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NuFi > 2018 > November

What is a blockchain? What is the blockchain?

What is a blockchain?

Many people have heard the word “blockchain” – it seems to be the financial buzzword of the year.

But, when you ask people “What is a blockchain?” then other than knowing it is the underlying technology behind cryptocurrencies, most people have no idea what a blockchain is or why its important.

The simplest way to describe what a blockchain truly is, is to call it a “decentralized public ledger.”

Before we can get into the nuance of how a blockchain applies this in a technical sense and what the advantages are, let’s get on the same page about what these terms mean.

Let’s start off by stripping away the “decentralized” part, and focusing on what a “public ledger” is.

If English is your first language, you probably feel you have a decent grasp of that concept just from the two words alone. “Public” accessible to everyone. “Ledger”, a book or record of financial information. But, I’d still ask that you follow along with our analogy below, because there is important nuance we’ll unpack when applying this concept to the blockchain.

What is a public ledger?

To better understand what we mean by a “public ledger” I’m going to take you through a story that I’ve shared with my students over the years to help them understand the blockchain.

The Village Ledger

What is a blockchain?

I want you to imagine a little tropical island village.

A lush paradise with a series of huts, surrounding one large middle structure.

This tropical island paradise is home to five different families. For simplicity sake, we’ll simply refer to them by number such as “Family #1.”

Our society lives in a pre-modern civilization. They are a simple farming community. They can read and write, and have iron tools – but, they don’t have electricity, and haven’t even begun to use things like oil or coal for fuel.

This simple farming community spends their year harvesting coconuts. They tend to them throughout the spring, harvest them in the summer and then in Autumn, they trade the coconuts with a more advanced society on the mainland in exchange for supplies to get through the winter.

The Island Problem

Early on in this societies existence, they realized they had a problem. The families small huts couldn’t act as storage for all the coconuts that each family had harvested.

They needed a better place to store the coconuts, so the families came together and built a large structure at the centre of the village where all the coconuts would be stored. And, at the end of the season, the community would just trade all the coconuts at once.

Since certain families were larger than others, they both contributed more coconuts to the collection, and needed a larger share of the supplies to get through the winter, and so they needed to come up with a way to track contributions for each family.

The Island Ledger

What is a blockchain?

To solve their problem of tracking how many coconuts each family contributed, the inhabitants of our island decided to create a ledger book and put it on a shelf outside the coconut storage hut.

On the front page of this ledger was a list of each family’s name, and the amount of coconuts they owned in the storage unit:

Family #1 — 100 Coconuts
Family #2 — 85 Coconuts
Family #3 — 115 Coconuts
Family #4 — 125 Coconuts
Family #5 — 75 Coconuts”

On the internal pages of the ledger, there were a series of transactions, at first these were just families adding coconuts:

Family #1 added 3 Coconuts – June 22nd

Family #2 added 4 Coconuts – June 25th

But, the families then realized something else. They now had the ability to trade among one another without physically exchanging coconuts. They could instead just update the ledger. So now we have transactions that read:

Family #1 traded Family #3 5 Coconuts for 2 quarts of milk

Then “Family #1” would lower their balance of coconuts from 100 down to 95, and “Family #3” would raise their count of coconuts from 115 to 120.

This public ledger allowed the families to know if individuals truly had the money without seeing it. It also allowed them to trade assets between them without having the items in physical proximity, and it created very rudimentary forms of debt and credit (as technically a family could be negative in coconuts and owing to another family.)

This system works fairly well except for one caveat – trust.

The Trust Problem

What is a blockchain?

Our islanders have known one another for generations, and the five families trust one another. They know that the information in the book is updated by people they trust, and so they don’t need to ask for proof when looking at the numbers.

However, one day, a new family moves to the island and sets up a home. The islanders are quick to welcome “Family #6” and teach them their ways. A few of the families even donate a couple of coconuts to the new family to help them get started and they update the ledger to read:

Family #6 – 20 Coconuts

The next morning “Family #6” goes to “Family #1” and offers to buy their cow. “Family #6” says they are willing to pay 300 coconuts for it. In disbelief, “Family #1” goes to consult the ledger and see how many coconuts the new “Family #6” has.

When they look at the ledger they see a transaction from last night that reads:

Family #6 added 700 coconuts – June 28th

And the balance of at the front of the book now shows:

Family #6 – 720 Coconuts

Now the Island ledger system is broken, because the community has one “bad-actor” that they can no longer trust.

Back to the Blockchain

What is a blockchain?

Ledger systems have been around for a long time, but, they require “trust”. We  either trust all the individuals in the system, like our island community did or we have to trust middlemen like banks, who often charge large fees.

