IS4302 Blockchain and Distributed Ledger Technologies Week 7 Fall 2024 PDF

IS4228: Information Technology and Financial Services IS4302 Blockchain and Distributed Ledger Technologies Week 7: Cryptocurrencies and NFTs © Copyright National University of Singapore. All Rights Reserved. Overview Cryptocurrency NFT...

IS4228: Information Technology and Financial Services IS4302 Blockchain and Distributed Ledger Technologies Week 7: Cryptocurrencies and NFTs © Copyright National University of Singapore. All Rights Reserved. Overview Cryptocurrency NFT 2 Cryptocurrency and NFTs Overview Cryptocurrencies: Digital, decentralized currencies powered by blockchain. NFTs: Unique digital assets, non-fungible, and stored on blockchains. Both rely on trust and immutability of blockchain. 3 What is money? (Economic Theories) Minsky’s Viwe: “everyone can create money; the problem is to get it accepted” Money is a two-sided balance sheet operation Money cannot exist until acceptance has occurred Anyone can make promises or offer to go into debt but that the ‘problem’ is to find someone who is willing to become a creditor. 4 What is money? (Economic Theories) Minsky’s Viwe: “everyone can create money; the problem is to get it accepted” Metallist Theory: Money originated from barter, based on valuable commodities (e.g., gold, silver). 5 What is money? (Economic Theories) Minsky’s Viwe: “everyone can create money; the problem is to get it accepted” Metallist Theory: Money originated from barter, based on valuable commodities (e.g., gold, silver). Chartalist Theory: Money derives value from state- sanctioned means of payment (taxation). 6 Metallist vs. Chartalist Debate Metallist: Money’s value derives from its intrinsic worth (e.g., gold, Bitcoin as ‘digital gold’). Chartalist: The state controls the value of money (e.g., central bank money, potential CBDCs). Cryptocurrencies have elements of both: Metallist: Store of value (Bitcoin). Chartalist: Community and network validation 7 Metallist theory Money, though it may come to serve other functions, is supposed to have originated as a medium of exchange. Exchange, it is argued, was initially conducted on the basis of barter. ‘double coincidence of wants’ Money, then, is said to have arisen spontaneously in the private sector in order to eliminate some of the inefficiencies of barter. 8 Metallist theory Money, though it may come to serve other functions, is supposed to have originated as a medium of exchange. Exchange, it is argued, was initially conducted on the basis of barter. ‘double coincidence of wants’ Money, then, is said to have arisen spontaneously in the private sector in order to eliminate some of the inefficiencies of barter. What is the thing chosen to serve as money? Why money has value? 9 Metallist theory Money must be ‘a thing that is useful and has exchange value independently of its monetary function’ Intrinsic value of money Metallic currencies (usually gold or silver) are accepted because they were themselves valuable commodities with certain properties. 10 Metallist theory Money must be ‘a thing that is useful and has exchange value independently of its monetary function’ Intrinsic value of money Metallic currencies (usually gold or silver) are accepted because they were themselves valuable commodities with certain properties. How much of their value is tied to their non monetary use? 11 Metallist theory It is not always clear whether the precious metals chosen to serve as a medium of exchange were in an ‘unworked’ state or whether they had been minted/coined. Identifying the quantity and quality of the metal. Commodity money requires a stamp or guarantee before it could circulate widely. 12 Metallist theory It is not always clear whether the precious metals chosen to serve as a medium of exchange were in an ‘unworked’ state or whether they had been minted/coined. Identifying the quantity and quality of the metal. Commodity money requires a stamp or guarantee before it could circulate widely. Who performed this minting/identification function? 13 Chartalism theory Chartalists recognise the power of the state to demand that certain payments are made to it and to determine the medium in which these payments must be made. 14 Chartalism theory Chartalists recognise the power of the state to demand that certain payments are made to it and to determine the medium in which these payments must be made. Adam Smith: “A prince, who should enact that a certain proportion of his taxes should be paid in a paper money of a certain kind, might thereby give a certain value to this paper money.” 