Office Hours #Q&A #WWDC #transcript
Recording and transcript of the June 9, 2026 Asymco One Office Hours, recorded the day after Apple's WWDC 2026 keynote. Horace Dediu shares his impressions of the event and takes questions from Asymco One subscribers.
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Asked by Jay Goldberg
Q: Do you think Apple will start investing heavily in AI data centers?
There's rumors and actually statements from Apple saying that they're working on a server chip. Google has a server chip. Amazon's got a server chip. These are effectively aimed at Nvidia. And if you can make something, you tend to do it. Now, of course, there's some protection — Nvidia's got other special sauce, but their margin is everybody's opportunity. They have a huge margin. And everybody's writing huge checks. As I say, hyperscalers are just handing over their entire cash flows to Nvidia. And that means their shareholders' entire wealth is being handed off to Nvidia shareholders. So there's a transfer of wealth happening right now. Presumably, because we're going to get some benefit later, but if that's happening and people are irritated by it, they're going to find a way to do what Nvidia does.
And Apple, of course, can and will do that. Now, whether that'll get deployed at the edge or in Apple's own cloud — because they probably also don't want to write checks to Nvidia, and they'll say, well, we can do it, and we won't necessarily sell them, like Google wants to. They'll probably just use them themselves. And that's something certainly they're capable of.
The question I was always asking is how many are we talking about? Because if it's in the tens of millions, or even single-digit millions — for Apple, single digits. Is it worth it to develop your own designs? There's a limit to how many you can deploy. And probably you're going to have to replace them every so often, so there's a question about how much it costs to keep on the treadmill.
But it is an interesting question, and I think everybody's capable of doing what Nvidia's doing. But it's about execution, timing, delays. Look at what happened with the Qualcomm chip — how long it took Apple to finally deploy the communications chip relative to the amount of grief it had to deal with. First, of course, it moved out of Intel. It moved out of Qualcomm now, and now the question is, is it going to move out of the server supplier chain? And that's a complex decision. But again, Apple's not doing it because they want to be in that business. It's more that they want to avoid dependency.
This was one of the questions asked by the participants in Asymco's May 2026 Office Hours live Q&A sessions, open to Asymco One subscribers.
See also: May 2026 Office Hours
An Office Hours question asked by Fred S., May 1, 2026
Q: Ever since Johny Srouji started talking about Apple Silicon and the power consumption for the performance and the unified memory, and now we've seen the Mac mini surge, I just wonder about high-end computing. The whole area of where that Mac architecture may go beyond its success as an individual consumer computing product. From all the high-end workloads that might be coming their way.
The story of Apple is one of personal computing. It's not a story of servers, it's not a story of clouds, it's not a story of centralized computing. They've tried once or twice to make a server product, and they abandoned it. They've even abandoned the high-end Pro product, and created the almost-as-fast Studio product.
Now, that does not mean they're shying away from high-power computing. They're just saying, we're going to put that high-power computing in a desktop, or in the laptop, or even in the phone. Everyone who's grown up throughout the personal computer era can remember Moore's Law, and how exponential growth has driven computation to levels that seemed impossible just a few years earlier. We've hit some slowdowns, but fundamentally, the potential exists.
And by the way, it's not even a classic computational CPU problem. We're dealing with AI. We're mostly dealing with high bandwidth, large data, and we're dealing with simple calculations on it in parallel, which means the architecture is much more around large matrix computations. This is why Nvidia came from graphics. Graphics was the same problem — a graphics accelerator is a matrix problem. And so is machine learning. So different variations of these have come in as a sort of a parallel to the CPU, the general computation problem.
The idea Apple has is that they're going to catch up with whatever is done on the server, they're going to do it on the device. You can call it Edge, you can call it personal — the old term was personal computing.
I may be naive, but I think we'll get very powerful desktop computers that can do what is essentially AI, but for the individual. The other aspect here is that Apple is a consumer company, not a B2B company — it's a B2C. They want to bring that power to as many people as possible. And they're certainly delivering hundreds of millions of computers a year. Nvidia's making tens of millions of computers a year. Apple is capable of doing orders of magnitude more.
So I think they're going to affect the disruption in AI. It's not going to be that there's no profit in AI, it'll be that it'll be done with Edge more, especially as it doesn't have to be a world model — it can be a personal model. If you want to look up something globally, you can use the cloud, but if you want to deal with tasks in your world, you're going to work with Apple computers.
It may take years to get there. But in the meantime, I don't think a centralized service — these OpenAI, or Anthropic, or Microsoft, who are trying to make us a singular superintelligence — is necessary for everyone. It'll be a good reference, but it's not how you want to handle your personal information. So I think that's what the future is, and I think Apple's very much planning for it.
It sounds cliche, but when Apple started, it was IBM that dominated computing. And IBM was about centralized computing, and their thesis was everything we now call "the cloud" — but it was all in one big computer that served the entire organization, whether that organization is a government or a big company. And then we went to mini computers, then we went to desktop computers, then we went to portable computers.
Then, fast forward 25 years and we had Google. Well, now central computing is the internet. In the internet, everything needs to be indexed to be able to be found. So they created an index in the cloud. And then a lot of companies moved that computing they used to have locally into the cloud, as a shared resource from Amazon, AWS, and others, and that became cloud compute. Even now, those are the drivers for growth for Microsoft and Amazon and Google.
The AI part of that is tiny — there's revenue from AI, but there's a lot of revenue from cloud. That still is valuable. But that's not a job for consumers. You do some things in the cloud — you store things, you search, you communicate in messages and so on. But most of the data that matters to you will get also indexed locally, so you can pull up your photos, pull up these things, and it'll be a blend of the two.
So that's where Apple lives, and I don't see anything fundamentally changing about this, because computation tends to commoditize. Software tends to be replicated. Algorithms tend to be replicated. In fact, even the AIs we have today were all because people publish papers, and one company invents it, another implements it, as was the case with the transformer. As far as I understand, it was Google who actually wrote the paper on it.
Editor's Note: This was one of the questions asked by the participants in Asymco's May 2026 Office Hours live Q&A sessions, open to Asymco One subscribers.
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In yesterday's post, I proposed a way to inspect the Google-Apple distribution deal. It could be understood as a flat-rate deal where default placement of Google search in Safari is paid for with a constant run rate. This was the assumption for a few years with estimates for this run rate ranging widely.
Alternatively, it could be understood as a commission rate where payments are in proportion to ad sales. This is the 36% commission rate that has leaked during the antitrust trial.
Finally, it could also be seen as an access fee for each individual. This is the 17c/user/day that seems apparent from my calculations.
If one were to critique these options, I would disqualify the flat rate as unfavorable to Apple since the user base grows and behaviors can shift. The distribution commission sounds ideal but it would be problematic to enforce. How exactly can one track the precise income obtained by Google for each use of search, maps or YouTube on iOS or MacOS devices reliably enough with an audit trail for Apple to inspect?
For these reasons, I believe the fee of $x/user (or possibly active device as a proxy) makes more sense. The burden would be on Apple to prove that they have such active users/devices while Google could sample their metrics to confirm. Data on active users and devices are figures that Apple already supplies publicly and a method for determining them likely could stand scrutiny by outsiders. The server logs showing active devices can't be too onerous to share.
And so that's the model I'm going with. Having said that, the formulation of compensation for what is a complex distribution deal is likely complex. The abstraction to users/devices is one we have to live with given the challenges of inspecting the invisible.
That's the model of the present. The future however is clouded by the potential interference of authorities. In this case, an antitrust prosecution of Google is asking whether the way Google buys distribution is anti-competitive. The legal arguments are beyond scope here but the gist of it is that buying exclusive distribution when you are dominant may close options to not-so-dominant competitors.
The consequences, if we are to believe the commentary, are that the deal with Apple could be declared illegal and thus, stay with me here, Apple would lose a lucrative source of income.
Let me repeat this for emphasis: If Google were found guilty of anti-competitive behavior, Apple would be punished.
Let me expand for emphasis: If Google were found guilty of anti-competitive behavior, Google will be forced spend far less and be marched off a gangplank to swim in far greater profits.
Given this commentary one wonders why Google's management and legal team aren't begging the judge to rule against them and why Google shareholders aren't hoisting the prosecuting team on their shoulders.
The deal between Google and Apple exists only because both Google and Apple find it to be a better alternative to not having a deal or having any another deal. It does not exist because Apple benefits and Google doesn't or that Google benefits and Apple doesn't.
As I've explained the first post in this series, Google's benefit is distribution or access to 1.3 billion very valuable customers. For this they pay quite a lot and Apple receives quite a lot in turn. The relationship is shown in this illustration:
But—and here you should pay close attention—Apple also pays something for that benefit. Apple's $26b+ income from Google's TAC payments are in exchange for offering access. To Google. Not to someone else. And not to itself. Apple's costs are opportunity costs.
If Google had not offered the area marked with a question mark in the image above then Apple would have found alternatives. Alternatives that it's saying no to today.
Apple's alternative to the deal is what needs to be studied.
Could, for example, Apple have signed Microsoft for Bing access in Safari? Sure! They probably didn't because, as they declared, the quality of Bing would not be as good and as a result most people would switch out of it and thus result in lower revenues. Then again, perhaps Apple could make a fortune from Microsoft. Apple could have enabled Microsoft to rise to 40% market share in search, and also improving its quality. How much would that be worth to Microsoft? How much additional opportunity could Microsoft create from establishing such a strong consumer-facing franchise—something they have struggled to obtain even with vast expenditures. Surely Microsoft could be convinced to split revenues 50/50 for what would be all marginally zero-cost new upside!
Could Apple have developed its own search? Sure! They probably already did. Internet Search is a lot easier in 2023 than it was in 2007. Costs for computation, communication and storage drop exponentially while the number of internet hosts has stopped growing. Apple uses indexing in Siri and each iPhone, Mac and iPad runs a local search engine (Spotlight). Again, there are reasons why this is not as good or easy as signing Google up. But on the other hand, perhaps Apple could be making a killing on search. Why accept a 36% commission from Google when they could take 100% of 40% of all Search?
But most importantly, a declaration that this deal is invalid simply means that Apple and Google would craft another deal that would work around the restrictions. And that new deal would probably turn out to be more beneficial to Apple.
Why, I hear you ask?
Because Google would ask for the changes! Google would be forced to re-negotiate because they lost at trial. If that were the case, Apple would naturally ask for concessions. The most certain outcome would be that Apple will be paid even more for access to its users.
How much more? Remember that Google must ensure access to Apple's customers. According to my calculations Apple customers deliver almost 40% of its advertising revenues. The 36% commission suggests that there is plenty of head-room. Apple could ask for 50% and meter the results on a different basis. This would be a 39% increase in pricing for distribution.
This would result in a deal worth $41 billion/yr.
To implement workarounds, the companies would need to bridge their servers in order to ensure metering along new metrics. There would a great deal of complexity. But it would be worth it because both would find such a deal better than alternatives.
Fundamentally, the relationship between Google and Apple exists and will continue to exist because it is mutually beneficial and a better alternative to any other agreement or no agreement. If the current deal is found unsound, for whatever reason, a new deal will be created because it will need to be created.
Apple sits in a better position today than it ever did. Its customer base is growing while its pricing power with consumers is growing. In contrast, Google is the process of explaining that it did not break any laws. This while losing Android users to Apple. How does this lead to a vulnerability for Apple?
What we are witness to here is Apple increasing its distribution pricing power while simultaneously decreasing its opportunity costs.
The idea that Google being found guilty of anti-competitive behavior would result in a "hit to Apple earnings" is preposterous and fails on first inspection. The exact opposite is the likely outcome.
This is a transcript of an Asymetric podcast. It was lightly edited for legibility.
Judd Rubin: Three continents, one conversation, this is Asymetric. We are very excited to have Balaji Srinivasan with us today. Balaji, you're a busy man, Horace you're on the run as usual, so why don't we dive right in. Thanks for joining us today.
Balaji Srinivasan: Good to be here. Good to see you, Horace.
Horace Dediu: Likewise.
Balaji: I know you from online, from Twitter, or at least, I know of your work. It’s always interesting for people to understand how they're maybe thought of by folks who are maybe a little bit on the periphery. And I, we've, always thought of you as the most quantitative Apple analyst, I guess you and [John] Gruber would be the two people who, if you're in the Apple ecosystem, might be the most perceptive commentators outside of Apple itself.
Horace: And John's a qualitative guy, right, so that makes sense.
Balaji: Yeah, exactly. And I'm not like a huge, I mean, it's funny, certainly I have a lot of Apple equipment, but I wouldn't consider myself an Apple fanboy, per se. I converted to Apple when they supported BSD in OSX, because it was a better compute experience.
And, for the last, almost 20 years, the typical developer/engineer/founder, whatever, set up has been a Mac laptop locally, and then all your compute is on AWS or a Linux box or something in the cloud.
Horace: Yeah, me too, actually, because when I started my university work, it was all on Unix, and this was in the days of VAX computers, Digital Equipment, and I just loved that interface at the time of DOS. This felt like, you know, ages ahead. And then I moved from a console to a workstation, which would have been a large screen using the X windowing system and that was my career for five years.
I wasn't even on a PC anymore, I wasn’t using a Mac, but in 2000 when they switched, roughly around that time they switched to being, like you said, BSD. And I was like, okay, Mac is the way to go. Anyway, we don't want to talk about necessarily Apple, tell us what you're working on these days.
Balaji: Sure. I've actually got the crypto plan for world domination that I thought I might discuss with you. Which is essentially how if you're a crypto maximalist, so to speak, how I think crypto is the most important threat to the Big Five.
And essentially the plan for the next decade for how crypto goes after, not just FinTech, but Messaging, Log-in, Social, Search; Crypto Phone, Crypto OS, compilers, databases, advertising, actually reinventing CPA (cost per action), hosting, data centers, creator monetization, and then, on the back end, equity, compensation, privacy, and then most importantly: values.
I actually think that people are underestimating the scope of how big of a deal crypto is and that the Big Five don't really get it. The Big Five, meaning, Google, Apple, Facebook, Amazon, Microsoft.
And there's pieces of their empires that I haven't yet figured out how crypto might disrupt. Amazon's physical logistics, for example, but there's much more of it that is crypto vulnerable than I think people think. And your audience might be interested in this. Some of this is new, even, for maybe my audience.
So we could go area by area. And push back.
Horace: Yeah, the one thing I would caution on, is this usage of the word disruption, because I'm also a student of Clay Christensen. To what extent what I challenge you to answer is, to what extent might these Big Five find [crypto], possibly sustaining?
So if they would say, ‘Oh, well, thank you very much. We'll take it from here.’ So, I agree that there's an opportunity here to disrupt, but many times people just assume change is always disruptive, but change can be sustaining as well. So, please tell us.
Balaji: So, actually, on that point, there's a colloquial usage of disrupt, which just means a change. And then there's the more technical, the Clayton Christensen version, which is, it starts out as sort of an inferior product in some ways, but it's 10x on one axis, it's sort of underestimated. And then it takes the bottom end of the market, and then zooms up to the top in such a way that the incumbent finds it difficult to adopt it because it attacks their margins and so on.
Right? That's assuming the kind of, more technical --
Horace: That's what I mean, yes. That's low end disruption. There's also new markets where it basically carves out for itself a new niche and it does things that nobody's asked it to do. Or markets that are non-consuming, like, you know, emerging markets or something like that, and grows from that base as opposed to low end.
But, yes, generally speaking, that it comes in and is not good enough initially.
Balaji: Yeah, so I think that this fits, as I'll go through each of these examples, I think each of these fit both the sort of colloquial usage, as well as the more technical usage. But let me go one by one and just talk through these points.
So first, at a high level, I'm actually pretty confident that, with the exception actually of Facebook and Twitter, I think crypto is kryptonite to large companies because they don't understand it. And in particular, they're sort of frozen by antitrust and they can't take on more regulatory risk, even if they had the personalities internally to do so. I actually give a lot of credit, even if I think Libra was misguided in some respects, in terms of implementation, I give a lot of credit to [Mark Zuckerberg] for trying to get into crypto relatively early and putting out a project. Even if, in many respects, I think the parameters were flipped, as I can get into, to simply push through that relatively early, starting in 2018, when the other companies didn't get there is because he has a founder's mentality still.
And I think Twitter is actually the dark horse here where it's the furthest ahead on Bitcoin, specifically, as opposed to crypto more generally, that's an internal distinction in the community that I can talk about. But I don't think that Google, Apple, Microsoft, Amazon actually get it because they're not founder led.
And also because they're under this regulatory microscope.
Horace: By the way, just a funny story. So I'm here in Germany because I'm at an event for e-bikes called Eurobike, or just bikes in general. So I'm a fan of Micromobility, I've been talking about it for a couple of years now. I get the same impression. I've spoken to people at those companies that they're not seeing it, they’re not feeling it. Their entire mobility focus is still automotive. It's not that there's a cognitive problem. They understand the idea, but they can't actually implement it, it's this innovator's dilemma thing.
Balaji: Yeah. I mean, it gets to the fundamental thing, right? Which is that a founder is able to say, ‘Hey, we were doing X for such a long time and X got us to where we are, but now we're doing, not X. We’re doing the opposite of that.’
And they have the credibility to turn the entire organization, in particular, to impose short-term costs for long-term benefit to cannibalize or disrupt, in the colloquial sense, an existing product for a new one.
You know, Satya [Nadella, Microsoft CEO] is actually the exception. I would put him, if I rank order the existing companies by their crypto friendliness…
What's interesting is it's the $100 billion and $10 billion and $1 billon companies that are much more crypto friendly than the trillion-dollar companies.
So Shopify, for example, gets it, right? Coinbase. Stripe, I think, is coming around. So the ones that are sort of like the sophomores or the juniors, as opposed to the seniors, are going to, I think, use this to slip stream. And I think this is a disruption again, you know, I know you're from the Christensen club, so I may use that colloquially, so poke at it.
I think this is a change or an alteration or a forcing function, whatever you want to call it. That is actually on par with the desktop to internet transition. That you can think of this as, just like you went from on disk to online, the transition from online to on chain involves a similar number of cultural and technical changes that render the current generation, basically like the Borlands and DEC Alphas and so on of the previous generation.
Horace: So tell us how do you think that… You gave a lot of examples, of things going on chain --
Balaji: Yeah, so let's go to specifics. Let's start with the obvious, which is FinTech. One of my colleagues, friends, Chris Dixon runs the crypto fund at a16z. He observed a while ago that many Unix command lines became apps.
For example, GIT became GitHub. That's an obvious one, but had these command line chat apps that effectively became Facebook and IRC and Slack and so on and so forth, right? Command line apps turned into full-blown UXs. Crypto is actually the reverse in some ways where every FinTech app can be turned into a crypto command line. For example, Affirm or PayPal or Funbox, or, many of these things that essentially are doing cashflow transformations of some kind can be written as a few lines of code in Solidity. Which is Ethereum's programming language. And that alone is actually kind of a big deal where you can write that down and then just start piping arbitrary amounts of money through it, between countries, where it really is the internet of money. Any user can route money to any other user, if both users have a crypto address, if they have a Bitcoin address or an Ethereum address for the purpose of smart contracts.
And so that's just a fundamental backend change. And one way of thinking about it is over the last 10 years, since the financial crisis, Dodd-Frank basically stopped the issuance of new banking charters. Were you familiar with that? Did you ever see the graph of that?
Horace: No. No, tell us.
Balaji: So, you're a graph guy - I've got a chart on this somewhere on Twitter, but basically the way that they dealt with the banks' failure during the financial crisis is to effectively reward them by eliminating their competition entirely by refusing to issue new bank charters for almost a decade. And, here's the graph over here.
The state's solution to the financial crisis was to stop issuing commercial bank charters for almost a decade and to reward failure by regulating away competition via Dodd-Frank.
The network solution was FinTech and now DeFi.
The reason I bring this up is FinTech is a front end, Blockchain is a backend. Over the last 10 years... You're probably familiar, at least to some extent, with the FinTech side of things. Imagine if, when I sent you a message via Gmail, that behind the scenes, Google printed out the email, put it on a Pony Express, took it to you cross continent, scanned that and put that into your inbox.
And it looked like it was digital, but it actually had this antiquated pre-internet backend of a two or three-day delay in there, but the company did the best it could to obscure that. You know, all of those hacky steps in between, yeah? That's a good analogy for what FinTech is, where it's this shiny web-like front end, but on the back end, you're dealing with pre-internet mechanisms for settlement where it's often FTP or flat files or some horrible Cobol-era file format. It just wasn't set up for the workloads that we have when you actually press on that. Right? Once you set it up and you give people the expectations of being as performant as a Facebook or a Twitter or a Gmail, and you start putting huge workloads through - that the financial system doesn't anticipate, you get things like the Robin Hood issue of earlier this year.
Horace: Yep.
Balaji: Right? You make people think that it can handle internet-like workloads. But it can't, it just kind of simulated that. Taking that Gmail analogy a little bit further, with Gmail, every email that I send you is basically non-fungible. In the sense that each one is just a different set of characters. But if it was fungible, if it was money where every dollar is the same as every other dollar, Google could… when I hit a button to send you a hundred bucks, Google could just extend you effectively a hundred bucks on credit where it's assuming I'm good for the hundred bucks. Right?
