An Introduction to Blockchains

May 6, 2023

AN INTRODUCTION TO BLOCKCHAINS

First, what is the blockchain?

A global ledger of information. Where everybody agrees on the same datasets.
The internet’s data problem. You do not own your data. It’s been sold. Over and over again. Big Tech and Big Banks own your personal data. Not you.
Decentralized networks create trust. Information is now going from centralized to decentralized, now creating the internet of value.
Your data is not portable. You cannot copy data from one website to another. But with digital blockchain wallets, you own your data and can plug in and out from anywhere in the world.

BLOCKCHAIN FUNDAMENTALS

What is a blockchain?

First, what is a block? One block contains a timestamp, transaction details and sender/receiver data. Every ‘new’ block is linked to a previous block, creating a chain in the process.

Blockchains are a global ledger of information where everybody agrees on the same ideas. Global blockchains will become the world's system of record.

Blocks are verified at each step. Every new block generated must be verified by each node before being confirmed, making it almost impossible to forge transaction histories.

Why does this matter? Blockchains are creating the internet of value. An opportunity for people to own information.

What makes Blockchains unique? Blockchains face three technological challenges: decentralization, scalability, and securability. This is known as the Blockchain Trilemma.

What are the advantages of the blockchain? Decentralization and transparency. By eliminating third-parties we reduce the possibility of a single point of failure, such as a large bank or centralized intermediaries.

What are the disadvantages of the blockchain? Blockchains can be complex, computationally intensive, and expensive to implement. They are also unregulated. With immutability only the majority can reverse or change transactions. Scalability limits to the number of transactions the network can process.

BLOCKCHAIN CONSENSUS

How to build global consensus

What are the types of networks? The world has centralized, decentralized and distributed systems. Decentralized means that there is no single point where the decision is made. Decentralization is at the core of blockchain technologies.

What are centralized systems? Centralized systems are systems that use client/server architecture where one or more client nodes are directly connected to a central server. This is the most commonly used type of system in many organizations where a client sends a request to a company server and receives the response.

What are decentralized systems? Decentralized means that there is no single point where the decision is made. A decentralized system in systems theory is a system in which lower level components operate on local information to accomplish global goals.

What are distributed systems? A network of independent nodes, each representing a “process” with the purpose is to accomplish a common goal. There can still be a potential failure of individual components. The correctness of a distributed consensus is defined as achieving one’s goal.

How are Decentralized systems similar but different from Distributed systems? Distributed means that the processing is shared across multiple nodes, but the decisions may still be centralized and use complete system knowledge.

Combined, distributed building and decentralized systems can deliver collaborative problem solving. These methods differ in how they build communities and how they would handle potential attacks. Behind every great blockchain there is a great consensus algorithm

How does cryptocurrency mining work? Mining updates the blockchain. Transactions are bundled into blocks and verified. New blocks are appended to the blockchain. Mining introduces new coins to the network. The mining process decentralizes the coin minting process with no central party issuing out coins/currency.

What are Blockchain Nodes?

Why do blockchains need to agree? For decentralization to work, there has to be a way for the network to maintain its integrity. Everyone has to be assured that all transactions are valid and that no one on the network is cheating by double spending or reversing transactions. The process of everyone on the network agreeing that transactions are valid in the absence of a central authority is known as “achieving consensus.” It is the network nodes that achieve this consensus among users, helping to make the blockchain secure.

How Does a Blockchain Work? Before we move on to discussing blockchain nodes, it is important to understand how blockchains work first. Blockchain is a class of distributed ledger technology (DLT) that functions as a decentralized digital ledger of transactions that is designed to copy itself to multiple devices within a network. This means that a chronological and complete record of every network transaction gets to be distributed to a series of devices. These devices are called nodes and they are responsible for keeping a blockchain fair, secure and immutable.

What Is a Blockchain Node? A node is generally a point of intersection or connection in a telecommunications network. A node may also mean any system or physical device that is connected to a network and can execute certain functions like creating, receiving or sending information via a communication channel. The explanation of a node varies depending on the protocol layer being referred to.

Blockchain nodes refer to a network’s stakeholders and/or their devices, which are designated to keep a copy of the distributed ledger and serve as communication points that execute various essential network functions. A blockchain node’s main purpose is to verify the validity of each succeeding batch of network transactions, called blocks. Each node has a unique identifier attached to its device that allows it to be distinguished from others in the network.

A proof-of-work (PoW) blockchain like Bitcoin (BTC) or Monero (XMR) incorporates miners, which are tasked with the following.

However, only “full nodes” are required to keep all of the blockchain transactions on their devices. These types of nodes are responsible for validating blocks and transactions. Lightweight or light nodes, on the other hand, have minimal storage requirements as they only need to download block headers in order to verify transactions. Neither of these versions of a full node necessarily come with a block reward.

Another way to classify a blockchain node is its availability. For instance, a node that is designated to continuously send updates throughout the network and always be online is considered an “online node.” In contrast, offline nodes are only required to download an updated copy of the ledger each time they reconnect to the network in order to ensure that they are synchronized with every other node.

People might choose to run full nodes for a variety of reasons, including increased privacy or a desire to support their network of choice. Lightweight nodes and full nodes alike come with wallets that can be used for making cryptocurrency transactions. Full nodes provide greater privacy, as outside observers have a hard time distinguishing between transactions being processed by the node and transactions sent by the person running the node.

How to Run a Node? Being a node operator on any particular blockchain has several system requirements. Ensuring that you have the proper node setup is crucial for your node to be fully functional and synchronized to the network you aim to serve. As mentioned earlier, you can refer to each blockchain’s respective websites to check hardware and software requirements, as well as setup guides.

What does a Node do? Depending upon the Blockchain, there can be innumerable roles based on certain tasks but the basic functions of a node come down to: 1) Accepting or rejecting transactions; 2) Managing the transactions and their validity; 3) Storing the cryptographically linked blocks; and 4) Acting as a point of communication.

