The Delusion of Decentralisation at Scale
Decentralisation and adoption curve. Attempting to set global prices is a new thing. Ukraine at the crossroad. Emerging new tech leaders.
The Delusion of Decentralisation at Scale (long read)
Geopolitical Watch (China’s response to NATO strategy. Are France and Germany the weak link of EU). Ukraine in a precarious position.
The state of the market (the looming geopolitical risk). The new tendency to solve crises through price setting.
The Delusion of Decentralisation at Scale
We heard loud calls for decentralisation over the past ten years. First, decentralised finance. It sounds good, but it in practice it fails right when its adoption begins to spread after a promising start. I discussed the problem with the concept of true decentralised finance in my review of ARK Innovations Best Ideas 2022 earlier this year when I anticipated the occurrence of serious problems. The recent developments in the crypto world have validated these concerns. It is hard to argue against the scepticism when a large promoter of decentralised finance goes from $25b cash on hand to $147m in a few weeks. It sounds a lot like Bear Sterns in 2007/2008.
The aspiration for decentralisation has a strong emotional resonance because it plays on one of the most (to me THE most) fundamental right we all yearn for: freedom. This concept is the opposite of control, which we dislike with a passion. We want to be in charge of our own destiny, hence the instinctive negative perception of large institutions, even if they are benevolent and useful.
Decentralisation and Rule Based Freedom
What does freedom actually mean? When you ride a horse in the middle of a limitless prairie, as much as you like, without any danger, that feels like freedom. Or driving uninhibited in unpopulated areas. I love driving on long Australian roads that stretch in front of me as far as I can see beyond horizon. It gives me a sense of unadulterated freedom. That sense diminishes somehow when I get back to the city, yet I still feel free to a certain extent. This is because I, along with everyone else, observe the general social rules willingly, knowing that if we do otherwise it would be chaos.
A good country is one in which these rules are woven in such way that individual rights are protected while at the same time they allow its people to freely pursue their own goals, live their own lives with minimum interference. The balance between personal freedom and adherence to community protocol is perhaps the most precious achievement of democracy, and one of the most difficult.
Individual freedom and collective freedom are conflicting concepts that are always in a fragile equilibrium. The balance between the two is critical because they cannot exits without each other.
A lone person in the middle of the desert is arguably free, but that freedom is meaningless because it cannot manifest as an exercise of free will, there are no goals to be set, no challenges, no achievements.
Collective freedom without individual freedom is not true freedom either. That is dictatorship. When the rules ares too stringent, individuals cannot set their own goals freely, which at an aggregate level it translates into a community unable to choose, decide, vote on a new course of action, and therefore lacking the ability to face unexpected challenges.
The purpose of a free community is to prosper and live better, and the only way to achieve that is through free association of individuals that work on goals that are aligned with their own aspirations and with the needs of the community as a whole. The combination of associations changes continuously in response to learned experience, transformation of the community itself, and formulation of new goals.
Transgressing individual freedoms must be made known, understood, and processed to adapt existing rules or create new ones by the community aiming to protect both individual and collective freedoms. This is not possible unless we accept one key compromise: the need for an overseeing mechanism that collects that information, compares cases and makes a judgement call that either result in an arbitration, change or creation of a new rule. You need to cede a bit of subjective control to obtain a higher order objective ruling that protects your interest from future losses against others intended or unintended transgressions.
Descentralisation must be seen in context. In a small social circle with members with similar interests, skills and abilities, near decentralisation is possible, even desirable. This is based on tacit knowledge, a concept proposed a few decades ago by Michael Polanyi, which is possible when members of a group have a common shared history and a close social and working relationship. As soon as you expand the group, tacit knowledge ceases to perform its function because it cannot be generated anymore. This is why accelerated, disruptive innovation at the earliest stage of adoption occurs mainly in tightly knitted groups. When the innovation is distributed to wider populations the adoption is not possible without support and clear instructions needed to compensate for the absence of tacit knowledge.
In mathematical terms, a network comprising of a large number of nodes with multiple dynamic attributes will require the collection of information from each individual nodes and publish that information for the purpose of optimisation of the interaction between nodes. This is a complex routing problem. The decision to exchange goods for mutual benefit needs to consider which nodes have the relevant goods, their quality and cost.
