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Decentralizing Money, Trust and Privacy

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

CONTENTS

     

Preface            .................................................................................  i

Chapter 1        Journey to Programmability………………………………. 1

Chapter 2        Systematic Stability for Uncertain Societies.......... 9

Chapter 3        Satoshi’s Mystery.................................................. 29

Chapter 4        The Idea and Execution…………………………………….47                                

Chapter 5        Battle of Cryptography .......................................  55                                  

Chapter 6        Balancing Centralization & Decentralization…..   77                                          

Chapter 7        Money and Cryptoeconomics.............................. 79 

Chapter 8        Decentralized Applications and The Metaverse…98

Chapter 9        Tokenization and the DeFi Matrix...................... 100                                                       

Chapter 10      TradFi Investment Lessons Applied in Web3……150

Appendices     ............................................................................. 385

References      ............................................................................. 453

Index               ............................................................................. 457

 

 

 

 

 

 

 

 

 

 

 

Chapter 1: Our Journey to Programmability

 

Imagined Orders

In elegant Web3 style, the pseudonymous Bitcoin inventor Satoshi Nakamoto describes the Bitcoin creation in an online forum by writing,

 

“The root problem with conventional currency is all the trust that’s required to make it work via faith in banks, governments, and other sorts of third party middleman” (Nakamoto, 2009).

 

Satoshi argues that well-functioning societies are formed based on a trust foundation and that the lack of checks and balances over the minting process of traditional fiat money leads to corruption. Bitcoin, Satoshi argued, creates consensus via decentralized and math-based software rather than faith-based imagined orders regulated by third-party banks or governments.

 

 “Imagined orders allow strangers to trust each other because they derive a shared sense of beliefs from the same stories”,  wrote Yuval Harari in his best-selling book, Sapiens.

 

The above sentence describes how trust from imagined orders enables humans to cooperate on a colossal scale across society. Powerful imagined orders derive strength from simplicity and ability to evoke human emotion, but also from being logical, impactful, and resistant to fraud-proofs. The easier an imagined order is to understand, and the more feeling that the imagined order unleashes, the stronger the imagined order becomes. God is a perfect example of a powerful imagined order as God provides a simple to understand yet logical explanation for the complexity of our universe while simultaneously encouraging cooperation via fear of punishment for undesirable behavior.

 

Although society became more secular in the Information Age spanning 20th and 21st century, no atheist scientist has successfully disproved God's existence. Unlike the concentration to few religions in the non-secular part of the world religious concentration that has occurred over time, the religions of hunter-gatherers were highly decentralized. According to most historians, the dominant religion among these tribes was Animism. Still, the lack of interaction between different tribes meant that the totality of the Hunter-gatherer society consisted of more religions than tribes. As agricultural technology advanced, these tribes became small farms. Shortly after, farms became large villages, further shrinking the number of religions.

 

 

 

God, Money, and Bitcoin

As humanity began concentrating and forming larger cities to protect against violence and theft around the birth of Jesus, minor religions like spiritualism and Ancient Greek Theology became increasingly irrelevant. Instead imagined orders like Money and religions including Christianity, Buddhism, Hinduism, Islam, and Judaism emerged or strengthened. While prominent religions facilitated a moral compass across city and nation-states in a more hierarchical society, Money became a critical trust-generating mechanism between two or more counterparties engaging in trade. For example, non-Romans generally accepted the Roman Empire currency denarius, a form of silver introduced in 211 BC. The denarius is generally considered the first reserve currency in the world. After the fall of Rome and the Dark Ages that followed, global trade intensified again following the 15th-century gunpowder revolution.

 

With more powerful weapons and a low global supply of silver and gold, commodity-based currencies became too valuable to leverage purely for financial payments. Paper-based Money then emerged, which enabled the formation of sizable nation-states using Money to pay military forces for law enforcement and protection against enemy nation-states. Strong military forces also decreased the Catholic Church's power and with powerful merchants running nation-states, the Pope could no longer demand unlimited shekels from feudal lords fearful of angering God. As nation-states expanded in size, religious diversity further decreased significantly. Nation-state emergence simply reduced both the role of the Church as a powerbroker and the number of religions in society.

 

The most recent change to Money as an imagined order other than Bitcoin occurred when Nixon released the US dollar from the gold peg in 1971. By making the US dollar ultimately faith-based, Nixon installed the modern utility-based neoliberal economics, which, combined with US fiat money, is the dominant imagined order in version 2022 of society. Economics and State replacing God and State symbolizes the ascent of Money during the information age. Instead of spreading the word of God, modern priests evoke the prose of the almighty weather lord under the veil of science. Like a medieval pope, 21st-century economists are urging society to sacrifice their living standards by sending modern shekels to nation-states via negative interest rates and inflation in the global fight against climate change. Unlike God and Money, which engineered imagined orders to accommodate directly or indirectly the powerful at the expense of the people, Bitcoin software is engineered to democratize trust in Money by people.

 

 

The First Online Payment Application

The Bitcoin blockchain revolutionized Money as a store of value by depending on immutable software code to create trust between users of the Bitcoin payment network. However, before Bitcoin, an ideologically diverse group of young scholars spearheaded by Peter Thiel set out to make the first platform for online payments in PayPal. Due to bombastic articles often with a conservative tilt authored or approved by Theil while a law school student and editor at the Stanford Review newspaper, a common misconception is that Theil and company, via leveraging technology, set out to destroy nation-state governments backed by strong militaries funded by Paper-based Money. PayPal opponents argued that the technological greatness of a global online payment platform would facilitate money laundering for terrorists and criminals. It is worth noting that arguments against PayPal in the early days were similar to those against decentralized blockchains. For example, opponents argue that a successful Bitcoin blockchain becomes the primary payment method for terrorists. In contrast, proponents argued that a successful Bitcoin blockchain provides a revolutionary income tool for people in the developing world often suffering from dictatorships. Although eBay bought PayPal in 2004, the money laundering argument never materialized for either PayPal or Bitcoin. However, there is a subtle yet essential distinction between Bitcoin and PayPal from a payment network perspective.

 

Bitcoin is a decentralized, commodity-based, and censorship-resistant payment network, while PayPal is a traditional profit-incentivized LLC not much different than Bank of America. The difference between PayPal and Bitcoin leads to unique outcomes similar to the political outcomes due to subtle differences between liberal individualism and neo-liberal collectivism. Austrian and Nobel-Prize-winning economist Fredrich Hayek argued that true liberal democratic principles like Bitcoin find a basis in decentralized individualism rather than centralized neo-liberal collectivism. Hayek outlines the meaning of true democracy by writing:

 

“To the great apostles of political freedom the word had meant freedom from coercion, freedom from the arbitrary power of other men, release from the ties which left the individual no choice but obedience to the orders of a superior to whom he was attached. The new freedom promised, however, was to be freedom from necessity, release from the compulsion of the circumstances which inevitably limit the range of choice of all of us, although for some very much more than for others.”

 

Hayek believes that liberalism and neo-liberalism share the exact definition of equality but that neo-liberalism uses the term freedom based on collectivism rather than individualism. To Hayek, albeit with good intent, neo-liberalism implies that governments use a planned economy approach to determine what is best for the collective. According to Hayek, the cost of collectivism is less or even zero individual freedom. Like true liberalism defines freedom, Bitcoin is a grassroots democratic movement that generates adoption via superior and decentralized peer-to-peer technology.

 

Meanwhile, PayPal, like neo-liberalism, leverages aggressive marketing to generate profits. Perhaps profits are the motivation behind why Thiel makes bombastic statements like “Governments use inflation and sometimes wholesale currency devaluation . . . to take wealth away from their citizens.” PayPal would make that impossible” and “Paper money is an ancient technology,” The slight difference in what drives Bitcoin and PayPal adoption is similar to the little difference in how liberals and neo-liberals define freedom.

 

Bitcoin drives adoption with a foundation in liberal freedom, while PayPal acts like an improved

centralized bank based on a tweaked neo-liberal version of freedom or what Hayek calls “new freedom.” From a liberal democratic perspective, Bitcoin is revolutionary technology compared to the traditional banking system, and PayPal is just a superior bank. However, although PayPal wanted to replace the centralized banking system with another ideal centralized system does remove the fact that PayPal was a revolutionary fintech platform, it does provide evidence of why Peter Thiel supported Donald Trump in the 2016 US Presidential election.

 

 

PayPal

Although PayPal disrupted traditional banking by processing online payments immediately between users' peer-to-peer rather than in two days, the idea of creating PayPal inspired the democratization of payments via leveraging technology. Thiel and the team thus designed the blueprint for the coming smartphone revolution for centralized and decentralized payment applications. As a fresh University of Illinois computer science graduate, the 23-year-old Max Levchin generated the idea behind leveraging handheld devices for peer-peer payments. Max met with Thiel and explained his concept over coffee on a likely sunny 1998 summer day in Palo Alto, California. Before meeting Max, the idea of cybercash, as outlined in the visionary book, The Sovereign Individual, heavily influenced Thiel. After meeting Max, Thiel immediately invested 250,000 US dollars in Max's idea and soon joined the company first named Fieldlink as CEO. Together, Max and Thiel wanted to create an online payment platform on the most popular handheld device.

 

In 1998, there was no Android, iPhone, or even Blackberry, only the Palm Pilot, which was a problem because Palm Pilots lacked encryption-appropriate security to do business. Although Max was a cryptography expert, Peter asked one of the inventors of encryption, Martin Hellman, if he would meet with Max to discuss how to incorporate cryptography into Palm Pilots. During that discussion, it was clear that Martin thought Max knew more about cryptography than most cryptography PhDs. The insights provided by Max were enough for Martin to join Fieldlink as an advisor providing much-needed credibility for asset-raising purposes in return for a small equity stake. Chapter 5 explains how Martin facilitated modern encryption still leveraged by all computers in 2022. Shortly after Martin joined as a Fieldlink advisor, the company increased in both size and value, and Peter asked some of his former Stanford classmates to join the journey, among them is the self-proclaimed dictator David Sacks. With coffers filled up to the brim from successful asset raising, Fieldlink became Confinity in 1999.

 

Outlined in a business plan dated May 10, 1999, Confinity's idea was to replace the security of traditional banking services with software. Due to recent advances in computing, the Confinity team argued that the combination of cryptography-secured software with a user-friendly wallet allowed handheld electronic devices to frictionlessly send Money peer-to-peer without banking intermediaries. Although sounding eerily similar to Satoshi's vision of Bitcoin, the application was centralized. However, in addition to offering customers peer-to-peer payment services, Confinity also offered a full range of other online financial services. Before renaming Confinity to PayPal, Peter Thiel merged with Elon Musk's online bank company X to form the "PayPal Mafia ." In 2022, the team behind the first payments application is now known as the PayPal Mafia. The following reasons why the PayPal mafia believed a MobileWallet application was superior to services provided by traditional banks in 1999:

 

"(1)  Exponential growth of the small device market. In five years, between 30 and 100 million handheld computers will be in use, up from about three million today. Wireless handheld computers, which will become available in mid-1999 will increase hand-top functionality and therefore accelerate this trend even further. Over the same period, the cell phone market will grow to one billion worldwide, up from about 300 million today.

 

(2)  Exponential growth of electronic finance ("efinance"). The demand for electronic financial services has grown at an even greater rate (upwards of 200% per year), paced by the explosion of online commerce and the inception of internet banking. Confinity will create a unified platform for all efinance away from the desktop, in the real world.

 

(3)  Major technological barriers to entry. Encryption technology is essential for robust finance. Accordingly, Confinity's MobileWallet contains proprietary security protocols (specially designed for handheld computers) to prevent theft, fraud, and other forms of financial abuse. Our team of developers has a background in both cryptography and in designing massively scalable servers, giving Confinity a significant lead in bringing its new security platform to market."  

 

Note that all three predictions in the Confinity's business plan were beyond crystal-ball home runs, but bullet number 3 deserves extra attention. Keep in mind that I am no cryptography expert nor a historian. However, I try to keep things factual and scientific to the best of my ability throughout the book because democratizing money is too important not to spread as widely as possible because today more consumers than ever use smartphone-based financial applications.  With Thiel joining rumble as an early investor in 2022 and Elon Musk buying Twitter, there are rumbles of a reemergence of the original PayPal Mafia idea. In this book, my goal is to share my thoughts on the global impact of cryptography in a digestible manner via historical analogies. The book speculates on the identity of Satoshi, decomposes central banking, and investigates similarities between computational and market ecosystems. Finally, the book also envisions how secure Internet browsing will move humanity forward and ends with some investment tips for Web3. In chapter 3, Satoshi's Mystery, we investigate how cryptography may have significantly influenced why Peter Thiel became the first investor in Facebook and Elon Musk bought Tesla.

 

 

God, Money, Bitcoin, and Language

Existing imagined orders often slowly appreciate in strength over time, but not always. Sometimes existing imagined orders are disrupted by technological advancement. One such advancement is Language. As cities grew taller and denser over time, writing systems evolved from simple symbols drawn in caves to more advanced symbol and alphabet based writing systems. As of 2020, English, Chinese, Hindi, and Spanish account for 45% of the global population. However, in 1900, the most common language was Mandarin, accounting for 25% of the total population, while English only accounted for 10% of the population. Since 1900, Chinese Mandarin has dropped 50% with population growth, while English has seen an increase of over 500%, growing from 200 million to almost 1.4 billion speakers.

 

The rise in English speakers speaks volumes about the global impact of the US rise to power during the 20th century. Since the US became the dominant nation-state following Industrialization, which was accelerated by early Silicon Valley advancements in information technology, God as the most critical imagined order has fallen from the grace of heaven. Although the US pretends to follow God, the imagined orders spearheading Neo-liberalism is the control of Language and Money. As a result, the US now controls global missions. Before current US dominance, the Royal British Empire was the world power. However, perhaps the most dominant force in history was the Roman Empire ranging from centuries before and after the birth of Christ. However, unlike previous periods in history, the US public is no longer a theocracy, but a democratic Money and Language dominant nation-state in a world threatened by the developments emerging from advances in information technology via the Internet and Blockchain.

 

 

David Chaum

Before Bitcoin in 2009, US Computer scientist David Chaum developed the first cryptography-based technology for digital currency. His idea was simple as he recreated the equivalent of fiat by digitally writing on a piece of paper, "if given to someone, this note is worth 1 USD". If the digital note in Chaum's example is immutable, people may trust its value more than a central bank-controlled fiat dollar. Just like the central nervous system regulates the human body via releasing and contracting hormones, the blockchain network regulates the global payment system via incentives for resource allocation and idea generation on the Internet without depending on intermediaries. The Internet is helpful for gathering, storing, and analyzing data virtually to make informed decisions and solve problems in the real world. Like the biological and market ecosystem,  the Internet is an evolving network that generates new data continuously. With expanding adoption globally during the 21st century, the Internet is decentralizing both expression and sourcing of information and talent.

 

Before the Information Age, the productive minority subsidized the unproductive majority of journalists at prominent newspapers like New York Times or the Sunday TImes basically paying for their coworkers' salaries. Blockchain may transform Money and banking per the PayPal Mafia mission like the Internet revolutionized information and news. Currently, the global economy depends on fiat currency and government credit as the two dominant forms of Money. The benefit of fiat currency cash is privacy, but a well-known flaw with a cash-based system is that it needs bootstrapping, meaning that someone needs to create some Money in the system in the first place so that people can transact. Another cash issue is that sometimes people need to hold more cash to make expensive purchases. For example, most people need a mortgage, a form of credit, to buy a house. Most people cannot buy a home using cash, so a mortgage is often required. A mortgage is a form of credit, and poor lending and borrowing incentives associated with mortgage credit may lead to systematic economic risks, like the Great Financial Crisis in 2008. Another flaw of credit is that customers must provide sensitive information including name, address and national ID number for online purchases, which is why third parties like PayPal 2022 sometimes handle credit security.