Why we need nodes? Nodes are essential to a blockchain network’s operation since they keep every participant honest and ensure data reliability. Most blockchain networks employ methods to incentivize users to run full nodes, mostly through monetary rewards like mining or staking. Regardless of the incentives, there are also users who voluntarily set up their own full nodes simply because they believe in a project’s future and want to support and protect it as much as they can.

However, keep in mind that running a full node incurs costs and risks. And although there are multiple guides available online, the process of setting them up can be too technical for those who are unexposed to blockchain and programming. Basically, it all comes down to how much time and effort you are willing to invest in this endeavor.

Node recap: A node is one computer in a network of many that follows rules and shares information. The term “node” is sometimes used interchangeably with the term “full node,” but they are not the same. A “full node” is a computer in the Bitcoin network that stores and synchronizes a copy of the Bitcoin network’s entire blockchain history. Full nodes are important for several reasons, not the least of which being that they vote on proposed changes to the network. When more than 51% of full nodes don’t agree on a proposal, it gets skipped. Sometimes this leads to a hard fork, as was the case in 2017 with the Bitcoin Cash fork. {{word-count}}

How to find consensus

What is Consensus? Consensus refers to the rules by which a blockchain network operates and confirms the validity of information written in blocks. Confirming this information can be complicated with large networks involving large numbers of people, hence the need for a consensus algorithm.

To ensure correctness, one uses a consensus algorithm achieving the following:

Validity: any value decided upon must be proposed by one of the processes
Agreement: all non-faulty processes must agree on the same value
Agreement and validity are safety properties: honest nodes will never decide on trivial, random, or different value
Termination: all non-faulty nodes eventually decide
Termination is a liveness property: all nodes eventually decide on a value

How did the the original consensus algorithm work?

The original consensus algorithm is Bitcoin’s proof-of-work (PoW) algorithm. Proof-of-Stake (PoS) is another popular consensus algorithm that works somewhat differently but seeks to achieve the same goal. Many DeFi protocols utilize PoS. Both algorithms rely on full nodes for the validation of transactions and enforcement of network rules.

Anyone can download the entire Bitcoin blockchain and validate blocks. This increases both the security and the decentralization of the network, as more copies of the ledger come into existence and can be referenced by others. Bitcoin nodes can be run by anyone in the world with the proper hardware and an internet connection.

What is a Hashing function? A hash is a function that meets the encrypted demands needed to solve for a blockchain computation. Hashes are of a fixed length since it makes it nearly impossible to guess the length of the hash if someone was trying to crack the blockchain. The same data will always produce the same hashed value.

What is a Cryptographic hash function? A hash function with three special properties: Preimage resistance, Second preimage resistance, Collision resistance. This ensures trust in a trustless environment. Hash functions = mathematical fingerprint.

Preimage resistance: Whose fingerprint is this?
Second preimage resistance: Can you find someone with the same fingerprint as you?
Collision resistance: Can you find two random people with the same fingerprint?

What are digital signatures? Recipients given the (message, signature) pair should be able to verify:

Message origin: original sender (owner of private key) has authorized this message/transaction
Message integrity: message cannot have been modified since sending
Non-repudiation: original sender (owner of private key) cannot backtrack

What makes valid transactions? Proof of ownership (a signature), Available funds, No other transactions using the same funds

What is a Hash puzzle? A Hash puzzles need to be: 1) Computationally difficult 2) Parameterizable 3) Easily verifiable

What is a Validator?

At a high level, a validator is used to approve a transaction that has been submitted by a user or blockchain client. A transaction is simply data that has been submitted to be added to a blockchain and can include anything the blockchain was created to be used for. The most known example is a record of a cryptocurrency payment but can also include ledger data such as supply chain tracking information.
The logic that is used to run the validator in the blockchain are called transaction processors. These processors are coded in the appropriate blockchain class and called when transaction parameters need to be checked for completeness. If all parameters are accepted, the validator will then pass the transaction to a Node which will add it to the blockchain.
Nodes are computer systems that use their computational power to confirm these transactions and act as the physical hardware validation of the process. After the validator code uses logic to determine if a transaction should be approved, the heavy processing power needed to update the Blockchain Merkle Tree is completed by these Nodes. Miners typically are the users that run Nodes as there is no other incentive to run the software on the computer. Miners get rewards in the form of fractions of a block reward (such as BTC) for their efforts of using their computational power.
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What is a Smart Contract?

Code that facilitates, verifies, or enforces the negotiation or execution of a digital contract. A trusted entity must run this code. Ethereum empowers developers to design and implement their own game theory systems in the form of smart contracts. Smart contracts render transactions traceable, transparent, and irreversible.

A smart contract is a self-executing contract with the terms of the agreement between buyer and seller being directly written into lines of code. The code and the agreements contained therein exist across a distributed, decentralized blockchain network. The code controls the execution, and transactions are trackable and irreversible.

Smart contracts permit trusted transactions and agreements to be carried out among disparate, anonymous parties without the need for a central authority, legal system, or external enforcement mechanism.

What is a Merkle tree? A tree constructed by hashing paired data (the leaves), then pairing and hashing the results until a single hash remains, the merkle root. In Bitcoin, the leaves are almost always transactions from a single block.

What is a Nonce? A nonce ("number only used once") is a number added to a hashed block that, when rehashed, meets the difficulty level restrictions. The nonce is the number that blockchain miners are solving for. What is the nonce range?

What is a Merkle root? The root node of a merkle tree, a descendant of all the hashed pairs in the tree. Block headers must include a valid merkle root descended from all transactions in that block.

What is the Byzantine fault tolerance? Describe the generals attack story: The problem is that several Byzantine generals and their respective portions of the Byzantine army and have surrounded a city. They must decide in unison whether or not to attack. If some generals attack without the others, their siege will end in tragedy. The generals are usually separated by distance and have to pass messages to communicate. The practical Byzantine fault tolerance algorithm (PBFT) solves for high throughput, scalable, low cost, and is semi-trusted.

