ACAMS-CCAS-EN-G Study Guide PDF

Certified Cryptoasset AFC Specialist STUDY GUIDE Version 1.08 acams.org Credits and Copyright Certified Cryptoasset AFC Specialist Task Force We would like to thank the following individuals for their significant contribution to the development of the Certified Cryptoasset AFC Specialist certification: Jennifer Morrison, CAMS, Brandi Reynolds, CAMS, Holger Pauco-Dirscherl, CAMS, CAMS-Audit CAMS-Audit, CCAS CAMS-RM, CAMS-Audit, CAMS-FCI, CGSS, CTMA Iqbal Azad, CCAS Teresa Anaya, CAMS Mayya Gabueva, CAMS Richard Ashbrooke-Motte Faisal Islam Leonardo Real, CAMS Michael Blackwell, CAMS, Joseph Mari, CAMS Seth Sattler, CAMS CAMS-RM Kenneth Simmons, CAMS, Sana Khan, CAMS, CAMS- Eoghan Nihill, CAMS, CAMS- CAMS-RM, CAMS-Audit, RM, CGSS, CCAS RM, CGSS, CCAS CAMS-FCI, CGSS Elena-Andreea Capatina, Hedi Navazan Nicholas Smart CAMS Eva Crouwel, CAMS Fabrizio Lorini, CCAS George Voloshin, CAMS, CGSS Gilberto Figueroa, CAMS Carolyn Dicharry, CAMS, Ezequiel Wernicke CAMS-Audit John Ashley Adam Chamely Alexandre Pinot, CAMS Yuri Broodman, CAMS, Minakshi Yerra, CAMS Anna Stylianou, CCAS CAFCA Annette Perales Anthony Jerkovic, CAFCA Yulia Murat, CAMS April Hannan, CAMS Wren York, CAMS Arisa Matsuzawa, CAMS, CCAS William Voorhees, CAMS Aub Chapman, CAMS, Thurstan Felstead, CAMS, CAMS-Audit CCAS acams.org Charlotte Lowry, CAMS Chris Bagnall, CAMS, CAMS- Tanya Montoya FCI Sylvia Auguste, CAMS, Christos Christou, CAMS, Daniel Sankey, CAMS CAMS-Audit CGSS Sterlin K. Lujan, CCAS David Haveron Meredith Beeston Marko Talur, CAMS, CCAS, Simon Knight, CAMS David Vijan, CAMS CAFCA Maura Liconte, CAMS Shilpa Arora, CAMS Diego Rosero, CAMS Sherri Scott, CAMS, CAMS- Dwayne King, CAMS, CAMS- Shelley Grayson, CCAS Audit, CAMS-FCI FCI Elaine Sun Kinsey Cronin, CCAS Nick Wright Greg Wlodarczyk Jas Randhawa Pamela Clegg, CAMS Patricia Young, CAMS Eric Goldberg Fabian Fuchs, CAMS Katie Thornton Lynn Li, CAMS, CAMS-Audit, John Waterstram, CAMS Joby Carpenter Paige Stewart, CAMS Kathryn Westmore Lee Sullenger, CAMS Jose Lapadula, CAMS Hans-Georg Beyer, CAMS Nicholas Clark. CAMS Matthias Bauer- Mari-Liis Kurg Langgartner, CCAS Jeongeun Park, CAMS, Delphine Forma, CCAS Nico Di Gabriele, CCAS CAMS-Audit, CGSS Neil Reiter, CAMS Gregory Dellas, CAMS, Cory Howard, CAMS, CCAS CAMS-Audit, CAMS-RM, CGSS, CTMA, CKYCA, CAFCA Matthias Greiller, CAMS, CAMS-RM, CCAS, CGSS, CKYCA, CTMA acams.org ACAMS Product Staff Eric Solecki Michelle Rance, CAMS Heather Carroll Sarah Morrow Tiffany Alcorn Adam Cochran Astrid Rouleau, CAMS Sarah Gillis Marco Tham, CAMS Melinda Fleming Jeff Yastine David Payne John Cannon Jacqueline Zavala Iliana Colón, CAMS Lindsay Pfisterer Sean Packwood Brenda Fewox Charles Ball Ron Myers Crystal Ferguson Edith Velasquez-Bendeck Kathleen Carlson, CAMS Nicole Lewis Todd Beck, CAMS Amanda Dominique Anielka Gutierrez Mary Little acams.org This document is designed to be printed in black and white. © 2022 Association of Certified Anti-Money Laundering Specialists, LLC (“ACAMS”). All rights reserved. Only a licensed learner may download or print this document and such use must be limited to personal study. You may not otherwise share this material. No other use is allowed without express written permission from ACAMS. acams.org Cryptoasset and Blockchain STUDY GUIDE Version 1.07 acams.org Credits and Copyright This document is designed to be printed in black and white. © 2022 ACAMS. All rights reserved. As a licensed learner you may download or print this document. It is copyrighted material. Do not share. No other use is allowed without express written permission from ACAMS. acams.org Table of Contents Getting Started.............................................................................................................. 5 Introduction................................................................................................................ 5 Learning objectives......................................................................................................................................... 5 Cryptoasset Infrastructure....................................................................................... 6 Introduction................................................................................................................ 6 Researching blockchain technology case......................................................................................6 What would you do?....................................................................................................................................... 7 Feedback............................................................................................................................................................... 7 Learning objectives.........................................................................................................................................8 Blockchain introduction.......................................................................................... 9 Blockchain.............................................................................................................................................................9 Blockchain types (Public, private, consortium, hybrid)......................................................... 10 Blockchain common features................................................................................................................ 11 Blockchain transparency........................................................................................................................... 12 Blockchain models for consensus: Proof of work..................................................................... 13 Blockchain models for consensus: Proof of stake.................................................................... 14 Blockchain transaction security............................................................................................................ 15 Blockchain infrastructure.......................................................................................................................... 16 Cryptoasset.............................................................................................................. 17 Cryptoasset........................................................................................................................................................ 17 Centralized versus decentralized cryptoasset types............................................................. 18 Cryptoasset characteristics.................................................................................................................... 19 Cryptocurrency versus fiat currency............................................................................................... 20 Cryptoasset mining............................................................................................... 22 Cryptoasset mining...................................................................................................................................... 22 Mining pools and hash rate...................................................................................................................... 23 Cryptoasset mining geopolitical issues.......................................................................................... 24 Blockchain in action.............................................................................................. 25 Blockchain in action (Case example: Sadie’s Blockchain Mining Group)................. 25 Cryptoasset transaction validation (Case example: Proof of stake)........................... 26 Cryptoasset Types and Business Models........................................................... 28 Introduction............................................................................................................. 28 Purchasing cryptoassets case.............................................................................................................. 28 Cryptoasset and Blockchain Page i Version 1.07 What would you do?.................................................................................................................................... 29 Feedback............................................................................................................................................................ 29 Learning objectives...................................................................................................................................... 30 Virtual asset.............................................................................................................. 31 Virtual asset........................................................................................................................................................ 31 Bitcoin................................................................................................................................................................... 32 Altcoin................................................................................................................................................................... 33 Privacy-centered cryptoasset............................................................................................................. 34 Initial coin offering......................................................................................................................................... 35 Ethereum............................................................................................................................................................ 36 Token..................................................................................................................................................................... 37 Non-fungible token...................................................................................................................................... 38 Centralized versus decentralized cryptoasset types (Reminder)............................... 39 Stablecoin types: Asset-backed compared to algorithmic.............................................. 39 Central bank digital currency................................................................................................................. 41 Stablecoin types (Case example: TerraUSD)............................................................................. 42 Virtual asset service provider........................................................................... 44 Virtual asset service provider................................................................................................................ 44 Crypto ATMs..................................................................................................................................................... 45 Centralized compared to decentralized exchange.............................................................. 46 Virtual asset service provider lending services.......................................................................... 47 Mixers and tumblers.................................................................................................................................... 48 Virtual asset service provider compared to decentralized finance............................. 49 Decentralized applications and decentralized autonomous organizations........... 50 Cryptoasset in action............................................................................................ 51 Privacy-centered cryptoasset (Case example: Hiding ownership)............................. 51 Mixers and tumblers (Case example: Mixer sanctions)........................................................ 