 

The dominant form of Money in 2022 is therefore the blended fiat and credit system, which combines cash, borrowing and lending to facilitate payments. Although the cash-based debit card is the most common payment method in the world, most customers in the US leverage credit cards for online purchases. Before paying online, credit and debit card users must provide user information to intermediaries or merchants like PayPal and Amazon. The dominant intermediary architecture in financial payments lets users provide credit card details to PayPal rather than merchants, which improves credit card and personal information security. However, with PayPal there is a single centralized point of failure and customers can only communicate with merchants indirectly via PayPal as an intermediary. Blockchain solves those problems by decentralizing, encrypting and verifying transactions cheaper than PayPal while at the same time improving transaction security and removing the single point of failure issue.  Currently, the cash-based system has an advantage over cryptos regarding the relative valuation of goods and services as prices of fiat currencies like dollars are more stable. Still, Blockchain is the only technology that, together with the Internet, will create the global interoperable financial Web3 system in the future.

 

 

 

The Evolution of Mankind

The complex and exponential expansion of global dependency on large-scale virtual computer networks connected via the Internet and Blockchain across and within nation-state borders has shaped the Information Age revolution. The emergence of computer giants like Microsoft, Apple, and IBM and the 18 billion dollar bankruptcy by the US manufacturing capital Detroit in 2008 symbolizes the structural shift of western society from Industrialization to Information. In 2022, the Detroit bankruptcy remains the most significant city bankruptcy in US history. At one point, Michigan accounted for 56% of all car-industry employment in the US, and in 1950 over 1.85 million people moved to Detroit to manufacture cars for Ford, General Motors, and Chrysler. However, Detroit's massive downfall first accelerated in the early 1990s, as the world became globally connected with consumers and businesses adopting Internet-capable computers via Marc Andreesen's company, Netscape. The problem of car manufacturing ranging from 1950 to 2008 in the US was two-fold.

 

First, unlike industrialization, information technology creates global competition. For example, if country A produces high-quality products cheaper and faster than the domestic country, then country A should be responsible for the production, and the domestic country should import the goods. In the Industrial Age, lack of information created trust problems and supply-chain friction between nation-states, which allowed domestic producers to maintain expensive onshore production. While US manufacturing became heavily unionized, distrust between cross-border nations simultaneously became solvable via Internet communication. Despite diminishing returns of US worker productivity due to the Internet, unions continued to exercise authority over plant owners, increasing worker benefits disproportionally to the value created by plant workers. Before Detroit's bankruptcy, the average union automobile worker in 2008 earned 74 USD per hour compared to 47 USD per hour at Toyota with benefits.

 

Second, Detroit assembly workers were well-compensated, and built cars that required little to no cognitive ability. The booming car-industry therefore disincentivized education to develop Information Age talent. The high-school graduation rate in Detroit was just 50% in the 1980s, as people seeking a higher level of cognitive education for their children likely moved elsewhere. The Information Revolution meant outsourcing car-manufacturing and other manufacturing jobs to other nations became much cheaper, which means Detroit feel behind the curve on societal evolution.

 

 

The Problem With Web2

Rather than investing in developing factory technology to produce cars at lower per unit costs, western countries like the US invested heavily in developing and exporting superior information technology. The US industrial labor costs were offshored in countries like China, which maintained deflated prices of manufactured goods like cars and clothing. As the first and later second generation of the Internet progressed, more computers came online, which grew the virtual Internet network. The US and other European countries like Sweden zeroed in on software expansion while the benefits of importing goods and services simultaneously scaled. However, the cost of offshoring  manufacturing jobs  became clear when Covid-19 shut-down the global supply chain. The dependency on a well-functioning global supply chain for cheap goods is therefore not always a positive.

 

Detroit took the first hit from offshoring, but following Covid-19 the entire world is experiencing record inflation due to the worldwide supply chain crisis persisting from the start of 2020 until 2022 and onward. One of the main problems causing the supply chain crisis is that the first generation of the Internet advanced faster than humans can adapt, which is creating software fragmentation and distrust between nation-states. For example, the storage of private information on servers in the US tech mecca, Silicon Valley, or with servers with CCP needs to end by leveraging blockchain technology for decentralizing information. By merging the computational and financial market ecosystems via blockchain technology, Internet 3.0 will therefore scale much further as trust between nation-states will increase again.

 

My thesis is that Blockchain technology through cryptoeconomics incentives will create a trusted censorship-resistant marketplace without a single point of failure, which will expand global cooperation, align incentives, improve supply chains and expand productivity growth. Imagine, therefore, the ideas generated by enhanced cooperation of 8 billion people working together as a team to solve future existential threats. As a result of blockchain’s superior method of generating trust among anonymous participants, blockchain will democratize capital access like the Internet democratized information access. Despite the Internet revolution of the 90s, two billion people worldwide remain unbanked, which makes it tough to access capital. However, in a blockchain-based token economy on top of the Internet,  unbanked persons with web3 wallets can access capital on an equal basis, which is similar to how the Internet allows those without libraries access to information. In addition, Web3 users can provide decentralized services in a sharing economy, like providing data storage via Filecoin or providing liquidity on Uniswap.

 

 

Web3

the broadest level of abstraction Web3 therefore behaves similarly to the incentive based real free market economy. The earliest idea of Web3 is derived from a 1988 transformational Information Age paper on computational systems labeled, Markets and Computation: Agoric Open Systems[1], where MIT Researcher and AI Eric Drexler and computer visualization specialist  Mark S. Miller, demonstrates how leveraging market mechanisms to allocate resources in computing systems. The idea presented by Eric and Mark is that open source is generally superior to a command based computational systems. The evolution of Internet that began with small Internet protocols and continued growth via the formation successful big technology firms, the idea of Drexler’s and Miller’s Agoric open system in combination with Internet and Blockchain will revolutionize the computational system by making Internet productivity more similar to the capitalist free market. Ultimately blockchain technology combined with Cryptoeconomic incentives. The second generation of Internet sparked by the 2009 Bitcoin invention, leverages Blockchain to distribute capital more efficiently than the traditional financial system. With more access to information and capital, Internet and Blockchain will unleash the online innovation potential. Imagine the ideas generated by a species consisting of 8 billion capitally, informationally, genetically and energetically enhanced people working together as a team to solve future existential threats. Executing these perhaps unimaginable ideas will lead to an optionlike and exponentially growing world extending beyond the confines of dear Gaia and perhaps instead moving mankind into a virtual and potentially interplanetary future. The combined evolution of the internet, blockchain, biotechnology and renewable energy networks is now the driving force behind our coming information, capital, genetic and energy revolution. There is no doubt in my mind that the intersection of internet, blockchain, biotech and renewable energy will unleash unimaginable amounts of untapped potential hidden in nature, our DNA and less developed countries leading first to Metcalf law type of economic network effects and end with a human singularity event. I define a singularity event as a moment for which humanity evolves into the next form of our Darwinian ladder, which has happened a handful of times spanning earth's multi-billion year history. Humanity in current form was built bottom up from space dust evolving from single cell bacteria to become complex sentient biochemical structures with consciousness. Mankind’s next step in evolution is leveraging technology to prepare both intellectually and physically for becoming digital and physical greatness. The innovation of software that executes via decentralized incentives rather than via instruction by centralized planners means that humanity is in the infancy of the Virtual and Interplanetary Age. The key to profiting as society transition from the Information Ag into the future is investing in Blockchain plumbing. New software based pipes modernize Internet roads, bridges, capital and consensus to create infrastructure for the development of decentralized applications, social media platforms, insurance and prediction markets, metaverse gaming, file storage and other future opportunities.

 

·       Increases trust between market participants

·       Lowers barriers to entry

·       Speeds up transaction settlement

·       Increases transaction and information security

·       Provides an energy efficient alternative to the current global financial system

·       Allows anyone becomes a liquidity provider

·       Expands credit worthiness intra and inter nations

 

In broad stroked, successful decentralized application  tokens likely possess the below two qualities, which we will analyze using a hypothetical scoring system later

 

A: token incentives are aligned with utility

B: token overcomes the cold start problem

 

In a perfect world, investors should seek long exposure to tokens with A and B properties and short ones failing either A or B or with relatively worse A and B properties than tokens with similar characteristics across web3 protocols, but also use some of the traditional tools.

 

Exponential Growth

Perhaps surprisingly, the idea of leveraging cryptography for generating enough trust between a network of trustless participants to trade has existed spanning at least three millenniums starting with Herodotus first documentation of ancient Greek stenography used to trade military information in plain sight around 500bc. With a starting value of around 1 trillion dollars in 2022, the future market value projections of the blockchain industry therefore ranges from 20 to more than 100 trillion dollars. However, the technology and infrastructure necessary to actually execute trades between untrusting parties without relying on third party institutions like banks on a global cross border basis using a decentralized and appended blockchain consensus mechanism first emerged in the latter half of the 20th century with advances in computing hardware, software, Internet speed and mathematical Public Key Cryptography. The first blockchain that successfully combined all necessary components including cryptography, Internet, technology and infrastructure necessary to execute a decentralized blockchain consensus mechanism was Bitcoin in 2009.  Given the nascent nature of the Blockchain industry and its capacity to create a database of immutable truth, process transactions exponentially faster than centralized counterparts, democratize capital and own private information, the Herodotus team believe that the market value of digital assets like crypto tokens and protocols will grow by at least a factor of 20x to perhaps even more than 100x.

 

First things First

Although the world is improving,  many people that the fabric of society has fundamentally changed since the beginning of the Covid-19 pandemic, but 99.9% is not sure what or why. In past transformational periods in history, the driver of change is most often explained by historians long after the end of the prior revolution, but something the Information Age is likely  different. Structural drivers of revolutions rarely repeat, but change often rimes with technology. Since Alan Turing used computers to crack there has been a rapid improvement in information technology and revolution occurs as rapid technology change the fabric of society. The driving factor is  that the overwhelming majority remain luddite during change and fail to adopt the skills needed to manage life in a  more technologically advanced society. For example,  during the agricultural revolution, technology domesticated grains, which required weapons to protect resources. In the Industrial Age, advancements across information, violent and energy technologies like the printing press, gunpowder weapons and mechanical engines required the formation of large nation-state alliances to protect resources. Note that both the Agriculture and Industrial Age increased the need for violence via centralized authority. However, the borderless network effects resulting from Internet and Blockchain technology actually decreases the effectiveness of violence and instead requires individual mastery of skills to cooperate with virtual networks across nation-state borders. While a small minority had foresight and ingenuity to harvest much of the profits via mastery of early information technology, global governments engaged in Industrial Age redistribution of wealth via monetary and fiscal policy. Instead of realizing that the Information Age requires citizens to have marketable skills for independency in a borderless world, most nation-states used simulative economic policies to promote status quo. Just like farms required society to adapt to village life and Industry to nation-state life, information technology requires society adapt to Internet life.

 

 

Technology and Revolutions

When the majority are expressing luddite objections to obvious benefits of technology, historical patterns of revolution emerge. The most dangerous pattern is first the reemergence of political radicals offering easy solutions to complex problems, which is followed shortly by violence. For example, the pro-longed incapability by society to master Industrialization together with unexpected events lead to the French Revolution during the Industrial Age. In 2022, the nation-state based economy came to a grinding halt as Covid-19 emerged, while companies profiting from the networks effects of the  virtual economy raked in record profits. The unregulated and borderless nature of software technology allowed smart people to adopt early, as the Information Age revolution had already taken place pre-pandemic. The source of our gut-feeling is  therefore hidden in plain sight by computational complexity. Prior to public adoption of computers and development of large computer networks via Internet in the late 1990s, computers like guns before WW1 were just simple machines unable to run more than one “bullet” programs without pressing the trigger multiple times. Although the idea of large scale computational systems began at some point during WW2 with the emergence of encryption technology, computer advancements continued slowly until the latter third of the 20th century. Just like the printing press and steam engine facilitated global trade networks during the Industrial Revolution, the simple operability of graphic computers ignited explosive innovations in computation starting in the 1980s.

 

Shifting Power Dynamics

The user-friendly and frictionless nature of global, borderless, and virtual Internet network continues to accelerate smartphone adoption across the world in 2022. As users becomes increasingly dependent on all sorts of services provided by online businesses, more nodes online result in scaling network effects, which is increasing the complexity of the global computation system. The increasing complexity of networks generally benefit network experts, which holds true for other ecosystems like markets and biology. In the market ecosystem, financial experts have benefitted enormously from the expanding complexity in financial markets over the past 100 years. To facilitate resource allocation and innovation, financial experts and nation-states develop new markets over time like the public stock, fixed income, commodities, currencies, real estate and now also the digital asset market. There exists no person that is an expert in all markets, but experts in growing markets are generally more well-compensated compared to the remain experts in the economy.  Just like the financial network effects benefit experts, the scaling computation market is structurally changing the power dynamics between nation-states, institutions and individuals. Prior to the Internet, centralized programming teams could easily manage computing systems formed by independent computers running simple software. However, in 2022, global public, private and financial information is stored and exchanged via a virtual network consisting  7 billion interconnected computers. Such complexity requires local programming expertise beyond the  technological capacity nation-state governments. Although Artificial Intelligence machines may self-execute, we assume going forward that networked computers require human instruction to perform tasks and that the instructors are responsible for outcomes. Most computers during Biden’s Presidency are connected to the Internet. Computers therefore coordinate  with large networks of other computers to efficiently allocate computing resources. As a result, computation systems are fundamentally similar to ecosystems like biology or financial markets. The general goal across most ecosystems is to support life and provide stability via distributing resources.

 

Poor Incentives Leads to Bad Networks

Due to the complexity of from larger and more interconnected networks, the benefit of expertise in sub-components expanding at a higher pace than other sub-components in growing networks can also lead to misallocation of resources. Leading up to the Great Financial Crisis in 2008, financial experts innovated new complex financial instruments that were supposed to lower the risk of house mortgages, but the complexity of these products were poorly understood by governments and consumers. The lack of expertise in finance by government officials, creates moral hazard. With decreased “statistical” risk of mortgage default meaning lower failure rates of loan repayments, banks by spreading the risks via bundling mortgages together could lend more to homeowners in the form of larger mortgages for a relatively lower interest rate. However, when financial difficulty hit and interest rates rose, most home-borrowers failed to repay mortgages simultaneously, which crashed the housing market. To save the financial market, the Obama Administration lead by Ben Bernanke bailed out banks at the brink of failure from not receiving their promised mortgage repayments. Executives at large banks lending out money with regards to “statistical” rather than “real” risk both profited heavily from the housing boom and were save by the government housing bust. I will talk more about Treasury and Central banking in relation to cryptocurrencies in chapter 6 on cryptoeconomics, but happened was that US Central Bank chief essentially printing more money. If there is more money, then the value of fiat money goes down. The creator or creators behind the pseudonym Satoshi Nakamoto was or were furious about these bank bailouts and innovated the Bitcoin blockchain to incentivize monetary stability via software in response.

 

The Price of Currency Stability

A single US dollar is worth around 0.01 grams of gold. However, back in 1971, that same dollar could be exchanged for slightly less than 1 gram of gold. The purchasing power of the dollar against gold has therefore declined by 100x over the past 50 years. In terms of real value, a 1971 dollar is worth around 0.14 dollars in 2022. The US dollar’s cumulative inflation of 600% over the past 50 years follows the historical pattern for world reserve currencies, as the price paid for a country to enjoy a dominant stable currency to exchange goods and services is a function of stimulatory monetary and fiscal policy. If central banks and governments are willing to sacrifice short-term pain for long-term gain by tightening and avoiding printing in periods of strength and uncertainty respectively, then cumulative inflation of fiat currency lessens. For example, if FED’s 2% long-term inflation target was achieved, the 1971 dollar would only have experienced 269% instead of the current 600% in cumulative inflation. In the book, How Not to be Wrong, the American mathematician and author Jordan Ellenberg illustrates mathematically why the relationship between centralized and decentralized methods of government control with prosperity is a quadratic function maximized somewhere in the middle. Although complex system maximizes prosperity by adding decentralized leadership, systems are sometimes better off with more centralization all else equal. For example, the purpose of financial markets was to efficiently distribute economic resources in an economy constrained by imperfect information and with poor incentives experts and central planners can together destroy entire economies.