How do we ensure that all nodes make the same decision? Nodes can send incorrect/corrupted values.

What is the Byzantine agreement? In a distributed system, a quorum is a set of nodes sufficient to reach agreement.

What if you don’t necessarily trust certain nodes in the quorum? How can the we still achieve consensus?
Decentralized control: no central authority that authorizes consensus
Low latency: consensus achieve in a few seconds
Flexible trust: nodes choose who they trust, don’t have to trust the entire network

How do we determine quorums in a decentralized way? Solution: introduce quorum slices. Subset of a quorum that can convince one particular node of agreement. Individual nodes decide on other participants they trust for information

The Proof of Stake (PoS) algorithm now used by Ethereum]]. Attacks are more expensive, more decentralized, energy efficient

What is Proof of stake?

Alternative Consensus algorithm where voting power is directly proportional to economic stake locked in the network.

In Proof-of-Stake, you can specific properties you want to maintain a “defender’s advantage”. Introduce penalties, Punish malicious behavior much more greatly than in POW but Security comes from putting up economic value-at-loss. Discourage malicious behavior with explicit consequences.

What are the drawbacks of Proof of stake? Liquidity problem as funds are locked up, Low participation can cause centralization, Can rewrite history of blockchain if someone with a huge stake sells private keys and the rich get richer: Richest participants given easiest mining puzzles in pure proof-of-stake

The Proof of Work (PoW) algorithm used by Bitcoin. It has slow throughput and is expensive to mine. Reward subsidies will eventually end and miners will eventually receive only subsidies. System limited to 21m bitcoins.

How to use PoW? What is the PoW process? Everyone accepts valid transactions. How do we ensure no one is cheating? Proof of work requires CapEx (buy ASICs and other equipments) and OpEx (power and real estate cost etc) to participate in securing the network. Those are realized costs, whether or not the miner is successful.

What are the drawbacks of proof of work? In POW, there is no defender’s advantage: The cost of attack and the cost of defense are 1:1. The constraints are inflexible (i.e. computation, electricity) There is nothing in place to prevent or discourage malicious actors. Proof of Work simply allows it.

How does Proof of work validate peers? Instead of siloed decisions, PoW has proposers and voters. The proposer submits a transaction to everyone else. Peers cast votes. Only save after receiving a certain number of votes.

How to mine the proof of work problem? Proof of work problem: costly and time consuming to solve, easy to verify. The Goal is to find the hash of a valid block header with value less than a target value.

What is the proof of work problem? Think of mining as a massive competition. A huge game of hungry, hungry hippos (a random process). The faster a hippo chomps the more likely it is to win. Calculating hashes faster increases chances of winning.

The Proof of Stake (PoS) algorithm now used by Ethereum]]. Attacks are more expensive, more decentralized, energy efficient

What are the incentives for mining and transaction fees?

If the Genesis block is the first block of the blockchain, then Proof of work is the amount of computational work required to build the next block. Parent block is the block that immediately precedes the next block
Miners can cheat with invalid transactions, add blocks randomly without proof, mine on top of invalid blocks
Mining solves the problems with double spending
Double spend: successfully spending the same money more than once
Tom promises ten bitcoins (BTC) to Billy in one transaction and promises ten bitcoins (BTC) to Ted in another, but he only has ten bitcoins (BTC) in total. Tom is performing a double spend attack.
When Tom attempts to double spend, he will be rejected by observing peers. Peers vote “no” on his proposal, as they notice multiple transaction trying to spend the same funds.

Miners are rewarded with a certain number of bitcoins for finding each successful nonce; ethereum adds punishment because it requires stake in mining, hence, strengthening the protocol security features.
Limited number of transactions per second

How do miners verify transactions? Miners verify new transactions.

A full-fledged Bitcoin miner (“Full node”) must:

Download the entire blockchain to store the entire transaction history
Verify incoming transactions by checking signatures and confirming the existence of valid bitcoins
Create a block using collected valid transactions
Find a valid nonce to create a valid block header
Hope that your block is accepted by other nodes and not defeated by a competitor block
Profit!

What are public and private keys? Security is hidden in plain sight. Nearly impossible to guess with random generation. Each entity is represented with a unique public key. A corresponding private key acts as a key to “unlock” the public key. Private key chosen at random, public key generated from private key. Public key for receiving, private key for redeeming.

Identity in daily life:
Houses have addresses and mailbox keys
Emails have aliases and passwords
Bitcoin has public keys and private keys

Mining Pools

What are the Mining incentives - Block rewards? Miner receives BTC for every confirmed block. Miner includes special transaction to self. An profit incentive for honest behavior. Mining halves every 210,000 blocks. The BTC supply cap is 21,000,000

What are Mining incentives – transaction fees? Tx creator sets tx fee (Voluntary but necessary). Extra income for miners on top of block reward (Incentivizing as reward diminishes). Higher transaction fee => faster confirmation time. TX_Fee = Input – Output When block reward becomes 0, TX fees will become primary source of revenue for miners

What are Mining pools? Mining pools allow individual miners to combine, or ‘pool’, their computational power together to reduce variance in mining rewards, are run by pool managers or pool operators and the pool manager usually takes a cut of the mining rewards.

What is censorship resistance and why is it important? Discuss how China and other nations have done this well.

What are the mining scalability problems? Bitcoin blocks are created every 10 minutes and can only hold 1 MB of transactions. In 2015, blocks begin to run out of space, transactions go unconfirmed. The Block Size Debate raises questions about decentralized governance

What is the Game theory behind competitive mining? Bitcoin miners competing, proving they produced a specific block, as well as half the network having to agree on the next block, is the first game theory to work in the context of digital currencies. This has worked well for seven years. Three components: players, strategies, payoff. Two types of games: zero sum and non-zero sum

Consensus Summary

The challenge with any system is communication. It becomes tougher with millions of users doing millions of transactions simultaneously. To solve this problem, we need to find consensus.

Consensus is critical in the online and offline world. Blockchains solve this by using math as a single source of truth. It's important to understand how different chains operate, ranging from central to decentralized nodes.