52 Cryptoasset Wallets and Transactions............................................................... 54 Introduction............................................................................................................. 54 How to buy cryptocurrency case....................................................................................................... 54 What would you do?.................................................................................................................................... 55 Feedback............................................................................................................................................................ 55 Learning objectives...................................................................................................................................... 56 Blockchain transactions.......................................................................................57 Blockchain transactions............................................................................................................................ 57 How to buy a cryptoasset........................................................................................................................ 58 Unspent transaction output based blockchain transactions............................................ 59 Peer-to-peer blockchain transactions.......................................................................................... 60 Cryptoasset trading...................................................................................................................................... 61 Cryptoasset and Blockchain Page ii Version 1.07 Blockchain applications other than cryptocurrency.............................................................. 62 Wallets....................................................................................................................... 63 The value of cryptoasset.......................................................................................................................... 63 How an owner controls a cryptoasset............................................................................................. 64 Wallets.................................................................................................................................................................. 65 Wallet types and attribution.............................................................................. 66 Unhosted compared to hosted wallets..........................................................................................66 Cloud wallets.................................................................................................................................................... 67 Hardware wallets........................................................................................................................................... 68 Hot wallets versus cold wallets.............................................................................................................69 Transactions in action.......................................................................................... 70 Blockchain transactions (Case example: Bob sends money to Maria)...................... 70 How an owner controls a cryptoasset (Case example: Opening an online wallet).................................................................................................................................................................................... 71 Cryptoasset Analytics...............................................................................................73 Introduction..............................................................................................................73 Blockchain analytics salesman case................................................................................................. 73 What would you do?.................................................................................................................................... 74 Feedback............................................................................................................................................................ 74 Learning objectives...................................................................................................................................... 75 Blockchain events and risks............................................................................... 76 51% attacks........................................................................................................................................................ 76 Hard and soft forks....................................................................................................................................... 77 Smart contract................................................................................................................................................ 78 Smart contract consumer risk.............................................................................................................. 79 Block halving.....................................................................................................................................................80 Cryptoasset tracing............................................................................................. 82 Cryptoasset anonymity versus pseudonymity.......................................................................... 82 Cryptoasset anonymity (Case example: Is Bitcoin anonymous?)................................ 83 Privacy-centered cryptoasset (Reminder)................................................................................. 84 Cryptoasset tracing..................................................................................................................................... 84 Cryptoasset tracing (Case example: Child exploitation site)........................................... 85 Mixers and tumblers (Reminder)........................................................................................................ 86 Blockchain monitoring and analytics tools...................................................................................86 Coin tracing across exchanges........................................................................................................... 87 Attribution................................................................................................................ 89 Wallet research and attribution........................................................................................................... 89 Attributes of a block and sources of data.....................................................................................90 Cryptoasset and Blockchain Page iii Version 1.07 Clustering............................................................................................................................................................ 91 Benefits of UTXO tracing.......................................................................................................................... 92 Analytics in action.................................................................................................. 94 Coin tracing across exchanges (Case example: Bitfinex exchange)......................... 94 Attribution (Case example: CashFXgroup.com)...................................................................... 95 Conclusion.................................................................................................................... 96 Cryptoasset and Blockchain Page iv Version 1.07 Getting Started Introduction Learning objectives After completing this learning experience, you will be able to: Describe how the blockchain functions, what cryptoassets are, and how mining creates coins. Describe the cryptoasset types and business models. Describe how transactions occur on the blockchain and the purpose and types of wallets. Describe how analytics help protect against blockchain events and risk and assist in cryptoasset tracing and attribution. Cryptoasset and Blockchain Page 5 Version 1.07 Cryptoasset Infrastructure Introduction Researching blockchain technology case You live in the city of Venice. You are an AML professional working at a large bank. Your bank is considering whether to offer cryptoasset services in the future. You are assigned to research the functions of blockchain technology and report back to your supervisor. You do not know very much about cryptoassets or blockchain technology. In your research, you learn that Bitcoin was the first widely known cryptoasset on a blockchain. Blockchains are distributed ledgers, which means they exist on multiple servers and anyone, anywhere, can access the data. The blockchain makes it possible to trace the entire life of a cryptocurrency coin. Additionally, blockchain transactions are faster, more secure, and less expensive than traditional banking. This is amazing technology! You want to report that cryptoasset accounts could significantly expand your bank’s opportunities, but you need to be sure. So, you continue your research. You learn that transactions on the blockchain can never be changed. Blockchain uses a process called “encryption” to secure data and stores this data on the blockchain permanently. Users known as “miners” are responsible for verifying transaction data and publishing it on the blockchain. Now it is time to report your findings. You are excited to present a summary of your research to your supervisor. You explain that the blockchain is a distributed ledger system on a worldwide network that can be accessed by anyone. You tell your supervisor about the opportunities that this could bring for your bank. This includes an increase in customers and faster, more Cryptoasset and Blockchain Page 6 Version 1.07 affordable transactions. Your supervisor is still not convinced. She does not understand how the blockchain can be secure. If anyone can access the data, couldn’t someone hack the system? What would you do? How do you respond? Blockchain benefits might outweigh the risks. Encryption makes hacking very difficult. Miners stop hacking attempts. Tracing stops hacking. Feedback The best response is to explain that the blockchain’s encryption feature makes hacking very difficult. However, you should acknowledge that cryptocurrency can be stolen if users do not protect their account information. This is also true for normal bank accounts. The other responses are not as strong or are incorrect. Many businesses believe that the benefits of blockchain do outweigh the risks. However, that is not what your supervisor is asking. Your supervisor wants to understand how blockchain works and how it prevents hacking. Miners do not stop hacking attempts. A miner's main role is to validate transactions and publish them to the blockchain. Coin tracing tracks the life of a coin. It does not prevent hacking. Cryptoasset and Blockchain Page 7 Version 1.07 Learning objectives After completing this module, you will be able to: Describe the types of blockchain and how they function. Describe the types of cryptoassets and recognize how they differ from fiat currency. Explain how cryptoasset mining works. Explain how the blockchain works. Cryptoasset and Blockchain Page 8 Version 1.07 Blockchain introduction Blockchain A blockchain is a decentralized, distributed public ledger. It is a database that uses encryption to store blocks of data and chains them together chronologically. It serves as the single source of this data and is immutable, or unable to be altered. This shared, immutable ledger allows the recording