And that is essentially the mechanism by which a lot of FinTech companies operate where they're like a central buffer that makes users think that this stuff is instant and fast, but it's actually not on the backend. Okay, so FinTech is a front end. Blockchain's a backend, where it's a genuine innovation.
So it's almost like this flanking thing where bank charters were cut off. FinTech built all of these fancy front ends on top of banks by doing deals with banks, by now, more recently starting to get licenses in Utah and places like that. And then blockchain, the crypto space, built a completely different set of rails where they essentially, over 10 years, got people to accept these things as money-like.
And now they're coming together where, with Robin Hood, with Square, most FinTech companies are aware that crypto is a big deal. It's not going away. And the reason many of them have a hard time getting their head around it is that it flips basic assumptions.
What Satoshi did with Bitcoin is he flipped absolutely basic assumptions. Where the concept of Bitcoin starts with the idea that deflation is actually good if it's coming from productivity. The typical macroeconomist would say hyperinflation is bad, but deflation is also bad. A little bit of mild inflation is good. This is what you'll read in every Econ 101 textbook.
Horace: Yep, that's true.
Balaji: And so Satoshi said, actually, no, that's not the case.
You want to have users be able to hold their own funds and you want to have a fixed monetary policy that gives certainty for investing in the future. That can't be monkeyed around with, by the Fed open markets committee, to bail out banks and stop transactions and so on. That meant so many flips of fundamental premises.
Number one, digital gold being good rather than bad. Number two, that users should be able to custody their own money rather than having it at banks and they should be able to take that risk. Number three, that transactions by default should all be able to go through. So it's like a default approved as opposed to a default sanctioned and so on and so forth. They basically just flipped fundamental premises.
And when you flip fundamental premises, you can often get to just a completely different environment, completely different worldview, completely different set of solutions. I mean, it's like land animals versus sea animals or like Google's culture versus Apple's culture, right?
I mean, now they've become more similar but Apple for a long time, it used to be very private internally and Google was very public internally. Both of them worked on their own terms, but were just fundamentally different in terms of their premises and axioms.
Horace: Let me get back to this example you gave us, of online as a way to do fundamental transactions. Now, one of the things that, and this seems very much, like you said, behind the scenes, because from the front end the consumer is given an illusion of technical competence. But in the backend, it's actually still jury rigged.
Now, the thing that I would ask is what does that mean and how does it feel different for the consumer? Because if you fix the backend, then yes, it's much more robust and clean and probably safer. But I think that the way it affects behavior is not so much that people feel different about that interface, but rather that they will do more of it.
In other words, that, like you said, it was about volumes that caused the cracks to appear in Robin Hood. So to me, the question, the reason, let's say I'm not skeptical, but I'm slightly reluctant to dive headfirst in on crypto is that I'm asking all the time is: How does it feel different for the end user?
And the end user would have to have some sort of emotional response to this change and say, ‘Wow, this is really amazing! Now it's much better.’ Or, ‘Now I can do things that I couldn't do before.’ So what I would posit is that the change you speak of would allow the users to suddenly say, ‘You know, I may do a wire to pay for a very large sum, but now I would do it a hundred times a day. Or I would do it to pay my friend, or I would do something financially that I never did before.'
And I, by the way, I feel this pain a lot because I live in two countries and you probably do as well, and you have to always transfer money and it's an absolute nightmare. And it's almost confiscatory in the way they steal money on the way, to try to transfer funds internationally.
So do you see this driving new user behavior or is it simply that you fixed something that was broken?
Balaji: Absolutely, excellent question. Let me give a few points on that. An interesting thing Evan Williams once said, in a sort of counter-intuitive way, was that the way to get people to adopt an app is to not do something totally different, but to take something they're already doing and just cut out steps. Make it just faster, simpler, etc.
You know, people were blogging and then they did Twitter. People were blogging and then they did Medium and made it simpler, with front end editing. And that's one view, that technology is incremental. But the other view is it's transformative. Wait a second - our lives are so different than the past.
And here's how I reconcile those, then let me get to specifics. If you go from physical mail to email, just sending point to point email, to a group email with reply all. To a group email with reply all where you add attachments of images to a Facebook thread, to then real-time chat in something like Slack or Discord where you're attaching images.
Each one is an incremental step over the previous one. But if you were to think about how expensive it would be to do a Facebook thread by physical mail. You'd have, I don’t know, a thousand friends and you'd be printing out the thread each time and sending postcards to each of them, with someone saying LOL…
If you would just diagram that out and see how many packets were moving back and forth between those thousand participants of which maybe 95, 99% of them are, actually, not even participating. So therefore they wouldn't even go and send in their postcards. And you'd say how much of a cost that would be on the legacy postal system?
At a certain point, when it's a million postcards to be one simple Facebook thread that we take for granted that has some images and a reply and maybe a link or something like that. Well, then the quantitative difference makes a qualitative difference.
Horace: Absolutely. Yup.
Balaji: Right? And in the same way, that's basically what's happening with crypto. And one way of thinking about it is - and this is now changing, but in the first 10 years, what crypto was best for and by the way, within crypto the term ‘crypto’ is an overarching thing that encompasses... There's just different people who have a beef with the term. One group, are those people for whom, you know, crypto used to mean cryptography, right?
And the second are those folks who think of Bitcoin as its own area, as distinct from crypto in general. I think crypto is the right term for the space as a whole. I think, in particular, cryptocurrency and blockchain is to cryptography roughly as the internet is to software. Software is not synonymous with the internet. Computer science is not synonymous with the internet, but it’s certainly the most frequent deployment and monetization point for it. And, in the same way, I think many cryptographic concepts will be deployed and monetize within the blockchain and cryptocurrency space.
On the second thing, just to finish this little tangent for a second, Bitcoin people think of Bitcoin as the only real cryptocurrency and everything else is a scam and a fraud and blah, blah, blah.
Which I don't believe. And I don't think Satoshi Nakamoto believed that, but this is something you'll probably hear more and more of.
But just in terms of that term, ‘crypto’ is basically thinking of the space as a financial and technological and efficiency related movement. There’s also a very strong overlap, which I'll get to on the ethical aspects and how it's actually a pro-freedom movement. And those overlap. And a Bitcoin maximalist would be like purely on the pro-freedom side, or in their mental model of it.
Okay. Just coming back up the stack. So, end-user benefit basically in the first 10 years, crypto benefited what I'd call the power users and the marginalized. The people who are at both ends of the spectrum. It's the exact opposite of the bell curve.
It's not the person in the middle. It's a person at the extremes. And so that's why I like the example of, ‘Hey, I'm buying coffee at Starbucks. You know, this crypto thing doesn't seem like too much of a benefit.’ It's actually a good point. And the reason is crypto is good for transactions that are very large, very small, very fast, very international, very automated and/or very transparent.
So those six things: large, small, fast, automated, international, transparent.
Your Starbucks [order], maybe it's 10 bucks or 15 bucks, whatever, for coffee and bagels or something like that. You know, big city prices nowadays. That's not a very large nor very small transaction. It's not millions of dollars. It's not a cent. It doesn't need to be very fast because to clear it, settlement can happen over a day or something like that. It doesn't need to be ridiculously fast. It doesn't need to be very automated because with both you and the clerk, there are humans monitoring the transaction on both ends.
It's not very international. You're both literally in the same coffee shop and doesn't need to be very transparent. There's no reason for either of you to have that receipt on chain. So everybody thinks about coffee payments because that's maybe the most frequent thing that people actually buy on a daily basis.
There are not too many other things. People used to buy a newspaper on daily basis, but they don't really do that anymore. They may have a subscription, but they don't consciously buy it. So relatively a few other things you buy on a daily basis. You don't buy a chair on a daily basis. You don't buy a computer on a daily basis.
So they think about their coffee purchase, but that's actually sort of the opposite. So where crypto is actually really good - let's start at the power users first. The power users can be split into two overlapping groups, which are engineers and investors. Both of them are trying to do things like, for example, move a million dollars across the world to Japan in a day to do something, right?
The engineer might be doing that because they're moving money around on the back end of Airbnb or Uber or PayPal or something like that. They're pooling capital from lots of users and trying to do something with it. Take the profits from one area and move it to another. Accept all of these wire transfers in different currencies and convert them into USD within Airbnb's main account, something like that.
Brian Armstrong, founder of Coinbase, saw what a big deal this was as an Airbnb payments engineer. He realized it was not a solved problem. That's actually how he got into Bitcoin originally. So as an engineer, you understand it from that perspective. An investor understands it from a similar perspective where you want to do an international wire and, you know what? It's actually still a pain to do that.
Wires get lost. There's [the matter of] correspondent banks. It's a huge pain to do a wire trace or something. But you know what's really simple? If both sides use USDC, which is the stable coin I helped launch, but it's the number two stable coin in the world. Maybe the number one, if you think of it, as in terms of legal stable coins, you can go to a website, stablecoinstats.com.
Right now, it's $26 billion outstanding in USDC and over the last 24 hours, it was $694 million in volume. Okay. That's quite a lot of wire.
Horace: Impressive. Yeah. That’s striking.
Balaji: That's striking. The whole space is bigger than people get from the outside.
A good metaphor is crypto is a country. It's a fractal country of a hundred million people, which is bigger than most people realize. Cambridge had a study on this last year. It's probably bigger than that now, but it's a hundred million people who hold some crypto, according to the surveys, spread across countries.
And the key is you have to have that sort of value flip right in your head to think of it as money. It's basically like, do you think of the yen as money or not? Do you think of the ruble as money? And if you do, then you can participate in the Japanese or the Russian ecosystem. And if you do not, then you do not.
But crypto is like a country that is exponentially expanding. And there's a million people at the core and then 10 million people around that and a hundred million and it'll keep growing. And then once you’re part of this economic environment, all these other people accept cryptocurrency as money, all of these things become possible.
And once the other person, on their side, accepts USDC as a dollar equivalent, well, I can hit enter. And just like how sometimes you'll send somebody a file and you'll talk to them on the phone for a minute or 30 seconds, and they'll be like, ‘Oh, okay. I got the file in my inbox, done.’
You can now do that with an international wire transfer with USDC. You can hit enter, and they will see it on chain in a few seconds. Now, at first, all that's doing is it's similar to the transition from mail to email, where you go from a two to three day delay to seconds. But then over time that increases the metabolism of business.
For example, I sold a company, Earn.com, to Coinbase several years ago.
One of the things we did there was kind of a V1 of this where we would accept Bitcoin from somebody in Greece or Japan, let's say $10,000 worth. And then we were able to issue a thousand $10 amounts of Bitcoin to a thousand individual people in different places for microtasks.
And the thing is that, because I could get that $10,000 wire or wire equivalent from them same day, you didn't have to know whether they were good for the money.
Horace: I think it's unbelievable. But let me bring you back to the Big Five and the questions [from earlier in the discussion]. We just did FinTech, I think convincingly, the next question is how does this, which yes, it will increase metabolism, but how –
Balaji: How does it disrupt the Big Five?
Horace: Yeah. In particular, those examples you gave: messaging and platforms and coding and all these other things.
Balaji: Let me just tie up one last point on the previous thing, if you don't mind. I mentioned [crypto] is good for the power user and the marginalized.
So the power user - the dev or the investor wants to move millions of dollars around the world with the keystroke. The marginalized, that's somebody who just wants to hold on to a bank account equivalent. That's somebody in a Venezuela or a place where the currency is being inflated. Or Nigeria, where people are being pushed out by the police.
But it's also anybody who's de-platformed or canceled or ostracized, or basically locked out of the financial system for whatever reason. Like the OnlyFans.com thing recently, [which is an] obvious example of something where… That's what cryptocurrency sells, where the banking system can't just lock you out.
And what's interesting is sometimes these are the same entity at the same time. Something like binance.com, for example, is both a power user of crypto but it's also marginalized where it's sort of on the margins of the legal systems in the world.
A couple of other quick points on this before I move on.
One thing people often talk about is, ‘Where are all the use cases for crypto?’ Well, now there are many of them are out there. You know, I've actually got a post on this: And What Has Blockchain Ever Done For Us?Crypto has transformed crowdfunding, it's transformed international wire transfers, it's transformed gold.
Just those three applications are worth trillions of dollars, but there's way more. If you go to defipulse.com, it's transformed loans, it's transformed derivatives. Many of these applications are actually out there and already at substantial scale.
But a very important point is speculation was installation. Without people speculating that this thing could be big, it wouldn't have had a price. Without it having a price you couldn’t treat it as money. Without it being treated as money, you couldn't build all of these apps. The loans wouldn't work because it'd be just sending zero for zero.
The thing about crypto, in particular, is it has the opposite emergence mode from social networks. You know, we've now been tuned to such an extent to DAUs (daily average users) and MAUs (monthly average users) and whatnot, that we sort of forget in the 2000s, that those were metrics that people scoffed at and poo-pooed because social networks were piling up all the users, but where the money, you know?
Even as late as 2012 or 2013, there was an article, something like why Facebook will never make a significant profit. And just a few years later, [people were saying] ‘Oh my God, they're so evil, They're dominating the world.’
The New York Times had an article in the early 2000s, Google's Toughest Search is For a Business Model, right. And of course, Amazon.bomb.
And you've seen all these kinds of things. With Facebook in particular, it piled up users. It made money, actually, pretty early on, but Twitter, Pinterest, Snapchat, this entire model of piling up users before making money was, and is, a common one. Now people understand it so much that they think that's the default emergence mode of new technology,
But crypto flips that. Where it piled up the money before it had the users. Making money, almost in the literal sense, before the users came. So it flipped it around. And so instead the question people were asking is, ‘Oh, where's the utility?'
Now it's actually coming.
But I wanted to point that out. It's the opposite of the social network model, MAUs and DAUs, there’s a totally new set of metrics you need for crypto, which are not daily active users, but daily inactive holders - that is people who are holding for the long-term and are committed to it.
So that's macro, let's go to specifics. So I mentioned FinTech. Pretty much every FinTech app is going to get backend blockchain-ified. Unless there is some prohibition within the country on that. And if that is the case, it'll probably get out-competed internationally, even if it has a captive market at home.
And the reason for that is, if you think about an email address, it is something which is uniform across geographies. I don't need to look up the postal code of this, or the zip code of that. With an email list, you don't need to know whether somebody is in Nigeria or Switzerland or India. Just hit enter and you send it. That uniformity alone is something that blockchain addresses give you. It’s way easier to do a cross-border deal with somebody in Japan and Brazil or Nigeria with the smart contract than it ever was before.
In fact, one might even argue international business didn't even really exist before smart contracts and cryptocurrency. And the reason I say that is if a Brazilian company wants to acquire something in Bangladesh - -
Judd: You need locals.
Balaji: Yeah. You know, what you might do is say, all right, there's not too much law on the Brazil - Bangladesh interface, but there'd be U.S. - Brazil and U.S. - Bangladesh. So let’s set up an intermediate there and work through the precedents on both sides and get A plus B and B plus C.
The other country you might use for this is China, but if we actually go down to brass tacks and think about what the obligations are for each side and how the legal systems interact, you sort of need that centralized intermediate, the U.S. and China are the only two countries that do so much business worldwide.
There's probably a Chinese enterprise in Bangladesh, probably a Chinese one in Brazil, and so you could make the things add up and the laws add up and the property rights add up. But that's something that only works at scale. For large companies doing those kinds of transactions, you can make it work and you'd probably set up a U.S. or Chinese intermediary to help make it work. To lubricate it.
But if you wanted to do it direct - how do you do direct? These people don't speak each other's language? They certainly don't know or trust each other's legal system. So all kinds of weird peccadilloes. But on chain, everybody can read the same code. So, essentially, the pooling of money, the friction of diligence, the consistency and uniformity of naming, all of those things are 10x improvements just from a developer-investor standpoint, the power user standpoint with FinTech.
So all FinTech gets disrupted by blockchain. That's very clear to me, it's already happening in some ways, but that's very obvious. All right, let me pause there and get your thoughts, feedback, and then I’ll move on to the next one.
Horace: Yeah, exactly. I love the way you framed it in those six categories of applicability.
Most people don't experience small transactions or international or transparency's not a concern of theirs. But that allows me to classify this as the type of disruption where it would allow things to happen which normally wouldn't happen. It would allow, like you said, inter[national] deals to happen in ways that no one would even think of doing today.
And as a result, it's sort of a new market disruption. It would unify people who are now divided by country boundaries. It would unify them in, as you said, this new country, this country of coin, [of] which they would be all effectively citizens that would somehow communicate and understand each other so much better, because they are not divided by these artificial boundaries. And I think that would, if you said the exponential growth is current[ly happening], then it would encompass a substantial part of the globe. And that in itself is so powerful that we can't even fathom the consequences of. But it's effectively, in the FinTech world, I think what you're saying, and I'm sort of reading ahead of it here, so what you're saying is that once that platform or that foundation is laid, you can imagine a lot of new things emerging and that will build new empires. Is that where you getting at?
Balaji: Yes. I actually think crypto is to America as America was to Europe. Like you can, and let me explain what I mean by that. It's actually-
Horace: No, I get it, yeah.
Balaji: And just like you had, so why is that actually a good analogy and not just simply verbiage? If you know different kinds of distance metrics, the most obvious distance metric is the great circle distance on the surface of the earth between two people.
That's just the distance as the Crow flies. You know, on the surface of globe. There's another distance metric, which is the geodesic distance between two people in a social network. You could have, for example, you and I right now are closer geodesically than we are geographically. And then there's people outside who are closer geographically than geodesically. People I don't know, or haven't spoken to, but they’re within a mile of me or, or within a mile of you.
And so those metrics, they actually have typologies associated with them. Just like you can have a cartography of continents, you can have a cloud cartography of who is close to who in the social network. In many ways, you're probably closer to people in Cupertino and New York and various financial capitals around the world than you are to people who are a mile away physically.
And that is something, when you start visualizing what that cloud continent looks like, with all the nodes colored by what coins they hold, you know, a big orange for Bitcoin and blueish for Ethereum and so on and so forth. You start getting a visual that looks a lot like the European incursion into the New World.
Without, of course, any Native Americans or anything like that, it's sort of the pure expansion of different demographics into this new region where people are spending more and more of their time. And VR will make this more than a metaphor. It'll actually be like physical space.
Now the one thing I would edit on your point is that when I said crypto's a country and you said without internal boundaries, there actually is a lot of crypto tribalism. So it's actually an interesting thing where just like there was the New World and the Old World, there's a crypto world and the fiat world, and there are conflicts within the crypto world and there are alliances with folks in the fiat world.
So it's actually an interesting analogy to the age where the French and the English and the Spanish and so on all slugged it out for the Americas. Again, without the native population there, it's sort of the pure version of that. So with that as an analogy, it's something where you can build things from scratch. All these ideas that were infeasible in the Old World, like democracy or so many innovations that the U.S. had in terms of governance and —
Horace: The federation, the transportation networks, the frontier, the way the U.S. was constructed, mostly accidentally, allowed it to become a superpower.
And I think the continental scale of it, which again was accidental by acquisition of territories peacefully and not peacefully, but generally Europe was stuck in a centuries old grid of monarchies, feudalism and all the other baggage they had carried. It just wasn't able to have a frontier mentality. I sometimes think that that conquest of land, that the open horizons is reflected in the dynamism and the ability to invent that followed.
Balaji: Yes. This is Frederick Jackson's Turner's frontier thesis, and one can argue whether these changes were all good or all bad. I think there were some both good and bad innovations that came back from the New World to the Old. For example, The French Revolution, they were in part inspired by The American Revolution, but had a much worse result.
Communism actually, there were a fair number of Americans that were involved in it. There's a book by Kenneth Ackerman, for example, Trotsky in New York, where he raised money in New York. Also Lenin was basically released by the German government. Even the New York Times had something of this, like Lenin was a German agent.
So some of that stuff that came back to Europe from the Americas, that’s not that well-known, but it's also not that obscure. You can Google around and find it. Some of that stuff that came back from the Americas was not good, but some of it was. The modern railroads and the history of how many technical innovations came back from the U.S. to everywhere else. From mass production to, I mean, in some ways bad, but the atomic bomb, nuclear power, all of these things that you would not have had without that fresh new, clean slate to build things and have influence back [the Old World].
And I think that's very similar to what we're seeing in crypto, where in many ways it's already changing the financial system. The most obvious is every government in the world, every bank, knows what CBDCs (Central Bank Digital Currencies) are, at least in concept. And China is shipping a digital Yuan. Which means that a post on a message board by a pseudonymous guy 10 years ago has shook the entire world, and is already a topic for not just discussion, but active execution by the governments of a billion people.
And that's, that’s-
Horace: Just while we're on this cultural aspect, what is your opinion on who Satoshi is? I'm curious as you seem to know —
Judd: Are you Satoshi?
Balaji:. No, I'm not Satoshi. I wouldn't tell you if I was Satoshi, but I'm not Satoshi.
Judd: What if we asked twice?
Balaji:. What's that? What if you asked twice? Ha ha. No, I mean, Satoshi Nakamoto had a very important combination of skills.
First, he was a world-class programmer. The thing about something like Bitcoin is computer security. The late Dan Kaminsky, who was a friend of mine and absolutely a genius in computer security had an article in 2013 where he said, I tried to hack Bitcoin and I failed. And this was very exciting.