This becomes a huge challenge, especially in the digital space. This is why there is an important difference between a ‘public ledger’ and a ‘blockchain’.

It’s a weird concept to wrap your head around, but everything on the internet is essentially a file on a computer. Like a .jpeg picture file that you might have sitting on your desktop. (Yes, this is an oversimplification, but, for the non-technical among us, it is accurate enough to understand the concepts at hand.)

If I have a picture on my desktop and I send it to you, there is no way for me to know what you do with it. Even if you send me the picture back, you could have duplicated the file and still have a copy. To send you a digital file, I require either the ability to:

  1. Trust that you will handle the file to my specifications.
  2. Or, not care about what you do with the file as it will have no negative impact to me.

If I can’t trust what you will do with a file, how can I trust you to report the right amount of money (or coconuts!) to me?

Creating Internet Money

What is a blockchain?

In the early 90s, when the internet was fairly new, there was a lot of discussion on how to use the web for payment systems.

There were even multiple attempts of people creating an “internet currency.”

These services all faced a number of challenges.

Challenge #1 – Centralization Cost and Adoption:

Some of these services that popped up required you to pay huge transaction fees. If I wanted to send $100 to my friend across the globe, they might only receive $80 by the time all the fees are taken.

To make matters worse, my friend already had to have signed-up for an account with this service in order for me to send them money.

Challenge #2 – Centralization Trust and Existence:

Furthermore, if I was using a centralized service, I had to both trust the service was reporting the real amount of money (and not going to steal my money) – but I also had to trust that the service was going to be around for a while.

Many of these services operated like an early PayPal. But, because they were transacting in non-federally regulated currencies they weren’t insured or held to any standard. If I had bought $100 worth of e-Gold in order to transfer it to my friend, and the e-Gold service shut down, then I lost my $100 and there was nothing more that I could do.

Challenge #3 – Decentralized Trust:

Around the time of these scammy services, there was a lot of discussion of if you could create a “decentralized” service in which there was no central server, or administrator. The responsibility of the service would be shared by the community – much like our Island Ledger.

Every attempt to create such as system was met with the same challenge. No matter how much they screened their members, eventually a bad actor got into the system and greed took over ruining it for everyone else.

The Advent of the Blockchain

What is a blockchain?

The internet had failed on a few occasions to bring us a public ledger system that could operate without us needing to trust all of the participants. That was until the 24th of May 2009, when a mysterious individual named Satoshi Nakamoto posted an academic paper called “Bitcoin: A peer-to-peer electronic cash system

Not a lot is known about Satoshi Nakamoto, in fact, to this day no one is sure of his real identity. No one has ever met him, and in 2010 he left the Bitcoin project and stopped communicating with anyone through his online handles. Since then his fortune of over 1M Bitcoins (at their peak worth $20B) has remained untouched.

No one knows who Satoshi Nakamoto is/was, or if it was even a single person. What we do know is the Bitcoin “whitepaper” introduces the first concept of a digital blockchain aimed at allowing a decentralized public ledger system that is “trustless.”

The basics of Bitcoin’s blockchain

What is a blockchain?

Since Bitcoin was the first blockchain ever created/implemented, we’re going to talk about a number of the features in terms of Bitcoin’s blockchain.

It’s important to remember that while blockchain’s differ in features, the core of what makes it a blockchain is that it is some sort of “trustless” “decentralized public ledger.”

We’ll start with a high-level overview of Bitcoin’s blockchain, which may sound very technical, but after that we’ll break down each part so it is easier to understand.

Bitcoin’s Blockchain – A high-level overview

Bitcoin’s blockchain is very similar to our public island ledger. “The Blockchain” itself is a public record of balances and transactions that exist between users.

Instead of tracking the exchange of coconuts however, this blockchain tracks the balances of Bitcoin.

Instead of a ledger having listings for each family like “Family #1” each user has a “wallet.”

Wallets are given their own unique “public key” and “private key” that are used to manage the wallet and allow the user to send transactions.

The ledger is used to keep track of how many “Bitcoins” each wallet has. (Although just like in our coconut example, bitcoins never actually move to different wallets, they only update the numbers in the ledger.)

The ledger (the blockchain) is a big data list of transactions, balances and events, that are split into small chunks called “blocks” and copies of it are stored on thousands of computers around the world.

Whenever a wallet makes a transaction the decide the amount to send “sign the transaction” with their private key and send it to the network.

Then every computer that is connected to the Bitcoin blockchain by “mining” checks their local copy of the ledger and validates if the user has the balance, if their “private key signature” matches the public key, and if they’ve signed the transaction. If they have the “node” (mining computer) validates the transaction with a “Yes” vote.

As long as more than 51% of computers agree that the transaction matches with their record, then the transaction is approved and takes place, because they have reached “consensus”.

