The Cryptocurrency Ecosystem

The Cryptocurrency Ecosystem

This is Part 2 of the post. You can find the Part 1 of the Post here.

While we are all familiar with the different fiat currencies — US Dollar, Euro, etc. let us first introduce some of the main cryptocurrencies. Most of us would probably have heard of Bitcoin, but, there are many more cryptocurrencies than just Bitcoin. Below are seven of the more popular cryptocurrencies which have built a strong reputation for themselves, and in which most of the crypto transactions take place today.

You may be surprised to know that while there are less than 200 fiat currencies in the world, there literally are thousands of cryptocurrencies as of this writing (over 7,000 listed on CoinMarketCap, as at November 2021).

From Part 1 of this post, we understand that each currency is most proximately surrounded by Layer 1 institutions, which govern the policies about the currency (for instance, US Treasury and Federal Reserve for the US Dollar) and the banks that allow us to make payments in terms of the currency.

The Layer 1 institutions around a currency — the banks — primarily solve two basic problems for that currency

· No Double Spend: They ensure that there is no way the same money can be spent twice, as they ensure that every unit of the currency is accounted for. If a payment is made from Alice to Bob, then Alice’s account is debited and Bob’s account is credited and Alice cannot double spend the same money once again to make another payment to say Charlie with the same funds. The banks and every organization allowing financial payments will ensure this.

· Transaction Authenticity: Every transaction that is executed in the ecosystem, is a valid transaction and one cannot randomly get a credit or debit into their account, without proper authorization for the transaction and proper records being maintained with details about who is being debited, who is being credited, with what amount of which currency and as on which date/time. If there are any disputes relating to any transaction then the Layer 1 institution can readily refer to the records on the basis of which individual transactions were executed.

These are done by the Layer 1 institutions, who also facilitate the actual execution of the payment transactions, represented in the currency. However, these Layer 1 institutions are considered as centralized institutions — whether the government authorities or the banks. If the government of a country so chooses, they can order the banks to shut down, not transact, or refuse transactions for specific individuals, by blocking their bank accounts. Additionally, every transaction is recorded resulting in lack of anonymity to the parties in a transaction.

Cryptocurrencies too have Layer 1 institutions surrounding them, and they solve the exact same problems of no double spend and transaction authenticity, but additionally, they provide the following key benefits:

- The Layer 1 institutions are decentralized — which means, that anyone can play the role of the Layer 1 institution. So there is no authority who can control the currency or the payment networks and the network is always available to transact — no authority can shut it down.

- They keep every transaction anonymous by using a combination of public and private keys consisting of extraordinarily long combinations of letters and digits and the transactions only recording the public keys. The identity of the parties in a transaction, are not known to anyone and as such complete privacy is possible to the transaction though the whole world can see that a transaction has been executed, as it would be part of the block chain. But, no one can know which are the two parties to the transaction as their identities are not revealed but, only the Public Keys are known.

Layer 1 Transactions — Payments

So, if we consider the Bitcoin as an example, then the Layer 1 institutions can be represented as follows:

The Layer 1 Institutions are just a bunch of decentralized Computing Nodes (Node N1 through N8 in the illustration) run by different people / institutions, who just download the computing software and can join the network and start participating in the network. There can be any number of nodes which participate in the network, and these nodes are just computers which have the software of the blockchain running on them. These Layer I ‘institutions’ of a cryptocurrency such as Bitcoin are also referred to as Miners or ‘Validators’ and they also help execute and administer the system. Incidentally, the term Coin or Token is used to refer to a cryptocurrency. There are some differences between Coins and Tokens, but we will save that for another day.

The blockchain software ensures that all miners / validators are treated equally and the only difference is the hardware power that one uses at each Node. A node with a larger computing power will be able to validate and execute more transactions, while a node with lesser computing power will be able to validate and execute lesser number of transactions.

The blockchain software used by all the nodes enforces the Protocol and the process of validating each transaction is called the Consensus Mechanism[1]. Since there are many nodes in the bitcoin network, every transaction would need to be propagated to all the nodes and the authenticity of it evaluated by a majority of the nodes. The nodes use computing power to perform a validation of the transaction, using cryptography, which is where the crypto in cryptocurrencies comes from. The crypto computations used to validate the transactions are typically performed by multiple nodes and the node that completes it first is the one that gets rewarded, and the others would confirm the validation is indeed correctly performed. In case of any conflicts, then the version of the majority of nodes, obtained by consensus, is the final one.