of transactions and tracking of assets in a business network. Assets traded on a blockchain network can be tangible assets, such as machinery or land, or intangible assets, such as patents or bonds. There are many characteristics of blockchain technology that provide benefits for users. A blockchain always consists of nodes, miners, and blocks. Nodes are computers used to access blockchain networks. Miners are users who verify transactions and add new blocks to the blockchain. Blocks are structures of transaction data for cryptocurrency transactions. Every chain of data consists of multiple data-filled blocks. The data in the block is sealed forever and is attached to a random number called a “nonce” and is the result of a cryptographic function called a “hash.” In a blockchain, each block has a unique nonce and hash, which makes it extremely difficult to manipulate the blockchain. To make a change, the entire block would need to be re-mined along with any other blocks in its chain. This would require an enormous amount of time and computing power. Once a blockchain is mined, it also must be verified by other nodes on the network. Blockchain technology offers many benefits. Blockchains are immutable, which means they are permanent and cannot be altered. They also offer transparency, as all users can access a copy of the ledger. Blockchains are decentralized, meaning that no central governing authority has decision- making power over them. They are also secure because they consist of individually encrypted records. Additionally, blockchain offers faster settlements than traditional banking system transactions. Cryptoasset and Blockchain Page 9 Version 1.07 Blockchain types (Public, private, consortium, hybrid) One of blockchain technology’s most commonly used features is the ability to carry out transactions and exchange information through a secured network. However, distributed ledger technology can be used in a variety of ways and for different uses. There are two primary types of blockchain: private blockchain and public blockchain. The most popular blockchains are public blockchains, such as Bitcoin and Ethereum. In addition to private and public blockchains, there are two additional types of blockchains: consortium and hybrid. A public blockchain is nonrestricted and permissionless, meaning that anyone with access to the internet can participate as an authorized user. A public blockchain allows users to access all records, verify transactions, and complete proof of work. A private blockchain is restricted and operates only within a closed network. A single organization controls the security, permissions, and authorizations. Only selected members can access a private blockchain network. A consortium blockchain is a semi-decentralized network that multiple organizations manage. Banks and governments commonly use this type of blockchain. It is neither private nor public and is considered a semi-private blockchain. Hybrid blockchains are a combination of private and public blockchains. They allow users to have control over who can access which types of data stored on the blockchain. In the hybrid model, certain data is available on the public blockchain while the rest stays within the private blockchain. Each of these models has advantages and disadvantages. Public blockchains are trustable, open, and transparent but also are difficult to scale and consume much energy. Private blockchains can conduct many transactions per second but allow few participants. A consortium blockchain is scalable, secure, and fast. Hybrid blockchains protect user privacy and are also cheap and fast. However, both hybrid and consortium blockchains are less transparent than the other types. Cryptoasset and Blockchain Page 10 Version 1.07 Blockchain common features Financial institutions have kept ledgers with paper and pen for hundreds of years to track their accounts. The innovation of a digital, open ledger is a key feature of blockchain technology. Because every activity is recorded and shared across the network, all users can view transactions, providing complete transparency. The blockchain is considered immutable and permanent. This means no one can remove or alter the transaction data, and anyone can track the process in real time forever. Blockchain technology also allows for decentralization, meaning no single authority has entire control. There is only one single and secure ledger within a blockchain. The immutability of blockchain is one of its most recognized features. Blockchain ledgers are equally permanent due to cryptographic signing, which uses a mathematical algorithm solved by a unique hash. Each new transaction block contains the hash of the previous block, creating a chronological chain that cannot be broken. To maintain its immutability, every blockchain has an algorithm-based consensus mechanism used to approve and verify transactions. This feature, along with the overall transparency of blockchain, eliminates the need for a third party. Anyone can join or leave the blockchain without disrupting the verification process. This feature also contributes to the blockchain’s efficiency, due to the fast speed of transaction settlements compared with traditional finance. Blockchain technology increases the capacity of the entire financial system. Many computers can function together, eliminating dependency on any one machine. The technology brings additional security because blockchain data is stored on multiple devices rather than in one central system. Because a ledger exists in multiple places throughout the world, it is extremely difficult to hack or change. Other key elements of the technology are mining and the application of blockchain in smart contracts. Mining is the process of authenticating data on the blockchain. Smart contracts are programs stored on the blockchain and executed automatically, allowing businesses to automatically enforce contracts and agreements. Cryptoasset and Blockchain Page 11 Version 1.07 Blockchain transparency Transparency is a key principle of blockchain technology. No one can alter, remove, or falsify the secure chain of digital records. Blockchain users can have access to the structure and data of each transaction block, including the date and time, as well as references to previous blocks. The availability of this information ensures that data is protected from alterations that would lead to reference modification or misrepresentation of values or volumes. Many features of blockchain contribute to its transparency. Blockchain transactions are traceable. A new transaction can only be added to the blockchain after it is validated by all the computers and devices, also known as “nodes,” in the distributed ledger network. In addition, users have real-time access to the information on the blockchain. This increases reliability because the information is readily available, and backups exist on various network nodes. Accountability and auditability are other important features of blockchain transparency. Blockchain technology can be used for various forms of audits, such as financial audits, regulatory audits, and compliance audits. During a financial audit, for example, an auditor can examine financial statements on the blockchain. This allows an auditor to have access to all past transactions, rather than picking a random sample for the audit. This feature assures both the auditor and the public that transactions are accurately examined. The transparency of blockchain also allows government agencies to combat any misuse of public resources and fraud. Transaction information is permanently stored on the blockchain, and any modification results in a new block that references the original transaction information. A great amount of processing power is required to carry out transactions in different network nodes. This is another way to ensure that information is valid before it is permanently stored. Cryptoasset and Blockchain Page 12 Version 1.07 Blockchain models for consensus: Proof of work It is extremely important for decentralized cryptocurrency networks to ensure that users do not spend the same cryptoassets twice. To guarantee this, the networks use a system that allows all the computers in a network to agree on the present state of the distributed ledger and which transactions are legitimate. This system is called a “consensus algorithm procedure,” “consensus network,” or “consensus mechanism.” Proof of work was the first cryptocurrency consensus mechanism. It started with Bitcoin in 2009. Proof of work provides a high degree of security, which is one of its major advantages. Proof of work is a major consensus mechanism cryptocurrencies use to verify the legitimacy of new transactions added to the blockchain. It secures the integrity of new data and allows entities within a decentralized network to trust one another. It prevents users from double spending or using the same units in different places. Proof of work ensures the transparency and accuracy of transactions. However, proof of work has disadvantages. Proof of work can be vulnerable to the unauthorized use of a person’s devices by cybercriminals to mine for cryptocurrency. This is called “cryptojacking.” Proof of work consumes a high amount of energy for processing power and is therefore not environmentally friendly. Proof of work transactions take longer to settle and cost more than the alternative proof of stake mechanism. Using proof of work, miners around the world secure and verify transactions by solving complex mathematical problems. Miners who solve the problems must update the blockchain with the recently verified transactions. If the other network participants verify that the newly added data is correct and valid, the winner is rewarded with cryptocurrency. This process prevents users from manipulating the system and ensures network security. Since the beginning of cryptocurrencies, proof of work has provided a secure, decentralized process of executing transactions. It has been used by many major coins, including Bitcoin, Litecoin, and Dogecoin. Cryptoasset and Blockchain Page 13 Version 1.07 Blockchain models for consensus: Proof of stake Proof of stake and proof of work are two of the consensus mechanisms used to validate cryptocurrency transactions. Proof of work allows for competition between miners who work to solve cryptographic puzzles. In contrast, proof of stake randomly selects miners to validate transactions. These validators are selected based on the stake they have in the blockchain. Proof of stake is more environmentally friendly than proof of work because it uses less energy. Proof of stake still uses cryptography, but its level of energy consumption is much lower because miners do not need to solve extremely complicated mathematical puzzles. Proof of stake originated in 2012 with Peercoin and has become a popular mechanism for blockchain networks to validate transactions. Proof of stake requires validators to stake cryptocurrency in the form of collateral to add a new block to the blockchain. Staking is when users pledge their own coins for transaction verification to earn a percentage-rate reward over time. Typically, users do this through a staking pool, which is similar to an interest-based savings account. Staking gives miners the right to check and verify new transaction blocks to add to the blockchain. Although staked coins are locked and inaccessible, validators can unstake them for the purpose of trading. Validators who accurately check a transaction are rewarded with cryptocurrency and a transaction fee. However, validators lose their stake holdings if they add a block with inaccurate information. Participants who stake more coins are more likely