All the computers who were “mining” split up the transaction fee as a reward.

Where is the ledger stored?

What is a blockchain?

Unlike in our island ledger example, the ledger is actually not one physical ledger. It exists as copies across thousands of computers around the world. These “Bitcoin Blockchain Nodes” store the entire history of the ledger. Anyone can download a copy of the blockchain (ledger) and become a node.

How is information stored in the ledger?

All the transactions and balances of a blockchain are stored in data chunks called “blocks”.

If we were on our island ledger, this would be the equivalent of one page in the ledger. We fill up a ledger page with transactions and then move to the next page.

In Bitcoin, one block is produced every 10 minutes, and it is filled with the latest transactions. That information is sent out to all the computers connected to the network.

What are wallets?

Instead of having line items in the ledger for each family, users instead have “wallets” which are their entry in the ledger to store their Bitcoin.

These wallets are identified by a “public key” which is also known as their “Bitcoin Address”

What is a public key?

A public key is a bit like an address, if I want to send you a letter, I need to know an address where you live.

In Bitcoin, wallet addresses are random strings of letters and numbers. For example:

1A1zP1eP5QGefi2DMPTfTL5SLmv7DivfNa” this address was the first one ever created (referred to as “The Genesis Address”) and is owned by Satoshi Nakamoto.

Public keys/addresses aren’t very user friendly when presented as random strings, but, it’s actually very important that these strings exist because they interact with private keys.

What is a private key?

What is a blockchain?

A private key is kind of like a password for accessing and controlling your wallet. It’s something that only you know, and you can’t ever share.

Unlike passwords, private keys cannot be changed.

The public key and private key are actually linked together through a complicated mathematical function that creates both of them.

When you have a private key you can use it along with the math function to produce the public key, but it is mathematically impossible to use the public key to figure out the private key.

This is what allows us to “sign” transactions. Using our private key our wallet creates an encoded string (such as turning “ABC” into “123”). This string, when created by the private key, can be decoded by the public key (although the encoding/decoding can’t work the other way around).

This allows us to prove “this transaction was indeed signed by the person who owns this public address” even though we don’t know the key.

The equivalent for our island ledger would kind of be like each family having a wax seal to stamp their transactions with. Perhaps each stamp had a very unique feature that only that family knew how to create. This means that even though you didn’t see them apply the stamp to the paper, you know it must have been them who stamped the page.

Private keys are complicated stamps, that are impossible to duplicate or trick and will always match the public key.

What is a node?

A node is any computer system connected to the blockchain network. Nodes monitor and help to validate transactions through a process called “consensus”.

What is Consensus?

What is a blockchain?

Each node has the ability to vote on a transaction. In blockchain technology there are a number of methods of counting votes and deciding how nodes agree on transactions. These are called “consensus mechanisms” – essentially “how do the computers reach consensus” or “how do we decide when enough of us are in agreement.”

On our island ledger, this would be like letting each family vote on whether they believe the transactions to be real/true, and only counting the transaction if enough of the families voted yes.

The main point of consensus mechanism is to decide three things:

  1. How do we decide who gets a vote?
  2. How many votes do they get?
  3. How many votes minimum are required to approve/deny a transaction?

If we look at our island example this might break down something like:

  1. Do all members of the village get individual votes or do only the families get to vote?
  2. Should family get more votes if they have more family members? Should their vote hold more weight if they contribute more coconuts?
  3. Is a transaction real if 3/5 families agree? Or do 5/5 families have to agree?

For the Bitcoin blockchain the model they use is called “Proof-of-Work.”

What is Proof-of-Work?

Proof-of-Work is the consensus mechanism for the Bitcoin blockchain.

Some people advocated that each “wallet” should simply have one vote on a blockchain. The challenge with this becomes it costs nothing to make a wallet, and it costs no resources to run a wallet.

If I was a bad-actor, I could simply make 1M fake wallets, tell the blockchain I was sending a big transaction and have all my fake wallets say it was true. Then your wallet would believe I had sent you the bitcoin, even if I didn’t have any to send.

To solve this problem Satoshi Nakamoto suggested the method of Proof-of-Work, in which computers must partake in “mining” in order to have a vote in the network. Because of the way mining works, its resource intensive and you can only have one mining program open on one computer.

This creates an economic cost for voting, and proves some level of identity, making it so that people can’t cheat the voting system.

What is mining?

What is a blockchain?

Mining is basically using your computer to solve a complicated math problem. A random number and a “hashed” encryption string of letters and numbers is also generated.