 

How Information Age Markets were Developed

When modern nation-states began forming during Industrial Age, the world consisted of isolated nation states with volatile leadership, as wars dominated both western Europe and America. The independency of nation-state economics in the Industrial Age infancy meant that network effects resulting from cooperation from trade remained less complex when compared with the modern economy. As technology expanded, the network effects grew stronger during the Industrial Age and as a result the economic system become more complex. Some countries felt left out from the economic benefits that came with advancing technologies and two world wars were fought to settle the differences spanning 1915 until 1940. Network effects from nation-state dependency grew after WW2 and became the infancy period for Information Age. Despite the 600% absolute decrease in USD purchasing power since 1971, the US is the country that has experienced most capital investment. Even in the Information Age, most of the world trust both the strength of the US military power and laws protecting private property owners. That is why on relative fiat currency basis, the US is the strongest fiat currency in the world is generally considered as the world’s reserve currency. The nation states that adopted the US capitalistic free market approach benefitted most as complexity rose from increasing network effects, while countries following the communistic centrally planned market approach spearheaded by Soviet Union like East Germany and North Korea lagged behind.

 

Two Extreme Methods of Resource Allocation in Markets

Generally, the United States and Soviet Union/China represents the two extreme methods of economic resource allocation in markets are pure communism and capitalism. In pure communism, the central planner makes all resource allocation decisions to distribute resources fairly. In pure capitalism, decentralized planners compete against each other to monopolize ownership of resources. In a small word without many complexities the benefits of central planning are rational and the decentralized planners are unnecessary. However, the utility derived from decentralized planning is difficult to conceptualize because only complex systems require decentralization. The idea behind decentralized planning is that experts are better than central planners in localized areas of their expertise at resource allocation. The proponent of decentralized planning argue that incentives prevent total monopoly by one entity. In a complex system, there is no central planner that can understand the ins and out of everything.  The complexity of markets is described by Benoit Mandelbrot by comparing markets to physics. Note that computational systems like markets are a complex system.

 

Physics vs Markets

According to Mandelbrot, the objective for a physicist when creating a mathematical model is to quantitatively explain the behavior of a natural phenomenon for either practical purposes or out of pure academic curiosity. Over time, physicists have successfully developed models answering fundamental questions explaining our existence. The immense success of statistics physics therefore gave birth economic and financial modeling in the early 1900s. Rather than explaining nature, the purpose of financial modelling is used to explain markets. The goal for modern economists varies from making money, creating safer market and optimizing how governments should conduct monetary and fiscal policy. While economists like Mandelbrot believed markets behaved like a black box, the modern view by nation-state governments is that markets are a deterministic garden of eve where issues can be solved via monetary and fiscal policy. If an economy existed in isolation on island the modern view works, but in the complex real world simple strategies sometimes cause more problems than solutions. The black box philosophy not prevent economists from trying to achieve full employment, but it does prefer a more decentralized approach. If governments were more realistic about limitations on market impact that could actually enhance job markets.. As an out of the box thinker, Mandelbrot provides ideas that both complements and challenges orthodox economic theory. He provides evidence for why tail risk follows power rather than Gaussian laws and with his fractal market hypothesis theory he provides an alternative view on the behavior of markets, and we will describe this further in chapter 6.

 

Let’s use an example to explain the two economic extremes

For the past 50 years, data shows growing wheat and nothing else would produce the most amount of food for a communist nation-state. Despite disagreement from farmers on how to maximize food production and also increase focus in other areas of the market, communist leaders unilaterally decide that farmers should only grow wheat all year round. The grain expert farmers know that wheat does not grow well in  years with extremely cold weather, which happen to occur 1 in every 50 years. If there is an extreme cold snap, the communist nation-state may experience starvation. However, leaders of a decentralized economy know that farmers might produce less amount of total food in any given year, but trust their expertise. As a result, decentralized economies do not experience food shortage in cold years. The idea is that decentral planning expands the total amount of information in an economy by allowing decision making based on information gathered from the source, which prevents systematic disaster. As grain experts profiting from selling grains, farmers have both the time, expertise and incentive to make optimal agricultural long-term decisions, while central planners suffer from balancing the education needed to make informed decisions with time constraints. Despite all the complexities of decentralization, trusting free market forces via incentives and pricing mechanisms therefore generally leads to systematic outperformance over time.

 

Markets vs Computational Systems

While markets generally distribute financial resources via a combination of taxation, spending, labor and private investment, computational systems distribute information, security and financial resources via decisions made and databases owned by large corporations and governments. Unlike markets, computer science began as a centrally planned command economy.  Like guns and other simple machines, early computers operated in vacuum without any sort of network effects. The first computers were actually used by US and UK to decrypt German military communication in WW2. The software of these early computers was simple enough to be centrally managed by a group of people working at the US and UK intelligence agencies. However, as computer networks scaled over the next 70 years, the complexity grew exponentially. Software bugs became common and for stability purposes, computing systems evolved to become more and more similar to free market systems. The network complexity most likely starting in early 1990s arising from scale therefore required the computer science equivalent of market economy farming experts.  In a 21st century was Web2 dominates, programmers are the farming equivalent experts that are employed by governments and Institutions to solve various computational problems. Although programmers often have absolute freedom to solve any problem they want via their programming skills, employers and politicians remain in charge of resources allocation. If programmers need more resources to solve computational problems, they must work on projects that are in line with the central planning vision of Facebook or Google. However, when Satoshi invented Bitcoin in 2009, the first censorship resistant form of virtual property ownership emerged. The most significant consequence of digital property ownership is that talented programmers no longer need Facebook, Google or the government to gather resources. Instead, programmers could open source fund their project with currency developed outside the resource control of central planners. Just like Internet decentralized computation and information, the Bitcoin blockchain therefore decentralized resource allocation. The combination of Internet and Blockchain is creating what we label the Web3 based computing system. 

 

Two Steps Back is Sometimes One Step Forward

Contrary to popular belief, adoption of new technology sometimes emerges from regressive ideas, which holds true for both computers and Bitcoin. Mainstream adoption of computers took place after graphics based computers replaced text based computers made computers much simples to operate. Although modern computers replaced text with symbols, most of the evolution of information technology evolved from symbols to text. For example, ancient societies used to carve simple symbols into caves. Over time these simple symbols progressed to become advanced symbol, which is how early communication networks were developed. In 2022, Mandarin remains a sophisticated representation of the symbol based languages, but unlike the Chinese, a majority of the world communicates via text based alphabets. Computer adoption therefore emerged from language regression by going from text to symbols rather than symbols to text. The main reason for why graphics based computing became popular is because learning how to program computers is a difficult and time consuming skill for the average person to acquire. As a result, the programming requirement for text based computers meant adoption of Internet technology was impossible before Apple launched the world’s first computer with graphic rather than text based interface. The idea behind replacing text with graphics was to separate programming from computer operation.

 

The Apple Game Changer

Instead of instructing computer execution via programming, Steve Jobs believed users should instruct computers by clicking graphical symbols that represent pre-programmed instructions. For example, pressing graphics that represent the  turn-off  programming instruction shuts-down the computer. Graphic based computers were simple enough to operate, which allowed for mainstream adoption. More people capable of using computers then unleashed unimaginable progress in Internet technology. However, when generation Z reaches retirement age, the most significant consequences of the Information Age revolution other than Symbols, Bitcoin and TCP,IP will likely not arise from Blockchain or Internet technology innovations. But instead, how Web3 freedom improves economic resource allocation to unlock new capacity for innovation across fields like transportation, energy and biology. Although computers are replacing much of the physical economy with software today at a pace faster than that of 4-time Olympian Usain Bolt running 100 meters, the future Web3 plumbing system will more efficiently distribute capital and information via Blockchain and Internet pipes to the next generation of innovators within physics, atoms, genes, and energy.

 

 

Overall vs. Specific Improvements in Technology

What is the last non-information-based technology that improved noticeably changed our lives? Has humanity run out of ideas in areas other than information technology? Excessive regulation? Inflation?

 

·       Transportation: Flight time from New York to London is around 7 hours and unchanged since 1960.[2]

·       Energy: There are 437 low carbon emission and operable nuclear plants supplying approximately 2653TWh of electricity in 2021, which equals the total electric output generated by nuclear power in 2009. [3] Note that since 2010 around 66 nuclear power plants have been decommissioned.

·       Biology: The cost of the FDA drug approval process is greater than 1 billion dollars per drug approval.[4]

 

Above are just a few examples of evidence that technology that unleashes real economic growth across sectors like transportation, energy, and biology has, for the past 50 years, experienced stagnation. Maybe humanity has run out of ideas, or executing them is too difficult. The costs associated with inefficient government regulation and expensive institutional gatekeeping is the Occam's razor explanation for explaining technological stagnation. Examples of overregulation include inefficient taxation, implementation of costly intermediaries, and setting high industrial barriers to entry, all expensive liquidity premiums that individuals must pay in the form of higher taxes, inflation, and interest rates. However, the technological progress associated with Web3 decreases the centralized power of nation-states while enhancing privacy, creativity, and security.

 

Many fear an Orwellian future where a single all-powerful institution controls data unless society decentralizes. After Bitcoin, Web3 emerged, providing capital to the most innovative people in the world with ideas developed outside the control of government regulation. These ideas include unleashing a path to make private information ownership private once again via leveraging the exponentially growing blockchain sector. Via Asymmetric-key encryption, blockchain secures confidential information in the cloud, just like Amazon and Google. Still, the difference is that only private key holders can approve access to personal information. Without relying on third-party data providers, blockchain technology allows people to securely text, transact, upload and store sensitive private information about finance, health, and many other areas.

 

 

Problems with Centralized Computer Systems

Suppose the bitcoin blockchain unleashed decentralized ownership of assets and the 2014 development of Ethereum the power to create fractionalized ownership through smart contracts. The creation of decentralized applications providing users with the ability to store information with absolute privacy might be the key to driving an explosion in blockchain adoption. Storing user data allows for significant innovations like new drug therapies, financial applications, and security products. However, when third-party centralized databases store user data, malicious actors can exploit users.

 

There are two big problems with keeping information central. The first problem is that a central database creates a single attack vector. For example, malicious hackers may create havoc by accessing potentially damaging medical information stored by hospitals about political and business leaders or even everyday people. The second problem with centralized databases is owners sell data without consent to malicious actors. A perfect example of the second problem is when Facebook sold private user information without consent to Cambridge Analytica. The latter firm provided an advantage for the Republican side in the 2016 US election. However, suppose information is stored on a decentralized database instead. Then data is not owned by a single centralized entity, and all communication is encrypted, meaning hackers cannot leverage single attack vectors and no information reveals individuals.

 

 

Benefits of Computer System Decentralization

When a decentralized database executes correctly, everyone owns all information, and the information is encrypted. Blockchain, therefore, solves the central attack and principal agent problems associated with a centralized database. In addition to impacting consumers within nation-states, these costs are also changing how entrepreneurs and institutions allocate time and money to grow the global economy. In 2022,  technology is now at a critical point where supercomputers fit in our hands, remote work is efficient, and users can transact peer-to-peer without banks via cryptocurrency. Blockchain technology has since 2009 benefitted from the unregulated wild-west. However, the stinky New York subway, excessively high energy costs, and the yet-to-be-repeated moon landing by Neil Armstrong exemplify the overall technology stagnation. Nothing describes a 1960 politician better than the following quote by Peter Thiel when presenting to 21st-century politicians at the Omni Hotel technology conference in 2013:

 

"the 1960s politicians promised flying cars, but we got 140 characters on Twitter".

 

The government was not regulating transportation, energy, and biology back when James Watt invented the steam engine in 1775; Benjamin Franklin discovered electricity, and Charles Henri Leroux isolated the molecule behind aspirin in 1829. Following these early inventions, the energy, transportation, and biology sectors remained unregulated. Just like the exponential growth experienced by Internet technology over the past 50 years, industrial sectors' unregulated nature accelerated physical technologies' improvement. Including gas-powered cars, antibiotics, and spaceships during the 19th century; technology not yet invented is impossible to regulate, ask Apple co-founder Steve Jobs.

 

 

 

Contrarian Obsession: Apple

Before Internet became the wild-west of the 1990s, only people with a passion for computer technology had the capacity and will to drive innovation due to a combination of secrecy, complexity and high cost associated with programming early computers. Although US government were in possession of modern computers even before Eisenhower’s Presidency, extensive public computer adoption leading up to the 7 billion people using computers today had to wait until Steve Jobs and Steve Wozniacki decided to launch Apple Inc. in 1976. Out of the two Apple Co-founders, there is no doubt that Steve Wozniacki had the passion for technology and the required computer whiz capacity to program the modern computer before competitors. Wozniacki never Jobs designed both the hardware and software of the early Apple computers. However, Wozniacki’s idea of how to create a programmable machine that follows an exact set of instructions was noting new, but rather just an improved version of the theoretical computer created around three centuries ago by the British polymath and cryptanalyst, Charles Babbitt. Worth noting is that the theoretical computer became the blue print for the first physical computer created by Alan Turing. The technology itself behind Apple was therefore not the separating factor, but rather that was how Steve Jobs imagined people would prefer to interact with computers in the future. After dropping out from Stanford, Jobs enrolled in Calligraphy classes at Reed college in 1972, which is the study of penmanship. At Reed college, Jobs developed a passion for making text look visibly pleasing. Obsession is common to creative people, but obsessing over visually appealing text is not. Interestingly, the first 3 Apple computers were text based just like the computer of their main competitor IBM. As a result, Jobs obsessed over how to design text of the Apple computers interface to outcompete IBM. However, as a true contrarian, Jobs had an epiphany after seeing the graphical Xerox machine, which inspired Jobs wanted to make  graphic rather than text based computers. In the biography about Steve Jobs, the author writes how envisioned a future where all abstraction of text is  replaced with graphical buttons. As a result, Apple perfected the mass development graphics based computers. When both Wi-Fi and battery technology became powerful  enough to hand-held smartphones, Apple was finally able to capitalize on Jobs contrarian passion for graphics to create the world first smartphone without the “blackberry “or physical keyboard. As a result of Jobs contrarian obsession with Graphics, Apple was in the best place to mass produce modern smart phones. The Apple Co-founders obsession is encapsulated  by his famous Stanford commencement speech prior to passing away to early from cancer: “people with passion can change the world”.

 

 

Fusing Passion with Popular

A great question is asking yourself what future area is most likely to attract passionate entrepreneurs and at the same time suffer from untapped potential?  My reply is investing in new areas created by fusing two unique areas to release energy and a product that the public unknowingly needs and desires.  Contrarian obsessionistas combine popular with unpopular ideas to invent both companies and markets by fusing two industries together like blockchain and biology, computer science and finance or retail and technology. A great example is biotech. In the past, biology was an area that in the past was considered untouchable, but spearheaded by people with contrarian obsession like RNA sequence Jennifer Doudna. Merging Doudna’s obsession with technology created an entirely new gene editing space producing over billions of dollars in market value. Great investing is not just how many dollars each current dollar generates in the future, but also the opportunity cost of not using those current dollars today. Great investors may sacrifice future earnings by paying medical treatment for a sick family member or vacationing in geographic areas threatened by climate change.  Perhaps contrary to popular belief, empathetic good people are therefore better investors on average even if their dollar stack may not equal that of investors with a laser focus on growing dollar stacks.  Balancing current with future expenditure is something all humans share in common and to become a great investor in terms of maximizing dollars to increase future purchasing power, the single most important factor is placing capital in areas with huge growth opportunities, which in turn are areas driven by capital owners with a passion. Just like Jobs loved penmanship, the most famous cryptographer in history, Alan Turing, loved mathematical puzzle at a time when those types of puzzles were unpopular. For Alan solving puzzles is like basketball players to score points and  that immediate dopamine feedback that Alan received from successful codebreaking changed world.[5] Although cryptography has always been one of the least favored concentration in mathematics, code breaking becomes super popular with nation states in times of war, which we will describe thoroughly in the history of Cryptography Battles chapter 5.  

