Steven Nerayoff, Founder & CEO, Alchemist; Architect of the ICO
I had the pleasure of meeting Steven at Jeff Pulver’s party in Silicon Valley. Steven founded seven companies in Silicon Valley and New York City. He was either a founder or advisor at Ethereum, Lisk, Bancor, tZERO, ZenCash, ZCash, Ripio, Aion, Storm and many others. Steven’s innovative work as the legal architect of Ethereum’s record-setting token sale continues to be the basic structure used throughout the world today. Steven invented the concept of “utility”, specifically by using the concept of “gas” or “fuel” for legal purposes. More recently he founded Alchemist, specializing in blockchain project development and investment. He has been kind enough to share his experience as the de facto legal architect of the ICO. He also shared his thoughts on the future and importance of the coming revolution. We discussed many topics ranging from mortgage backed securities, ideas for tokenization of home ownership and other appreciating assets, new protocol and infrastructure companies that will be needed, how different large companies will adopt or fail to adopt blockchain technologies, and many other topics. What follows below is a limited selection of salient points taken from my notes of our discussions. Here are Steven’s words.
Andrew asked me about my role in the creation of Ethereum and the ICO. I got involved in Ethereum because I was captured by Vitalik Buterin’s vision, genius and, above all, by his altruistic world view. I saw someone trying to make the world a better place. That was very important to me. My specific role was to find a legal structure such that a recognized law firm would give us an opinion that our structure would enable us to sell something that was most probably not a security. My eureka moment was when I realized that Ether has functionality. The fact that you need to use gas to either send it or you need to use gas to fuel decentralized applications was the key. The gas’s functionality. That is the genesis of what became known as the utility token and that gave rise to the explosion of ICOs using that framework and corollary uses.
We wanted to do a crowd sale and we wanted to find a legal means of doing that. I came up with the concept of analogizing Ether to a good, e.g. gasoline, by using gas’ functionality and that was accepted by some former SEC folks and was given a “more likely than not” opinion by a major New York law firm that Ether was not a security, the only opinion ever given in this space to date. That legal framework we came up with is effectively the genesis of the ICOs that have occurred since then. I would call that the law of unintended consequences.
In my opinion, people then took the valid legal construct that I developed and abused it in many instances where there wasn’t functionality or a native token. Ether for example could have been sufficient for many of these other projects. They certainly do not all need their own token to achieve their goals. They still tried to use the same legal framework. In many ways it sparked an explosion in ICOs by showing people a legal pathway. On the other hand, it caused a lot of abuses that were effectively using the legal pathway where factually it did not fit the framework that I developed. They didn’t use it properly and were just abusing it.
At Ethereum we were looking to raise enough money to actually build out the network and protocol. The token was simply part of that. It was not necessarily designed to last for years, but in our case this is what happened. The foundation happened to have a lot of funds, because Ether went up so much in value. That was just a consequence of the Ethereum adoption. With many projects since then, the use of proceeds has been sparse at best. Many projects want to raise money for years to come. I don’t believe this model for ICOs for new blockchain projects are necessarily the right way to replace classic venture capital financing. With us it was unintended to capitalize the company for years and many stages to come. We would rather build out the basic functionality, put it out there and then, based on the success or adoption, it could be run like any other business.
We changed our model from a for profit model to a non-profit model. We originally considered taking venture capital funding and we had offers, but we decided to go down the non-profit route instead to make it more neutral as an open source project. We raised $18m and Bitcoin promptly dropped in half. Ethereum was effectively built on $10m of funding. A bit shocking when you see these much less ambitious projects saying they need $100m, $200m or $300m to build out the technology. The engineering team was actually pretty successful. The marketing was grass roots. It wasn’t a very expensive endeavor. We got evangelists and did over 15 meetup groups around the world and we had first mover advantage. Ethereum was easy to use. It was the first smart contract platform akin to imagining you had a PC without an operating system. Now we had an OS that applications and programs could be built on. Bitcoin wasn’t very functional or something you could build on. Now all of a sudden you had a protocol that had functionality.
The funds were intended to build the protocol and present it to the world and have the world make a decision to adopt it or not. The foundation did not support itself from funds from the crowd sale. The reason the foundation has been able to support itself is because the project was successful and Ether went up in price and the foundation owned Ether. It was able to what would normally in the traditional venture capital world be Series A, B, C, D financing rounds. It was able to do that effectively because its own success caused one of its assets to appreciate and to provide the foundation value that they could then sell to support themselves. This is similar to a company getting to the next level and all of a sudden having cash flow show up.
