[U17] DeFi:Square as AWS:Amazon
Square is building an open Decentralized Finance business on top of Bitcoin
Dear Reader,
This week in Product | Strategy | Innovation we provide an update on Jack Dorsey’s evolving strategy for his fintech company Square [E5]. Square provides a range of products and services for Small and Medium-sized Businesses (SMBs) to transact sales with consumers, manage workers, access capital, etc. This Seller ecosystem was Square’s beachhead market over its first 3-4 years starting with a small square device attached to a mobile phone to process credit card transactions. Square started offering products and services to consumers through Cash App in 2013. No bank account is needed to use this service. Direct deposit into Cash App and adding a debit card are popular features beyond peer-to-peer payment among friends and family. Cash App can now be used as a digital wallet to convert cash into stocks, ETFs and Bitcoin.
Jack Dorsey and recording artist Jay-Z announced in May 2021 that Square had closed a $302 million dollar transaction for majority ownership of the on-demand, music and audio streaming service Tidal. Recording artists have been a key resource to scale the growth of Cash App. However, Dorsey and Jay-Z see the bigger opportunity in how creators monetize their work in the future. Non-fungible tokens (NFTs) and smart contracts offer ways for a creator’s intellectual property and their fans to disrupt and disintermediate traditional recording labels in the digital age.
As Square looks beyond SMBs to scale its Seller ecosystem, it can add new features and services to meet the needs of corporate enterprises. Square as a corporate enterprise itself converted a portion of its cash holdings into just over 8,000 Bitcoin worth over $250 million as of July 18, 2021 with 1 Bitcoin at USD $31,790.
Centralized Finance
Traditional financial services covering banking, lending and trading are highly regulated and managed by centralized systems operated by governing bodies. This structure has evolved to manage risk, but also adds complexity for consumers to access auto loans, mortgages and trading securities like stocks and bonds.
Regulatory bodies in the United States like the Federal Reserve and Securities and Exchange Commission (SEC) set the rules for centralized financial institutions and brokerages. These institutions and brokerages play a key role in the global economy with offices around the world. The US Congress can amend the rules for these institutions and brokerages over time. Banks with over $50 billion in assets are now required to undergo stress tests with the Federal Reserve.
As a result of the actions taken by these centralized systems and their governing bodies along with the regulatory bodies to manage risk, there are few paths for consumers to access capital and financial services directly. We cannot bypass centralized infrastructure of banks, exchanges and lenders, who earn a percentage of every financial and banking transaction as profit. We all have to pay to play.
Decentralized Finance
Traditional financial services are disrupted by Decentralized Finance (DeFi) through disintermediation of the banks, exchanges and lenders and empowering consumers and even businesses with peer-to-peer services. An example would be cash deposited into a savings account at a bank. A savings account balance up to $250,000 is generally insured from losses through the FDIC in the event the bank fails, but the savings account might only earn 0.50% interest. The bank then lends out money against those deposits with 3.0% interest and keeps 2.5% as profit or 5x what the depositor makes with their savings account. The DeFi scenario enables peer-to-peer lending with no middle man. The person lending money makes the whole 3% interest in the above scenario.
Blockchain and cryptocurrency are the enabling technologies that make DeFi possible. Centralized finance requires a private ledger owned and maintained by the institution or brokerage to record transactions for auditing and problem resolution if an issue comes up. DeFi requires a decentralized, distributed public ledger to record transactions using encrypted digital technology referred to as a blockchain. This public ledger is distributed to all parties of a DeFi application as identical copies that record each transaction in encrypted code. This secures the blockchain by providing users with anonymity, plus verification of payments and a record of asset ownership that’s (nearly) impossible to alter by fraudulent activity.
Decentralization is possible because the centralized infrastructure of the institutions and brokerages is not needed to manage the distributed blockchain. All transactions are verified and recorded by parties using the same blockchain for a DeFi application. These parties maintain the blockchain through a process of solving complex math problems and adding new blocks of transactions to the chain. Blockchain is the underlying technology for Bitcoin and other cryptocurrencies, but DeFi expands the cryptocurrency use case for blockchain with decentralized applications (dapps) and protocols including smart contracts. Although Bitcoin is the most popular cryptocurrency with a current market cap just under $600 billion, Ethereum has emerged as the most popular cryptocurrency for DeFi because it is more adaptable to support dapps and protocols with Ethereum-based code.
Some emerging DeFi use cases:
Traditional financial transactions ranging from payments, trading securities, lending, borrowing and insurance.
Stable coins peg the value of a cryptocurrency to a fiat currency like the USD. Fintech venture Circle has the leading digital stable dollar with 26.4 billion USDC (US Dollar Coins) in circulation as of July 11, 2021.
Yield harvesting allows cryptocurrencies to earn interest by lending to a counter party. Lower risk, lower interest DeFi yield farming will could compete with bonds in the future.
Non-fungible tokens (NFTs) create digital assets out of traditionally non-tradable assets like videos or tweets. Anything digital that could be recreated with unlimited copies can now be associated with a fixed number of tokens to certify that number of a unique tradable asset.
