Sequoia Productive Capital

Wednesday, October 27, 2021Wednesday, October 27, 2021

Two weeks ago, in The Death and Birth of Technological Revolutions,¹ I puzzled about exactly where we were in the Age of Information and Telecommunications: were we still in the turning point, as Carlota Perez, the author of Technological Revolutions and Financial Capital believes; into the Synergy phase of Deployment, where society re-organizes itself around the new paradigm; or into the Maturity phase where the current technological era starts to fizzle out, even as the next era starts to take root?

While my tentative conclusion at the end of that piece was that we were entering the Maturity phase, over the last couple of weeks I have increasingly come to believe that we are earlier in the cycle than I suggested: we have exited the turning point, and are firmly in the Synergy phase.

Evidence of Synergy

Perez identified six elements of her model that are transformed in a technological revolution:

Here are some brief comments about a few of these, before I spend more time on financial capital and production capital.

Technological Revolution

The culmination of the current technological paradigm is mobile + cloud; I already made the case in 2020’s The End of the Beginning that tech history was best understood as consisting not of multiple eras — mainframes, PCs, mobile, etc. — but rather as a multi-decade transformation from a computer-as-destination to computing-as-background:

This last point gets at why the cloud and mobile, which are often thought of as two distinct paradigm shifts, are very much connected: the cloud meant applications and data could be accessed from anywhere; mobile made the I/O layer available anywhere. The combination of the two make computing continuous.

What is notable is that the current environment appears to be the logical endpoint of all of these changes: from batch-processing to continuous computing, from a terminal in a different room to a phone in your pocket, from a tape drive to data centers all over the globe. In this view the personal computer/on-premises server era was simply a stepping stone between two ends of a clearly defined range.

It’s arguable that concepts like metaverses represent one final step down this path, and the final unification of the cloud and interaction; I don’t think that means we aren’t in the deployment period technologically speaking though: continuous computing is here (even if it might become even more immersive).

Techno-Economic Paradigm

In line with the nature of continuous computing, the techno-economic paradigm is Everything as a Service, a concept I wrote about in 2016:

Services sound a lot like software: both are intangible, both scale infinitely, and both are infinitely customizable. It follows that a services business model — payment in exchange for service rendered, without the transfer of ownership — is a much more natural fit for software than the transaction model characteristic of manufacturing. It better matches value generated and value received — customers only pay if they use it, and producers are rewarded for making their product indispensable — and more efficiently allocates fixed costs: occasional users may be charged nothing at all, while regular users who find your software differentiated pay more than the marginal cost of providing it.

The services business model is obviously dominant in terms of software: all new software companies are SaaS companies, and old-line companies like Microsoft and Adobe have long since transformed their licensing-based business models to the SaaS business model. All of these businesses make huge investments in fixed costs (building the software), and reach profitability by leveraging the zero marginal cost nature of software and the Internet to scale as large as possible as quickly as possible.

Meanwhile, all of these new companies operating with a SaaS model themselves depend on public clouds like AWS, which has the exact same model, just at even larger scale: gargantuan investments in fixed costs, made profitable by leveraging the zero marginal cost nature of software and the Internet to scale as large as possible as quickly as possible.

This isn’t just an enterprise story, though: huge consumer platforms like Facebook or Netflix are themselves services, operated on the same business model of massive investments in fixed costs, scaled via the zero marginal cost nature of the Internet. Of course the monetization may differ: Netflix charges a subscription, which aligns payment (continuous) with the delivery of value (continuous). Facebook monetizes via ads:

Some of these ads are for subscription-based services
Some of these ads are for other digital businesses like games based on the same economic principles
Some of these ads are for e-commerce

E-commerce might seem like an exception to the services narrative, but while you do get to keep the goods that are delivered, everything about how e-commerce functions is as a service. Shopify has made huge investments in fixed costs to provide a selling platform for goods that are stored in rented space in 3PL warehouses and delivered by companies like Fedex for a fee, which is another way of saying payment for services.

Here again Amazon is the ultimate example of this model: the company has made massive investments in everything from its online store to its distribution centers to even its own planes and delivery vehicles, and an ever-increasing share of its e-commerce revenue comes from merchants effectively renting access to the entire stack; merchants are still selling goods, and consumers are still receiving them, but everything in the middle is a software-driven service with a software-derived business model.

Local services are being impacted as well: Uber, Doordash, Instacart, etc. are only possible in a world of massive compute capacity and ubiquitous smartphones; this enables customers to order cars or food from anywhere, and drivers or delivery workers to know where to go and what to bring. This goes hand-in-hand with the COVID-driven rise in remote work: yes, only a portion of society has the luxury to work from anywhere (probably because they work in a digital services industry), but what is notable is the transformation of manual labor, from Amazon warehouses to Doordash delivery drivers, that has arisen to serve their needs.

Socio-Institutional Framework

This was the primary focus of my previous Article. Perez has long been puzzled by the seeming lack of response by governments to the new technological paradigm; I think that response is coming into sharp focus, but it is easily missed because it is rather dystopian:

What is worth noting, though, is that you can make the case that China has entered the Synergy phase in which government has aligned with technology to profoundly impact China’s citizens. That this entails mass surveillance, censorship, and propaganda doesn’t undo Perez’s thesis; it perhaps punctures her optimism.

There are signs a weaker, yet in some ways similar, form of synergy has happened in the U.S. as well; soon after the Dotcom Bubble came the Patriot Act, and while the political motivations were the 9/11 terrorist attacks, the implementation was very much about leveraging technology for government ends. The extent of this synergy only became clear in 2013 when the Snowden revelations exposed a vast web of surveillance conducted by tech and telecommunications companies in partnership with the NSA.

Then, over the last several years, there has been a concerted effort to push tech companies to increasingly limit misinformation on their networks, and post corrective information instead; it doesn’t take much squinting to re-label both efforts as censorship and propaganda. This is not, I would note, to pass judgment as to whether those efforts are right or wrong (although I am skeptical); merely to note that there may be more evidence of synergy between the government and tech than it seems. It’s all a bit dystopian, to be sure, but revolutions by their nature are unpredictable; it wasn’t a certainty that liberal democracy would triumph in the fourth revolution, much less the current one.

There is also an argument to be made that the dramatic shift in monetary policy over the last 13 years — prompted by the Great Recession, but interestingly enough perfectly aligned with the smartphone era — is itself evidence of synergy: tech is inherently deflationary, which could be balancing out the inflationary potential of printing new money. This, needless to say, is a very complex topic, which is why I didn’t include it in my previous article; consider this paragraph as a point of speculation.

Financial Capital and Production Capital

One of the most important principles in Perez’s model is the difference between Financial Capital and Production Capital and the roles they play in the Installation period versus the Deployment period (just look at the name of the book!). Perez explains:

Financial capital is mobile by nature while production capital is basically tied to concrete products, both by installed equipment with specific operational capabilities and by linkages in networks of suppliers, customers or distributors in particular geographic locations. Financial capital can successfully invest in a firm or a project without much knowledge of what it does or how it does it. Its main question is potential profitability (sometimes even just the perception others may have about it). For production capital, knowledge about product, process and markets is the very foundation of potential success. The knowledge can be scientific and technical expertise or managerial experience, it can be innovative talent or entrepreneurial drive, but it will always be about specific areas and only partly mobile…

All these distinctions lead to a fundamental difference in level of commitment. Financial capital is footloose by nature; production capital has roots in an area of competence and even in a geographic region. Financial capital will flee danger; production capital has to face every storm by holding fast, ducking down or innovating its way forward or sideways. Yet, though the notion of progress and innovation is associated with production capital – and rightly so – ironically when it comes to radical change, incumbent production capital can become conservative and then it is the role of financial capital (whether from family, banks or ‘angels’) to enable the rise of the new entrepreneurs.

Financial capital is critical in the Installation period of a technological revolution. Because it is mobile and seeking a return it flows to new technologies that are just emerging; in the case of the current era that meant chips, then software, then services. Financial capital is also highly speculative, and provokes a frenzy that leads to a bubble, which is exactly what happened in the Dot Com era.

Production capital, on the other hand, is harvested from profitable businesses that re-invest their earnings to improve their products and expand their markets during the Deployment period. This has clearly been happening with the largest tech companies: one of the best investments one could have made over the last decade would have been stock in Apple, Microsoft, Google, Amazon, and Facebook, not because they needed investor capital, but because they were so generating such exceptional returns from reinvesting their own profits.

Indeed, the fact that the big 5 tech companies were so clearly powered by production capital is one of the reasons why I have always been skeptical that we are still stuck in the Turning Point; at the same time, it is not as if the venture capital industry had disappeared.

Financial Capital = Venture Capital

Venture capital is another name for Financial capital; Perez writes:

As far as truly new ventures are concerned, innovators may have brilliant ideas for which they are willing to take huge risks, devoting their whole lives to bringing their projects to reality, but if finance is not forthcoming they can do nothing.

This is how I described venture capital in 2015’s Venture Capital and the Internet’s Impact:

In the case of startups, during the 45 years after Arthur Rock founded the first venture capital partnership in 1961, the vast majority of new firms needed significant funding from day one. Hardware startups of course needed specialized equipment, the funds to make prototypes, and then to set up actual manufacturing lines, but software startups, particularly those with any sort of online component, also needed to make significant hardware investments into servers, software that ran on said servers, and a staff to manage them. This was where the venture capitalists’ unique skill-set came into play: they identified the startups worthy of funding through little more than a PowerPoint and a person, and brought to bear the level of upfront capital necessary to make that startup a reality.

The point of that article, however, was to explain how AWS — a service — was transforming venture capital; now new products could be built in someone’s bedroom, leading to the rise of angels writing much smaller checks to much smaller teams achieving much larger impact much more quickly than ever before. This made a venture capitalist’s job easier in the short term — now they were writing checks based on existing products and growth metrics, instead of PowerPoints — but in the long run it meant that venture capital was becoming commoditized.

The story doesn’t end there: the trouble for venture capitalists is that they are getting squeezed from the top of the funding hierarchy as well: a new class of growth investors, many of them made up of traditional limited partners like Fidelity and T. Rowe Price, are approaching unicorn companies on a portfolio basis…Sure, this is relatively dumb money, but that’s where those angel and incubator relationships come in: if startups increasingly feel they have the relationships and advice they need, then growth funding is basically a commodity, so why not take dumb cheap money sooner rather than later?

Interestingly, just as in every other commodity market, the greatest defense for venture capitalists turns out to be brand: firms like Benchmark, Sequoia, or Andreessen Horowitz can buy into firms at superior prices because it matters to the startup to have them on their cap table. Moreover, Andreessen Horowitz in particular has been very open about their goal to offer startups far more than money, including dedicated recruiting teams, marketing teams, and probably most usefully an active business development team. Expect the venture capitalist return power curve to grow even steeper.

Brand, though, can only resist commoditization for so long; a16z in particular has dramatically accelerated its growth, and now the most famous brand name of all is going even further.

Sequoia’s Transformation

Sequoia Partner Roelof Botha wrote yesterday on Medium:

Innovations in venture capital haven’t kept pace with the companies we serve. Our industry is still beholden to a rigid 10-year fund cycle pioneered in the 1970s. As chips shrank and software flew to the cloud, venture capital kept operating on the business equivalent of floppy disks. Once upon a time the 10-year fund cycle made sense. But the assumptions it’s based on no longer hold true, curtailing meaningful relationships prematurely and misaligning companies and their investment partners. The best founders want to make a lasting impact in the world. Their ambition isn’t confined to a 10-year period. Neither is ours…

Today, we are excited to announce our boldest innovation yet to help founders build enduring companies for the 21st century. In our U.S./Europe business, we are breaking with the traditional organization based on fund cycles and restructuring Sequoia Capital around a singular, permanent structure: The Sequoia Fund.

Moving forward, our LPs will invest into The Sequoia Fund, an open-ended liquid portfolio made up of public positions in a selection of our enduring companies. The Sequoia Fund will in turn allocate capital to a series of closed-end sub funds for venture investments at every stage from inception to IPO. Proceeds from these venture investments will flow back into The Sequoia Fund in a continuous feedback loop. Investments will no longer have “expiration dates.” Our sole focus will be to grow value for our companies and limited partners over the long run.

This announcement, in Perez terms, is as clear as could be: Sequoia is transforming itself from financial capital to production capital. Instead of LP’s investing in funds that make speculative investments in risky endeavors, Sequoia wants to keep long-term positions in companies that have proven business models and are embarking on the decade (or longer) process of improving their products and expanding their markets to the entire world.

This also, I suspect, represents the formation of a sort of “Silicon Valley Inc.”; while the big 5 can entirely self-fund, the nature of the SaaS business model is such that companies with proven product-market fit are better off losing more money up-front rather than less:

Customers, once acquired, are like annuities that make money years into the future, but the cost to acquire them has to be paid up front.
The core software product represents a huge fixed cost investment that is leveraged by scaling to as many customers as possible.

The combination of these two factors means that SaaS companies take longer to self-fund, even if their models are proven; what Sequoia can do with their model is invest in an entire portfolio of these companies and hold onto them indefinitely, effectively recycling money from mature companies into nascent ones, much as Apple or Microsoft invests profits from their current products into the development of new ones. On an individual company level it looks like venture/financial capital; as a collective it is much more akin to production capital, especially once you realize that many of these companies, thanks to angels and AWS, are already fairly de-risked.

Moreover, while Sequoia’s announcement feels so momentous because of their long history in the Valley, institutions like Tiger Capital are already playing the exact same game; the era of production capital is firmly upon us, which means we are clearly in the Deployment period of Perez’s model.

Growth and Crypto

In Perez’s model the Growth element in the Deployment period means “converging growth of most industries using [the new] paradigm”; that seems inconsistent with a reality where tech continues to provide a huge amount of growth relative to the rest of the economy.

I think, though, that is a problem of definition: we still have a habit of calling everything that runs on a SaaS model a tech company, even if the actual industry or service being rendered isn’t about tech at all. Is Warby Parker a tech company? Is Carvana? Is DoorDash? The list goes on-and-on: new companies are created using technology, but of course they are! Calling everything a tech company is like calling a shopping mall a car company; sure, it was enabled by and undergirded by the automobile, but what in that era wasn’t? To return to The End of the Beginning:

Indeed, this is exactly what we see in consumer startups in particular: few companies are pure “tech” companies seeking to disrupt the dominant cloud and mobile players; rather, they take their presence as an assumption, and seek to transform society in ways that were previously impossible when computing was a destination, not a given. That is exactly what happened with the automobile: its existence stopped being interesting in its own right, while the implications of its existence changed everything.

That leaves the question of crypto; given its oppositional nature to the current paradigm — decentralization, encryption, and ownership — it is clearly something completely new; moreover, the capital chasing returns in crypto is clearly financial capital, not production capital.

It’s certainly possible for a new paradigm to emerge alongside an existing paradigm; Perez notes on multiple instances her model is stylized, and details multiple periods of overlap. What is notable, though, is that crypto draws talent from the same pool that drives the IT revolution, and it’s unclear what the impact of this drain will be on the current paradigm. The optimistic take is that the shift to remote work will dramatically increase the available talent pool to tech-companies-that-are-actually-just-companies, and it’s one I share: the opportunity now is in new markets, not new tech, and open source software, along with public clouds, provides a strong foundation for any new company.

That suggests that crypto will continue to exist in a bit of a parallel universe, which makes sense; it already has its own currencies, after all. That is another way of saying I think that crypto is still very early in its lifecycle; 2017 wasn’t the big crash, nor will the next one be — remember that tech had its own internal boom-and-bust cycles in the three decades between the introduction of the Intel processor and the Dotcom bubble. Nor is this a bearish take: those three decades were exceptionally profitable for everyone involved — including Sequoia, which was founded in 1972. Perhaps its successor, the one that shifts to providing productive capital for crypto companies decades from now, has already been born.

Do read that piece first, if you haven’t, and Jerry Neumann’s overview of Perez’s theory. ↩

The Death and Birth of Technological Revolutions

Tuesday, October 12, 2021Wednesday, October 13, 2021

What was especially remarkable about Carlota Perez’s Technological Revolutions and Financial Capital was its timing: 2002 was the middle of the cold winter that followed the Dotcom Bubble, and here was Perez arguing that the IT revolution and the Internet were not in fact dead ideas, but in the middle of a natural transition to a new Golden Age.

Note: the following is a woefully incomplete summary of what is a brilliant — and very readable — book. Jerry Neumann has written an excellent overview of Perez’s theory at Reaction Wheel; I highly recommend reading that first if you are unfamiliar with Perez’s work.

Perez’s thesis was based on over 200 years of history and the patterns she identified in four previous technological revolutions:¹

The Industrial Revolution began in Great Britain in 1771, with the opening of Arkwright’s mill in Cromford
The Age of Steam and Railways began in the United Kingdom in 1829, with the test of the ‘Rocket’ steam engine for the Liverpool-Manchester railway
The Age of Steel, Electricity and Heavy Engineering began in the United States in 1875, with the opening of the Carnegie Bessemer steel plant in Pittsburgh, Pennsylvania
The Age of Oil, the Automobile, and Mass Production began in the United States in 1908, with the production of the first Ford Model-T in Detroit, Michigan
The Age of Information and Telecommunications began in the United States in 1971, with the announcement of the Intel microprocessor in Santa Clara, California

Perez’s argument was that the four technological revolutions that proceeded the Age of Information and Telecommunications followed a similar cycle:

However, this process is usually disjointed; Perez writes:

In real life, the trajectory of a technological revolution is not as smooth and continuous as the stylized curve presented in Figure 3.1. The process of installation of each new techno-economic paradigm in society begins with a battle against the power of the old, which is ingrained in the established production structure and embedded in the socio-cultural environment and in the institutional framework. Only when that battle has been practically won can the paradigm really diffuse across the whole economy of the core nations and later across the world…

In very broad terms, each surge goes through two periods of a very different nature, each lasting about three decades.

As shown in Figure 4.1, the first half can be termed the installation period. It is the time when the new technologies irrupt in a maturing economy and advance like a bulldozer disrupting the established fabric and articulating new industrial networks, setting up new infrastructures and spreading new and superior ways of doing things. At the beginning of that period, the revolution is a small fact and a big promise; at the end, the new paradigm is a significant force, having overcome the resistance of the old paradigm and being ready to serve as propeller of widespread growth.

