June 2019 Commentary
In this month’s letter I would like to talk about one of the companies in our Portfolio: Chainlink. We first started purchasing $LINK tokens around $0.45 in the month of April. Please read the previous description from the March newsletter to understand the nature of its business. In June, they have announced a new collaboration with Oracle Software to enable 50 qualified start-ups to sell data on Chainlink’s decentralized platform. In September, Chainlink is expected to announce a partnership with Microsoft and with bank conglomerate, SWIFT. This integration was announced after their integration with Google. Chainlink has announced its Mainnetlaunch in June. It has been a month, but many new partnerships are being announced very frequently.
Chainlink is as fundamental to blockchain as Google is to the Internet. Chainlink provides access to decentralized real-world data to blockchains. You can imagine it as a toll-bridge between the real-world data and blockchains, where this toll bridge is owned by all the token holders of Chainlink. Chainlink raised $32 million from the ICO, while issuing a total of 1 billion $LINK tokens. Out of these 1 billion tokens, 35% is reserved for Node Operators, 35% was sold to public and 30% will go to the company for continued development. When we analyse the company, we investigate all aspects of its technology, team, ability to execute, competitors and the economics of the token. This month, we like to focus more on the token economics and how this token accrues value.
Chainlink platform allows Smart Contract Applications(SCA) to purchase real-world data from its node operators. This data could be any real-world data such as sensor feeds, published interest rates of 10-year US Treasuries, GPS location data, the market price of a security, etc. These SCAs are every kind of application you can imagine and many that we cannot imagine. These SCAs will be developed by insurance companies, banks, bond holders paying coupons, real-estate transactions,institutions issuing credit default swaps, and more.
How big is this market? OTC Derivative market alone is worth close to $595 trillion.For a recent example, World Bank raised A$110 million Australian dollars ($80 million) by issuing a two-year bond entirely on the blockchain using Chainlink’s decentralized oracle solution. Chainlink nodes will be paid in LINK tokens only. SCAs cannot use fiat money, as it is useless on the blockchain – all Chainlink transactions will be conducted on-chain in LINK. SCA operators can spend fiat money purchasing oracle services, but it must be converted into LINK tokens at the market pricebefore it can be moved on-chain. Chainlink node operators are providing very high value data to the SCAs. Node operators can be any institution or individual, which imposes huge risks to the operations of SCAs. To reduce this risk SCAs will ask node operators to post collateral before providing any data. This helps ensure that any dishonest individuals or institutions who provide bad data aredisincentivized – operators that provide false data are financially punished as their collateral is forfeited to the SCAs. Individual SCAs can also demand a highlevel of collateral and reputation score for their application in order to mitigate risks. The system allowsqualified node operators to earn LINK token fees from SCA developers, providing financial incentive to provide and maintain quality node operation and data provision services.
The business process (in this case, to issue a bond) can be described as below:
Chainlink system is designed mainly for institutions to automate various business operations, eliminating the trusted third parties. You can imagine these node operators to be major companies in the Fortune 500: Google, Oracle, commercial banks, S&P, Moody’s, etc. All these Node Operators need to own LINK tokens and stake them as collateral in order to be able to service SCAs. The supply of available LINK tokens can never increase and is set to 1 billion. The crypto markets bring a very new concept that does not exist in traditional stock markets, which is scarcity. In my previous letter, I have described Bitcoin and LEO token. Let us compare the LINKtoken economics to Bitcoin and LEO.
In the case of bitcoin, the maximum number of tokens is fixed at 21 million. We are aware that it will not reach that number till year 2140, but after year 2040 or so, the rate of growth is very slow, which is as good as being a fixed supply. Therefore, as the demand for BTC increase as a store-of-value or as medium of exchange increases, it will automatically make the price go up. Why? In a free market, supply and demand of any commodity will determine its price. If the supply is fixed, the only mechanism available to accommodate the increase in demand is by raising the prices.As people want more bitcoin, its price must increase over a long enough horizon. If the demand for bitcoin falls, it will also reduce the price of bitcoin, as the supply cannot change. In the case of LEO, the token supply will continuously reduce due to Bitfinex’s constant buying which will cause the price to slowly increase over time.