 

 

Defining Contrarian Obsession

I agree with Mr. Jobs that the optimal approach for generating higher dollar stacks tomorrow is to invest today in areas where entrepreneurs are likely to demonstrate future passion, but that are also untapped almost like pissing against the wind. Investing in future passion, while also pissing against the wind is what I call contrarian obsession. Entrepreneurs driven by contrarian obsession are not only passionate about the area of innovation and building process, but they also obsess over creating products so supreme and difficult to replicate that their companies become capitalistic monopolies; they love proving people wrong! In addition, if a majority of people believe an idea is bad then the probability of capturing the entire market value generated by executing on that idea increases.  Musk is passionate about climate change and space so he drove electric car and Rocketship innovation, Gates loves automatization so he created the number one computer software company in Microsoft and West obsessed enough over fashion to establish the Yeezy brand. Contrarian obsessionistas needs to eat a whole pie because a slice is just not enough and when the pie has been created they love flipping a bird to the majority. I mean, there is a reason why Gates, Musk and Bezos run into antitrust issues and conflicts with uncle government. The good thing is that products created by these entrepreneurs generates enormous benefits to society! Just like the unlimited possibilities of the early Internet, the unregulated cryptocurrency market is forming the blockchain based Web3.In addition to , cryptography was among the least popular concentrations in mathematics.

 

 

Is Regulation Halting Internet Innovation?

While governments still allow talented developers in computer science to manipulate bytes so that computer software can precisely execute the coded instructions to solve problems like cross-border communication, the Internet in 2020 is no longer the same unconstrained Internet as in the early 1990s.

With AI worries and information harvesting by enemy nation-states, the flipside of a free Internet is software fragmentation, with some governments believing that virtual information is tearing down the virtual equivalents of the Berlin wall that kept East and West Germany separated Despite generating enormous life quality improvement to society by for example expanding access to medical care and information, which has contributed to increasing both the HALE healthy life measure by 8% and global life expectancy by almost 6six years from 66.8 to 73.4 years between the year 2000 and 2019, many experts now believe that the Internet is perhaps becoming a catalyst for deglobalization as freemium based business models have replaced money with information as hard currency. And, like any capitalistic system with profit incentives,  monopolies are often a byproduct as a majority of the hard currency is harvested by owners of superior companies offering superior products, which is why governments historically breaks up big companies like Standard Oil.  However, the difference between centralized and physical technology in energy, transportation and biology,  Internet and now also Blockchain monopolies  reach beyond  the nation state monopolies. I therefore expect that a majority of governments will try to onshore software platforms in response to private user and business information becoming more and more concentrated and harvested with and by a few dominant US internet companies based in Silicon Valley, which in turn creates nation state internet silos. These silos mean internet users in different countries are unable to communicate with each other on the same online platform like in the past 20 years, which may lead to distrust and jealousy between both user and countries across the world. Ultimately, internet silos and software fragmentation will have a real economic impact causing onshoring of physical supply chains, which in combination with money printing will generate fiat inflation like the world has never seen before. In addition to increased likelihood of hyper-inflation, the information contained with these large internet firms may potentially become a method for political leverage against political enemies in other nations. Fiat inflation and hostile leveraging of private user information against our future leaders is to me the greatest threat against humanity and limiting their likelihood should be mankind’s main objective. I firmly believe that decentralized blockchain technology the solution to software fragmentation because in a decentralized world people will act more honestly as less monopoly pressure points targeted for political leverage will exist. I therefore think that the Ethereum Merge is a great step in the right/decentralized direction and thus one of the most important events in human history if successful. And in 100 years, the largest consequence resulting from the Information Age revolution dating back to today is not going to be within Blockchain or Internet technology, but how freedom creates the capacity to innovate physical stuff across the transportation, energy and biology sectors. Although computers are replacing much of the physical economy with software, the Web3 plumbing system will distribute both capital and information via Blockchain and Internet pipes to the next generation of innovators within atoms, genes and energy.

 

 

 

The Information Age and Beyond

To unleash human potential, incentives across all individuals in our human network must be aligned to prevent powerful centralized rent seekers and corrupt politicians from achieving personal gain by division. Our political system must balance centralization with decentralization to be both nimble and agnostic. Sometimes quick decisions without a democratic process is needed, but a majority of time a system benefits from relying on predetermined equal weight principles democratically and transparently agreed upon in advance including free access to information and meritocratic access to capital as well as equal access to both genetic enhancement and renewable energy.

Step 1  Internet Inspiration – free access to information

 

The Golden Age of Computing

Nothing describes the exponential advances in  computing power experienced between 1975 to 2022 better than comparing the dimensions of the iPhone 14 to the first personal computer by reading the headline of a 1975 New York Times article describing the world’s first home computer, “I.B.M. Corp. Introduces A 50 pound computer” [6]. In addition to the first home computer weighing more than 22kg, the cheapest price of the I.B.M. 5100 computer was 10,000$, which came with a luxurious 16kb storage capacity and an incredible 10 cm screen. In return for paying just 55,000$ in today’s dollar, nerds in 1975 could therefore purchase computers weighting almost 100x more and containing less than 8 million times the storage space with about the same screen since as the standard 200g and 128gb iPhone 14. Scientists were able to go from computers with storage capacity to save 2600 words in 16kb to supercomputers that without problems store movies, albums and spreadsheets, but at the same fits in our pockets in just 50 years,. From a computer weight perspective that is like shrinking the average 70kg human being to a female guinea pig and in storage capacity terms about the difference between the mass of the same 70kg human and earth. 

 

The Mother of All Demos

Prior IBM’s successful home computer launch in 1975,  Steve Jobs and Apple had already failed  to launch Lisa, which was Apple’s first version of  the home computer and named after Steve’s daughter Lisa. However, before Apple and IBM  began mass producing computers,  both computers and the Internet had been around for around 25 years, but only for specialists like the Stanford researcher Douglas Engelbart who is known for showing of the first computer mouse in a 1968 YouTube video called, “The Mother of All Demos”[7]. In podcast on Spotify with host Joe Rogan the summer of 2022, the founder of the first computer gooey Mosaic and now VC entrepreneur, Marc Andreessen, describes how the early Internet consisted of just 4 computers in the beginning, but that these early computers had capacity to both send electronic messages and offer videogames of similar quality to publicly famous games developed in the 1970s like  Pong and Asteroids. Interestingly, Marc refers to the early Internet as nodes similar to how peer to peer blockchain technology like Bitcoin describes the user responsible for Bitcoin network. security.  One of these early Internet computers happened to also be operated by Douglas Engelbart who was able to produce work thanks to US government military spending from the Darpa program.

 

Yes, the US Government Invented Internet

If computing progress by Douglas and other academic research activities funded by Darpa was foundational for creating effective Internet protocols like TCP/IP and HTTP to drive Internet adoption on the back-end, then the most fundamental invention for Internet adoption on the front-end was the merge between symbolic and text based communication system. Unlike language development in the real world, computers started as a text based system rather than an interface with symbols and emojis representing file storage, web browsers and applications known on iPhones today. The driving factor of Internet adoption is arguably Apple’s invention of the computer interface gooey, which abstracted away complications associated with text based computing. However, in language development people communicated first via symbolic writing like Egyptian hieroglyphs and to later invent the full-writing system, which was a protocol likely developed in Mesopotamia around 3400 BC. Writing systems based on merging text with symbols built on top of the Internet now allows humanity to securely store and swiftly share information so that smart individuals can leverage historical inventions and information to improve society.

 

 

Education Began the Industrial Revolution

The idea to use the past to improve the future via quicker spread and improved storage of information is why Johannes Gutenberg’s printing press invention was such an accelerating invention for the Industrial Age, as scaling the text system allowed for human ingenuity increase by a 10x  speed, which was the speed that information could now be copied and spread around the world[2]. The advancement of computer hardware, Internet software and now blockchain technology is simply the printing press on steroids. With the printing press, only institutions could afford to distribute information at scale. For the entire 20th century, large news outlets, book companies and academic institutions were therefore almost entirely responsible for global information consumption. If inventors, academics or authors shared unpopular ideas not shared by gatekeeping institutions those ideas were not distributed widely to the public. Also, physical books and newspapers are expensive so they are not distributed to poor areas in the world, which are parts with untapped potential. However, with internet bloggers, content creators and financial analysts may share their views peer to peer over the world wide web, which means information that can be accessed anywhere in the world by anyone holding access to a smart phone or computer. Basically, the internet is a platform used to share and distribute information for educational purposes so that anyone with smart ideas may raise capital and build a new cool company to help humanity move forward

 

Information Disruption was Invented in the 1970s

People often argue that social media companies is disrupting traditional media, but the real Internet disruptor is the facilitation peer to peer communication via the sophisticated plumbing system behind the Internet carefully developed over the last 30 years of the second millennium not platforms built on top of the Internet. The most important pipes of this virtual plumbing system were Internet protocols like the 1971 FTP, 1977 TCP/IP and finally the 1992 HTTP. The TCP/IP protocol was the first Internet protocol simplifying how to share information between two computers. If only two computers exist in the world TCP/IP stinks, but if there are 1 billion computers in the world that are all leveraging the TCP/IP protocol, then the TCP/IP protocol has reached the critical mass adoption where alternative replacements becomes too costly to implement. Just like steel companies use public roads to ship steel for profit, giant technology companies like Facebook, Amazon and Google leverage foundational Internet protocols to create software applications for profit.  And like roads or the NYC subway system , these three inventions remain foundational for the Internet today, which demonstrates the resistance of these early Internet protocol pipes despite better alternatives. However,  if the software application created by Big Tech can be replaced by blockchain pipes, then ownership of these application can become decentralized and public just like the early internet protocols.

 

 

Step 2 – Blockchain – meritocratic access to capital

 

My Expertise

As stated in the prologue, my first introduction to blockchain technology was meeting Vandy’s Bitcoin king in 2012 and it took me five years to overcome the misconception of  associating blockchain with Bitcoin still common in 2022 when blockchain technology is simply just one of the four revolutionary components to Bitcoin. Since 2017, I have spent over 6 years trading, reading, writing, videoing and living cryptocurrencies, while at the same time working full time at the largest Quantitative hedge fund in the Nordics. I graduated with a master’s degree in mathematical finance and economics   To fully understanding all concepts in this book without willingness to leverage internet for certain concepts is not easy. The fact is that blockchain technology by itself is complex because the underpinning technology is a mix of cryptography, game theory and economic incentives central bankers contradict themselves by stating that central bank digital currencies will balance privacy with anonymity. If you are familiar with Marvel movies like Thor, Ironman and Captain America, then you know that the Marvel Franchise follows a multiverse none-chronological timeline to unleash creativity, which ultimately captivates the audience and thus generates a continuous stream of blockbusters. Like Marvel, our story is not going to be chronological. Instead, our exploration will jump from key historical contributions to a future with endless opportunities, but now let’s get back On-Chain!

 

Believing the Chain

Before launching the computer, the IBM founder Thomas Watson SR was once quoted saying there is no need for more than 5 computers in the world split between US defense, civilian use and the remaining three for insurance purposes. In Journal of Cryptography, the first public description of blockchain technology was published as method to time stamp digital assets in a paper by cryptographers Stuart Haber and Scott Stornetta in 1991. Among uninitiated, Bitcoin is often confused for blockchain to mean the same thing and vice versa, but the 1991 blockchain paper by Haber and Stornetta proves why Bitcoin and blockchain is related but also totally different. Just like a car needs an engine and gas to operate Bitcoin needs blockchain and electricity, while blockchains like motor engines can operate independently of Bitcoin and cars. Blockchain is a new type of technology used to ensure the integrity of data storage recording transactions between blockchain users both with or without central authority, while the 2009 Bitcoin launch was the first widely adopted blockchain based digital asset by the public and we will expand on how both Bitcoin and blockchain technology operates in chapter 2. Like all previous technologies in history, new technology needs to reach a critical mass before adoption resiliency[8] and the best analogy for blockchain based protocol adoption like Bitcoin and Ethereum is therefore early Internet protocols like TCP, I and HTTP, which like blockchain are concepts expanded upon in chapter 2.

 

 

Adding Resource Allocation to the Internet Equation

Internet is an excellent tool to distribute information without relying gatekeepers like newspapers, corporations, governments and universities, but the Internet also needs self-sufficient method to efficiently provide capital to those individuals that can use acquired information to start businesses. In the Internet world, financial decision power over final capital allocation decisions remains centralized, which means that a few key players basically hold monopoly power over what ideas to be funded and executed upon by entrepreneurs and startups, which means our society has yet to unleash our true human potential. However, in a blockchain based economy, capital access is democratized like internet democratized access to information.  Although technology has vastly improved our societies financial capabilities over the past 30 years including transaction speed and lowering costs, our financial institutions remain centralized and there is lots of friction when transacting between different jurisdictions. In a world where millions of transactions occur daily these financial institutions therefore accumulate wealth through transaction fees, which creates outsized profit and power compared to value created for a few key institutions in our society.  These financial institutions then use the money that they accumulate to increase salaries, distribute to shareholders or to invest in startups so that they can generate even more money in the future. Blockchain and cryptography can create the same level of security for financial transactions as a bank without paying a salary to anyone to monitor that transaction. Instead the blockchain itself is responsible for keeping a record on who buys what from who.

 

Why Blockchains will Distribute Capital

Blockchain will potentially expand capital access to populations that are currently unbanked similar to how internet provided access to information to people without education. Drawing from a larger talent pool increases the likelihood of innovation leading to  increasing productivity and accelerate economic growth, which ultimately expands life quality.  Blockchain is part of  the distributed ledger based technology (DLT) family and firms may leverage blockchains to improve internal communication and information both from a storage and distribution perspective without depending on cryptocurrencies like dogecoin or Bored Ape NFTs. Like most technologies, there is no one size fits all market participants blockchain. Developers of cryptocurrencies and other DLT based technology must therefore balance risk-rewards associated leveraging different blockchain types, settlement finalities, transaction speeds, scalability, contestability, environmental impact and security. Governments generally prefer blockchain types that are permissioned based rather than permissionless (decentralized) and environmentally friendly, while libertarians are willing to marginally sacrifice the environment if that sacrifice provides a more censorship resistant and private blockchain. Unlike central databases, DLTs unlocks a potential to disintermediate markets and improving via reducing costs, increasing speed, creating transparency and improving security. Underpinning blockchains is the so called consensus mechanism, the blockchain equivalent of a soccer referee, that leverage transparent pre-agreed upon software code to ensure that individual blockchains are consistent, honest, accurate and updated. Although I prefer blockchains that leverage decentralization, monopoly consensus mechanisms exist for private blockchains like BFTi and pBFT or Big Tech consensus mechanisms like Facebooks DiemBFT[9], which is preferred sometimes. For example, hedge funds often depend on intellectual property (IP) like investment algorithms to profit in financial markets and all that IP must remain hidden from the public because otherwise other hedge funds could just copy the secrete sauce. Although many various types of consensus mechanisms exist, the first and biggest consensus mechanism is the decentralized proof of work PoW algorithm leveraged by Bitcoin and second is the Proof of Stake algorithm used by Ethereum and most other well-known alternative cryptocurrencies like Solana, Near and Avalanche. In addition to BFTi, pBFT, DiemBFT, PoW, PoS and DPoS the are less well-known consensus mechanisms like proof of elapsed time PoET, which is a privately developed consensus mechanism that aims to prevent energy consumption and excessive resource utilization. For libertarians blockchain creates are fairer meritocratic world via consensus mechanisms rather than  they consider easily corrupted central authorities.

 

Before Bitcoin

All cryptocurrencies must solve the holy trilemma of scalability, security and decentralization. Ultimately, the market will decide the optimal blockchain. The two main consensus mechanisms are PoW and PoS. A big difference between PoW and PoS is that the “race” in PoS is much shorter. In fact, the PoS race is so easy that one modern smart phone can solve the problem. Many coins start with PoW and when the network grows large, the coin moves too PoS. That is because with a larger network there is more decentralization, which makes it more difficult for participants to collude and cheat the system. The main issue with PoW is that it takes a lot of energy to solve the puzzles, which is bad for climate change. There should however be a switch to renewable energy, but that will only be done by miners if there is an incentive/cheaper to do. What did happen as well with PoW is that ETH and BTC miners could earn so much that its incentivized growth in faster computing and hardware. In PoS, the miners invest in the native coins so that they can stake more and have a higher chance of solving the block puzzle. That means switching too PoS should increase the price of coins as demand increases. Finally, if you do not want to be a validator under PoS, you can use your voting power to delegate it to someone that is a validator. In this case, no special equipment or knowledge is needed. If above confuses you, don’t worry! In Chapter two, we will dig deeper into blockchain technology by analyzing the four revolutionary components leveraged to create Bitcoin.