15 Chartalism theory Chartalists recognise the power of the state to demand that certain payments are made to it and to determine the medium in which these payments must be made. Adam Smith: “A prince, who should enact that a certain proportion of his taxes should be paid in a paper money of a certain kind, might thereby give a certain value to this paper money.” The value of sovereign money depends on its usefulness in settling tax or other liabilities to the state. The value of money comes from “a Chartal means of payment”. 16 Metallist v.s. Chartallist Fundamental difference: what is the most essential function of money? Metallist: medium of exchange Chartallist: means of payment Both functions are essential for traditional currencies. These two theories are not always contradicting each other in the cryptocurrency world. The common feature of the two theories: trust Provided to some degree by the immutability feature of blockchains. 17 18 Characteristics of cryptocurrencies Identity management of the writers/validators of the blockchain recording the cryptocurrency Public blockchain Private blockchain Permissioned blockchain Consensus algorithm of the blockchain Proof-of-work Proof-of-stake … Supply of the cryptocurrency Mining Coin offerings Both 19 Blockchains Underlying Different Cryptocurrencies Public Blockchains: Open to all users and validators (e.g., Bitcoin, Ethereum), highly decentralized. Transactions visible to all; trust ensured through PoW or PoS. Private Blockchains: Restricted access, both in use and validation Often used in enterprises (e.g., Hyperledger). Permissioned Blockchains: Hybrid of public and private, where some participants have more control (e.g., Ripple). 20 Ethereum and Smart Contracts Ethereum: Allows easy creation of tokens that function like crypto currency, but rely on Ethereum’s L1. Used for ICOs, NFTs, DeFi (Decentralized Finance), and more. 22 Initial Coin Offerings (ICOs) ICOs: Fundraising method for blockchain projects, akin to an IPO but without regulation. Utility tokens are issued, often giving holders access to future services/products. High risks: Many ICOs have failed or lost value 23 ICO – Initial Coin Offerings A company issues some coins where some of this company’s products/service can be accessed exclusively by these coins (aka utility coins). The coins are offered to the public, generally before the products/service is available. Main purpose: fundraising Used by both established (Telegram, Ripple) and start-up companies. Analogous to IPO, but unregulated. 24 ICO EY analyzed 141 ICOs from 2017, and the result is At Sept 2018, 86% below listing price, 30% lost substantially all their value. 25 ICO mania is now largely over Characteristics of cryptocurrencies Differences in these characteristics make the cryptocurrencies very different from each other in Usage Security Privacy Financial influence … 27 Bitcoin Public blockchain Proof-of-work system Supply is stable Coin rewards for mining 50 per block initially and halved approximately every four years. Security against double spending attacks depends on the incentives of the writers. 28 Bitcoin Financial performance Demand comes from markets need privacy and speculation (and possibly manipulation) Demand fluctuates significantly Price fluctuates significantly The fixed supply limits monetary policies on it (if the writers do not want to change the rules). Avoids hyperinflation from printing money Currency increase cannot match with the growth of the economy (marketplace), so significant deflation can be expected if the market grows, which is costly. 29 Stablecoins and CBDCs Stablecoins: Cryptocurrencies pegged to stable assets (e.g., USD). Examples: Tether (USDT), USD Coin (USDC), DAI, and Binance USD (BUSD). Provide stability in price but require trust in the underlying assets and issuer. Central Bank Digital Currencies (CBDCs): Government-issued digital currencies. Offer the benefits of crypto (speed, security) with the stability of sovereign backing. Example: China’s Digital Yuan. 30 How Stablecoins Work Backing Mechanism: Stablecoins are pegged to an external reference asset to maintain stability. Fiat-backed: The stablecoin is backed 1:1 by fiat currency held in reserve (e.g., USDT backed by USD). Algorithmic: Uses algorithms and smart contracts to adjust the supply of tokens to maintain price stability (e.g., TerraUSD before its collapse). Crypto-backed: Stablecoins are backed by other cryptocurrencies as collateral (e.g., DAI backed by Ethereum). Pegging: The value of the stablecoin is tied to the reserve asset or pegged currency (often USD). 