to be selected to validate new blocks, although anyone who stakes can potentially be chosen as a validator. One disadvantage of proof of stake is that it is less secure than proof of work. Miners are not required to spend energy to participate in the proof of stake consensus process. Therefore, malicious individuals could potentially acquire enough stake tokens to take significant control over a network. This could result in funds being stolen from blockchain users and potential security breaches. Cryptoasset and Blockchain Page 14 Version 1.07 Blockchain transaction security Blockchain transactions are secured through cryptographic signing, which allows for the asynchronous validation of transactions. This validation allows cryptoasset holders to prove their ownership without having to reveal their actual private keys, which are the secure codes needed to access their cryptoassets. Anyone can complete this process, but it requires a significant amount of computing power. Blockchain miners must review the cryptographic signatures on transactions and confirm their validity before publishing them to the blockchain ledger. This process allows users to keep their information and funds safe and secure. Blockchain users’ private keys grant ultimate control over the funds held in their corresponding accounts to whoever has access to them. Therefore, it is extremely important to guard the security of private keys and ensure that they are never exposed to untrusted operators. The use of private keys for cryptographic signing generates a mathematically verifiable output that anyone on the blockchain can validate without access to the private key. The ability to validate cryptographic signatures without access to the original private key allows for a distributed ledger from which users can come and go at any time and still maintain trust in the system. Anyone can review the blockchain ledger at any time to verify and validate the transaction signatures. Blockchain miners are then responsible for creating new blocks, or groups of transactions that have been validated and that pass the current rules and requirements of the blockchain. These rules vary from one blockchain to another, but they generally incorporate a cryptographic process that must produce the correct output. Cryptoasset and Blockchain Page 15 Version 1.07 Blockchain infrastructure Blockchain is a general ledger system in which anyone can participate and have confidence that the information on the ledger is accurate. Blockchain is completely open and distributed and allows its entire history to be reviewed and verified through mathematical algorithms. Blockchains are built on the “hierarchy of trust” concept. This means that users called “miners” must first validate a transaction before it is published. Once validated, transactions are batched together in groups called “blocks.” These blocks are chained together chronologically, creating the concept of blockchain. The blockchain can then be used to transport information. Blockchain creates a constantly growing ledger system by adding new blocks to the chain of previously validated blocks. Because new blocks depend on the previous blocks, they must be verified before they are added to the chain. In some situations, different miners can validate two blocks simultaneously. This creates a forked system in which two valid systems compete to be the main chain. These situations quickly resolve themselves within a few blocks when the network chooses a primary chain to follow. As the chain grows, it becomes increasingly difficult and almost impossible to change the contents of a previously validated block. This is because any change to a block would require changes for all blocks that follow. While this might be possible in a closed network with a single authority, blockchain is much more complicated. Blockchains are distributed and stored among all users, and every user must validate the data received. Any change must be accepted by the majority of the network. Blockchains ensure that all information is transparent by distributing the data among all participants and using common sets of mathematical algorithms to validate. Anyone who has a copy of the data and is familiar with the algorithms can verify transactions at any time. This level of trust allows blockchains to operate in this unique way. Cryptoasset and Blockchain Page 16 Version 1.07 Cryptoasset Cryptoasset Cryptoassets are broadly defined as a form of digitally stored value with investment and currency-like qualities. Cryptoassets rely on distributed ledger technology and encryption. They serve to generate, store, move, and exchange value for investment, development, and purchasing. When Bitcoin was first developed, it was effectively a reward system to provide users with a degree of value for leveraging decentralized distributed ledger technology. Since that time, cryptocurrency and cryptoassets have become a billion-dollar marketplace with various products and services. Cryptoasset has no single correct definition. Cryptoassets have many characteristics of both currencies and commodities. The terminology and requirements for cryptoassets are not definitive or consistent globally, even among regulators. Cryptoassets include cryptocurrency itself, such as Bitcoin, as well as non- fungible tokens (NFTs), initial coin offerings (ICOs), security tokens, and more. Cryptoassets can be used for different purposes depending on their type. To distinguish among the types of cryptoassets and differentiate cryptocurrency from other digital currencies, consider whether legal tender is tied to the product. For example: ICOs are a funding source and can be an investment, but they are not a currency. Stablecoins are similar to cryptocurrencies, but they are lower risk because their value is tied to the market value of a commodity or currency. Cryptocurrency is a digital currency that is not linked to fiat currency or legal tender and is subject to market demand. Central bank digital currency is a digital currency backed by a government authority that eliminates the risk of bank failure and cash loss and can be used as currency by consumers. Cryptoasset and Blockchain Page 17 Version 1.07 NFTs are cryptoassets that serve as digital ownership of digital items, such as artwork. They do not have purchasing power and are not a cryptocurrency. Digital money and e-money, such as store-branded gift cards and other digital representations of fiat currency, are not cryptoassets. Centralized versus decentralized cryptoasset types The concepts of centralization and decentralization can be applied to cryptoassets as well as networks and exchanges. A cryptoasset’s level of centralization refers to the extent to which it is issued, operated, managed, and regulated by a central party. Decentralized cryptoassets, including Bitcoin and Ethereum, do not rely on a centralized authority to function. The centralization or decentralization levels of a cryptoasset can vary. Many factors can help determine whether a cryptoasset is centralized or decentralized, including how the cryptoasset is issued and how it is redeemed and burned, or removed from circulation. The level of centralization or decentralization of a cryptoasset does not necessarily depend on its underlying blockchain and can often be determined by the cryptoasset itself. For example, a company might issue a stablecoin as an ERC-20 token on the decentralized Ethereum network. However, the token would be centralized if the company places limits on its selling, quantity, or redemption. Central bank digital currencies (CBDCs) are likely to be considered centralized due to the strict policies central banks maintain. Even CBDCs issued on a decentralized blockchain are not truly decentralized because of the bank’s ultimate authority over their issuance, redemption, and circulation. Similarly, a single party’s ownership of the majority stake or mining power of a cryptoasset might concentrate enough power for the asset to be considered centralized. Many pros and cons exist for both centralized and decentralized cryptoassets. Centralized assets’ high levels of control and oversight create safer economic environments for users. However, the success of the single controlling party often determines the success of the cryptoasset, increasing the risk of a Cryptoasset and Blockchain Page 18 Version 1.07 single point of failure. Decentralized cryptoassets’ lack of a single controlling party reduces risk from a single point of failure and allows them to be used as alternatives to regulated currency. However, because they lack central oversight, decentralized cryptoassets might be more prone to money laundering-related offenses and fraud. Cryptoasset characteristics Cryptoassets are digital assets that can be transferred through the internet and stored on computers, mobile devices, and other digital devices. The main difference between cryptoassets and other digital assets is the implementation of blockchain technology, which makes them secure from counterfeiting. It allows users to operate independently from third parties, such as banks and governments. Because cryptoassets combine the openness of the internet with the security of cryptography, transactions can be borderless. This characteristic provides users with a fast way to complete transactions and verify them without the involvement of third parties, such as banks. To transfer a cryptoasset, most blockchains use a public key called an “address” and a private key, which is similar to a password. No other details about the user are attached to the blockchain network. Though users operate anonymously, there are often ways to trace transactions back to an individual through investigative techniques. Deposits to KYC exchanges and buying goods or services are examples of transactions that can be traced back to an individual. Blockchain network users are located throughout the world, which makes it difficult for governments to shut down a network. Cryptoassets are also resistant to jurisdictional restrictions, because only the account’s public and private keys are required to complete a transaction. Many cryptoasset exchanges build out functionality or partnerships to offer programmability, such as rewards programs and interest programs for their assets. Cryptoassets can also be programmed for use as bearer instruments, which are a type of security such as shares or bonds that grant ownership to their holders. Security is extremely important for cryptoassets. Hackers only need to obtain access to a pair of keys to steal all assets saved in a blockchain address. Some Cryptoasset and Blockchain Page 19 Version 1.07 participants in the market might take advantage of the lack of regulations within some jurisdictions to manipulate prices and commit fraud. Cryptocurrency versus fiat currency Fiat currency is legal tender issued by a central government without the backing of a physical commodity such as gold or silver. In contrast, cryptocurrency is a decentralized form of currency that is generally not supported or issued by a government. Most cryptocurrencies, including Bitcoin, ether, and Monero, are not real currencies like coins and bills. They are not backed by gold or silver and are not backed by governments. Rather, they are digital representations of stored value tied to the fluctuating market value of their coins and tokens. Cryptocurrencies use cryptography to secure transactions. Both fiat currency and cryptocurrency can be bought, sold, exchanged, invested, and used to purchase goods and services. The value of fiat currencies is influenced by holders’ confidence in the issuing government and their relative value against other currencies. Because