The point that he made was that, in most applications, security can rightfully be a little bit of an afterthought. That’s to say that in the early years of the web, maybe not so much today in 2021, but in the early years of the web, you just needed to stand up a site and get users. And you could sort of assume that there wasn't that much to be hacked and people didn't care that much. And so people would optimize for growth over security, because if you have growth and no security, then you can hire engineers and add the security later. But if you have security and no growth, you have no money, and it doesn't matter. Nobody cares if it's secure.
And the thing that's different about cryptocurrency is that security is a fundamental characteristic. If it's hacked, even once, if you can duplicate coins, inflate coins, and that's a persistent issue and an unfixable issue, then the value goes away.
So security wasn't an afterthought. Satoshi built the code like you'd build the code for a space shuttle. Where it was just a different mentality from the very start. And so, first of all, he’s a genius programmer. But, second, he clearly had a deep humanities background to build something — I mean, with many kinds of inventions, there's Newton and there's Leibniz. You know, there’s an idea in the air and there's simultaneous invention of some kind.
But Bitcoin wasn't like that. It really was something where one person's genius shaped the world and it took a while for people to catch up. And it wasn't like there were a lot of contemporaneous Bitcoins with similar ideas. It was something where it was kind of out there and it took a while for people to get it. And even still today, people don't get it because it flips premises.
And unless you're actually reasoning from first principles… people will quote Econ 101 as if it's like some kind of inoculation against this thing that’s at a trillion dollars [in market value]. It's similar in my view, by the way, the American, just to digress on this for a second, the American school and maybe the international school of macroeconomics, I think is similar to like Soviet economics where the Soviet Union had all of these prizes that were given out for Marxist economics. But it didn't amount to a hill of beans because their premises were actually wrong. Some of it was good. Like, I think Kantorovich did linear programming. Some of the math was useful, but it was something where the premises were wrong. And one of the reasons for that is that with macroeconomics, you can't actually run experiments very easily. Because the maximum that we know in macro is something like communism doesn't work. In the sense if you compare a North Korea versus South Korea or China before Deng Xiaoping to Hong Kong and Taiwan and Singapore, or East Germany versus West Germany. You take ethnically similar populations, you partition them, run the experiment for 40 years, communism impoverishes one side of the country versus the other. We've now seen that multiple times. So that's the extent to which you can see that within macroeconomics and so in that sense you've got controlled experiments, but that's not actually the fundamental principle of macroeconomics.
It's something more like John Lanchester wrote this in London Review of Books, you know, almost a decade ago. And Tyler Cowen wrote about it. The fundamental principle of macroeconomics is governments aren't households. Meaning governments can print money, meaning governments can seize things at gunpoint, and so on and so forth.
And this type of stuff, this kind of discussion goes to philosophical roots. It goes to economics. It goes to history. It goes to policy. It's inseparable.
Horace: But just to build on that, the way I would say it, governments typically have a monopoly on violence. What it boils down to is that they can do these things, which are not allowed by households, is because they have armies.
Balaji: Yes.
Horace: They have police forces that effectively are armed. Citizens may or may not be armed, but generally never could match the firepower of the state. So this is — the monopoly on power is monopoly on violence, at this moment.
Balaji: That's right. And the thing about that is that the modern school of macroeconomics is backed not by mathematics, but by guns. Actually, Paul Krugman, in an interview with Joe Weisenthal said, fiat currency, if you like, is backed by men with guns. It's like Mao’s thing, “power comes from the barrel of a gun.” Whereas, and so once we're honest about that, we're like, oh, it's not Econ 101, it's AR-15. Right? And so once you realize, okay, that's actually the backing. These fancy formulas, it's just like the Soviet Union, the Marxist stuff was backed by AK-47. Right?
So once you realize that, okay, well, I'll give you another one, which is Bitcoin is backed by SHA256. So Bitcoin is actually backed by cryptography and mathematics versus violence. And that's just a fundamentally different set of premises. So the reason this is inescapable to talk about is that you can use JavaScript without really knowing much about history. But to understand the problem that Bitcoin solves, you really do need to understand history and philosophy. And that's why Satoshi was-
Horace: Yeah, exactly. I was going to bring you back to Satoshi. So he's a humanist and he's also a programmer par excellence. But you also speak of him in the past tense. Why do you do that? Is he not still with us? And what’s happened, what will happen with his share of Bitcoin?
Balaji: Well, nobody knows. It's something, which is interesting, where it shows that with good enough OPSEC, to my knowledge, nobody's actually, de-anonymized him.
A lot of people suspect that Satoshi was close to Hal Finney, who was an early extropian and programmer, but nobody knows for sure. Some people think it's Nick Szabo. I don't think it's Nick because Nick has never published code to my knowledge. So I don't think he could have done it himself, but Nick has published ideas that are clearly influential on Bitcoin. But the reason we speak of it in the past tense is for him to authenticate a message he'd have to do so from the private keys that are associated with early Bitcoin addresses that we know belong to him that only he would hold.
He could trivially do that. And he has not done that in last seven years. And Hal Finney actually died of Lou Gehrig's disease, I believe, around that same time. So it sort of connects that Hal Finney might be Satoshi, but it's not known. And nobody really wants to poke into it because in many ways what Satoshi did, it’s amazing that it was a human being who did it, like a single human being. And I think it really was a single human being because something like that is just sort of hard to do as a team. Satoshi… the fact that he has disappeared means that Bitcoin is “decentralized,” or rather it is one of the forces that makes Bitcoin feel decentralized.
It is something where there's no identifiable leader, yet it has massive global adoption. Now, you can argue, well, the core developers and the miners and the reference client, and so on, are points of centralization. Each of these are tested over time. I think mining centralization just got tested. People had made the point, oh, China could take over mining, but China just cracked down on mining.
It was a huge drop. If you looked at the Bitcoin mining charts, the hash rate dropped from, I think, around 180 exahashes to like 80 exahashes. That's a huge drop. The biggest drop I think ever in Bitcoin history. And all that happened was what you'd sort of predict by looking at it. Transactions slowed down for a little while, and now it's back up to 140 exahashes.
So China, which is probably the largest and most organized and ruthless and technologically competent state, all the things combined, took a hard swing at Bitcoin mining, actually pushed it out of the country. Bitcoin kept ticking. So Satoshi's absence has helped decentralize it because everybody can imprint their own thing on it.
In this sense, Bitcoin is like Linux where ferocious competitors like Google and Facebook still collaborate on Linux. And the reason is Linux is a demilitarized zone where one party's contributions cannot be deleted or removed by the other parties. It is a true commons where you can give, but not really take back.
And that's what Bitcoin is like: a truly decentralized technology where every user is a root user. Nobody else can de-platform you, nobody else can take away your funds. It is something where you have parties that can be highly dis-aligned, but aligned on BTC. Very, very powerful thing.
And a big part of that comes from Satoshi’s absence and disappearance.
Horace: Okay. Take us home then, back to the Big Five. How do we think about all this building up to something much more visible.
Balaji: All right, so the first 10 years, we can very much compare the current era to the year 2000 for the internet where you had infrastructure, you had Yahoo, you had AOL and you had the early broadband connections.
You have the first billionaires, you had everybody knowing what the internet was, but a lot of the applications of daily use didn’t yet materialize. And there were a lot of people who’d use the internet to check news or send email, but you could basically get away with a completely offline life, even in the year 2000. By the year 2010, that was not true.
And by the year 2020, it's flipped the other way around. Now you need a phone in many places in Asia to get in with your vaccine passport and so on and so forth. And so I think that's similar to where crypto is today. Where the infrastructure is being built out. We have the exchanges, we have the mining, we have the coin developers.
We have the first billionaires. We have widespread awareness of it. But yet today, you can still live a completely crypto free life. I do not believe that will be true by 2030. And I believe it will be totally flippened by 2040, where it'll be crypto first for the entire financial system. But let me go to specifics, okay?
So we talked about FinTech. Every loan, every mortgage, it'll start with all the digital stuff first because that’s which is easiest. The stuff that has an offline correlate to it, like mortgages, will be harder because you have to have so-called crypto oracles recording the transfer of things offline. But all the FinTech stuff, that's kind of obvious.
Okay, then messaging. The big thing about crypto is it allows for provably, encrypted end-to-end encrypted messaging. See when, nothing against WhatsApp, but it just tells you that it's end-to-end encrypted. They could have a bug in the implementation. It's not easy for the user to verify that. You know, it feels the same as Facebook Messenger.
It's trusted [as] end-to-end encryption, but then you can get backdoors and stuff put in. Whereas with crypto messaging… You know, it's funny, when you say cryptocurrency is taking two concepts that seem to be totally distinct like encryption and money, they have, of course, come together since the advent of HTPS and credit card payments on the internet twenty-five years ago.
But crypto has put them directly together in a very powerful way. In the 1990s and the 2000s people talked about this thing, they still talk about it, called the public key infrastructure problem, which is if you could assume that everybody had public and private key pairs, you could imagine this magical world where all of these privacy preserving things were possible.
Now many of your [listeners] may not know what public and private key pairs are. Roughly speaking, a public key is like a sealed envelope that you can give out and people can then put a message in there and seal it up and send it. And only you with your private key can actually see what's inside that envelope.
They can send you messages that only you can decode. There's many other uses for them, but that's one way of explaining them. The thing about it is, when you talk about everybody having a private key and public keys that are out there, well, you could do secure messaging.
For example, if your public key is out there next to your Twitter account, I could just take that public key. I could gin up a message. I could post that to you publicly, but only you would be able to decrypt it. The reason public key, private key, the whole public key infrastructure problem has been hard to solve is you need people to keep their private key available and secure at all times. So if you want to keep it available, you can just put a post-it note on your desktop computer, but it wouldn't be secure. If you want to keep it secure, you could go and put it in a lockbox somewhere, but it wouldn't be available. You’d forget where it was.
To have something be secure and available at all times is actually very expensive. It's like your wallet, it’s like your cell phone. It's something which, you've got eyes on it at all times. And that's something which basically has to be on your person and you need a strong incentive for doing it.
And so the big thing that crypto has done is it's made that incentive literal. It's money. If you lose your private keys, you lose money. And so because of that, everybody, millions of people, hundreds of millions, billions of people will have private keys that they can encrypt messages with. And so that will unlock end-to-end encrypted messaging in a provable way where you don't have to trust WhatsApp, or what have you.
And that's going to become more and more important as you're seeing, for example, Apple ran all these billboards on privacy and, I’m not sure what your stance is on that, but the CSAM thing, if you saw that, recently was basically cracked. Where people were able to put fake caches on people's devices to make it seem as if they had CSAM on there, but they didn't.
And I think you're going to see more and more of this, where there's a lot of advertising based assertions of privacy that are then eroded by some action and people will not want to take the Big Five’s word on trust. They already don't. And they're going to want provable end-to-end encrypted messaging.
We already saw this earlier this year, where there was an exodus in part from WhatsApp to Signal over some rumors that’s WhatsApp’s new terms of service were making it more feasible to eavesdrop on you. And I'm not sure how true that was or not, but you're actually starting to see consumer demand for privacy, which people didn't think existed.
Let me pause there. That's messaging, let's talk about that.
Horace: I think therefore the, let's say, the disruptive technology, as opposed to business model, is trusted encryption. And I think that what you're saying, effectively, is that the incumbents are going to struggle to implement. That's why I'm struggling. I'm thinking of it as a competitive question.
But if the struggle seems to be what you're suggesting, this is asymmetric or contrary to the way they would implement this new demand for privacy.
Balaji: Yeah, here’s the thing. A lot of people tried to separate blockchain and cryptocurrency.
They were like, ‘Oh, this blockchain thing is a great database, but this crypto thing it's weird and unregulated and volatile and it's bad. And so let's do it without that.’ And they tried to do enterprise blockchain where eight banks would get together and have some shared database. And that actually was the worst of both worlds solution where it had all the complexity of enterprise and all of the technical complexity of blockchains.
And the thing is that every application of blockchains will involve a crypto component. So the reason that big companies will find it hard to adopt this is… Why do people have these public and private key pairs? Because they have cryptocurrency, probably because they have an Ethereum or a Bitcoin address or a wallet locally on their computer. That is the prerequisite.
That installation is like having a web browser locally on your computer. And from that you can access internet. If you have a crypto wallet on your computer, you can access the financial internet. And if you do not, you cannot. And so these big companies, because they haven't yet grasped the nettle of how important it is to have Bitcoin and Ethereum integration in their messaging and payment apps, will not get that until too late.
They'll try their own in-house solution because they understand open source, but they don't understand open state. You know, they understand open source in the form of GitHub and open source code and whatnot. But open state is yet another level where it's not just a source code that’s public, it's a database that’s public. The Bitcoin blockchain is public. The Ethereum blockchain is public. Every user is a root user. It's shared state. It's the next step after open-source. They just don't get that culturally. And by the way, I wouldn't call it trusted end-to-end encryption. I'd actually call it something slightly different, which is verifiable end-to-end encryption.
It's end-user verifiable. So that's the big difference. Trust only if you can verify.
Horace: So that gets us to messaging. Potentially you get a situation where unless they buy the whole concept, as you said, the implementation has to be coin plus blockchain. So it's not just blockchain. It has to have this, sort of, pain.
Well, I call it pain because it's like you suffer if you lose, you know, it's verifiable
Balaji: Yes. That's right.
Horace: And, so I think what you're getting at culturally in terms of what's asymmetric about this technology is that it's not just utility, it's utility plus consequence. And that consequence or consequential nature, I think, is what is difficult to absorb for, not just the Big Five, but almost any larger platform company or technology as we know it.
We get into a state of triggered, let's say, consequences, which are negative. And people are just squeamish about it. And I think that you can't be a manager in these companies and say, ‘Man, the consequences of this, I mean, we could get sued, you know?’
Balaji: Exactly.
Horace: Am I getting close?
Balaji: Absolutely. Because, you know, what’s more scarce than financial budget? Risk budget.
Horace: Yes.
Balaji: Yeah. These giant companies have cash cows and are under regulatory scrutiny. So they don't have the risk budget.
They don't have the appetite for risk. And it's actually true that their risk is greater than that of a small company on doing this because they're under the microscope more. That doesn't mean it's impossible. [Jack] Dorsey has managed it with Twitter, but that may be because he's just under the level of scrutiny, where the Big Five are under that maximum scrutiny.
But even Facebook has actually said, ‘You know what, we're going to take the hit on this.’ I give them props for trying in the space. Simply as a founder, it's actually a non-trivial thing to do, but it is one of these things where the short-term incentives are so strong to not take a risk. And you really need CEO buy-in to do it.
I mean, as I said, Satya did a decent job on this, where Microsoft was relatively early on Ethereum support on Azure, and so on. And there's some of that. There’s some of the public cloud stuff they're doing, like the safe things. But putting it into Google Pay or Apple Pay or things like that, or buying it at the corporate level, these guys are all going to be late adopters on that because the risk budget isn't there. You need consensus within the company. And the thing about a crypto company is everybody is hired from the crypto country. Everybody's hired and they already have that consensus.
It's similar to the 1990s and early 2000s, and people thought open source was communism. Ballmer said something like that. If you remember that in the year 2000-ish. And this is hard to remember right now, but if you remember in the early 2000s, there was a cultural and ethical movement around tech, related to open source that was pro-Linux, anti-Microsoft, anti-corporate in some ways and so on. And that actually gave a lot of the early energy for people in technology thinking of themselves as the good guys.
And then over time the good guys became the big guys. And now they are sort of in play at safe corporate mode with lots of MBAs and spreadsheets and chiseling of customers and all the stuff that is hard to escape when you've got millions or billions of users and all this regulatory pressure. But it just changes your culture.
Then on top of that, they've got all of these political disputes internally at the company and leaks and all of this stuff. And so now crypto is like the next version of that, where it is not simply a technology, it has an ethical component to it. It has that philosophy, that community aspect, where it is returning power to the user, it is pro-privacy. It is decentralization as opposed to these centralized tech companies. That by the way, as a user —
Horace: I would even take it a step further. It has an ethical component, which may be a bit squishy, but I'd say it has even a political component. And I think by political here, I mean it's divisive in some ways. And you have to accept the premise that as a participant, you have essentially a partisan point of view.
And that itself is a giant leap because I think the neutrality of, the implicit neutrality, of a company’s governance is like, ‘You know, we play both sides of the aisle where we're going to be.’ And I don't mean this in the sort of left-right sense. But this is a new dimension.
Balaji: Absolutely.
Horace: And if you want to participate, you have to be willing to put yourself in that state. I sensed this myself because I find myself being drawn into this world. And that's been uncomfortable for me because I do not wish to be partisan. I do not wish to be political.
I do not wish to make a statement with my support for a currency or whatnot. But this discomfort also attracts me in the sense that, intellectually I'd say, ‘Well, that's interesting.’ We call the show Asymetric - as an asymmetry, it's fascinating, right? That you have to be in that dimension now. And that's what I think fundamentally would be the root of the disruption. In the true sense.
Balaji: That's right. I think I was able to articulate this in a recent post. That's the difference between Web 1, Web 2 and Web 3.
So Web 1, roughly, was about technology risk. Can we even build it? Can we make packet switched networks? Can we make web browsers, all of that stuff? Can we make operating systems? Okay. Web 2, it wasn't that tech risk went away completely, but much more of it shifted to market risk. Now that you had open source databases and you had all of this open source tooling, a lot of it was, ‘Hey, we know we can build it.We can snap together this web app or later this mobile app, but will people buy it?’
Will this consumer behavior be adopted? Will they use, you know, Snapchat versus FrontBack? If you remember FrontBack, there were a lot of these fruit fly type experiments with consumer internet, in particular, where the risk was not so much, ‘Will the app work?’ It is, ‘Will people actually buy it, will they use it?'
And now we're in the third stage, which is Web 3. With crypto [related] things, we know we can build it. The tooling has now become mature enough that it's not, again, there is still technical risk, but you can launch a token or a coin and we know people will buy it.
It's actually kind of interesting that there's almost always going to be some demand for the thing, at least, you know you can get it off the ground. But the question is now will people ban it? So in other words, Web 1 was about tech risk. Web 2 was about market risk, but Web 3 is about regulatory risk.
Horace: Yeah, that’s what I mean by political. I think I've used this word in maybe my own way because regulatory ultimately gets into the question of politics and that isn't, again, the classical left-right divide, but more like, ‘What is your philosophy? What do you believe in?’ What matters is your point of view and, and that you're forcing people to have that.
That's the thing here. I think it's forcing people and you cannot separate them any more, saying, ‘I'm neutral. I just believe in tech.’ It's forcing you to make a stand and that’s a very uncomfortable position for any corporate entity. It forces them to become partisan, in a way, on this dimension.
And that is what they will resist. I'm sort of taking your point here. And I'm trying to, myself, think of how this becomes disruptive
Balaji: You’re right. You’re right. When you're serving a billion people, they have an Innovator's Dilemma-like thing. The problem for them is that this is a, whether you want to call it political belief or partisan belief, or what have you, ethical belief, in decentralization, which is growing exponentially.
If you think about the number of crypto adopters as just one metric, it's like a hundred million today. And it was certainly not that in 2010. Sub 1,000,000, probably, sub10,000, probably sub 1,000, even in 2010. So that's massive, massive growth, but it's growth that they feel that, probably correctly, that it would be challenging for them to tap into without taking a significant messaging and risk budget hit.
Now, again, can they do it? I mean, as I said, Dorsey has managed it. I think Facebook could have, rather than doing Libra or Diem, they could have just built Bitcoin and Ethereum into their Messenger app and started with that. And that would have been smart. And they could still do that in VR, potentially. They're at least further ahead.
They've actually taken some of the hits internally on getting there. They've got some engineers, but the biggest companies that want to be all things to all people and do inoffensive things… You know, the thing which people tell startups, they tell them focus, focus, focus, focus, focus.
You almost can't focus too much on some micro demographic. You win there and then you level up, and you win there and you level up again. And the big company is not going to be able to focus because they're all things to all people. And that's now something which is no longer simply a market thing, but it's also a political / ethical thing, where you have to essentially bet on decentralization.
Horace: I'm starting to get it. Do you want to get into some of the others - we've done messaging, do you want to get into some of the others?
Balaji: So we talked about FinTech. We talked about messaging and, by the way, messaging is not simply, just like you go from email to group mail to Facebook threads.
Messaging starts with one-to-one messages, but every single messaging app will be rebuilt with verifiable end-to-end encryption, where you'll use your, probably your Ethereum name, but you could do one to one messages. You could do one to N, you could do N to N. You could do blogs, you could do blogs behind encryption walls.
You can do Slacks. All of these things are being built around so-called DAOs (Decentralized Autonomous Organizations) today, which combined sort of messaging plus corporate governance plus communities. So, relate to that login.
So right now, a huge moat for these big tech companies is log-in. With Apple login, with Facebook login, with Google login, with Twitter, where they've got hundreds of millions of users and you can use their APIs and implement logging onto your site, but you're also subject to them.
They can cut you off. That's no longer the case with something like ENS (Ethereal Name Service), where you can log in as Horace.eth. Just your local private keys are determined, not a password that can be reset, not account that you can be deplatformed from. That is a fundamental change where the solution to that equation, the private key, is held locally on your computer and that's the sufficient and necessary condition to log in.