The second half is the deployment period, when the fabric of the whole economy is rewoven and reshaped by the modernizing power of the triumphant paradigm, which then becomes normal best practice, enabling the full unfolding of its wealth generating potential.

What made Perez’s observation so trenchant in 2002 is that part in the middle: the turning point.

The Post-Dotcom Era

While the Installation Period begins with irruption as new technology emerges in pursuit of real world applications, it eventual transitions into a full-blown frenzy as speculative capital pursues increasingly fantastical commercial applications.

Reality, though, catches up, and the bubble pops.

This financial frenzy is a powerful force in propagating the technological revolution, in particular its infrastructure, and enhancing – even exaggerating – the superiority of the new products, industries and generic technologies. The ostentation of success pushes the logic of the new paradigm to the fore and makes it into the contemporary ideal of vitality and dynamism. It also contributes to institutional change, at least concerning the ‘destruction’ half of creative destruction.

At the same time, as mentioned before, all this excitement divides society, widening the gap between rich and poor and making it less and less tenable in social terms. The economy also becomes unsustainable, due to the appearance of two growing imbalances. One is the mismatch between the profile of demand and that of potential supply. The very process by which intense investment was made possible by concentrating income at the upper end of the spectrum becomes an obstacle for the expansion of production of any particular product and for the attainment of full economies of scale. The other is the rift between paper values and real values. So the system is structurally unstable and cannot grow indefinitely along that path.

With the collapse comes recession – sometimes depression – bringing financial capital back to reality. This, together with mounting social pressure, creates the conditions for institutional restructuring. In this atmosphere of urgency many of the social innovations, which gradually emerged during the period of installation, are likely to be brought together with new regulation in the financial and other spheres, to create a favorable context for recoupling and full unfolding of the growth potential. This crucial recomposition happens at the turning point which leaves behind the turbulent times of installation and paradigm transition to enter the ‘golden age’ that can follow, depending on the institutional and social choices made.

This certainly seems to describe the Dotcom Bubble, which was not only destructive to speculators directly but the economy broadly, even as its excesses, particularly in terms of broadband build-up, funded the infrastructure that would fuel the Internet over the next two decades. And, by extension, those two decades would seem to be the Golden Age of the “Deployment Period.” That certainly seems to be the case with technological dispersion: today over four billion people have access to the Internet, and thanks to the global nature of the web, those in developing countries can consume and create on the same platforms as the most well off.

Moreover, the “Capital” part of Perez’s theory seems to fit as well: some of the best returns over the last fifteen years have been in established public companies like Apple, Microsoft, Google, Amazon, and Facebook — “Production Capital”, in Perez’s nomenclature. Venture capital, meanwhile, which is theoretically speculative “Financial Capital”, has increasingly become professionalized and standardized, thanks in part to the rise of cloud platforms like AWS; building a new SaaS company to take on another old-world vertical certainly takes hard work, but the playbook is fairly well-known.

This was my thinking behind 2020’s The End of the Beginning; I wasn’t thinking of Perez when I wrote that, to be honest, even though I reached for the automobile example. It just seemed clear to me that the post Dotcom Bubble era had reached its natural endpoint as far as market structure was concerned; whatever came next would look significantly different.

Perez disagrees.

The Imminent Golden Age

While the introduction to Technological Revolutions and Financial Capital makes the case that the Dotcom Bubble was the Turning Point, Perez now thinks we are still waiting for the Golden Age — and that there may be another crash in the future (Perez now includes the Great Recession as part of the current revolution’s Turning Point).

I respect your view. Theories belong to the public. But I see the present as the 1930s, the turning point of the IT surge. We have had 2 frenzies and we have not yet had a golden age. The power of AI, IoT, 3D, robots, blockchain is there to be shaped https://t.co/FybfqgLJLM

— Carlota Perez (@CarlotaPrzPerez) March 31, 2019

Perez’s link is to the Financial Times’ Tech Tonic podcast; the pertinent part starts at the 3:48 mark:

The important thing is that the previous revolutions had the Golden Age after the recession that follows the crash. And we could now perhaps have a global sustainable Golden Age. I think it is perfectly possible with the current technologies.

What would be necessary to bring that Golden Age about? How do we need to tilt the playing field to make that happen?

Well “tilt the playing field” is the word. The first thing we have to understand is that every Golden Age has had to do with social-political choices made by governments, because capitalism really only becomes legitimate when the greed of some is for the benefit of the many.

I think in order to tell you what needs to happen next time I have to give you an example from the past, because otherwise we don’t learn anything from history, and that’s why it’s important to understand how revolutions happen before. The mass production revolution brought the post-War boom. Now what happened then? If we look at the 1930s, we have some similarities with today. We see xenophobia, we see a lot of people angry and following at that time fascism and communism, now all sorts of extremisms right and left, leaders that really offer heaven even though they cannot delivery, but the whole thing is that people are angry and disappointed.

But you also have something else which is very important, which is that there is an enormous technological potential which is not being used. Not enough investment is going in the possible innovations because there is not enough demand, and demand is normally created by some policies. But it has to be policies that are adequate for that particular revolution. So what was the previous revolution? It was about mass production. So what was the direction in which it was tilted?

Well, first of all it was the World War. And with the World War it was obvious that producing a lot of weapons made a lot of good business sense. They became cheaper and better and so on. But then at the end of the war, governments did something very important: they created a set of policies that favored suburbanization. Before the automobile you had railways, so you only had stations, and the land in-between was very cheap, it had no way of being used. But once you have the automobile you can build cheap mass-produced houses to put lots of electrical appliances inside and the car at the door. And at the same time governments made the welfare state so that workers could buy those houses. So you have home ownership and consumerism, that’s one of the directions, and the other direction was the Cold War of course, so that you had innovation going in the two directions.

If we had stayed in what was visible in the 30s, it was very difficult to imagine this Golden Age that came after the war. The same thing is happening to us now. In order to get the technologies to go in the right direction, you’ve got to tilt the playing field, and I hold that the most effective way of doing that today is tilting it towards ‘Green’.

Perez’s view on how a focus on “Green” policies could fuel a Golden Age are well fleshed-out in papers like A Smart Green ‘European Way of Life’: the Path for Growth, Jobs and Wellbeing; one insight that I find very compelling is that the demand that drives job growth is less about the technology itself and more about the new lifestyle that the technology enables (just like suburbanization drove the previous revolution).

It’s worth noting, though, that Perez has a somewhat darker interpretation of the 1930’s in Technological Revolutions and Financial Capital (emphasis mine):

Regarding recovery in the 1930s, one cannot look at the USA only. In Germany, with Hitler’s rise to power, the institutional framework was reoriented to facilitate the development of mass production (and later of mass destruction and genocide). The war economy that began after 1933 in Germany could be seen as a synergy phase of a sort. Fortunately, the Nazis failed to conquer Europe and lost the war; otherwise, National Socialist Germany might have been the center of a longer-lasting fascist world. At that same time, the Soviet economy too was developing very fast with another mode of growth that was also capable of intensively deploying mass production. This wide range of options for the deployment of that particular paradigm — including the Keynesian democracies that will have the USA as their core — is an indication of how much is at stake and how much is decided about the future of each country and of the world at the turning point of each surge.

This isn’t a throwaway observation; Perez’s chart of technological revolutions is clear that the U.S. and Europe were on different timelines:

The implication of this observation is that the “Synergy” phase is amoral; it is not guaranteed that the alignment of government with the new technological revolution and its resultant impact on people leads to a “better” outcome as far as liberal democracy is concerned. Perez noted in a footnote:

The mass-production revolution, which marked most of the institutions of the twentieth century, underlay the centralized governments and massive consumption patterns of the four great modes of growth that were set up to take advantage of those technologies: the Keynesian democracies, Nazi-fascism, Soviet socialism and State developmentalism in the so-called ‘Third World,’ each with very wide-ranging specificities.

Synergies are not always golden.

The China Model

Another observation from Perez is that new technological revolutions create the conditions for newcomers to “leapfrog”:

In periods of paradigm shift there is a window of opportunity for real catching up as well as for forging ahead. Belgium, France and the USA caught up in the installation period of the second surge; Germany and the USA forged ahead in that of the third. Most of Europe, Japan and the Soviet Union, caught up in the fourth (though the latter fell dramatically behind with the fifth).

This is where the absence of China from Technological Revolutions and Financial Capital is notable. The only mention is in the postscript:

Yet, in the globalized world of the present paradigm, demand is also global. The best promise of massive market expansion would seem to be in the incorporation of more and more countries to global growth, investment, production and consumption. Growth in the larger countries of the developing world, together with China, Russia and the ex-socialist group of Eastern Europe, could serve as a first tier to pull the others forward. It is quite obvious that these potentially huge markets are a very long way from saturation.

This was a view reflective of the era in which it was written, in which it was assumed that the Internet, in conjunction with globalization, would liberalize and ultimately democratize China. In 2000, President Bill Clinton, upon the occasion of the establishment of Permanent Normal Relations with China said in a speech:

When China joins the W.T.O., by 2005 it will eliminate tariffs on information technology products, making the tools of communication even cheaper, better, and more widely available. We know how much the Internet has changed America, and we are already an open society. Imagine how much it could change China.

Now there’s no question China has been trying to crack down on the Internet. (Chuckles.) Good luck! (Laughter.) That’s sort of like trying to nail jello to the wall. (Laughter.) But I would argue to you that their effort to do that just proves how real these changes are and how much they threaten the status quo. It’s not an argument for slowing down the effort to bring China into the world, it’s an argument for accelerating that effort. In the knowledge economy, economic innovation and political empowerment, whether anyone likes it or not, will inevitably go hand in hand.

Things obviously didn’t work out that way; if anything the Internet has allowed China to push its values onto Americans. What is worth noting, though, is that you can make the case that China has entered the Synergy phase in which government has aligned with technology to profoundly impact China’s citizens. That this entails mass surveillance, censorship, and propaganda doesn’t undo Perez’s thesis; it perhaps punctures her optimism.

There are signs a weaker, yet in some ways similar, form of synergy has happened in the U.S. as well; soon after the Dotcom Bubble came the Patriot Act, and while the political motivations were the 9/11 terrorist attacks, the implementation was very much about leveraging technology for government ends. The extent of this synergy only became clear in 2013 when the Snowden revelations exposed a vast web of surveillance conducted by tech and telecommunications companies in partnership with the NSA.

Then, over the last several years, there has been a concerted effort to push tech companies to increasingly limit misinformation on their networks, and post corrective information instead; it doesn’t take much squinting to re-label both efforts as censorship and propaganda. This is not, I would note, to pass judgment as to whether those efforts are right or wrong (although I am skeptical); merely to note that there may be more evidence of synergy between the government and tech than it seems. It’s all a bit dystopian, to be sure, but revolutions by their nature are unpredictable; it wasn’t a certainty that liberal democracy would triumph in the fourth revolution, much less the current one.

A Crypto Revolution?

As the tweet above makes clear, Perez relishes debate about her theories; I am one of many writers on the Internet who have had the distinct pleasure of getting an email out of the blue from Perez, and having a conversation where she pushes and prods to understand the other’s point of view, confident it will make her theses stronger.

And, in that spirit, I have to confess I’m not sure if this rebuttal to Perez’s current position — my sense that we are in the maturation phase of the technological revolution, complete with government synergy — is correct or not. Perez has noted that COVID-19 could end what she thinks is the elongated turning point era, much like World War II ended the elongated turning point era of the previous revolution (at least in the U.S.). It is notable, for example, that the tech industry has also been an essential element in various government lockdown strategies during the COVID pandemic, most obviously by making it possible for the economy to continue to function while people work from home, and also in enabling a work-from-home lifestyle via e-commerce and food delivery services, with all of the commensurate jobs entailed in providing these services. That is a fundamental change to society that is only getting started — perhaps a new Golden Era is in fact imminent.

At the same time, it is notable that crypto, the most obvious candidate for the next technological revolution is not — contra Perez — an obvious extension of the current era. The overarching story of Stratechery has been the rise and consolidation of the aforementioned Big 5 tech companies, and the entire premise of Aggregation Theory is the inevitability of centralization in a world of frictionless abundance. Crypto, though, is about the introduction of scarcity; its payoff is decentralization, at the cost, at least for now, of convenience and speed.

Perez writes in Technological Revolutions and Financial Capital about what the Maturity phase looks like:

This is the twilight of the golden age, though it shines with false splendor. It is the drive to maturity of the paradigm and to the gradual saturation of markets. The last technology systems and the last products in each of them have very short life cycles, since accumulated experience leads to very rapid learning and saturation curves. Gradually the paradigm is taken to its ultimate consequences until it shows up its limitations.

Yet, all the signs of prosperity and success are still around. Those who reaped the full benefits of the ‘golden age’ (or of the gilded one) continue to hold on to their belief in the virtues of the system and to proclaim eternal and unstoppable progress, in a complacent blindness, which could be called the ‘Great Society syndrome’. But the unfulfilled promises had been piling up, while most people nurtured the expectation of personal and social advance. The result is an increasing socio-political split…this is a time when deep questions about the system are being asked in many quarters; the climate is favorable for politics and ideological confrontations to come to the fore. The social ferment can become intense and is sometimes quelled with social reforms.

Meanwhile, in the world of big business, markets are saturating and technologies maturing, therefore profits begin to feel the productivity constriction. Ways are being sought for propping them up, which often involve concentration through mergers or acquisitions, as well as export drives and migration of activities to less-saturated markets abroad. Their relative success makes firms amass even more money without profitable investment outlets. The search for technological solutions lifts the implicit ban on truly new technologies outside the logic of the now exhausted paradigm. The stage is set for the decline of the whole mode of growth and for the next technological revolution.

That seems awfully descriptive of the current era, no? Products that break through reach saturation in record time (see TikTok reaching a billion users in three years, or DTC companies that seem to max out in only a couple of years), while the future of established companies seems to be quagmire in legislators and the courts, even as profits continue to pile up without obvious places to invest. And if the government’s response to the revolution has been disappointing, that also may be because of the revolution itself.

Moreover, to the extent the dystopian picture above is correct — that the real synergy has been between centralized governments and centralized tech companies, to the alarm of both those abroad and in the U.S. — the greater the motivation there is to make the speculative investments that drive the next paradigm, especially if that paradigm operates in direct opposition to the current one. To be sure this framework does imply that crypto is full of scams and on its way to inflating a spectacular bubble, the aftermath of which will be painful for many, but that is both expected and increasingly borne out by the facts as well. What will matter for the future is how much infrastructure — particularly wallet installation — can be built-out in the meantime.

For what it’s worth my suspicion is that the current Installation period for crypto — if that is indeed where we are — has a long ways to run, which is another way of saying most of the economy will remain in the current paradigm for a while longer. The time from the Intel microprocessor to the Dotcom Bubble bursting was 30 years (and, it should be noted, there were a lot of smaller, more localized bubbles along the way); Satoshi Nakamoto only published his paper in 2008. Thirteen years after 1971 was 1984, the year the Mac was introduced; the browser was another 9 years away. It’s one thing to see the future coming; it’s something else entirely to know the timing. On that Perez and I can certainly agree.

I wrote a follow-up to this Article in this Daily Update.

This list is transcribed from the second Table 2.1 — there are two — on page 11 of 2014 paperback edition of Technological Revolutions and Financial Capital ↩

Facebook Political Problems

Wednesday, October 6, 2021Monday, October 11, 2021

Stratechery provides analysis of the strategy and business side of technology and media, and the impact of technology on society.

So begins my about page, and there is no company that expands to fill the space afforded by that description quite like Facebook. This does, on one hand, provide for endless amounts of content, much of which, frankly, I would like to move on from; it also means that writing about one aspect of Facebook is fraught with risk: just because you defend one aspect, or attack another, does not mean one is making a comment on the entirety of the corporate beast. Word limits, though, are a thing — yes, even on the web — which means that one can never cover all of one’s bases in any one individual article.¹

So consider this piece self-service, of sorts: this Article will be what I link to in future posts with the caveat, “I’m not talking about Facebook political issues today; if you want my big-picture take follow this link.”

Which will take you here.

A quick aside about timing: this post is being written the day after Frances Haugen appeared before Congress; I’m not writing about her testimony specifically, as I felt it covered very little new ground. Saying as much, though, did seem to prompt a lot of misunderstanding and, frustratingly, allegations of bad faith, which, optimistically, might have been alleviated by a link to an article like this one.

What I did want to do is — word limit be damned — write a post about Facebook’s political problems, as I perceive them, in their entirety. I do think the media gets a lot of things wrong about Facebook, not because there aren’t problems, but because the problems are more profound than the issue of the day. So here’s my best shot.

Facebook’s Benefit

This is perhaps an odd place to start, but it cuts to the core of why I do see real benefits to Facebook’s existence in the world, and is an important part of the trade-off calculations I make in the sections that follow.

I believe that the economy of the future will, if we don’t stifle it along the way, look considerably different than the post World War II order dominated by large multinational corporations whose differentiation was predicated on distribution. Instead the future looks more like a rainforest, with platforms that span the globe and millions of niche businesses that sit on top.

I am, given my career, biased in this regard, but the rise of platforms like Shopify, Etsy, Substack, and the App Store is evidence that new careers can be built and untold niches filled when the entire world is your addressable market. The challenge in a worldwide market, though, is finding the customers who are interested in the niche being filled; this is where Facebook’s ad offering is very much a platform in its own right.

Facebook, via its integration with a host of third party sites and apps, makes it possible for those sites and apps to collectively understand and target prospective customers with the same sort of proficiency that first-data powerhouses like Google and Amazon do, and they don’t need to hold or understand any third-party data to do so. It is difficult to overstate what a big deal this is: suddenly a Shopify merchant can compete with Amazon, a D2C startup with Unilever, or a blog with the New York Times.

Moreover, Facebook’s platform, unlike many of its competitors, is entirely automated and auction-driven; that means that small businesses have the same shot at customers as their far larger competitors do. Facebook is also very adept at simplifying the process (in exchange for more margin, of course): simply specify how much a customer is worth to you, and Facebook will deliver that customer. It’s an advertising platform that truly levels the playing field, and I think it is a very good thing for the world.

