When looking at maturing, staking-based decentralized networks, it’s important to see how network operators (nodes, validators, etc.) assume risk for their reward.
It’s neither ping nor bandwidth that determines the macro tectonics of the web; its sovereign laws.
With a relatively mature network like Tezos, we’ve observed that proof-of-stake works well, but we have also observed consolidation in the staking community with not only fee structures, but with software in use and malicious activity. It’s to be expected that as a network matures, we will see some coalescing around certain parameters. However, when third parties build excellent software that takes the risk of getting slashed to near-zero, a victory has been declared in a finite game of staking operators.
In the staking universe, there are generally two groups of people: those who have the money and those who know how to run the money; they are rarely one in the same. The institutional investors are interested in maximizing returns, but given how volatile the underlying asset is, they would prefer to run ‘conservative software’ and settings to minimize the chances of a slashing event (i.e. financial punishment for bad behavior). In most networks, a slashing event will nullify any staking rewards earned over a long investment period. If the noderunner has an off-chain agreement with the institutional owner to cover slashing penalties (as most do), the profit nullification for the noderunner is amplified exponentially.
The notion of ‘conservative software’ is misrepresentative; within most distributed systems, most of the nodes are running identical software. Slashing penalties are generally placed into two buckets: 1. Actions with malicious intent, and 2. Actions as the result physical failures (downtime, slow response, etc.). As a noderunner (read: one who has no money but knows how to run it), you are placed in a compacting scenario. The only way to make your operation more profitable is: 1. Get more value under management, and 2. Run your operation more efficiently. In the second scenario, noderunners will push their hardware to the minimum specs, run in less secure physical spaces, and do anything else to be above network minimums for the lowest fixed costs. This isn’t necessarily a good or a bad thing, it just is.
Hedge/VC funds understand this dynamic well- they are the legacy financial system’s equivalent of noderunners. While they don’t have as much money as their LPs, they know how to run it. As a GP, Parallel method (through both growing AUM and increasing efficiency, for example) is almost always the fastest route to more money in one’s pocket. It is well understood that within this method, lower recurring operational costs (i.e. hiring assistants, renting offices, etc.) equals more dollars. However, hedge/VC funds have one thing that noderunners do not- the ability to generate alpha. These GPs can take more conservative or aggressive positions with their investments in a multitude of ways: company stage, bet sizing, personal experience, alignment of the stars, or any method they can stuff into a pitch deck; for some, pure luck can generate alpha, and subsequently, more dollars in their pocket.
Most noderunners have no concept of alpha generation in their business. The game is all about growing AUM, operational efficiency, and off-chain contract optimization. This is a function of how the major proof-of-stake networks are built, and is a requisite step in the direction of pure internet decentralization. Given these dynamics, we will continue to see more consolidation in the PoS noderunner space, especially from exchanges, who are perfectly positioned to capture huge swaths of the validation market. This march is in the opposite direction of the anti-fragile decentralization we’re all looking for.
We are starting to see a shift away from traditional ubiquitous service structures (like Google- where is your Gmail server?) toward structures like ProtonMail’s. Here is the #1 feature listed on ProtonMail’s website:
”ProtonMail is incorporated in Switzerland and all our servers are located in Switzerland. This means all user data is protected by strict Swiss privacy laws.”
Why is the jurisdiction of the physical server location the number one selling point of a state of the art SaaS offering? Because the internet isn’t flat, and Proton’s core customers know it.
In general, the tectonics of the web move slowly (until they don’t). Trends emerge and dissipate organically in many areas, but when a sovereign jurisdiction enacts a law, the entire landscape shifts. An example of a law that resulted in an internet earthquake is Australia’s Anti-Encryption Law: The Assistance and Access Act of 2018.
Read More on this dumpster fire here:
https://www.wired.com/story/australia-encryption-law-global-impact/
After this law was enacted, Australia became a digital mountain range. The risk of an individual’s data passing through Australian soil has now increased exponentially. This isn’t something that you are thinking about actively when logging into Gmail during your visit to the Gold Coast, but given that Google has operations in Australia, you are now open to unfettered government access to your data. If you follow the global surveillance market, you know that Australia is a member of the Five Eyes, and automatically shares this data with New Zealand, Canada, The U.K, and The U.S. This is serious if you are an individual, yes, but what if you’re a member of a sovereign government? What if you’re the leader of a small nation in the middle of tariff negotiations?
Again, where is your Gmail server?
They will operate in the valleys of the internet; as we’ve observed with centralized companies like Proton, we will continue to see a move away from surveillance-heavy jurisdictions like the U.S. into smaller and more privacy-focused sovereigns. The economies of scale necessary for things like Netflix to operate are multiple orders of magnitude larger than what is needed to run core services like email and chat. These are ‘lightweight’ services and are not subject to the same infrastructure costs as high-throughput applications. This is the reason most email is free to the user; it’s cheap to offer and the provider gets to read all your shit.
As modern incentive-based decentralized networks begin to operate more of the core infrastructure of the internet, we will see a massive opportunity space unfold in sovereign arbitrage. There will be services that are subject to abusive legal requirements in some locations, and there will be some jurisdictions where noderunning is outright illegal for a given service (e.g. Tor exit nodes).
We’ve seen similar things in banking and offshoring in the hedge/VC space. There is a reason that most crypto funds (and many non-crypto funds) operated by American citizens are based in the Cayman Islands. Doing this is perfectly legal and generally the most optimal structure for everyone involved.
The future networks that will utilize this strategy include things like:
Decentralized VPN/Mixnet providers like NYM: https://nymtech.net/
Decentralized file storage providers like Arweave: https://www.arweave.org/
Decentralized zero-knowledge exchange REN: https://renproject.io/
Decentralized dead man’s switch software Sarcophagus: https://sarcophagus.io/
While all the above networks serve vastly different markets, they have one thing in common- their primary profit motive for the noderunner has very little to do with traditional internet economics like ping or bandwidth. The primary profit driver of noderunning in these networks is the ability to operate in a sovereign territory wherein the node is legal.
The noderunner is now able to generate alpha by any of the following means: breaking the law in a sovereign territory where the underlying service is illegal, hiding services and dis-associating the physical location away from the service, or spinning up operations in a jurisdiction with no laws against the service. Governments will continue to play whack-a-mole with different services like they did during the ICO boom, but unlike with ICO, these networks are self-annealing. When nodes in a given territory are shut down by government action, the profitability of nodes in legal sovereign territories increases in direct proportion.
These economics are not new, there is just a digital layer on top of them now. There is a reason that you can list a handful of tiny islands known for their liberal financial policies- I would call these the ‘valleys’ of the traditional financial system:
The Cayman Islands
Gibraltar
Malta
The Seychelles, and many more.
It’s important not to simply assume that every small island nation is a financial valley. We don’t see the same behavior from New Caledonia or Jamaica- why? (I genuinely have no idea because I wasn’t even close to being alive when the aforementioned were being transformed into offshore havens. If I had to guess, I would assume it had something to do with wanting to stay in the good graces of superpowers, but who knows).
We can see some nations emerging as preferred digital domiciles like Switzerland and The Netherlands. They have taken the spirit of their comparatively liberal privacy laws and transformed them in a way that works for the internet. It’s not perfect, but at least these jurisdictions are codifying legal arrangements about how things should work; this is in stark contrast to the U.S. which tends to form laws via enforcement to create precedent.
Now that finance and internet infrastructure are merging into a single mega-industry, where will the future valleys of the internet be formed?