The irony is that the first killer app for Ethereum turned out to be ICOs. A lot of people bought Ether because they saw adoption and because they wanted to use Ether to fuel their decentralized applications. However this was an unintended consequence. You never know where your killer app will show up. Just as VisiCalc became the first killer app for the PC, another unintended consequence is that ICOs became the initial first stage killer app for Ether. People needed to buy Ether to participate in most ICOs, because most were based on the Ethereum protocol. VisiCalc you may remember was the first spreadsheet. People didn’t know what to do with these things called computers and all of a sudden, these guys came out with VisiCalc and that gave boom to entire industries. The private equity industry could not exist without spreadsheets. No one expected the spreadsheet to be the killer app of the computer. The killer app of the Internet was the web browser – Mosaic and later Netscape. You don’t need to look any farther than the DAO where the $150m that they raised was a staggering 13% percent of the entire Ether supply at the time.
On a longer tail approach of where this is heading is towards securities becoming tokens. That is an absolute gargantuan probably largest revolution in financing that we have ever seen. I see a quadrillion dollars or more in this. What you will see is new financing for not just blockchain projects. We’re talking about mainstream financing of businesses for equity, for the 200 trillion dollars in the bond market, sovereign debt market eventually, which is the mother of all markets, trillions in real estate assets, another hundred trillion in equities. All of these will in one form or another either tokenize or be issued or de-listed from a traditional exchange and re-issued on a security token exchange.
The reason this will happen is because of what a token can do for a company. A security is a static instrument. A token is a malleable and interactive instrument that is programmable as opposed to a static digital instrument. That is revolutionary. The concept that a security can be programmed and is now a piece of code as opposed to just some digits is more than revolutionary or transformational. It’s mind boggling if someone were to tell you 10 years ago before Bitcoin that securities would be programmable and functional.
There are many ways we have not yet touched the surface of discovery, because we are at the bleeding edge beginning of this. Some early case studies proving to be popular include the use of a security token that also has utility features in it so you are doing a traditional financing under traditional securities laws; however, it has utility functionality such as customer engagement. For example, a Fortune 500 company that has retail locations could say this weekend anyone that owns 5000 tokens that would have previously been 5000 shares of stock, can get 10% off in our stores. You just walk in with your digital wallet to show you own those tokens and get 10% off. Now the company has persuaded their biggest asset of supporters, i.e. their shareholders, to increase their engagement, turning shareholders into customers and turning customers into “shareholders.” This is an example of using a security to now incentivize behaviors that a company would want to encourage from its shareholder base that previously could not be done.
There are two revolutions going on. There is an underlying revolution that is similar to the commercialization of the Internet that is the underlying plumbing. The plumbing of almost every industry is going to be affected by blockchain technology. It will be less consumer facing similar to the way people thought Linux would be used by consumers and then it became a big enterprise technology that changed the backend of a lot of companies. It did create a revolution just not in the way everybody thought it would. Similar to that, underlying blockchain is going to affect virtually every industry. Because they are all connected they will need to fall in line and have a blockchain solution. They will benefit from all of the advantages blockchain offers and improve over the current solutions.
Secondly, there is a separate but related fintech revolution that is going on that partly does involve underlying plumbing for fintech companies that is related to the token itself that sits on top of the protocol. The protocol allows you to make the token programmable. The purists may say that this is not a pure use of blockchain technology but it is a consequence of what blockchain technology can allow you to do and the consequence of that may be large or larger than the underlying technology was originally meant to do.
If you go back to Satoshi and Bitcoin, Satoshi looked at Bitcoin as two parts. There was the Bitcoin protocol and there is the Bitcoin token. It is confusing to people because he named them the same thing. One thing I think Satoshi probably could have done better would have been to have called them two separate things the way we do with Ether and Ethereum. They are related but perform separate functions. I think people that only want to support projects that have a pure blockchain use case are missing the point. It’s simply beyond bigger than big.
One of the reasons I recognized Bitcoin right away was because of three parts of my business experience. Part I is that when I was a practicing attorney at Orrick, I was involved in the creation of the mortgage backed security. Most of what I did as an attorney was with asset backed securities. Part II was the three internet companies I founded in Silicon Valley. Part III is that I was a very active participant in the gold market as a consequence of being a student of economic theory.