Perceived Problem One: Privacy

The flipside of Facebook’s advertising platform is the reality that the company absolutely does ingest huge amounts of data. It is worth noting, though, that a big chunk of the most private human readable data is content that users give Facebook themselves when they use the site; Facebook combines that with all of the data it collects in all of those connected apps and sites — which are primarily about measuring conversions — in its Data Factory to create machine-learning driven profiles that undergird its advertising. What Facebook does not do is sell user data, not only because data undergirds its advertising business, but also because nearly all of that data would be unintelligible and worthless to any entity other than Facebook.

As I noted in Privacy Fundamentalism, it is tempting to imagine this data as being something akin to a file of your life just laying around for anyone to peruse; Apple has implied precisely this with some of its recent ads. The reality, though, is far more mundane: the nature of computers and the Internet is the spewing of data everywhere, and it is only in aggregate, in a data factory, than any insight from this collection of vectors can be derived, and only then in the context of a larger application like targeted advertising conducted at massive scale. It is exceedingly unlikely that Facebook could even make the data about any one individual readable by a human, and there is no incentive to do so; not only do third party apps and sites have no need nor desire for individual level data, neither do advertisers — Facebook’s entire value to both is as a matchmaker at scale.

To my mind, the reality of data on Facebook is well worth the trade-off for the value Facebook’s advertising delivers to niche-focused businesses. Moreover, I feel much better about Facebook as a data mediator than about modular advertising stacks where data really is bought and sold. I do understand that lots of folks disagree with me on this point, but again, everything is a trade-off, and I think this one is worth it.

Perceived Problem Two: Competition

The core of my Framework for Regulating Competition on the Internet is distinguishing between platforms and Aggregators; platforms are extremely valuable, because of the opportunities they enable, but are also more subject to abuse, because companies taking advantages of those opportunities are beholden to the platform. Aggregators, on the other hand, dominate their markets by controlling demand; suppliers are not locked in, but are rather seeking end users, who themselves can visit another website or open another app at any time. The societal value of Aggregators is lower than Platforms, but the extent to which they can inflict harm is more limited as well — competition really is just a click away.

To that end, the only extent to which Facebook is a potential antitrust concern is in terms of advertising, thanks to its massive amount of proprietary data and highly advanced data factory. At the same time, Facebook’s auction driven format ensures that Facebook is not gouging advertisers, and the effectively infinite potential inventory in digital means that competitors are not locked out from building competing products; the only scarcity is audience attention. Moreover, tradeoffs matter here as well: Facebook having extremely effective data is good for businesses on its platform, and there are privacy concerns with forcing Facebook to share.

On the consumer side, I simply don’t see any anticompetitive concerns at all. Consumers are not locked into a single communications app, but can and do multi-home, and can switch between competing services with a swipe. Facebook’s challenge is in continuing to keep users opening and using its apps, and there is plenty of evidence the company is struggling to do just that.

A decade ago Facebook responded to this challenge by savvily buying upcoming communications apps like Instagram and WhatsApp; I do think that this reduced competition in the sector, particularly from an advertising perspective, and I do think there is a case for regulators to look much more critically at Aggregators buying other would-be Aggregators. That noted, in 2021 Facebook — even with Instagram and WhatsApp — faces more competition than ever before; the market worked, and regulators are very much on guard for similar purchases. Facebook is going to have to keep users with what it has, or builds.

Political Problem One: Facebook’s Competence

These first three points, taken together, paint a picture of an exceptionally well-run company and a very attractive business; there is a reason why Facebook is worth around a trillion dollars. At the same time, it is that exceptional competence that starts to explain Facebook’s current political predicament.

Andrew Bosworth, Facebook’s New CTO, wrote an internal memo in 2016 about Facebook’s commitment to growth that later leaked to BuzzFeed; it is essential to understanding Facebook:

We talk about the good and the bad of our work often. I want to talk about the ugly.

We connect people.

That can be good if they make it positive. Maybe someone finds love. Maybe it even saves the life of someone on the brink of suicide.

So we connect more people

That can be bad if they make it negative. Maybe it costs a life by exposing someone to bullies. Maybe someone dies in a terrorist attack coordinated on our tools.

And still we connect people.

The ugly truth is that we believe in connecting people so deeply that anything that allows us to connect more people more often is *de facto* good. It is perhaps the only area where the metrics do tell the true story as far as we are concerned.

That isn’t something we are doing for ourselves. Or for our stock price (ha!). It is literally just what we do. We connect people. Period.

That’s why all the work we do in growth is justified. All the questionable contact importing practices. All the subtle language that helps people stay searchable by friends. All of the work we do to bring more communication in. The work we will likely have to do in China some day. All of it.

The natural state of the world is not connected. It is not unified. It is fragmented by borders, languages, and increasingly by different products. The best products don’t win. The ones everyone use win.

I know a lot of people don’t want to hear this. Most of us have the luxury of working in the warm glow of building products consumers love. But make no mistake, growth tactics are how we got here. If you joined the company because it is doing great work, that’s why we get to do that great work. We do have great products but we still wouldn’t be half our size without pushing the envelope on growth. Nothing makes Facebook as valuable as having your friends on it, and no product decisions have gotten as many friends on as the ones made in growth. Not photo tagging. Not news feed. Not messenger. Nothing.

In almost all of our work, we have to answer hard questions about what we believe. We have to justify the metrics and make sure they aren’t losing out on a bigger picture. But connecting people. That’s our imperative. Because that’s what we do. We connect people.

In the seventeen years since Facebook was founded the number of people using the Internet has grown from around a billion people to around 4.5 billion people; in developed countries the Internet is close to being universal, but developing countries are steadily catching up:

Of those 4.5 billion people, 3.5 billion use at at least one Facebook service on a monthly basis; 2.8 billion use at least one on a daily basis. That is exactly the sort of competence I was referring to above. As Bosworth notes, though, Facebook’s growth isn’t just about competence, but about a single-minded determination to do everything possible to make Facebook synonymous with the Internet.

Here is the problem, though: it is not at all certain that the Internet is good for society. I believe it is — I just articulated a positive vision for the democratization enabled by Facebook advertising, to take but one small example — but there are obviously massive downsides as well. Moreover, many of those downsides seem to spring directly from the fact that people are connected: it’s not simply that it is trivial to find people who think the same as you, no matter how mistaken or depraved you might be, but it’s also trivial to find, observe, and fight with those who simply have a different set of values or circumstances. The end result feels like an acceleration of tribalism and polarization; it’s not only easy to see and like your friends, but even easier to see and hate your enemies with your friends.

This is, as I noted, an Internet problem — as Facebook is happy to tell you — but the truth is that Facebook, thanks to its uber-competent focus and execution on growth, effectively made the Internet problem a Facebook problem. Sure, you can make the case that had Facebook not pursued growth at all costs there would be another social network in its place — and frankly, I believe that Twitter gets off far too easy in discussions about deleterious impacts on society — but the reality is that Facebook did win, and just because some of its spoils are rotten doesn’t absolve the company of responsibility. If you are going to onboard all of humanity, you are going to get all of humanity’s problems.

Secondly, Facebook pursued this growth without questioning if the obstacles it faced — the fact that “The natural state of the world is not connected. It is not unified.” — perhaps functioned as useful buffers; instead the company, particularly founder and CEO Mark Zuckerberg, was blinded by a Messianic impulse to create the conditions for global governance. Zuckerberg wrote in 2017’s Building Global Community:

History is the story of how we’ve learned to come together in ever greater numbers — from tribes to cities to nations. At each step, we built social infrastructure like communities, media and governments to empower us to achieve things we couldn’t on our own. Today we are close to taking our next step. Our greatest opportunities are now global — like spreading prosperity and freedom, promoting peace and understanding, lifting people out of poverty, and accelerating science. Our greatest challenges also need global responses — like ending terrorism, fighting climate change, and preventing pandemics. Progress now requires humanity coming together not just as cities or nations, but also as a global community.

This is especially important right now. Facebook stands for bringing us closer together and building a global community. When we began, this idea was not controversial. Every year, the world got more connected and this was seen as a positive trend. Yet now, across the world there are people left behind by globalization, and movements for withdrawing from global connection. There are questions about whether we can make a global community that works for everyone, and whether the path ahead is to connect more or reverse course.

This is a time when many of us around the world are reflecting on how we can have the most positive impact. I am reminded of my favorite saying about technology: “We always overestimate what we can do in two years, and we underestimate what we can do in ten years.” We may not have the power to create the world we want immediately, but we can all start working on the long term today. In times like these, the most important thing we at Facebook can do is develop the social infrastructure to give people the power to build a global community that works for all of us.

What is particularly striking about this excerpt is the jump between the second paragraph, when Zuckerberg nods towards “questions” about reversing course, and the third paragraph which makes clear those questions were never seriously considered. And how could they be — “Connecting people. That’s our imperative. Because that’s what we do. We connect people.” Facebook’s combination of competence and drive ensured Internet problems were Facebook problems, and Zuckerberg’s missionary zeal didn’t give space to consider what might go wrong.

This is the first, and perhaps most important, political problem Facebook has: the Internet causes real problems, and Facebook willingly made itself responsible for those problems, with no real understanding that the problems even existed.

Political Problem Two: Facebook’s Scapegoating

While I just linked Bosworth’s 2016 memo and Zuckerberg’s 2017 manifesto, it’s important to note that the latter was something new: Facebook explicitly committing itself to use its power to enact change. Before that nothing mattered but growth, which produced a very curious dynamic: Facebook had tremendous power but by-and-large declined to exercise it. This created the conditions for Donald Trump, which I explained in The Voters Decide:

Given their power over what users see Facebook could, if it chose, be the most potent political force in the world. Until, of course, said meddling was uncovered, at which point the service, having so significantly betrayed trust, would lose a substantial number of users and thus its lucrative and privileged place in advertising, leading to a plunge in market value. In short, there are no incentives for Facebook to explicitly favor any type of content beyond that which drives deeper engagement; all evidence suggests that is exactly what the service does.

Said reticence, though, creates a curious dynamic in politics in particular: there is no one dominant force when it comes to the dispersal of political information, and that includes the parties described in the previous section. Remember, in a Facebook world, information suppliers are modularized and commoditized as most people get their news from their feed.

This has two implications:

All news sources are competing on an equal footing; those controlled or bought by a party are not inherently privileged.

The likelihood any particular message will “break out” is based not on who is propagating said message but on how many users are receptive to hearing it. The power has shifted from the supply side to the demand side.

This is a big problem for the parties as described in The Party Decides. Remember, in Noel and company’s description party actors care more about their policy preferences than they do voter preferences, but in an aggregated world it is voters aka users who decide which issues get traction and which don’t. And, by extension, the most successful politicians in an aggregated world are not those who serve the party but rather those who tell voters what they most want to hear.

These dynamics were in many respects the same as the advertising dynamics I described above: on Facebook both small companies and large companies have an equal shot at customers, and both Party insiders and complete outsiders have an equal shot at voters. Moreover, it’s a dynamic that is even greater when combined: Trump famously used Facebook advertising to far greater effect than the Clinton campaign. And, at the same time, the New York Times, itself demoted to another attention seeker in a Facebook world, famously spent huge amounts of time on Clinton’s emails.

What seems clear in retrospect is that the latter two entities made peace (and avoided introspection) by making Facebook the scapegoat for Trump’s election. This was true in a way — Facebook created the conditions for someone like Trump to win — but the furor that followed suggested something much more explicit: within days the conversation was about Fake News and Russian influence being the key factors, not campaign mistakes and questionable coverage decisions, and certainly not the fundamental way that the media environment had changed.

That enmity has clearly persisted: what is striking about Facebook’s political problems in the United States is how they are not consistent across the world. Sure, Facebook fights its battles, with publishers in particular, but they’re mostly about money; it is in the U.S. where Facebook is, at least on one side of the aisle, uniquely despised, and held solely responsible for the Internet’s inherent issues. TikTok’s algorithm is far more addictive than Facebook’s, and dangerous for minors, and YouTube has played perhaps the leading role in the spread of anti-vaccine information, but it is Facebook that gets all of the blame.

Political Problem Three: Facebook’s Power

There is another, more subtle problem related to the previous point: that Facebook power, which was latent in 2016, and which Zuckerberg made a bid to leverage for a utopian outcome in 2017, is increasingly irresistible to the powers that be. It has been fascinating watching the parade of Congressional hearings where Facebook has been harangued endlessly for not doing enough about misinformation by Democrats, while Republicans demand that Facebook stop censoring; both threaten regulation if the company doesn’t do better. Left unacknowledged by the left is that the company dramatically scaled up the number of people and money devoted to controlling what was allowed on the platform, and what was not; the right, meanwhile, apparently didn’t notice that Zuckerberg consistently stood up for Trump’s right to the platform.²

At the same time, this too is a consequence of Facebook’s success with growth: centralized power is, as James Madison wrote in Federalist No. 47, inevitably leveraged for political gain:

The accumulation of all powers, legislative, executive, and judiciary, in the same hands, whether of one, a few, or many, and whether hereditary, self-appointed, or elective, may justly be pronounced the very definition of tyranny. Were the federal Constitution, therefore, really chargeable with the accumulation of power, or with a mixture of powers, having a dangerous tendency to such an accumulation, no further arguments would be necessary to inspire a universal reprobation of the system.

Madison was obviously talking about government, but isn’t that exactly what Zuckerberg effectively aspired to be? From that manifesto:

For the past decade, Facebook has focused on connecting friends and families. With that foundation, our next focus will be developing the social infrastructure for community — for supporting us, for keeping us safe, for informing us, for civic engagement, and for inclusion of all.

“Social infrastructure for community” may not be government in the Westphalian sense, but at Facebook scale it is something far more powerful; at the same time, given that Facebook doesn’t have guns, it was inevitable that an all-out effort would be made to capture it.

The reason to present all of these problems in unison is that they all exist in parallel; writing about just one of them, as I did yesterday, doesn’t mean that I don’t acknowledge the others, particularly the first one, about Facebook internalizing the fundamental flaws inherent in humanity. In other words, to argue that it is not in Facebook’s interest as an ad platform to have angry political discussions doesn’t change the reality that having people interact more will entail more angry political discussions, amongst every other discussion that humans are liable to have.

This also makes the case for why I do think the world would be better off were Facebook a much smaller company: its political problems — both for the company and for the world — are irrevocably tied to its size. Unfortunately the only means we have to break a company up — antitrust — don’t really apply; Facebook presents a societal problem, not a competitive one. Moreover, per political problem three, politicians don’t want a smaller Facebook; they want a compliant one.

And so, the most likely outcome is that Facebook simply doubles down on information control, perhaps with some regulation that is far more likely to hinder new startups — stricter limits on data, for example, or increasing liability for user-generated content — than it is to materially harm Facebook. Not much will change, at least in the short term.

Politics and Internet 3.0

The capture of Facebook, though, will have consequences, in much the same vein as January’s industry-wide move against Trump; from Internet 3.0 and the Beginning of (Tech) History:

It turns out that when it comes to Information Technology, very little is settled; after decades of developing the Internet and realizing its economic potential, the entire world is waking up to the reality that the Internet is not simply a new medium, but a new maker of reality…

It is difficult to believe that the discussion of these implications will be reserved for posts on niche sites like Stratechery; the printing press transformed Europe from a continent of city-states loosely tied together by the Catholic Church, to a continent of nation-states with their own state churches. To the extent the Internet is as meaningful a shift — and I think it is! — is inversely correlated to how far along we are in the transformation that will follow — which is to say we have only gotten started. And, after last week, the world is awake to the stakes; politics — not economics — will decide, and be decided by, the Internet.

Here technology itself will return to the forefront: if the priority for an increasing number of citizens, companies, and countries is to escape centralization, then the answer will not be competing centralized entities, but rather a return to open protocols (crypto projects are one manifestation of this, but not the only ones). This is the only way to match and perhaps surpass the R&D advantages enjoyed by centralized tech companies; open technologies can be worked on collectively, and forked individually, gaining both the benefits of scale and inevitability of sovereignty and self-determination.

The freedom of open source and the self-determination of crypto have always been attractive both technically and philosophically. Centralized platforms like Facebook, though, were just so easy. That, though, is why these political shifts matter: I understand the skepticism about crypto in particular, but I think critics who see only the scams or are focused on the challenges miss the fact that countries want to be sovereign and individuals want to be free. The more that U.S. tech companies are consumed by U.S. politics the more motivation there will be to pull the future forward.

This is where I am jealous of those who do nothing but attack Facebook; no nuance is, if nothing else, succinct. ↩
More on January 6 below ↩

Cloudflare’s Disruption

Thursday, September 30, 2021Monday, October 11, 2021

From Protocol:

Cloudflare is ready to launch a new cloud object storage service that promises to be cheaper than the established alternatives, a step the company believes will catapult it into direct competition with AWS and other cloud providers. The service will be called R2 — “one less than S3,” quipped Cloudflare CEO Matthew Prince in an interview with Protocol ahead of Cloudflare’s announcement Tuesday morning. Cloudflare will not charge data-egress fees for customers using R2, taking direct aim at the fees AWS charges developers to move data out of its widely popular S3 storage service.

R2 will run across Cloudflare’s global network, which is most known for providing anti-DDoS services to its customers by absorbing and dispersing the massive amounts of traffic that accompany denial-of-service attacks on websites. It will be compatible with S3’s API, which makes it much easier to move applications already written with S3 in mind, and Cloudflare said that beyond the elimination of egress fees, the new service will be 10% cheaper to operate than S3.

Cloudflare has always framed itself as a disruptor; R2 lives up to its reputation.

Cloudflare’s Evolution

I already wrote earlier this year about Cloudflare’s unique advantages in a world where the Internet is increasingly fragmented, thanks to the distributed nature of its service, and why that positioned the company to compete with the major cloud providers in the long run. What is worth referring to with this announcement, though, is this clip I posted of Prince’s initial launch of Cloudflare at TechCrunch Disrupt 2010, particularly this bit from the Q&A:

So from a competitive standpoint, obviously you’re intruding on some of the stuff that the bigger boys are doing, and they’ve been at this for a long time. What’s to stop them from coming in and replicating your model?