Your computer needs to randomly generate numbers until it finds one that, when combined with the other number the blockchain gave us, that it produces a matching hash string. (Hashed strings are when you take any letter and number combination and change it based on a set of rules. Very similar to secret codes or “decoder rings” that you might have had as a child – except these rules are complicated algorithms)

This description is a bit confusing, so here is a simple example. Imagine I give you the letters:

ABC

And the encoded string:

234ZAB

You don’t know the method I used to encode the string, all you know is that you have to randomly guess three numbers. When you have a guess you can ask me if is right and I will say “Yes” or “No”.

You have to keep guessing until I say “yes.”

In our simple example, the method of encoding might be “-1”

So I may take the numbers 3, 4, 5 and subtract one from each of them, so they become 2, 3, and 4.

Then I may take the letters A, B, C and subtract one (or move one letter back in the alphabet for each) and have them become Z, A, B.

As we know, your computer needs to guess a string to put in front of “ABC”. In this case we need “345” so that when it is combined with “ABC” it becomes “345ABC”. When we pass it through our “hashing function” of “-1” it becomes the encoded string “234ZAB”.

This is a super simplified version of how the computers are randomly guessing numbers to check against a secretly encoded string.

What is the purpose of mining?

Actually, nothing. It’s pointless. The numbers are entirely random and not used for anything.

The only goal of mining is for it to take time and be hard. You essentially get more voting power on the blockchain the more guesses per second your computer can produce.

While mining, these nodes also verify transactions by checking that someone’s “signed transaction” matches with their “public key” but this process is trivial for computers and takes fractions of a millisecond.

In our island ledger concept, this would be similar to the process of the family creating their unique wax seal. It is something tedious and challenging that ensures the work is genuine because the effort required to try and cheat the system outweighs the benefit of tricking the system.

What is a blockchain?

Why do people mine?

Mining is a common method of distributing cryptocurrency like Bitcoin. Since  you need to provide an economic incentive for people to use their computers resources in mining, they are rewarded with Bitcoin.

In the beginning of Bitcoin, Satoshi Nakamoto decided that there would be 21M Bitcoin produced. To help randomly and fairly distribute them, they would be awarded to users who find the solution to the next block puzzle when mining.

Each 10 minute block consists of the “block prize” and the total transaction fees from users who sent transactions during that 10 minute time window.

The first set of blocks yielded 50 Bitcoins each as a block prize, and that amount gets lower over a set time period (roughly every 4 years). The goal is eventually that, once all 21M coins are mined, that the fees earned from transactions will be enough that miners will continue to mine for Bitcoin and help secure the network.

What does it mean to say a blockchain is “trustless”?

“Trustless” or “Trustlessness” are new concepts. Right now, we think of systems, communities, groups of people and individuals as “thing we trust” and “things we do not trust”.

It is ultimately a scale between 0% – 100%. I can 100% my bank, or I can 30% trust my bank (which ultimately means I don’t really trust them.)

Trustlessness, or trustless systems, are (usually economic) systems which exist without the need for trust. I don’t need to trust or not trust other nodes on the blockchain. It is literally impossible for them to successfully lie to me or manipulate my transaction. If I own some Bitcoin, no other person in the world can take that away from me. It’s not like a bank or PayPal who can freeze my funds. I have trustless access to those funds, and trustless control over them.

What does it mean to say a blockchain is “decentralized?”

What is a blockchain?

A decentralized system is one that has no central point of failure or control.

For example, PayPal is a single corporate entity in the United States. If PayPal Inc, goes out of business, you will no longer be able to use PayPal to hold or transfer your funds. If PayPal inc, decides to freeze your assets, you no longer have any opportunity to reclaim them except through interacting with PayPal.

A blockchain, however, is decentralized. There is no “Bitcoin Inc” or any other company that runs Bitcoin. Bitcoin cannot be shut down or destroyed.

The public ledger is decentralized because copies of it exist on tens of thousands of computers all over the world. If I turn off my computer, it doesn’t shut down the Bitcoin blockchain. The blockchain keeps progressing and in the morning when I turn on my computer again, it will just catch up with the ledger by downloading the latest blocks.

Blockchain vs Public Ledger

So we now understand that the key differences between our classic “public ledger” system and a blockchain boil down to:

  1. Decentralization: Everyone has a copy of the ledger.
  2. Trustlessness: Impossible to fake validation methods (private/public keys) mean that the data we see in the ledger must be true.
  3. Consensus: Everyone in the system gets a vote when it comes to validating the data.

Bringing it Back to the Island

So if our island was to implement many of these features we would now have a system where:

  • Each family earns votes based on how many coconuts they produce.
  • Each family stamps transactions they are part of with a special wax seal that only they can make.
  • Each family votes to decide if they believe the stamps to be real and genuine in each transaction and at least 51% of the families must agree or the transaction is removed from the ledger.
  • Each family keeps their own copy of the ledger, and updates it by asking other families for the latest updates and only recording the transactions if more than 51% of families agree on the transactions.
  • In exchange for helping to validate transactions, each of the families are rewarded with a small cut of the transaction as a fee.