In case of LINK, it has better token economics than both BTC and LEO. We expect that the total value of SCAs will continue to rise with time, as this market is already enormous. Once established, there is a constant demand from SCAs to purchase LINK tokens if they need to utilize Chainlink Oracle services. These SCAs can purchase as much LINK as needed using fiat money, which can only grow towards infinity. They may use unlimited fiat money to purchase a small percentage of the limited token supply of LINK. When SCAs use this LINK to pay node operators, they would expect the node operators to stake their own tokens first in a smart contract. Staking effectively removes the LINK tokens from circulation and locks them up in the smart contract during the period the contract is open. As a result, the more demand there is for LINK token, the more gets locked up into smart contracts and thus the available supply decreases. It creates a wonderful feedback loop. The more people want it, the less of it is available. Therefore, the price has to go up over long-term. Any investors like us that understandthis token economics will immediately rush to buy. That will cause the price to go even higher. Node operators will be reluctant to sell as they need to keep their stash in order to provide services to the SCAs.
Node operators’ ability to earn these LINK tokens is purely determined by how many tokens they are willing to stake. If World Bank is issuing a bond for $50 billion, they would expect the node operators to put up say a collateral of even 2%, node operators have to post tokens worth a billion dollars. This allows them to earn more LINK tokens by servicing the SCAs. It is similar to receiving interest for depositing money in a bank account, but with a big difference. Receiving interest on fiat money bank deposit is good, which facilitates compounding of money. But it has two big problems. First, your counterparty can go bankrupt (ex: Enron bonds, Argentina treasuries, etc.). Second, you are constantly losing value via inflation as new money is continuously being printed. If you receive an interest of 2%, but your currency is inflating at a rate of 6%, the purchasing power of your fiat money is decreasing at a rate of 4% (or -4%). Interest-generating cryptocurrency such as LINK fixes both problems. Your interest is paidout of a fixed supply of tokens (fixed supply sets the inflation to 0%) and there is no counter-party risk as it is being managed by a smart contract on a decentralized network.
Another analogy I can use to describe this is by using bitcoin. Currently if you own bitcoin in your wallet, there is nobody who can pay you an interest in bitcoin. Even if they agree to pay say 2%, how can they can pay if the bitcoin price keeps rising? The interest payment in BTC has to come from the existing holders or miners. It cannot be created from thin air using fractional reserve banking. Imagine if you could hold bitcoin in a wallet and you are able to earn interest in bitcoin, without trusting any third party. Also imagine that the more bitcoin you held in your wallet, the larger your interest percentage payment is. In this kind of situation, will any holder of bitcoin have any incentive to sell? No. Since your interest payments are coming in the form of scarce fixed supply tokens, you know it will appreciate in price. This will lockup increasing amounts of LINK in contracts and continuously reducing the supply. This incentive will push the price higher bringing new investors who again want to buy for its investment value to receive interest payments as passive income.
These feedback loops continuously drive the prices higher. This makes the team allocation of 350 million LINK tokens more and more valuable with time. This allows the team to expand and hire better programmers and improve the tools available for this decentralized network. This strengthens its network even more as it will have more funding resources to build better developer tools. This widens its moat every day, increasing the demand for its decentralized network. SCAs will continue to demand more data, which will continuously increase its demand. Node operators have no incentive to sell. Why would anyone be interested in selling when they are not only gaining passive income, but a passive income in a token that can only appreciate in price?
Can competitors displace Chainlink? It is hard to displace Chainlink due to many reasons.
- Access to banking infrastructure and APIs to SWIFT and major banks as ground level partners
- Chainlink’s Intel partnership allows it to build SGX technology chipset
- Centralized Oracle services are not dependable for high value transactions. The incentives of this network remove the bad actors via staking
The network effects of Chainlink and its first movers advantage propel it forward. This interface for the real-world APIs and data feeds is a natural monopoly. We expect an announcement with SWIFT in late September and another announcement with Microsoft in August. The team has ensured that there is large institutional support for this project. We believe future is bright for Chainlink.