1.3 Web 3.0 Tokenization and Decentralized Finance

Question 1

What are the two types of tokens and the difference between them? What is a tradfi example?

Answer 1

Fungible and non-fungible tokens - the key difference is the ability to replicate. e.g. a twenty-dollar bill can be easily exchanged for another twenty-dollar bill, and they both can be spent in the exact same way without any distinction between them, while an NFT is a unique digital asset that is not interchangeable with other like assets (e.g., artwork).

Question 2

What is tokenisation? What is a token? How can it be secured/enhanced?

Answer 2

The process of linking a token to another asset. A token is an identifier plus metadata that is associated with a specific asset. It can be secured using blockchain technology, and enhanced with a smart contract that will only allow the token to be used if pre-set conditions are met.

Question 3

In what way is token similar to a derivative?

Answer 3

It is a digital (financial) asset that represents value linked to another asset.

Question 4

Web 1:
Web 2:
Web 3:

Answer 4

Web 1: read-only interface enabling users to search for info (search engines)
Web 2: read-write interface, allowing contribution of content (e.g. social media)
Web 3: read-write-execute: enables cooperating and transacting directly without the use of an intermediary/middleman

Question 5

Web 3.0 is based on DLT which uses I, O and DP. The goal is to enable _______.

Answer 5

Web 3.0 is based on distributed ledger technology which uses interconnected, open and decentralised protocols. The goal is to enable P2P automation.

Question 6

Four differences between the digital and traditional economy?
1. RA
2. LI
3. G
4. SD

Answer 6

1 resource allocation - in TE, humans use tech to aid decisions on capital allocation and marketing, while in DE algorithms make these decisions quicker and with no emotional anchors
2 location independence - no need for physical locations to sell products (can access anywhere at any time and save money on storefront)
3 growth - more scalability in the DE
4 supply and demand - better data in the DE (better and real time) to align S&D

Question 7

Definition of fiat currency?
- what
- value
- risk

Answer 7

Government issued currency backed by the faith of the government, with the currency’s value based off the promise of the government rather than being linked to a physical commodity (e.g. historically gold). Primary risks are inflation and government default.

Question 8

Cryptocurrency definition:
- what
- example
- pegged? (2)
- risks

Answer 8

• Digital currency which is stored online.
• Examples include BTC and ETH
• Some are pegged to fiat currency (e.g. stablecoins or central bank digital currencies (CBDCs) while others are linked to commodities e.g. gold
• Primary risks are liquidity, volatility, fraud and potential regulation

Question 9

What are blockchain tokens?

Answer 9

This is a broad term for ownership of an asset that is created, traded, and stored in digital form. Blockchain (i.e., distributed ledger technology) is often used to facilitate these transactions.

Question 10

Six types of blockchain tokens?
1 AT
2 PT
3 ST
4 UT
5 GT
6 RT

Answer 10

1 asset tokens - backed by another asset (gold, digital asset, real estate)
2 payment tokens - e.g. cryptocurrency
3 security tokens - provide a share in another security, which is commonly a company issuing a digital currency (this is what happens when a company hosts an ICO)
4 utility tokens - promotional tool giving the owner special access to a blockchain connected product or service
5 governance token - provide a seat at the decision-making table for a digital asset
6 reward token - analogous to reward miles or cash back offers on a credit card

Question 11

Smart contracts are agreements that are (1). Once pre-specified conditions have been met, then the actions in the contract will be initiated. They are (2) and are managed using (3). They also eliminate the need for (4).

Answer 11

1 pre-coded by an algorithm
2 tamper-proof
3 blockchain technology
4 a trusted intermediary to vet transactions

Question 12

What is a DOI/UOI?

Answer 12

DOI is a digital object identifier which is a digital fingerprint to identify a specific object on the internet (e.g. assigned to documents and publications)

UOI is a universal object identifier which extends the concept to any digital asset or a digital representation of a physical asset (e.g., a person, a piece of equipment, or a parcel of real estate).

Question 13

What is a distributed ledger in the purest sense?

Answer 13

It is a database that is shared and synchronized across multiple locations.

Question 14

Another name for decentralised applications?

Answer 14

dApps

Question 15

What is an interplanetary file system (IPFS)?

Answer 15

Where large files (e.g., video files, large databases, etc.) are broken down into smaller segments with each segment stored in a different location. They can be combined again very easily using a token.

Question 16

When large files are broken down and stored in different locations, sometimes they are so large/complex that they need machine learning to get involved with segmenting and reconnecting the files - what is the name for this Web 3 storage solution?

Answer 16

Federated learning.

Question 17

How are files stored for dApps? (Small vs big, IPFS and FL)

Answer 17

Small files can be stored in a single digital location and accessed using a token. Large files (e.g., video files, large databases, etc.) may need to be broken down into smaller segments with each segment stored in a different location. They can be combined again very easily using a token. This type of storage solution is called an interplanetary file system (IPFS). Some datasets are so large and complex that they need machine learning to get involved with segmenting and reconnecting the files. Federated learning is the term for a Web 3.0 storage solution that involves machine learning.