If you have that you can log in. And if not, you can’t. So that completely changes login where it means that for example, you can't be deplatformed from social networks. It means you can authenticate also without people necessarily knowing who you are besides the fact that you have that key.
It's a structural shift in how you actually even log into systems and it's sort of like phone numbers or emails. Where, if I have a collection of your phone numbers or your emails, like on a sub stack, or in a set of numbers that have opted into text messaging, I can contact you. But even better than that, because nobody can even intermediate with the phone number the telcos could in theory, stop you. But with this kind of messaging login combination, they can't really stop me from messaging somebody on ENS.
So that disrupts Facebook login, Twitter login, Google login, LinkedIn login, all those - and it’s already happening with applications like Uniswap, for example, you could log in with ENS.
Number four: Social. So when you've talked about messaging and login, you get to social and social is basically just sending lots of different kinds of messages back and forth to each other.
Decentralized social networks are now actually out there and early and working. Just technologically - Mirror, Bitclout, Capsule Social, many others. A lot of the DAO chat-style networks are out there. I've invested in a bunch of these. I'm going to invest in more, no particular endorsement of any one of them, but decentralized social networks are now actually out there where every like and post equivalent is actually on chain versus simply in a centralized database. And the way of thinking about what a big deal that is is you do not have root access to Twitter's database or Facebook's database. But with a decentralized social network, a developer can hit enter and print out every tweet equivalent from the beginning. They can print out the social graph, they can index a social graph and they can search the social graph.
So there's applications, so-called block explorers. This gets us from Social into Search. One thing that is not very much thought about, because this battle happened almost 10 years ago, is how Google strive mightily try to buy Facebook. They were really annoyed at the emergence of Facebook and LinkedIn and Twitter because they were dark to them.
These are graphs that they couldn't search and they knew how big it was going to be. And they were like, ‘Oh, we're only gonna be able to index the open web, this is closed.’ The only thing that really came out of open social was the open graph standard. But they weren't able to get these social networks to open up their databases because, of course, they could make more money with them closed than open because if the database were open and anybody could read and write to them, well, they would not be any more the monopoly provider of advertising on their platform.
That's why Twitter shut down Tweetdeck and deplatformed all these companies that were initially building on its open protocol, it made more money with advertising vs having an open protocol. The critical thing that decentralized social networks have solved is the alignment of interests between the developers and the users and the platform creators where everybody just benefits from the token’s appreciation. And now you can build on this decentralized social network in a way that you could not do so on Twitter, because they'll deplatform you. You can't build on Facebook's API, they’ll deplatform you if you get successful enough.
So decentralized social networks, don't just enable decentralized social they also enable decentralized search because an underappreciated aspect of Google… First, a lot more searches are done on Twitter these days than people realize. I think it's, it's crept up quite a lot relative to Google. I'm not sure if you have this behavior, are there days where you search on Twitter more than on Google?
Horace: Not more, but there are days. And when I do, it's frustrating because I don't find searching on Twitter easy.
Balaji: It's not that easy, but —
Horace: But I sense what you're saying. Also with the Facebook problem that the shift to social from web was, I think Google dropped the ball there. I think that's one of the greatest failures that they didn't manage to transition to social in any way.
Balaji: Yeah, they got YouTube. That’s their big one that they did get.
Horace: YouTube was, yeah, it's the best thing they've done actually since search.
Balaji: So alright, so extending this point, a very important technical point where you’re thinking about search is [that] closed social network databases are harder to index in the open web, but blockchains are easier to index in the open web. And, this actually is something which most people don't realize, blockchains, until really the last year or so, were for the most part used to contain financial data.
And so block explorers like Blockchain.com or btc.com, that are indexes of the Bitcoin blockchain, or Etherscan.io [which] indexes the Ethereum blockchain. Those don't look like search engines to people, really, because the data structures they were indexing were things that weren't really things you thought of as being on Google.
You're looking for Bitcoin addresses and transactions and later on smart contracts and tokens, but these are very high volume search engines. And to show how behind the eight ball Google is, Google hasn't built a block explorer for Bitcoin, even. Or any of the major crypto chains. Forget even Ethereum, they haven't done Bitcoin. And that’s so within their core competency, it has zero regulatory risk, but just shows how behind they are, that they haven't done that in 2021. The reason that's important is what we've just proven over the last year, which is a huge milestone, is something like Bitclout or Mirror shows that you can host social networking data on a blockchain. There are others like Hive and Steam that have also shown this. And once it's all on chain, it becomes so much easier to index for the purposes of search.
People for example, stood up a thing, cloutavista.com to index Bitclout. This is a demo, I'm not saying any particular decentralized social network will win, but in 10 days they were able to stand up the search engine.
How long would it take you to stand up a search engine for Twitter? It would take basically forever because you need access to their API. They're not going to give you access to the API. And if they do, it's going to be very throttled and very expensive, and you'll have to raise venture just to pay for that. They can cut you off or change it at a moment's notice. They don't care about your business. And even if you give them a hundred percent of the company, they might not care.
Search will be transformed by block explorers. There's so many different ways from a technology standpoint that blockchains are easier to index.
Just one example, there are entire PhD dissertations that are written on freshness indexing. You've got a million websites, you've got a limited crawl budget. You can't crawl all of them every second. It'll make the servers mad, but it'll also use up your own bandwidth. And they don't update every second.
So how do you actually crawl them? Well, you have to have some statistical model of when they're likely to get updated and you have to go back to the website when it's predicted to have been updated and you have to have some provision for them going from one update a week to one update a day when you see a lot more changes than they used to have, and you're updating your parameters… It's this huge mathematically complicated thing.
And that's just one aspect of search indexing. And all that goes away with blockchains because you just subscribe and you get a block every 10 minutes or one minute, and it's got all the changes there. So, just the architecture obviates that entire —
Horace: It’s self indexing.
Balaji: It’s self indexing. You get a change set. You know, this is also related to the broader move towards, log structured databases and so forth, which, if you've got listeners who know about what's been happening in data science, that's been a big deal. But it all kind of comes together where you have Kafka and so on.
These change sets that are coming in, you can just subscribe to them as opposed to having to go out and get them. You don’t have to crawl. So that simplifies fundamentally - that alone makes search easier.
Okay. Going a little bit further. The Crypto Phone, you know what's happened recently with Apple and the CSAM thing?
The reason that it's bad for Apple to be searching your phone like that is today they're searching for photos with incredible possible levels of false positives, because people can put these adversarial machine learning images on somebody's phone and frame them for a very serious crime.
Tomorrow, though, they can use the same technology to scan for cryptowallets on phones. And it may be ordered to do so by governments. So that alone is going to mean, and there's already pushes for a crypto phone out there. Foundation Devices, for example, there are people who are building it. But a crypto phone is also important because of other things like payments. You have all this pressure on Google and Apple for payments.
The fact that you've got login, payments and identity, getting decentralized and app developers making more money and users having their funds secure. These are the kinds of pressures that could actually lead to a new mobile operating system. And actually that gets to the next point, which is Crypto OSes.
So that's actually where, unbeknownst to most people, the operating system innovation today is happening in crypto. The reason is, a blockchain like Ethereum has a compiler and a database and a built-in programming language, and is as complicated as a web browser in many ways. Because you can write programs on it.
You don’t just write programs on it. You write programs that interface with other programs on it. Ethereum is a programming environment where one Solidity program can call another. That's what it means to be composable. You know, you can take a loan and you can pipe it into a Dex (decentralized exchange), and you can pipe that into interest, and so on and so forth.
So the innovation in operating systems is happening in crypto where the operating system and the payment system and the login, and then eventually the social network, they're all just kind of baked into one thing that's happening in plain sight. But that's actually what comes after Android and iOS and Windows and so on. It's in plain sight and it's an operating system that also has the community, the fan boys, which are critical for it, because they're all the token holders.
Horace: I’m already extrapolating what you're saying. So my concern now is this, what you're saying is effectively, then… Let me put it to you from an investor's point of view and say, okay, I got you. It sounds like the value of Apple, Google and others will probably start to evaporate.
Balaji: Well, I wouldn't say… it's gonna take like 10 or 20 years. These are huge incumbents —
Horace: Like I said, I’m just extrapolating. I ask you this then, okay, what would you do instead? Who would take their place? And the answer, if I may, it sounds like there is no way to concentrate profit anymore in an operating system. Because, by nature, this isn't going to be replaced by another Apple or another Google.
Those business models will simply not longer be viable. You're going to have to find ways of creating value elsewhere. Because what you're saying, effectively, is search is not value accruing. Platforms that are effectively communication platforms are no longer accruing. And so that includes Facebook and messaging. And even the phone itself. So then, what would be the new empires if there were new empires to be built?
Balaji: The coins.
Horace: The coins themselves?
Balaji: Yes. Because basically, if you think about the whole fiduciary duty model of a corporation and people have pushed back on that, they said, ‘Oh, you know, a corporation has duties to the community, not just to its shareholders’ and so on.
Crypto answers that by making the community the shareholders.
Horace: So would you recommend any coin in particular or is, are they all pretty good?
Balaji: Well, they’re definitely not all pretty good. I would say if you're just starting out, buy Bitcoin. That’s just where to start.
I think Ethereum is also, obviously, at very large scale, and those are like the number one and two. Once you are familiar with… If you can only do one thing, buy Bitcoin. If you're a little more adventurous, buy 50/50 Bitcoin and Ethereum. Beyond that, I could go on for hours and hours about different kinds of coins and what they do.
But what I will say is if you think about what happened with the internet, it took all these different forms of media, like radio and television and newspapers, and it turned them all into packets. And what crypto is doing is it's turning every single existing financial instrument into on chain debits and credits.
Because ultimately what is a loan? It's debits and credits somewhere. What is a mortgage, what is a derivative? What is equity? What is a cap table? And the fundamental mechanism of value creation… what’s the most important data structure in Silicon Valley? You can argue it was the cap table. You know, the capitalization table determines who holds what equity. And that little Excel data structure, with a thousand odd rows is what led a thousand odd people to build Google in 2004 and align all these people from around the world to build this amazing thing. Even more than their billion row data sets.
That cap table is now on chain. If you go to something like the Brave Basic Attention Token, or any of these other tokens, and you look on Etherscan, you go from a thousand people to 50,000 or 100,000 or even 1,000,000 people that hold a given token.
So you've scaled up the basic aligning function of Silicon Valley, the equity shares for shareholders, into something that is not equity, but it's like Equity 3.0 or the sequel to equity. The problem with this, of course, is the reason crypto is not equity is it's API keys. It's something which you can use to interface with an app.
It is your encrypted messaging system. It is your login. It's all these things that a share doesn't do. And so fitting it into older classifications, like the SEC and others want to do is just sort of like trying to treat every packet that's being sent to your house as physical mail and requiring you to get a stamp for it and saying, 'Oh my God, I can't believe how bad you are. You're not in compliance. You don't have a stamp.’
It's this old way of looking at things that I don't think is going to survive long-term. I think we're in the middle of, you know how there's a Reformation and then the Counter-Reformation you're familiar with that. Right?
Horace: Yeah, sure.
Balaji: We're in the middle of what I would call the Decentralization and the Counter Decentralization in both the U.S. and China. They're pushing back on decentralization. Pretty hard in China and fairly hard in the U.S. And I think it's going to increase.
But I think the rest of the world also has a say. And I think what's really under-appreciated is, and this is kind of related to this also, you know, that Google, Apple, Microsoft, Amazon, Facebook have to deal with; the rest of the world no longer wants to have American tech companies be able to deplatform their political leaders in these countries. Or unbank them. And they don't want the Chinese companies to do so either because the new boss would be same as the old boss. So I wrote a series of articles on this, where what I think happens is that the new non-aligned movement is the aligned movement, the decentralized movement. Where just like many of these countries have actually said, ‘Hey, you know, for military or government purposes, we should look at open source software first versus proprietary software.’
They're going to, over time, shift to using Bitcoin and Ethereum and other decentralized cryptocurrencies for different purposes. Because they are a transaction and soon communications networks that cannot be shut down by American or Chinese companies. And that's another thing which a Google or Apple or Facebook can't really compete with because the whole point is it's not them. Unless they manage to launch a fully open source project.
You know, React is something Facebook launched that is a genuinely open source project that people can use. Because even if Facebook cuts them off, you can go and modify it. Unless they actually launch a chain and take the whole hit of doing that, they won't have the trust. Because people don't want them to have server side control.
So going a little bit further, advertising and e-commerce. So, the engine of Facebook and Google is CPM and CPC ads. Costs per impression. And then per click. Every thousand impressions, every click, you pay them. They don't usually do full CPA advertising where you only pay them when something is sold.
If [you’re] Casper mattresses, though, what you'd want to do is you say, ‘Hey, I'm selling a mattress for X dollars. I only want to pay Google when I've got a conversion that came through Google.’ The issue with this is Casper as an incentive to understate the number of conversions and Google has an incentive to overstate it.
You would need an incorruptible neutral third-party ledger of all transactions in order to actually do full CPA advertising. And guess what? That's what the blockchain is.
So CPA advertising is going to be an area where I think that's going to start really hitting the Big Five in an area where they don't expect it because the people within the crypto community, on both the e-commerce and the consumer side, the merchants and the consumers are at sufficient scale where if a pure CPA thing was introduced, it would just be better.
It would be something where you might offer discounts to people because of it. It gives you better analytics. And then what this also does by the way, is it's better for merchants because it means automated accounting. All the stuff that you're currently paying PwC or all these guys to do, can be turned into a shell script if all your stuff is on chain. Which is a huge thing, because it also automates diligence and then automates M & A, you can start actually stacking things. Once you, I mean, we're talking five or 10 years out, but once you start going from, okay, all transactions are on chain, then all financial statements are on chain, then actually M & A can be put on chain because these higher order abstractions can be built on it.
And this is sort of like saying in 1990, well, once you've got emails, you'll have blogs and social networks. We're looking far out, but that's what happens once you start having more stuff on chain, it becomes more programmable. Okay, so CPA advertising: there’s e-commerce, there’s accounting, a few more pieces.
[Let’s talk about] hosting. AWS. So, centralized hosting is going to be tricky to fight head on for awhile because you know, the scale, the capacity of blockchains isn’t there yet. But it's improving dramatically. And if you look at Filecoin and Chia, and of course, Bitcoin itself, Ethereum… one of the most remarkable things is a moat that I thought 10 years ago would be very difficult to disrupt, which is just the sheer scale of Facebook and Google's data centers, right?
That's something that seemed like only a huge centralized company could do. We have now proven that if the protocol is fixed, people will do massive multi-billion dollar international data center build outs, not just for Bitcoin mining, but for Chia and Filecoin and many other lesser well-known coins.
If the protocol can make money, people will buy the hardware and they will rack and stack it. And that means that many things that we think of as companies will be turned into monetizeable protocols and decentralized in this way. So the hosting, the data centers will get there.
Creator monetization. This is another attack where, you know, Facebook and Twitter are now trying to do these newsletters and so on. But for 10 years, 15 years, they really didn't give creators a cut. And with crypto, creators, don't just things like NFTs, they don't just make money from art, they can make money from equity-like appreciation. People can buy into their coin to go and attend their events, or you could log into a Substack equivalent by just holding enough of the coin.
So this combines like the earlier things I was saying about login. So the crypto, the encryption, the payments are kind of the same thing. It also kind of attacks the Big Five and other tech companies on the backend. It's like holding a coin is in many ways better than equity compensation. It's liquid, it's marked to market. If it's legal in a country, you would just do that.
Some countries are just going to be smart and they're going to stop with all this stupid stuff from the 1930s and orange groves… just using 100 year old regulations to harass founders today. You have to deal with it because that's what the environment is.
And you can, I think, make a very strong argument that crypto is not the same as equity because you can use it for API keys, you can use it for other things. But eventually there'll be countries, and actually, even in the U.S., Wyoming has passed DAO laws.
There are states within the U.S., both subnational and international regulators that are enlightened and are going to say, absolutely, we want the entire stock market on chain. We want the stock chain. We want the transparency, we want the throughput, we don't want to have the Robin Hood situation where we're still dealing with DTCC (Depository Trust and Clearing Corporation) and these antiquated ways of recording stock transfers with paper certificates. We want modernity, we don't want to talk about orange groves and try to fit a square peg into a round hole.
So I think equity compensation, the backend, that gets transferred to coins. And these companies that are used to outbidding are not going to be able to do so, because if you actually look at the growth of Bitcoin and Ethereum and other coins over the 2010s, as remarkable as the growth in the Big Five tech companies are, those coins make them look like slow growth companies.
The story of the 2010s, in retrospect, with zero offense to Uber or Airbnb or Stripe, it was Bitcoin. That was the biggest hit of the 2010s. It was bigger than all the other startups combined, because it wasn't a startup. It was a coin.
I mentioned FinTech, messaging, login, social, search, crypto phone and crypto OS, advertising, hosting, data centers, creator monetization, equity compensation.
There's also values. You know, this is very important, actually. It almost goes unsaid, but it shouldn’t. The initial values that tech stood for back in 2012, or thereabouts, Twitter called itself ‘the free speech wing of the free speech party.’ And there was a huge emphasis on this during the Arab Spring. And of course with open source. And that strain still exists. The current non-free and focused, very state aligned thing where you're censoring people, for contesting, what the WHO is saying, where the WHO changes what it said last week is, is basically the Western equivalent of the Chinese censoring Li Wenliang for getting the message out.
And I certainly don't agree with everything that is said on social networks, but I do agree that the centralized authority is not always right. And to simply treat that as truth and censor people who are saying something contrary to that means it's not a free society anymore.
So the values aspect, anybody who cares about those values, and those are some of the most ideologically motivated and committed engineers, those folks are going to crypto. Then there’s, obviously on the privacy end, you only get verifiability if you've got the private keys locally.
So you put all that together and that's actually a recipe for attacking enormous swaths of the whole thing.
There's one other aspect I'll add there, which is when the back ends become open, this actually disrupts APIs in a very fundamental way. Because right now, yes, you have APIs, but they're pretty siloed. You'd use a bunch of APIs in your app, but to make Stripe talk to Shopify, to this or that, maybe you'd use Zapier or maybe you'd write your own customer integration. It's not that easy to work with because you don't have root on those databases.
With crypto backends you do have root, you have total root access. Every user can look at every single row of the, it's not exactly a row, but every entry in a blockchain. Any user who owns coins can write and any user with sufficient compute can write blocks. And so, because of that, anything that's like the next Google Docs or the next messaging app that's built on a blockchain has much better interop[erability] between chains because it transforms what an API is.
API access, your API key, is holding the coin. And you can do anything you want so long as you hold enough coin, within compliance of the protocol. So what I just outlined, that’s essentially a recipe for 10 years of disruption.
Horace: Absolutely. But let me say this - I think it's not just disruptions of the Big Five as you put it, or maybe Big 100. A lot of possible asymmetries here. But my concern or, rather, optimism even, is that this is about institutions more, even, than private equities. It's institutions that have been built throughout the Industrial Revolution. And you talked about putting equities on, the very idea of holding paper to represent something else. The very idea of institutions, which are there to ensure transactions and trusts.
Those, again, I'm sort of parroting the ethos of coin, but you've effectively shown the roadmap as how it happens in the ways that are very tangible. My point is this - because when I wanted to have the show with you was to ask a sort of a profound question.
Is someone living in a 21st century, as my son was born in 2005, will they see as much change throughout their life as someone born in 1900? Or even someone born in 1800 living through the 19th century.
So if I asked this question of myself, because it's not so much about me but the next generation. And I struggled with this question because I felt like the first 20 years of this century, haven't been all that exciting in the same way that the first 20 of the last century or even the one before it. If you think about the 18th Century, sorry, 19th Century- early 1800s were very volatile. There were the Napoleonic wars. And then we ended up with the Industrial Revolution taking off. Steam engines, railroads. It was a crazy century. And then you get to the 20th and you've got World War I already would have passed [by now]. We would have had the invention of the airplane, the mass production of automobiles.
We were heading into the Roaring 20s by now, and the 21st Century looks pretty lame so far. And I thought to myself, you know, all of these changes… I am a technologist. So I think of all the changes that we saw in the previous centuries, it was due to technological innovation, due to inventions.
And the formation of the Industrial Revolution was fueled by capitalism. That's what we call it, capitalism. But I ask myself, and I’ll put the question to you, is: Do you think someone born in 2000 and then living 100 years, which is not improbable, would they experience this century in as much of a sense of wonder and change and drama that the 20th Century, now, of course, there's a lot of negative things have happened. But, fundamentally, someone born in 1900 dying in the 1990s would have seen a completely different world.
And that's exciting. That's very exciting to think that you're part of this dramatic, poetic change. And good and bad, but generally progress. And I would say I'm excited now from what I heard, that possibly the 21st Century will be even more exciting because it certainly would undo a lot of things, if what you say is true, but also might create new things we cannot imagine.
Certainly, 1900 Man would not have imagined life in the 1990s, no way. And I don't know if we can, and we should be humble about what will be created from this creative destruction that has to happen. But do you believe, as I do that, should we be optimistic that something will emerge, that will be even more exciting than than the last century?