The process of obtaining the consensus is done by what is called as the Protocol. The Protocol also ensures that not every node needs to perform the computation and if a majority of the nodes agree on a transaction, then that transaction is recorded in something called a block. A block consists of many transactions clubbed together.

Each of these blocks are further chained together, where each successive block has the reference to the previous block, and therefore, the entire technology or protocol is called the blockchain.

The Validator nodes get rewarded for doing the crypto computations and new cryptocurrencies are created or ‘mined’ to reward them, as part of the validation process. That is why this process of validation of the transactions is also called as mining. There usually is a limit to the number of coins that can be mined in each network. So, once the last coin is mined, even then, the ‘miners’ or rather the ‘validators’ would still be required to continue mining or rather validating the transactions.

So, that is the Layer 1 of a coin. It primarily allows for payments to be made using the coin as the currency of the transaction, pretty similar to a Layer 1 transaction in a fiat currency, and the role of the banks are played by the Nodes. The one big difference from the fiat currency ecosystem is that these nodes are decentralized. What this means is that no single entity controls the network. So, unlike a fiat currency, where the government of a country can control its currency through the banking network, in a cryptocurrency, the nodes are decentralized and as such, no one entity can exercise control over the network. Now, while Banks have accounts where money is stored, cryptocurrencies have wallets where one can store / hold their coins and the coins are transacted at exchanges. At an exchange, the coins change ownership pretty much like money changes ownership in a bank on execution of a payment transaction.

So, the Bitcoin Ecosystem would consist of the Network, Wallets and Exchanges.

Layer 2 Transaction — More sophisticated than Payments

The fun starts with the Layer 2 of cryptocurrencies, pretty much like Layer 2 Institutions of fiat currencies such as Stock Exchanges or Insurance Companies, which allow for higher order financial transactions to be executed, which could even be in the form of contracts, such as Insurance Policies. So, there are Layer 2 Networks surrounding the Layer 1 Network of a cryptocurrency.

These Layer 2 Networks, allow for digitally-defined decentralized applications, called dApps, based on digitally-defined contracts, called smart contracts, to be defined and executed. These can be Insurance Contracts or Loan Contracts just like those we are familiar in the fiat currency ecosystems. However, they can be a lot more complex contracts too, since the smart contracts are defined in computingcode. However, all of these dApps would be defined in terms of the coin which is at the heart of the network on which they are defined.

This point needs some elaboration. Currently, in our US Dollar financial ecosystem, when we make a purchase, whether in the physical world or online, we make the payment in USD. However, imagine a world in which if you were to purchase online, say on Amazon, then Amazon has a currency of their own — lets call it AMZ and you would first exchange USD with AMZ and then spend AMZ on the Amazon Network. All the goods you would see on Amazon would be priced in AMZ, and so, that currency becomes the unit of every transaction you execute in that network. Similarly, Layer 2 Transactions, such as dApps, which are executed by the Layer 2 Networks, are usually in terms of a cryptocurrency of their own. Occasionally, they could also be in terms of the coin of the Layer 1 Network that they surround. But, that is rare. The exception would be a Layer 2 Network such as Lightning uses the same coin as the Layer 1 Network — Bitcoin or also referred by its acronym BTC. This means on the Lightning Network, you would still continue to use BTC as the currency of all transactions.

Another major Layer 1 Network, which is just as important, if not more than Bitcoin is the Ethereum Network. The Bitcoin Network was originally designed for payments, and therefore it does not extend very well for execution of dApps on it. The Ethereum Network however, was created ground up to enable the definition and execution of dApps.

The Ethereum Network is surrounded by Layer 2 Networks such as Polygon, xDai or LoopRing, which however, do NOT use the ETH — the currency at the heart of the Ethereum Network. They have different coins at the heart of their network, similar to the hypothetical example we used for a currency called AMZ for transactions on Amazon.

The Polygon Layer 2 Network is built around the MATIC coin, xDai Layer 2 Network has the STAKE coin and the LoopRing Layer 2 Network has the LRC coin at its heart. The currencies ETH can be converted into MATIC or STAKE or LRC and vice versa, just like any currency like USD can be converted into Euros and back.

The Layer 2 Networks provide infrastructure pieces which extend the functionality or efficiency of the underlying Layer 1 Network. For instance, the Bitcoin Layer 1 Network, is slow and executing a transaction takes time. Secondly, given the continuing rise in the price of Bitcoin and the popularity of Bitcoins, both the number of transactions as well as the number of users have increased exponentially, resulting in a lot more work to be done by the Nodes to validate all the transactions. The cost of each transaction resultantly is much higher, as the Validators need to invest in larger computing resources to be able to validate the increased number of transactions and since they are rewarded in Bitcoins, with the rising cost of each Bitcoin, the cost per transaction is continuously rising.

