China’s Open Source Development Has Lessons for the US

Lex Sokolin, a CoinDesk columnist, is Global Fintech co-head at ConsenSys, a Brooklyn, N.Y.-based blockchain software company. The following is adapted from his Fintech Blueprint newsletter.

The news cycle is obsessed with a global technology competition between China and the United States. Whether we look at artificial intelligence, 5G, blockchain or the Internet of Things, these next generation platforms are supposed to be the battleground between the world’s latest economies. The fighting is getting unfair. We can look at India and its band of over 50 Chinese apps, including the super app WeChat, or we can analyze the Donald Trump treatment of TikTok, put up for a fire sale and justified with jingoistic rhetoric.

However, competition in the next century is going to be far more complex than intellectual property ownership. It is going to be waged over multinational open-source networks, reintegrating finances and economies into a digital global superstructure. We have to develop clearer ways of thinking about this competition, and in this entry we will discuss one such framework. But first, why is there such extreme positioning over technology assets by both China and the U.S.? The simple answer is pain, and the economic havoc wrought by the coronovirus epidemic on the world.

The West has had the worst quarter in recent economic history – down 10% both in the U.S. and the eurozone. I’ve written before how the shock of opening up to capitalism in the USSR led to a 45% GDP collapse over half a decade, resulting in life expectancy decreasing by 10 years for the average Russian due to alcoholism and violence. We aren’t going to see something of that scale in the U.S., but we will see continued social unrest, deep racial tension and restructuring. Perhaps this is productive stress. More likely, it is a pressure cooker with a hefty price.

China is holding up a bit better in the coronovirus environment, based on stronger national control over people, technology and narrative. The country’s second quarter saw 3.2% relative GDP growth (though arguably the first-quarter collapse was sharper in China than elsewhere). China has expanded control over Hong Kong, and made big investments into artificial intelligence and blockchain, which the West continues to view in a generally negative light. Chinese fintech giant Ant Financial is planning  a $30 billion initial public offering (in Hong Kong) at a $200 billion valuation.

And now these tensions come together in a farcical way around TikTok.

Most people see TikTok as a way for teens to socialize and negotiate popularity. It creates memes and celebrities through algorithmic recommendations. This isn’t Amazon or Well Fargo, by comparison.

To Donald Trump and the American national security apparatus, it’s a Trojan horse pulling private data and various functional information from a global user base of 1.5 billion people (80 million in the U.S.) into the machine learning maw of the Chinese Communist Party. It is hard to parse the claims around TikTok in a substantive way because we’re dealing with privileged intelligence. But I will note the following:

The middle road would suggest TikTok is indeed more aggressive in gathering user data for processing than the other social networks, but that it may have business or compliance reasons to do so. 

The American social networks are also keen to over-gather data, but they do so under a business model context they inherited out of the rise of the internet. Further, the current economic pressure from the virus is likely yielding unsavory jingoism and performative short-term punishment to distract from the presidential election in a historically stressful year.

With those issues out of the way, the interesting bit that remains is intellectual property and open source competition. This is the common complaint about Chinese business – that patents and copyrights are not respected and used for that nation’s betterment. If only they did not “steal” Western technology, they would not be so far ahead, goes the argument. I don’t quite buy it.

Competition in the next century is going to be far more complex than intellectual property ownership. It is going to be waged over multinational open-source networks.

In particular, I don’t quite buy it because of what is happening on Ethereum and public blockchains. You might have noticed that ETH and BTC had both strongly appreciated over the last week. There are many narratives floating around as to why this happened, but the most straightforward one is the rise of decentralized finance, with its $4 billion in collateralized lending. Another narrative would be the technical upgrade of Ethereum 2.0, which is meant to start going live shortly. Forgive me for talking about price. But in this case, it appears to be a nice proxy for adoption.

How was this technology able to grow, pulling in billions in financial assets and millions of users, without any protection on intellectual property at all? All of this is open-source software, which you can download, audit, copy (i.e., fork) and redeploy. It is a technology that has been under study in China for nearly five years and remains open, competitive and becomes only stronger when integrated into the Chinese Business Services Network.

The framework

Let’s establish a framework that creates a clear distinction between (1) a defensible network effect that accrues from operating a market, or a value chain of industry players, and (2) the maturity level of the technology itself. In the past, you would sequence the creation of the idea, building it from scratch, and then blitz-scaling it in a linear fashion. If it took a long time to create an idea, you would want legal protections that allowed you to then build it and profit from it. If somebody copied your idea immediately, it would appear that the time spent on research and development was essentially stolen. Thus, recourse to the law.