Balaji: Yes, though, let me get my take on that, I actually did a whole interview - it’s funny because we think about some of the similar things, but I did a whole interview with Sotonye, which you might find interesting on this topic of 1800s, 1900s, 2000s, actually, in its own way.
My thesis is 1950 was sort of peak centralization. And in many ways, if you go forward and backward in time, we're getting more decentralized from then. So 1950, you had one telephone company and two super powers and three television [networks]. You had AT&T you had the U.S. and U.S.S.R., and you had ABC, CBS, NBC.
If you go forward in time, 1991, the internet frontier opens, NSF (National Science Foundation) repeals its acceptable use policy and allows commerce on the internet. Backward in time, 1890, the frontier closes, the western frontier. Frederick Jackson Turner, his [essay], the frontier thesis, where he talks about how actually it was the frontier that made America, more than even democracy or capitalism.
It was exit, it was immigration, it was the free soil. And the fact that people could just start a new community or a new business, or go out west and, and make their name on nothing that gave America its character. Now, of course, there's the Native Americans and so on, which obviously complicates that story.
With the internet you have a frontier that did not have that issue. And if you go backwards and forwards, there's lots of parallels where as the centralized state in the west, its grip loosens. We see the Coronavirus and the Spanish Flu. We see left and right fighting in the streets. And we saw that in the 1920s and 1930s.
We see the tech billionaires, and we have the Robber Barons of the past. We see the private banking era of the past, and we have the cryptocurrencies of the present. We see the same, well, not the same but similar, arguments in William Jennings Bryan’s Cross of Gold speech on monetary policy was a huge thing in the late 1800s in the U.S. and digital gold is an issue again.
We see fundamental arguments over the role of the state and all this stuff with sanctuary cities, and gun laws being different at local level from the federal level and states pushing against the federal government as similar to some of the tectonic plate movements in the 1930s with the federal government versus the states. And then also even the mid 1800s.
And what I think happens is all of those things get resolved in the opposite direction this time. Where if you ramp up from, arguably, the 1700s, you might track it all the way back to 1492, or something like that. But at least from the 1700s to 1947, technology's favored centralization.
You've had railroads, telegraph, radio, television, movies, mass media and mass production, where a few people could control a lot. And then you go to de-centralization with the transistor, the personal computer internet, remote work, smartphones and now cryptocurrency where you're decentralizing power away from the Maos and the Stalins and the Pol Pots. And even the FDRs. The people who run these gigantic countries, where who's the number two after them? All of this power is concentrated in a few people.
Now we're actually decentralizing it out. And, in many ways, people talk about inequality rising, but actually in many ways, equality is rising and that's actually what people have a problem with.
And what I mean by that is A) global income equality is converging because China, India, other countries have been rising, relatively, they were very poor 40 years ago. But it's not just them. It's also chunks of South America and Southeast Asia and Eastern Europe and Russia, and so on.
B) consumption inequality is plummeting because a kid in Nigeria or India or Brazil has basically the same Google experience as Larry Page because it costs just fractions of a cent. And then C) and this is to my point, power inequality is decreasing because some kid in India or Nigeria is not going to grow up to be the president of the U.S. but they can become the founder and CEO of their own tech company. Or their own crypto protocol. And so they can rise in a different way, which doesn't include migrating to the U.S. and doing that whole 20th Century rigmarole.
So I do think it's an exciting century in many ways. I actually think the 20th Century was a much worse century than the 19th Century, because the 20th Century was two world wars and communism and socialism for much of the planet.
It was okay in the U.S. and Western Europe. But [for] much of the planet, it really sucked. And now it actually might flip where the U.S. and Western Europe, the U.S. more so even, that feels like it's kind of… Maybe not all of the U.S. I'm actually bullish on individual states like Wyoming and Colorado and cities like Miami and so on. They've gotten behind crypto. And the reason I just keep saying, ‘crypto crypto,’ is because, as we just went through, the sheer scope of applications is difficult to realize until you've gone through it. It's really a big deal. It's a civilizational technology. It's not simply like a toaster oven or something.
So those states have gotten behind crypto. I think there's pieces of the West that are going to be good, there’s pieces that aren’t. And it's almost like a flip of the 20th Century where it's the East that is more capitalist, that's India in particular, but it’s also east Asia, it is probably Eastern Europe that is maybe more capitalist than the U.S., much of the U.S., and much of Western Europe.
So, that's my broad scope of history.
Horace: Yeah, I wouldn't be as… my judgmental question on better or worse was not really that most people would be better off or [had] suffered more, but more in this poetic sense. We feel like we've made progress
Balaji: Acceleration, yes. Yes.
Horace: And the 20th Century… I don't think that you can argue that the technologies that emerged, that someone born in that century would have witnessed —
Balaji: Yes, they go from out houses to flush toilets, and so on.
Horace: Yeah, exactly. Not distributed very well, but the thing about the 21st is I cannot imagine how it's going to go. But to me, I sense that we will [eventually] feel like we're making progress. And I think we'll feel, because the first 20 years, it hasn't felt like that. I mean, we've certainly had a lot of… the joke goes, you know, we didn't get flying cars, but we got 132 characters.
So there's going to be much more coming. And I think there's a sense of wonder in the sense of opportunity, a sense of optimism in the sense of the decentralization. But also, like I said, that optimism around the small states. I live in Finland now, but my point is -
Balaji: Yes. Small states, yes.
Horace: I said this once, the 20th Century was the century of the large state. The superpower was every everyone's idea of success. But now, I think it's going to be much more the small states that are going to be the 21st Century giants, if you will.
And so that's my point. I agree that it might be a very different feel from an individual point of view, but I think, as a civilization, we're probably going to look back, or historians will look back on 21st and say, what was the defining thing?
Like, I think of the 19th Century, sort of as the steam century. And I think of the 20th as the chemical engineering [century]. You know, at the end of the day, it was the fact that we built everything on top of energy that was suddenly released, right?
Balaji: Well, it's interesting, because I'd say the 20th century had a lot of stuff.
You can argue this, but going up to the moon landing. Then after 1969, outside of digital technology, things really slowed down. It's hard to think of some, I mean there's a microwave oven and stuff like that. This is the point Thiel has made, people have made this with the website, WTFhappenedin1971.com.
I think partially it is the gold standard, but partially it is, essentially, the sort of risk aversion that arose after that point in time. When nuclear power plants were made very difficult to build and regulations were enforced in such a way that it was just difficult to take risks, voluntary risks.
There's actually a great book, Where Is My Flying Car?, have you read that?
Horace: No, but I can imagine what it says.
Balaji: It's by J. Storrs Hall. It's self published. It has a really bad looking cover, but it's really good. It's something where you learn something from every few pages. Highly recommended —
Horace: I did my own conference once on the subject of what happened to modernism.
The idea of utopia, it being foreseen in the 1950s based on technological progress, which, I put it to you this way. So if you were born in 1900, by 1950, you were middle-aged. But you would have seen all of this progress. And if you were, technologically sort of extrapolating it you'd say, well, that's where you get the flying cars by the 1990s.
So you see the ad copy, the way advertisers were, and the usual visuals from the 1950s of flying, or progress in agriculture, in transportation, progress in, not so much computation, but the extrapolation of the first half of the 20th Century.
And I pointed out that the last place where such optimism existed was in the tech sector because the rest of the country, the rest of the world, felt like it was in stagnation. And, again, we can quibble on this or discuss this on another episode. But I think we're in agreement that possibly this is the key.
If someone were to look back on the 20th and then say, okay, maybe it was internal combustion. But someone looking back on the 21st would say it's Bitcoin.
Balaji: Yes.
Horace: It’s crypto. That's the biggest thing that happened in this century.
Balaji: It is. I actually do think Bitcoin, the impact of it is at least on par with the steam engine. Maybe more like the Reformation or even the Bible, in terms of where it's going to be long-term. It is just such a fundamental, it's a social technology, because it just changes the relationship of people to each other and decentralizes power in this very, very, very fundamental way. And I don't think people get that.
Horace: I think that's a great thesis. That's what I wanted to do in this show is to sort of zoom out as much as possible. But you took us zoomed in to explain that these are the building blocks. And it's hard for people to, you need —
Balaji: Yes, crypto is too zoomed out in some ways, right?
Horace: Yeah, but you need the mind that can grasp this, can go both ways. And that that's very hard, flexible plastic minds. I've spoken to people in the community who are very nuts and bolts. And then there are some who are very idealistic and some very ideological. And most people, when they look at this and say, ‘My God, it’s filled with nerds and it's filled with ideologues. They're a bunch of maniacs.’ So it's important to bridge those two somehow. So thanks for all that.
Balaji: Hopefully this was good. We talked about applications and of relevance to your audience. Happy to do it again. This was great.
Horace: Excellent. Thanks so much.
Research #Theory · 26 comments
You can hear this as an MP3.
[It's important to understand just how much the theory has evolved in the last 10 years. Much more perhaps than in its first eight.]
Doug Kaye: Hello, and welcome to IT Conversations, a series of interviews recording and transcripts on the hot topics of information technology. I am your host, Doug Kaye, and in today’s program, I am pleased to bring you this special presentation from the Open Source Business Conference held in San Francisco on March 16 and 17, 2004.
Mike Dutton: My name is Mike Dutton, and it is my pleasure to introduce to you today Clayton Christensen. Professor Christensen hardly needs an introduction. His first bestseller, “The Innovator’s Dilemma,” has sold over half a million copies and has added the terms “disruptive innovation” to our corporate lexicon. His sequel -- and you have to have a sequel to be a management guru -- is entitled “The Innovator’s Solution” and is currently Business Week’s bestseller’s list. Professor Christensen began his career at the Boston Consulting Group and served as a White House fellow in the Reagan administration. In 1984, he cofounded and served as chairman of Ceramics Process Systems Cooperation. Then, as he was approaching his 40th birthday, he took the logical step of quitting his job and going back to school, where he earned a doctorate in Business Administration from Harvard Business School. So, today he is a professor of Business Administration at Harvard Business School where teaches and researches technology commercialization innovation. Professor Christensen is also a practicing entrepreneur. In 2000 he founded Innosight, a consulting firm focused on helping firms set their innovative strategies. And according to a recent article in Newsweek, “Innosight’s phones ring off the hook, and the firm cannot handle all the demand,” very similar to all the startups in open source here today. So, please join me in welcoming Clayton Christensen.
Clayton Christensen: Thank you, Mike! I’m 6 feet 8, so if it’s okay, I’ll just…the mic picks up okay. I’m sure delighted to be with you, especially because there is blizzard in Boston today; my kids have to shovel the snow!
As Mike mentioned, I came in to academia late in life, and the first chunk of research that I was engaged in was trying to understand what it is that could kill a successful, well -- run company. And those of you who are familiar with it, probably know that the odd conclusion that I got of that was that it was actually good management that kills these companies. And subsequent then to the publishing of the book that summarized that work, “The Innovator’s Dilemma,” I’ve been trying to understand the flip side of that, which is if I want to start a new business that has the potential to kill a successful, well -- run competitor, how would I do it? And that’s what we tried summarize in the book, “The Innovator’s solution.” It’s really quite a different book than the “Dilemma” was, because the “Dilemma” built a theory of what is it that caused these companies to fail. And then in the writing of this solution, I’ll just give you analogy for where we came out on how to successfully start new growth businesses.
I remember when I first got out of business school and had my first job. I was taught the methods of total quality management as they existed in the 1970’s, and we had this tool that was called a “statistical process control chart.” (Do they still teach that around here?) Basically you made a piece, you measured the critical performance parameter and you plotted it on this chart, and there was a target parameter that you were always trying to make the piece to hit, but you had this pesky scatter around that target. And I remember being taught at the time that the reason for the scatter is that there is just intrinsic variability and unpredictability in manufacturing processes.
So, the methods that were taught about manufacturing quality control in the ‘70’s were all oriented to helping you figure out how to deal with that randomness. And then the quality movement came of age, and what they taught us is, “No, there’s not randomness in manufacturing processes.” Every time you got a result that was bad, it actually had a cause, but it just appeared to be random because you didn’t know what caused it. And so the quality movement then gave us tools to understand what are all the different variables that can affect the consistency of output in a manufacturing operation. And once we could understand what those variables were and then develop methods to control them, manufacturing became not a random process, but something that was highly predictable and controllable.
Well, I think that today the creation of new growth businesses is where the quality movement was 30 years ago, and that is that there’s just a widespread belief that it’s random and unpredictable. So, for example, every time venture capitalists invest in a new company, they invest in the belief that it will be successful, but the odds are that two out of ten really become successful, and the whole industry is structured to help them deal with the alleged variability in creating new growth businesses. And for established companies who launch new products, every time they invest in a new product, they think it will be successful, but actually 75% fail. And so a lot of the methods that are taught for how to manage innovation are really structured around how to deal with the alleged unpredictability. We think that it is not intrinsically unpredictable. If we can actually understand the variables that affect the success of new businesses that we’re trying to start, that we can succeed with a much higher probability than has historically been the case.
And so that’s what I want to talk about is, “What are these variables that we have to control?” And in kind of an unabashed way, I’m going to structure this around theories of strategy and management. And the word “theory” gets a bum rap amongst some managers because it’s associated with the word “theoretical,” which connotes “impractical.” But a theory is actually a very practical thing because it’s a statement of causality, a statement of what causes what and why.
And so, like gravity is a theory; it allows to predict that if you jumped out of a window on the top floor of this hotel, you’re going to fall, and you don't have to collect experimental evidence on that question. And what this means is that every time a manager takes an action, it’s actually predicated upon a theory in her head that, “If I do this, I’m going get the result that I need.” And every time you put a business plan into place, you’re actually employing theories in your mind that if you do these things, you will be successful. It’s just you don’t know quite often what the theories are that you’re employing and aren’t aware whether they’re good or bad. So, I just want to try to discuss with you some of the theories that we’ve tried to draw upon to put together this work, especially as they relate to how you would create a successful open source software business and how the companies that might be disruptable or threatened by open source software create new ways of growth that will keep them healthy.
So, I’m going to… move to the next slide please. These are the questions that you’ve got to get a lot of things right, but 10 questions that you need to get right in building a new growth business are, “How do we beat the competitors?” “How do we know what customers we ought to focus on with our first product?” “When we are focusing on a set of customers, how do we know whether they’re going to want to buy the product that we have in mind?” “How do we distribute to them, and how do we build a brand that communicates what we want to communicate to them?” “Of all of the things that have to be in place for the customers to benefit from the product, which should we do ourselves and what can we rely upon partners and suppliers to provide?” “How do we keep our product from getting commoditized?” “Who should we hire to run this new business, and what kind of person if we hired to run it would kill the business?” “How do we structure the organization, and if it’s within an established company, where is the right home for the new growth business to live?” “How do we know when we’ve got the right strategy, and how do we know when the strategy that has been working will not work in the future?” And finally, “Whose money should we take to fund the business and whose money, if we took it, would kill the business?” turns out to be quite an important question.
And so I want to just walk through the models that we propose you can use to think your way through these questions as far as we can go in the time that we have. And then we’ve got some time at the end for you to call all of this into question or send barbs or criticisms, or ask other questions as you see fit.
So, lets start at the top one, and it turned out that this one was really quite readily answerable by the model of disruption that we summarized in “The Innovators Dilemma,” and for those of you aren’t familiar with it, I’d like to just walk through that as quickly as we can. There are three parts to this model.
The first one is represented by that line, and what it suggests is that in every market, there is a trajectory of improvement that customers are able to utilize over time. And a good way to visualize that is in the car industry. Every year the car companies give us new and improved engines, and yet we can’t utilize all the improvement that they give us because you’ve got nuisances like police that put a crimp on how much of the engine we can use.
Now to keep the diagram simple, I’ll just depict that ability to utilize improvement as a single line representing the median customers in a market. But if you can remember that there’s really a distribution of customers in every market, and so at the high end, really demanding applications that are never satisfied with the best they can find, and at the low end, pretty unsophisticated folks that are overserved by very little. So, that’s the first piece of the model is there’s an ability to utilize improvement.
And then the second one is that in each market there’s a trajectory of improvement that the innovating companies provide as they introduce new and improved products. And the most important finding on this is that this trajectory of technological progress almost always outstrips the ability of customers to use that improvement. And so it means that a company whose products aren’t good enough to be used by customers in the mainstream of a market at one point can improve its products at such a rapid rate that it overshoots what they’re able to use at a later point in time. Now they may keep buying that product out here; they just can’t utilize all the improvement that’s made available within it.
And a good way to visualize this one is, if you go back to the early years of the personal computer industry when we were first learning how to do word processing. Do you remember how often you had to stop your fingers and let the Intel 286 chip inside catch up to you because it wasn’t good enough even for a simple application like word processing? But as Intel has introduced faster and faster chips that it can sell for more attractive profits to demanding customers in higher tiers of the market, now that they’re at a 3 -- gigahertz Pentium IV processor up here, they’ve way overshot the speed that mainstream business users are able to use.
Now at the same time, there’re still some freaky people at the high end that need even faster chips, but they’ve overshot what the mainstream can use. Now some of the innovations that allow a company to move up this performance trajectory are simple incremental year -- to -- year engineering improvements, and others are this sort of dramatic breakthrough technologies. Like in telecommunications, the change from analog to digital and from digital to optical were very complicated technological tour de force. But they had the same effect on the industry as the simple ones, and that is they sustained this trajectory of performance improvement.
And what we found, as you may know in that study, is that it actually doesn’t matter technologically how difficult or radical that innovation is, that almost always the incumbents win these battles of sustaining innovations. Again, it just doesn't matter technologically how hard it is. It just seems like, if it helps them make a better product that they can sell for more attractive margins to their best customers, they figure out a way to get it done.
But then there was this other kind that we call the Disruptive Technology that comes into the market every once in a while, and open source clearly is one of these. And we called it “disruptive” not because it was a dramatic breakthrough improvement, but instead of sustaining the trajectory of improvement, it disrupted and redefined it and brought to the market a product that was crummier than those that historically had been available. In fact, it performed so poorly that it couldn’t be used by customers in the mainstream. But it brought to the market a simpler and more affordable product that allowed a whole new population of people now to begin owning and using it, and then, because trajectory is so steep, what takes route in a simple application then can intersect with the mainstream. And so that’s the basic model of disruption.
One the companies that has tried to use this a lot in the last few years in managing their strategy and new product development has been Intel because, as I mentioned, they’ve gone from a point of having a product that wasn’t good enough to now overshooting the volume of the market. I got invited to go out to a meeting there because, through the late 1990’s, Intel, they were coming into the low end of the processor market in entry -- level computer systems.
Much cheaper processors were made by Cyrix and AMD, and they were just killing Intel at the low end; in fact, their market share in entry -- level systems dropped from 90% to 30% in 18 months. And it felt great actually to get driven out of the low end, because as they were losing the volume in the most price -- sensitive tiers of the market, they were replacing the volume at the high end with much more attractive margins, and so overall their reported gross profits were improving, and Wall Street just loves gross margins! And so it felt good until they saw this dumb model, and then it helped them see, “My gosh! If we lose the low end today, we may lose the mainstream tomorrow!”
So they I got to come out and have this meeting with their executive staff and their chairman, Andy Grove, who is in the audience. And I was going through this, and he had a real puzzled look on his face, and then it was like a teacher’s dream and the light bulb turned on, and he raised his hand, and he said, “I see what’s wrong with your idea.” He went up and he crossed out the word “technologies” there and he said, “Clay, if you frame this as a technological problem, you’re going to mislead the world.”
And unfortunately, “The Innovators Dilemma” had just been published and I couldn’t get it out. But he said, “If I get the idea, I would characterize it as just straightforward technology that disrupts the business model of the leaders, and that’s what makes it so hard.” And he then went on to give his view of the puzzle that had been in my mind that it kind of triggered the whole line of research, and that was living in the Boston area, how can digital equipment get killed?
I remember watching digital equipment grow up through the ‘70’s and ‘80’s. It was probably the most widely admired of all the companies in the world economy. And when you read articles in the business press about why they were so successful, it was always attributed to the brilliance of the management team. Then about 1988, they just fell off a cliff and began to unravel very quickly, and when you then read articles in the business press about why they had stumbled so badly, it was always attributed to the ineptitude of the management team. They were the same folks running the company.
And so for a while, I scratched my head and wondered, “How could good managers get that dumb and that fast?” That really is the bad management hypothesis, is the most ready explanation that we can offer for the failure of most companies. But the reason it didn’t quite fit right in this case is that every minicomputer company in the world collapsed in unison. Is was not just digital, it was Data General, Prime, Wang, NEXT, Hewlett Packard, and you might expect them to collude on pricing, but to collude to collapse was a bit of a stretch, and this had to be something more fundamental going on.
And that’s what really precipitated this question. And so Andy then went on to give his view (let’s go to the next slide) of what happened to digital equipment. And he said, “In the first place, if we are able to line up in this room the sequence of mini computers that Digital introduced to its markets, they didn’t skip a beat.” If you peeled the covers off and looked at the technologies that were required to make a good mini computer better, anything that helped them make a better product that they could sell for higher margins to their best customers, they got it done.