That’s it. That’s essentially a blockchain without electricity, without the internet, without any technology at all. Blockchains seem big and scary, but, when we think of them on our little tropical island it’s pretty straight forward.

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Kik (the company behind the Kin ecosystem) recently launched their first beta app “Kinit” on the Google Play Store. The launch received polarizing feedback with both an out-pouring of positive reviews on the Play Store, but, some tough criticisms from both the community and reporters who failed to understand parts of Kik’s strategy.

A Quick Recap of the Main Criticism:

  1. From the Community: “They aren’t doing any marketing of this launch!
  2. From the Community: “Their future plans are only to market to developers!
  3. From TechCrunch’s John Biggs: “ By encouraging usage they drive up the token price and token velocity and by launching a general beta full of cutesy imagery and text they are able to avoid the hard questions about developer adoption until far into the future. While the KinIt app is probably not what most Kin holders wanted to see, it’s at least an interim solution while the team builds out sturdier systems.
  4. From CCN: “There isn’t any business model — how will this work?
  5. FUDsters and haters: “Kik hasn’t done much since the big ICO
Over the next series of posts, I’m going to address each of these points, explain why I believe they are fundamentally flawed, and address why I think Kin’s strategy is headed in the right direction.

They aren’t doing any marketing of this launch!

One of the main points that the community is making right now, is that Kik and the Kin Foundation are not currently doing anything to promote the Kinit app. Before we dive into the reasons that this is the right decision, it’s important to remember some background:
  • Kinit is a beta.
  • “Beta” in technology projects is very different than “beta” games which are normally just early access.
  • Kinit is limited to one country currently (the US).
  • Kinit is only available on Android during the beta.
  • Kin is still testing their new Kin blockchain (based on Stellar).
Given the above, there are two reasons why Kik should not be marketing Kinit to the general public right now. # 1 — Understanding the Chasm: Heavily marketing a beta launch, especially to the general public, is a horrible idea. Consumers fall into a number of different categories in terms of their willingness to adopt new products, and their ability to be forgiving about bugs and expectation gaps.
Image result for crossing the chasm
When a startup or new product launches into beta, they focus on a “minimum viable product” (MVP) which is essentially a first draft of their product with slimmed down feature sets. This MVP often acts as the beta for innovators and early adopters to help test, refine and give feedback upon. These users are part of an early market that exists outside of the mainstream. They are used to using early, incomplete, and complicated products, and will stick with the products even if there is a lot of friction or frustrating bugs. (Chances are, if you are reading this you are in the ‘Early Adopter’ category. Because crypto has not yet “Crossed the Chasm.”) After that early market group, you reach a point called “The Chasm.” This is the gap between early adopters and a mainstream market. “The Chasm” is tremendously challenging for products and startups to cross, and it often ends up being a fatal point in the growth trajectory of most startups. Beyond “The Chasm,” most consumers expect a complete, polished, easy to use and easy to understand product. These mainstream users don’t know anything about wallets or private keys and they’ll abandon any app that has simple bugs, including:
  • Frequent typos or grammar issues.
  • Poor layouts.
  • Auto-rotation glitches.
  • Issues with SMS/2FA.
  • Overlapping text.
  • Poor support on certain devices.
Not to mention that they’ll be far less forgiving on things like the amount of surveys, and amount of offers they want to be able to redeem on a recurring basis. Mainstream users are picky. Unlike early adopters (you) they don’t have emotional, ideological or financial connections to a product. They will look for any excuse to churn out and never use your product again. They also cost more to reach as you often have to educate them on the purpose of the product. #2 — The Leaky Bucket: In marketing, when we advertise to new users and try to get them to adopt a new product this is called our “marketing funnel” — the “marketing” that most people talk about is usually paid advertising that takes place at the “awareness” level of the funnel.
When looking at the effectiveness of a campaign, we take detailed measurements on a marketing funnel (I won’t get into these here, but if you are unfamiliar with funnel metrics I can highly recommend Andrew Chen’s post on “How to Create a Profitable Freemium Business.”) The most important factor to understand is that we pay out at the top of the funnel, but we profit from the bottom. Think of it like trying to fill a bucket at your tap. You are paying for the water coming out of your tap, but, you are only benefiting from the water that goes into the bucket. But, if you drop any water from the bucket, it goes down the drain and you can never put that specific drop back in your bucket. If your bucket has no leaks, then this isn’t a problem. But, your bucket does have leaks.
Related image
All product buckets do — but the goal is to minimize the leaks. Right now, when someone discovers Kinit the leaks are:
  • 100% of users who use iPhone.
  • 5% of users who use an Android device running versions older than 4.4.
  • 100% of users outside the US.
  • Users who are frustrated by bugs.
  • Users who can’t SMS verify.
  • Users who don’t feel there are enough surveys.
  • Users who don’t feel there are enough redemption rewards.
  • New landing pages which are still being optimized.
  • New onboarding flows which are still being optimized.
  • Lack of churn mitigation and reengagement from the app.
  • and many more.
Paid marketing funnels are tough for free apps, and so they need to have an air tight funnel. You may be thinking “Yeah, but, I hear of developers who get $0.50 — $2 cost per installs when marketing their apps so Kin should just go buy 1M users!” and while that is true, it doesn’t account for retained users and it isn’t viable at this scale. Paid marketing has a tremendous challenge wherein the larger the audience you try to reach, the less cost efficient it becomes. While getting 10,000 installs for $1 — $2 a piece is trivial, getting 1M installs using paid marketing channels is likely to cost more in the order of $7 — $12 per install at scale. (Math post to follow later in the series!) This matter is made worse by the fact that on average only 33% of users retain on apps after the first 30 days. This means Kin could be effectively paying $21-$36 per user (excluding gift cards) which would be a terrible strategy. $1M spent on partnering with established developers, apps that are growing and have higher CPAs due to freemium models, and partnership teams is going to go a lot further than 300,000 purchased users. The goal of Kinit is to act as a central wallet point within the Kin ecosystem, and so as the ecosystem grows users will naturally be on-boarded to the app. #3 — Kik is spending money on acquisition: Lastly, it’s important to realize that Kik IS spending money within their marketing funnel. They are just spending it in the “engagement” / “retention” part of the funnel rather than on awareness. The gift cards within the Kinit app are currently having their cost compensated by Kik. I’d hazard that the compensation is around the 75% mark. So even if we assume that a user only receives one $5 gift card during their entire beta, then that means Kik has spent $3.75 on making it easier for that user to earn the gift card and retain the user. Takeaways & TL;DR:
  • The app is a beta, and not ready for a picky mainstream audience.
  • Advertising to a mainstream audience before your product is ready for them makes it MUCH more costly to advertise to them in the future.
  • Spending money on awareness campaigns is wasteful until you iron out your conversion funnel.
  • Paid acquisition marketing (at the awareness stage of the funnel) is effective for small businesses. When trying to scale a company to tens of millions of users it loses efficiency and requires a much higher RoI margin that a free app like Kinit doesn’t have.
  • Kik IS spending money on marketing, by compensating the cost of user gift cards in Kinit. This is money spent at the engagement/retention phase of a marketing funnel, which is by far the most cost effective stage.