 

Network Protocol Evolution and City Example

Although the world wide web distributes information globally circumventing traditional gatekeepers like newspapers, corporations, governments and universities, the Internet needs a method to efficiently provide capital to those individuals that can use acquired information to start businesses. Even with the internet, capital allocation remains centralized with a few key players basically holding monopoly power over the ideas being executed by entrepreneurs and startups, which means our society has yet to unleash our true human potential. However, in a blockchain based economy, capital access is democratized like internet democratized access to information. Although technology has vastly improved our societies financial capabilities over the past 30 years including transaction speed and lowering costs, our financial institutions remain centralized and there is lots of friction when transacting between different jurisdictions. In a world where millions of transactions occur daily these financial institutions therefore accumulate wealth through transaction fees, which creates outsized profit and power compared to value created for a few key institutions in our society.  These financial institutions then use the money that they accumulate to increase salaries, distribute to shareholders or to invest in startups so that they can generate even more money in the future. Blockchain and cryptography can create the same level of security for financial transactions as a bank without paying a salary to anyone to monitor that transaction. Instead the blockchain itself is responsible for keeping a record on who buys what from who.The best metaphor for explaining the evolution of virtual network protocols is starting a society on a plot of land. The first step is to settle on land with optimal initial conditions to scale a society. These optimal conditions are provided by geography protocols like the water protocol. When water supply is secure, society can  investment in new society protocols like roads and buildings, which transforms society over time from a plot of land containing good initial conditions to a city with 10 million people and sky scrapers. However, irrespectively of city size, the water protocol will remain foundational because humans need water. Note that for information sharing purposes, the email protocol may be the water equivalent to scale Internet, while the Proof of Work consensus mechanism may for security reasons be the water equivalent to grow a Blockchain network. With further capital investments, new important hard to replace society protocols  like a subway system emerge. For example, New York was a revolutionary transportation method for large cities in 1904. In 2022, NYC subway system remains resilient as New York has reached the number of good enough society protocols besides the subway system to reach the critical mass to always be city. NYC will simply survive as a city even if other cities have better infrastructure protocols. Just like the 1904 NYC subway system remains resilient to alternative city transportation systems, some of the early Internet and Blockchain protocols will remain resilient.

 

Step 3 – Equal Access to Genetic Enhancement

 

What Efficient Information Distribution Resource Allocation Will Unleash In the Future: Biology

The Internet and blockchain are networks that efficiently distribute knowledge and capital to untapped areas of the world, while biotechnology enhances the untapped potential of every individual. Access to untapped genetic potential must be distributed on an equal basis as all people being equal is a core tenant of mankind. Pursuing biotech research that widens both wealth and genetic inequality is extremely dangerous even if that research may eradicate disease, remove undesired traits and increase IQ.

However, gene-editing technology is here to stay and if only autocratic countries pursue gene-editing technology, then democracies are in danger. Besides staying ahead of potential enemy threats, genetics plays a huge part in determining the pursuits of a person. Pursuits are generally motivated by some sort of gratification like glory, money, love or passion. Upbringing in combination with genetic ability are the two most significant influencers to our pursuits.  For example, if you are over 215 cm tall, the likelihood of you playing in the NBA is almost 20%. If you also have an IQ crossing a certain threshold, however, that might decrease the basketball pursuit in favor of pursuing theoretical physics because that is what may motivate people with higher intelligence to enjoy doing all else equal. Although IQ and height are not pure functions of genetics as poor training or nutrition may impact both of these qualities, IQ and height remains an important determinant for a person’s future pursuits. For all of us short basketball players adding 10 cm so that we can be taller than our peers and therefore more likely to become NBA players makes sense, but if everyone becomes 10cm taller than the genetic increase doesn’t really matter. Unlike height, IQ is not relative. If all people become more intelligent, then the world is likely a better place all else equal. With smarter people, new ideas are developed which in turn grows the economy and improves life for everyone. With synthetic biology and genetic research, a world where everyone is smarter and disease free is a possible future. Unlocking the genetic potential of future generations will most likely help our world move one step closer to the singularity.

 

Step 4 – Unlimited Energy

 

What Efficient Information Distribution Resource Allocation Will Unleash In the Future: Energy

Energy on earth is abundant, but our method to extract that energy is unsustainably impacting the environment and therefore an existential threat to humanity. Currently, our economy is powered by oil, which is a highly polluting approach to harvest energy. Changing from oil to renewable energies like wind and solar or dangerous but efficient nuclear power can decrease humanity’s carbon footprint and perhaps save the world. Leading scientists worry that climate change is behind increases in both temperatures and natural disasters making earth uninhabitable in the future. However, humanity has shown time and again throughout history that collective human imagination and teamwork can develop tools to prevent man-made disasters. Eighteenth century economist Thomas Malthus believed that providing food for a geometrically growing population was impossible in the 21st century, but thanks to farming technology improvements, Malthus' end of the world theory was proven wrong! Like food production, humanity must invent new technology to more efficiently harvest energy to create a sustainable future. I believe that with further advancements in web3, blockchain technology and genetic research, entrepreneurs and scientists will invent humanity out of a climate catastrophe. For example, blockchain technology like bitcoin provides a foundation for developing meritocratic allocation of resources so that top entrepreneurs’ may be invariant to location and who they know to instead receive capital based purely on creating companies necessary for executing on humanity’s greatest ideas. In addition to creating a network that democratically allocates resources, mining bitcoins is less expensive using solar than oil power. Potentially increasing mining profitability therefore incentives firms to build solar farms in otherwise unproductive areas of earth to mine bitcoin. For example, Block and Tesla led by Musk and Dorsey have already developed a prototype for mining bitcoin using solar power in Texas. Blockchain will therefore expand energy extraction using renewable energy sources. At the moment, solar and wind power in combination with nuclear fission is by far the lowest hanging fruit to solve current energy dependencies and marginal advancements are guaranteed. Although improving sustainable energy technology is the easiest path forward to prevent climate change, further advancements in energy harvesting like fusion power may save earth and make both humanity interplanetary and digital. Applied methods for harvesting fusion energy are currently under development. Unlike fusion’s distant nuclear fission cousin, which releases energy by splitting atoms, fusion generates energy to power tools by smacking atoms together like two cars colliding.  What makes fusion preferable to fission is that after energy has been created there is no polluting radioactive material that needs secure storage for hundreds of years. Creating fusion reactions by crashing cars is relatively easy, but manipulating energy generated by a car collision is difficult. In an interview with the All in Podcast lead by Jason, Chamath, David , Elon stated that the sun is a great example of a fusion reactor and that using solar power is most likely the efficient approach to harvest energy in future. However, although Elon believes in Solar, he is in the spaceship building business and spaceship fueled by fusion is a dream for any science fiction nerd. Not surprisingly, Elon has therefore created the world’s first AI powered tokamak fusion reactor to generate fusion energy. Like me, Elon imagines a world where humanity may be manipulating the power of the sun. With fusion power, humanity would be able to create high tech spaceships for interplanetary travel.

By leveraging untapped genetic and energetic potential in combination with meritocratic and free access to capital and information, humanity is on a path to climb the Darwinian ladder.

1.     Internet distributes information and expands knowledge

2.     Blockchains are global immutable decentralized power structures for accessing capital

3.     Biotechnology provides humanity with access untapped genetic potential

4.      Renewable energy allows movement at a friction of current costs

 

Similarities between Early Internet and Blockchain

Internet and Blockchain protocols are accelerating the Information Age revolution to unleash innovation across transportation, energy and biology. To overcome extinction threats like climate change, nuclear catastrophes or hyperinflation, nation-states must increase economic incentives to improve infrastructure via decreasing regulation to attract the next generating of resource allocators and  innovators. However, the real spark for turning Industrialization into historical footnotes are all the marginal contributions derived from the historical battle between code breakers and cryptographers inspiring the creation of the Turing computing machine, which in practice demonstrated how a few scientists through merging in-depth knowledge of cryptographic mathematics and computing power can destroy the military communication network of the most powerful nation-states in the world like Germany in WW2. Today, the Internet and Blockchain power asymmetry harvested via domestication of bytes, software and computers continues to decrease the effectiveness of traditional nation state violence, while promoting both competition between nation-states and incentivizing the creative genius of individuals to invent new versions of the Turing Machine like Bitcoin and Ethereum, which ultimately transfers power over resource allocation, economic productivity and money from Governments to Sovereign Individuals.

 

Revolutions in History

Just like the Hunter Gathering Age ended with grain domestication to spark the agricultural revolution 12,000 years ago, engineers started technology domestication sparked the industrial revolution somewhere between 500 to 150 years ago. Technology scaled the human capacity for productivity via inventions like the printing press and steam engine, which expanded  literacy rates beyond the tipping point needed to eliminate a monopoly on information held by the catholic church and generated unparalleled economic growth. Back in year 2000, the future of Internet, similar to blockchain and cryptocurrencies in 2022, was a hotly debated topic with some believing that Internet was revolutionary, while others predicting that Internet was just a passing fad. Among people forecasting that Internet was a fad, were more mature technology entrepreneurs and billionaires like Microsoft founder Bill Gates whom per the 2005 Danish book, communication replaces transport, was quoted publicly stating while attending the annual Comex trading event in 1994 that Internet lacked commercial opportunity in the next 10 years. In addition to the comments at the Comex event, Gates famously stated in his unrevised version of his 1995 biography, The Road Ahead, that applications built on top of the Internet would fail to lure consumers to the world wide web. Keep in mind that as founder of Microsoft, Bill Gates was the equivalent of Elon Musk in the 1990s so his public words carried weight.

 

 

Ahead of Time does Not Always Mean Always

Among people that believed Internet was revolutionary back in the 1990s, were often young entrepreneurs like Peter Thiel inspired by futuristic science fiction novels like Neal Stephenson’s, Diamond Age, and educational non-fiction books such as, The Sovereign Individual, authored by futurist James Dale Davidson & British journalist William Reese-Moog. These entrepreneurs believed that Internet presented an opportunity to revolutionize the world via leveraging Internet application software to increase economic productivity similar to how machines like the steam engine accelerated productivity during the 19th century Industrial revolution. Note that some of the people believing in the Internet revolution were certainly also afraid of how the centralization of technology may lead to government surveillance abuse resulting from Internet technology and I will talk more about the dystopian fear of centralized technology like AI later on in the book. However, just when Gates revised his bearish views of Internet to become bullish instead, the dotcom bubble burst. Luckily for Gates, Microsoft was during the time of the dotcom crisis a more mature technology firm with recurring revenue and therefore outperformed stock market peers during the dotcom bust by approximately 25%. by only decreasing -53% from peak valuation, as the cumulative drawdown from peak to valley for the premier technology stock index, Nasdaq, was -78%.  Note that later on in this book we shall investigate how similar the drawdown and shakeout of Internet stock is to the drawdown and shakeout of Blockchain assets. But with an explosion like adoption after the dotcom Armageddon, Internet’s user base grew massively by shaking off all the dead weight from fraudulent now bankrupt Internet companies.

 

But Sometimes it Does

Prior to the millennial shift around 0 people owned smartphones, while over 7 billion people use Internet on smartphones almost on a daily basis in 2022. Although the actual start date of the Information Age revolution is not yet set in stone, one can argue the date to be set prior to the turn of the second and third millennium and perhaps as early as the Turing machine invention to defeat Enigma in WW2 in the 1940s because the Turing machine provided a small group of people with the allies to intercept the messages between Germany’s leadership and the Navy Generals in charge of the powerful German U-boats. Following WW2, Internet and computer technology advanced rather slowly for 30 years in secrecy by US military, but after public revelations by academia in the mid 1960s, the likelihood of a secular Information Age revolution exponentially expanded as foundational Internet protocols like TCP, IP were created in the 1970s to support the first Apple and IBM computers. I therefore argue that society by 1970 already had transitioned to the  Information Age rather than remaining in the nation-state confines of the Industrial Age. In 2022, smartphones with online connections is  generally considered a necessity like food, energy and family, which decreases the importance of physical borders, which in turn diminished the power of the Industrialized nation-states.

 

Network Protocol Evolution: City Example

The best metaphor for explaining the evolution of virtual network protocols is starting a society on a plot of land. The first step is to settle on land with optimal initial conditions to scale a society. These optimal conditions are provided by geography protocols like the water protocol. When water supply is secure, society can  investment in new society protocols like roads and buildings, which transforms society over time from a plot of land containing good initial conditions to a city with 10 million people and sky scrapers. However, irrespectively of city size, the water protocol will remain foundational because humans need water. Note that for information sharing purposes, the email protocol may be the water equivalent to scale Internet, while the Proof of Work consensus mechanism may for security reasons be the water equivalent to grow a Blockchain network. With further capital investments, new important hard to replace society protocols  like a subway system emerge. For example, New York was a revolutionary transportation method for large cities in 1904. In 2022, NYC subway system remains resilient as New York has reached the number of good enough society protocols besides the subway system to reach the critical mass to always be city. NYC will simply survive as a city even if other cities have better infrastructure protocols. Just like the 1904 NYC subway system remains resilient to alternative city transportation systems, some of the early Internet and Blockchain protocols will remain resilient.

 

 

Nation States and Geography

When Tim Marshall wrote the book Prisoners of Geography outlining the geographic importance of nation-state success, he hinted at the possibility that technology might overcome some economic challenges caused by geography. Perhaps the technology that Tim was subconsciously describing is a combination of Internet and Blockchain to create virtual trustless economies, but despite advances in technology, the geography of physical borders surrounding individual nation-states remains significant during the Information Age transition period, which is why geography and the corresponding abundance of natural resources remains a great predictor of future potential of geopolitical conflicts between nation-states. Although Russia claimed the previously Ukrainian peninsular Crimea in 2014, Tim describes in his 2015 book how the land between Moscow and Kiev is flatland lacking beneficial borders and why the lack of beneficial geography explains why Russia would further invade Ukraine later on, which could be used as an argument against NATO expansion. In addition to serving as defense mechanisms against future military assault and although abundance of natural resources can both prevent and cause future economic recessions, beneficial nation-state geography generally strengthens government control internally. The broken supply chains, record levels of inflation and geopolitical instabilities of the world in 2022 are, as Tim states in prisoners of geography,  derivatives from how geographic location corresponds with nation-state state capacity to leverage violence. Although the 2022 market instability is partly an exogenous function of geography, political leaders in both democracies and autocracies are practically incentivized to treat economic issues as an endogenous disease cured by conducting radical fiscal and monetary policy to remain in power like heroin addicts looking for smack instead of solving problems by weaning of the stimulus addiction. In our current centralized system, poor geographic location leads to suboptimal economic policy decisions by sovereign nations and therefore predictably increases the likelihood of a more severe economic crash. As predicted by legendary author and futurist George Orwell’s hall of fame science fiction novel, 1984, which outlines a dystopic future involving excessive leveraging of government surveillance to control the population, people in the west and above all else China are awakening and is finally questioning the purpose of all this data collected from our digital foot prints by governments. If abuse of  that data collection comes to light, then software fragmentation can occur both within and between nation-states.The distrust online may cause software fragmentation and if so also impacting the real economy by slowing down of supply chains. Perhaps global nation-state distrust is actually the main reason for record high global inflation in 2022.

