Definitions Flashcards
How can you prove that you have created digital
content at a certain point in time?
You could register your data with something like a patent
office: You bring your data, they store it and issue a
receipt, record the storing time in a ledger, post it online
(like SSRN).
Can you propose a solution that does not require a
trusted third party?
• Print the digital content out and put it in a ledger
• Distribute the ledger so that everybody can verify the data for themselves
– the stamp on the envelope can serve as time-stemp
– Wide distribution of the ledger is important because otherwise somebody can establish an alternative ledger by distributing the ledger
more widely.
What is the problem with printing out digital ledger and distributing it?
1) Creating and sending out ledgers extremely costly
2) People would have to be incentivized to keep and store the ledger
Hash digital content and post it in newspaper
- An algorithm called the hash-function is applied to any digital document that needs to be time-stamped
– The outcome is a short code
– Information about time and date is added - A stack of hashes of digital documents is hashed again and
the resulting code is posted in the NYT for everybody to see.
-> Distributed ledger
What does a hash function do?
Input is converted to a hexi-decimal “hash”
by scrambling it in a way that is impractical to
invert
What are the possible input to a hash function?
Anything that can be stored in digital form – Text – Data – Video, music, photographs – Fingerprints, irises – Etc.
What’s the purpose of the hash-code?
– It maps out digital content of any length into a unique, short string.
– Registering this short string is equivalent to registering the whole digital
content.
What’s the purpose of the distributed ledger?
– It makes faking the ledger if not impossible at least very costly.
– The originality of the ledger need thus not be guaranteed by a third
party.
– (Nevertheless, a third party is involved in the process, thus it’s not a fully
decentralized solution)
What is electronic cash?
Basically, a digital version of cash
Fungibility
One unit of digital cash is indistinguishable
from any other unit of the same digital cash.
– Owner is whoever is in possession
– Even if units of cash have a serial number, you do not have a claim to a specific unit of cash.
What can you credibly establish using the ledger??
o The person owning electronic cash
o The amount of electronic cash owned by that person
o A record date at which that person owned electronic cash
The ledger cannot provide
o A mechanism that allows us to verify the identity of the other person
o A cryptographic way of fully digitally recording data that ensures the integrity of the data
o A check whether that person has spent the electronic cash since the record date (double-spending problem)
Innovations brought together by
Nakamoto (2008)
Digital signatures: Using double-key cryptography to make secure transfers of assets from one wallet to another (British intelligence,1970s)
• The Blockchain: Recording new data sequentially in a write-only, indelible ledger (IBM, 1976)
• Proof-of-work: Validating new data by cryptographic “consensus” proof, in recurring 10-minute open competitions, instead of relying
on a trusted third party (Nakamoto, 2008)
Who updates the blockchain?
• Haber and Stornetta (1991)
– A trusted third party codes blocks
– The chain is public, becoming a distributed ledger that can be verified by anyone
• Nakamoto’s (2008) crowd-sourcing solution
– Network members compete to create new blocks
• The competition is called proof-of-work
• Proof of work: Solve a puzzle that solely requires computing power
• Node which solves the puzzle first creates the block
• Node earns a reward IF block is accepted as correct by the network
– Anyone can join the network and take part
Who updates the blockchain?
• Haber and Stornetta (1991)
– A trusted third party codes blocks
– The chain is public, becoming a distributed ledger that can be verified by anyone
• Nakamoto’s (2008) crowd-sourcing solution
– Network members compete to create new blocks
• The competition is called proof-of-work
• Proof of work: Solve a puzzle that solely requires computing power
• Node which solves the puzzle first creates the block
• Node earns a reward IF block is accepted as correct by the network
– Anyone can join the network and take part
Proof-of-work competition
- Create a hash of the above four components that satisfies a predefined condition
- For example: “The first four digits of the hash need to be zeros”
- Challenge: Find a “nonce” (number) that creates such a hash.
Incentive mechanism
The expected return from mining is higher for
creating correct blocks than for creating manipulated blocks.
When does incentive mechanism fails?
One party holds onto more than 51% of the nodes and can thus validate an incorrect block
What makes the blockchain brilliant?
• It is impossible to change one entry in the
blockchain w/o having to change the entire chain.
• The blockchain essentially is an easy-to-handle and
fool-proof transaction recording technology.
• It naturally offers a feature that is essential for the
functioning of markets: trust.
Bitcoin
is a virtual currency traded and recorded by
a peer-to-peer network on a “blockchain”
– Peers are equally privileged, equipotent participants in the application.
– They form a peer-to-peer network of nodes.