The Lightning Layer 2 Network, built around the Bitcoin Layer 1 Network, allows for faster execution of Bitcoin transactions and also supports lower value transactions, as the cost per transaction is also much lower on the Lightning Network. So the Lightning Network adds speed and lower costs to the Bitcoin Network.

Returning to dApps, most of these decentralized Apps (dApps) today are being built on Networks other than Bitcoin, such as on Ethereum and other Layer 1 Coin Networks such as Polkadot (which has the Coin DOT at its heart), Solana (which has the coin SOL at its heart) and EOSIO (which has the coin EOS at its heart). Remember this picture?

These other Layer 1 Networks — Ethereum, Polkadot, Solana, EOSIO, are only four of the many Layer 1 networks that exist which have their own Coins — ETH, DOT, SOL and EOS at their center, similar to the Bitcoin network has the coin BTC at its center. So, the world of cryptocurrencies have many more coins than just the Bitcoin! dApps can be built directly on a Layer 1 Network like Ethereum or on Layer 2

Networks like the Polygon Network, or even a Layer 3 Network downstream of it. In fact many dApps are built on top of multiple Networks, to make them available to maximum number of users.

The dApps are for Lending or Borrowing cryptocurrencies or Insurance Contracts. The dApps for Lending or Borrowing coins allow for a yield to be earned or interest (APR or an Annual Percentage Rate) to be paid . They can require posting of collateral which also would be expressed in terms of cryptocurrencies.

More advanced dApps can be AMMs (Automated Market Makers) on Decentralized Exchanges. In a conventional Stock Exchange, trades are executed, when Buy Orders are matched with Sell Orders. However, most of the Exchanges such as NASDAQ and NYSE today are Hybrid Exchanges which also have Market Makers who provide continuous Bid and Ask quotes for certain securities which are traded on these Exchanges. These Market Makers ensure there is always a Quote in the system, whether there is a matching order or not and these Market Makers provide liquidity to the securities for which they provide the Quotes.

However, in these Stock Exchanges, both the Exchange and the Market Makers are centralized, which means the Exchange Authorities or the Brokers who are acting as the Market Makers, can decide to change the rules at any time. In the crypto world however, there are both Centralized Exchanges (CEXs) and Decentralized Exchanges (DEXs). Centralized Exchanges like Binance, Coinbase, Huobi, Kraken, Kucoin, Bitfinex, etc. are owned by institutions who run these exchanges very similar to institutions that run the Stock Exchanges we are familiar with. However, these Institutions perform the role of order execution, and therefore, while the underlying assets are cryptocurrencies, these Institutions have full visibility into who is selling and who is buying and also, can impose restrictions on when investors can withdraw funds, etc. Resultantly, these centralized crypto exchanges do not still provide all the benefits of dealing in crypto currencies. This is where Decentralized Exchanges or DEXs come in.

The DEXs run on the block chain technology and as such have (very) Smart Contracts driving them. In fact, these Smart Contracts are so complex that they are referred to as Decentralized Autonomous Organizations or DAOs. These artificial ‘organisations’, are actually pieces of very complex algorithms written in computer code that run on the blockchain network. They can run on Layer 1 or Layer 2 Networks. For instance, the Curve Finance DAO is a DEX that runs on Polygon Layer 2 Network, which runs on the Ethereum Layer 1 Network.

Curve Finance DAO is an Automated Market Maker, allowing for investing of coins or tokens, by creating what are called as Liquidity Pools. So, an Investor in a Coin like ETH or MATIC can invest in a Liquidity Pool run by Curve Finance DAO and earn a yield or interest for the lending they are doing to the liquidity pool.

Its like you own the shares of IBM, but instead of letting your investment sit idle, while you are invested in IBM, you can lend those shares of IBM and earn an interest on it. These lending operations and payment of yield etc. are automated and the calculations are automatically computed and yield paid out daily after an initial lock-in period. The lending by each investor could be handled by dAPPs which automate the whole process of receipt of coins, investment in pools, calculation of interest, etc.

So, that pretty much rounds up the first course in Cryptocurrencies. I hope this first course helped you to understand the wonderful world of cryptocurrencies better and would motivate you to take the plunge.

Arun Pingaley is the CIO of a Social Enterprise.  He has over three decades of experience in the field of finance and technology.

[1] Consensus Mechanisms are primarily of two types today — Proof of Work (PoW) or Proof of Stake (PoS). There are others too, but, for what is covered in this article, it is not necessary to understand these mechanisms.