There are companies that are doing things at the high end of the market, and they make very fat margins doing it. I’m really a big fan of Clay Christensen, he was a business school professor of mine, and I like the idea of businesses that come in from below. The big incumbents have an Innovator’s Dilemma trying to come down and deal with a company like ours, but we welcome the competition. We think we make a really great product. It’s designed for a certain type of users that are very different than the users that a larger company might be trying to attract.

Prince was spot-on about the competitive response of incumbents to Cloudflare’s offering for the long-tail of websites: it never came, because Cloudflare was serving a new market. This is how Christensen defined new market disruption in The Innovator’s Solution:

The third dimension [is] new value networks. These constitute either new customers who previously lacked the money or skills to buy and use the product, or different situations in which a product can be used — enabled by improvements in simplicity, portability, and product cost…We say that new-market disruptions compete with “nonconsumption” because new-market disruptive products are so much more affordable to own and simpler to use that they enable a whole new population of people to begin owning and using the product, and to do so in a more convenient setting.

That’s not the end of the story, though: new market disruptors don’t stand still, but can leverage the huge runway provided by the new market to build up their product capabilities in a way that eventually threatens the incumbent. Christensen continued:

Although new-market disruptions initially compete against nonconsumption in their unique value network, as their performance improves they ultimately become good enough to pull customers out of the original value network into the new one, starting with the least-demanding tier. The disruptive innovation doesn’t invade the mainstream stream market; rather, it pulls customers out of the mainstream value network into the new one because these customers find it more convenient to use the new product.

This was Cloudflare Workers, edge compute functionality that was a great match for Cloudflare’s CDN offering, but certainly not a competitor for AWS’s core offerings. Back to Christensen:

Because new-market disruptions compete against nonconsumption, the incumbent leaders feel no pain and little threat until the disruption is in its final stages.

This is where R2 comes in.

The AWS Transformation

In a vacuum, most businesses would prefer making a fixed cost investment instead of paying on a marginal use basis. Consider Spotify’s music-streaming business: one of the company’s core challenges is that the more customers Spotify has the more it has to pay music labels — streaming rights are a marginal cost. A streaming service like Netflix, on the other hand, that spends up front for its own content, gets to keep whatever increased revenue that content drives for itself. This same logic applies to computing capacity: buying your own servers is, in theory, cheaper than renting compute from a service like AWS.

When it comes to compute, however, reality is very different than theory.

First, usage may be uneven, whether that be because a business is seasonal, hit-driven, or anything in-between. That means that compute capacity has to be built out for the worst case scenario, even though that means most resources are sitting idle most of the time.
Second, compute capacity is likely growing — hopefully rapidly, in the case of a new business. Building out infrastructure, though, is not a linear process: new capacity comes online all at once, which means a business has to overbuild for their current needs so that they can accommodate future growth, which again means that most resources are sitting idle most of the time.
Third, compute capacity is complex and expensive. That means there are both huge fixed costs that have to be invested before the compute can be used, and also significant ongoing marginal costs to manage the compute already online.

This is why AWS was so transformative: Amazon would spend all of the up-front money to build out compute capacity for all of its customers, and then rent it on-demand, solving all of the problems I just listed:

Customers could scale their compute up-or-down instantly in response to their needs.
Customers could rent exactly as much compute as they needed at any moment in time, even as they were able to seamlessly handle growth.
AWS would be responsible for all of the up-front investment and ongoing maintenance, and because they would operate at such scale, they would get much better prices from suppliers than any individual company could on its own.

It’s impossible to overstate the extent to which AWS changed the world, particularly Silicon Valley. Without the need to buy servers, companies could be started in a bedroom, creating the conditions for the entire angel ecosystem and the shift of traditional venture capital to funding customer acquisition for already proven products, instead of Sun servers for ideas in PowerPoints. Amazon, meanwhile, suddenly had a free option on basically every startup in the world, positioning itself to levy The Amazon Tax on every company that succeeded.

The scale of these options became clear to the world in 2015 when Amazon broke out AWS’s financials for the first time; I called it The AWS IPO:

The big question about AWS, though, has been whether Amazon can keep their lead. Data centers are very expensive, and Amazon has a lot less cash and, more importantly, a lot less profit than Google or Microsoft. What happens if either competitor launches a price war: can Amazon afford to keep up?

To be sure, there were reasons to suspect they could: for one, Amazon already has significantly more scale, which means their costs on a per-customer basis are lower than Microsoft or Google. And perhaps more importantly is the corporate culture that results from a “your-margins-are-my-opportunity” mindset: Amazon can stomach a few percentage points of margin on a core business far more comfortably than Microsoft or Google, both fat off of software and advertising margins respectively. Indeed, when Google slashed prices in the spring of 2014, Amazon immediately responded and proceeded to push prices down further still, just as they had ever since AWS’s inception (the price cuts in response to Google were the 42nd for the company). Still, the question remained: was this sustainable? Could Amazon afford to compete?

This is why Amazon’s latest earnings were such a big deal: for the first time the company broke out AWS into its own line item, revealing not just its revenue (which could be teased out previously) but also its profitability. And, to many people’s surprise, and despite all the price cuts, AWS is very profitable: $265 million in profit on $1.57 billion in sales last quarter alone, for an impressive (for Amazon!) 17% net margin.

Those numbers last quarter are up to $4.2 billion in profit on $14.9 billion in revenue for a net margin of 28%: Amazon has increased its margins, even as Microsoft and Google have increased their focus on the cloud. A big reason is that Microsoft in particular has pursued different customers, coaxing existing businesses to the cloud, thanks in part to their early focus on hybrid solutions.¹ Google, meanwhile, has been even further behind, particularly in terms of matching AWS’s sheer breadth of services (even if they weren’t always technically great), making it harder for businesses already used to AWS to shift.

The egress fees R2 is targeting, though, have played a big role as well.

S3’s Egress Pricing

S3 is the OG Amazon Web Service: it launched on March 14, 2006, with this press release:

Amazon Web Services today announced “Amazon S3(TM),” a simple storage service that offers software developers a highly scalable, reliable, and low-latency data storage infrastructure at very low costs…

Amazon S3 is storage for the Internet. It’s designed to make web-scale computing easier for developers. Amazon S3 provides a simple web services interface that can be used to store and retrieve any amount of data, at any time, from anywhere on the web. It gives any developer access to the same highly scalable, reliable, fast, inexpensive data storage infrastructure that Amazon uses to run its own global network of web sites. The service aims to maximize benefits of scale and to pass those benefits on to developers…

S3 lets developers pay only for what they consume and there is no minimum fee. Developers pay just $0.15 per gigabyte of storage per month and $0.20 per gigabyte of data transferred.

Prices have, as you might expect, come down over the ensuing 15 years:

A gigabyte of storage today is $0.023, a decrease of 85%
Moving data into S3 is free, a decrease of 100%
Moving a gigabyte out of S3 is $0.09, a decrease of 55%

These numbers are the base rates; prices vary based on different storage tiers, whether or not you use Amazon’s CDN, and, more importantly, whether or not you have a long-term contract with AWS (more on this in a moment). What is consistent across all of those variables, though, are differences in cost between moving data into AWS, and the cost of moving data out; a blog post from earlier this year called the difference AWS’s “Hotel California”:

Another oddity of AWS’s pricing is that they charge for data transferred out of their network but not for data transferred into their network…We’ve tried to be charitable in trying to understand why AWS would charge this way. Disappointingly, there just doesn’t seem to be an innocent explanation. As we dug in, even things like writes versus reads and the wear they put on storage media, as well as the challenges of capacity planning for storage capacity, suggest that AWS should charge less for egress than ingress.

But they don’t.

The only rationale we can reasonably come up with for AWS’s egress pricing: locking customers into their cloud, and making it prohibitively expensive to get customer data back out. So much for being customer-first.

Even if companies are careful to not make any of their back-end services AWS-specific, the larger you grow the more data you have on AWS, and moving that data off is an eye-watering expense. And so, when another company builds a service that looks interesting — like, say, Cloudflare Workers — it’s easier to simply wait for Amazon’s alternative and build using that, and oops, now you’re even more locked into AWS!

What is happening in terms of the value chain is straightforward: Amazon paid fixed costs for its infrastructure, and is charging for it on a marginal basis; all of the upside here accrues to AWS, as seen in the service’s margins. That is also an important part of AWS’s retention strategy: for most AWS customers the easiest solution to rising costs is to simply sign a long-term contract, dramatically decreasing their prices (again, Amazon has the margin to spare) while ensuring they stay on AWS that much longer, accumulating that much more data and relying on that many more AWS-specific services. Hotel Seattle, as it were.

That blog post, by the way, was co-written by Prince, where he made the case that based on Cloudflare’s understanding of bandwidth costs, AWS was making a 7959% margin on US/Canada egress fees; Prince’s conclusion at the time was that AWS ought to join the Bandwidth Alliance and discount or waive egress fees when sending data to Cloudflare (which doesn’t cost AWS anything, thanks to an industry-standard private network interface), but two months on, the true point of Prince’s post was clearly this week’s announcement.

R2’s Low-End Disruption

From the Cloudflare blog:

Object Storage, sometimes referred to as blob storage, stores arbitrarily large, unstructured files. Object storage is well suited to storing everything from media files or log files to application-specific metadata, all retrievable with consistent latency, high durability, and limitless capacity.

The most familiar API for Object Storage, and the API R2 implements, is Amazon’s Simple Storage Service (S3). When S3 launched in 2006, cloud storage services were a godsend for developers. It didn’t happen overnight, but over the last fifteen years, developers have embraced cloud storage and its promise of infinite storage space.

As transformative as cloud storage has been, a downside emerged: actually getting your data back. Over time, companies have amassed massive amounts of data on cloud provider networks. When they go to retrieve that data, they’re hit with massive egress fees that don’t correspond to any customer value — just a tax developers have grown accustomed to paying.

Enter R2.

The reason that Cloudflare can pull this off is the same reason why S3’s margins are so extraordinary: bandwidth is a fixed cost, not a marginal one. To take the most simplified example possible, if I were to have two computers connected by a cable, the cost of bandwidth is however much I paid for the cable; once connected I can transmit as much data as I would like for free — in either direction.

That’s not quite right, of course: I am constrained by the capacity of the cable; to support more data transfer I would have to install a higher capacity cable, or more of them. What, though, if I already had built a worldwide network of cables for my initial core business of protecting websites from distributed denial-of-service attacks and offering a content delivery network, the value of which was such that ISPs everywhere gave me space in their facilities to place my servers? Well, then I would have massive amounts of bandwidth already in place, the use of which has zero marginal costs, and oh-by-the-way locations close to end users to stick a whole bunch of hard drives.

In other words, I would be Cloudflare: I would charge marginal rates for my actual marginal costs (storage, and some as-yet-undetermined-but-promised-to-be-lower-than-S3 rate for operations), and give away my zero marginal cost product for free. S3’s margin is R2’s opportunity.

Modular Disruption

Cloudflare, at least in AWS terms, remains a minnow; the company had $152 million in revenue last quarter, 10 percent of AWS’s revenue upon its unveiling six years ago. Prince, though, is thinking big; from that Protocol article:

“We are aiming to be the fourth major public cloud,” Prince said. Cloudflare already offers a serverless compute service called Workers, and Prince thinks that adding a low-cost storage service will encourage more developers and companies to build applications around Cloudflare’s services.

That is one way this could play out: R2 is a compelling choice for a certain class of applications that could be built to serve a lot of data without much compute. Moreover, by virtue of using the S3 API,² R2 can also be dropped into existing projects; developers can place R2 in front of S3, pulling out data as needed, once, and getting free egress forever-after.

Still, AWS is far more than storage; the second AWS product was EC2 — Elastic Compute Cloud — which lets customers rent virtual computers that by definition are far more capable than a necessarily limited edge computing service like Workers, along with a host of database offerings and the sort of specialized services I mentioned earlier. Not all of these will necessarily translate well to Cloudflare’s distributed infrastructure, either.

Again, though, Cloudflare’s distributed nature is the entire reason the company’s cloud ambitions are so intriguing: R2 may be a direct competitor for S3, but that doesn’t mean that anything else about Cloudflare’s cloud ambitions has to be the same. Go back to Christensen and The Innovator’s Solution:

Modularity has a profound impact on industry structure because it enables independent, nonintegrated organizations to sell, buy, and assemble components and subsystems. Whereas in the interdependent world you had to make all of the key elements of the system in order to make any of them, in a modular world you can prosper by outsourcing or by supplying just one element. Ultimately, the specifications for modular interfaces will coalesce as industry standards. When that happens, companies can mix and match components from best-of-breed suppliers in order to respond conveniently to the specific needs of individual customers.

As depicted in figure 5–1, these nonintegrated competitors disrupt the integrated leader. Although we have drawn this diagram in two dimensions for simplicity, technically speaking they are hybrid disruptors because they compete with a modified metric of performance on the vertical axis of the disruption diagram, in that they strive to deliver rapidly exactly what each customer needs. Yet, because their nonintegrated structure gives them lower overhead costs, they can profitably pick off low-end customers with discount prices.

This is where zero egress costs could be an even bigger deal strategically than they are economically. S3 was the foundation of AWS’s integrated cloud offering, and remains the linchpin of the company’s lock-in; what if R2, thanks to its explicit rejection of data lock-in, becomes the foundation of an entirely new ecosystem of cloud services that compete with the big three by being modular? If you can always get access to your data for free, it becomes a lot more plausible to connect that data to best-of-breed compute options built by companies focused on doing one thing well, instead of simply waiting for Amazon to offer up their pale imitation that doesn’t require companies to pay out the nose to access.

Moreover, like any true disruption, it will be very difficult for Amazon to respond: sure, R2 may lead Amazon to reduce its egress fees, but given the importance of those fees to both AWS’s margins and its lock-in, it’s hard to see them going away completely. More importantly, AWS itself is locked-in to its integrated approach: the entire service is architected both technically and economically to be an all-encompassing offering; to modularize itself in response to Cloudflare would be suicidal.

At the same time, this is also why Cloudflare’s success in becoming the fourth cloud, should it happen, will likely be additive to the market: companies on AWS are by-and-large not going anywhere, but there are new companies being formed all of the time, and a whole bunch of companies that have yet to move to the cloud, as well as the aforementioned Internet fragmentation that plays to Cloudflare’s advantage. Here it is a benefit to Cloudflare that it is a relatively small company: opportunities that seem trivial to giants will be big wins, giving the company the increasing scale it needs to flesh out its offerings and build its new cloud ecosystem. Success is not assured, but the strategy is sound enough to make Prince’s late professor proud.

Amazon resisted hybrid for a long time, because it’s a technically terrible solution relative to just moving everything to the cloud, which is to say that Amazon made the same mistake all of Microsoft’s competitors make: relying on a “better product” instead of actually meeting customers where they are and solving their needs ↩
Copying APIs is a favorite tactic of Amazon when it comes to open source projects. ↩

The Apple v. Epic Decision

Monday, September 13, 2021Tuesday, September 14, 2021

The vast majority of Judge Yvonne Gonzalez Rogers decision in Epic v. Apple is both straight-forward and predictable; I wrote that the iPhone company would likely win when the lawsuit was filed, and argued that the law was firmly on Apple’s side in App Store Arguments. That is indeed what happened: Apple won, and it wasn’t particularly close; Epic has already filed an appeal, but I doubt it will succeed.

What was surprising, though — and, frankly, a much more interesting question for the Court of Appeals — is that Judge Gonzalez Rogers also issued an injunction banning Apple’s anti-steering provision; while I do think Apple’s anti-steering provision is anti-competitive, this injunction is an odd outcome of this specific case, and a source of much confusion about what this decision was actually about.

Market Definition

The most important part of any antitrust case is market definition. Epic argued there is a smartphone market consisting of iOS and Android, and then on iOS there is a distinct “iOS App Distribution” market, and downstream from that a “iOS In-App Payment Solutions” market. Apple, on the other hand, argued that all of digital gaming was a market, including not just Android but also consoles and PCs.

Judge Gonzalez Rogers disagreed with both, defining the market as ‘mobile game transactions’. Epic’s argument was, as expected, dismissed out of hand; Supreme Court precedent is extremely skeptical that there are single brand markets, and the primary exception (Eastman Kodak) is only applicable if customers are unaware of aftermarket limitations at the time of purchase. In fact, customers are not only aware of Apple’s walled garden policies, but it is in fact a selling point for the iPhone, which means customers know what they are getting into when they choose the iPhone over Android.

In disagreeing with Apple, Judge Gonzalez Rogers first ruled that digital games are a distinct market from general non-gaming apps; the list of reasons are worth noting:¹

Having considered and reviewed the evidence, the Court concludes based on its earlier findings of facts that the appropriate submarket to consider is digital game transactions as compared to general non-gaming apps. Indeed, the Court concluded that there were nine indicia indicating a submarket for gaming apps as opposed to non-gaming apps: (i) the App Store’s business model is fundamentally built upon lucrative gaming transactions; (ii) gaming apps constitute a significant majority of the App Store’s revenues; (iii) both the gaming, mobile, and software industry as well as the general public recognize a distinction between gaming apps and non-gaming apps; (iv) gaming apps and their transactions exhibit peculiar characteristics and users; (v) game app developers often employ specialized technology inherent and unique to that industry in the development of their product; (vi) game apps further have distinct producers — game developers — that generally specialize in the production of only gaming apps; (vii) game apps are subject to distinct pricing structures as compared to other categories of apps; (viii) games and gaming transactions are sold by specialized vendors; and (ix) game apps are subject to unique and emerging competitive pressures, that differs in both kind and degree from the competition in the market for non-gaming apps.

Next Judge Gonzalez Rogers ruled that mobile gaming transactions were a distinct market from digital gaming transactions generally:

As an initial matter, Apple’s own documents recognize mobile gaming as a submarket. One industry report describes mobile gaming as a “$100 billion industry by itself” that accounts for 59% of global gaming revenue. While PC and console gaming has grown more slowly, mobile gaming has experienced double-digit growth driven by “the free-to-play model” with in-app purchases. “Remarkably,” this rapid growth “has not significantly cannibalized revenues from the PC or console gaming markets,” which suggests that consumers are not necessarily substituting among them. Another industry report describes distinct user bases for mobile gaming: young children, teenage girls, and older adults are disproportionally likely to be mobile gamers only. Multiplatform gaming, by contrast, is driven by teenage boys and young adults under 25.