31 Fiat-backed Stablecoins Mechanism: A company holds reserves of fiat currency in a bank (e.g., USD, EUR). Stablecoins are issued 1:1 to the fiat currency held in reserve. Users can redeem stablecoins for the equivalent amount of fiat currency. Example: Tether (USDT) claims to have reserves in USD, though transparency issues have caused concern. 32 Crypto-backed Stablecoins Mechanism: Stablecoins are issued against cryptocurrency held as collateral. Typically, these stablecoins are over-collateralized to account for volatility. If the value of the crypto collateral drops, more collateral is required or the stablecoin can be liquidated. Example: DAI (issued by MakerDAO) is backed by Ethereum and uses a system of smart contracts to maintain stability. Risk: High volatility in the collateral asset may trigger automatic liquidations, causing price instability. 33 Algorithmic Stablecoins Mechanism: Supply and demand of the stablecoin are regulated algorithmically. When the price rises above the peg (e.g., $1), new coins are minted to increase supply. When the price drops below the peg, coins are burned or removed from circulation. Example: TerraUSD (UST) used an algorithmic mechanism, backed by Luna. This system collapsed in 2022, leading to market failure. Risk: If the algorithm fails to maintain the peg, the system can collapse, as seen with TerraUSD. 34 Algorithmic Stablecoins Risk: If the algorithm fails to maintain the peg, the system can collapse, as seen with TerraUSD. 35 Algorithmic Stablecoins Risk: If the algorithm fails to maintain the peg, the system can collapse, as seen with TerraUSD. 36 Tether Basically a bank that provides privacy (like Swiss bank), but No auditing, regulations,… Formerly claimed that each token was backed by one USD, but on 14 March 2019 changed the backing to include loans to affiliate companies. The Bitfinex exchange was accused by the New York Attorney General of using Tether's funds to cover up $850 million in funds missing since mid-2018. "magic Tethers out of thin air“ Manipulation of Bitcoin with Tether? 37 Terra and Luna crash LUNA is the native cryptocurrency of the Terra ecosystem. Before the Terra Luna crypto crash happened, the cryptocurrency was among the top 10 largest crypto coins in the world by its total market capitalisation and also one of the most popular. 38 Central Bank Digital Currencies (CBDCs) Definition: Digital currencies issued directly by central banks, designed to represent the digital form of a nation's fiat currency. Purpose: CBDCs aim to improve payment systems, reduce transaction costs, and provide greater financial inclusion. Key Feature: Unlike cryptocurrencies, CBDCs are fully regulated and backed by the government. 40 How CBDCs Work Structure: Issued and managed by central banks. Available to the public or financial institutions via digital wallets. Transactions are recorded on a permissioned blockchain or central database controlled by the central bank. Types of CBDCs: Retail CBDCs: Used by individuals for daily transactions (e.g., Digital Yuan in China). Wholesale CBDCs: Used by financial institutions for interbank settlements. 41 Wholesale CBDCs in Action Use Case: Bank of Canada’s Jasper Project. Used for interbank settlements and large transactions between financial institutions. Reduces settlement times and enhances security. Advantages: Reduced transaction costs for financial institutions. Instant settlement, reducing risk in the financial system. 42 Central bank digital currencies (CBDC) Stablecoin issued by central banks. Usually one to one to the country’s sovereign currency. Why CBDC? How are they different from Alipay, Paypal, PayLah, …? It’s about data/information! Those applications are on the consumer side. They collect information about consumers for marketing. They are not capable of handling loans to businesses. Information on loans to businesses is essential to government’s decision making. 43 CBDC Without CBDC, central bank only knows how much currency it issued, But not how much currency is being circulated (loaned by commercial banks). Central bank does not know exactly for each industry, how much money goes into. With CBDC, central bank can keep track of such information, which is helpful in making macroeconomic policies. 44 Money multiplier Money supply: the total value of money available in an economy at a point of time, measured in different levels. Multiplier between different levels of money supply a given reserve is lent out by a bank, then deposited at a bank (possibly different), which is then lent out again, the process repeating and the ultimate result being a geometric series. 