 

 

 

What is Real and What is Not Online

In addition to government surveillance,  hot topics like social media, hate speech and banking are now frequently discussed on virtual chat boards and even distributed widely by traditional news media using a unempathetic disrespectful tone. I would not be surprised if you agree the tone is almost equivalent shouting in someone ear without considering the tinnitus experienced by that other person. Sometimes Internet users are hiding behind anonymous identities, and in later chapters we discuss how blockchain may keep identities anonymous, but still bring consequences to those who misbehaves. However, the fundamental problem is that the vast network connectivity in the Information Era magnifies differences. The key fact here is that people being different is actual a good thing! The problem with a centrally planned internet is that the idea of one size fits held dearly by the nation-state based industrialization model does not work in the Information Age. Especially, since  bit, algorithm and Internet based computing technology is expanding faster than what our brains can handle through education of that technology. In addition to creating social fragmentation and tribalism, the exponential growth of technology in 2022 translates to a more complex and interconnected global economy. When ideas flow freely across a number of information streams over the Internet rather than via traditional media outlets, population cultures and ideologies between different nation-states becomes apparent. These differences create cooperation difficulties between government institutions like Central Banks, Congress and Presidents across nation-state borders, which makes cooperation super complex to understand all individual components needed to regulate the  global economy. For example, many developing countries are have in earlier year borrowed US dollars to fund infrastructure projects, and if the US dollars strengthens over 30% like it has done against other currencies like SEK or GBP during 2022, then developing countries goes bankrupt as debt payments for these countries increase proportionally at 30% with the US dollars, which means that the FED hiking rates impact not just US anymore but the global economy. The full complexity of the 2022 economy also means that people like you and I are unable to comprehend who, what or if no one is responsible for the disastrous 2022 numbers like the 8.4% inflation tax on US consumers, tens of thousands dying in a pointless war between Russia and Ukraine, 7.0% mortgage rates and the -23% drop in S&P 500.

 

 

What Does Volvo and Seatbelts Share in Common With Open Source Technology

Although Volvo was originally a Swedish car brand, consumers in most nation-states independently choose drive Volvo mainly because of the security reputation. Volvo cars not only revolutionized the car industry by lowering traffic deaths through both introducing and not filing a seatbelt patent in 1959, but the Swedish car company simultaneously also identified the power of open source technology to generate future profits. Open source follows the idea that innovation creates optionality to profit from future innovations, which is a mantra generating  21st century Silicon Valley billionaires at a pace only matched by the French growing grapes for the technology and wine industry respectively. Logically, seatbelts use has drastically decreased risks associated with driving a car. If vehicles are safer, then more people are likely to spend money on car purchases. More money expands market value and fattens profit margins for Volvo cars, which ultimately rewards the Volvo shareholders. In addition to benefiting those willing to risk money by investing in Volvo, a higher market value all else equal increase the car industry capacity to attract more sophisticated engineers that require higher wages to specialize on developing and improving cars like creating more fuel efficient engines rather than applying their engineering skills in another field.

 

So, if you knew the world benefit of Volvo cars not patenting seatbelts, but nothing else about Volvo cars future prospects, and was given the opportunity to support Volvo cars with any amount of money above 0 in 1958 knowing that you will never see a dime of that support money again, would you support Volvo?

 

Yes or No?

 

If Yes - then you either believe in open source products and that Volvo is a firm with capacity to harvest some of the extra yields generated from expanding the total car industry market value or you are perhaps just an altruistic person.

 

If No - then either you are the Joker who enjoys watching the world burn or you are a capitalist that believes in the fundamental right to earn profits from taking risks. If you are a capitalist and you knew Volvo would invent the seat belt before everyone else, then you would likely have invested in Volvo shares rather just support Volvo because even if Volvo never files a seat belt patent, the expected value of Volvo car shares is likely greater than 0 with seatbelt introduction expanding the total market value of the car industry. What I am trying to say with above is that most  of us would in hindsight support Volvo monetarily even if Volvo goes bankrupt, as the value of not patenting seatbelts lives on forever.

 

Now, let’s repeat the Volvo example by replacing Volvo with a piece of software technology that could have the same potential impact on the world as the steam engine. Again, would you support or at least invest in an internet steam engine knowing at least that others believe in the potential benefits to the world of this new software? Probably not with 99% certainty!  Of the three uninformed answers for not owning bitcoin, I dislike the volatility and environment argument and I will let you know why later in the book, but the crime argument holds merit. One of the most common misconception of people only reading gifs, memes and headlines. The thing is that the criminal community will always prefer fiat over crypto, and also 100% use both cryptographic communication and currency transfer money independently if bitcoin is legal or not. Drug dealers never stopped dealing drugs and gay people never stopped having sex because it was illegal. Not surprisingly, the US government legalized gay marriage and will soon also legalize weed, which is the most popular federal drug for consumption in US.

 

 

Follow up Teaser: Seatbelts vs Bitcoin

The lack of knowing the full scope or at least admitting to not knowing the cause and effects of the more complex Information Age economy by government institutions is breaking down trust both within and between nations-state. The world needs a solution to overcome challenges presented by the Information Age and I think that the best solution is to leverage open source blockchain to create on-chain trust, enforce cooperation via economic incentives and negate unintended negative side-effects of regulation by an uneducated government. Although nation-state governments will remain in the Information Age, some government powers must shift to individuals by leveraging a combination of blockchain and internet technology to bring back the perception of freedom again. Prior to sitting down for a roller coaster journey describing how overcome challenges brought on by the Information Age via analyzing the historical evolution of the components making up blockchain technology including inventions in cryptography, economics, computer-science and mathematics over a period spanning 3 millenniums to emerge in 2009, I require that you first ask yourself these following six questions about seat belts and then the same 6 question about Bitcoin and then I will tell you my answers. Vitalik made

 

The Seatbelt Questions

1. How many people do know that currently wears seat belts when driving?

2. What are some reasons for why or why not they wear seat belts or do they even explain?

3. Have you spent time researching seat belts outside of what your mom told you?  

4. Do your feel that your friends know the difference between cars and seat belts?

5. Did you ever learn how to put on a seat belt in school?

6. Was Volvo’s choice to open source/not patent the seat belt in 1959 inspired by good?

 

My Seatbelt Answers

Question 1)

In conjunction with Michigan implementing the mandatory seat belt law in 1985, historical research outlined in a 2020 history channel by David Roos showed that only 14% of adults in Michigan regularly wore seat belts in cars during 1980s, which was according to the history channel [10]. Some drivers did not like seat belt laws very much and therefore used the 1980s twitter equivalent tools of posting physical mail to local politicians in Michigan comparing the introduction of mandatory seat belt law rules imposed by Hitler. Note that Michigan’s seat belt law was introduced more than 12 years after the US government required all new cars to have seat belts in their cars. In 2022, only 90% of US drivers wear seat belts,  but the people not wearing seat belts are a dying breed. Meanwhile, seat belts are still not mandatory to wear in the lone state of New Hampshire.

 

Question 2)

The main reason for not wearing seat belts is laziness or some idiotic response like “if I do not wear a seat belt, I drive better and that sad part is that we all have that friend. Back in 1980 Michigan a common reason for not wearing a seat belt was the restrictive nature around the neck area. I think Darwin took care of those people.

 

 

Question 3)

I cannot answer for you, but my mom and dad printed the seat belt thing into my brain. Whenever opening a car door, I can almost hear my mom and dad whisper “put on you soon seat belt” in my ear.

 

Question 4)

The car was invented prior to the seat belt, which made people think that seat belts were different from cars when mandatory laws to wear seat belts were introduced. If the car and seat belt feature were invented simultaneously, I think seat belts would have been adopted immediately. However, after 60 years of Darwin, I think the majority understands why no car today is produced without seat belts, while simultaneously understanding that a seat belt is an independent feature complimenting a great car, but 30 years ago in Michigan that line of logic about seat belts and cars was not entirely clear.

 

 

Question 5)

 If only 14% of people used seat belts when driving cars, I think that schools need to teach the benefits of seatbelts. However, if 90% drivers wear seat belts, then teaching seat belt classes is unnecessary. However, I was never educated on seat belts in school.

 

Question 6)

 Yes, I think that Volvo’s management were inspired by good by realizing  how many lives wearing seat belts would save society if seat belts were introduced to all cars. Greedy profit incentives resulting from safer cars was secondary.

 

 

For most of us seat belts are objectively important and we know the difference between a car feature of like seat belts and car itself,  but now  I require you to ask the same six question  about bitcoin and Blockchain. For me, Bitcoin needs Blockchain the same way as seat belts needs cars to be effective. I also think that Bitcoin, Blockchain, Cars and Seat belts all have important independent features from another that inspire economic growth and security in society. However, differences exist so let’s investigate them by answering the questions below:

 

 

Bitcoin Questions

1. How many people do know that currently or in the past own bitcoin?

2. What are some reasons for why or why they do not hold bitcoin or do they even explain?

3. Have you spent time researching Bitcoin and blockchain outside of gifs, memes and headlines?  

4. Do your feel that your friends know the difference between blockchain and bitcoin?

5. Did you ever learn about Cryptography in school?

6. Was Satoshi’s choice to open source/not patent Bitcoin in 2008 inspired by good?

 

My Bitcoin Answers

 

Question 1)

 If above was rephrased to state “how much of the world population hold bitcoin?”, then the first answer on search engines in countries with Internet and ownership of cryptocurrency freedoms will answer that approximately 1% or around 100 million out of the 10 billion global population own more than 0 bitcoins.

 

Question 2)

In US, 9 of 10 people are Blockchain aware so if Americans were asked to answer question number 2), then I promise you that those in the 1% of population owning bitcoin will provide radically different answers ranging from good ownership reasons like for portfolio management purposes and Bitcoin’s gold like properties to bad reasons like the maximalist almost anarchist belief in bitcoin, while those in the 99% of population not owning bitcoin will answer I do not know, high volatility, crime and negative environment. Out of those four possible answers, I respect the “I do not know” or a longer explanation of why crime prevents bitcoin ownership.

 

Question 3)

is derived from question 2) and asks “have you or your friends spent time researching Bitcoin outside of memes, headlines and gifs?”. Unless question 2 is answered with a sarcastic “I don’t  care”, then I would automatically know that persons answer to question 3). I suggest asking a family member question 2) right now and then guess that members answer to question 3)!

 

Question 4)

If people can motivate why they own bitcoin, then they should generally have capacity to explain the difference between bitcoin and blockchain on a simple layman level. However, the people not owning bitcoin will probably not know and likely not even care about the difference between bitcoin and blockchain. However, for some reason newspapers love drawing parallels the volatile of moves of fraudulent alternative crypto and well-established use cases of blockchain like Bitcoin! The reason newspaper love negative cryptocurrency headlines is because lots of people not owning bitcoin love reading about  bad news about Bitcoin for some reason. Perhaps, negative bitcoin news inspires emotions similar watching natural catastrophe in some distant part of the world on the weather channel.

 

Question 5)

I love the question 5 because for some reason I did not know about cryptography around five years after bitcoin was created in 2009, which means I certainly did not learn about cryptography in school except for perhaps the legendary use of the monoalphabetic Caesar cipher used by Roman emperor Julius Caesar to plain sight communicate written military strategy with Roman generals. The fact is that entire Internet and US electric grid in addition to nuclear codes leverage cryptography for security purposes. Someone figuring out how to create a homemade quantum decryption system is therefore a global safety threat on par with homemade nuclear bombs. Note that you will learn about the amazing history of cryptography in chapter 4 of this book including why cryptography was the main reason for German defeat in both WW1 and WW2. Cryptography is therefore a powerful tool and the latest techniques are not widely distributed or taught in school for normies.

 

Question 6)

If Satoshi was inspired by good or out of central bank spite when creating Bitcoin, I do not know. But yes, I think that the Satoshi team were inspired by good when realizing how many lives that open source programmable money like Bitcoin would save society if bitcoin was adopted by users and governments globally. Greedy profit incentives resulting from improving security and efficiency of the financial system were secondary.

 

 

Balancing Law & Freedom: Bitcoin vs Seatbelts

The motivation behind the seatbelt opponent and Bitcoin proponent example is to demonstrate how the act between balancing freedom of choice can be either a complex or simple yet complex problem. Unless you are a murder maximalist, you probably do not fancy a country without a law against murder and you also believe in varying degrees of personal freedom,. However, when governments violate personal freedoms emotional response follow, which can lead in most extreme cases to revolutions. The main purpose of governments is serving and protecting citizens by leveraging data and common sense to design laws that balances societal security concerns by disincentivizing criminal abuse without impeding on the individual right to personal freedom. During the industrial age ending with early Internet in late 1990s,  governments were advanced enough to regulate few and less complex topics like mandating seat belt laws, but the explosive advance of Internet technology has exponentially increased the complexity of managing the balance between privacy with control. Especially, since the average age of a US Congressmen in the 117th Congress is 58.4 years. There is just no way in hell that 58 year old politicians are educated enough to design complex technology regulation and the direct consequence of undereducation is the fear of under regulation. Unless you are a cynic and believe that there are unknown powers seeking to divide and conquer the world behind the scene, what is happening right now is over regulation. Due to fear of the unknown impacts of technology, governments are impeding on the sovereignty of individuals. These governments are therefore now pushing generational talent to blockchain technology, which is why we see an explosion in well-functioning and revolutionary decentralized platforms outside of the government control.

 

What We Feel Deep Inside in 2022

Based on the disastrous 2022 numbers on inflation, deaths in Russia and Ukraine, mortgage rates and equity indices, I think that a majority us are feeling the failure of government priorities. Not only the government response to the Covid-19 pandemic or the government has focused on clamping down on the 1 trillion dollar cryptocurrency industry, but also how government are taking ownership of policy errors like reconsidering how the green policy agenda contains perverted incentives that is limiting nuclear and fossil fuel energy and exacerbating future problems of climate change, while Europe without energy sources to keep warm likely will experience the coldest winter since the 18th century French revolution and how to protect people online without completely eliminating the freedom of speech. I agree with climate activists that climate change is key, but even Greta Thunberg finally agree that Germany should not shut nuclear power if the alternative is burning coal.  I think we are all looking for a solution, but sometimes we must sidestep governments and take some personal accountability. Rather than eliminate personal freedom in new more complex information based world era, which impedes on the government’s ability to protect and provide for its citizen. The perhaps greatest impact of the information age is how computers allow people to choose in what country to live and work, which likely accelerates if Governments continuously fail to align laws and regulation with economic incentives necessary to attract the technology entrepreneurs. The Industrial revolution depended on simplicity for spearheading the nation-state model. The idea of simplicity is that if Governments can design policy based on innovations like seat belts without worrying about opponents taking their talents to another government, industrialization also generated a lot of wealth, which also sparked the creation of the Internet. However, the complexities of even early Internet in combination with the nation-state model meant industrialization is over centralizing power to governments  with nation-states ever since US emerged victorious in WW2. Although US government funding played a large part in the creation of the world wide web, the transformation of society into a computer based society means society is currently undergoing the information age revolution.

 

Common Sense Prevails

The significant improvement by using seatbelts simple to understand yet adopting common sense law to use seat belts took a long time for government to enforce. Unlike seatbelts, Bitcoin is the first online computer invention not leveraging fundamental Web2 Internet protocols like HTTP or other traditional protocols foundational  for the Internet. Both seat belt opponents and Bitcoin proponents independently believe laws for seat belts and against bitcoin violates personal freedom. Although seat belts were invented back in 1959, public seat belt opposition slowly shifted to acceptance from 0% in 1959 to 14% in 1980 and finally 90% in 2022. Despite such a slow adoption rate, seat belt adoption benefitted from massive US government support via regulation, while Bitcoin the lacks both government education and regulation, which has instead created a situation where the public view of Bitcoin is perhaps more polarized in 2022 then when Bitcoin was first created in 2009. The most significant influence behind seat belt adoption in US is clearly data, which shows that saving lives trumps not using uncomfortable neck straps. However, if Bitcoin lacks clear support from most nation-state Governments, then the value of data for driving Bitcoin adoption is much more important. Accumulating enough data to convince the critical mass of a nation-state population to enforce seat belt laws took more than 30 years in US and in New Hampshire seat belts remains voluntary. Based on the slow rate of seat belt adoption, Bitcoin therefore needs more time to mature and accumulate data to prove that the idea of purely censorship resistant and decentralized programmable money, trust and privacy has a place in society.