– One node == Bitcoin client
Bitcoin consensus algorithm
- New transactions are broadcast to all nodes
- Each node collects new transactions into a block
- In each round, proof-of-work determines a random node to broadcast its block
- Other nodes accept the block only if all
transactions in it are valid - Nodes express their acceptance of the block by
including its hash in the next block they create
Mining
is the process of adding a new block of
transactions to the blockchain
proof-of-work
Puzzle that needs to be solved to mine a block
Consensus mechanism needs to prevent
– Stealing bitcoins
– Denial-of-service attack - when miners do not put a transaction through and it does not happen.
– Double spend attack
The task of bitcoin miners
- Listen for transactions
- Maintain blockchain and listen for new blocks
- Assemble a candidate block
- Find a nonce that creates a valid hash of your
block - Hope your block is accepted
- Receive a reward in terms of minted bitcoins and
transaction fees
Mining pools
– can be joined by any miner willing to contribute “hashes” to the pool
– charge a fee for pooling miners
Benefits of Mining pools
– Risk sharing benefit of mining pools
• Certainty equivalent more than doubles
• Risk sharing benefits increase in pool size
– No other economies of scale
– Mining pools escalate the arms race in PoW blockchains
– Mining pools do not necessarily undermine
decentralization because fees increase in pool size,
implying a limit to pool size
Bitcoin scripts
Transaction code contains bitcoin scripts
– Script is a simple, stack based language
– Turing incomplete (cannot run loops)
– Supposed to be very simple and robust, to protect from
denial-of-service attacks
What happens if transactions > throughput?
– Miners can choose freely which transactions to include
– Transaction fees become critical in getting a transaction recorded on the blockchain
Does congestion have an impact on transaction fees?
– Demand for transaction settlement positively related to fees
– Regular users forgo blockchain settlement in times of congestion
– Will transaction fees alone be able to compensate miners?
Blockchain’s impossibility triangle
Buterin (2015): goal of the blockchain technology is to achieve
decentralization.
– To receive wide adoption and application, consensus provision needs to be accurate and scalable.
– Bitcoin blockchain achieves decentralization and consensus record at the same time, but doing so reduces its scalability.
– Records made in large scales with decentralization are hard to synchronize and achieve consensus.
• Abadi and Brunnermeier (2018) outline the economic trilemma:
– When a blockchain is decentralized and correct, the lack of dynamic
rent by various recordkeepers necessarily implies that the system is
costly;
– when the system is decentralized and maintained at low cost,
recordkeepers may misreport;
– when the consensus is correct and maintenance of the system is cheap,
the outcome is incompatible with free entry and information portability
(compared with traditional reputation-based system) conditions.
Ethereum
is a decentralized, open-source blockchain
with smart contract functionality.
Ether
is the native cryptocurrency of the
platform.
– Miners receive Ether for their service: mining reward and
transaction fees.
– In order to run applications or smart contracts on the Ethereum
blockchain, you need Ether.
Gas
reflects the amount of computational effort required
to execute specific operations on the Ethereum network.
– Transaction fee = Gas x Gas price = Gas x (Base fee + tip)
What is a smart contract?
A set of promises, specified in digital
form, including protocols, within which the parties
perform on these promises, Nick Szabo, 1996
– Not really smart
– Not necessarily legal
– Not necessarily a contract
Smart contract on Ethereum
– a program that runs on the Ethereum blockchain,
consisting of code (its functions) and data (its state) with a
specific address on the Ethereum blockchain.
– Deploying a smart contract is a transaction, requiring Gas
– Deployment is irreversible!
Tokens
are digital coins with extended functionality
– Like digital coins they can be owned and traded
– Unlike coins, their functionality goes beyond the store of value,
e.g., they can have
• Voting rights
• Cash-flow rights
• Asset-rights
• Service-rights
• Product-rights
Fungible-tokens
One token is like the other, all tokens
generated from the same smart-contract have the same value
Non-fungible-tokens
Each token is unique, values differ most
likely
Decentralized Applications (Dapps)
is an application that is mostly or entirely
decentralized
– Frontend usually is a web user interface (mobile DApps are possible too, but currently not as well supported)
– Backend is a set of smart contracts on the Ethereum blockchain
– Has a unique name based on the Ethereum Name Service(ENS)
– Data may be stored on- and off-chain
DAO
Decentralized autonomous organization
– In principle a smart contract that defines the rules by which
the organization is governed
– Membership can be based on tokens or permission-based
systems (applications)
What’s recorded on Ethereum’s
blockchain? And how?