Decentralised Finance (DeFi)
The promise of decentralised finance at scale in which there are no intermediaries and where every member is free to do business with anyone without ability to discover value and optimise their trade timely is fraught with danger. Even if all the participants have good intentions, this system is extremely inefficient at best. The risk of large opportunity costs is real, as the network members are overwhelmed with the work they need to do in the discovery process. This renders the network ineffective, as a collection of random interactions. If you add malicious actors, the risks become enormous. This is exactly what has happened in the crypto DeFi world.
The larger the decentralised network the higher the risks. The crypto DeFi platforms have one thing in common: they have been developed at light speed. The rapid growth means that they implicitly extrapolated the experience from the early stage, the “tacit knowledge” phase, to the stage of mass adoption. The explosive growth carried risks that haven’t been exposed until too late.
I highlighted the risk of crypto DeFi in my analysis of ARK Innovation’s Best Ideas 2022. Trust is essential to efficiency and freedom:
Perhaps the real meaning of ideal decentralisation expressed in Best Ideas 2022 report is the absence of government control, which is not to be trusted because its power is susceptible to corruption and abuse resulting in the erosion of liberties, and ultimately in inefficient economics.
In reality, trust always needs some form of authority acting as a guarantor, but that authority doesn’t necessarily have to be the government. Trust requires unambiguous rules and capability to gather information about the system’s current state. This information is accessible, based on facts that inspire confidence the system works, and when it doesn’t, the authority (or authorities) has the ability to promptly rectify the errors. That is in itself an asymmetric distribution of power, due to the centralisation of influence. The key to a benign and impartial network is to have a transparent authority accessible to all participants that requires a small maintenance tax. That tax is the cost of doing business.
The latest casualty of unbridled delusional enthusiasm for decentralised crypto finance is Celsius’s bankruptcy. Its vocal advertising of freedom and friendliness in contrast to dark, greedy, vile traditional banks is part of its proclaimed DNA.
Ironically, “Banks are not your friends” by Celsius is now free advertising for traditional banks as good friends to have in turbulent times. Celsius’ Customer Care pledge “to allow anyone and everyone to unbank themselves and enjoy financial freedom” sounds hollow now.
The Delusion of Decentralised Creativity
The idea of decentralisation as a formula for equality is not limited to finance. I recently listened to a Web3 with a16z podcast on Decentralised Creativity and Collaboration on Web3 with Chris Dixon and Sonal Chokshi and their guest Rob McElhenney. I recognised the same pattern of delusion manifested in crypto finance (centralisation is bad, it should not occur, and it will not occur if we are not careful).
The centralised creativity model proposed by Rob McElhenney is based on a platform that works like this: a group of 25 writers sit in a room and the two pre-designated leaders propose a topic, then individuals in the group get to agree, propose alternatives and vote. Once they agree on the topic, the creative process begins with each writer contributing to the material.
Rob says that new leaders can emerge from the group and spin off into a new group by adding new writers. In principle anyone can join as “you don’t have to be a professional writer to have good ideas”. Each writer has power. Sonal was particularly excited by the idea of the group deciding who to kill in a TV episode. Rob mentioned that the top leadership, the ones that run the creative platform, decided that 13 rules must be accepted and observed by everyone before any creative work starts. As an example of improved creativity Sonal mentioned how Marvel introduced a Pakistani woman as a character which would have not happened if the script was written by one writer. The course of the discussion is an illustration of a cultural shift in the show business which tries to use a collaboration model that responds, and perhaps mimics, to opinions expressed on social media that re-creates and almost rebrands the successful classics like Star Wars, Toy Story (Lightyear), and Marvel.
The glaring miss in this podcast is the economic model. Interestingly, the other miss is the audience. This is a writer inner looking perspective. Why is the audience never discussed? Because the speakers are talking about their customers, who are writers. Their interest is to capture a market share of writers that can produce contents at low cost. The underlaying goal of decentralised creativity to maximise output on a good profit margin. Remember, the podcast is a16z production promoting the project of decentralised creativity in which they are key investors.
The presentation of free, open and collaborative creative spirit never mentions the financial side, except for Sonal’s exclamation: “fuck on the emotional attachment because I want financial state to do great. I am creating things and I want creative reward”. That is perhaps an accurate description of how things work: creativity needs financial incentives and investment.
What is the business model that makes possible a creativity at scale? The invisible blockchain, invoked so often as a revolutionary technology, is not sufficient because it lacks valuation, relevance and discoverability (no part of its job description). Web3 will need an advertising model, a propagation system that brings value to everyone and where everyone is able to discover value aligned with their own interests. Such system can not be built without massive investment, and massive investment will not be built without asymmetric reward skewed toward those who invest and build.