Judge Gonzalez Rogers cited further evidence about the extent to which mobile gaming business models differed from consoles and PCs, and Apple’s own expert evidence that showed only a small amount of cross-over in popular titles.

Ultimately, I found Judge Gonzalez Rogers’ market definition reasonable, although Apple could argue on appeal that all of digital gaming should be included. What is more notable, though, is the strong distinction Judge Gonzalez Rogers draws between games and non-gaming apps:

First, given this market definition, this case was only about mobile games. That is good news for app developers who have their own antitrust complaints about Apple’s policies, and also a reason for Apple to not take this ruling as a complete endorsement of their policies.
Second, this ruling does suggest that Apple ought to — and now has the judicial imprimatur to — treat games differently than other apps.

This is perhaps the most important takeaway from this decision; so much of the company’s App Store troubles have come from applying rules and regulations that are appropriate for games to other areas of the App Store that are totally different, and now the company has license to come up with two sets of rules for what, Judge Gonzalez Rogers ruled, are two different markets.

Market Power

With that definition established Judge Gonzalez Rogers ruled that Apple did not have monopoly power in ‘mobile gaming transactions’:

Apple has between 52%-57% share of the mobile gaming transaction market, which is significant but not enough to be a prima facie case of monopoly power.²
There is no evidence of a restriction in output, i.e. the mobile gaming transaction market continues to grow, despite the fact there is evidence that Apple’s 30% commission rate is artificially high.
While iOS and Android have substantial advantages, there is some evidence of increased competition in the mobile gaming space in the form of the Nintendo Switch and cloud gaming services.

Judge Gonzalez Rogers did note:

Given the totality of the record, and its underdeveloped state, while the Court can conclude that Apple exercises market power in the mobile gaming market, the Court cannot conclude that Apple’s market power reaches the status of monopoly power in the mobile gaming market. That said, the evidence does suggest that Apple is near the precipice of substantial market power, or monopoly power, with its considerable market share. Apple is only saved by the fact that its share is not higher, that competitors from related submarkets are making inroads into the mobile gaming submarket, and, perhaps, because plaintiff did not focus on this topic.

This paragraph explains why Apple may wish to appeal the definition of the market specifically; it is an important consideration in the anti-steering injunction which is addressed below.

What is unaddressed by this ruling, and by antitrust law in general, is the reality that the mobile gaming transaction market is a duopoly; this is a problem with tech regulation generally, as I noted in United States v. Google:

This gets at a larger problem in many tech markets: the tendency towards duopoly, which often lets one company cover for the other acting anti-competitively. In the case of Apple and Google:

Android’s presence in the market means that Apple can act anticompetitively with its App Store policies (which Google is happy to ape).

Apple’s privacy focus justifies decisions like limiting trackers, restricting cookies, and cutting off in-app analytics; Google happily follows Apple’s lead, which impacts its advertising rivals far more than it does Google, improving their relative competitive position.

Apple earns billions of dollars giving its customers the best default search experience, even as that ensures that Google will remain the best search engine (and raises questions about the sincerity of Apple’s privacy rhetoric).

This isn’t the only duopoly: Google and Facebook jointly dominate digital advertising, Microsoft and Google jointly dominate productivity applications, Microsoft and Amazon jointly dominate the public cloud, and Amazon and Google jointly dominate shopping searches. And, while all of these companies compete, those competitive forces have set nearly all of these duopolies into fairly stable positions that justify cooperation of the sort documented between Apple and Google, even as any one company alone is able to use its rival as justification for avoiding antitrust scrutiny.

Judge Gonzalez Rogers does note that it is unclear whether Google “could increase output in the short run in order to erode Apple’s market share”, but the real problem is that Google is content to simply share the market with Apple and earn their own supracompetitive commission rate.

The IAP System

Most of the rest of Judge Gonzalez Rogers’ decision balances Apple’s alleged anticompetitive conduct, including its ability to maintain outsized profit margins on the App Store because of the lack of competition for iOS App Stores and In-App Payment alternatives, with its procompetitive justifications, including enhanced security, intrabrand competition with Android-based phones, and its right to protect its investment in intellectual property.

The first two procompetitive justifications work as a set: Apple convinced Judge Gonzalez Rogers that App Review provided an additional unique and valuable layer of security above-and-beyond operating system-based security measures, and furthermore, that the companies approach to app distribution and monetization was not only not detrimental to customers, but was actually a selling point for the iPhone (as noted above this also explains why the App Store was not covered by the Eastman Kodak exemption).

Apple also won on the intellectual property point, as expected, but this is where the decision starts to get a bit complicated. Judge Gonzalez Rogers emphasized throughout the decision that Apple had a right to a commission on apps, but not necessarily 30%:

First, and most significant, as discussed in the findings of facts, IAP is the method by which Apple collects its licensing fee from developers for the use of Apple’s intellectual property. Even in the absence of IAP, Apple could still charge a commission on developers. It would simply be more difficult for Apple to collect that commission.

Indeed, while the Court finds no basis for the specific rate chosen by Apple (i.e., the 30% rate) based on the record, the Court still concludes that Apple is entitled to some compensation for use of its intellectual property. As established in the prior sections, Apple is entitled to license its intellectual property for a fee, and to further guard against the uncompensated use of its intellectual property. The requirement of usage of IAP accomplishes this goal in the easiest and most direct manner, whereas Epic Games’ only proposed alternative would severely undermine it. Indeed, to the extent Epic Games suggests that Apple receive nothing from in-app purchases made on its platforms, such a remedy is inconsistent with prevailing intellectual property law.

What is important to note is that this was not a complete win for Apple’s argument in court: there the company argued that the intellectual property for which the company deserved to be compensated was not simply the App Store and all of its attendant services, but also its entire stack of developer tools, from APIs to Xcode and everything in-between. This argument enraged developers like Marco Arment:

Apple’s leaders continue to deny developers of two obvious truths:

That our apps provide substantial value to iOS beyond the purchase commissions collected by Apple.

That any portion of our customers came to our apps from our own marketing or reputation, rather than the App Store…

To bully and gaslight developers into thinking that we need to be kissing Apple’s feet for permitting us to add billions of dollars of value to their platform is not only greedy, stingy, and morally reprehensible, but deeply insulting.

Judge Gonzalez Rogers agreed:

No one credibly disputes that Apple and third-party developers act symbiotically. Apple gives developers an audience and developers make Apple’s platform more attractive. Thus, Apple earns revenue each time a developer earns revenue creating a feedback loop. However, as revenues show, the ultimate effect appears to vary within developer groups depending on how a developer chooses to monetize its app.

Further, there is substantial evidence that Epic Games, and perhaps other larger developers, bring their own audience to iOS. Fortnite was already popular when it arrived on iOS and Apple sought exclusive Fortnite content to attract new users. That said, Epic Games wanted Apple’s user base, to which it did not have access, as it had already saturated its other options. Also, Match Group found that the majority of new users from the App Store organically searched for its apps (e.g., by typing in “Tinder”), while Apple contributed only 6% of discovery. For these developers, Apple’s role in generating in-app purchases was “nothing” but it continued to receive a 30% commission on in-app purchases.

Therefore, the intellectual property to which Apple is entitled to receive a commission is more narrowly defined: IAP, which Judge Gonzalez Rogers defined as such:

Apple’s IAP or “in-app purchasing” system is a collection of software programs working together to perform several functions at once in the specific context of a transaction on a digital device. Apple uses the system to manage transactions, payments, and commissions within the App Store, but it also uses the system in other “stores” on iOS devices, such as “the iTunes Store on iOS, Apple Music, iCloud or Cloud services” and “physical retail stores”. The system is not something that is bought or sold…

More specifically, Apple’s IAP, as used here, is a secured system which tracks and verifies digital purchases, then determines and collects the appropriate commission on those transactions. In this regard, the system records all digital sales by identifying the customer and their payment methods, tracking and accumulating transactions; and conducts fraud-related checks. IAP simultaneously provides information to consumers so that they can view their purchase history, share subscriptions with family members and across devices, manage spending by implementing parental controls, and challenge and restore purchases.

Apple also intends the system to provide the customer with a single interface which can be used, and trusted, with respect to all purchases regardless of the developer. Importantly, the system has become more sophisticated over time, but the record does not detail the various versions…

Creating a seamless system to manage all its e-commerce was not an insignificant feat. Further, expanding it to address the scale of the growth required a substantial investment, not to mention the constant upgrading of the cellphones to allow for more sophisticated apps. Under current e-commerce models, even plaintiff’s expert conceded that similar functionalities for other digital companies were not separate products. Under all models, Apple would be entitled to a commission or licensing fee, even if IAP was optional. Payment processors have the ability to provide only one piece of the functionality. There is no evidence that they can provide the balance. Thus, the Court finds Epic Games has not shown that IAP is a separate and distinct product.

Forgive the long excerpt, but understanding this definition is critical to understanding this case as a whole. What Gonzalez Rogers is saying is that IAP is not the App Store app or the payment processing or any other discrete offering, but rather the totality of its digital e-commerce system. It is the intellectual property undergirding this IAP system that Apple is entitled to monetize in whatever reasonable way that it sees fit. And, to take this section full circle, not only does Apple have a right to monetize IAP, forcing developers to use IAP enhances its other two procompetitive justifications:

If Apple could no longer require developers to use IAP for digital transactions, Apple’s competitive advantage on security issues, in the broad sense, would be undermined and ultimately could decrease consumer choice in terms of smartphone devices and hardware…to a lesser extent, the use of different payment solutions for each app may reduce the quality of the experience for some consumers by denying users the centralized option of managing a single account through IAP. This would harm both consumers and developers by weakening the quality of the App Store to those that value this centralized system.

That was a lot of legalese, but this is the takeaway: IAP is distinct intellectual property from developer tools broadly; it is the entire set of app management tools, not just a payment processor; and Apple has legitimate competitive justification to require IAP be used for in-app purchases.

The Anti-Steering Injunction

I mentioned above that this was where the decision got a bit complicated; notice that I just used “IAP” and “in-app purchases” to represent two distinct concepts. Specifically, it seems clear that Gonzalez Rogers has defined “IAP” to be Apple’s overall commerce system, while “in-app purchases” are purchases made in an app. In other words, Apple is justified in requiring IAP for in-app purchases.

This is the essential bit of context for making sense of the only part of the case that Apple lost: the injunction against the App Store’s anti-steering provisions, which states:

Apple Inc. and its officers, agents, servants, employees, and any person in active concert or participation with them (“Apple”), are hereby permanently restrained and enjoined from prohibiting developers from (i) including in their apps and their metadata buttons, external links, or other calls to action that direct customers to purchasing mechanisms, in addition to In-App Purchasing and (ii) communicating with customers through points of contact obtained voluntarily from customers through account registration within the app.

As noted above, Gonzalez Rogers maintained throughout the decision that while Apple was certainly entitled to a commission, the appropriate rate was likely lower than 30%; here she argues that the App Store’s anti-steering provisions made the correct rate impossible to discover:

Apple’s own records reveal that two of the top three “most effective marketing activities to keep existing users coming back” in the United States, and therefore increasing revenues, are “push notifications” and “email outreach”. Apple not only controls those avenues but acts anticompetitively by blocking developers from using them to Apple’s own unrestrained gain. As explained before, Apple uses anti-steering provisions prohibiting apps from including “buttons, external links, or other calls to action that direct customers to purchasing mechanisms other than in-app purchase,” and from “encourag[ing] users to use a purchasing method other than in-app purchase” either “within the app or through communications sent to points of contact obtained from account registrations within the app (like email or text).” Thus, developers cannot communicate lower prices on other platforms either within iOS or to users obtained from the iOS platform. Apple’s general policy also prevents developers from informing users of its 30% commission.

These provisions can be severed without any impact on the integrity of the ecosystem and is tethered to legislative policy. As an initial matter, courts have long recognized that commercial speech, which includes price advertising, “performs an indispensable role in the allocation of resources in a free enterprise system.” Restrictions on price information “serve to increase the difficulty of discovering the lowest cost seller . . . and [reduce] the incentive to price competitively[.]” Thus, “where consumers have the benefit of price advertising, retail prices often are dramatically lower than they would be without advertising.” Antitrust scholars have recognized the same: “The less information a consumer has about relative price and quality, the easier it is for market participants to charge supracompetitive prices or provide inferior quality.”

Notice the references to “other platforms”; those are the web, Android, or, in cases like Fortnite, other consoles. Judge Gonzalez Rogers’ argument is not that Apple has to allow different payment options within an app — as noted in the previous section, that is Apple’s right to control, and even mandate — but rather that Apple can’t stop a developer from telling users that they can go outside the app to another platform to acquire digital content.³

The most obvious way this might have an impact is through developers offering lower prices if users are willing to pay on the web. Apple could theoretically counter this by requiring developers to offer the same price everywhere, but it seems unlikely that would pass muster with Judge Gonzalez Rogers. Note, though, that IAP is not going anywhere: external links can sit next to IAP, but they can’t replace it, and they can never be as well-integrated as Apple’s offering is.

Back to the decision:

Thus, although Epic Games has not proven a present antitrust violation, the anti-steering provisions “threaten[] an incipient violation of an antitrust law” by preventing informed choice among users of the iOS platform. Moreover, the anti-steering provisions violate the “policy [and] spirit” of these laws because anti-steering has the effect of preventing substitution among platforms for transactions. Apple has not offered any justification for the actions other than to argue entitlement. Where its actions harm competition and result in supracompetitive pricing and profits, Apple is wrong. Accordingly, the harm from the anti-steering provisions outweighs its benefits, and the provision violates the UCL under the balancing test.

The “UCL” is California’s Unfair Competition Law, which is broader than U.S. antitrust law, and includes provisions for “incipient violations” and “unfair conduct”; this is the legal underpinning for Judge Gonzalez Rogers’ injunction. This is also the other part of the ruling that Apple may appeal: the company already argued in court that Judge Gonzalez Rogers should not consider violations under the UCL separately from violations under federal antitrust law, and while Judge Gonzalez Rogers took particularly scathing interest in Apple’s anti-steering provisions during CEO Tim Cook’s testimony, they were not a major focus of Epic’s case. It’s also unclear on what grounds a case about “mobile game transactions” resulted in wholesale changes to the entire App Store.⁴ Moreover, the Supreme Court recently ruled in favor of anti-steering provisions in a case about American Express’s policies; Gonzalez Rogers made a good argument that this situation is different, but that is open to interpretation. And, of course, UCL is a California law, but Gonzalez Rogers said the injunction applied nationwide.

Apple’s Next Move

To reiterate what I said at the beginning, this was a near total victory for Apple, and a devastating defeat for Epic. Not only did the Fortnite-maker not gain the opportunity to build their own app store or have their own in-app purchases, Judge Gonzalez Rogers also ruled that Apple was justified in revoking the development license for not just Fortnite but all of Epic’s subsidiaries, including Unreal Engine. That means that Epic, at least for now, can’t work on its licensable engine for other developers.

More broadly, while some of Apple’s claims were curtailed, its App Store model was by-and-large found to be legal (at least for games). Even the injunction against anti-steering made clear that Apple can, if it wishes, insist that apps include its IAP system alongside links to another platform (i.e. the web). Might Apple start insisting that Netflix and Spotify re-add IAP at the same time they put in links to their websites?

I think that would be unwise, for two reasons.

First, while antitrust cases are decided by the courts, it is important to remember that the question at hand is about statute interpretation, not constitutionality. That means that Congress can simply change the statutes, or, in the specific case of the App Store, pass laws explicitly undoing Apple’s approach. If that happens this case is moot, which is to say that Apple would do well to appease would-be regulators, instead of doubling-down on its current policies.

Second, not only did this case demonstrate that games are by far the biggest revenue drivers in the App Store (around 75% of revenue, and 98% of in-app purchases), but Judge Gonzalez Rogers’ decision made the case that the games market is distinct from the broader app market. This is an opportunity that Apple should embrace to treat games differently.

This would result in a two-prong strategy: first, expand on Apple’s recent settlement with the Japan Fair Trade Commission to make clear that all non-game apps (not just “Reader” apps) can link to external websites for payments, effectively ending the anti-steering provision for non-game apps, while second, appeal the anti-steering injunction in this case. Should the company win the latter it can both fully deliver on its commitment to App Store security in terms of games, making all purchases run through IAP, even as loosening the reins on non-game apps both relieves regulatory pressure and, more importantly, expands the economic possibilities of the app economy.

This is biased advice, to be sure; it’s exactly what I’ve been begging Apple to do for years. The risk of taking so long to change course is decisions like this: Apple won on almost every count but one, but that one has the potential to cause Apple a fair bit of trouble. Games have always been a vector for scams and abuse; it would have been much better (and profitable) for Apple to keep tight control of the category while giving ground elsewhere. Now it has to deal with a blanket injunction and critics who still don’t think it is enough.

I wrote a follow-up to this Article in this Daily Update.

The full exposition of this reasoning is on Page 61 of the ruling ↩
This is generally held to require at least 65% market share ↩
This is admittedly unclear from the one page injunction, so I can see why some observers are arguing that the injunction allows alternative in-app purchase flows; however, this argument simply doesn’t make sense in the context of the entire ruling, which makes clear that alternative platforms are websites and other operating systems ↩
Not that I’m complaining! ↩

Tech Epochs and the App Store Trap

Tuesday, September 7, 2021Thursday, September 9, 2021

Matthew Brooker, writing for Bloomberg Opinion, is worried about Xi Jinping leading China into a trap:

The middle-income trap describes how economies tend to stall and stagnate at a certain level of development, once wages have risen and productivity growth becomes harder. Relatively few make the transition to high-income status. The history of those that have, such as South Korea and Taiwan, points to a need for the state’s role to retreat as markets advance. Ad hoc interventions by governments may work at more basic levels of development. At higher income levels, economies become too complex for command-and-control management by individuals. Systems are increasingly what matters. Rules that are transparent, predictable and fairly applied enable market forces to take over the job of directing economic activity, raising efficiency and allowing innovation to flourish.

This inevitably implies some ceding of power by the rulers. It also potentially implies political change. South Korea and Taiwan both transitioned from authoritarian to democratic political systems as they became richer. The largest high-income economies are almost all democracies. Xi, a believer in the historic mission and preordained victory of the Communist Party, is far from receptive to such a message. The party has embraced markets, but from a position of superiority. Like laws, they are there to be used, when useful; the party remains supreme, above all.