Question 18

What is composability?

Answer 18

Breaking down a financial service into functional building blocks (the entirety of the components is known as a stack).

Question 19

What is the goal of composability?

Answer 19

By breaking down a financial service into functional building blocks, create a robust service offering that is standardized and interoperable (i.e., works well with other technology pieces)

Question 20

What are the two high-level parts of the DeFi technology stack? (IS and FS with latter containing 4 layers: AL, AL, PL, AL)

Answer 20

1 infrastructure substack: combination of Web 3.0 services and tools that collectively enable the DeFi service. For example, blockchain technology is part of the infrastructure substack.

2 functional substack: combination of interoperable (i.e., interchangeable) financial services with multiple layers:

a. application layer - layer is a series of P2P, consumer-facing applications. Examples include personal banking, loans, mortgages, or asset trading services.
b. aggregation layer - layer bridges related services together. This is similar in concept to traditional banking services that cover a spectrum of customer needs.
c. protocol layer - layer involves the software protocols working in the background to support a specific task.
4. asset layer - layer involves units of value. These could be fungible or non-fungible tokens that represent assets.

Question 21

What are the four layers of the functional substack?

Answer 21

Application layer. This layer is a series of P2P, consumer-facing applications. Examples include personal banking, loans, mortgages, or asset trading services.

Aggregation layer. This layer bridges related services together. This is similar in concept to traditional banking services that cover a spectrum of customer needs.

Protocol layer. This layer involves the software protocols working in the background to support a specific task.

Asset layer. This layer involves units of value. These could be fungible or non-fungible tokens that represent assets.

Question 22

What layer of the functional substack involves units of value?

Answer 22

Asset layer

Question 23

What layer of the functional substack bridges services together?

Answer 23

Aggregation layer

Question 24

What layer of the functional substack involves software protocols?

Answer 24

Protocol layer

Question 25

What layer of the functional substack involves consumer facing applications?

Answer 25

Application layer

Question 26

What are the two primary ways that buyers and sellers are paired? What is the name for the process of pairing buyers and sellers?

Answer 26

Process of pairing buyers and sellers is known as price discovery.

Two ways:

1. central limit order book: transparent electronic list that stores the desired limit prices and share sizes for transactions from both buyers and sellers. Counterparties can be matched in an orderly manner.
2. dealer platforms: non-exchange-based locations for matching buyers and sellers. If prices are offered from only one dealer, then it is called a single-dealer platform, while a multi-dealer platform features prices from several dealers.

Question 27

What are the 5 stages of electronic trading?
1 D A/C
2 PT A
3 TSG
4 TE
5 PT A

Answer 27

1 Data access/cleaning. In this stage, data is located and cleaned so that it can be properly accessed.

2 Pre-trade analysis. Cleaned data can be reviewed to identify trading opportunities. Strategies can be formed to pursue alpha using forecasts, manage risks, or minimize trading costs.

3 Trade signal generation. Pre-trade analysis evolves into identifying specific assets to be used.

4 Trade execution. Once trades have been structured, an algorithm will execute trades on centralized exchanges using the available central limit order book.

5 Post-trade analysis. This step evaluates the profitability of the trades placed. The goal is to improve the process.

Question 28

What are the three primary types of decentralized exchanges?
1. AMM
2. OB DEX (OC/OC)
3. DEX A

Answer 28

1. Automated market makers (AMMs). Enables P2P trading using smart contracts. Instead of using a central limit order book, AMMs use a liquidity pool, which is a shared pool of user-supplied tokens facilitating price discovery
2. Order book DEXs - this is a record of all known prices at which a transaction could occur on a decentralized exchange.
   a. On-chain order books - transactions are vetted and recorded on the blockchain directly. This process involves miners who validate the transaction.
   b. Off-chain order books - transactions are cleared by a third party not directly on the blockchain. These third party “relayers” can speed up the transaction time, but they are also only quasi-decentralized
3. DEX aggregators - platforms attempt to offer better price discovery by aggregating the available prices from several different DEXs

Question 29

Nine concerns with tokenised trading:
1 L
2 S
3 F
4 BI
5 F
6 SCE
7 R
8 UX
9 MM

Answer 29

1 liquidity - low liquidity. many new platforms, but few users on each.
2 speed - DEX platforms are often slower than CEX platforms due to blockchain complexities
3 fees - fees can be higher when using a DEX. This is partly due to the lower volume of DEX transactions relative to CEX transactions
4 blockchain interoperability - more aggregators are needed to facilitate ease of switching between blockchain platforms
5 fairness - trade validation can sometimes be seen as unpredictable and unfair
6 smart contract errors - due to high level of complexity in some newer smart contracts, errors have resulted
7 regulation - developing area because the structure of DeFi can undermine the authority of central banks
8 user experience - steep learning curve to develop a user interface that accomplishes the required tasks and is also convenient and aesthetically pleasing
9 market manipulation potential - e.g. Gamestop, decentralized market participants could use algorithms and a platform to manipulate prices in mainstream financial markets