 

Satoshi created Bitcoin and Volvo created Seat Belts

As global nation-state and union leaders like US President Biden, UK Prime Minister Sunak and ECB Chair Christine Lagarde voice strong opinions about cryptocurrency regulation including a possibility of launching nation-state backed Central Bank Digital Currencies (CBDC), only 16%, 10%, and 12%  of American, Eurozone, and UK households actually own bitcoin as of 2022. Globally, El Salvador leads the way with a as bitcoin is considered legal tender, the Asian country Thailand is the cryptocurrency loadstar with around 20% of  the Thai population owning bitcoin, while the Chinese communist party has banned cryptocurrency completely. However, despite the ban around  That means 99.1% of Americans would likely gloat or be optimally indifferent if bitcoin crashed from 20,000 US dollars to 0 tomorrow. With such a high degree of familiarity and low percentage of bitcoin ownership, mainstream news organization profiting from advertised based clicks therefore has an incentive to generate negative cryptocurrency, which rather than Bitcoin education and data is severely influencing Americans. For example,  Bitcoin follows the typewriter’s path to extinction, I believe that Bitcoin is the most important invention since the steam engine. Having 90% of the population being aware yet  indifferent or against a technology like blockchain that also happened to quickly make 1% of the population extremely rich together with government headwind makes generating negative Bitcoin news an attractive opportunity for newspapers to write negative against to generate clicks. Following up on the six questions asked in the beginning, I think deep inside that at least a small portion of people reading the news wonder how some people are passionate proponents for Bitcoin and blockchain, while always reading articles of how the price of Bitcoin is dropping, bad Bitcoin is for the environment and criminals use Bitcoin to launder money. My goal with this book is to orange pill people with that feeling of how something so bad like blockchain convinces smart people across the entire political spectrum to buy bitcoin. Although the simple answer to that question is that technology is a-political, but this book aims to decompose the complex answer.

 

 

 

The Sovereign Individual

Although science fiction writer Neil Stephenson introduced the concept of Internet money in the popular science fiction novel Snowcash, the term cybercash was coined more seriously by authors William Rees-Moggs and James Dale Davidson in the 1997 non-fiction book, The Sovereign Individual. These two British visionaries describe in detail how they predict Sovereign Individuals will shape society nation-state power declines, as access to information via the world wide web will instead unleash the creative genius of individuals. With work from anywhere is possible via the Internet, governments must provide public services like education and physical infrastructure more efficiently than competing governments to attract workers. The Sovereign Individual therefore represents a sort of utopian future for libertarian minded people where individual entrepreneurs, writers and creators are proportionally rewarded by society for outsized welfare improvements via inventions leveraging the network effects of virtual Internet technology extending beyond the physical realm of geographical borders.  The idea of a coming Information Age inspired the visionary Peter Thiel, Elon Musk, and a range of “Sovereign” software developers with extensive backgrounds in engineering  and cryptology. Although the dream of a cryptographically decentralized peer to peer payment protocol never materialized due to 9/11 and the corresponding enaction of the 2001 US Patriot Act, which prohibited encryption based online privacy for Americans, PayPal was to my knowledge the first billion dollar in market value project with aims of combining a peer to peer information based Web2 with what we define today as a peer to peer information and financial based Web3.

 

 

 

 

Our Journey

My journey into cryptography allowed my father to become the first LP of California based Pantera Capital, which is the first and longest existing US hedge fund in the digital assets. Although I learned about cryptocurrencies early, I used my first bonus to purchase bitcoin 2017 and since then my passion for cryptocurrencies expanded exponentially. The next three hundred pages leverages the curiosity sparked and inspired by my meeting with Vanderbilt University’s now defeated drug dealing Bitcoin king to go on a journey deciphering if the cryptographic computing revolution is a tool leveraged by libertarians and criminals to become rich without environmental consideration, change the world by transforming atoms into bits, physicality into virtual reality and monopolies into communities or perhaps something in between. Together across the next 12 chapters likely printed on digital machines rather than physical books, we aim at decoding some of the largest mysteries surrounding Money and Cryptography throughout history by breaking down the special relationship that exist between balancing human yearning for privacy with a need for government to control fiat currency. At the end of our journey, we are not arriving at a destination, but instead our journey will to unleash further creativity by questions assumptions held dearly by a majority of the human population feeling comfortable in the atom based world and hopefully spark executable ideas for how applied cryptography can improve privacy in future societies via programmability without creating anarchy. Although heavily weighted towards the 21st century due to the exponential expansion of internet users, our decoding journey will leverage tools derived from a wide range of concepts across historical periods from Caesar Ciphers, 500bc Ancient Greek Stenography, Vigenere disks and Enigma to Turning Machines, RSA, Internet, Bitcoin and Quantum computing. Historically, advancements in ciphers, blockchain and decentralized executable technology have been kept hidden from the public by the ruling class for military security reasons not only in US and UK, but also older societies like ancient Greece and currently by other intelligence agencies due to blockchains reliance on cryptography, money and privacy. Although I will try my best to decompose blockchain concepts in a digestible manner,  promises are impossible as blockchain technology is complex, which becomes extremely clear when even PhD central bank executives fail to not state contractions when speaking publicly about how to regulate the digital asset space.

 

 

My Journey

The process of learning and accepting Web3 is labeled the orange pill, which is a clever term invented by merging Bitcoin orange with the blue or red pill from the Matrix. Hearing how users are introduced to Web3 often involves a super quirky story and mine was not different. My crypto journey began in 2013, while vising my cousin in Nashville, Tennessee. In true crypto-quirk fashion, I was introduced to Web3 via a Bitcoin money laundering drug dealer and  Vanderbilt engineering student. My orange pill indoctrinator, was of Asian and White mixed race with a small nose and at medium height neither intimidating nor a pushover. Due to his drug dealing background and having eyes bulging out of the socket, the first thing I assumed was that the mixed race man was high, but he possessed this intense and intelligent stare that pierces through your soul equivalent to a 3D airport security scanner. Although I remember internally debating over a couple of minutes of chatting if the drug dealer was breaking the first rule of drug dealing by consuming his own supply, I decided that Vandy’s Bitcoin king was not high  as he spoke with succinct clarity about the benefits he derived from selling drugs via Bitcoin anonymously over the Internet, which above all else prevented the not so advanced university security from tracing his drug dealing interactions with customers. In a story almost preaching the darkest fears outside of negative environmental impact and regulation avoidance of the most hardcore 2022 Bitcoin sceptic, the drug dealer told me all the details of Bitcoin starting with owning an untraceable physical USB wallet connected to a pseudonymous Bitcoin address online that allowed customers with their own pseudonymous Bitcoin addresses to transfer the Bitcoin networks native cryptocurrency BTC virtually on-chain via the Bitcoin network in return for receiving drugs in the real world. On April 1st 2013, one BTC coin was translatable into 100 US dollars and in 2021 the BTC/USD exchange rate surpassed over 60,000 USD per bitcoin. Back in 2013, the drug dealers story made a huge impression on me and since then I have been hooked on digital assets and its capacity to protect financial privacy on the internet. After I told my cousin about my encounter with the mysterious drug dealer, I found out about the Bitcoin Satoshi Nakamoto inventors white paper called “a Peer to Peer network”. After reading the entire Bitcoin white paper without knowing or even learning anything about hash functions, blockchains, Sha algorithms, consensus mechanism and game theory, I decided to download the first centralized custody application for storing crypto in Coinbase and borrow my dad’s credit card to buy some BTC. He stopped me from using the card, but became an investor early himself and below picture clearly shows I have owned a Coinbase account since 2013!

 

From Centralization towards Decentralization

With my introduction to bitcoin in hindsight, the objective of the next 299 pages is providing frameworks and ideas for how blockchain technology will tilt the economy away from 100% dependency on centralized institutions towards decentralized applications and private users for generating GDP growth by leveraging unique properties of blockchain to remove middlemen so that users can transact directly peer to peer. In a user independent economy, cooperative actions based on principles derived from game theory applications are incentivized by merging our personal identities with the blockchain ledger via the internet. As a result of merging our physical and virtual identity, all user actions are time stamped and recorded digitally on-chain, but ownership of information about those actions remain private and not sold to advertisement companies or hedge funds by information gathering centralized parties like big technology or banking firms. On-chain identities also allow smart people with good ideas to create a track record necessary to accumulate resources without depending on rich investors for sourcing those funds, which means entrepreneurs can cater to ideas improving the public quality of life directly rather than being incentivized to create companies that can squeeze lots of juice from low hanging fruit on behalf of powerful capital allocating institutions. Smart people creating novel decentralization and artificial Intelligence technology will therefore likely compete and perhaps even displace some services currently at a high societal cost being provided by traditional big banking and technology institutions.

 

 

Summary

Our journey will leverage and combine concepts from Cryptography, Technology, Mathematics, Economics, History and Politics to demonstrate why Bitcoin thanks to internet’s global and digital network effects  unlike previous inventions history has attracted and unleashed entrepreneurial imagination from a global talent pool to develop technology aiming to expand the quality of life via financial transparency and meritocracy on par with advancements in life quality during the industrial revolution. The next 300 pages will therefore focus on marginal developments in history across areas and topics within computers, economics, mathematics and cryptography which in combination shaped the creation of Bitcoin and then also imagining how the foundational blockchain based technology of Bitcoin inspires movers and shakers to build the next generation nation state, monetary system and Internet. Although the 2009 Bitcoin creation may follow the faith of once novel technologies like typewriters or fax machines, Bitcoin will like Jesus at minimum sacrifice itself and give birth to an era of decentralized and programmable trust transforming the fundamental democratic rights of privacy, ownership and freedom from the real world into the virtual world and beyond.

 

 

Chapter 2: Stability Amidst Uncertainty

 

Imagined Orders

The power of imagined orders is that sharing common myths provide trust between two otherwise untrusting parties in large societies. Although the idea of imagined orders like chivalry, religion, money, laws and liberalism are valuable fundamental concepts that have inspired cooperation between men and women since inception of mankind, the until today clearest explanation for how imagined orders serve as trust mechanisms and therefore creates stability in an otherwise chaotic society is outlined by author Yuval Hariri in the best-selling book, Sapiens. According to Hariri, most species can at most form trusting relationships with 150 others of the same kind, which worked well for the hunter gatherer society, but not so great for the larger societies in the agricultural age and onward. Imagined orders enforced by feudal kings, religious leaders and nation-state governments therefore fills the trust void of large untrusting societies.

Effective Altruism vs Economic Incentives

The modern imagined order idea is efficient altruism, which emerged in the late 20th century as a result of the multi-centennial secular technology transition spanning the entire Industrial Age era to the science based Information Age. Via effective altruism, nation-states create frameworks where third-parties provide an overarching control mechanism similar to the Catholic Church in Europe prior to the gunpowder revolution in the 15th century. As technology is decreasing the power of violence that was previously monopolized by the nation-states by for example allowing one person to create a small army of autonomous drones at almost no cost, the effective altruism framework creates the justification for concentrating power with institutions to leverage privacy invasive tools like the internet to find people with divergent behaviors via monitoring or simply just shutting down coal plants to save the planet. Effective altruism essentially repackages Bible morality via a combination of utility theory derived from mathematics, economics and philosophy to replace God with the utility of future ghosts or the so-called people that may live in the future. Backed by the assumption that earth will continue to exist for a billion years without man made impact,  efficient altruists conclude via simple math that there will be trillions of people living in the future, which means there is a shit-ton of future utility to account for. However, instead of the religious approach to repenting via sending silver to the pope, effective altruists will leverage economic utility theory to morally enforce rather than encourage energy sacrifices or fiat currency donation to state or corporation controlled entities responsible for building the infrastructure needed to maximize utility of trillions of in future generations.

 

 

 

 

God, State and The Network

The security of the Bitcoin blockchain network is developed from a consensus mechanism based on mathematical encryption to immutably track exact bitcoin ownership without depending on centralized authorities like banks by Satoshi Nakomoto in 2009, societal consensus was almost exclusively based on God and State. Although there are many good use cases of God and State, the problem is that both God and State are structurally based on hierarchy in which single persons’ or establishment groups attain relatively disproportionate amounts of power and control. For God based nations, power centers include institutions like the Christian church headed by the Pope and for State based countries, power equivalents include wealthy political donors and the political cabinets of powerful nations like the US or perhaps even dictators like Hitler. Note that most times power centers are genuinely enforcing beneficial consensus according to delegated powers, but sometimes that enforcement is detrimental to society, ranging from having a slight impact on day to day activities to being an outright Orwellian nightmare, as commandments and laws can be manipulated. In State run societies, for example, I believe the large majority is vehemently against Hitler’s manipulation of German law for selfish aspirations and China’s law leveraging to clamp down on citizens with behavior considered negative by the CCP. That same majority most likely also considers God based societies leveraging wonky interpretations of religious scriptures to relegate women to basically becoming second class citizens as bad societies. However, as demonstrated by the Bitcoin invention, the Network has arrived as a potential Leviathan God and State rival to successfully achieve consensus with the added bonus of delegating control to a blockchain instead of malignant God and State power leaders and centers. With users adopting the Ethereum blockchain and equivalent competitors, Bitcoin has proven how blockchain technology can leverage computer programming based consensus like smart contracts to verify all types of digital information on an essentially immutable and censorship resistant database beyond the reach of both God and State. For example, the history taught in schools by God and State societies is based on the interpretation of events by the winning side.

 

Computational Networks Introduce Incentive Based Software Alternatives to Traditional Systems

In US, history may argue the importance of how capitalism generates economic growth, while Chinese students may learn how capitalism is a tool used by the US for expanding western ideals and influencing how eastern nations should conduct foreign policy with China. In a well-executed Network based society, however, consensus follows immutable and censorship resistant computer code owned by everybody and beyond the reach of malignant God and State power centers to change on-chain history. The Network is the ultimate cooperative society where good behavior is rewarded and too much bad behavior likely disincentivized. The economic growth achieved through superior cooperation by Network participants will dominate both God and State, which is why I believe Network based societies will grow exponentially and ultimately achieve diplomatic recognition. Just like imagined orders including chivalry, religion and nation-state are powerful enough concepts to inspire people to self-sacrifice, the effective altruism movement provides an ingenious narrative for enforcing a sense of moral duty on people to perform sub-optimal actions for themselves today to maximize the utility of people that will inhabit the world in the future. However, instead  of placing the idea of effective altruism with third party intuitions, we should transparently track actions on blockchain software. And, chapter 4, I will investigate why blockchain is the software version of Harari’s idea of imagined orders.

 

 

Overcoming the Lizard Brain

Before diving deep into historical development inspiring the creation of Bitcoin and later improvements to blockchain technology, we must first understand the meaning of temporal discounting, which is a consequence calculation that most animals perform directly or indirectly every day with a varying degree of sophistication. Temporal discounting is just a fancy textbook term derived from the field of Economics to represent how people continuously balance actions today with actions tomorrow. Unlike other species, the relative Homo sapiens superpower is that our brain can suppress unwanted electric signals generated by our impulsive lizard brain to evaluate potential consequences on our future well-being arising from momentary emotional decisions. As illustrated by evolutionary biologist Richard Dawkins in his book ingeniously named the Selfish Gene, most other animals have not developed  their neocortex enough to understand temporal discounting and therefore exclusively act based on lizard brain impulse to maximize chances of passing on genetic material to the next generation. The idea of utility developed from economics underpins the traditional nation state economies today irrespectively if that is achieved via command or free market economics.

 

Defining Economic Utility

In economics, the ability to balance now with the future to maximize utility is coined temporal discounting. For example, in terms of financial theory, the term maximizing utility is often replaced with maximizing profit where the annual risk-free interest rate on bank deposits represents how much current dollars are worth in one year’s time. The risk-free interest rate on bank deposits in finance therefore represents the opportunity cost or temporal discount of the utility derived from dollar value tomorrow. Animals lacking temporal discounting ability are indifferent between earning 50% or 3% interest on bank deposits, while rational Homo Sapiens are more likely to sacrifice buying a chocolate bar today in order to buy two chocolate bars tomorrow if the interest rate on bank deposits are higher. With 8 billion people continuously considering how todays actions may impact the future, temporal discounting becomes an invisible driving force for change in society.  The difference between scientific and economic forces like gravity versus temporal discounting is that gravity obeys the fundamental laws of nature, while irrational human behavior from 8 billion individuals also influence the latter. We need to add how temporal discounting optimized is economically rational. Economists consider people optimizing temporal discounting as economic rational men, but in practice temporal discounting at both an individual and societal level is impossible. Not only do people have conflicting objective functions, but humans are in absolute terms both overconfident and outright bad at exante optimizing current actions to maximize future utility. For example, a 1980 Swedish study asked approximately 80 American and Swedish graduate students if they are better than average drivers. Not surprisingly, a total of 88% and 77% of the Americans and Swedes considered themselves greater than average drivers, which in psychology terms is referred to as the Lake Wobegon effect after a radio show asked parents in Lake Wobegon if their child is gifted above average.