Chris Dixon makes the case of centralisation arguing that it is essentially an evil that needs to be avoided. In two simple diagrams he demonstrates how inequitable Web 2 has become as a few dominant players control the Internet (Apple, Google, Facebook)
He believes that Web3 will grow large, but stay at the beginning of the S curve to be permanently attractive and cooperative. This is naive to say the least. One could say it is even disingenuous considering that he is a partner at a16z, one of the largest venture capitalists, which Jack Dorsey accused it in a rare public outburst as the new controllers of Web3. Creators cannot earn for a living if their work is not widely successful, and that is not possible without distribution and discovery.
The wide adoption is not possible without businesses who are capable of collecting, aggregating and processing information, analytics, production and distribution in a competitive and profitable manner, otherwise they would not be able to raise the capital and attract investment needed to build such business. When that happens, the idea starts moving on the S curve upwards. It is an inevitable process. If the idea doesn’t follow that path, it dies.
Clayton Christensen explained this very well in Innovators Dilemma. It’s the power law of numbers. This means centralisation is in charge again. Is that evil? Is that even a bad thing? Not necessarily. A good product or service that reaches the maturity at the beginning of the S curve is at a stage of broad acceptance and accessibility. The original innovators have become efficient, productive and stable and their products are affordable. This is the dividend stage, but also the stage where improvement starts falling; a new idea is needed and someone somewhere is about to start a competing S curve.
A more accurate description of the relationship between decentralisation and innovation platforms is symbiotic and temporary. Decentralisation is possible at early stages of adoption, but as more users join the platform the need for efficiency solutions accelerate along the S curve. Increased efficiency is made possible through consolidation of platform solution providers. In the later stages, new adopters (the laggards) join only because the platform is dominant, documented, well recognised and connected.
Similar to DeFi, the promise of decentralised creativity at scale presents a risk for those who invest their life effort into this idea. NFT phenomenon has already gone through the first stage of disappointment. People bought NFTs at the top of the market paying top dollars only to realise that their assets have had their value dramatically reduced. The idea that collaborative creativity where everyone can be a writer is a terrible attempt to discount the role of genius, the misfit, the weird talent who if they would be a member of the consensus building group of 25 would have their ideas shot down in a blink of an eye. These groups will never produce an Alan Edgar Poe. Good for average community hobbyist groups, but not for geniuses.
Many writers who dream of fame and money (as Solan astutely put it: fuck emotion, I want financial gain) will spend a good chunk of their lives working hard without receiving the reward they hoped. The real talented see this through and choose other ways of rising to fame outside consensus building, decentralised network of averages. This is similar to the early days of open source when many software coders worked long hours for free only to wake up years later with mixed feeling of pride, betrayed and waste. In the end a few large companies took over the world of open source (Red Hat, now part of IBM, Oracle, and Google). The relentless drive for efficiency always wins.
Geopolitical Watch
Are France and Germany the weak link of EU block?
For a very long time France and Germany have been in direct contact with Berlin, often to the publicly expressed frustration of Eastern European countries. After the Ukrainian war started the French and German leaders continued to contact Kremlin until Putin’s disdain and the war atrocities made that dialogue too unacceptable to continue. However, if Kremlin ever wants to negotiate, they know who to go to first.
NATO’s recent strategic blueprint characterises China as a challenger attracted a strong reaction in China. While noting the expansion of NATO, the key strategic point is to influence France and Germany in favour of China and away from US.
“NATO currently has 30 members and will have added two more members by the end of the year. The opinions of these 30 members on China-related issues are very diverse, and as a result, there are multiple voices within NATO regarding China.
“For example, whereas the US and the UK try to be tough on China, using harsh language, Germany and France are relatively more neutral and moderate. Therefore, China should seize the opportunity to form unbreakable diplomatic ties with these European nations as a key link in the chain that will stop senseless words and deeds which will end up causing European nations to turn against us.
EU is united in its condemnation of Russia’s aggression, but there is a visible rift between the East and West which China seems to be keen to exploit.
Ukrainian leadership’s reaction to Germany’s intention to continue buying Russian gas could backfire. It is understandable why president Zelensky wants EU to impose total embargo of Russian oil and gas, but it is not practical. The markets don’t work like that either, and he risks alienating the population of those countries who experience a sharp increase of cost of living.