But he reminded me, “Do you remember how crummy those early personal computers were?” They were toys. In fact, Apple sold the Apple II primarily as a toy to children. It wasn’t good enough to be used by customers in the main stream market as it existed in the late ’70’s and early ‘80’s, and that meant that the more carefully Digital listened to its customers and tried to reflect their unmet needs in the properties of their next generation product, they got no signal that the personal computer mattered because, in fact, their customers couldn’t use it. And so it took root as a toy, and then because this trajectory improves at such a rapid rate, within a few years it intersected with the main stream needs, and it wasn’t just digital, it was the whole population that got blown out of the water.
And he said to his earlier point, “This wasn’t a technology problem. Digital’s engineers could have designed a PC with their eyes shut.” But they had a business model, and the minicomputers were quite expensive and complicated, and in order to sell them, they had to be sold direct to the customer, and the selling process involved the lot of training and support and service. You just had to have costs like that in the business in order to play in that game.
Given that kind of a business model, Digital had to make about 45% gross profit margins, and a typical computer sold for about $250,000. Now, in that environment, as in most companies environments, people are walking in to senior management all of the time with proposals to make better products. Well, some of the proposals that management was entertaining entailed making a better computer than Digital had ever made before. If you look at those proposals, they typically promise gross margins of 60% and the machines could easily be sold for half a million dollars.
But at that same time that management was trying decide if they should invest in those things, other people were walking in with proposals to invest in personal computers because it was quite obvious by the early ‘80’s, that this was going to be a big market. But if you look at those business plans, in the very best of years they promise gross margins of 40% and they were headed down to 20%, and these machines could only be sold for $2000.
And so Andy said, “So really, the decision the management had to make was, “Should we invest our money to make better products that our best customers could use that would improve our profit margins, or should we invest our money to make worse products that none of our customers could use that would ruin our profit margins? What should we do?” And I’m pretty quick, and so what I said was, “Andy, since you’re in this situation, my advice is to bale out and become a professor.” But then I realized that the very same thing is happening to the Harvard and Stanford business schools. We have become very good and very expensive, and we’re getting disrupted by crummy, low -- end, on -- the --job learning experiences like you’re having today! A little bit later I want to talk about that because it really is quite frightening for us!
But anyway, this is kind of my answer for the first of these questions that you need to get right, which is, “How do you beat the competitors?” And the answer is, that if you come into an existing market with a better product, the odds are that the competitors will get you because you’ve taken a piece of real estate up there that is financially attractive for them to pursue. If you come into the market with a disruptive product, the odds are that the entrant will win because you set up a situation where they’re motivated to flee rather than fight. And if you pick a fight like that where they don’t want to fight you because it’s in their interest to move in some other direction, it’s a great way for a little company to beat a big company. And so that’s the answer to the first question of why disruption is a great tool to beat the competition.
Now, I want to skip down. If you look at the stodgy companies today, and really crawl back inside of their history, most of them started out as disruptive innovators. It’s interesting in Japan. I had a student who went back to Japan and became a senior official in their Ministry of International Trade and Industry a few years ago, and he, poor guy, got sentenced to having to write plan for the resurrection of Japan’s economy.
And he worked on this thing for about two years and then called up and said, “I don’t think there’s any hope for Japan.” And he was looking at it from a macroeconomic policy perspective and came over and we talked about it for a couple of days. And then what hit us is that every one of the industries that constituted a fundamental engine of Japan’s economic miracle in the ‘60’s, ‘70’s and ‘80’s did this.
And so, those of you who have gray hair may remember that Toyota came into our market in the ‘60’s with a crummy, rusty, subcompact model called the Corona that no self -- respecting non -- college student would think of owning, and now they make Lexuses. And Sony came in with crummy transistor radios, and now they’re the best consumer electronics maker in the world. Their steel industry came in with the lowest quality steel in the world, and now they’re the highest quality steel companies. Canon did it in photocopiers, and Seiko did it in watches, and over and over.
And just like it happens in our economy, now those companies have become huge global giants, making the highest quality products, serving the most demanding tiers, and there is no growth up there. If they had tried to somehow cobble together the computer from outsourced subsystems or modules that fit together according to some industry standard, they couldn’t have done it because the establishment of the interface standards takes so many degrees of freedom away from the design engineers that they would have to back away from the frontier of what’s possible. And when the product isn’t good enough, competitively you can’t back off the frontier. And so that meant that in order to play in that game, you had to do everything in order to do anything. There is a huge advantage to being integrated and having a proprietary architecture in this era when the functionality isn’t good enough.
And so in the early years of that industry, IBM just dominated its world. And in the similar period of the automobile industry, General Motors and Ford just dominated their world. And the question comes, “What happens once the functionality and reliability become more than good enough for what customers in the less demanding tiers of the market can use? What do you do to get traction with these kinds of customers if you want to build a new business serving them?”
And the answer is that what’s not good enough now changes, and what begins to matter to these customers is, “I can’t get what I need fast enough, and I can’t get exactly what I need as fast as possible.” And so improvements in speed to market and the ability responsively to give every customer exactly what they need, that constitutes a new trajectory of innovation along which improvements are rewarded with attractive prices and increases in market share.
And in order to compete in this way to be fast and flexible and responsive, the architecture of the product has to evolve towards a modular architecture, because modularity enables you to upgrade one piece of the system without having to redesign everything, and you can mix and match and plug and play best of breed components to give every customer exactly what they need. And because there are clean interface standards here, when that happens, the industry disintegrates. (And this is just the chart that I put together with Andy Grove a few years ago to illustrate the rough concept.)
So here the rough stages of value added in the computer industry, and during the first two decades, it was essentially dominated by vertically integrated companies because they had to be integrated given the way you had to compete at the time. We could actually insert right in here “Apple Computer.” (Let me go back to the prior slide.) Do you remember in the early years of the PC industry Apple with its proprietary architecture? Those Macs were so much better than the IBM’s. They were so much more convenient to use, they rarely crashed, and the IBM’s were kludgy machines that crashed a lot, because in a sense, that open architecture was prematurely modular.
But then as the functionality got more than good enough, then there was scope, and you could back off of the frontier of what was technologically possible, and the PC industry flipped to a modular architecture. And the vendor of the proprietary system, Apple continues probably to make the neatest computers in the world, but they become a niche player because as the industry disintegrates like this, it’s kind of like you ran the whole industry through a baloney slicer, and it became dominated by a horizontally stratified population of independent companies who could work together at arm’s length interfacing by industry standards.
One of the things is that to us was most interesting is that where the money is made flips on both sides of this equation. We wrote an article about this that we published in the Harvard Business Review called “Skate to Where the Money Will Be” in honor of the ice hockey star, Wayne Gretzky. Somebody asked him, “How come you’re so good?” and he said, “Well, I never skate to where the puck is; I always skate to where the puck is going to be.”
And the notion here is that if you create a new business that tries to position itself at the point in a value chain where really attractive money is being made, by the time you get there it probably will have gone, and you can tell where it’s gone in a very predictable way, and that’s what I want to try to get at here. Over on this side of the world, the money tends to be made by the company that designs the architecture, the system, that solves what is not good enough. Because it’s functionality and reliability that’s not good enough, the company that makes this systems that is proprietary and optimized tends to be at the place where most of the profit in the industry is made. Because the performance of that kind of a product isn’t dictated by the individual components, of which it is comprised; this is determined at the level of the architecture of the system, and that is where the money is made.
So in the early years of computing, IBM had a 70% market share; they made 95% of the industry’s profit. In the similar era in automobiles, General Motors had a 55% market share; they made 80% of the industry’s profit. And if you were a supplier to General Motors or IBM, you just lived a miserable, profit -- free existence year after year because the components did not solve the problem of what was not good enough; the system solved the problem.
But on this side, when it becomes more than good enough and the architecture becomes modular, where the money is made flips to the inside of the product. And a good way to visualize this is just imagine that you were working as a computer designer for Compac, and your boss said, “I want you to go design a better computer than Dell.” How are you going to do this? Put in a faster microprocessor, more gigapixels on the screen, higher capacity disk drive, or anything you can do, the competitors can just copy instantly because in a nonintegrated word, you’re outsourcing from a common supplier base, and when the architecture of the system is modular, and it fits together according to industry standards, the better products are not created through clever architectural design; the performance of the product is driven by what’s inside.
And so the ability to make money migrates from the system to the subsystems that define the performance and allow these guys to keep moving up market. And so that’s the answer for why in the computer world IBM in the design and assembly of computers made all of the money, and it was not in the components. And so when they got into the personal computer business, they thought that the same formula would hold here, and so they outsourced the components and stayed in the design and assembly of the computer, and they did just what Wayne Gretzky said don’t do. They skated to where the money used to be and outsourced where the money would be.
You can see the very same thing happening in the automobile industry today. Automobiles have become more than good enough for what all but the most demanding customers are able to use. Our family is a great example. We just sold our Toyota Corolla after about 180,000 miles of loyal problem -- free service. Just a beautiful car! but my kids hadn’t been willing to ride in it for about the last four years because it went out of style about five years before it wore out.
And so, do I need Toyota to give me an even more reliable car next year? I can’t absorb more reliability. And so this very same thing is happening in the automobile industry. Over here, when the architectures were like that, it took six years to design a new car; now it takes two years. You can walk into a Toyota dealership today and custom order a car assembled exactly to your spec, and it will be delivered in five days, about as fast as Dell can deliver a computer assembled to your spec.
And the way they’re becoming this way, fast and responsibly flexible, is the architecture of the automobiles have evolved from a proprietary and interdependent architecture to a modular architecture. Over here, they source components from hundreds of suppliers, no one of which made a difference. On this side, they source components from a few suppliers that they call “tier -- one suppliers.”
On the left hand side, for example, Dana Corporation supplied axles. On the right hand side, Dana Corporation supplies a complete rolling chassis with all of the suspension system and everything. And the smoothness of the ride, or the feel of the ride, isn’t dictated by Ford anymore, it’s dictated by Dana because that problem is solved in the rolling chassis. Similarly, Johnson Controls on the left hand side supplied seats; on the right hand side they supplied the entire interior cockpit subsystem and Delco supplies the electrical system and Bosch, the breaking system, and so on.
And true to form, the industry has had to disintegrate. And so the integrated giants that dominated over here, General Motors, packaged up all of its components operations and sold them off in a company called Delphi Automotive, and Ford packaged its components operations off and sold them off as Visteon. But you can see that the car companies did exactly what IBM did when it put Microsoft and Intel into business, and that is, they sold off the pieces of value added, the subsystems, where in the future the money would be made in order to stay at the level of value added, which is the assembly of a car, where in the past the money was made.
This also highlights, for me, a process of what you would call “commoditization.” And what commoditization means is a company’s product getting better and better and better and better, and you reach a point where these folks aren’t benefited by an even better product, and so their willingness to pay a better price for an improved product diminishes to the point that you can’t get pricing to stick for an improvement.
And that’s one dimension of selling a commodity is, you just can’t get a premium price for a better product. The other dimension of commoditization is that your ability to differentiate your product disappears. Here, this is highly differentiable; here, it’s not at all differentiable. And so the process of a company’s products becoming commoditized is just a very natural result of the interaction of the technological progress in customers’ ability to utilize that progress.
Even a brand can become commoditized. And most companies think that, “Well, if our product is really not differentiable, at least we take refuge in having a brand.” If you think about it in these terms, a brand has value when you’re marketing upward to customers who are not yet satisfied with the best they can find, because the brand serves to close as much as is possible the emotional gap. But once the product is manifestly more than adequate and you’re marketing down to overserve customers, the brand really does not create value, and the brand itself can become commoditized.
Now, I want to try to walk into how you can use this way of thinking in a concept that’s called the “law of conservation of modularity.” And I want to illustrate this in a view of what I think is going to happen on the hardware side, in particular in the semiconductor industry, and then try to use that to think about what open source software could mean.
And the core concept of the law of conservation of modularity is that -- if you can just visualize -- if you are writing a software application to run on Windows, you might go to Redmond and knock on the door and say, “Would you please just let me into Windows? And if I could just change these 25 lines of code, the application would run so much better!” But Windows doesn’t dare open the door, do they? because it has an interdependent architecture, and if you change a couple of lines, who knows what else would get screwed up!
And so the application has to be suboptimized and conform itself to Windows so that Windows could be optimized. And the reason is, according to (I’ll go back a slide) this model, historically in order to fuel Dell moving up market so that it could keep competing against Sun Microsystems at the margin there, the fuel that allows Dell to move up is the microprocessor inside and the operating system inside.
That’s what constrains its up -- market progress. And so the microprocessor and the operating systems have a proprietary and interdependent architecture even while Dell’s product has a modular architecture. And so, back to the software analogy. The application has to be suboptimized so that Windows could be optimized. But if you’re writing an application to run on Linux, because Linux has a modular architecture, you don’t even have to knock on the door. You just walk in, change what needs to be changed as long as you don’t screw up the interfaces, and the modularity and conformability of Linux allows the application to be optimized.
And so one side or the other needs to be modular and conformable to allow what’s not good enough to be optimized. If you think about it in a hardware context, because historically the microprocessor had not been good enough, then its architecture inside was proprietary and optimized and that meant that the computers architecture had to modular and conformable to allow the microprocessor to be optimized. But in a little hand held device like the RIM BlackBerry, it’s the device itself that’s not good enough, and you therefore cannot have a one -- size -- fits -- all Intel processor inside of a BlackBerry, but instead, the processor itself has to be modular and conformable so that it has on it only the functionality that the BlackBerry needs and none of the functionality that it doesn't need. So again, one side or the other needs to be modular and conformable to optimize what’s not good enough.
Now, there was a guy at Bell Labs a few years ago who published an article about Moore’s Law, and what he showed is that in pursuit of Moore’s Law – now the vertical axis here is the complexity of the circuit, which may roughly equate to the speed of the circuit. In the pursuit of Moore’s Law every year, the fabs and applied materials make 60% more transistors available on an area of silicon than were available the prior year.
But if you look at the ability of circuit designers to utilize transistors year on year, they’re are only able to utilize 20% more transistors than they were the year before for any given level of complexity of circuit, and the reason is they just have design budgets; they don’t have enough money or time to design circuits that are complex enough to utilize all the transistors that Moore’s Law makes available.
What that means is, for most of the volume applications in the world, circuit designers are actually awash in transistors. Even while at the very high end, they still need even finer line widths and demand that Moore’s Law take the next step to that next node of technology, but they’ve overshot what most circuit designers are able to utilize. And so, what this would then predict is that circuits which on this side had to be proprietary and interdependent in their architecture, over here, now the way you compete to win the business of those people is going to change and you’re going to need to be very fast and flexible and responsive and be able to deliver systems on chips that offer every application exactly the functionality that they need and none of the functionality that they don’t need.
And so, how the law of conservation will play itself out is, this is kind of my sense of how the industry was structured in the past. So the microprocessor wasn’t good enough. That meant that the desktop computer had to have a modular architecture to conform itself in order to allow this to be optimized because the line widths on the circuit were not good enough.
The equipment that was made by companies like Applied Materials and Tokyo Electron, each piece of equipment was optimized. It had its own proprietary architecture, and in the sequence of steps that a wafer has to go through, there was no attempt, nor could you make an attempt, to synchronize the flow of material across those machines. Each piece of equipment had to be optimized for itself. That meant that the fabs had to be laid out in a modular way bay by bay, and the sequential steps in the process had to be buffered or modularized by having gobs of working process inventory in those fabs. And that made the fabs very slow, but they actually had to optimize this rather than vice versa because this wasn’t good enough, and then the components that comprise applied materials equipment did not matter at all. So the money was made here and the money was made here, and these guys, these guys and these guys lived a miserable, profit -- free existence.
Now in the future, in handheld devices, I’m just talking about this little piece of the world, but I think it applies to almost any situation where logic gets embedded in a system. But, I’ll talk about a handheld device like the RIM BlackBerry. It’s the device itself that is not yet good enough and, therefore, you cannot back off the frontier of what’s technologically possible. It has to be optimized with a proprietary interdependent architecture. That means that the processor inside of a BlackBerry has to be modular and conformable to allow that to be optimized.
Now you think about this, where these chips are now customized chips delivered to every customer’s application, and the design cycle out there in the customer’s end is measured in months rather than years. The fabs up here would take three months often to work an order through all of that inventory in the fab. And for a fab to take three months to deliver an order in a world down here where these are really fast -- cycle custom designed products, is just intolerable.
And so the fabs are going to need to figure out how to deliver products really fast, and that means that over the next few years rather than being laid out in bay structure, a fab is going to need to reconfigure itself in a single wafer process so that they can process silicon like Toyota makes cars, with very little inventory in the process, and that’s what make them really fast.
And nobody has figured out how to do that yet, but the pressure from the market will mean that it’s the fab that is not good enough on this critical performance dimension, which is, get every customer exactly the circuit they need as quickly as they can do it. That then means that the manufacturing equipment from companies like Applied Materials needs to be modular and conformable so that the fab can optimize the flow of product through itself.
And this is possible now because Moore’s Law has overshot what most circuit designers can utilize, and this is possible because these products don’t need a Pentium IV processor, and so you can back away from the frontier. And so what it means is that the places in the value chain where attractive profits can be earned are going to migrate from where they are today in a very predictable way.
So, I’m not a software engineer or designer, but this is what I think Linux does, or MySQL or Apache, whatever it is, is that because of the open source character of it, the architecture is modular. And what that means is -- let me back off from this. What this really tells me is that, like the microprocessor is going through a process of commoditization as it overshoots and becomes modular and undifferentiable. But, whenever that happens at one layer of value added that there is a process of commoditization, it initiates a reciprocal process of decommoditization at the next level of value added.
So, whereas the device up here was a commodity, this is not a commodity. Whereas a fab was commodity, this is a proprietary architecture that’s not a commodity and so on. So -- and I’ll come back to the software world -- there’s a fellow named Tim O’Reilly who’s done a lot of thinking about this that some of you may know. (Is that you? We just emailed. Stand up. He’s a lot smarter than he looks actually!) And another guy who runs a company in Santa Clara called Tensilica, who has thought a lot about this law of conservation of modularity. Tensilica makes these modular integrated circuits.
So the operating system is going, because of Linux, from a proprietary to a commoditized modular architecture, and what you’ll see happen then, because the very modularity of the open source architecture allows it to conform itself to allow the application to be optimized. And the operating system in many ways just folds itself in to the application and disappears.
And so my sense is if you look at how Red Hat lives, ostensibly they’re an operating system vendor, but really what the value that they create is at the next layer, the software that keeps the operating system from ever crashing and keeps maintaining itself, and that’s what is not good enough. And the conformability of Linux allows them to sell what you might call an application that is just extraordinarily optimized, and that’s becoming an noncommodity.
And similarly, in the Oracle world, the database software is proprietary and optimized, and a lot of money was made there, but MySQL allows to you to just fold the database into whatever the next layer of value added is so that it can be optimized, the application can be. And Google runs on Linux, and the operating system disappears into the search engine.
And so I don’t think that you could say that open source is a movement and nobody has figured how to make money in it, it is just where the money is made migrates to a different layer in the value -- added chain and, in fact, it facilitates the decommoditization of the next layer because what’s not good enough can now be optimized. And so that’s my rough…Tim, do you want to clarify any of that gibberish? Or did I get your argument right?
Tim O’Reilly: I’m actually talking about it tomorrow, but actually I’m really struck by something else that you are saying here, and actually I’m going to disagree with you about Red Hat because what I think Red Hat is much more analogous to is your fab. I look at Apple with Mac OS X has done something that’s much more analogous to folding the value into an application layer on top, but what Red Hat does, and what I think really all Linux vendors do, and actually somebody else in the audience, Ian Murdoch, is really a leading thinker on this.
He’s right over here. It’s really that the critical competency of open source distributions is actually the active assembly. I think that’s really an interesting thing, and we were starting to see that what Ian’s new company does is really focus on really custom distributions and that ability to be responsive, to be faster. So I think there’s a lot of different elements in the story. You did actually correctly characterize my argument that we’re driving value up to things like Google on top of Linux.
There are many, many instances of that, but there is a lot of other pieces of the story. I think there is another one, too. I’m jumping into things that we’re going to ask you in the questions, but I think that your whole fabrinology here, you’re starting to have a lot of people starting to play with FPGAs, for example, where you’re actually literally doing a lot of the processor work in a quick responsive way, and then some.
Clayton Christensen: Okay! Thanks, Tim. I had a student write an article about cellphones and where the value migrates there because, in many ways, a Nokia and a Motorola phone have been over on the left hand side where the proprietary architectures, then they do their own processors, they do their own operating system optimized, but now those cellphones have so many features that the limitations on the system are not in the handset themselves, it’s elsewhere in the system.
And so we wrote a couple of things that forecast that the handsets are going to become modular, and because of that then, where the money is made in that value chain is going to migrate to the back end. And it’ll become a disintegrated industry, and the way to make money would be for Motorola to sell its chip sets to a thousand Chinese assemblers and for Nokia to sell its operating system to a thousand Chinese assemblers, and all of those guys colliding against each other in commodities would then drive the pricing of those things down and so on, and that’s the way the world would work.
And sure enough, Motorola subsequently announced that they were opening up their system and selling chip sets to anybody who wanted to buy. And then, according to this student, Nokia announced that it would make its operating system available to anybody who wanted to buy, and so I’m thinking, “Boy, these guys are brilliant because they followed Clay’s advice.” But then Nokia announced that it was almost giving its operating system away, and I thought, “Those idiots! That’s where the money is going to be made,” but then my student said, “No, they’re a lot smarter than you, Clay, because of the law of conservation of modularity.