cryptocurrencies are not government-backed, their worth is determined only by their current market value. Neither cryptocurrency nor fiat currency has any inherent value. Both are only worth their assigned or perceived value. Both also have purchasing power that can only be leveraged where allowed. Beyond that, fiat currency and cryptocurrency have little in common. Fiat currency must be government-issued. When used in physical form, fiat currency is broken into denominations, such as a US$1 bill or a US$5 bill. Fiat currency can only be leveraged in jurisdictions where the government has agreed to accept its value. A euro, for example, would not be a valid currency in the US. It would need to be exchanged at a financial institution for the equivalent amount in US dollars. Fiat currency is subject to exchange rate fluctuations and inflation, but its denominations’ value remains accepted. In contrast, cryptocurrencies can be purchased with any other currency in the world. They can also be leveraged for purchasing power wherever they are accepted. This makes cryptocurrencies appealing in jurisdictions with few financial services or an unstable currency. Compared with fiat currency, cryptocurrency as a means of international payment also usually results in Cryptoasset and Blockchain Page 20 Version 1.07 lower transaction fees and faster payment processing times. However, because cryptocurrency lacks government backing, its value and purchasing power vary significantly. For example, the fiat currency value of a US$10,000 wristwatch is clear. However, the number of Bitcoin needed to purchase the watch could fluctuate significantly hour by hour, based on market activity. Cryptoasset and Blockchain Page 21 Version 1.07 Cryptoasset mining Cryptoasset mining Mining is the method by which some cryptoassets, such as Bitcoin, are generated and transactions involving new coins are verified, therefore providing the method to issue cryptocurrencies. Users, known as “miners,” extract or produce new assets similar to the way gold miners extract precious metals. While gold miners extract gold from the ground, cryptoasset miners obtain assets from the virtual space. Miners also act as auditors for the blockchain network by validating transactions. The process of mining cryptoassets consists of validating new transactions and adding them as a block to the blockchain. Mining requires sophisticated technological equipment and a lot of computational power to solve extremely complex math problems. Many users share mining responsibilities because the blockchain is a decentralized system. It randomly selects different miners to verify a group of transactions, known as a “block.” When a completed block is validated, it is added to the blockchain, and the miner proceeds to the next one. When a block is invalid, the miner discards it and generates the block again. A block is only considered valid when the majority of miners verify that the first miner's proposal is correct. This method prevents users from double spending cryptoassets because their transaction must be validated first. To select a random miner, the blockchain network generates a complex math problem that can be solved with a series of hashes. The first miner who finds a hash to solve the problem can validate the block. Miners compete among themselves to find the correct hash and solve the problem first. There is no way to know the correct hash, so the miner who generates the most hashes has the highest chance of winning. Therefore, miners must use machines that can generate many hashes quickly. The miner who validates a transaction correctly is rewarded with newly created cryptoassets and is paid a transaction fee by other miners. The new Cryptoasset and Blockchain Page 22 Version 1.07 cryptoassets are considered freshly mined and therefore have no transactional history. This provides the owner with assurance that the assets have not been used maliciously. Mining pools and hash rate A mining pool is created when individual cryptocurrency miners join together to share their computational power across the internet and split the rewards earned. By sharing their computing resources, the miners increase their ability and pace to generate solutions to complex mathematical functions, known as “hashes.” By increasing its hashing power, or hash rate, which is expressed in units of hash per second, the pool can mine for cryptocurrency rewards at a faster pace. Creating hashes requires computational power, and a high hash rate indicates that a network has a significant amount of computational power. The increasing popularity of cryptoassets requires a higher hash rate, as this increases a network’s security. By combining resources, mining pools can increase their likelihood of mining assets and earning rewards. Mining pools were created because, to have a profitable business, the value of a miner’s rewards must outweigh operational costs. The main costs are for computers and electricity consumption, as well as the time it takes to generate hashes and earn cryptocurrency. In the past, miners used their own personal computers to mine cryptoassets and earn rewards. But as more of a cryptocurrency is mined, the hash rate necessary to unlock additional rewards increases. This is partially due to the increased need for security as the use of cryptoassets increases. As cryptoassets became more profitable, miners with factory-scale operations and specialized machines entered the industry. These advanced systems increased the hashing power of the network. But they also make it more difficult for individual miners to compete. To solve this problem, small operators join mining pools. A pool shares its cryptocurrency rewards based on the hash rate that an individual’s computational power provides to the group. The pool’s administrator typically charges a service fee for membership. Cryptoasset and Blockchain Page 23 Version 1.07 Cryptoasset mining geopolitical issues Cryptoasset mining operators are attracted to jurisdictions with the most favorable business conditions. These conditions might include the cost of electricity, moderate weather, sufficient internet access, favorable laws and regulations, and business incentives. As a result, some jurisdictions have a large concentration of cryptoasset miners, whereas other jurisdictions have fewer. The resulting geopolitical issues associated with cryptoasset mining include power consumption and other environmental concerns, as well as the security and stability of data networks. Operators and miners must develop strategies for mitigating these risks. A cryptoasset miner’s hashing power, or hash rate, is a measure of the miner’s computational mining speed. But risks to network stability and security can occur when hashing power is centralized in a few locations or among a concentrated group of miners. For example, if a location with control over a high percentage of hashing power were to lose electricity due to a natural disaster, the network would become less secure and more vulnerable to external attacks. Additionally, if one country or group of countries were to accumulate enough hashing power, it could potentially take control of the entire network. To mitigate these risks, jurisdictions must provide incentives for participating in mining operations. This helps to decentralize the network and prevent any one country or group of countries from gaining too much control. Public concerns are also increasing about the cryptoasset mining industry’s electricity consumption, as well as its large carbon footprint from generating power through fossil fuels. However, green energies can be used for cryptoasset mining to reduce the ecological impact. These include solar, wind, and hydroelectric energy. Cryptoasset and Blockchain Page 24 Version 1.07 Blockchain in action Blockchain in action (Case example: Sadie’s Blockchain Mining Group) Sadie’s Blockchain Mining Group (SBMG) has been in operation for one year. When Sadie started the group, she built a dedicated mining facility that focuses on proof of work blockchains, primarily Bitcoin. Over the past year, SBMG has contributed to the Bitcoin blockchain’s ongoing operation by working to validate and publish new blocks of transactions. The group has successfully mined approximately 12 blocks and has claimed block rewards and transaction fees in the form of Bitcoin (BTC). When the price of BTC reaches an all-time high, Sadie decides to cash in some of SBMG’s earnings from the past year by sending 50 BTC to a cryptocurrency exchange called CoinPeak Pro, where it can be sold for fiat currency. Sadie first learned about Bitcoin in 2015 when the value of BTC was lower and the rewards per block were larger. This attracted many people who began competing as miners to earn rewards. As the value of BTC increased, so did its popularity. More people became knowledgeable about how Bitcoin operates and learned that there are only a limited number of possible block rewards. Many entrepreneurs, including Sadie, realized that getting involved with Bitcoin early would result in larger rewards, which would then grow in value over time. Sadie started her plans to launch SBMG in 2018. Meanwhile, a man named Jim has recently become involved with Bitcoin after hearing about it on television. After doing some research, Jim is ready to start investing and uses CoinPeak Pro to purchase 10 BTC with fiat currency. When CoinPeak Pro receives and processes Jim’s trade request, the 10 BTC he purchases comes out of the 50 BTC that SBMG posted for sale. Jim later decides to withdraw his 10 BTC and transfer them to his personal cryptoasset hardware wallet. This transaction joins hundreds of other pending transactions that are waiting to be confirmed on the blockchain. A few minutes later, a new block, which includes Jim’s withdrawal, is mined and confirmed by SBMG. Cryptoasset and Blockchain Page 25 Version 1.07 Key takeaways Many blockchains would be unable to operate without miners, who: Validate transactions between senders and receivers. Create new blocks. Allow new cryptoassets to enter circulation. Cryptoasset transaction validation (Case example: Proof of stake) Sofia has been investing in cryptoassets for several years and recently started a validator pool for a proof of stake blockchain. Sofia uses her private key to generate a new public key for the validator pool, which is then converted into a shorter public address that she shares on several websites. To join the pool, users must log in to their wallets and create a staking transaction to pledge their support. This transaction contains the user’s public key, Sofia’s public receiving address, and other details. Once the transaction is signed by a user’s private key, anyone on the blockchain can verify it. After a few days, Sofia’s validator pool has enough staked support to be considered trustworthy and starts producing rewards. Sofia uses her wallet to create a transaction that divides and sends the rewards to validators’ public addresses. She then signs the transaction with her private key, and it is available on the blockchain for validation. Over the next several weeks, Sofia’s validator pool continues to grow in success. Viktor, a new user, has been watching the blockchain and notices that Sofia’s address has been collecting more and more rewards. Viktor decides to try to steal Sofia’s funds. He sets up a powerful computer and starts scanning the blockchain to find as much information as he can about Sofia’s address. He successfully finds her public key along with her public address, but he cannot find anything else. He runs every cryptographic process he can to convert the public key into a private key but eventually realizes it is