To build a trustless system, you need to incentivize for the truth.

CRYPTOCURRENCIES

What is the demand for crypto?

What is a cryptocurrency? A cryptocurrency, crypto-currency, or crypto is a digital currency designed to work as a medium of exchange through a computer network that is not reliant on any central authority, such as a government or bank, to uphold or maintain it.

A cryptocurrency is a digital or virtual currency that is secured by cryptography, which makes it nearly impossible to counterfeit or double-spend. Many cryptocurrencies are decentralized networks based on blockchain technology—a distributed ledger enforced by a disparate network of computers. A defining feature of cryptocurrencies is that they are generally not issued by any central authority, rendering them theoretically immune to government interference or manipulation.

Key takeaways

The advantages of cryptocurrencies include cheaper and faster money transfers and decentralized systems that do not collapse at a single point of failure.
The disadvantages of cryptocurrencies include their price volatility, high energy consumption for mining activities, and use in criminal activities.
Individual coin ownership records are stored in a digital ledger, which is a computerized database using strong cryptography to secure transaction records, to control the creation of additional coins, and to verify the transfer of coin ownership.

What is the blockchain trilemma? The trilemma consists of three technological challenges: decentralization, scalability, and securability.

Bitcoin is coin centric. It is the most popular and valuable cryptocurrency. An anonymous person called Satoshi Nakamoto invented it and introduced it to the world via a white paper in 2009.

Image: Embedded in the programming of this first bitcoin was the text "The Times 03/Jan/2009 Chancellor on brink of second bailout for banks." The text refers to a headline on that date from the British newspaper The Times, and is generally seen as proof of the date bitcoin was first mined.

Bitcoin is an anonymous service with no central registry. It is inexpensive to create multiple identities. Multiple identities => multiple opportunities to cast votes

Benefits of bitcoin

Pseudonymous: cryptographic identities allow for accountability
Democratic: decisions made through consensus protocol that doesn’t require trust
Immutable: ledge of truth
Uncensorable: difficult to be controlled by one party
Distributed: no central point of failure

Ethereum is a blockchain app platform to build smart contracts. The primary purpose of Ethereum is to build a platform for decentralized applications and smart contracts. It is an extension of the original Bitcoin thesis. Ether is the currency used to compensate miners.

What are Ethereum smart contracts? Smart contracts in Ethereum are like autonomous agents that live inside the network. They react to external transactions are called to perform specific functions. The contracts have direct control over: Internal ether balance, Internal contract state and Permanent storage.

What is the purpose of Ethereum smart contracts? Store and maintain data that represents something useful to useful to users or other contracts. They can Manage contract or relationship between untrusting users like financial transactions (i.e. escrow, insurance). Also Provide functions to other contracts such as serving as a software library. Smart contracts can also require complex authentication such as Multi-signature access.

What is the Ethereum Virtual Machine? Every Ethereum nodes run EVM as part of its block verification procedure. The network consensus removes the need for Trusted Third Party. Anything in violation of contracts requires subverting the entire network. Now secure peer-to-peer agreements that live on the blockchain forever. The Ethereum Virtual Machine runs contract code that gets executed on every node is EVM code.

What is an Initial Coin Offering? An Initial coin offering (ICO) is a new, unregulated way of raising funds. The crowdsales include details such as how to buy tokens, participating exchanges, token distribution rules and token price. they can align incentives of development teams and early investors. For example, Ethereum had a token sale.

What are the limitations of an ICO? There is no central party (VC/PE) to carry out due diligence on behalf of investors. Due diligence of ICOs is assumed to be done by the crowd itself. Not everyone reads the full whitepaper. Managing thousands of investors can be distracting and overwhelming task for small teams with potential to turn into a PR disaster.

What is the legal uncertainty with ICOs? It determines on the language of the whitepaper, on whether it is a Security or Access token. Not much guidance here yet but we'll discuss how investments have to pass the Howey test to be considered a security in the valuations chapter.

Security token: An investment vehicle similar to stock in a company
Access token: Allows early access to products and services

What is a Crypto Exchanges? A cryptocurrency exchange, or a digital currency exchange (DCE), is a business that allows customers to trade cryptocurrencies or digital currencies for other assets, such as conventional fiat money or other digital currencies.

Securities Law

What is the Howey test? In the U.S., investment contracts must pass the Howey Test to be considered a security. To pass the Howey Test an investment must meet these four traits: (1) an investment of money, (2) in a common enterprise, (3) with the expectation of profit and (4) to be derived from the efforts of others.

Are crypto an equity or token securities? why BTC/ETH are NOT considered securities. BTC/ETH fail this test. For starters, both applications are decentralized. No one person controls or stands to profit from the sale. Second, these are utility tokens. Ether on the Ethereum network is used for specific applications. It is not designed to make a profit or deliver a return. Third, owners and developers don't have aligned incentives. Token owners can make money but that doesn't mean specific applications will do well or even profit.

Ripple/XRP didn't pass the Howey Test as we mentioned earlier this week. The SEC fined the team $1.3b for selling unregistered securities. The primary reason for this is because the XRP token was used to fund Ripple's payment network.

Are Cryptocurrencies Legal? Fiat currencies derive their authority as mediums of transaction from the government or monetary authorities. For example, each dollar bill is backstopped by the Federal Reserve. But cryptocurrencies are not backed by any public or private entities. Therefore, it has been difficult to make a case for their legal status in different financial jurisdictions throughout the world. The regulatory landscape is constantly changing. Most countries allow the use of crypto as a currency but ban the mining of crypto.

HOW TO VALUE THE BLOCKCHAIN

What's my investment framework?

My Investment Research Process

Remember, this is an introductory course on how to value blockchains. These are complicated assets that cannot be viewed in the same form as traditional assets. They are intangible yet transparent. The transparency helps make clearer decisions. Always do your own research. None of this is investment advice.

How do I find investment ideas?