By opening up their operating system and making it essentially free,” he asserted, “what that then allows is the operating system becomes modular and conformable so that Nokia could keep optimizing hardware and keep the hardware part of the system proprietary.” Had they let it became a truly modular world, then Microsoft was there sitting with its own operating system ready to move in and make all the money in the assembly of a modular handset, and maybe the strategy that Nokia followed, it is actually kind of clever to essentially wipe out the value that is created at the operating system layer in order to keep playing the game where they had an advantage over Microsoft.
(Okay, now I want to click ahead.) They’re just one other set of concepts that I wanted to go over, and then we could just have some questions. This last one was the question, I think, number two on our list of, “How do I know who are the right customers to target with my new technology?”
And I think from what little I know about open source, there are a lot of wrong customers that have been targeted that have caused a lot of expense in brief. Now, where this idea came from is actually in one of our MBA classrooms. And I had written an article about the disruption of the Harvard Business School, and what it asserts is that our MBA’s have become extremely expensive.
I would never criticize Stanford in public, so I’ll just talk about Harvard. They cost about $130,000 to hire. And if you look at who recruits on our campus, operating companies have a very hard time recruiting because they’re so expensive and they can’t fit our expensive graduates into their salary structures. So who recruits increasingly are venture capitalists, private equity investors, Mackenzie and Goldman Sachs.
Now, the operating companies aren’t getting lower quality talent; they’re just going into undergraduate programs and raking out the best engineers and others that they can find, putting them to work, and then two years later at the time when many of them would leave to get an MBA, the companies are saying, “Nope, you don’t need an MBA!” “We have GE Crotonville or we have Motorola University or Intel University. IBM spends $500 million dollars a year in management training. We’ll train you right here!”
So anyway, I wrote a case about how on -- the -- job training is disrupting the Harvard Business School, and one of the students raised her hand and, in a very polite way, she said, Well, excuse me, but I think you can only be disrupted if you have overshot what the market needs, and frankly I am not overserved by your teaching.” So I was convinced that Harvard was getting it, and yet it was very clear that she wasn’t overserved. And so it helped me think through that there are actually two different kinds of disruption, and I want to just talk that through.
So, one type of disruption, we’ll plot on this chart, and what we showed before is that if a company’s entry strategy is to bring a better product into an established market, the probability that it will build a successful growth business is zero because of these asymmetries of motivation that exist. Now, incidentally, if a venture capitalist funds a venture that tries to do this, and they actually do come into an established market with a better product, if their strategy is to turn around quick and sell out to the incumbent leader, they can actually turn in a nice piece of money, but it’s not a strategy to create a new growth business.
Now, one type of disruption we called a “low -- end disruption,” it just takes root in the very same market where the incumbent leaders are, but it just picks it off at the low end, and they build a business model that can make money at the discount prices that’s required to steal the business down here. So it doesn't create a new growth market, but it does create a new growth business. And the examples I’ve used in my writings of steel mini -- mills, they did this. Discount department stores did that. They didn't create a new market; they just had a lower cost business model, and the incumbents were motivated to flee rather that fight.
But the other type of disruption, and this is what corporate education is, we called the “new market disruption,” and it comes out in a new context, and so it’s almost like you have a third plane of competition out here. And by bringing a product that is so simple and inexpensive, a whole new population of people can now afford to own and use a product who historically couldn’t do it because they didn't have the money or the skill, and it creates a booming new market out in this new plane of competition and doesn't effect the business of the original players at all for a very long time.
The personal computer was one of these, right? So I remember when I got out of grad school, when I had to compute, I had to take my punched cards to the corporate mainframe center, and the expert ran the job for me. Because it was so expensive and inconvenient, we didn't compute very much. But when the personal computer was introduced, it was so inexpensive and so idiot simple that an idiot like me could now begin to compute for himself in the convenience of my own office.
And at the beginning, out here in this new plane of competition, those early PC’s could barely do word processing. But because I hadn’t been able to do anything myself, I was delighted to have something that wasn’t very good. And then as the PC and the software associated with it got better and better and better out in this third plane of competition, ultimately it got good enough that it started to then suck applications out of the back plane into the new plane, and little by little the customers left the established players. And so the effect of the disruption was the same in that the established leaders got killed; it just is kind of a different animal bringing something that is so much more affordable and simple that a whole new group of people can now begin to do it for themselves.
I want to just illustrate this with a couple of examples from history, and then think through how open source software might be affected by this principle. This is the historical example: The transistor was a disruptive innovation relative to the vacuum tube because when it emerged in the late 40s and early 50s, it simply couldn’t handle the power that was required to be used in the markets that existed at the time, the big tabletop radios and floor standing televisions and so on.
Every one of the vacuum tube companies took a license to the transistor, but they carried the license into their laboratories and they framed it as a technological deficiency. In other words, the transistor isn’t enough yet to be used in the market. And if you could go back and get all of the expenses out of these companies, they probably in aggregate spent $2 billion in today’s dollars, investing, trying to make solid state electronics good enough that you could make big products out of them.
And while they were trying to do that, over here -- now I’m going collapse this back into two dimensions, but when you see green, I really mean that that’s taking root out here in the third plane of competition. The first application was a germanium transistor hearing aid in 1952. A tiny little market, but it valued it for the very attributes that it made it useless in the mainstream, and that was low power consumption. And then in 1955, Sony introduced its first pocket radio. And those of you with gray hair remember how crummy those things were, just static laced, very low fidelity, wouldn’t get a signal from much of a distance.
But Sony chose to sell the pocket radio to the rebar of humanity, people we call teenagers. And the teenagers were delighted to have a product that was not very good because their alternative was no radio at all, and it allowed them to do something that they had wanted to do, but never could do, and that is listen to Rock -- n -- Roll out of the earshot of their parents.
So a booming new market emerged in this third plane of competition, and these guys back here felt no pain because they were all new customers. Had Sony tried to sell its pocket radio to the parents, a crummy product would have been judged to be crummy because they had the alternative of a high quality vacuum tube radio. Then in 1959, Sony introduced its first portable television, and again, they competed against nonconsumption. They made it so affordable and simple that a whole new population of households who didn’t have a big enough apartment to have a big floor standing TV or didn't have enough money to buy one, now they could own one, and because the alternative was no TV at all, they were delighted with the crummy product.
And again, a booming new market emerged in this third plane of competition until the mid 1960’s. And now solid state electronics was good enough that it could handle the power required to be used in making these big devices. And bam! within three years, all of the applications got sucked out into the solid state world, and the vacuum tube companies were just dead, and these are venerable institutions like RCA. And the punishing thing is that it’s not that they didn't see the technology coming. They saw it before Sony did.
It was not that they weren’t aggressive and visionary. They invested far more money trying to make the technology good enough than did Sony as they were building these growth businesses. The punishing thing is that they targeted the wrong customers. They targeted consumers, and the only way the customers here would have adopted the new technology is if it were better than the old technology and more cost effective. That was a very demanding technical hurdle for the vacuum tubes companies to surmount. As they came out and competed against nonconsumption in contrast, Sony had a much more modest performance hurdle because they just had to make the product that was better that nothing, and the customers were delighted.
Now, where you see this happening today is voice recognition software. So, the next time you go to a computer superstore, go to the voice recognition software shelf and pick up a box there that’s called the IBM ViaVoice. Now don’t buy it, but just look at it! They have a picture of the customer on the box, and it’s an administrative assistant who is sitting in front of her computer wearing a headset speaking rather than word processing.
You think about the value proposition that IBM has to be making to this woman. She types 90 words a minute. She is 99% accurate. If she needs to capitalize something, she just instinctively presses shift and cruises through. And IBM has to say, “No, don’t do that anymore. I want you to put this headset on and teach yourself to speak in a slow and distinct and consistent manner in complete sentences. If you must capitalize, you must pause, speak the command “capitalize,” pause, speak the word you want to capitalize, pause, speak the command “uncapitalize,” pause, please be patient, we are 70% accurate, this will get better we promise.”
This is not an attractive proposition to this customer. And IBM has -- I’ve not worked with them at all, but as I understand it -- they’ve spent maybe $700 million trying to make voice recognition technology good enough that it can be used in that market. This is a very difficult technical hurdle to surmount. Meanwhile, while they are investing that aggressively, Lego comes up with these robots that recognize “stop,” “go,” “left,” “right,” and the kids are thrilled with the four word vocabulary, and then press -- or -- say -- one kinds of applications take root, and now directory assistants ask you to say the city and state and so on, and much simpler, and an interesting market is emerging.
I bet maybe the next place it takes route is in chatrooms because the kids don’t spellcheck or capitalize anyway, and they would rather speak than type. And maybe then the next application would be, when you see these stubby fingered executives with their BlackBerrys trying to peck out emails, and their fingers are four times the diameter of the keys, they’re only 70% accurate. If somebody gave them a voice recognition algorithm that really didn't have to be very good so that they could speak their wireless email rather than peck it out, I bet they’d be thrilled with the crummy product. And ultimately, as it takes route in these new applications, it may get good enough that we can do word processing with it, but it’ll be a long time.
I’ve asked myself, “Why would the IBM engineers have picked off the most demanding application conceivable for this technology,” and it probably resides in the resource allocation process of the company, because it’s not just IBM, everybody does it. You got to rule out stupidity because they’re at least as smart as us, but in order to get funded, the people who had the idea knew that they just couldn’t stand up in front of senior management without PowerPoint and just say, “I’m sure there’s going to be a lot of ‘press or say’ when stuff happens some time.
They never get funded. But they have to do a PowerPoint presentation that has financial projections, and they have to be able to say that we hired a consulting firm and they did a market study and, there are 37.9 million administrative assistants who spend this many hours a day word processing, and this is how big the market is, and in order to get funded it forces the company to target the market that ultimately causes them to fail.
And the digital camera people like Kodak fell victim to the same process. These digital cameras are potentially disruptive, and so in order to make a digital camera good enough that people would opt to take a digital rather than a film image, they have to cram it full of charge couple devices, and that drives the price point up so high that the only people who can afford to buy a digital camera are the people who own film cameras, and so then the reward for success once they got a good enough digital cameras is they don’t sell film.
So a massive investment and no growth. And meanwhile, we see taking root out in a third plane of competition, credit -- card -- thickness cameras that have just dirt -- cheap CEMA sensors, and now CEMA sensor -- based imagers in cellphones that take crummy images, but they’re so much better than nothing at all, that a booming new market is emerging. And whether a disruption creates new growth or threat to the core business in many ways is driven by this very same thing.
Our daughter just finished a mission for our church in Mongolia where she had been for a couple of years, and we went over to get her in August when she finished her service. And I’d always wondered whether solar energy was ever going to be commercially viable because the European and American governments have probably invested $15 billion trying to make solar energy good enough that we could use it in our markets.
If you think about it, this a very difficult technical hurdle because our homes are filled with air conditioners and power sucking computers and microwave ovens. And you got minor problems like nights and clouds that get in the way and, it is a very difficult problem! And so the technology making solar cells with this as the core market that they invasion is very expensive and optimized to try to wring the most power possible out of the materials and technology that are available.
Anyway, when we were in Mongolia, our daughter took us to this big open -- air market in the capital city Ulaan Baatar. There was this big line of stalls in this market where the vendors are selling dirt -- cheap solar cells shrink wrapped with 6” televisions and rabbit ears antennas, and they’re just walking out of marketplace! Because half the population of Mongolia doesn’t have access to power over a grid. And it doesn't really matter if it was cloudy today; I couldn’t watch TV yesterday.
And there are about two billion people in South Asia and Africa who don't have access to electric power at all, and it turns they don't have air conditioners and microwave ovens in their homes, and they’re delighted with something that won’t be very good. Now whether solar energy ever takes root as a viable commercial technology, I don’t think it’ll ever get driven in the sophisticated engineering labs of North America and Europe. It will be by folks out there in the third plane of competition competing against nonconsumption and get better and better all the time.
So as I look at how different companies have tried to deploy Linux. What this would suggest is that if IBM tries to shove Linux down Merrill Lynch’s throat in its core internal mainframe computer system, there are just so many complicated interdependencies when you insert a new technology into an existing system of use, that you’re running into all kinds of problems.
But I think at that end of the world where you see open source taking root is in web servers, which is a totally new application taking root out here in Internet -- based computing. And as it gets better and better and sucks applications out of an internal system to a web -- based model, then gradually Linux disrupts, as a new market disruption UNIX, in those tiers of the market. But it does it not by a direct attack, but by taking root in a new application.
And similarly what it would forecast, and again I say this is just what the model says, is that any attempt to deploy Linux right onto a desktop, there are just so many complicated and unforeseeable interdependencies when you insert a new technology into an existing system of use. So many other subtle things would have to change, and it would have to become better than the existing thing in the ways that the consumer measures goodness, I wouldn’t expect it to take root.
But because of the law of conservation of modularity, as it takes root out in the new plane of competition with wireless handheld devices, because the modularity of Linux allows the device to become optimized. And then as it gets better and better, applications get sucked off the desktop into the handheld device, and that would be the mechanism by which the Microsoft proprietary operating system would get disrupted by Linux. I mean, I don’t know if that’s true, but that’s what the model would predict.
Well, there are a bunch of other questions that we didn’t answer, but I hope this gives you a flavor of at least the way we’ve been trying to think our way through some of these problems. And this book that we wrote about it, “The Innovator’s Solution” gives the models that address the other questions. If you have any interest, they’re there, or I just work at our business school, it won’t get finished off for another 20 years. Disruption is a process, not an event. So you could contact me at Harvard if you have any other questions.
Anyway, criticisms or barbs or…. Yes?
(Question by a speaker too distant to be heard clearly.)
Yes, that would work, kind of, in that it’s so much better than nothing and it’s a new system of use to an extent. The problem is if, in fact, they bump into existing systems of use, and that is application software that just don’t run well on that, then you would expect them to run into problems, but China is a much easier place to deploy it then existing markets. Yes?
(Question by another speaker too distant to be heard clearly.)
Well, that’s a great question. Can I give you a longer answer than you asked for? When we were having this case discussion about the disruption of Harvard Business School, I walked into the classroom and took a vote of the students, and there were 100 students in the class. “How many of you think Harvard’s in trouble?” Three students raised their hand; 97 -- there were no abstentions -- voted that, “Don’t worry, be happy, this could never happen to our school.”
And so I asked if one of the three who was worried why he was worried and he said, “Well, there’s a real pattern here,” and he lists out the elements of the pattern and then he said, “Now look in the case and everything that happened to all of these other people is happening to us. That’s why I am worried.” So then I turned to the don’t -- worry -- be -- happy crowd and said, “So why aren’t you worried because it fits the pattern so closely?”
And everything that they cited related to the data, that more people are applying to Harvard then ever before, our students are getting more money than ever before, and the more money they get paid, the higher…we’re much further ahead of Stanford on the rankings, and so on. And so we had this argument back and forth.
So then I asked one of the students who was the most vociferous defender of Harvard’s invincibility, “So imagine you were dean of the school, what evidence would you need to see to become convinced that this is a problem that we need to address?” And he said, “Well, I would look at Harvard’s market share amongst the CEO’s of the global 1000 corporations, and if it starts to dip, then I’d worry.”
And I said, “Well, when you saw that data, would it signal that the problem needs to be addressed, or that the game is over?” He said, “Oh, yeah, the game would be over!” And so I turned to the rest of the don’t -- worry -- be -- happy crowd and said, “So any of the rest of you, imagine you were dean. Could you give me data that would convince you that it was time to take action?” And actually, every piece of data that they could come up with was evidence that the game was over.
And the idiot -- simple insight that we got is that data is only available about the past. And yet, the way we teach our students, at our school we teach by the case method and if the student makes a comment in a case discussion that can’t be backed up by his analysis of the data in the case, the instructors are trained to crucify the student on the spot. And so we enshrine the virtues of data -- driven analytical decision making in the way we teach at our business schools, and the our students go to work for McKinsey and they carry data driven analytics to the nth degree, but in many ways the very ways we teach them condemns our managers to take action when the game is over.
But the scary thing for Harvard is that this means that we need to take action based upon a theory, not evidence. And that’s how I got into this thing that, well crum, we’re always using a theory anyway, because a theory is a statements of cause and effect. We just hope we have better theories.
So at the time IBM made the decision, there was no theory to guide them; there was only evidence of the past, and the evidence of the past was that the money was made at the system, not in the components. And now, as you have a theory, hopefully it’s a good theory, then it allows companies who face this transition to make a decision about whether they ought to create an interdependent or a modular architecture, and when it’s going to flip.
For example, what’s going on right now with wireless access to the Internet; it’s not good enough, it needs a proprietary system. And so companies that have tried to cobble together a system around WAP standards, for example, it’s prematurely modular. And the companies that have an interdependent system like DoCoMo and J -- phone in Japan, they’re making bundles of money, and they’re also out competing against nonconsumption for the business of teenagers. So that’s what I hope to accomplish, is that we can look into the future and make statements about what will happen before the data is clear, but in the past that hasn’t been possible. Yes, Tim?
Tim O’Reilly: I have a question about the theory of conservation of modularity. (The rest of the question is obscured due to the distance of the speaker).
Clayton Christensen: Yeah, I think it would be, Tim. In other words…but you have to think of it in relative terms. So, what is it in that system in the value chain of the system that gets delivered to the customer is not good enough, and that tells you then what has to be optimized, and you’ve got to be integrated across that interface that optimizes it, and what is next to it that needs to be broken up. And you’re thinking about it, I think, in a healthy way. Yes?
(Question by another speaker too distant to be heard clearly.)
Yes, his question is. “Does the theory predict that the profits will disappear in every market or that they will just be made by different parties?” And it’s very much the latter. In fact, for marketing purposes, we called this concept the “law of conservation of modularity.” In the book, we called that “law of conversation of attractive profits.”
And again, at one layer as it moves towards commoditization by overshooting and becoming modular, the adjacent layers move towards decommoditization, and so the ability to make money will shift. So like in the car industry, the subsystems, the tier -- one suppliers are not yet manifestly more profitable than the car assemblers, but we should see that transition occurring over the next few years as the power in that industry shifts and so on. Yes?
(Question by another speaker too distant to be heard clearly.)
Well, I don’t think I can repeat your statement, but I hope everybody heard it. I think the concept is that when you have a modular architecture, it truly is undifferentiable because the pieces fit together in a pattern that everybody follows, and so the product is not differentiable. And in a disintegrated industry structure, the cost structure of the company is heavily variable because you outsource the components.
And so a variable cost structure means that the scale curve is flat, so small companies and large companies have the same cost, and the product is undifferentiable, and that’s why it’s very hard to make money as an assembler of a modular system. In a proprietary system, it’s just the opposite, that the proprietary architecture yields a highly differentiable product, and it’s a heavy fixed cost because the design of a proprietary product is expensive, and so that creates steep scale economics, meaning that the big players sell -- that’s a recipe for minting money versus not making money.
And so whether MySQL gets folded in to optimize some other application, or Linux gets folded in to some other application, or they try to fold an application into the operating system, where the money will be made is where you’re optimizing the performance of something that is not yet good enough, and that’s really all I can say, because then that creates a condition in which a proprietary architecture will win, and that’s where money gets made. So, I got to believe that a lot of money stays in the system, that it just gets made at a different level.
(Comment by another speaker too distant to be heard clearly.)
This merits a microphone here.
Member of audience #1: I’m the guy from MySQL and I think that the value is being produced in the layer above the infrastructure, so in web services specifically. So look at Amazon, Yahoo, Google, who all use standardized open source modular components that they pay virtually nothing for, and then they create a highly interdependent system with a very high value that they can sell out the customers, and they make much more money than the open source players, so I guess that’s part of an answer.
Clayton Christensen: Great! Thank you. There, in the middle…?
(Question by another speaker too distant to be heard clearly.)
Northeast. Yeah. Microsoft is in the Northwest.
(Continuation of speaker too distant to be heard clearly.)
I will just conjecture because I do not consult for them or anything like that, but that NT is a disruption relative to UNIX, and that system has just been moving up market and squeezing the UNIX and the risk world up to the high end of the market. And then Linux on web servers has inserted itself there. It’s an interesting question whether, Microsoft…in the absence of Linux, I think Microsoft would’ve had a really exhilarating…there was a lot of headroom above them.
Whether Linux limits the further up market march as applications move to a web -- based system, I don't know. I also think that it’s just very hard for me to imagine the core franchise of an operating system on a desktop as being threatened in the foreseeable future because of the reasons that we’ve talked about. Now, the growth markets they may very well have a difficult time catching.
I also see them launching their own disruptions against other folks, which is really a great idea, and so they’ve got database software coming up against Oracle, and they have got Great Plains, but SAP needs to be disrupted. There are a very complicated, high -- end, overshot interdependent system, and there’s a lot of growth there, and so they’re doing a lot of interesting and useful things.
But I think the critical thing as per what he said is if they want it keep being profitable, there’s a mindset that while we milk the operating system business over here, in the future, operating system is not where the money will be made, and so don't somehow try to make money off of Linux. Use Linux to somehow optimize the next layer up and shift how we make money there. But they’re a tough company, and a good company.