Curious what all the fuss is about? Check out the Kinit app where you can earn and spend the Kin cryptocurrency every day! [thrive_leads id=’3175′]
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Metcalfe’s Law

Unless you work in the telecom industry, you may never have heard of “Metcalfe’s Law.”

And rightly so, as Metcalfe’s law is a simple and obscure mathematical observation relating to the impact/reach of a telecommunications network.

The law states that the potential of a network is simply the number of nodes squared, or mathematically:

n2

All this means, in its basic form, is that the network is more valuable the more people that use it.

For example, if you had a phone that could only call one other phone, then that network has a low value, as there are only two possible connections. Phone A can call Phone B, and Phone B can call Phone A.

If you add an extra phone to the network (for a total of 3 phones) then your total number of connections doesn’t just increase by one. Instead, if you have phone A, B and C you can now have connections:

  • A calls B.
  • B calls A.
  • A calls C.
  • C calls A.
  • B calls C.
  • C calls B.

So whereas a network of two phones had 2 connections, a network with 3 phones has 6 connections. This compounding growth curve is represented on a graph by the equation. The growth of value in a network scales exponentially, giving us what we call “the network effect.”

How does this work outside of telecom?

While it may make sense for a telephone network (or computers on the internet), how do we apply this to systems outside of telecoms?

My favorite example involves currency and gift cards. But before we dive into that example, we need to define a few terms. When we think about the world of gift cards, there are two types: “closed-loop” and “open-loop.” They get their name from broader concepts which can be applied to financial systems.

Closed-Loop Financial Systems

Closed-loop financial systems are ones in which the flow of money is controlled and can only be earned or spent in certain places.

For gift cards, this is like buying a gift card for a specific company such as McDonald’s.

You give $10 to McDonald’s, they give you a gift card valued at $10, and they know you can only spend it at McDonald’s.

Another example would be something like tokens in an arcade. You’ve purchased the tokens, which are the closed-loop currency, and can only use them in that arcade. Outside of the arcade they have very little value.