I have spent a fair bit of time over the last few months discussing China’s recent crackdown on its tech industry; to me one of the most interesting questions is whether China’s renewed quest to catch up technologically, particularly in the area of semiconductors, might suffer from the country’s recent crackdown. Dan Wang argued in Foreign Affairs (and previously, in a Stratechery Daily Update interview) that U.S. sanctions were exactly the sort of spur the country needed:

China’s private entrepreneurial firms have driven the bulk of the country’s technological success, even though their interests have not always aligned with the state’s goal of strengthening domestic technology. Beijing has, for example, recently begun cracking down on certain consumer Internet companies and online education firms, in part to redirect the country’s efforts towards other strategic technologies such as computer chips. This has meant that China’s most impressive technological achievements—building state-of-the-art capabilities in renewable energy, consumer Internet services, electronics, and industrial equipment—have as often been driven in spite of state interference as they have because of it.

Then came U.S. President Donald Trump. By sanctioning entrepreneurial Chinese companies, he forced them to stop relying on U.S. technologies such as semiconductors. Now, most of them are trying to source domestic alternatives or design the necessary technologies themselves. In other words, Trump’s gambit accomplished what the Chinese government never could: aligning private companies’ incentives with the state’s goal of economic self-sufficiency.

What happens, though, if the priorities of those private companies shifts from winning in the market to satisfying the Party? Is there a cost to losing world-class founders and entrepreneurs like ByteDance CEO Zhang Yiming and Pinduoduo CEO Colin Huang? It is one thing to align private incentives with state incentives; it is an open question if doing so by removing the drive for dominance and outsized profits ends up being a case of one step forwards, and two steps back.

Tech Epochs

In 2014 I described the The Three Epochs of Consumer Tech to that point; to summarize my argument (which, as is always the case seven years on, isn’t perfect):

The PC epoch had Windows as its operating system, productivity software as its killer app, and email was the dominant communications medium.
The Internet epoch had the browser as its operating system, search as its killer app, and social networking, particularly Facebook, was the dominant communications medium.
The mobile epoch had iOS and Android as its operating systems, the sharing economy as its killer app, and messaging was the dominant communications medium.

At the time I posited that the next epoch was unclear; I listed wearables, Bitcoin, and mobile applications like Uber as possibilities, although settled on messaging as being the most likely to be the fourth epoch.

Then, in 2020, I argued we had reached The End of the Beginning:

There may not be a significant paradigm shift on the horizon, nor the associated generational change that goes with it. And, to the extent there are evolutions, it really does seem like the incumbents have insurmountable advantages: the hyperscalers in the cloud are best placed to handle the torrent of data from the Internet of Things, while new I/O devices like augmented reality, wearables, or voice are natural extensions of the phone.

In other words, today’s cloud and mobile companies — Amazon, Microsoft, Apple, and Google — may very well be the GM, Ford, and Chrysler of the 21st century. The beginning era of technology, where new challengers were started every year, has come to an end; however, that does not mean the impact of technology is somehow diminished: it in fact means the impact is only getting started.

Indeed, this is exactly what we see in consumer startups in particular: few companies are pure “tech” companies seeking to disrupt the dominant cloud and mobile players; rather, they take their presence as an assumption, and seek to transform society in ways that were previously impossible when computing was a destination, not a given. That is exactly what happened with the automobile: its existence stopped being interesting in its own right, while the implications of its existence changed everything.

That article was about the overall shift in computing from mainframes to PCs to mobile, which mirrored the shift from one room computing to desktop computing to cloud computing:

This is a progression where the potential for crypto-based computing and its inherent decentralization fits right in (especially as politically-motivated tech companies provide the impetus).

Note, though, that these two articles don’t mirror each other exactly: Epoch 2, the Internet epoch, wasn’t really about the underlying hardware at all; rather, it was the PC epoch that provided the foundation for the Internet epoch. Google and Facebook would have been much less valuable if there weren’t already hundreds of millions of people with PCs and Internet connections; a similar reduction in value would have occurred if Microsoft had been able to control what people accessed on the web, and on what terms.

It was the Internet, meanwhile, that gave mobile the fuel to get off of the ground; remember how Steve Jobs introduced the iPhone:

Jobs wasn’t wrong — Apple absolutely did reinvent the phone — but it did so on the back of concepts that already existed: the iPod, mobile phones, and, most importantly, the Internet. And then Apple introduced the App Store.

The App Store Economy

Thirteen years on and its easy to lose sight of just how important Apple’s approach to the App Store was not only for the iPhone but also developers. John Gruber, in the wake of South Korea passing a law opening up in-app payments, wrote on Daring Fireball:

I think the latter half of Apple’s statement is true — user trust in in-app purchases will decline…there’s no denying that the result of any of these laws would be to make iOS and Google’s Android more like Macs and PCs. There’s also no denying that people make far more digital purchases and install far more apps on their mobile devices (iOS or Android) than their PCs (Mac or Windows)…

But I am confident that the overwhelming majority of typical users are more comfortable installing apps and making in-app purchases on their iOS and Android devices than on their Mac and Windows PCs not despite Apple and Google’s console-like control over iOS and Android, but because of it. And if these measures come to pass and iOS and Android devices are forced by law to become pocket PCs, I think there’s a high chance it’ll prove unpopular with the mass market. The masses are not clamoring for the app stores to be opened up. These arguments over app stores are entirely inside baseball for the technical and business classes. I’ve had non-technical friends and relatives complain to me about all sorts of things related to their iPhones over the last 10 years, but never once have any of them said to me, “Boy, I sure wish iPhone apps and games could ask me for my credit card number to make purchases, and that the overall experience of using apps was more like the anything-goes nature of using the web or my desktop computer.” Never. It doesn’t just seem that the unintended consequences of such legislation is being under-considered; it seems as though it’s not being considered or acknowledged at all.

Perhaps I’m wrong, and it’ll all work out just fine. Anyone who claims to know how such a scenario will turn out is full of shit. But from what I’ve seen over the last few decades, the quality of the user experience of every computing platform is directly correlated to the amount of control exerted by its platform owner. The current state of the ownerless world wide web speaks for itself.

It’s easy for developers to measure the 30% that Apple takes of their earnings, or the cost it takes to implement the company’s in-app purchasing APIs, or the time it takes to deal with App Review. It’s much harder, particularly in 2021, to appreciate the extent to which Apple increased the total addressable market for everyone, not simply by inventing a device that could be used everywhere, but also by enforcing a distribution model that made consumers feel safe and thus willing to try out far more apps than they ever did on PC. And Gruber is right, that even now it is possible that loosening the App Store rules might have unintended consequences on those same developers chafing under Apple’s control.

At the same time, I think that Gruber underrates the impact of the “ownerless world wide web”; yes, I myself wrote an article in 2015 entitled Why Web Pages Suck,¹ and yes, that is an inevitable outcome of a lack of centralized quality control. An arena where anything goes, though, doesn’t simply make it possible to produce garbage, but also things that are completely new to the world: rules that limit bad things have the unfortunate side effect of limiting good things that the rule-maker never considered.

One example, if I may be so immodest, is this site: not only did I not have the wherewithal to build an app in 2013, the App Store only offered Newsstand subscriptions for established publications; I could, though, build a web page, and leverage services like Stripe to charge subscriptions. Yes, Apple has since expanded the use of App Store subscriptions, but in almost all cases that support has chased use cases, from streaming to reading to video to collaboration and cloud services, that were first pioneered on the ownerless world wide web.

What is new to the App Store are the shift of more and more productivity applications to subscription billing. This trend, to be fair, started with Microsoft and Adobe, but even basic utility apps have followed suit. What is not clear is if, in a vacuum, this is particularly good for their business: for years small apps thrived on the PC and especially the Mac by leveraging Internet distribution and monetizing via paid upgrades, which struck a balance between making more money from your best customers, a necessity for every business, without introducing subscription fatigue and a sense of resentment from marginal customers not sure if they can justify the ongoing expense.

The App Store, though, is not a vacuum: it is an economy where Apple sets the rules, and I’ve been writing about how traditional developer business models simply weren’t enabled for as long as this site has been around; by 2015 it seemed clear that the era of mobile productivity apps was going to be a disappointing one:

That, then, means that Cook’s conclusion that Apple could best improve the iPad by making a new product isn’t quite right: Apple could best improve the iPad by making it a better platform for developers. Specifically, being a great platform for developers is about more than having a well-developed SDK, or an App Store: what is most important is ensuring that said developers have access to sustainable business models that justify building the sort of complicated apps that transform the iPad’s glass into something indispensable.

That simply isn’t the case on iOS. Note carefully the apps that succeed on the iPhone in particular: either the apps are ad-supported (including the social networks that dominate usage) or they are a specific type of game that utilizes in-app purchasing to sell consumables to a relatively small number of digital whales.

Six years on and not much has changed; iPad hardware continues to improve, the consumption experience remains fantastic, and the Pencil has unlocked interesting new use cases. Killer apps, though, that are uniquely possible on the iPad, are still quite rare; Apple pitches the device as a PC replacement, but even then the most advanced demo is Photoshop. It is as if the iPad specifically and productivity software on iOS generally is in a sort of “middle-income trap”: the obvious tools are there, and giant software developers with their subscription plans can justify building complex apps, but the innovation in the ecosystem has never lived up to Jobs’ vision.

Challenges, Creators, and Metaverses

I do think the mobile productivity ship has sailed, particularly in terms of the iPad. It’s a fine device with fine apps, and it’s great for consuming media. And, I should note, Apple sold $30 billion worth of the devices over the last 12 months. That is hardly a flop — quite the opposite, in fact.

Go back to the analogy at the beginning of this Article, though: a country in the middle income trap is by nearly every objective measure a massive success. That is certainly the case for China, the development and growth of which has done more to alleviate human poverty than any event in human history. Today China is in many sectors, particularly labor-centric manufacturing, the most advanced economy in the world, with world-class cities and infrastructure that puts much of the U.S. to shame. The challenge now, though, is to not simply catch up to the West but to surpass it, and that means innovation in ways that go beyond applying Western technology to China-specific use cases and taking advantage of leapfrog opportunities (like payments); whether that innovation can be achieved as control is re-centralized is one of the most important questions of the next decade.

Apple, meanwhile, is seeing more challenges to its centralized control of the app economy than ever before, from antitrust lawsuits to potential legislation to run-ins with regulators around the world. At the same time there is an ongoing explosion in completely new digital-first business models, including the so-called creator economy and meta-verses like Roblox, and over the horizon, the crypto-economy.

It is those challenges that will, slowly but surely, force Apple to give up control. Last week’s news that Apple, after settling with the Japan Fair Trade Commission, will allow “a single link” to ‘reader’ apps² on a worldwide basis suggests a new more open approach and a stubborn refusal to give up iron-fisted control of the App Store economy all at the same time. Time will tell if Apple decides to rethink the App Store in one fell swoop, or if regulators dismantle Apple’s regime piece-by-piece, and potentially geography-by-geography, in a way that harms Apple’s core business.

What is important, though, is that these changes happen sooner rather than later, for the sake of tech’s fourth epoch.

The Fourth Epoch

If consumer tech’s second epoch — the Internet — was built on and enabled by the first — the PC — then it follows that the fourth epoch is built on and enabled the third. Both the creator economy and metaverses fit the bill: yes, some creators can make a go of it on the web, but I’ll be the first to say that that is only possible because of social networks. What seems more likely are that creators emerge on platforms built to accommodate them, and those platforms themselves will sit on top of mobile. That is even more likely to be the case when it comes to metaverses, which are likely able to deliver superior experiences as a native app than as a web app.³

The problem is the App Store: if Apple is taking 30% of every transaction, and the platform owner their own share for having created the opportunity and toolset for the creator, then that means creators need that many more fans to make a living, reducing the number who are successful. It’s the same story for metaverses: Roblox isn’t remotely profitable, even as it pays its developers pennies-on-the-dollar, thanks in large part to Apple taking 30% for the pleasure of existing on iOS. Apple is absolutely right that the App Store created economic opportunity; it is also taking it away from an expanding universe of creators and developers who have no reason to interact with iOS APIs.

What is particularly frustrating about this state of affairs is that it is not as if Apple is making things easier for creator platforms: look no further than Twitter’s new super-follows feature, which is easy-to-understand from a user perspective — pay X amount of dollars to get access to subscriber-only tweets — but only because Twitter is creating in-app subscriptions by hand for every super-tweeter, and even then is limited to 10,000 in-app purchase options. Other creator platforms like Twitch create convoluted token-based subscription schemes to get around Apple’s in-app purchase limitations that obfuscate prices and result in worse outcomes for the creators in terms of retaining customers; customers, meanwhile, pay more in the app than they do on the web to cover Apple’s fees; these fees, quite clearly, exist because of the company’s total control of apps, not because any value is being provided.

Of course these are big well-known companies fighting with the biggest, most well-known company; the question, as always, is about the companies that aren’t formed, the creators that aren’t empowered, the metaverses that die on the vine because developers couldn’t make money, or the platform creator couldn’t justify the risk. Looking back it’s easy to see how Microsoft and Windows could have stifled the Internet epoch; Apple (and Google!) ought not hold back the full potential of the app-platform epoch.

Epoch Bridges

I’ve written a lot about the App Store over the entire course of Stratechery generally, and over the last year specifically. Yes things are hopefully changing, and that is a reason for analysis, but I could see an argument that emerging technologies like crypto are much more interesting.

To that point, though, it’s worth noting that there is one additional reason beyond greed or control of the customer experience why Apple and Google might not be motivated to loosen their control of apps: if crypto is tech’s fifth epoch — and there is a very good chance that is the case — then it is very much in the crypto-industry’s interest to pay attention to and weigh in on these App Store battles. Remember that the Internet provided the bridge from the PC to mobile; in a well-functioning market apps and platform-level APIs would provide the bridge from mobile to crypto. Just think about all of the obstacles there are in making crypto applications user-friendly and accessible to general users, and how much more would be possible if mobile were as open and configurable as the PC.

And, of course, it is worth considering how bad that might be in the long run for Apple and Google. If those in power are primarily concerned with protecting their position then perhaps it is inevitable that innovation is a casualty.

I wrote a follow-up to this Article in this Daily Update.

Also in response to Gruber! ↩
“Reader” apps are defined in the App Store Guidelines as apps that “allow a user to access previously purchased content or content subscriptions (specifically: magazines, newspapers, books, audio, music, and video).” ↩
The question as to whether Apple is handicapping mobile Safari is separate but related. ↩

Regulators and Reality

Wednesday, September 1, 2021Thursday, September 2, 2021

It is coming up on two weeks since the FTC refiled its case against Facebook;¹ from the Wall Street Journal:

The Federal Trade Commission filed a new version of its antitrust lawsuit against Facebook Inc. on Thursday, seeking to jump-start its case with bolstered allegations that the company is abusing a monopoly position in social media…The FTC’s amended complaint comes after a federal judge in June dismissed the agency’s original lawsuit, saying it didn’t make sufficient allegations to support claims that Facebook engaged in unlawful monopolization.

With its new, 80-page lawsuit, the FTC seeks to tell a longer, more detailed story about why it believes Facebook is a dominant force that uses its power to hobble any rival that might threaten its market position.

As a quick refresher, the original lawsuit was filed last December and, as I noted at the time, completely failed to characterize Facebook as a monopoly. U.S. District Judge James Boasberg agreed; from his opinion dismissing the case:

Although the Court does not agree with all of Facebook’s contentions here, it ultimately concurs that the agency’s Complaint is legally insufficient and must therefore be dismissed. The FTC has failed to plead enough facts to plausibly establish a necessary element of all of its Section 2 claims — namely, that Facebook has monopoly power in the market for Personal Social Networking (PSN) Services. The Complaint contains nothing on that score save the naked allegation that the company has had and still has a “dominant share of th[at] market (in excess of 60%).” Such an unsupported assertion might (barely) suffice in a Section 2 case involving a more traditional goods market, in which the Court could reasonably infer that market share was measured by revenue, units sold, or some other typical metric. But this case involves no ordinary or intuitive market. Rather, PSN services are free to use, and the exact metes and bounds of what even constitutes a PSN service — i.e., which features of a company’s mobile app or website are included in that definition and which are excluded — are hardly crystal clear. In this unusual context, the FTC’s inability to offer any indication of the metric(s) or method(s) it used to calculate Facebook’s market share renders its vague “60%-plus” assertion too speculative and conclusory to go forward. Because this defect could conceivably be overcome by re-pleading, however, the Court will dismiss only the Complaint, not the case, and will do so without prejudice to allow Plaintiff to file an amended Complaint.

As I noted in June, the FTC’s problem was not laziness, but that Facebook doesn’t have a monopoly; given that, you won’t be surprised to learn that I don’t find the FTC’s new case compelling.

The FTC’s Case

Here is the FTC’s new attempt to define Facebook’s market of “personal social networking services” (all quotes are from the amended complaint):

Personal social networking services consist of online services that enable and are used by people to maintain personal relationships and share experiences with friends, family, and other personal connections in a shared social space. Personal social networking services are a unique and distinct type of online service. Three key elements distinguish personal social networking services from other forms of online services provided to users.

First, personal social networking services are built on a social graph that maps the connections between users and their friends, family, and other personal connections…

Second, personal social networking services include features that many users regularly employ to interact with personal connections and share their personal experiences in a shared social space, including in a one-to-many “broadcast” format…

Third, personal social networking services include features that allow users to find and connect with other users, to make it easier for each user to build and expand their set of personal connections. The social graph also supports this feature by informing which connections are suggested or available to users. Within the United States, the most widely used personal social networking services are Facebook Blue, Instagram, and Snapchat.