Like any other idea, it comes down to research. There are no shortcuts here. Remember, crypto is native to the internet. It was not found in the ground or traded under a tree. So to find the best ideas you must begin with the internet. Start with Reddit, Twitter and Discord. These online communities are where ideas are sourced and made.

What does the price tell me?

Buffett famously said that price is his due diligence. Crypto is no different. With an active liquid, investors can identify when and where money is moving. The plus is the market is always open. The negative is the market is always open. The price tells you the market value.

How do you do your research?

At the end I'll give you a few resources to read and review. They will improve your research process. Look, there are speculators and investors. Long-term investments require a deeper understanding of the fundamentals. Similar to what is offered in this course. My research process consists of qualitative and quantitative notes. What does that mean? Well I talk with investors, developers, read papers and do simple model. If the idea make sense, I make an investment. If not, I skip and move on.

How can I learn more about the team and projects?

I recommend viewing the project websites to learn about the Teams, Investors, Developers, Partners and Customers.

What is a whitepaper?

In crypto, a whitepaper is an in-depth report explaining the technical details of a project. It is not light reading. Most papers breakdown the unique characteristics of a token. This is where you can the technical information and the purpose of the project.

How can I view the security of a token?

There are two security questions you need to be aware of. Who owns the assets and what are the loopholes? This can be a technical question. Cold storage and self-custody wallets will give you control of your crypto assets. Exchanges, bridges and hot wallets are vulnerable to hacks.

For specific tokens, you will need a deeper understanding of decentralization, nodes and coding. Security strength is determined by a number of variables.

Where can I find the supply limit?

The supply limits can be on any crypto pricing website like Coinbase or CoinMarketCap. Depending on what you invest in, the supply limits can change. Very few assets have a limited supply like Bitcoin.

Where can I learn about crypto regulatory concerns?

Every country has its own set of Accounting and Regulatory concerns regarding crypto and investing. We recommend speaking to a professional for specific regulatory questions.

‍What are the best social networks to find information?

Reddit, Twitter & Discord groups

How can I think long-term in crypto?

Think in terms of use case. Crypto is software. First, ask yourself if the software can be used? Does it have utility? Once you have achieved the bare minimum then you can understand the long-term value.

To be confident you need to put in the work. Don't skip out on a few hours of due diligence when money is on the line. This goes for crypto or any investment for that matter.

My Investment Template

When investing, I use a simple template. It begins with a summary, quantitative and qualitative analysis, an understanding of the risks and clear catalyst.

The Summary provides a Background describing the investment opportunity.
The Qualitative analysis breaks down the Business, Product and Industry. For example I'll ask myself, What problems do blockchain/cryptocurrencies solve? Why do they exist?
The Quantitative analysis breaks down the Financials, Valuation and expected Returns.
Risks cover Business, Product and Industry threats.
The Catalyst defines 1-2 elements that impact my investment. This may include the market, a specific event or Insider transactions.

The Ethereum Valuation Model

In this example, we'll breakdown the valuation model for Ethereum. This not investment advice. It is a demonstration to show how the economics of one cryptocurrency. Every token has its own economic model. The economics are constantly changing overtime.

As explained earlier, Ethereum is an operating system. It complements most cryptocurrencies in the ecosystem. Today we can value the user activity on-chain. Today Ethereum is an income producing asset and can be valued based on cash flows.

Model Summary

Today, Ethereum like Bitcoin, has become a store of value. Its value is based on scarcity and security. The Ethereum network has been upgrading the system for the past several years to accomplish two things: 1) reduce transaction fees and 2) to become more energy efficient.

If you are familiar with Ethereum then you know its currency, Ether ($ETH), has been used for DeFi and NFT applications.

In simple terms, a blockchain is a decentralized database that sells storage space. It's a business that sells services. We can compare valuations of business using Price to Sales (P/S) or Price to Earnings (P/E) ratios. Let's do it for blockchains.

My thesis: Ethereum, as the most decentralized blockchain, is the best positioned for the massive scalability enabled by roll-up technology. This is when end users pay low transaction fees on L2s while Ethereum mainnet remains expensive but secure settlement layer.

Breakdown inflation

Since the EIP-1559 upgrade in 2021, ETH owners have profited from the reduction in total ETH supply. Let me explain.

"If we assume that in 20 years $ETH supply will drop to 100M from current 118M (at current projected annual supply decline of -2.5%, it would drop to 71M!), above prices would go to $12.5k (not staked) and $15k (staked)." You can review the total burn on ultrasound.money

Just the fee burn "buyback" impact is significant as it's value all accrues to the token]

After transition to Proof-of-Stake model (PoS), [$ETH] stakers will get the unburned part of the transaction fees that now goes to miners. This will be a direct profit distribution from the Ethereum network to ETH stakers. A form of a dividend.

The only cost for the Ethereum network is security. It's paid as [$ETH] issuance (block rewards) to block producers, currently miners but in PoS - ETH stakers. There are no other costs for the network. Hardware, electricity etc. are covered by 3rd party providers.

So we have two types of cashflows: indirect (fees burn) and direct (fees + block rewards to stakers). Based on them and an expected growth rate of the Ethereum revenue, it's possible to build a DCF model to assess a fair value of [$ETH]

Breakdown security

After Bitcoin, Ethereum is the most secure and decentralized network. This can be verified by the number of validator nodes in the system. They incentivized to ensure accuracy and secure the blockchain.

What is most unique about Ethereum is the level of revenue the network generates. What are the projected ETH earnings? $14.2B. projected for 2022.

Remember, Ethereum is a decentralized blockchain network with no costs.

All costs are paid for by a decentralized network of validators.

Thus all revenues are profits for the sake of a DCF model.

You can also view the crypto fees to understand how profitable other networks are

Ryan Allis created a cash flow showing how ETH will reach $10,000 based on a 25% growth rate and 35x P/E ratio. Remember every financial model is only as good as its assumptions. He demonstrates how issuance is a structural supply, fees are structural demand.