impossible. This is because the mathematical process used to generate a public key from a private key is asymmetrical, meaning it only goes one way. In the process, information is removed and cannot be recovered from just the public key. Cryptoasset and Blockchain Page 26 Version 1.07 Key takeaways Without access to the private key, blockchain users cannot access other users’ funds. Transaction information is generally public. Public keys can be shared publicly to receive funds. Private keys should be kept safe. Cryptoasset and Blockchain Page 27 Version 1.07 Cryptoasset Types and Business Models Introduction Purchasing cryptoassets case You have just received your first bonus check at work. You plan to use some of it to purchase cryptoassets. You have researched cryptoassets by listening to podcasts, reading blogs, and talking to others. You have determined that there are many legitimate options available, but you are not sure which to choose. You know that Bitcoin is the original cryptocurrency. Bitcoin can be used for payment and investment purposes. Because Bitcoin is one of the most popular forms of cryptocurrency, many merchants and retailers accept it as payment. Like most cryptoassets, the value of Bitcoin changes significantly over time. This can sometimes present risk. However, these price swings might allow you to eventually sell your Bitcoin for a profit. Altcoins are any cryptocurrency that is not Bitcoin. Like Bitcoins, altcoins can be used for payment and investment purposes. Their value can also change significantly over time. Thousands of different types of altcoins are available on the market to meet a variety of needs. Many altcoins are designed to have specific strengths and features. Some of these include fast transaction speeds and energy efficiency. You like that many altcoins use less energy and are better for the environment. You are also interested in non-fungible tokens (NFTs). These are unique blockchain-based cryptoassets that cannot be exchanged for one another. They often exist in the form of an image or video created by an artist. You like that by purchasing an NFT, you can support the work of artists while gaining Cryptoasset and Blockchain Page 28 Version 1.07 digital copyright to use their work. You know that some NFTs have grown in value over time. However, they can also lose value, and are largely unregulated. There are so many options. You feel overwhelmed and unsure. What would you do? Which option would you choose? Buy Bitcoin because it is widely accepted. Research each asset’s risks and opportunities. Purchase an environmentally friendly altcoin. Buy NFTs to support artists. Feedback There is no wrong answer. However, the best next step is to research each cryptoasset’s risks and opportunities. You should make your decision based on thorough research. You should buy the cryptoasset that aligns best with what you are hoping to achieve and are willing to risk. If you are looking to invest in a cryptocurrency that is widely accepted as payment, Bitcoin might be a good option. You might want to invest in an altcoin if you are looking for a cryptocurrency that functions like Bitcoin but has additional features. There are so many altcoins to choose from, and some are environmentally friendly. NFTs might be the best option if you are interested in supporting artists and gaining digital copyright for their work. You have compared the risks and opportunities of each option. Now you can feel confident in your decision, no matter which asset you choose to purchase. Cryptoasset and Blockchain Page 29 Version 1.07 Learning objectives After completing this module, you will be able to: Compare and contrast the types of virtual assets. Describe the types of virtual asset providers and explain the products and services they provide. Recognize how privacy centered cryptoasset and mixers and tumblers obscure cryptoasset ownership. Cryptoasset and Blockchain Page 30 Version 1.07 Virtual asset Virtual asset The Financial Action Task Force (FATF) broadly defines a virtual asset as “any digital representation of value that can be digitally traded, transferred or used for payment. It does not include digital representation of fiat currencies.” Cryptocurrencies such as Bitcoin and ether are examples of virtual assets. Other types of virtual assets include stablecoins and several types of tokens. International definitions for virtual currency are constantly changing, and the use of virtual assets is expanding. Regulators are defining virtual assets as assets that are not backed by “real world” assets and are decentralized, functioning without the need for a regulated third party. They are also setting the rules for the risk profiles of different virtual assets. Cryptoassets are virtual assets that use cryptography as their underlying information security and communication technique. Cryptoassets include cryptocurrencies such as Bitcoin, ether, and alternative coins known as “altcoins.” Stablecoins are cryptocurrencies with value that is connected to another currency, commodity, or financial instrument, such as the US dollar. Many stablecoins are tokens, and examples include Tether (USDT), and Circle (USDC) on the Ethereum blockchain. Privacy coins are cryptocurrencies that preserve anonymity by obscuring the flow of money across their networks. Examples of privacy coins are Monero (XMR), Zcash (ZEC), and Dash (DASH). Virtual assets also include tokens, which are cryptocurrencies that are built on top of an existing blockchain, such as ERC-20 tokens. There are many different types of tokens, including utility tokens, security tokens, governance tokens, gaming tokens, non-fungible tokens (NFTs), and more. Virtual assets often live on a blockchain or another type of distributed ledger technology. These technologies promise to provide a faster and more secure transfer of virtual assets compared to traditional forms of transferring value. Cryptoasset and Blockchain Page 31 Version 1.07 Bitcoin Bitcoin was launched in 2009 by a developer, or perhaps a group of developers, using the pseudonym “Satoshi Nakamoto.” The motivation was the loss of trust in the banking system following the 2008 economic crisis. Although Nakamoto’s supposed Bitcoin holdings would amount to billions of dollars today, his Bitcoin wallets remain untouched. Presumably, Nakamoto was solely focused on his vision for blockchain, not profits, leaving the future development of the network in the hands of the rapidly growing developer ecosystem. The Bitcoin network is an electronic payment system. Its native cryptocurrency, also known as Bitcoin, is widely believed to be the first decentralized cryptocurrency ever invented. The network enables peer-to- peer payments, and Bitcoin can be used to both transfer and store value. According to Bitcoin’s white paper, Bitcoin was created to be a purely peer- to-peer version of electronic cash that allows online payments to be sent directly from one party to another without going through a financial organization. This network exists on what is known as a proof of work blockchain. The system requires a meaningful amount of effort to deter frivolous and malicious uses of computing power. It also prevents double spending, in which the same cryptoasset is spent more than once. A single Bitcoin can be divided into smaller units known as “satoshis.” Each Bitcoin comprises 100 million satoshis. As a result, users can choose to only purchase a portion of a Bitcoin. Since Bitcoin’s creation, thousands of alternative cryptocurrencies, known as “altcoins,” have launched, in addition to forms of cryptographic proof other than the proof of work method. Bitcoin has dominated the cryptocurrency markets. However, the network has shortcomings, including its slow and expensive transactions. To address those concerns, developers have created solutions on top of the Bitcoin blockchain, known as “layer 2 protocols.” A layer 2 protocol is a secondary framework built on top of an existing blockchain to solve the transaction speed and scaling difficulties faced by a major cryptocurrency network. The Lightning Network, for example, enables faster payment and lower transaction fees and allows users to conduct transactions off-chain, so it is suitable for micropayments. Cryptoasset and Blockchain Page 32 Version 1.07 Altcoin Any cryptocurrency that is not Bitcoin is generally referred to as “altcoin.” Altcoins were first created after the launch of Bitcoin in 2009. Many altcoins have been introduced in an effort to improve upon the perceived shortcomings of Bitcoin. The altcoin category includes various types of cryptocurrencies and tokens, including stablecoins, privacy coins, utility tokens, security tokens, gaming tokens, and memecoins. Much like Bitcoins, altcoins can be traded or used for payment and investment purposes. The most well-known altcoin is ether, which is native to the Ethereum network. After the launch of Bitcoin, developers around the world used its underlying technology while improving upon certain aspects by creating altcoins, or alternative coins. These improvements included increased transaction speeds and energy efficiency. The distributed ledger technologies that housed altcoins also evolved over time. While Bitcoin was built on a proof of work blockchain, altcoins have introduced new consensus mechanisms such as proof of stake. Today, altcoins make up a large portion of the market for cryptoassets. Altcoins can be classified into many subcategories, including payment tokens, stablecoins, security tokens, gaming tokens, and more. Certain altcoins also exist within their respective blockchains for a specific purpose. For example, ether is used to pay transaction fees within the Ethereum network. Other altcoins may be associated with a specific project, game, or even joke, in the case of memecoins. In addition, many new cryptoasset-based products and services have been developed on top of altcoin networks using smart contracts. Products such as decentralized finance lending and non-fungible tokens (NFTs) are examples of new offerings that have come about because of the growth of altcoin networks. Regardless of their association, altcoins are generally traded, invested, and used in payments much like other virtual assets. Cryptoasset and Blockchain Page 33 Version 1.07 Privacy-centered cryptoasset Privacy coins are privacy-centered cryptoassets that focus on anonymity. Unlike most popular cryptoassets, such as ether and Bitcoin, privacy coins use privacy-enhancing techniques to hide transaction information and are extremely difficult and sometimes impossible to analyze. Activity with privacy cryptoassets is often untraceable because the transaction information on the blockchain cannot be linked to unique addresses. This allows senders and receivers to remain anonymous and transactions to remain private. Most cryptoassets are pseudonymous, meaning that anyone using blockchain explorers and analytic software can track all activity on the cryptoassets’ blockchains. However, privacy coins use privacy-enhancing capabilities to hide any traceable information. Two of the most widely used privacy coins are Monero and Zcash. Blockchain activity information for a Monero transaction contains random hash keys, which cannot be linked to other transaction information, such as the amount, sender, or receiver. Additionally, a Monero public key can be used to provide a one-time stealth address. Each transaction has a unique private key that is the only way to search for the specific blockchain transaction. Similarly, Zcash allows users the ability to conceal transactions by using zero- knowledge proofs. These are calculations that can prove the validity of a transaction without revealing