The next several paragraphs attempt to explain why these are the only three apps in the space:

Personal social networking is distinct from, and not reasonably interchangeable with, mobile messaging services. Mobile messaging services do not feature a shared social space in which users can interact, and do not rely upon a social graph that supports users in making connections and sharing experiences with friends and family…

Personal social networking is distinct from, and not reasonably interchangeable with, specialized social networking services that are designed for, and are utilized by users primarily for, sharing a narrow and highly specialized category of content with a narrow and highly specialized set of users for a narrow and distinct set of purposes…

Personal social networking is distinct from, and not reasonably interchangeable with, online services that focus on the broadcast or discovery of content based on users’ interests rather than their personal connections. Prominent examples are Twitter, Reddit, and Pinterest…

Personal social networking is distinct from, and not reasonably interchangeable with, online services focused on video or audio consumption such as YouTube, Spotify, Netflix, and Hulu. Users employ such services primarily for the passive consumption of specific media content (e.g., videos or music) from and to a wide audience of typically unknown users…

TikTok is a prominent example of a content broadcasting and consumption service that is not an acceptable substitute for personal social networking services. TikTok users primarily view, create, and share video content to an audience that the poster does not personally know, rather than connect and personally engage with friends and family. The purpose for which users employ TikTok, and the predominant form of interaction on the platform, is not driven by users’ desire to interact with networks of friends and family.

There are two major problems with this argument: the FTC’s own definitions, reasonably understood, don’t reflect reality, and second, the definitions themselves have no relation to the actual market for online services.

Start with the parameters laid out by the FTC:

First, WhatsApp is a mobile messaging service. So how is Facebook acquiring it illegal? The FTC’s suit attempts to make the case that Facebook was worried that WhatsApp would evolve into a competitor had Facebook not purchased it, but then why doesn’t that concern apply to every other mobile messaging service? It is the height of motivated reasoning to spin the WhatsApp acquisition as anticompetitive while simultaneously excluding the entire category in which WhatsApp resides.
Second, arguing that Facebook is unique from every other social network other than Instagram and Snapchat completely ignores what the product actually does. Apparently the fact that LinkedIn lets you feature your resume (as does Facebook, by the way) means the fact that it is explicitly focused on maintaining and facilitating communications and connections doesn’t matter, despite the fact anything you can do on Facebook can be done on LinkedIn.
Third, while it is nice that the FTC bothered to include TikTok in their complaint — the December complaint didn’t mention the app once — any definition that says that Instagram is like Facebook but is not like TikTok is ridiculous. Both let you connect with people you know, but both are primarily focused on broadcast-follow dynamics, not interpersonal communication. This distinction, in conjunction with the previous one, is again motivated reasoning: Facebook is much more like LinkedIn, and Instagram is much more like TikTok, but that’s a problem for the FTC because it ruins their case.

The far bigger problem, though, is that everything I just wrote is meaningless, because everything listed above is a non-rivalrous digital service with zero marginal costs and zero transactional costs; users can and do use all of them at the same time. Indeed, the fact that all of these services can and do exist for the same users at the same time makes the case that Facebook’s market is in fact phenomenally competitive.

What, though, is Facebook competing for? Competition implies rivalry, that is, some asset that can only be consumed by one service to the exclusion of others, and the only rivalrous good in digital services is consumer time and attention. Users only have one set of eyes, and only 24 hours in a day, and every second spent with one service is a second not spent with another (although this isn’t technically true, since you could, say, listen to one while watching another while scrolling a third while responding to notifications from a fourth, fifth, and sixth). Note the percentages in this chart of platform usage:

The total is not 100, it is 372, because none of these services exclude usage of any of the others. And while Facebook is obviously doing well in terms of total users, TikTok in particular looms quite large when it comes to time, the only metric that matters:

This, of course, is why all of these services, including Instagram, Snapchat, and YouTube are trying to mimic TikTok as quickly as possible, which, last time I checked, is a competitive response, not a monopolistic one. You can even grant the argument that Facebook tried to corner the social media market — whatever that is — a decade ago, but you have to also admit that here in 2021 it is clear that they failed. Competition is the surest sign that there was not actually any anticompetitive conduct, and I don’t think it the FTC’s job to hold Facebook management accountable for failing to achieve their alleged goals.

Prices and Politics

Judge Boasberg, in his opinion dismissing the original FTC case, hinted at what seemed to be the FTC’s political motivations:

The Court’s decision here does not rest on some pleading technicality or arcane feature of antitrust law. Rather, the existence of market power is at the heart of any monopolization claim. As the Supreme Court explained in Twombly, itself an antitrust case, “[A] district court must retain the power to insist upon some specificity in pleading before allowing a potentially massive factual controversy to proceed.” Here, this Court must exercise that power. The FTC’s Complaint says almost nothing concrete on the key question of how much power Facebook actually had, and still has, in a properly defined antitrust product market. It is almost as if the agency expects the Court to simply nod to the conventional wisdom that Facebook is a monopolist. After all, no one who hears the title of the 2010 film “The Social Network” wonders which company it is about. Yet, whatever it may mean to the public, “monopoly power” is a term of art under federal law with a precise economic meaning: the power to profitably raise prices or exclude competition in a properly defined market.

Facebook clearly can’t exclude competitors, and, it should be noted, doesn’t even have the means to raise prices; the FTC, frustratingly enough, doesn’t appear to understand how Facebook’s digital ad market works. Eric Seufert wrote in an article entitled Dear FTC, repeat after me: ad platforms don’t set prices:

Multiple times throughout the complaint, the FTC declares that Facebook’s monopoly control over the market for personal social networking resulted in unnaturally high “advertising prices.” This is simply incorrect, and it reveals a lack of understanding of the digital advertising ecosystem and how advertising inventory is priced…

Digital advertising inventory on large platforms like Facebook is sold through an auction: advertisers bid for impressions, the highest bidder wins, and, depending on the auction design used, either the second-highest (in some flavor of a second-price auction, such as the Vickrey-Clarke-Groves auction design that Facebook employs) or the highest (in a first-price auction) bid sets the price for the placement. Most modern, sophisticated ad platforms allow advertisers to bid against conversions — purchases, registrations, etc. — versus simply bidding for an impression, and the ad platforms use campaign performance to throttle delivery based on calculated click and conversion probabilities for any given user…

The price that an advertiser bids on inventory is wholly dependent on the value of conversions that are produced by that platform. And the degree to which advertisers win auctions is dependent on the competition for that inventory. There is no reason to believe that any advertiser would be paying less for advertising inventory on the Facebook Blue app (or website) today if Facebook had not acquired Instagram or WhatsApp, or if any number of competitive products (but not TikTok!) had entered the very-specifically-defined market in which the FTC believes Facebook operates.

This is why Judge Boasberg’s line that “it is almost as if the agency expects the Court to simply nod to the conventional wisdom that Facebook is a monopolist” stings: Facebook is obviously not particularly popular in Washington D.C., but that is a wholly distinct matter from it being a monopolist. If the powers that be decide that the company needs new kinds of regulation, the answer should be new laws, not redefining antitrust to be about the specific implementation of a non-rivalrous digital service, destroying the credibility of the FTC as a regulator along the way.

Government and Private Industry

That noted, I have to be honest: the prospect of new laws makes me increasingly nervous as well. I absolutely get the case that these platforms are powerful in a way that is deeply suspicious to Americans, and understand the impetus for new regulation, but for me the last two years have been an eye-opening experience about capacity and capability. We have witnessed the federal government, under two different administrations, fumble its way through a pandemic, while its supposedly most capable branch oversaw a disastrous withdrawl from a 20-year nation-building effort that collapsed in a matter of days. The tech industry, meanwhile, has kept the entire world economy running remote with hardly a hiccup, even as other private companies conceived of, tested, and distributed over a billion vaccines and counting. Are we sure we want the former dictating how the latter run their businesses?

China, meanwhile, is going in the opposite direction, taking seats on the board’s of the country’s most innovative companies, driving out founders and killing IPOs, and even limiting when kids can play video games. The most favorable reading of China’s actions is that at least its state has demonstrated the capacity for action — witness how China has brought COVID under control within its borders — but that comes with a level of interference with fundamental freedoms that Americans will never tolerate, and still unanswered questions about just where innovation will come from when pleasing the government is every company’s top priority.

The appropriate response to this challenge — and China is absolutely a challenge — is to reject a top-down approach conducted via regulators with less capacity and greater encumbrances than Beijing, and instead let the tech industry and private companies generally continue to do what they do best: compete. This administration’s antitrust crusaders, unfortunately, don’t really get how markets work. This snippet from The Ezra Klein Show with Tim Wu, a National Economic Council member in charge of technology and competition policy, has stuck with me ever since I heard it in 2016; this was Wu’s takeaway from working in Silicon Valley for a silicon valley startup guilty of accounting fraud:

It kind of changed my thinking about the market and private industry. This was the height of the 90s, government doesn’t have the answers, trust the market, the era of government is over, and I worked in government. The Supreme Court wasn’t perfect, it was relatively public-minded, I don’t think the justices were on the take or anything like that, then I went to private industry, and you know, this was maybe a bad sample — it was WorldCom/Enron era — but these guys didn’t seem to possess any particular wisdom or any special insight into their industry even, they just were all about convincing people to buy a stock, move it up, and then dump it. It really changed my thinking. I actually think I changed my politics, both at the Supreme Court and in Silicon Valley, to become much more suspicious of private actors.

That certainly is about as bad a sample as you can get — I can see why Wu was disillusioned — but here’s the thing: Riverstone Networks, the startup he worked for, ended up in bankruptcy and no longer exists. That is the beauty of the private market — not that everyone is somehow smarter than government, but that there is actual accountability for failure. It’s why Silicon Valley celebrates startups, even though most fail, or are acquired: the best way to innovate is not through top down dictates, but more rolls of the dice.

Lessons Learned

This isn’t my first article about the FTC and tech; back in February 2020, when the FTC requested data from the big five tech companies and their history of acquisitions, I wrote First, Do No Harm; my argument then was that while it would have been better had Facebook not acquired Instagram, thanks to the company’s dominance, regulators risked over-reacting and upsetting a Silicon Valley ecosystem that was driving the U.S. economy.

Two years later, and I have to update my position: in a perfect world with perfect regulators I still think the Instagram acquisition shouldn’t have happened, but you can no longer plausibly argue that Facebook has any sort of monopoly power; look no further than recent tech earnings, where the prevailing story was how company after advertising-supported company was absolutely crushing it, in stark contrast to six years ago when Facebook really did look unstoppable. The market worked.

And, over that same post-February 2020 time period, we have been reminded regulators are not perfect, not even close, even as the tech industry has proven itself to be an even more important and capable asset than ever. Sure it may be a 90s cliché to argue “government doesn’t have the answers, trust the market”, but at some point the reality of the government we have, the competition we face, and the assets we can unleash, has to matter more than holding onto politics for politics’ sake.

I was on vacation 🤷‍♂️ ↩

Apple’s Mistake

Monday, August 9, 2021Wednesday, August 11, 2021

It was in August 2009, two months after the release of the iPhone 3GS, that the barbarians crashed the gates; from The Online Photographer:

The leading photo sharing site, flickr.com, charts the popularity of the cameras used by its membership. Recently the Apple iPhone has jumped into a virtual tie for first place with the Canon XTi. Furthermore, flickr states on its “Camera Finder” page that it can only detect the camera used about 2/3rds of the time, and that, therefore, cameraphones are under-represented on the graphs. Yikes.

The iPhone would go on to not only be the number one camera on Flickr, but in a far more compelling measure of its impact, create the conditions for Instagram, the photo-sharing network that eclipsed Flickr like Google once eclipsed Yahoo (Yahoo, of course, owned Flickr). Instagram itself was soon acquired by Facebook, which itself had benefited tremendously from the iPhone camera; having a good and ever-improving camera with you everywhere, paired with constant connectivity, transformed photos from memorials for special occasions to, in the words of Snap CEO Evan Spiegel, “part of the communication fabric of our daily lives.”

How is it, then, that a company like Facebook, which is mostly used on mobile — i.e. Android or iOS — made 20.3 million reports of Child Sexual Abuse Material (CSAM) in 2020, while Apple made only 265?¹ After all, there are almost certainly more photos on smartphones than there are on social networks — the former is in large part a superset of the latter.

18 USC § 2258A

U.S. Code Title 18 Part 1 Chapter 110 Section 2258A lays out how companies must handle CSAM (complete text here):

(a)Duty To Report.—

(1)In general.—

(A) Duty.—In order to reduce the proliferation of online child sexual exploitation and to prevent the online sexual exploitation of children, a provider—

(i) shall, as soon as reasonably possible after obtaining actual knowledge of any [CSAM], take the actions described in subparagraph (B); and
(ii) may, after obtaining actual knowledge of any facts or circumstances [suggesting imminent child abuse], take the actions described in subparagraph (B).

(B)I Actions described.—The actions described in this subparagraph are—

(i) providing to the CyberTipline of NCMEC [National Center for Missing & Exploited Children], or any successor to the CyberTipline operated by NCMEC, the mailing address, telephone number, facsimile number, electronic mailing address of, and individual point of contact for, such provider; and
(ii) making a report of such facts or circumstances to the CyberTipline, or any successor to the CyberTipline operated by NCMEC.

There is no escaping this responsibility when and if CSAM is discovered:

(e)Failure To Report.—A provider that knowingly and willfully fails to make a report required under subsection (a)(1) shall be fined—

(1) in the case of an initial knowing and willful failure to make a report, not more than $150,000; and
(2) in the case of any second or subsequent knowing and willful failure to make a report, not more than $300,000.

What is not required is that companies actively seek out CSAM on their services:

(f)Protection of Privacy.—Nothing in this section shall be construed to require a provider to—

(1) monitor any user, subscriber, or customer of that provider;
(2) monitor the content of any communication of any person described in paragraph (1); or
(3) affirmatively search, screen, or scan for facts or circumstances described in sections (a) and (b).

These two provisions get at why Facebook and Apple’s reported numbers have historically been so different: it’s not because there is somehow more CSAM on Facebook than exists on Apple devices, but rather that Facebook is scanning all of the images sent to and over its service, while Apple is not looking at what is in your phone, or on their cloud. From there the numbers make much more sense: Facebook is reporting what it finds, while Apple is, as the title of Section (3) suggests, protecting privacy and simply not looking at images at all.

Apple Protects Children

Last week Apple put up a special page on their website entitled Expanded Protections for Children:

At Apple, our goal is to create technology that empowers people and enriches their lives — while helping them stay safe. We want to help protect children from predators who use communication tools to recruit and exploit them, and limit the spread of Child Sexual Abuse Material (CSAM).

Apple is introducing new child safety features in three areas, developed in collaboration with child safety experts. First, new communication tools will enable parents to play a more informed role in helping their children navigate communication online. The Messages app will use on-device machine learning to warn about sensitive content, while keeping private communications unreadable by Apple.

Next, iOS and iPadOS will use new applications of cryptography to help limit the spread of CSAM online, while designing for user privacy. CSAM detection will help Apple provide valuable information to law enforcement on collections of CSAM in iCloud Photos.

Finally, updates to Siri and Search provide parents and children expanded information and help if they encounter unsafe situations. Siri and Search will also intervene when users try to search for CSAM-related topics.

John Gruber at Daring Fireball has a good overview of what are in fact three very different initiatives; what unites, them, though, and continues to differentiate Apple’s approach from Facebook’s, is that Apple is scanning content on your device, while Facebook is doing it in the cloud. Apple emphasized repeatedly that this ensured that Apple does not get access to your content. From the “Communications Safety in Messages” section:

Messages uses on-device machine learning to analyze image attachments and determine if a photo is sexually explicit. The feature is designed so that Apple does not get access to the messages.

From the “CSAM Detection” section:

Apple’s method of detecting known CSAM is designed with user privacy in mind. Instead of scanning images in the cloud, the system performs on-device matching using a database of known CSAM image hashes provided by NCMEC and other child safety organizations…This innovative new technology allows Apple to provide valuable and actionable information to NCMEC and law enforcement regarding the proliferation of known CSAM. And it does so while providing significant privacy benefits over existing techniques since Apple only learns about users’ photos if they have a collection of known CSAM in their iCloud Photos account. Even in these cases, Apple only learns about images that match known CSAM.

There are three ways to think about Apple’s approach, both in isolation and relative to a service like Facebook:² the idealized outcome, the worst case outcome, and the likely driver.

Capability Versus Policy

Apple’s idealized outcome solves a lot of seemingly intractable problems. On one hand, CSAM is horrific and Apple hasn’t been doing anything about it; on the other hand, the company has a longstanding commitment to ever increasing amounts of encryption, ideally end-to-end. Apple’s system, if it works precisely as designed, preserves both goals: the company can not only keep end-to-end encryption in Messages, but also add it to iCloud Photos (which is not currently encrypted end-to-end), secure in the knowledge that it is doing its part to not only report CSAM but also help parents look after their children. And, from a business perspective, it means that Apple can continue to not make the massive investments that companies like Facebook have in trust-and-safety teams; the algorithm will take care of it.

That, of course, is the rub: Apple controls the algorithm, both in terms of what it looks for and what bugs it may or may not have, as well as the input, which in the case of CSAM scanning is the database from NCMEC. Apple has certainly worked hard to be a company that users trust, but we already know that that trust doesn’t extend everywhere: Apple has, under Chinese government pressure, put Chinese user iCloud data on state-owned enterprise servers, along with the encryption keys necessary to access it. What happens when China announces its version of the NCMEC, which not only includes the horrific imagery Apple’s system is meant to capture, but also images and memes the government deems illegal?

The fundamental issue — and the first reason why I think Apple made a mistake here — is that there is a meaningful difference between capability and policy. One of the most powerful arguments in Apple’s favor in the 2016 San Bernardino case is that the company didn’t even have the means to break into the iPhone in question, and that to build the capability would open the company up to a multitude of requests that were far less pressing in nature, and weaken the company’s ability to stand up to foreign governments. In this case, though, Apple is building the capability, and the only thing holding the company back is policy.

Then again, Apple’s policy isn’t the only one that matters: both the UK and the EU are moving forward on bills that mandate online service companies proactively look for and report CSAM. Indeed, I wouldn’t be surprised if this were the most important factor behind Apple’s move: the company doesn’t want to give up on end-to-end encryption — and likely wants to expand it — which leaves on-device scanning as the only way to satisfy governments not (just) in China but also the West.