The lack of progress of Ukraine’s military in the Southern Ukraine is also a reason of concern. It is not clear if this is a calculated strategy (destroy the ammunition depots and command centres first, while training military personnel on the use of NATO equipment) or if it is the result of limited organisational capacity. Demanding heavy weaponry from the Germans is one thing, demanding them to forgo gas supplies is another. If Germany’s GDP growth plummets, donating military and financial aid to Ukraine will become much more difficult.
Is Ukraine Losing Support?
The incessant Russian bombing of Ukraine civil buildings with a large number of casualties is a big concern if Ukraine doesn’t respond with a significant success. This risks causing tensions inside EU, breaking the united front, which could result in delayed assistance to Ukraine on the battle field with catastrophic consequences. I believe this risk is underlying the pessimistic state of the markets. It is not only the inflation problem that makes the markets nervous, but the political instability that has enormous ramifications.
A handful of HIMARS doesn’t make a difference in the long run. President Zelensky firing the chief spy, amidst a lack of progress on the Southern front points to potential deep internal problems. It is worth noting that EU’s leaders are less vocal in their support of Ukraine. Annalena Baerbock, a staunch public supporter of Ukraine, sometimes even at odds with Olaf Scholz, has mentioned Ukraine only three times since mid-may in her official tweets. Maybe the Ukrainian leadership overstepped the line by demanding changes in EU countries economic policies and that, although understandable for leaders who see their country murdered in daylight, cooled the politicians willingness to express support for Ukraine at the expense of their own voting citizens.
It must be very difficult for Ukrainian military leadership to adjust in the middle of the war to new NATO equipment, strategies and tactics. Mistakes are being made. Perhaps it is not a coincidence when Zelensky went to Sievierodonetsk to push for a counteroffensive in a region encircled by Russian forces that Biden stated how the Ukrainian president would not listen to the American intelligence, dismissing the imminent war in early February. Was that Sievierodonetsk counteroffensive which proved so costly for the Ukrainian army another example of “not listening” too? We don’t know. What we know is that Ukrainian counteroffensive has stalled for over a month now and Russia has gradually gained large swaths of territories.
The West is barely moving. Accusations are flying, threats are made, but actions are lacking, or at least not visible. No one knows how to deal with an aggressor that keeps pounding cities, emptying vasts stretches of land of populace fleeing to the West side. The last couple of weeks has changed the balance of strength in favour of Russia considerably. If this continues for another few weeks, the west will not have any army fighting for them, no one to take NATO weapons against Russian. Then we will have a truly different world order. Inflation worries will be child’s play compared with what is to come.
The State of Financial Markets
JP Morgan financial report for Q2 is a good general summary of the market status:
“The truth of that is we’ve looked very carefully into the actual data and results and there is essentially no evidence of any weakness in the actual results,” Chief Financial Officer Jeremy Barnum said about the economy. “The questions are about the outlook.”
“If I had to use one word to describe it, it would be ‘complicated,’ ” Morgan Stanley Chief Executive James Gorman said about the economy, citing the effects of inflation and geopolitical turmoil.
(WSJ) - 14 July 2022
It is fascinating to watch how the US administration is trying to control prices
This is becoming an entrenched pattern for the US administration: try to control prices, not the production. The price gouging accusation of the oil industry taking advantage of the current crisis, the global tax ceiling and now the price cap of the Russian oil, all point to an ideological approach to dealing with the current challenges.
This approach has a resolute champion in Janet Yellen who supported the global tax and now the oil price cap. The treasurer has a long academic record which explains her preference for big regulations in favour of blue collar workers. Shell CEO made a diplomatic remark about the potential impact on the insurance industry, if the oil cap policy is to be applied in practice. But no one listens to the oil bosses who now are lower than the Saudis on the pecking order. Imposing prices when private initiative is the most effective way to allocate resources in times of supply crisis may create bigger problems.
Tech Stocks Recovery
Slowly, but surely, the growth tech stocks are clawing their way up. The CPI reading was so extreme, the market seems to see the end of the tightening cycle inching closer. ARK ETF has had substantial gains lately, albeit from a low base. Stocks with strong IP and balance sheet will see this through and rise stronger on the other side. This is a very interesting period when new generational leaders are emerging.
The bitcoin has stabilised but it is approaching a key technical test in a week or so which could see it plunge again.