Discounted cash flows don't apply to crypto

Maybe not in the traditional sense but the network model has changed. Up until last year, the network didn't have revenue in the traditional sense. Now we can track and own the cash flows from the underlying network activity.

What variables do I need to be aware of?

1) What if majority of txns move to L2s?
2) What if another L1 chain (eg. solana) wins?

Catalysts

More institutional investors buy ETH. Why? they will understand the power of a distributed computing network.
The next major buy-in will be when ETH transitions completely to Proof-of-Stake. Than stakers with 32 ETH will see real cash flows when owning this specific asset.
Institutions may view Staked Ether as Equity
L2’s will drive higher demand
Low gas fees will drive more total demand for ETH blockspace
L2s being cheap creates an incentive to use blockchains differently

What questions do I need to ask myself?

What are Ethereum’s current annualized cash flows?
What % of these are going to holders when ETH 2.0 launches in December 2021?
How much do you expect the annualized cash flows to grow in the future?

For more details, check out past ETH quarterly reports:

Resources

For additional resources, I recommend reading the Messari 2022 crypto thesis. Their research team has done a terrific job breaking down the future opportunities in the industry. It's 200 pages so I recommend devoting an entire weekend to this report.

If you want to do your analysis, I recommend reading the fundamentals of Axie Infinity. This study gives you a breakdown of the gaming community and its Play-to-Earn model.

BLOCKCHAIN APPLICATIONS

What are the use cases?

What are dApps?

A decentralised application is an application that can operate autonomously, typically through the use of smart contracts, that runs on a decentralized computing, blockchain system. Like traditional applications, DApps provide some function or utility to its users. However, unlike traditional applications, DApps operate without human intervention and are not owned by any one entity, rather DApps distribute tokens that represent ownership. These tokens are distributed according to a programmed algorithm to the users of the system, diluting ownership and control of the DApp. Without any one entity controlling the system, the application becomes decentralised.

Understanding dApps

A standard web app, such as Uber or Twitter, runs on a computer system that is owned and operated by an organization, giving it full authority over the app and its workings. There may be multiple users on one side, but the backend is controlled by a single organization.

DApps can run on a P2P network or a blockchain network. For example, BitTorrent, Tor, and Popcorn Time are applications that run on computers that are part of a P2P network, whereby multiple participants are consuming content, feeding or seeding content, or simultaneously performing both functions.

In the context of cryptocurrencies, dApps run on a blockchain network in a public, open-source, decentralized environment and are free from control and interference by any single authority. For example, a developer can create a Twitter-like dApp and put it on a blockchain where any user can publish messages. Once posted, no one—including the app creators—can delete the messages.

Decentralized applications (dApps) are digital applications or programs that exist and run on a blockchain or peer-to-peer(P2P) network of computers instead of a single computer. DApps (also called "dapps") are outside the purview and control of a single authority. DApps—which are often built on the Ethereum platform—can be developed for a variety of purposes including gaming, finance, and social media.

Decentralised applications have been popularised by distributed ledger technologies (DLT), such as the Ethereum blockchain or, more recently, the Hedera Hashgraph. DApps rely on the inherent security of both decentralisation and cryptography algorithms.

The trustless and transparent nature of DApps have led to greater developments in the utilisation of these features within the decentralized finance (DeFi) space.

DApps are divided into 17 categories: exchanges, games, finance, gambling, development, storage, high-risk, wallet, governance, property, identity, media, social, security, energy, insurance, and health.

How do dapps work?

Dapps have their backend code (smart contracts) running on a decentralized network and not a centralized server. They use the Ethereum blockchain for data storage and smart contracts for their app logic.

A smart contract is like a set of rules that live on-chain for all to see and run exactly according to those rules. Imagine a vending machine: if you supply it with enough funds and the right selection, you'll get the item you want. And like vending machines, smart contracts can hold funds much like your Ethereum account. This allows code to mediate agreements and transactions.

Once dapps are deployed on the Ethereum network you can't change them. Dapps can be decentralized because they are controlled by the logic written into the contract, not an individual or a company.

What are the Key takeaways?

Decentralized applications—also known as "dApps" or "dapps"—are digital applications that run on a blockchain network of computers instead of relying on a single computer.

Because dApps are decentralized, they are free from the control and interference of a single authority.

Benefits of dApps include the safeguarding of user privacy, the lack of censorship, and the flexibility of development.

Drawbacks include the potential inability to scale, challenges in developing a user interface, and difficulties in making code modifications.

What are the Advantages of dApps?

Many of the advantages of dApps center around the program's ability to safeguard user privacy. With decentralized apps, users do not need to submit their personal information to use the function the app provides. DApps use smart contracts to complete the transaction between two anonymous parties without the need to rely on a central authority.

Proponents interested in free speech point out that dApps can be developed as alternative social media platforms. A decentralized social media platform would be resistant to censorship because no single participant on the blockchain can delete messages or block messages from being posted.

Ethereum is a flexible platform for creating new dApps, providing the infrastructure needed for developers to focus their efforts on finding innovative uses for digital applications. This could enable rapid deployment of dApps in a variety of industries including banking and finance, gaming, social media, and online shopping.

Pros

Promotes user privacy
Resists censorship
Flexible platform enables dApp development

What are the Disadvantages of dApps?

The use of dApps is still in the early stages, and thus it is experimental and prone to certain problems and unknowns. There are questions as to whether the applications will be able to scale effectively, particularly in the event that an app requires significant computations and overloads a network, causing network congestion.

The ability to develop a user-friendly interface is another concern. Most users of apps developed by traditional centralized institutions have an ease-of-use expectation that encourages them to use and interact with the app. Getting people to transition to dApps will require developers to create an end-user experience and level of performance that rivals already popular and established programs.

The challenge of doing code modifications is another limitation of dApps. Once deployed, a dApp will likely need ongoing changes for the purposes of making enhancements or to correct bugs or security risks. According to Ethereum, it can be challenging for developers to make needed updates to dApps because the data and code published to the blockchain are hard to modify.