additional information. Other types of privacy- centered cryptoassets also have embedded technology to hide transaction amounts by using algorithms. Some only allow transactions to be processed inside secure hardware enclaves. Privacy coins have legitimate uses. In some cases, individuals wish to conceal their large cryptoasset holdings from the public out of concern for their safety. However, privacy coins are often not accessible on large, centralized exchanges due to regulatory risk. Criminals might use privacy-centered cryptoassets to conceal illicit transactions. Therefore, regulators often scrutinize privacy coins. Cryptoasset and Blockchain Page 34 Version 1.07 Initial coin offering An initial coin offering (ICO), or token sale, is a mechanism that allows a new cryptocurrency project, also known as a venture, to raise funds to develop new projects. When launching an ICO, a venture issues a certain number of tokens to the public in exchange for payment in cryptocurrency or fiat funds using smart contracts. ICOs are commonly compared to initial public offerings (IPOs). Speculators buy issued tokens in hopes of a future opportunity to liquidate the tokens for a profit. Certain tokens offer voting rights in a project. Others can be redeemed for future products and services offered by the project. ICOs often exist in the form of crowdfunding. They offer a certain amount of cryptocurrency to speculators or investors to purchase in exchange for fiat currency or other cryptocurrencies by using smart contracts. To carry out an ICO, the venture must publicize key information about the offering, including: When it will occur How to participate Any associated rules or limitations To gain interest, ventures often publish a white paper that describes the project for which the ICO is taking place. The venture can offer either fixed or variable terms related to the number of tokens sold and the price per token. Categories of tokens offered via ICOs include security and utility. Security tokens represent ownership similar to shares purchased in an IPO. Utility tokens allow speculators to redeem the token for the company’s products or services in the future. Governance tokens are a type of utility token that confers voting rights related to mining and protocol changes. The terms ICO and initial token offering (ITO) are often used interchangeably. Technically, an ICO involves the offering of a cryptocurrency, the native coin to a blockchain or other distributed ledger, while an ITO involves the offering of a token built on top of another blockchain. However, both types of projects are commonly referred to as ICOs. Cryptoasset and Blockchain Page 35 Version 1.07 Ethereum Ethereum is a decentralized blockchain platform that has a native cryptocurrency called “ether” (ETH). Ethereum is considered a programmable network because developers can develop smart contracts, decentralized applications, called “dApps,” and other programs on top of the Ethereum platform. The ERC-20 token standard is used by many altcoins and allows them to exist on the Ethereum platform without a native blockchain to reside on. Using a smart contract, the ERC-20 standard communicates information such as the token symbol and the total supply of the token. Ethereum transactions require a small amount of ETH, also known as “gas,” to be completed on the blockchain. Vitalik Buterin created Ethereum in 2013 and released it to the public in 2015. The Ethereum network builds on the concept of the Bitcoin network and was the first network based on smart contracts. In addition to its programmability, the Ethereum blockchain also supports the creation and exchange of non-fungible tokens (NFTs). Many altcoins use the ERC-20 token standard, which implements an application programming interface for tokens within smart contracts. The Ethereum Foundation, which supports Ethereum and related technologies, describes the Ethereum platform as “a marketplace of financial services, games, social networks and other apps.” Ether is the second-most popular cryptocurrency by market capitalization. ETH is divisible into smaller units called “Gwei,” and one ETH is equal to one billion Gwei. This means that interested parties can buy a fraction of an ETH. Developers involved in the growth of the Ethereum network intended for it to function as a world computer, or a shared global resource made up of computers around the world. This world computer is decentralized, meaning that no one person owns or controls the network. The smart contracts built on top of the decentralized computer allow developers around the world to create applications, including NFT marketplaces, dApps, and decentralized finance lending products. Cryptoasset and Blockchain Page 36 Version 1.07 Token A token is a virtual currency or denomination of a cryptocurrency. It is a tradable asset that resides on its own blockchain, and holders can use it for investing or purchasing. Tokens are built using smart contracts on an existing blockchain network, which are programs stored on a blockchain that run when predetermined conditions are met. For example, ether is the Ethereum blockchain’s native cryptocurrency, but ERC-20 tokens are issued using smart contracts on top of the Ethereum network. Similar to ether, Bitcoin is not considered a token because it is the native cryptocurrency of the Bitcoin blockchain. Just as they can do with native cryptocurrencies, users can buy, sell, exchange, transfer, and store tokens. Various types of tokens are available: Utility tokens are used for a specific product or service. Governance tokens are a type of utility token that give holders the right to vote on issues that govern the development and operations of blockchain projects such as games, lending platforms, and mixers. Security tokens are digital forms of traditional securities that represent a fractional share of a valuable underlying asset, such as a company, real estate, a painting, or collector sports car. They can be sold in token- generating events called "initial token offerings.” Gaming tokens are used to transfer value within gaming platforms. Non-fungible tokens (NFTs) are blockchain-based cryptographic assets that are provably unique. Many stablecoins, which are cryptocurrencies with value that is tied to that of another currency, commodity, or financial instrument, are also tokens. Examples include Tether, USD Coin, Shiba Inu, and Uniswap, all of which are built on top of the Ethereum blockchain. To raise funds, a cryptocurrency venture often issues an ICO, in which it offers tokens for sale to the public. Investors who are interested in the company can purchase the tokens in exchange for fiat currency or other cryptocurrencies. By doing so, the venture secures the funding needed to launch a project, and Cryptoasset and Blockchain Page 37 Version 1.07 investors can speculate on the value of the purchased tokens as the project develops. Non-fungible token Non-fungible tokens (NFTs) are cryptographic assets on a blockchain with unique identification codes and metadata. Unlike Bitcoin or other cryptocurrencies, NFTs cannot be traded or exchanged at an equivalent unit value. Each one has its own worth and value in the marketplace. NFTs can take the form of any unique digital or digitized asset, including art, images, videos, and more. NFTs are produced by artists and developers. They are recorded on the blockchain, resulting in an authenticated chain of creation and copyright ownership. Like cryptocurrencies, NFTs can have more than one market use. Whereas cryptocurrencies can serve as both an investment and a value transfer system for payments, NFTs can serve as digital asset copyrights and are digital assets themselves. The word “fungible” means something has similar characteristics to something else or is readily exchangeable. Cryptocurrency is fungible because, even across different types, the inherent type and value of the assets remain the same. NFTs, however, are non-fungible. They can be bought and sold, but each one is unique, with its own characteristics and marketplace value. NFTs cannot be exchanged for identical replacements like cryptocurrency. Ownership of NFTs is managed through unique identification data and metadata that no other token can replicate. NFTs are created through a minting process, which includes the creation of a smart contract. The contract is stored on the blockchain that assigns ownership and manages the transferability of the NFTs. At a basic level, smart contracts act as a tool to implement a sale agreement. NFTs can be any form of digital asset, but are most commonly associated with art, images, and videos. An NFT is developed by an artist, published on the blockchain, and then verified using the same technology. Because the blockchain is unchangeable and open for review, the NFT’s creator or owner can always be identified. This helps artists reduce the risk of copyright Cryptoasset and Blockchain Page 38 Version 1.07 infringement and the use of their work without payment. Unlike traditional art markets, sales recorded on the blockchain are transparent and easily viewed by anyone. Artists receive sale proceeds for original artworks or earn commission or royalties each time a reproduction of their original artwork is sold. However, NFTs can create challenges. They can be subject to fluctuation in market value. In addition, a digital modification of an existing NFT could be considered a new NFT, which might create copyright issues. In many jurisdictions, NFTs are largely unregulated. You should know which rules apply to NFTs in your jurisdiction. Centralized versus decentralized cryptoasset types (Reminder) A cryptoasset’s level of centralization refers to the extent to which it is issued, operated, managed, and regulated by a central party. Decentralized cryptoassets do not rely on a centralized authority to function. The centralization or decentralization levels of a cryptoasset can vary. Many factors can help determine whether a cryptoasset is centralized or decentralized, including how the cryptoasset is issued and how it is redeemed and burned, or removed from circulation. Stablecoin types: Asset-backed compared to algorithmic Stablecoins are most commonly created through a process called “minting,” which is the process of validating information, creating new blocks, and recording information on the blockchain. Asset-backed stablecoins are cryptocurrencies pegged to the value of other tradable assets, such as fiat currencies like the US dollar. Asset-backed stablecoins can also be linked to traditional commodities like gold or even to other cryptocurrencies like Bitcoin. In contrast, algorithmic stablecoins are not pegged to the value of an underlying asset. Rather, specialized algorithms and smart contracts manage Cryptoasset and Blockchain Page 39 Version 1.07 the supply of stablecoin tokens in circulation and ultimately determine the stability of a stablecoin’s price. Stablecoin-specific regulations exist in some jurisdictions, but not in others. Cryptocurrencies such as Bitcoin can have very volatile or unstable prices, making them inefficient to use in paying for goods or services. Stablecoins address this problem by tying the cryptocurrency’s price to a less volatile asset. The stablecoin reduces fluctuation risk and increases participation in the cryptocurrency marketplace. Asset-backed stablecoins are pegged to a unit of tradable value as collateral. For example, a fiat-backed stablecoin is tied to a jurisdiction’s currency, usually on a one-for-one basis. Fiat currencies and physical commodities such as gold are considered off-chain collateral because their value exists outside the blockchain. Stablecoins can also be pegged to the