dance, each enabling the other to re-define the world in which we live. As projects succeed and fail, composability will ensure that the direction of progress is ever forward. In true Darwinian fashion, the best ideas will emerge victorious and serve as new foundations for more to come.

Tokens have a crucial role to play in this new era. Where blockchains allow us to build a world of permissionless systems, tokens enable exploration at the frontier of human cooperation. With the advent of Ethereum, we now have the means to build incentive structures oriented around more than just layer 1 crypto assets. The implications of this are profound.

Up until this point in history, communities have largely been oriented by passion. Moving forward, economics will be increasingly injected into the equation. Layer 2 tokens enable communities to organize around financial incentives, attaching skin in the game to love of the game. This financialization of culture will turn social structures into micro-economies. When a set of philosophical principles are compounded via financial incentives, communities begin to look more like nation states than Facebook groups.

Tokens enable for us to attach skin in the game to love of the game.

Yet while tokens as an entire asset class will have (and already are having) a profound impact on society, one sub-category may come to rule them all - Non-Fungible Tokens (NFTs). There are more intricacies for us to explore as to how and why, but we now have the conceptual building blocks in place. With an understanding of the blockchain properties that enable them - networks, assets, composability, and the like - we can move to a more nuanced discussion of what NFTs are. And while I will save that discussion for Part 2, here is a thread thread that will help set the stage. See you soon.

https://twitter.com/punk6529/status/1443921334837338114