Cons

Experimental, may not be able to scale
Challenges in developing a user-friendly interface
Difficult to make needed code modifications

What is an NFT?

A non-fungible token (NFT) is a non-interchangeable unit of data stored on a blockchain, a form of digital ledger. Types of NFT data units may be associated with digital files such as photos, videos, and audio. Because each token is uniquely identifiable, NFTs differ from blockchain cryptocurrencies, such as Bitcoin.

NFT ledgers claim to provide a public certificate of authenticity or proof of ownership, but the legal rights conveyed by an NFT can be uncertain. NFTs do not restrict the sharing or copying of the underlying digital files and do not prevent the creation of NFTs with identical associated files.

NFTs have been used as a speculative asset, and they have drawn criticism for the energy cost and carbon footprint associated with validating blockchain transactions as well as their frequent use in art scams.

An NFT is a unit of data stored on a digital ledger, called a blockchain, which can be sold and traded. The NFT can be associated with a particular digital or physical asset (such as a file or a physical object) and a license to use the asset for a specified purpose. An NFT (and, if applicable, the associated license to use, copy or display the underlying asset) can be traded and sold on digital markets. The extralegal nature of NFT trading usually results in an informal exchange of ownership over the asset that has no legal basis for enforcement, often conferring little more than use as a status symbol.

NFTs function like cryptographic tokens, but, unlike cryptocurrencies such as Bitcoin or Ethereum, NFTs are not mutually interchangeable, hence not fungible. While all bitcoins are equal, each NFT may represent a different underlying asset and thus may have a different value. NFTs are created when blockchains string records of cryptographic hash, a set of characters identifying a set of data, onto previous records therefore creating a chain of identifiable data blocks. This cryptographic transaction process ensures the authentication of each digital file by providing a digital signature that is used to track NFT ownership. However, data links that point to details such as where the art is stored can be affected by link rot.

What are the NFT blockchain standards?

Specific token standards have been created to support various blockchain use-cases. Ethereum was the first blockchain to support NFTs with its ERC-721 standard and is currently the most widely used. Many other blockchains have added or plan to add support for NFTs with their growing popularity.

ERC-721107 was the first standard for representing non-fungible digital assets on the Ethereum blockchain. ERC-721 is an inheritable Solidity smart contract standard, meaning that developers can create new ERC-721-compliant contracts by copying from a reference implementation. ERC-721 provides core methods that allow tracking the owner of a unique identifier, as well as a permissioned way for the owner to transfer the asset to others.

The ERC-1155 standard offers "semi-fungibility", as well as providing an analogue to ERC-721 functionality (meaning that an ERC-721 asset could be built using ERC-1155). Unlike ERC-721 where a unique ID represents a single asset, the unique ID of an ERC-1155 token represent a class of assets, and there is an additional quantity field to represent the amount of the class that a particular wallet has. The assets under the same class are interchangeable, and the user can transfer any amount of assets to others.

Because Ethereum currently has high transaction fees (known as gas fees), layer 2 solutions for Ethereum have emerged which also supports NFTs:

Immutable X – Immutable X is a layer 2 protocol for Ethereum designed specifically for NFTs, utilizing ZK rollups to eliminate gas fees for transactions.
Polygon – Formerly known as the Matic Network, Polygon is a proof-of-stake blockchain which is supported by major NFT marketplaces such as OpenSea.

How do store NFTs off-chain?

NFTs involving digital art generally do not store the associated artwork file on the blockchain due to its size. The token functions in a way more similar to a certificate of ownership, with a web address pointing to the piece of art in question, making the art still subject to link rot. Because NFTs are functionally separate from the underlying artworks, anybody can easily save a copy of an NFT's image, popularly through a right click. NFT supporters disparage this duplication of NFT artwork as a "right-clicker mentality", comparing the value of a purchased NFT to that of a status symbol "to show off that they can afford to pay that much".

What about Plagiarism and fraud?

There have been cases of artists having their work sold by others as an NFT, without permission. After the artist Qing Han died in 2020, her identity was assumed by a fraudster and a number of her works became available for purchase as NFTs. Similarly, a seller posing as Banksy succeeded in selling an NFT supposedly made by the artist for $336,000 in 2021; with the seller in this case refunding the money after the case drew media attention.

The price paid for specific NFTs and sales volume of a particular author may be artificially inflated due to wash trading.

What is DeFi? To understand decentralized finance and how it works, it helps to understand how centralized finance differs from DeFi.

Decentralized finance eliminates intermediaries by allowing people, merchants, and businesses to conduct financial transactions through emerging technology. This is accomplished through peer-to-peer financial networks that use security protocols, connectivity, software, and hardware advancements.

From anywhere you have an internet connection, you can lend, trade, and borrow using software that records and verifies financial actions in distributed financial databases. A distributed database is accessible across various locations; it collects and aggregates data from all users and uses a consensus mechanism to verify it.

Decentralized finance uses this technology to eliminate centralized finance models by enabling anyone to use financial services anywhere regardless of who or where they are.

DeFi applications give users more control over their money through personal wallets and trading services that cater to individuals.

How Does DeFi Work?

Decentralized finance uses the blockchain technology that cryptocurrencies use. A blockchain is a distributed and secured database or ledger. Applications called dApps are used to handle transactions and run the blockchain.

In the blockchain, transactions are recorded in blocks and then verified by other users. If these verifiers agree on a transaction, the block is closed and encrypted; another block is created that has information about the previous block within it.

The blocks are "chained" together through the information in each proceeding block, giving it the name blockchain. Information in previous blocks cannot be changed without affecting the following blocks, so there is no way to alter a blockchain. This concept, along with other security protocols, provides the secure nature of a blockchain.

What are the key takeaways in DeFi?

Decentralized finance, or DeFi, uses emerging technology to remove third parties in financial transactions.

The components of DeFi are stablecoins, software, and hardware that enables the development of applications.

The infrastructure for DeFi and its regulation are still under development and debate.