value of other cryptocurrencies, which are then considered on-chain collateral. Asset- backed stablecoins experience less market fluctuation and are often used for lending, trading, and cross-border payments. However, issuers must safeguard the reserve assets to protect stability. By contrast, algorithmic stablecoins have no peg to an underlying asset, and instead use an on-chain algorithm to adjust supply and demand between the stablecoin and another cryptocurrency. The algorithm actively creates or removes tokens to maintain a fixed price. In theory, the algorithm provides stability and improves capital efficiency. In some cases, however, both asset-backed and algorithmic stablecoins can become depegged, or disconnected, from their stabilizing mechanism. Algorithmic stablecoins are particularly vulnerable to depegging from their software-based mechanism due to their heightened risk for malicious attacks by hackers or wide price swings in their associated cryptocurrency. Cryptoasset and Blockchain Page 40 Version 1.07 Central bank digital currency A central bank digital currency (CBDC) is a digital asset form of money issued by a country’s central bank. CBDCs, which are typically issued using blockchain technology, can be offered by a government to the general public. While many governments are exploring the possibility of issuing a CBDC, these initiatives are still at an early stage. If CBDCs become more widespread, they will most likely be used for payments, much like nondigital, central bank-issued currency. Asset-backed stablecoins, on the other hand, are issued by a private company rather than a government and are not considered legal tender. While CBDCs follow the monetary policy of a central government, asset-backed stablecoins do not. CBDCs rely on distributed ledger technology, such as blockchain. In most cases, governments issuing CBDCs use a permissioned blockchain, in which only select entities can access or make changes to the blockchain and a central entity can maintain control. This allows for benefits that cannot be offered by a permissionless blockchain, such as control over CBDC supply and the ability to decide which central entities retain ultimate control. Another advantage of CBDCs is their potential to lower the cost of currency transactions. Maintaining a central supply of digital currency might ultimately cost less in comparison to physical currency. In addition, the ability to trace full records of digital transactions in an immutable system is likely to appeal to governments. CBDCs hold the status of legal tender issued by the central monetary authority. Therefore, the domestic money supply of a government offering them would split into two local currencies: cash and CBDCs. If CBDCs were treated differently from cash, they could become decoupled, or separated, from the country’s monetary policy. CBDCs are different from other digital currencies such as stablecoins. Stablecoins are digital currencies that are tied to some other value, such as real-world fiat currency, other cryptoassets, an algorithm, or commodities. This asset backing helps to stabilize their value. Unlike CBDCs, stablecoins are issued by private companies and are not considered legal tender. Cryptoasset and Blockchain Page 41 Version 1.07 Stablecoin types (Case example: TerraUSD) In May 2022, the algorithmic stablecoin TerraUSD (UST), the native token to the Terra network, decoupled from its peg to the US dollar. Within two days, a single UST was worth only 35 cents. LUNA, the token meant to stabilize UST, similarly lost its value. To generate one UST, a process known as minting, one LUNA must be burned, or inactivated. Similarly, a UST must be burned to mint one LUNA. Thus, if one starts to lose its value, traders can swap it out for the other. In this case, however, the swapping opportunity failed due to a massive number of withdrawals, and both UST and LUNA lost their value. In April 2022, Terra’s high-interest savings account, Anchor Protocol, began reducing interest rates on deposits. As a result, many UST holders exited the Terra network. To exit, UST holders had to either destroy their UST by swapping it for LUNA or sell it on the stablecoin exchange called Curve Finance. The massive rush to sell UST caused its supply to tumble, and the supply of LUNA inversely skyrocketed. This pressure on the Terra blockchain caused major network congestion. As a result, many exchanges paused withdrawals on LUNA. The widespread minting of LUNA in exchange for UST caused the price of LUNA to drop significantly. Within five days, the supply of LUNA went from 343 million to 32.3 billion. The Curve Finance pool, in which UST was being frantically sold, became oversaturated with UST in comparison to its other stablecoins. Normally in this case, the pool would offer UST at a discount to help it rebalance. However, no traders bought UST at this time. The increasing discount offered for UST on Curve Finance caused it to continue depegging from the US dollar. Despite several emergency attempts to save the stablecoin UST and its companion token LUNA, neither was able to recover. Cryptoasset and Blockchain Page 42 Version 1.07 Key takeaways Algorithmic stablecoins pose risks. They are at risk of decoupling. Massive withdrawals due to public panic lead to lost value. Stabilizing tokens might lose value. Other stabilizing tools could help. Cryptoasset and Blockchain Page 43 Version 1.07 Virtual asset service provider Virtual asset service provider In 2021, the Financial Action Task Force (FATF) updated the definition of virtual asset service provider (VASP). The updated definition describes a VASP as any natural or legal person who, as a business, exchanges, holds, transfers, converts, and sells virtual assets for or on behalf of others, regardless of the underlying technology used. This definition encompasses a broad range of business types, including cryptocurrency exchanges, cryptocurrency automated teller machine (ATM) operators, wallet providers, custody solutions, and more. A VASP can have more than one business type, such as a cryptocurrency exchange nested inside an ATM operator. In its definition, FATF outlines five activities or operations that would qualify for VASP classification. To determine whether an entity is a VASP according to FATF’s definition, consider whether it is acting as a business and whether it provides financial services for or on behalf of others. VASPs are relatively easy to identify based on these criteria. A natural or legal person that has the intention of making a profit is acting as a business. Qualifying VASP activities or operations include: The exchange of virtual assets and fiat currencies The exchange of one or more forms of virtual assets The transfer of virtual assets The safekeeping or administration of virtual assets or instruments enabling control over virtual assets Participation in or provision of financial services related to an issuer’s offer or sale of a virtual asset In contrast, businesses that merely provide the necessary structure or underlying technology to allow other entities to offer services do not satisfy the definition of a VASP. A decentralized finance (DeFi) application such as a smart contract is not a VASP under the FATF definition. However, a DeFi business providing one of FATF’s qualifying operations might be classified as a VASP. Cryptoasset and Blockchain Page 44 Version 1.07 Certain common activities involving the exchange or transfer of cryptoassets might fall under the VASP definition, including cryptoasset escrow, brokerage, orderbook exchange, and advanced trading services. Crypto ATMs Similar to traditional bank automated teller machines (ATMs), crypto ATMs are physical kiosks that allow individuals to purchase cryptocurrencies using cash or a bank card. Bitcoin is the cryptocurrency most commonly supported by crypto ATMs, but altcoins are often supported as well. Some crypto ATMs also allow individuals to sell their cryptocurrencies for cash. Crypto ATMs typically move funds through a public key on the blockchain. The machine usually prompts a user to scan a QR code that corresponds with their ATM-supported wallet. The ATM sends the cryptocurrency to the wallet after the transaction is verified and completed, along with a record of the transaction. Crypto ATMs often seem more approachable and intuitive than online cryptocurrency exchanges because they operate as ATMs. They also allow anyone to buy and sell cryptocurrencies without a bank account, making them more accessible. The QR code system for entering destination wallets also reduces the risk of manual mistakes that might result in a loss of funds. Crypto ATM requirements vary depending on country and location, and many do not require any user identity verification. As a result, crypto ATMs are also susceptible to money laundering and other fraud activities. Wallet creation is a key part of the process of buying cryptocurrency using ATMs, and this can become targeted by scammers. The large number of crypto ATM machines, the ease of transactions, and their anonymity also promote their use for money laundering and drug trafficking. Kiosk operators do not typically communicate transactions with one another. Therefore, despite typical daily transaction limits, an individual could use multiple machines from different operators to launder cash quickly. Crypto ATMs offer easier access to the cryptocurrency market, particularly for the unbanked. They are popular for people to send payments or make alternative investments. However, consumer protection risks are heightened when crypto ATM companies market their services to individuals ignorant of the risks involved with cryptocurrency investing. Cryptoasset and Blockchain Page 45 Version 1.07 Centralized compared to decentralized exchange Centralized exchanges (CEXs) act as intermediaries, allowing cryptocurrency buyers and sellers to trade on their platforms in exchange for fees. Because the ownership of cryptoassets relies on private keys, CEXs hold customers’ private keys to retain control of their deposits. CEXs then supply liquidity to the tokens they choose to support and allow customers to trade among these tokens. Decentralized exchanges (DEXs) are noncustodial. DEXs do not hold users’ private keys, and they allow cryptocurrency buyers and sellers to connect directly through peer-to-peer (P2P) trading by using self-hosted wallets. CEXs provide sophisticated trading options and avenues for fiat conversions and connections to traditional financial services. CEXs also typically abide by local regulatory requirements. These compliance controls reduce the risks of trading malpractice and loopholes. DEXs are usually not owned or managed by any single company. Instead, they are governed in a distributed manner through a majority consensus. Users of a DEX hold their own private keys and have full ownership of their cryptoassets. When users trade cryptoassets, the DEX uses smart contracts instead of intermediaries to complete the trade. DEXs have varying degrees of decentralization. A DEX’s level of decentralization often depends on what consensus method, such as proof of work or proof of stake, is used to verify transactions. A DEX is often attractive for illicit activities. With no single controlling authority, a DEX is only as secure as its underlying blockchain or protocol. DEX users also do not need to undergo KYC onboarding processes, allowing users to retain their anonymity. However, because DEXs by default do not have centralized asset storage or a centralized network, the risk of targeted theft and cyberattacks might also be reduced. Cryptoasset and Blockchain Page

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