In fiat economic systems, we don’t really have any examples of a 100% closed-loop financial system. The closest we come is the Chinese Renminbi/Yuan which is a controlled currency. The Chinese government works hard to prevent Yuan from leaving the Chinese financial system, although it still does leak out through various black market channels.

It’s important to remember that closed-loop (and open-loop) aren’t categories. They are a sliding spectrum.

Open-Loop Financial Systems

On the other hand, open-loop financial systems are when money can be entered into a system that is not controlled. The most open example of this is any national currency, when you buy into it you are free to spend it anywhere in that country and can often find places around the world to easily accept and exchange your currency.

But, when we talk about gift cards, “open-loop” refers to a gift card that can be redeemed at multiple locations. One such example might be a gift card you can redeem at any store in your local shopping mall, or, if we want an even more open-loop card we’d use the example of pre-paid Visa gift cards, which can be redeemed just about everywhere.

Once again, as we can see, there is no example of a financial system that is 100% open, and there are multiple levels of “openness.”

Applying Network Value to Gift Cards

Now, let’s assume that I have four different financial instruments in my possession:

  1. A $5 bill.
  2. A $5 gift card to Einstein Bro’s Bagel Co.
  3. A $5 gift card to Starbucks.
  4. A $5 Visa gift card.

At first glance, if we were asked which of these is the most valuable, it might be tempting to say “Trick question! They are all worth $5!” But, given what we now know about how networks are valued, we may take a different approach.

When we think about selling these items, we instantly know that the $5 is the most valuable, because we would never sell a $5 bill for anything less than $5. The underlying reason for this is a $5 bill can be used anywhere and so we don’t discount it at all.

As for the rest of the cards, let’s take a look at what they are worth on second hand networks. If we go over to GiftCardGranny.com, we can look up the value of the different cards.

Einstein Bro’s Bagel Co.

When we look up the gift card at Einstein Bro’s Bagel Co. we can see that the average giftcard for their store is selling at a 35% price discount:

This means if we attempted to sell our $5 Einstein Bro’s Bagel Co gift card, we’d probably only get $3.25 for it.

Why? By exchanging $5 of an open-loop currency for a closed-loop currency, we are restricting the number of places we can spend it, which makes it less valuable. So the supply and demand of “people who want Einstein Bro’s Bagel Co gift cards” and “people who have Einstein Bro’s Bagel Co gift cards” is out of balance, and thus, sellers must compete on price discounting to get their money back into the open-loop.

Starbucks

So, by this same logic then, we may expect to see that our $5 Starbucks gift card is worth about $3.25 as well, right?

Instead, the average Starbucks gift card is only 13.56% discounted, meaning our $5 card is worth about $4.32.

Why the difference? When we look at these cards as “networks” we have to remember how we apply Metcalfe’s law – the number of nodes matter.

For gift cards, these nodes are:

  1. Starbucks locations.
  2. Number of people who want Starbucks.

Simply put, there are more Starbucks than Einstein Bro’s Bagel Co locations, and more people who prefer Starbucks to Einstein Bro’s Bagel Co. Therefore the network has more nodes and is more valuable.

Visa Gift Card

At this point, I think we all know what to expect:

The average Visa gift card trades at a discount of only 0.75%, making our $5 card worth roughly $4.96 – because it has a wider network with more nodes. More freedom for spending, more demand for buying.

The Value of Our Cards

So that makes our final value list:

  1. The $5 bill (Worth $5)
  2. The Visa gift card (Worth $4.96)
  3. The Starbucks gift card (Worth $4.32)
  4. The Einstein Bro’s Bagel Co gift card (Worth $3.25)

Applying the Law to New Economic Systems and Crypto

Now that we have an understanding of Metcalfe’s Law, it would seem to suggest that we could simply count the number of nodes or transactions within an ecosystem and accurately get the price of a currency, right?

Many folks who are far better economists and mathematicians than I am, have tried (with varying levels of success) to apply this model to cryptocurrencies; and while many models fit backtests [Read: Issues with Backtesting], they fail to accurately predict the growth of a cryptocurrency based on either its number of nodes (users) or the number of transactions moving forward. (Although many of them are really awesome models).

Why is this?

There are two main reasons for this:

  1. The original Metcalfe’s Law is designed to only measure the maximum potential value of a network. It does not measure the current or actual value.
  2. The original Metcalfe’s Law is designed to measure all nodes within a system at an equal value.

So while the general trend of “Network Transactions2” is historically true, this is more likely a matter of correlation, and not causation.

Different Transaction Values:

As we saw in our gift card example, not all nodes are of equal value or strength – and this is especially true of transactions in a financial network.