Decentralized finance (DeFi) offers financial instruments without relying on intermediaries such as brokerages, exchanges, or banks. Instead, it uses smart contracts on a blockchain. DeFi platforms allow people to lend or borrow funds from others, speculate on price movements on assets using derivatives, trade cryptocurrencies, insure against risks, and earn interest in savings-like accounts. DeFi uses a layered architecture and highly composable building blocks. Some applications promote high interest rates but are subject to high risk. Two of DeFi's goals are to reduce transaction times and increase access to financial services. The Ethereum blockchain popularised smart contracts, which are the basis of DeFi, in 2017. Other blockchains have since implemented smart contracts.

Some of the key attractions of DeFi for many consumers are:

It eliminates the fees that banks and other financial companies charge for using their services.
You hold your money in a secure digital wallet instead of keeping it in a bank.
Anyone with an internet connection can use it without needing approval.
You can transfer funds in seconds and minutes.

What is a DAO? A decentralized autonomous organization (DAO), sometimes called a decentralized autonomous corporation (DAC), is an organization represented by rules encoded as a computer program that is transparent, controlled by the organization members and not influenced by a central government. A DAO's financial transaction record and program rules are maintained on a blockchain. The precise legal status of this type of business organization is unclear.

Open membership: Some DAOs operate with a fully open membership policy. In these cases, joining a DAO is as simple as joining their [Discord]

Token Gated Membership: Some DAOs limit membership via token gating. In this model, the DAO member must authenticate that they hold the DAO's NFT membership token in their crypto wallet before they may enter the DAO's Discord server or website. Token gating allows for a membership that is fixed in size but can automatically change over time as people transfer the NFTs. Due to blockchain transaction fees, this flexibility comes at a cost.

What about DAO Governance?

Governance tokens
DAOs can create a governance token to coordinate its governance. These tokens are equivalent to shares in a traditional corporation. Governance is conducted through a series of proposals that members vote on through the blockchain.
Voting power
There are many ways to set up the relationship between governance token allocation and voting power. Some examples are:
Number of tokens is directly linear with voting power
Quadratic voting
Voting delegates

A DAO can set up a voting delegation system. For example, the ENS DAO put out a Call For Delegates when they set up their governance token. In such a system, an individual wallet may sign, on the blockchain, that they would like to delegate their voting power to a delegate of their choice for future DAO proposals.

What are the main issues with DAOs?

Social: Shareholder participation in DAOs can be problematic. For example, BitShares has seen a lack of voting participation, because it takes time and energy to consider proposals.
Legal status, liability, and regulation: The precise legal status of this type of business organization is generally unclear, and may vary by jurisdiction. On July 1, 2021, Wyoming became the first US state to recognize DAOs as a legal entity. American CryptoFed DAO became the first business entity so recognized. Some previous approaches to blockchain based companies have been regarded by the U.S. Securities and Exchange Commission as illegal offers of unregistered securities. Although often of uncertain legal standing, a DAO may functionally be a corporation without legal status as a corporation: a general partnership. Known participants, or those at the interface between a DAO and regulated financial systems, may be targets of regulatory enforcement or civil actions only if they are out of compliance with the law.
Security: A DAO's code is difficult to alter once the system is up and running, including bug fixes that would be otherwise trivial in centralized code. Corrections to a DAO require writing new code and agreement to migrate all the funds. Although the code is visible to all, it is hard to repair, thus leaving known security holes open to exploitation unless a moratorium is called to enable bug fixing. There were several notable coding problems in 2016 with "The DAO"

What is a blockchain wallet?

Security/Wallets Intro: “What, Why & How” Are We Going to Learn Security?

Why do you need blockchain wallet? First to send and receive bitcoins. Second to store your crypto safely and third to convert your crypto to fiat currency. Crypto wallets are equivalent to a bank account. They are Accessed with private keys.

How do we manage our public and private keys?

Wallets keep track of your private key to store, send & receive, and list transactions. They can be kept in warm and cold storage. Warm storage are smartphone apps and online wallets. Cold storage are paper, hardware and brain wallets.

You can choose your wallet type. Features can include multi-signature, privacy, network connections (security for full or 3rd party nodes) and who holds the keys (you or Coinbase).

How do keys work? Here is an example of Public Key to access Bitcoin address:

Bitcoin validating node will execute the locking and unlocking scripts in sequence. Locking scripts can be found in previous transaction output, specifies requirements for redeeming transaction Unlocking script can be found in transaction input, redeems the output of a previous transaction

Why Pay-to-script-hash? Offloads complicated script writing to recipients. Makes more sense from a payer-payee standpoint. Merchant (rather than customer) is responsible for writing correct and secure script. Customer doesn’t care what the script actually is P2SH is the most improvement to Bitcoin since inception

How do thin clients do simple payment verification?

Simple payment verification (SPV) is method for verifying if particular transactions are included in a block without downloading the entire block. It will keep track of your transactions only on lightweight or thin clients. SPV wallets contain a network node on the Bitcoin protocol without a blockchain.

Assumptions: incoming block headers are not from a false chain

Connect to many different nodes

Long term, chain is probably honest

Can’t really afford to put the entire blockchain on your phone

Creating a thin client is a decent tradeoff

What is Multi-signature account access? With regular Bitcoin addresses, each account 1 key or seed. Any single person can steal funds. With Multi-signature addresses, multiple signatures (i.e. 3 of 5 signatures) are needed to access an account.

What are some best practices for key generation? For starters, never reuse pseudonyms Why? Someone should not be able to determine how much bitcoin you own. Compromising one key is independent of the other ones. Keys are computationally easy to generate anyways. Wallet software will handle this

What are Wallet backups? like Hierarchical Deterministic (HD) wallets are deterministic and more convenient to know a seed or master key. Exchanges use these and have a one-way hash function with seed, index number and optional chain.

SUMMARY

What did we learn? So far, we've covered the Fundamentals, Consensus economics, Cryptocurrencies, Valuations and Applications. Later I will provide more details on each section.

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