Many other use cases will emerge through smart contracts enabled by more sophisticated protocols that operate on distributed, decentralized blockchains.
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Square, Bitcoin and DeFi
Bitcoin emerged when Satoshi Nakamoto published a white paper on the concept in October 2008 using a cryptography mailing list. Prior to that in August 2008, Nakamoto registered the domain bitcoin.org and created a website. The first code for Bitcoin and the genesis code for block 0 were released in January 2009. The Nakamoto white paper and the distributed, decentralized principles it presented probably attracted Jack Dorsey to Bitcoin once he read it.
Dorsey’s first move to support Bitcoin as CEO of Square was in March 2014 by adding services to allow Sellers to accept Bitcoin as a form of payment.
Buying, selling and holding Bitcoin was enabled for Cash App in January 2018.
In 2019, Square formed an independent team solely focused on contributing to Bitcoin open-source work for the benefit of all. Squarecrypto.org and its team support initiatives and projects and also provides grants to fund work by external teams.
In September 2020, Square launched the Cryptocurrency Open Patent Alliance (COPA), a non-profit organization encouraging crypto innovation and opening access to patented crypto inventions.
On October 8, 2020, Square announced it had purchased $50 million (or about 1% of total assets at the time) in Bitcoin to hold. As mentioned above, Square purchased more Bitcoin and now holds by last report just over 8,000 Bitcoin currently worth about $250 million.
On June 4, 2021, Jack Dorsey announced Square was considering expanding the digital wallet services provided by Cash App with a hardware wallet for Bitcoin.
That communication was followed up with another tweet on July 8th that Square had decided to move forward to build a Bitcoin hardware wallet.
Conclusion
All of these tweets by Dorsey around Bitcoin and cryptocurrency have led to what is likely an evolution in the corporate strategy for Square and shares some similarities to Amazon when they were at a similar stage in the 2nd decade in the company’s history. Square’s Seller Ecosystem has similarities to Amazon’s Marketplace for third party sellers. Square’s Cash App has broad consumer appeal and can be leveraged across Square just like Amazon does with Amazon Prime memberships. Once you are a Prime member, you spend more on Amazon and leverage more of its services.
But until now Square has focused on building out services to scale 2 ecosystems while Amazon realized a third Pillar when they launched Amazon Web Services (AWS). These 3 Pillars at Amazon (Marketplace, Prime, AWS) add scope, but also drive focus on what matters most to scale growth. AWS takes data services Amazon needs for its own use and then scales these cloud services for other companies to use, too. So if Square considers its ecosystems as Pillars what is its third Pillar?
On July 15, 2021, Jack Dorsey announced Square was creating a new business to build an open developer DeFi platform with a primary focus on Bitcoin. Instead of allowing different cryptocurrencies to develop their own use cases, it seems if Square is holding Bitcoin as a corporate asset and consumers are doing the same with Cash App, then Dorsey wants to expand the utility of Bitcoin beyond a store a value to drive more demand for the asset.
Square building out a business to develop an open DeFi platform is similar to Amazon announcing AWS would be offered to third parties in July 2002. This can be summarized as DeFi is to Square as AWS is to Amazon. In a prior update on Beyond the FAANGs [U12], we highlighted how Square sits within the largest global total addressable market (TAM) for global financial services estimated to reach USD $28 trillion by 2025. Dorsey has mentioned that he does not aim to destroy the centralized systems like other CEOs in the fintech industry, but he does want more people to have access to financial services. DeFi makes more services available to the most people. Think of the Private Banks like JP Morgan, Goldman Sachs and Merrill as Porsche. Chase, Bank of America, Citi and other top retail banks are Audi and the majority of banks and credit unions are Volkswagen.
DeFi is more like Uber in the transportation analogy. Porsche still exists, but Uber makes transportation more accessible. And what Dorsey plans for DeFi is similar to what Musk plans for Tesla with transportation-as-a-service using FSD and a Mobile App. Although Dorsey plans an open DeFi platform and Tesla is currently developing a closed FSD platform, both leaders aim to take existing services in different industries to the next level with key technology, talent and focused strategies.
One area for debate is whether it would be better for Square to leverage existing technology stacks from Ethereum, Cardano and other cryptocurrencies for DeFi and make those better versus building out a more comprehensive DeFi stack on top of Bitcoin. The key advantages of Bitcoin around security and reliability as a store of value can also hinder use for high volume transactions.
DeFi on top of Bitcoin will require a layer 2 framework like the Lightning Network to build out efficiency for transactions with the security and reliability of the layer 1 framework enabled by the Bitcoin blockchain. It seems Jack Dorsey has always seen Bitcoin as the superior cryptocurrency based on its founding principles around proof of work and is all-in on Bitcoin instead of best of breed for different applications. If Bitcoin is a store of value, the more demand you create for Bitcoin, the more valuable Bitcoin becomes. Go Jack!
Best,
Stephen
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Nothing in this post is intended to serve as financial advice. Do your own research. I’m long AMZN, SQ and TSLA mentioned in this update.