For example, here are four transactions:

  1. I transfer $5 worth of Bitcoin between two wallets.
  2. I transfer $500 worth of Bitcoin between two wallets.
  3. I purchase something worth $5 using Bitcoin.
  4. I purchase something worth $500 using Bitcoin.

We can’t assume that these transactions have all added equal value to the network. In fact, we could debate if the first two added any real value at all.

The two remaining purchases were value within an ecosystem, but, at very different scales.

Different Node Values:

If we want to think of nodes in terms of network services/participants rather than transactions (which would be useful if you are applying the model to something like the Kin Ecosystem) then we can look at a different case.

Imagine two developers add Kin into their app:

  1. “Developer A” has 1,000 daily active users (DAU) who love using their product, have an emotional connection to it and think it is an important part of their daily lives.
  2. “Developer B” has 500 DAU. They find the product useful, but in a solely functional manner.

In looking at Metcalfe’s Law we couldn’t equally weight these two systems, in fact because of the emotional component it wouldn’t even be fair to count the 500 DAU as 50% of the 1,000 DAU, as users with a strong emotional connection will pay more for something than those using it solely for function.

How do we solve for this?

That’s something I don’t have the answer to, and never will – at least not as a concrete formula. Metcalfe’s Law simply isn’t designed to predict the future price of a currency or network, primarily because to do so requires us to do complicated weighting and individual investigation for each node that makes it prohibitive.

How would we approach it? For us to evaluate the worth of a network I think we need to take into account:

  • The number of nodes.
  • The weight of that node compared to others within the system.
  • The value added by that node’s transactions.
  • The emotional weight users have to that node, measured by engagement KPIs.
  • The number of users on that node.

So, if Metcalfe’s classic law of n2 gives us the upper-bound value score of a network, then what we need to do is weight each node on some form of distribution and discount or increase the value of each node from there. In the end, we should end up with something that is a fraction of n2.

For a cryptocurrency like Kin, this might end up being something like:

((N1((f)(a)/2)+N2((f)(a)/2)+…+Nnth((f)(a)/2))2

Where:

  • Nnth is each individual node, represented by a count of N=1
  • f is the bell curve score of each node based on the value added to the network (solved as f(x) = y1 + ((y2-y1)/(x2-x1)) (x-x1)).
  • a is the bell curve score of each node based for user engagement, based on user engagement over number of users. (Same bell curve scoring as above).

 

Walking through the challenges

In this model, we take each node and give it a starting score of 1.

We then take their scores for “user engagement” and “value added” and grade them on a bell curve against all other nodes, giving us a weighted score for each. We then get the average of those scores. For example:

If N1 was the best node for “value-add” then it gets 100% or “1” and if it was a leading node for “user engagement” then it may get an 80% or “0.8” score for that.

We take the average of those two values and we get 0.9. We then discount the value of N by multiplying it by that weight. In this case, since the node started at “1” it is now a score of “0.9”.

We repeat that process for every node within the system and then we add up the final scores, after this we then square the sum of our result.

That will leave us with a number that is some sub-fraction of the classic n2 rule that is probably a more accurate predictor of the value of our network.

Does this really work? Is it accurate?

No, not at all. There are probably a number of issues with both my assumptions, and with the actual math equation. I’m not a mathematician. The point here is more to illustrate that in order to adapt Metcalfe’s Law, we would need to come up with complicated weighting mechanisms which makes it unrealistic to accurately predict the value of a currency.

The math gets very complicated very quickly, and the needed variables become almost impossible to measure.

Wait, so you are saying that we can’t predict the price of a crypto with Metcalfe’s Law?

Yes. Sadly, the goal of this article is to help you realize that Metcalfe’s Law is a mental model designed to help us think about measuring and growing value. It’s not something that we’ll likely ever be able to adapt and apply as a predictive tool.

At best, we’ll be able to adapt it in a way where we can accurately backtest/backfit data within acceptable bounds, but it likely won’t be a good indicator of raw price.

At the end of the day, Metcalfe’s Law won’t tell you the future price of your currency, but, understanding the principle of more nodes in a network equaling more value is important.

While many folks have created very complicated variants of Metcalfe’s Law to try and apply it to cryptocurrency and other financial systems, the only thing that has remained true is the simple n2.

Metcalfe’s Law is a theory. It’s a guideline to help you understand that networks grow value in a compounding and non-linear fashion. It wasn’t designed to predict the price of a network – the only thing you need to takeaway from Metcalfe’s Law is that if you want your cryptocurrency to be worth more, then adoption of earn and spend opportunities are the key.

TL;DR:

Metcalfe’s Law is about how “network effects” create compounding value. It will never be usable as a forward looking price predictor. But, it’s an important concept to understand in economics.

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