Cloud Versus Device

I think that there is another solution to Apple’s conundrum; what is frustrating from my perspective is that I think the company is already mostly there. Consider the status quo: back in 2020 Reuters reported that Apple decided to not encrypt iCloud backups at the FBI’s request:

Apple Inc. dropped plans to let iPhone users fully encrypt backups of their devices in the company’s iCloud service after the FBI complained that the move would harm investigations, six sources familiar with the matter told Reuters. The tech giant’s reversal, about two years ago, has not previously been reported. It shows how much Apple has been willing to help U.S. law enforcement and intelligence agencies, despite taking a harder line in high-profile legal disputes with the government and casting itself as a defender of its customers’ information.

This has a number of significant implications for Apple’s security claims, and is why earlier this year I ranked iMessage as being less secure than Signal, WhatsApp, Telegram, and Facebook Messenger:

iMessage encrypts messages end-to-end by default; however, if you have iCloud backup turned on, your messages can be accessed by Apple (who has the keys for iCloud backups) and, by extension, law enforcement with a warrant. Unlike WhatsApp, though, this is both on by default and cannot be turned off on a granular basis.

This caveat applies to almost everything on your iPhone: if you give in to the never-ending prompts to sign-in to iCloud and its on-by-default backup solution, your data is accessible to Apple and, by extension, law enforcement with a warrant. I actually think this is reasonable! I wrote this when that Reuters report came out:

Go back to what I said above: determined actors will have access to encryption and facial recognition. Anyone trying to argue whether or not these technologies should exist is not living in reality. It follows then, that we should take care to ensure that good actors have access to these technologies too. That means not making them illegal.

Second, though, legitimate societal concerns about the needs of law enforcement and the radicalizing nature of the Internet should be taken seriously. That means we should think very carefully about making encryption the default…This also splits the difference when it comes to principles: users have agency — they can ensure that everything they do is encrypted — while total privacy is available but not given by default.

I actually think that Apple does an excellent job of striking that balance today. When it comes to the iPhone itself, Apple is the only entity that can make it truly secure; no individual can build their own secure enclave that sits at the root of iPhone security. Therefore, they are right to do so: everyone has access to encryption.

From there it is possible to build a fully secure environment: use only encrypted communications, use encrypted backups to a computer secured by its own hardware-based authentication scheme, etc. Taking the slightly easier route, though — iCloud backups, Facebook messaging, etc. — means some degree of vulnerability that, let’s not forget, is sometimes justifiably leveraged. Law enforcement can get a warrant for those backups or chat logs, just as they can install a wire tap.

Again, this isn’t going to stop determined bad actors, but as I noted, nothing is. The question is what of the rest, those that get swept up by the worst sort of communities, and who commit legitimate crimes: what should their defaults be?

I made a similar argument about Facebook’s plans to encrypt-by-default Facebook Messenger conversations, which I opposed, even as I supported encryption-by-choice: I am not anti-encryption, and am in fact very much against mandated backdoors. Every user should have the capability to lock down their devices and their communications; bad actors surely will. At the same time, it’s fair to argue about defaults and the easiest path for users: I think the iPhone being fundamentally secure and iCloud backups being subject to the law is a reasonable compromise.

Apple’s choices in this case, though, go in the opposite direction: instead of adding CSAM-scanning to iCloud Photos in the cloud that they own and operate, Apple is compromising the phone that you and I own and operate, without any of us having a say in the matter. Yes, you can turn off iCloud Photos to disable Apple’s scanning, but that is a policy decision; the capability to reach into a user’s phone now exists, and there is nothing an iPhone user can do to get rid of it.

A far better solution to the “Flickr problem” I started with is to recognize that the proper point of comparison is not the iPhone and Facebook, but rather Facebook and iCloud. One’s device ought to be one’s property, with all of the expectations of ownership and privacy that entails; cloud services, meanwhile, are the property of their owners as well, with all of the expectations of societal responsibility and law-abiding which that entails. It’s truly disappointing that Apple got so hung up on its particular vision of privacy that it ended up betraying the fulcrum of user control: being able to trust that your device is truly yours.

I wrote a follow-up to this Article in this Daily Update.

Google made 547k ↩
Beyond the fact that it may be illegal ↩

Metaverses

Tuesday, August 3, 2021Thursday, October 28, 2021

Satya Nadella, for the record, was first: on May 25, 2021, during the keynote for Microsoft’s Build developer conference, he characterized a collection of Azure offerings as a metaverse:

Finally, as the virtual and physical worlds converge the metaverse made up of digital twins, simulated environments, and mixed reality, is emerging as a first-class platform. With the metaverse the entire world becomes your app canvas. With Azure Digital Twins you can model any asset or place with Azure IoT and keep the digital twin live and up-to-date. Synapse tracks the history of digital twins and finds insights to predict future states, and with Azure you can build autonomous systems that continually learn and improve. Power Platform enables domain experts to expand on and interact with digital twin data using low-code/no-code solutions. And Mesh and Hololens brings real-time collaboration.

The term “enterprise metaverse” came a month later at the Microsoft Inspire sales force keynote, but it was only on last week’s earnings call that most of the press caught on. As usual, no one cares unless Facebook is involved.

Metaverse Definitions

Facebook’s metaverse coming out party was this conversation between CEO Mark Zuckerberg and Casey Newton, which came on the heels of an internal presentation Zuckerberg gave at Facebook.

Newton: You told your employees that your future vision of Facebook is not the two-dimensional version of it that we’re using today, but something called the metaverse. So what is a metaverse and what parts of it does Facebook plan to build?

Zuckerberg: This is a big topic. The metaverse is a vision that spans many companies — the whole industry. You can think about it as the successor to the mobile internet. And it’s certainly not something that any one company is going to build, but I think a big part of our next chapter is going to hopefully be contributing to building that, in partnership with a lot of other companies and creators and developers. But you can think about the metaverse as an embodied internet, where instead of just viewing content — you are in it. And you feel present with other people as if you were in other places, having different experiences that you couldn’t necessarily do on a 2D app or webpage, like dancing, for example, or different types of fitness.

I think a lot of people, when they think about the metaverse, they think about just virtual reality — which I think is going to be an important part of that. And that’s clearly a part that we’re very invested in, because it’s the technology that delivers the clearest form of presence. But the metaverse isn’t just virtual reality. It’s going to be accessible across all of our different computing platforms; VR and AR, but also PC, and also mobile devices and game consoles. Speaking of which, a lot of people also think about the metaverse as primarily something that’s about gaming. And I think entertainment is clearly going to be a big part of it, but I don’t think that this is just gaming. I think that this is a persistent, synchronous environment where we can be together, which I think is probably going to resemble some kind of a hybrid between the social platforms that we see today, but an environment where you’re embodied in it.

The key difference between the Internet and the metaverse is the idea of “presence”; Matthew Ball, who has written extensively about the concept, including a ten-part Metaverse Primer earlier this summer, defined the Metaverse in 2020 as having these seven qualities:

Be persistent – which is to say, it never “resets” or “pauses” or “ends”, it just continues indefinitely

Be synchronous and live – even though pre-scheduled and self-contained events will happen, just as they do in “real life”, the Metaverse will be a living experience that exists consistently for everyone and in real-time

Be without any cap to concurrent users, while also providing each user with an individual sense of “presence” – everyone can be a part of the Metaverse and participate in a specific event/place/activity together, at the same time and with individual agency

Be a fully functioning economy – individuals and businesses will be able to create, own, invest, sell, and be rewarded for an incredibly wide range of “work” that produces “value” that is recognized by others

Be an experience that spans both the digital and physical worlds, private and public networks/experiences, and open and closed platforms

Offer unprecedented interoperability of data, digital items/assets, content, and so on across each of these experiences – your “Counter-Strike” gun skin, for example, could also be used to decorate a gun in Fortnite, or be gifted to a friend on/through Facebook. Similarly, a car designed for Rocket League (or even for Porsche’s website) could be brought over to work in Roblox. Today, the digital world basically acts as though it were a mall where every store used its own currency, required proprietary ID cards, had proprietary units of measurement for things like shoes or calories, and different dress codes, etc.

Be populated by “content” and “experiences” created and operated by an incredibly wide range of contributors, some of whom are independent individuals, while others might be informally organized groups or commercially-focused enterprises

As for the term “Metaverse”, it was coined by Neal Stephenson in 1992’s Snow Crash; this is how Stephenson introduced the idea:

The top surface of the computer is smooth except for a fisheye lens, a polished glass dome with a purplish optical coating. Whenever Hiro is using the machine, this lens emerges and clicks into place…The lens can see half of the universe—the half that is above the computer, which includes most of Hiro. In this way, it can generally keep track of where Hiro is and what direction he’s looking in…

A narrow beam of any color can be shot out of the innards of the computer, up through that fisheye lens, in any direction. Through the use of electronic mirrors inside the computer, this beam is made to sweep back and forth across the lenses of Hiro’s goggles, in much the same way as the electron beam in a television paints the inner surface of the eponymous Tube. The resulting image hangs in space in front of Hiro’s view of Reality. By drawing a slightly different image in front of each eye, the image can be made three-dimensional. By changing the image seventy-two times a second, it can be made to move. By drawing the moving three-dimensional image at a resolution of 2K pixels on a side, it can be as sharp as the eye can perceive, and by pumping stereo digital sound through the little earphones, the moving 3-D pictures can have a perfectly realistic sound track.

So Hiro’s not actually here at all. He’s in a computer-generated universe that his computer is drawing onto his goggles and pumping into his earphones. In the lingo, this imaginary place is known as the Metaverse. Hiro spends a lot of time in the Metaverse. It beats the shit out of the U-Stor-It.

Stephenson’s Metaverse had many of qualities Zuckerberg and Ball highlighted, including persistence, being synchronous and live, and the quality of being filled with “content and experiences created and operated by an incredibly wide range of contributors”; the vision in Snow Crash, though, had two crucial differences that made it fundamentally different.

The Missing Internet

The fact of the matter is that, contra Zuckerberg, the Metaverse of Snow Crash is virtual reality; when Hiro Protagonist, the, uhm, protagonist, wants to look up information in the Library, he needs to enter the Metaverse by putting on his goggles (he can ask the Librarian to speak to him while he is in the real world, but only after establishing his presence). What happens in the Metaverse does not impact what happens in reality (with the exception of Snow Crash — that is part of the mystery of the novel). This all makes sense in the book because the Internet does not exist.

Zuckerberg, however, is announcing Facebook’s new mission in a world with the Internet, which is why he tried to expand his definition to basically be Internet+. After all, we can already connect to the Internet from anywhere, and from any device; the Internet, too, is about not just gaming and entertainment, but all aspects of life. There is, admittedly, not much dancing, until you remember that Epic makes a fortune selling emotes, which lets your Fortnite character dance.

From this perspective Facebook’s grand metaverse mission sounds an awful lot like VR re-branded. And honestly, that’s perfectly fine! I’ve long been skeptical about Facebook’s investments in VR, but over the last year in particular, as Apple’s iOS changes have highlighted Facebook’s platform risk, I’ve come around to Zuckerberg’s point of view. There are far worse things for a massively profitable company to invest in than what could very well be a key platform of the future. And, naturally, whatever Facebook builds for VR will be accessible elsewhere, whether that be AR, mobile, or your computer; Facebook’s goal isn’t the Internet, it’s bigger than that.

The Missing Monopolist

Stephenson, for his part, never anticipated a company like Facebook. From a 2017 interview with Vanity Fair:

One of the things that’s been interesting to observe with the rise of social media is the way in which the same technologies that initially seemed to be uniting us have in fact driven us further apart. Do you see virtual reality as ultimately contributing to the same political polarization that we’ve seen divide Twitter and Facebook?

Well, first, I should make full disclosure that I totally did not see that coming. Even a few years ago, to say nothing of 25 years ago, I really didn’t see the whole social-media bubble thing coming and didn’t — even when I became aware of it — didn’t really get its significance until November 8, 2016. So, that one I missed. The way that the Metaverse is designed — keeping in mind that this was pre-Internet as we know it, pre-Worldwide Web, just me making shit up — there’s only one Metaverse. You have to go there, you can’t set up your own.

This is, in retrospect, the most unrealistic part of Snow Crash. The Metaverse is governed by the Association for Computing Machinery’s Global Multimedia Protocol Group; it is accessed and maintained by a fiber optic monopoly owned by one L. Bob Rife. Rife is the bad guy in the story, running a cult from an aircraft carrier and trying to use Snow Crash to break the minds of hackers like Hiro; it never occurs to Rife to leverage the fact that he owns the wires Hiro and everyone else depends on.

Indeed, Rife is, from the Ball perspective, a bit of a hero: his monopoly is a hands-off one, creating the conditions for not just persistence and being synchronous but also a virtual economy with full interoperability between the various entities in the Metaverse. The Metaverse simply exists in a way that, well, the Internet does: anyone can set up a server on the Internet, and anyone can buy a plot of land in the Metaverse.

In truth, though, this vision of the Internet feels increasingly obsolete: actually keeping a server online means having an Internet Service Provider, which may impose bandwidth constraints at best, and cut you off for arbitrary content rules at worse; national regulators in an increasing number of countries want to control the bits on local bandwidth, professing outrage at China’s Great Firewall even as their actions evince a certain degree of envy. The most economical and secure solution is to use the public cloud, but that subjects you to a private company’s terms of use, the violations of which make its unaccountable and unreachable executives prosecutor, judge, and jury. The situation is even worse if you want to reach potential customers: the vast majority of computing devices in the world are access-controlled by Apple and Google, which not only impose limits on content but also tax their economies at a 30% rate; the only interoperability that exists are the remains of the open Internet. One can certainly make the case that Stephenson didn’t see this coming either — except that he kind of did.

The Snow Crash Dystopia

Not all of the events of Snow Crash take place in the Metaverse; Stephenson’s real world is, arguably, far more interesting. Nearly everything is privatized, from neighborhoods to roads to law enforcement; private corporations (including the Mafia) operate “Franchise-Organized Quasi-National Entities” that own properties across the country and include citizenship and privileged access. Hiro, for example, is a citizen of “Mr. Lee’s Greater Hong Kong” (which is not affiliated with the city), and he flees to one of its properties midway through the book:

“Welcome to Mr. Lee’s Greater Hong Kong, Mr. Protagonist,” the security system says through a P.A. speaker. “And welcome to your guest, Ms. Y.T.”

The other taxis have stopped in formation along the curb. Several of them overshot the Hong Kong franchise and had to back up a block or so. A barrage of doors thunking shut. Some of them don’t bother, just leave the engines running and the doors wide open. Three jeeks linger on the sidewalk, eyeing the tire shreds impaled on spikes: long streaks of neoprene sprouting steel and fiberglass hairs, like ruined toupees. One of them has a revolver in his hand, pointed straight down at the sidewalk.

Four more jeeks run up to join them. Y.T. counts two more revolvers and a pump shotgun. Any more of these guys and they’ll be able to form a government. They step carefully over the spikes and onto the lush Hong Kong lawngrid. As they do, the lasers appear once more. The jeeks turn all red and grainy for a second.

Then something different happens. Lights come on. The security system wants better illumination on these people.

Hong Kong franchulates are famous for their lawngrids — whoever heard of a lawn you could park on? — and for their antennas. They all look like NASA research facilities with their antennas. Some of them are satellite uplinks, pointed at the sky. But some of them, tiny little antennas, are pointed at the ground, at the lawngrid.

Y.T. does not really get this, but these small antennas are millimeter-wave radar transceivers. Like any other radar, they are good at picking up metallic objects. Unlike the radar in an air traffic control center, they can rez fine details. The rez of a system is only as fine as its wavelength; since the wavelength of this radar is about a millimeter, it can see the fillings in your teeth, the grommets in your Converse high-tops, the rivets in your Levi’s. It can calculate the value of your pocket change.

Seeing guns is not a problem. This thing can even tell if the guns are loaded, and with what sort of ammunition. That is an important function, because guns are illegal in Mr. Lee’s Greater Hong Kong.

The folks with the guns are summarily disarmed by a cyborg dog — this is a science fiction novel! — but the point is that the rules in Greater Hong Kong are different than the rules in Nova Sicilia or Metazania or New South Africa or Narcolombia, despite the fact they all exist in what was nominally the United States (the actual government only actually exists in secured enclaves of its own). They are, quite literally, walled gardens.

In this way the Metaverse is actually a unifying force for Stephenson’s dystopia: there is only one virtual world sitting beyond a real world that is fractured between independent entities. There are connections in the real world — roads and helicopters and airplanes exist — but those connections are subject to tolls and gatekeepers, in contrast to the interoperability and freedom of the Metaverse.

In other words, I think that Stephenson got the future exactly backwards: in our world the benevolent monopolist is the reality of atoms. Sure, we can construct borders and private clubs, just as the Metaverse has private property, but interoperability and a shared economy are inescapable in the real world; physical constraints are community. It is on the Internet, where anything is possible, that walled gardens flourish. Facebook has total control of Facebook, Apple of iOS, Google of Android, and so on down the stack. Yes, HTTP and SMTP and other protocols still exist, but it’s not an accident those were developed before anyone thought there was money to be made online; today’s APIs have commercial intent built-in from first principles.

The Future of Metaverses

This is why I don’t think it is absurd that Nadella was the first tech executive to endorse the metaverse as a strategic goal. There is likely to be good business in building private metaverses for private companies, in a not-dissimilar way to Stephenson’s Franchise-Organized Quasi-National Entities made it easy for small-scale entrepreneurs to set up their own franchise-states.

Facebook’s goal is more audacious: the company already serves 3.5 billion users, which means creating a shared reality for over half of the world is a plausible goal. That reality, though, will likely sit alongside other realities, just as Facebook the app sits alongside other social networks. This metaverse is universal, but not exclusive.

What I am skeptical of is the idea of there being one Metaverse to rule them all; we already have that, and in this case the future is, in William Gibson’s turn of phrase, here — it’s just not very evenly distributed. I speak from personal experience: for two decades I have lived and worked primarily on the Internet; it’s where I experience friendship and community and make my living. Over the last year-and-a-half hundreds of millions of people have joined me, as the default location for the work has switched from the office to online (that “online” is primarily experienced at home does not mean that home is intrinsic to the work — “work from home” is a misnomer). This too is an inverse of Snow Crash, where most jobs are in the real world, and recreation in the Metaverse; the future of work is online,¹ and the life one wants to live in the reality of one’s choosing.

At least for a privileged minority; notably, in Snow Crash only a minority of people have access to the Metaverse ↩

Stratechery by Ben Thompson

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