Question 30

Seven traditional start-up/VC funding strategies?
1. B
2. AI
3. VC
4. BI
5. G
6. A
7. IPO

Answer 30

1. bootstrapping - founder using own assets to fund growth
2. angel investment - single investor giving capital in exchange for minority stake
3. venture capital - firm that raises funds from other investors provides professional expertise and capital
4. business incubators - business provides targeted growth acceleration and operational advice for a small equity stake. this is a pre-VC step, and may only need an idea at this stage.
5. grants - some funding is available in the form of public or private grants and loans
6. acquisition - more experienced firm may acquire a start-up who has a good idea
7. IPO - usually toward the end of a start-up’s lifecycle (exit strategy)

Question 31

What are two new (non-traditional) strategies for funding start-ups? (C and SPAC)

Answer 31

1. crowdfunding: social media approach that brings a large number of entrepreneurs together to collectively fund start-up opportunities
2. Special purpose acquisition companies: “off-the-shelf” publicly traded entity in which market participants can invest. A SPAC will exist for up to two years and attract money from investors with the goal of purchasing a private firm and bringing them public through a non-traditional pathway.

Question 31

Six key challenges facing traditional VC and angel investing strategies:
1 C
2 V
3 FR
4 TE
5 LU
6 R

Answer 31

1. Competition. VC investors are competing for a limited number of profitable, high-growth start-ups.
2. Valuation. Most start-ups do not understand their true underlying value.
3. Failure rates. Nine out of ten start-ups fail within three years of starting.
4. Technical expertise. VC firms have access to the technical expertise and models needed for start-up valuation. These proprietary methods can create information asymmetry.
5. Investment lock-up. VC investments might be locked up for long periods of time before unlocking significant profits.
6. Raising more funds. All VC firms and angel investors run into capital constraints.

Question 32

How can tokens/tokenisation help with VC strategies?

Answer 32

They can increase liquidity (can be split into subunits and traded freely) and the effectiveness of risk management, while decreasing settlement times and transaction costs. Being secured by blockchain technology is a risk management enhancement.

Question 33

What are five opportunities that DeFi offers to help bring a start-up idea to the general public?
1 ICO
2 STO
3 IEO
4 UTO
5 PTO

Answer 33

1 ICO - initial coin offering - cryptocurrency equivalent to an IPO. ICO investors get new cryptocurrency assets instead of receiving shares in a company. Raised regulatory attention because anyone can issue, and its not clear if they are a ‘security’ or not.
2 STO - security token offering. attempts to resolve the regulatory ambiguity of an ICO by issuing a security token that is a share in a company (similar to a stock). Can be traded on an STO exchange. Singapore Exchange hosts an STO exchange for this purpose
3. IEO - initial exchange offering. evolution of ICOs that functions on a centralized exchange rather than on the blockchain directly. The centralized exchange acts as a filter to ensure the validity of a new token issuance.
4. UTO - utility token offering. created to encourage usage of digital assets: gives the owner the right to participate in an activity or service within a digital ecosystem
5 PTO platform token offering - potential future innovation is a system run on platforms in which the platform operators will perform some underwriting service - i.e. investment banking for digital assets

Question 34

Why does DeFi present such a regulatory challenge (intermediaries)?

Answer 34

Traditionally, regulators target intermediaries with clear lines of jurisdiction. DeFi poses a significant regulatory challenge because it naturally removes intermediaries and no established jurisdictions exist.

Question 35

Six potential approaches for regulation:
1. SB
2. G
3. L
4. E
5. FT
6. RT

Answer 35

1. Regulatory sandbox - safe space where a DeFi innovator can develop a start-up idea with close supervision from regulators before releasing it to the general public
2. Guidance - Regulators can issue guidance on regulatory expectations for new ideas
3. Legislation - Regulators can review existing rules to see if any apply and make new rules when practical
4. Enforcement - Regulators can issue warnings, exemptions, prohibitions, and enforcement actions as needed
5. DeFi FinTech - solutions can be actively developed to target the desired good behavior. One example is the idea for a central bank digital currency (CBDC).
6. DeFi RegTech - develop DeFi technologies and tools that can police existing DeFi infrastructure. This is a very complex undertaking, but it is under consideration.

Question 36

WEF - six core areas of DeFi risk?
1. c
2. fm
3. t
4. o
5. lc/r
6. e

Answer 36

1. Consumers. Consumers face high asset volatility and the potential for fraud
2. Financial markets. There is inherent market risk, counterparty risk, and liquidity risk
3. Technical. Software failures can cause systematic DeFi risk.
4. Operations. There is the potential for human error in this process. There could be management issues, governance issues, or ongoing system maintenance issues
5. Legal compliance and regulation. DeFi can be used to evade legal and regulatory constraints.
6. Emerging. DeFi is becoming so interconnected with traditional financial markets that some macro-level risks have the potential to emerge. These include flash crashes and general market destabilization.