- Smart contracts, payments, votes, payouts are recorded
* Technically all are recorded as transactions, costing Gas
Stakers receive rewards and penalties
– proposer rewards for proposing a block that is validated by the committee
– attester rewards for validating proposed blocks
– attester penalties for failing to validate proposed blocks (being offline)
– slashings and whistleblower rewards
– inactivity leak penalty
If dishonest, stakers risk losing all their staked Ether
Decentralized Finance (DeFi)
Financial platforms or instruments which operate on smart contracts and are governed by token owners
Fiat-collateralized stablecoins
are straightforward to implement and
value if truly 100% fiat-collateralized
Crypto-collateralized stablecoins
are more difficult to implement and
value but offer more transparency because collateral is on-chain.
Why use stablecoins?
– Frictionless transfer of crypto-investments into a crypto-asset with low volatility
– Crypto-collateralized stablecoins may serve a whole range of purposes
Why would you want to mint DAI?
1. Reinvest into crypto-assets (Leverage) 2. Exchange into fiat-currency (Liquidity needs or hedge) 3. Lock into DAI savings rate (DSR) contract – Earns you an interest rate – Interest rate < stability fee (Hedge)
Decentralized exchanges (DEX):
– No intermediary, transact directly with another party
• Two kinds of DEXs:
– Order book-based DEX
– Liquidity pool-based DEX (seems to be the one with higher
adoption)
Can you swap currencies at the current exchange ratio?
Not really, an automated market maker (AMM) determines the ratio depending on the
amount you want to exchange
– Basic rule: The product of the liquidity (N) of both currencies must always stay
constant
→ The exchange rate gets less favorable the larger the amount you exchange
→ Similar to price impact when trading in a limit order market
Automated Market Maker (AMM)
AMMs determines the exchange ratio by applying a
constant production function:
N(Asset-1) x N(Asset-2) = Constant product
• Oracle provides the current market price. If exchange
ratio too far off, trade will not be executed.
– Oracles represent a reliable outside source, thus need to be
tamper-proof.
– Check to ensure price manipulation does not pay off.
• Arbitrageurs usually keep the exchange ratio a close
reflection of current market prices of the underlying
assets.
Economics of UNI
Why hold UNI tokens?
– At a future point 0.05 pp of the transaction fee will go to
token holders. Thus, Uniswap will generate cash flow for
token holders.
• Why give UNI away for free?
– Same principle as loyalty points. Management will profit
because they hold a lot of tokens themselves.
• Why inflate UNI tokens?
– Punish inactive UNI token holders
What are the characteristics of money?
– Unit of account
– Medium of exchange
– Store of value
What are the characteristics of currency?
- A bearer instrument
– Title runs with possession
– Transactions cannot be reversed
What is fiat-currency?
a government-issued currency that is not backed by a commodity such as gold.
Three types of digital assets
• Coins: General purpose medium of exchange and store of
value (such as Bitcoin)
• Security token: conventional security, recorded and
exchanged on a blockchain
– Cash-flow rights
– Reduce transaction costs (direct IPO costs > 7% of proceeds)
– Track ownership
• Utility token: tradable ownership rights of products or services
– Resemble crowdfunding presales
– Analogy: Sale of a seat in a stadium, where having a seat might either
entitle you to watch the game or play the game yourself
The Howey test
- an investment of money is made by the purchaser
- the investment is part of a common enterprise among
numerous purchasers - the success of the enterprise depends on the efforts of a
third-party promoter - a purchaser has an expectation of a financial return, such
as capital gains
Utility tokens benefits
Secure commitment from future customers
• Hasten network effects
• Reward network creators without giving them
operational control after the network has launched
what determines the value of utility tokens?
Price of tokens is determined by aggregating heterogeneous
users’ transactional demand, rather than discounting cash
flows
– Network effect is key driver of token value
– Network effect: the positive externality of one user’s adoption on
other users
• The equilibrium token pricing formula exhibits three features.
– Token value depends on the platform’s productivity, which captures
the platform’s functionality and other related factors (e.g.,
technology and regulatory environment).
– The user base enters positively into the pricing formula, capturing
the positive network externality of user adoption.
– User heterogeneity matters for both platform adoption and token
pricing.
Initial coin offerings (ICO)
An ICO is a fundraising method by which digital tokens are sold in the primary market
When is financing with tokens optimal?
An ICO without security features is optimal if
– the platform value derives from facilitating transactions rather than from
generating cash flows.
– long platform development phase or innovative business model subject to moral
hazard
• An ICO with security features (cash-flow rights)
– spurs network effects and platform adoption, but dilutes developer’s equity stake.
– cash-flow rights, causing dilution, exacerbate moral hazard problems
• Finance with (regular) equity and use fiat money for transactions only if
– Very high cash-flows or
– Very strong network effects or
– Moral hazard is severe
• Conclusion: model implies that start-ups with innovative business models,
which are particularly prone to moral hazard, optimally raise funds via ICOs