I often reread this article describing the Shenzhen manufacturing hub as “open-source manufacturing.” It articulates how Shenzhen rose to become a global leader in hardware, with Chinese firms building gadgets off Kickstarter before the original campaigns had even finished. Housing the factories that made branded Western goods, the Eastern generics had the same quality and came from the same assembly lines. The ideation phase of the entrepreneurial journey was skipped by copying, and resources were focused on lighting-fast execution.

In addition to having the manufacturing speed and engineering talent to actually build the goods, the firms also had another advantage. That advantage was a storefront on Alibaba, and a supply chain that powered a similar storefront on the Amazon marketplace. Thus, not only could something be made quickly, it could be sold on a platform with a built-in audience. It is this second part of the equation that most exacerbates the intellectual property complaint. If the entrepreneur had locked in its audience through brand affinity, the generics would not meaningfully matter.

But decentralized finance protocols, social media networks and marketplaces like Amazon and Alibaba demonstrate another principle. Even before you launch any particular product, you may be able to establish your niche and create a pre-commercial footprint, like a large, engaged following. Or, it could be your approved store profile on Amazon, or the inside track with the Apple iOS mobile application approval team, or an existing set of trading partners in institutional finance.

Take a moment to read this thread from the founder of the Synthetix protocol, a DeFi tool that allows people to create derivatives. It is an explanation of how to grow from $100 million to $500 million by engaging the community with economic participation.

Within the boundary of our framework, you start first by building out community participation through token distribution. People pay for the expectation of the delivery of the product and are aligned for the longer term. Then, you implement DAO (decentralized autonomous organization) governance, which drives engagement and allows the community to fix mistakes. The combination of the two recursively lands you into the upper right quadrant of a scalable software with a defensible market network.

Of course, this can go entirely wrong. The community might plunder a project instead of supporting it, like a management team paying itself bonuses in a leveraged buyout. There might be low participation and a lack of direction if an insufficient number of people are engaged. But at the very least we have a strategy.

This is similar to what incumbents do with their existing customer footprints. When rolling out new products, Facebook, Amazon, JPMorgan and the rest already have millions of people aligned with a brand tied to a commercial relationship. Launching a new product to this audience is orders of magnitude cheaper than acquiring users from scratch. And similarly, incumbents can capture innovation and ideation through corporate venture investments. This practically copies (or inexpensively acquires) product ideas for distribution.

Finally, we can see where copying a product without having an existing commercial community doesn’t have any positive effect. Take for example the forking of Bitcoin into Bitcoin Cash, or any other 50 or so clones of the coin. Or alternately, even the more contested forks like Ethereum Classic do not really compete for the dominant spot given the much smaller market presence.

When looking at prescription drug revenue, we can see that about 80% of it comes from brands and 20% from generics. This would be a fair assumption to carry over to our thought experiment about copying software.

Is it really worth it to posture about a global technology Cold War over 20% of the market? It is also possible that the 20% captured by the generics is a separate user niche entirely, with a different collection of preferences (e.g., more price sensitive), and therefore copying grows the overall pie.

So it goes

Let’s find a poetic end to the discussion.

Within a week or so, the project was copied in China, launched as YFII, and allegedly attracted several hundred million in crypto assets from large Asian investors. This caused a number of Western projects, like Balancer, to freak out and hide YFII from their interfaces (i.e., censor it) even though the code continued to execute on permissionless global networks. As people dug in further and tried to engage with the Chinese DeFi community, they saw a large WeChat group that was being used as a governance mechanism for the cloned project.

Was it a scam? Was it gambling? Was it a speculative project? Does it hurt the economic share of Yearn.Finance? Or does it open up a new market for ideas and exchange? Should DeFi projects censor scams, or imitation, or theft? 

I’d like to think there is a parallel world version of me, sitting in front of a screen on some late afternoon, agonizing over the human condition through the lens of fintech themes in another language. Maybe there is another *you* as well, reading that other text and wondering about your own twin in a strange culture.

What we twins have to agree on is that blockchain networks, open-source software, the Shenzhen manufacturing process, the Chinese blockchain services network, an increase in venture capital funding, and national software technology budgets have radically transformed the nature of competition. It’s not enough to have an idea and linearly bring it to the local market. We are playing on a different scale, with incentives and guidelines that look alien at first glance. Yet, this mutual discovery and the journey around it are a risk worth taking.