Member of audience #2: My question is about switching costs. Not certainly the one we stopped the new line of business, but in the one where a lower cost comes in and attacks. In that, case switching costs seems to me to have effect of the diagram of moving the curves further apart, and that, for instance defends Office against Open Office, is attempts to tie it in and keeping the switching costs very high.
Clayton Christensen: Yeah, it’s a very good point, and that’s why the cramming it into the blue space so often is expensive and fails whereas if you take root in a whole new plane of competition, you don’t run into the switching cost problem out there. It’s like this: The shortest distance between two points is not a straight line. Yes?
(Question by another speaker too distant to be heard clearly.)
Well, of course I think it’s a perfect theory or I would’ve changed it, right? The only way you can develop a better theory is to find anomalies that the theory won’t explain. And so I’ll tell you what I do think is that these pressures…are you familiar with the story of the minimill? So in the new book I understood that a lot better and told the deeper story that as that the minimills hit the rebar market, because they had a 20% cost advantage, they made tons of money.
And, of course, the integrated mills, because they were more profitable investments up, they got out of that business. And it felt great until 1979 when the minimills finally had the whole market to themselves, and then the price collapsed by 20% because, the insight I got was that a low -- cost strategy is only viable as long as there’s a high -- cost competitor around, and so they had to move up because that’s where the high -- cost competitor was.
And that’s why Dell has to race up market because it gives them the privilege of competing against Sun Microsystems. So I would say that those pressures to move up exist on everybody. Now, some companies, like in the pharmaceutical industry, they haven’t yet overshot very much, and so the forces are there, it just hasn’t played itself out.
In other industries, there are anomalies that I think you can explain, so let me tell about this and then there are some that I don't understand yet. Airlines. Southwest Airlines was a new market disruption. It’s that when they started out, they were competing against buses and cars, not against United, and so just like WalMart locked up the little cities, Southwest locked up the point -- to -- point routes between the little cities, and they’ve done okay.
But all of the other discount airlines have come in as a low -- end disrupter, not a new market disrupter, hitting the low end of the main market. The latest is Jet Blue, and they’re flying in and out of mainstream airports. And it’s easy for a discount airline to create a low cost structure; you just buy fully depreciated jets and higher nonunion people and so on. And you notice how many discount airlines have started over the last 20 years, and their average life expectancy is about four years.
As they hit the low end of the market, and it looks like a classic disruption, the problem is for the major airlines. Their cost structure is such that they cannot live without the volume at the low end of the market. And so the discounters can gain a little share, and then the major airlines just have set up shuttle by United or (Song) and swat them down, and then as soon as the discounter is gone out of business, then they shut down shuttle by United and go back up. And so it’s an eminently disruptable business, but the incumbents cannot flee; they have to fight. And so it makes it miserable for everybody except Southwest; they’re kind of in their own little world. So that's an anomaly which I actually think the theory can explain.
I can’t explain, for example, why EMC beat IBM. It wasn’t a disruptive technology, it was a better product, and yet they cleaned them out. And there are a couple like that, but I think it's a pretty pervasive phenomenon. Religion? I haven’t applied it to churches yet, but…
It’s a great question. How does this apply to Intel? So they were getting killed at the lower end, and they then developed what they call the Celeron chip and tried to sell it through the sales force. The problem was the sales force had a problem, because when they were trying to get a design win, say, at Dell, they had to choose, “Should we spend our energy trying to get a design win for a $300 Pentium processor that gives us 80% margins? Or should we get a design win for a $50 or $70 processor that yields 30% margins?”
So they set up a separate marketing organization out of Israel and gave it the responsibility to sell the Celeron chip and gave it a cost structure so that a $70 price point was attractive, and as soon as they put good technology in a business model that found the disruption attractive, bam! and they got the low end of the market back again. Cyrix was gone, AMD was nailed to the wall, and now the Celeron is the highest volume of all of the products in the line.
And now the next thing that is happening is the system on a chip, the modular custom -- configured processor that needs to be delivered very rapidly. And they have got a fab in Marlboro, Mass. with their StrongARM technology trying to do that. And I think this disruption it is a new market disruption here is a bigger deal.
(Question by another speaker too distant to be heard clearly.)
Yeah, they’re really…and that’s the evidence that the incumbents actually don't need to get killed, but they actually they’ve got to set up their separate organization that can focus on the new thing. And the reason you have to set it up separately is that the new game begins before the old game ends, and if you try to do the new thing within the established when you take your off the old game, and there’s still a lot of money to be made there.
There’s a company in Santa Clara called Tensilica that I think is very interesting. In the new market disruption, what happens…I’ll give you an analogy of how this works because I think it’s a big deal for the software industry. If you go back 30 or 50 years ago in organic chemistry, if you wanted a new molecule, you had to go to the labs at Dupont, and they employed the finest organic chemists in the world. And one of them would mix up a few atoms in a beaker and heat it up and draw a fiber out and look at it under a microscope, and then go down and talk to a colleague and say, “What do you think this is?” and the colleague would say, “I have no idea, but heat it up for ten more minutes and let us see what happens.”
And the miracle molecules that we know as nylon and polyester and Kevlar emerged from an unstructured trial -- and -- error problem -- solving process in the labs at Dupont. And nobody could do this like Dupont or like the engineers who were at Dupont; you just had to be the best experts in the world. But as they kept doing this over and over, they began to recognize patterns of cause and effect.
And when that realm of knowledge migrated out of an unstructured experimental problem solving mode down into pattern recognition, then you didn’t have to be nearly the world’s experts in order to make molecules. And so other companies like Dow and Union Carbide and so on could get into the plastics business. And then quantum theory took over, and quantum theory allows you -- I’m going to overstate the case a little bit -- it allows you to predict that if you put the atoms together in this structure in the molecule, these will be the properties of the material, and that then allows you to write a piece of software to reverse engineer, so if you need these properties, this is what the molecule has to be structured like.
And so now you really just need a BS in Chemical Engineering from Montana State and a good piece of software, and you can design better molecules faster and at lower cost than the world’s experts could a generation ago because it’s gone from unstructured problem solving to pattern recognition down to a rules base.
And in many ways the progression from interdependence to modular follows that same thing, so in a world of interdependence, you just need the best experts in the world and through trial and error and working things out, they create great systems. And modularity that defines how the pieces snap together is only possible when it’s down more of in a rules -- based world, and that allows now people with much less skill to do very sophisticated things because the technology is more rules based.
So what Tensilica is doing is the software that allows their customers to create custom -- configured processors tailored exactly to each situation, their target is to make it so idiot -- simple to design a custom configured processor that even a software engineer could design a processor to optimize the application. I think that is kind of slick, but now that the functionality is more than good enough and you can back off the frontier and the rules are not yet there but they are emerging, it could really change a lot of the world for somebody like Intel.
And another thing is that as the law of conservation and modularity works its way through, Intel needs to be an integrated company because at the high end, there’s not a clean design and manufacturing interface. But at the low end there are much better defined rules for design and manufacture, and so the fabulous companies and the focussed fabs are kind of taking over. It would be crazy if, as that disintegrated industry structure works its way up market, it would be crazy for Intel to sell off its fabs. And its finance people are going to want to sell them off because they’re so capital intensive, but the fab is the place where the money will be made if they are fast. Yes?
(Question by another speaker too distant to be heard clearly.)
Her question is. “What happens if these market disruptors get bought by big players and by the incumbents?” It actually is a great strategy. I want to say two things. Companies like Johnson & Johnson as the healthcare industry is getting disrupted in a pretty big way -- we don't have time to talk about it -- but they’ve decided, “We’re not good at getting these things off the ground,” but they’ve got a team of people that have these lenses on going around the healthcare industry, identifying little companies that are new market disruptors.
And so a company that has a technology that will allow you to do in the home what today you have do in an office, or will allow you do in an office what today you have to do in a hospital, that’s a new market disruption, and they’re actively trying to buy them. And then if they keep it separate and let them have their own processes and create their own business model and just give them their money, it’s a great way to generate growth. And J&J has generated…now every year they get about $9 billion of revenue from disruptive companies that they bought a decade ago. If they try to fold the company into the parent, then it destroys what they bought because it has to conform to the business model of the parent.
(Question by another speaker too distant to be heard clearly.)
Can I fit the University of Phoenix into the Harvard Business School’s picture? Yes, it is exactly one of those things. Not good enough, but there are 160,000 students at the University of Phoenix getting management degrees of one sort or another online, and it is getting better and better every year, and the students that they cater to are not people who would have had gone to a leading MBA program anyway, and therefore they’re really quite happy to able to do something that’s online and ostensibly not as good, but, geez! they’re getting good.
(Comment by the same speaker too distant to be heard clearly.)
Well, it is a good question. So the University of Phoenix is not something that Harvard should go after. If you go back to the model of skating to where the money will be, in the past…see Harvard is an integrated institution. We do the research. The research gets embodied in components that we call “cases and articles.” We assemble the components into courses. We produce the courses, we market the courses, we soak our students for money to finance the courses and everything.
And the architecture of the MBA program is interdependent, and so you can’t study marketing if you don't study product development, and you can’t study product development if you don’t study manufacturing, and you can’t study manufacturing if you don’t study cost accounting, and you can’t study cost accounting if you don't study organization design, because management is a big hairball, and you’ve got to study all of it in order to understand any of it.
But online or corporate education is modular, and so somebody will call up corporate training and say. “Geez, we got to give a strategy presentation to the board in June? Can you give us a week of strategy?” And it's not good as Michael Porters’ course, but it does a job. And then they learn a little strategy and go practice it, and then they call up and say, “We got to get better in product development? Can you find us two weeks of product development?” and so on.
And on that side, in a modular world where the money is made is not in the teaching of the courses, the assembly of the course. In our world, that’s where the money has been made. In that world, if Harvard could become the Intel inside of every corporate university -- and I’ll put my tongue in my cheek -- if we could make it foolproof for all of these unwashed instructors in corporate training programs to teach great stuff in compelling ways, we will create so much growth in education and we would still make all the money in the industry. But it is a very different business model than what we have now, but that would be the right play, but we do not have any data to support that.
Should we do just one more question? Well, we better not. Talk to you afterwards.
Guys, thanks for wasting the end of your day with me! You’re very helpful.
Doug Kaye: Thank you for listening to this special edition of IT Conversations. This edition was recorded at the Open Source Business Conference held in San Francisco on in March 2004. For more information regarding this and future OSBC conferences, please visit www.osbc.com. IT Conversations is a production of RDS Strategies LLC. This program is copyright 2004 by the presenter, Open Source Business Conference, and RDS Strategies LLC. My name is Doug Kaye, and I hope you will join me the next time for anther edition of IT Conversations.
Research #Nostalgia · 25 comments
During the first quarter of fiscal year 2014, we changed our organizational structure as part of our transformation to a devices and services company. As a result of these changes, information that our chief operating decision maker regularly reviews for purposes of allocating resources and assessing performance changed. Therefore, beginning in fiscal year 2014, we are reporting our financial performance based on our new segments; Devices and Consumer (“D&C”) Licensing, D&C Hardware, D&C Other, Commercial Licensing, and Commercial Other.
The previous reporting segments were:
The new are:
From Microsoft's FY14 Q1 10Q via Microsoft Investor Relations - Press Releases
The mapping between the old and new is not straight forward. There is overlap between D&C Licensing and the old Windows and perhaps between Entertainment and Devices and D&C Hardware but there are many gaps. There is also some overlap between the old "Business"/"Server" segments and the new "Commercial" but, again, they cannot be matched.
I show the difference between the two structures in the way revenues are allocated below, using color to try to show similarities.
Given the re-stated quarters it's possible to compare one year's historic performance at a segment level. For example, the company states that "Devices and Consumer revenue grew 4% to $7.46 billion" while "Commercial revenue grew 10% to $11.20 billion".
Since we don't have data older than one year, our ability to assess the company over longer time periods will be drastically reduced and a new picture will take a long time to emerge.
There is however one aspect of the new structure that needs to be appreciated right away: the allocation of costs has changed fundamentally. The company explains:
Cost of revenue is directly charged to the D&C Hardware segment. For the remaining segments, cost of revenue is directly charged in most cases and allocated in certain cases, generally using a relative revenue methodology.
We do not allocate operating expenses to our segments. Rather, we allocate them to our two segment groups, Devices and Consumer and Commercial. Due to the integrated structure of our business, allocations of expenses are made in certain cases to incent[sic] cross-collaboration among our segment groups so that a segment group is not solely burdened by the cost of a mutually beneficial activity as we seek to deliver seamless experiences across devices, whether on premise or in the cloud.
[my emphasis]
In that brief paragraph Microsoft has formally and in a financially binding way declared itself to being a functional organization. ((Welcome to the club.))
The mechanism seems banal: operating costs are no longer assigned to product divisions but to two large buckets. In practice this means that profitability (P/L) cannot be assessed or assigned to individual managers. The lack of P/L responsibility means that incentives from top to bottom have to be re-engineered. If this goes wrong, the Assets ((read: people)) of the company could evaporate.
If the assets go, then processes and priorities are for naught.
In other words, what the company is undertaking is a priority shift (to a functional structure to create integrated experiences) which requires a process change (whereby employees work according to new incentives) while preserving the fragile assets the company depends on (a motivated and skilled base of employees.)
This makeover is as ambitious as a re-org gets and the context, scope and target are as difficult as they can be. This is, after all, the largest software company operating the the most dynamic industry whose multi-sided markets are notoriously volatile due to disruptive forces.
The challenge also suggests why Ballmer left and who should replace him. A priority transplant operation requires a different set of skills than those held by the manager who created the processes for the previous set of priorities. That's the manager's dilemma: even if you foresee the changes needed and push for them to be enacted, your reward might be to be replaced by someone who can make the changes happen.
Those who envision and persuade for change are rarely allowed to enact it.
Research #Industry · 129 comments
Apple's latest product launch (new OSX, iPads, Macs and iWork/iLife) came with a change in pricing for software. OS X and iWork and iLife and updates are now made available free on new Macs and, in the case of the suites, on iOS devices as well.
Recall also that iOS updates are now free as well and that OS X had been reduced in price from about $129 to $29 with Snow Leopard in August 2009 and to $19 with Mountain Lion in July 2012. The iSuites have also dropped in price over time so the pattern of evaporating software prices is long-running.
But how fast and what is the impact? The historic performance Apple's Software business is not easily determined since it was always blended with additional businesses. Until September of last year, Software was reported as part of "Software and Services" and since then as part of "iTunes, Software and Services." Some assumptions allow the following picture to be drawn:
One additional wrinkle to the Apple software story is that OS X and iWork/iLife are not all the software titles available. Apple's software includes Pro apps as well as the non-free OS X server. The non-free software US prices are:
Given that and additional assumptions can lead to the following picture of the components of Apple's Software sales (in $ million/quarter).
Given this picture of the software business and the change in pricing, here is my forecast for the third and fourth quarters (in $ million/quarter):
The foregone revenues could be as much as $450 million from what would have been received with existing pricing model.
So the question that naturally arises is whether this is "worth it". Whether by offering free software hardware or service revenues rise.
Perhaps. Certainly service revenue in the form of iCloud might rise with more usage of iWork and iLife. But I don't think that this is the calculus underlying the decision. Remember that Apple does not have a Profit/Loss accountability. It's not necessary (and perhaps not even preferred) that a division balances costs and revenues. ((The graphs in this post (and the preceding 1900 on this blog) were created using Numbers.))
Fundamentally Apple remains a systems company where software is a key element in its definition of value. That is not changing. What is changing instead is the bundling of application software with the systems software and the system itself. The presence of iWork and hassle-free updating of that suite (and the same for the OS) means that utilization rates will increase.
I believe the logic for Apple is that usage of the products determines their value and therefore placing powerful software in the hands of more users means they will value the entire system more. This leads to the notion of greater "stickiness" or "lock-in" but also to higher satisfaction and loyalty, rate of upgrades and even more third party purchases and yet more usage.
This is the virtuous cycle platform custodians seek to engender. This is what Apple is trying to build and the transition of apps into the system bundle is part of this re-enforcement.
One wonders how long before Apple's approach becomes the norm for other platforms.
Research #Industry · 64 comments
In previous posts I described the patterns of asset value growth for Property Plant and Equipment at Apple and how that change has been thus far correlated to the production of iOS devices.
The analysis was based on looking at the declared value of the PP&E assets on Apple's balance sheet. These values include depreciation so they reflect not only the "spending" on new assets but also the value lost due to wear and tear. As such it's not a perfect measure of investment.
The better approach is to use declarations on the cash flow statement. Apple reports a specific cash flow related to PP&E: Under Investing Activities, Payments for acquisition of property, plan and equipment.
In the latest 8-K the amount for the 12 months ended September 29 the value was $8.295 billion.
Compare this with the statement in the Annual Report from one year ago:
The Company anticipates utilizing approximately $8.0 billion for capital expenditures during 2012, including approximately $900 million for retail store facilities and approximately $7.1 billion for product tooling and manufacturing process equipment, and corporate facilities and infrastructure, including information systems hardware, software and enhancements.
Compare also with the PP&E net asset value on the Balance Sheet currently at $15.452 billion but valued at $7.777 billion a year ago (an increase of $7.7 billion).
This means that Apple intended to spend $8 billion, actually spent $8.3 billion and realized a net asset gain (after depreciation) of $7.7 billion.
So there are no major surprises. The spending was only about 4% above expectations a year earlier.
The other pattern to observe is that the spending rose dramatically into the fourth quarter. The fiscal quarterly spending was:
I illustrate this pattern (and previous quarterly spending) in the following chart.
The question remains what is this $8.3 billion being spent on?
To help answer I also added the comparable spending (from cash flow statements) of a few other technology companies. Google, Amazon and Microsoft have been spending in the same range of $500 million per quarter. Over the past eight quarters the average spending of these companies has been:
Intel is different. Its average spend level has been $2.6 billion/quarter.
But Apple has just spent about 30% more than Intel. And it spent three times in Q3 than Google, 4.8x Microsoft and 3.8x Amazon.
The level of spending and growth from a far lower level implies to me that Apple is spending primarily on process equipment (aka tooling) rather than servers. Data centers are expensive at $1 billion for a large one, but they are not being built fast enough to account for $3.5 billion in one quarter.
Note that Apple's CapEx is above that of Intel whose fab-based semiconductor production method is known as particularly capital intensive. And Intel's Capital Expenditures have been increasing to all-time highs.
If Apple spent at Google levels on server infrastructure it would only be spending a quarter of what it's actually spending. If Apple spent on production at Intel levels it would only be spending three quarters of what it's spending.
In other words, Apple is spending at the equivalent of one Intel of fabrication and one Google of server infrastructure.
In a few days we will learn what the plan for expenditure for fiscal 2013 is. Historically, the company has roughly doubled spending for each year of the iOS platform. If that continues then Apple will be spending the equivalent of several Intels and several Googles.
Research #Market #Theory · 63 comments
HP's CEO Meg Whitman admitted that, when iPads are included, Apple will overtake HP as the world's leader in computer shipments.
“We need to improve our game and our products to take over the leadership position. Apple could go past HP in 2012. We will try to become the champion in 2013.
When the quarterly shipment data is seen as a chart the doubt of this happening disappears:
Note that the combined iPad+Mac has already overtaken Dell. In fact, the iPad alone overtook Dell in Q3 and might overtake HP in two quarters.
The iPad is growing at an average of 170% y/y (average of two quarters) while the Windows PC market is growing at an average of 1.9% over the same period (source: Gartner, company reports). The
Placing the iPad in the "competitor" category is an important admission for a PC company. Categorization choices make all the difference when thinking about strategy. The new tablet product may not appear at first glance to be competitive with the current definition of a PC (though it might very well be a personal computer.) But definitions tend to evolve. Categories are abstractly defined. The original PC was certainly not competitive with Mainframe computers and perhaps it still isn't. But that does not mean that usage (and hence value capture) did not migrate. Most people today would say a PC is a "real computer" and the Mainframe is simply an old computer.
Whitman notes that the iPad is not the only computer people use and most have a PC as well. That may be true as it was true when the PC was new. Most companies that supplied PCs to workers maintained large computers for "mission critical" applications like accounting and engineering. The two technologies lived side-by-side for many years. In fact, in the beginning there was a thriving market for software and hardware that would allow PCs to be used as terminals to access central computers. It wasn't until PC servers and server software like that from Novell and networking from 3COM became commonplace that mainframes and minis began to fade.
So in practice, there was no big bang start to the post mainframe era. The evolution of the PC went through stages. It was an isolated local computer, a client-server solution and then finally a web-enabled communication product on its way to ubiquity. But the era did change.
So if history serves as a guide, the displacement of the PC won't come from a direct substitution but a more sinister and hard-to-predict subversion through new applications and a re-definition of what a PC is. The driving forces are not just volumes but new input methods, new user interfaces, new jobs to be done, new software and many innovative companies working within an ecosystem.
If there is one difference today it's that things are happening a lot faster. A transition that took a decade is happening in three years today, even though the entire market is orders of magnitude bigger.
When I visualize the cycle time of technology change, I see it as the waveform to the left: as cycle time decreases (i.e. frequency increases), the opportunity (amplitude) also increases.