When you take those three experiences in combination and wrap it all up, the result was that when I saw Bitcoin it clicked right away. Within the first 12 months I approached some of my former partners and told them in 2012 that I believe this will become the next revolution in asset backed financing. Instead of issuing tranches you can just break it up into tokens with various programmable aspects to them.
Instead of having just one large financial institutional purchasing it you can have the public participate, which now opens it up to a worldwide market and create more liquidity for that market than traditional unprogrammable static mortgage backed securities ever did. This would lower the cost, allow more people to participate in the market, allow more flexibility and change the dynamic of how it actually occurs where you take much of the human element out of it and the counter party risk out of it in large part because via the smart contract and being in a trustless system everything is self-executing unto itself.
The key is to put assets onto the blockchain. With mortgage backed securities mortgages are put on there and, as they are paid off, the smart contracts just react as they are supposed to, something which is now a manual process. It should all be self-executing. The tokens themselves, rather being a static instrument that says you are in the second tranche of eight tranches and it just does this could be programmable over time but based on certain events, it could do different things. These are innovations that we haven’t even started to touch upon yet, but there is going to be complete revolutionizing of that entire market. This is an example of the larger financial markets being revolutionized by this.
I am not in the camp that financial institutions will be fully disintermediated by this. I am more in the camp that one of two things will happen. New institutions that we can’t even name today will be a different breed of financial institution that will pop up and be masters of this type of technology and finance. The smart financial institutions that actually adopt this technology will turbo charge their businesses. Lowering costs to the bank is secondary in my opinion. Of course, lowering costs for everybody is important, but adding a ton more liquidity and making it more frictionless is of even greater importance. The ones that will be disintermediated are the ones that don’t see it coming and do not adapt. You’ll see a whole new breed of financial institutions. There will be two camps of current financial institutions. Those that do not innovate and adopt this technology and those that do. The first will die. The second group are those that imitate the new breed of financial institutions that we can’t yet find. Those will thrive.
The third revolution will be true peer-to-peer transactional systems. Everybody that thinks it’s all going to be peer-to-peer are wrong. I say no. There will be a new crop of financial interactions and transactions that are based on peer-to-peer and decentralized applications for sure. You already see right now person-to-person, true peer-to-peer lending through a decentralized application on the blockchain that does not involve a financial institution. In that case currently it is serving a market that the financial institutions were not serving in the second and third world. Ripio Credit Network is a great example of that. They created a system where I can become a cosigner to any loan. I don’t need to know who the borrower is. I just get a profile. It can be small individuals, small businesses, banks can participate. Anyone can participate on their system. The borrower gets money from a lender and loans are being made. It’s growing exponentially. That’s an example of bypassing traditional banks and engaging in that market. The interesting thing about this is that a smart nimble bank now can actually thrive in a market that it never participated in before by actually participating in the Ripio Credit Network and becoming let’s say a guarantor on these loans or by making these loans. It’s not a winner take all. This is going to be multifaceted.
There is an opportunity for new or old financial institutions to participate in new markets and expand their markets into second and third world markets lending to individuals, businesses and banks thanks to the blockchain This is a large market we are talking about. Blockchain makes it much more feasible for these transactions to occur.
Andrew asked me about the large block of Ether that I gave away that at one point may have been valued in the billions of dollars. What happened there is that I gave the Ether to someone else who sold it early and they later gave me a few bucks. What’s perhaps more interesting is the point that I spent a tremendous amount of money and resources in helping the project and didn’t seek any remuneration or compensation or payment in Ether in return. I was doing this because I believed in Vitalik and his vision and believed it was a total game changer. Vitalik stayed with me for a long period of time living in my home. I rented an office that Ethereum people worked out of in the U.S. I personally signed the law firm’s bill for $250k in case the money did not come in, but the foundation paid it off. I would finish off by saying that I’d do it all over again.
It’s also important to say that there were other members of the founding team that were also very inspirational to me. Charles Hoskinson and Anthony Di Iorio are included in that. I worked with Joe Lubin. I thought Gavin Wood was beyond brilliant and could actually pull this off. That was a big deal. We didn’t know if we could actually pull this off. He’s one of the greatest cryptographers and cryptographic minds on the planet. It’s important to note that at least 100 people or so behind the scenes helped with this cause. And by no means should any one of us claim responsibility for the success of it. It really took all of those people to make this happen. Many of them will never be known but should be as they were each key elements.
Again, where we are today is just at the bleeding edge of what I am certain will be a gargantuan opportunity.