45 CBDCs vs. Stablecoins: A Comparative View Stablecoins: Issued by private entities, often less regulated. Backed by fiat, crypto, or algorithmic mechanisms. Higher risk due to lack of transparency and potential instability (e.g., Tether). CBDCs: Issued and regulated by central banks. Fully backed by national fiat currencies. More stable and trusted, but with less privacy. 46 Challenges and Risks of CBDCs and Stablecoins Stablecoins: Fiat-backed: Lack of transparency (e.g., Tether controversy). Algorithmic: Risk of collapse (e.g., TerraUSD). Crypto-backed: Volatility of collateral assets. CBDCs: Privacy concerns: Government access to transaction data. Centralization: Lack of decentralization compared to cryptocurrencies. Risk to traditional banks: Direct accounts with central banks may bypass traditional banks. 47 Comments and takeaways The differences among cryptocurrencies are huge. Although all called cryptocurrencies, they are fundamentally different things, with different features and usage. Common feature: trust. 48 Overview Cryptocurrency NFT 49 What Are NFTs? Definition: NFTs are unique, non-interchangeable digital assets stored on a blockchain. Each NFT is associated with a specific identifier, making it different from any other token (unlike cryptocurrencies, which are fungible). Represent ownership of digital or physical items (art, music, collectibles, virtual real estate). Key Blockchain: Most NFTs are created and traded on the Ethereum blockchain using the ERC-721 standard. 50 Trading NFTs Buying and Selling: NFTs are bought and sold on decentralized marketplaces (e.g., OpenSea, Rarible). Ownership transfer is secured by the blockchain, ensuring a tamper-proof transaction history. Smart Contracts in Trading: Smart contracts facilitate the transaction by executing predefined terms (e.g., transfer of ownership and payment). Royalties: Some NFTs are programmed to pay creators royalties every time the NFT is resold, providing ongoing revenue. 51 NFT Use Cases Art and Collectibles: Digital artists sell unique works directly to buyers (e.g., Beeple’s $69M NFT sale). Gaming: Players own in-game assets (characters, weapons, skins) and can trade or sell them on NFT marketplaces. Virtual Real Estate: Platforms like Decentraland and The Sandbox allow users to buy, sell, and build on virtual land. Music and Entertainment: Musicians can release limited- edition albums or concert tickets as NFTs. 52 NFTs CryptoPunks, one of the first NFT on Ethereum, has created more than 10000 collectible punks (6039 males and 3840 females) and further promoted the ERC-721 standard to become popular. CryptoKitties officially put NFTs on notice, and hit the market in 2017 with the gamification of the breeding mechanics. Participants fiercely competed at high prices to auction the rare cats, and the highest price reaches more than 999 ETH (equally 3M USD). NBA Top Shot: an NFT trading platform used to buy/sell digital short videos of NBA moments. … 53 An example workflow of NFT system NFT Digitize. An NFT owner checks that the file, title, description are completely accurate. Then, s/he digitizes the raw data into a proper format. NFT Store An NFT owner stores the raw data into an external database outside the blockchain. S/he is also allowed to store the raw data inside a blockchain, despite this operation is gas-consuming. NFT Sign The NFT owner signs a transaction, including the hash of NFT data, and then sends the transaction to a smart contract. 54 An example workflow of NFT system NFT Mint&Trade After the smart contract receives the transaction with the NFT data, the minting and trading process begins. NFT Confirm Once the transaction is confirmed, the minting process completes. By this approach, NFTs will forever link to a unique blockchain address as their persistence evidence. 55 An example workflow of NFT system 56 Value of NFT Liquidity Uniqueness Social value Speculation … 57 Challenges Usability Challenges Slow confirmation High gas prices Data inaccessibility A cryptographic hash as the identifier, instead of a copy of the file, will be tagged with the token and then recorded on the blockchain to save the gas. More generally, oracle problem Legal pitfalls Taxable property issues NFT Interoperability (cross-chain) … 58 Conclusion Unique Ownership: NFTs represent a groundbreaking way to establish and verify ownership of digital assets. Technological Foundation: Built on blockchain and smart contracts, NFTs are evolving as a powerful tool for creators, gamers, and businesses. Challenges Ahead: High gas fees, environmental impact, and legal ambiguities need to be addressed to ensure sustainable growth. Future Outlook: As blockchain technology evolves (Layer 2, PoS), NFTs will likely expand into new industries, including finance, identity, and virtual worlds. 59 Thank you! 60