 

Psychology Biases

Psychological biases like the Lake Wobegon superiority effect constantly influences our action and perception of our temporal discounting ability, which in addition to impulses caused by for example drug temptation are too strong or people lack the complete set of information to perform optimal temporal actions. Even if mankind’s ability to balance today and the future is far from perfect, the realization of imperfect temporal discounting iterated over many generations has allowed humanity to create systems that incentivize people to choose actions that hopefully generates long-term stability both for themselves and society. For example, historical hunter gatherers likely did not know of the term temporal discounting, but they certainly understood the concept innately. Historical evidence of temporal discounting includes how these hunters in early human societies both rationed and sometimes held off killing certain animals to allow for that animal population to replenish for future food security. Although saving food for later remains one of biggest issues during times of war, balancing the temporal discounting equation is heavily influenced by other innate human biases that sometimes work in the opposite direction. Besides suffering, nothing reflects human behavior more than market ecosystems. In theory, market is efficient because all prices of goods and services represent all available information, but all practitioners know that markets is not efficient because what is the rationale of AMC increasing by 500% in the middle of the covid-19 pandemic when no one goes to the movies? Well, all humans are impacted by human emotion. Computing systems are influenced by the same behaviors, but like markets the idea of incentives negate the lizard like brain behavior, but does not prevent all of them. The behaviors that researchers know impact markets are explained below:

 

 

Herding behavior is a bias making individuals follow the “pack”. For example, it is a status symbol to have the latest iPhone, which in turn drives up the price of the iPhone to irrational highs, even though there are substitute phones that are equally good at a much lower price. This happens in the market all the time. The price of bitcoin, marijuana stocks and tulips in the 1700s are just a few examples.

 

Prospect Theory is a loss aversion bias that demonstrates how people respond differently to the prospect of losing and winning money. The prospect theory states that people are risk seeking and willing to gamble when there is a certainty of losing money. However, if there is a certainty of winning money then people are instead risk averse. This is best illustrated by an example. The expected return between winning 100 KUSD with certainty or 1 million USD with a 10% probability is the same at 100 KUSD. Most people would then choose to get a 100 KUSD with certainty. If you flip the experiment so that one will lose a 100 KUSD with certainty or have a 10% probability of losing a 1 million USD, then most people would choose to gamble. This difference in preference is dependent on how people emotionally respond to gains and losses. This type of behavior drive the markets away from the efficient price.

 

The Gamblers fallacy bias is a behavioral bias existing because gamblers incorrectly believe that a past event makes a future event more likely even though these two events are mutually exclusive. A classic example of a gambler’s logic is the “this time is different”. A gambler would play the slot machine just one more time if the gambler has lost money on the past 10 tries. However, the odds of winning money playing slot machines at any given try does not increase with additional rounds – the rounds are independent! In financial markets, the gamblers fallacy can lead to investors holding on to stocks that have dropped massively in value because they hope that the stock price will revert to the mean.

 

 

 

Teaser: The Efficient Market Hypothesis

Pretend that you are at the most amazing cocktail party in Chicago in the early 1930s. Al Capone has provided the illegal booze so that everybody is drunk and happy. All of the guests are aspiring investors so they enjoy talking about the markets and you tell other guests that a market is defined by the nature of its participants. Arguing that the market is driven by human emotion would probably not lead to disagreement among the guests. However, if a guest asked you what the implications of an emotionally driven market is on asset prices then odds are that you might not have a great explanation. It stems from the fact that behavioral finance is the first field of study seeking to answer such a question and the theory itself was not developed until the late 1970s by the distinguished University of Rochester contradictionista (economist), Richard Thaler. Per its definition in the dictionary, behavioral finance is a theory that combines psychology and economics to explain how irrational human decision making impact markets and create anomalies in asset prices. If you understood the theory behind behavioral finance before or even after the great depression in the early 1930s, gangsta Capone would with 100 percent likelihood provided you with free booze at this party as your unique understanding about what drives and pops bubbles would generate a high return for Capone’s portfolio ceteris paribus. Reading this will therefore make you an excellent cocktail party guest and my hope is that, in the future, you will enlighten a crowd to get free booze.

 

Sensitive Shiller and Sir Greg: Behavioral vs Traditional Finance

The two leading financial theories is traditional and behavioral finance. Let us explain the difference between them using an example. At this 1930’s cocktail party, you first run into selfish Sir Greg, a traditional finance investor who is very rich and knows everything about the market. He also brags that his investment style maximizes his own and his clients’ utility. As a traditional investor, maximizing utility equals making as much money as possible through optimizing returns. Sir Greg then states that all his decisions are rational and that he avoids taking unnecessary risks. When another guest asks Sir Greg what he does for a living, he answers that he used to be a stock broker and that his business went bankrupt as a result of the great crash in 1929, which explains why he is currently looking for new clients. Standing next to Sir Greg, quietly, is Sensitive Shiller who has cautiously been thinking about whether or not to jump into the conversation with Sir Greg. Shiller’s reason for not joining the conversation is that he fears being made fun of rather than being praised for his opinion. Sensitive Shiller also works as a stock broker, but he understands his behavioral limitations and therefore tailors his client portfolios more to the behaviors of the client rather than to just optimizing return. Ultimately, Sensitive Shiller overcomes his fear and takes a leap into the conversation calmly explaining that he retained almost all his clients despite the great crash. Sir Greg enviously asks Shiller how he pulled it off and Shiller answers with one word - treasuries. Shiller models his portfolio like traditional investors by using quantitative measures such as expected return, variance and correlation, however, he also models qualitative measures of his clients to account for human nature. A common way to account for human nature is to use a layered portfolio approach by dividing up the client’s portfolio to meet 3 separate objectives. The first objective is generally to maintain the standard of living, the second tends to increase wealth slightly and the third increases wealth substantially. A layered portfolio approach signifies a behavioral investor and is a major reason for why Sensitive Shiller retained his clients. Shiller most likely over allocated money to the first objective by investing in treasuries, while Sir Greg focused mostly on goal 2 (equities) and 3 (risky equities).

 

Andrew Lo - the father of the Adaptive Market Hypothesis

Andrew Lo's AMH Revolution

A driving influence guiding Sir Greg and Sensitive Shiller is the efficient market hypothesis (EMH). Many people have heard the story about two economists walking down the road and the first economist spots a USB loaded with a bitcoin on the ground. The first economist then reaches for the bitcoin meanwhile the second economist utters, “If that bitcoin was real someone else would already have picked it up and that bitcoin must therefore be worthless”. According to EMH, there is no edge in investing or picking up free “bitcoins” as prices already reflect all available information. If that was the case then the traditional finance investor has an advantage, as the optimized portfolio should outperform a behavioral portfolio. However, opinion of economists follow a uniform distribution and this explains the inability to reach consensus about whether the market is efficient. The logic of EMH is that the more efficient the market, the more random is the price sequence generated by such a market and the more difficult the market is to forecast. If you analyze the market today, you can see that it is difficult to predict if prices will go up or down tomorrow even with the use of computers. However, Andrew Lo, a fellow more distinguished PHD contradictionista from Harvard University, developed a theory complementing the EMH based on behavioral assumptions under the name adaptive market hypothesis (AMH). Lo’s theory tests the foundation of EMH by using behavioral assumptions to poke holes in the EMH. If the market follows the AMH then one can conclude that human behavior will create predictable patterns in the market and investment practitioners using advanced unemotional methods, such as machine learning, can generate excess return in the markets.

Is Human Behavior, Information  or Combination Behind the Dot-Com Bubble?

Biased decision making have been thoroughly tested by numerous psychologists and economists such as Kahneman, Shefrin and Thaler. If we look at Sir Greg in the earlier example, he clearly suffers from gamblers fallacy, herding behavior and loss aversion bias. He suffers from gamblers fallacy and loss aversion because he held on to all his clients’ investments during the great crash hoping that it would revert back to the mean and from herding behavior as he, like most other investors in during the roaring 20s, put all his money into the stock market. The key in the previous sentence is “most other investors” because if it is possible to forecast that other investors suffer from emotional biases then it might be possible to forecast how any given event could drive the market away from its efficient price. The tricky part is that the cause and effect link between the event and market price outcome is none-linear. In Robert Shiller’s book, irrational exuberance, he outlines more than 12 different behavioral causes explaining the tech bubble in early 2000 and 3 of them are outlined below[2].

The internet boom resulted in online trading. In 1997 there was 3.7 million online account in the U.S. and by end of 1999 there was more than 9.7 million accounts. This encourages market participants to trade more frequently and thus exert their behavioral biases on the market.

 

The decline of inflation and the effects of money illusion. Inflation is measured as a change in the consumer price index and Shiller noticed in his research that people pay attention to inflation. Low inflation can boost stock market prices as the public considers a low level of inflation as a sign of a strong economy. Worth noting is that during the period 2008-2022, the federal reserve has inflated the market through quantitative easing to prevent deflation and market valuations have reached record high.

 

Expansion of defined contribution plans have forced individuals that previously was not investors to learn more about the markets and accept stock market investments as a viable strategy. Increasing the familiarity with stocks encourages investing.

 

 

 

Bubbles

Behavioral bubbles repeat themselves, but the cause of each specific bubble is more of an historical rime than a repeat. The above three bullets as outlined by Robert Shiller partially explains the dotcom bubble in the early 2000s and might also explain the bubble currently expanding in the 2020s. Obviously there are more than 12 variables, as Robert Shiller described in his book, “Irrational Exuberance”, impacting asset prices. Note also that for any behavioral bias causing investors to push the price of an asset up there is potentially a behavioral bias working in the opposite direction. This means that the cause effect relationship between investors and events takes place in a multi-dimensional space that humans are unable to visualize. What makes the relationship even more difficult to visualize is that the cause effect relationship is dynamic because the market is constantly evolving. Thus, the next generation of Sensitive Shillers must rely on computing power and statistical techniques to extract information from data to empirically model how collective human behavior impact market prices. Thanks to Moore’s law, computers are now powerful enough to solve complex problems such as self-driving cars, facial recognition and investing. We can therefore define a successful investor in finance 3.0 as one who provides the computer with an optimal framework of the game (the market) combined with the objective to outperform the returns generated by the market. This is synonymous to the definition of machine learning, which is the ability to automatically learn and improve from available data, instead of following static, explicitly programmed instructions.

 

 

However, the effective market does not always exist …

 

 

 

Summary

Temporal discounting is therefore leveraged as a tool to create stability in our society. Examples of systems derived from temporal discounting include farming, education, democracy, law, currency and internet. All of these stabilizing mechanisms have increased the power of centralized institutions and are great if they are led by good people, but history has shown that concentrated power is really bad when controlled by bad people. The next system that will drive humanity forward must incentivize centralized institutions to act in society’s best interest and I believe that system is blockchain technology, which through combining economic incentives, game theory and cryptography creates an immutable framework for generating trust in society. The largest consequence resulting from the internet revolution starting in late 1990s is replacing much of the physical economy with a virtual equivalent through bytes, software and computers instead of atoms, genes and evolution.

 

 

 

 

 

Chapter 3: Satoshi’s Mystery

 

Bitcoin Genesis

 Although network effects resulting from Internet protocols are responsible for sparking the Information Age revolution, network effects from blockchain technology adoption is the key for accelerating society going forward by changing the world from depending on a purely nation-state based model to lean on an optimal blend of borderless networks and nation-states where some government power is shifted to sovereign individuals via decentralized software on the Internet. Blockchain technology and decentralized software emerged from Bitcoin, which is a technology involving one of the greatest mysteries in history as the genesis Bitcoin block emerged in January, 2009.  The mystery involves Satoshi Nakamoto, which is the pseudonymous identity of the group or person that invented Bitcoin. When creating the world’s first software for programmable currency, Satoshi combined cryptographic encryption and economic incentives with Internet to securely and anonymously transmit bitcoins peer to peer from one Bitcoin user to another in a censorship resistant fashion via a distributed network of computers. Just like the Internet limited the power of government to control the flow of information on the world wide web, the idea of transmitting money via decentralized blockchain ledgers outside of the traditional financial system challenged the idea that governments have unique monopoly powers to create money justifying what William and James predicted in their book, The Sovereign Individual. Widespread cryptocurrency adoption creates a global payment system independent from nation-states. That is because crypto based transactions solve both privacy and security issues common to credit card users while at the same time maintaining direct merchant interaction like cash. Functionally, cryptos are more similar to cash than credit cards so they enjoy some of the benefits enjoyed by cash. These cash benefits include information privacy and allow for offline transactions directly between counterparties without third party involvement. The typical third party is a PayPal like institution or a bank so cryptos would cripple their ability to extract consumer information, which might explain the negative view of traditional institutions about the crypto space. Important to note is that Bitcoin users do not enjoy the same level of anonymity as with cash because it is possible to trace Bitcoin spending based on user pattern in the public ledger. However, the crypto space is evolving quickly and there might be other blockchain protocols that can technologically circumvent this issue. Unlike cash, bitcoin is also not completely offline, but it is worth noting that Bitcoin relies on a peer to peer network, which is fractally resilient like the internet and not based on some sort of central database.

 

 

 

The Blind Signature

In 1983, American computer scientist David Chaum created the first cryptography based technology preventing fraud when transferring money peer to peer. Chaum’s general idea involved creating digital money functioning outside of the traditional banking system, but with the same properties of traditional paper money. The idea of disintermediating banking also inspired PayPal and Satoshi. The difference is that PayPal offered a range of financial services including cheaper money transfers, while Satoshi created Bitcoin almost out of spite of irresponsible monetary policy by central banks. The difference between PayPal and cryptocurrencies is best explained by Chaum’s logic when creating digital cash, which is described in a Bitcoin textbook taught to students at Princeton University. If you write on a piece of paper – “if given to someone this note is worth 1 USD “ -  and sign it, you have effectively created cash as long as people trust that the note is worth 1 USD and that the cash has not already been spent, which is exactly how fiat currency works. The difference is that fiat currencies are backed by governments and monitored by the central banks, while this 1 USD note is not. The process of creating a promissory note with a signature can be recreated digitally by using hash functions instead of handwritten signatures. Obviously, signature problems remain even with digital notes as the note could already have been spent. This is called the double spending problem. Chaum solved the double spending problem by using cryptography based on the following logic. The first step is to digitally put a unique serial number on every crypto “note”. The next step is to add your signature to verify the note’s worth. Finally, a server is used to prevent double spending by monitoring signatures and serial numbers, which is cumbersome if done by hand, but not when the process is digital. To prevent the serial number from being tied to a person, Chaum created a blind signature, which means that note recipients got to pick the serial number. The numbers picked by the recipient should be long and secret so that the number is impossible to guess and unavailable to the note signer. The problem is that this type of digital currency needs a central server ran by trusted third party like a PayPal. Unlike Chaum’s original cryptographic idea, Bitcoin is peer to peer and no central server is needed, but the bitcoin network still utilizes the basic principles of Chaum’s idea of a cryptographic digital currency.

 

Digital Pseudonyms

The cleverest move by Satoshi Nakamoto besides actually creating Bitcoin was the decision to use to use a pseudonymous name. The digital pseudonym technology leveraged by the likes of the Bitcoin inventor was first defined publicly by David Chaum in a 1981 paper named, Untraceable Electronic Mail, Return Addresses, Digital Pseudonyms: “A digital pseudonym is a public key used to verify signatures made by the anonymous holder of the corresponding private key. A roster, or list of pseudonyms, is created by an authority that decides which applications for pseudonyms to accept, but is unable to trace the pseudonyms in the completed roster. The applications may be sent to the authority anonymously, by untraceable mail, for example, or they may be provided in some other way (Chaum, 1981),” wrote Chaum describing how cryptography is a method to communicate peer-to-peer via email in secret through leveraging asymmetric key cryptography. The idea is that the public key can receive messages from all private keys approved by an authority. In the simplest form, each public is connected to a private key, but cryptography makes deriving the private key from the corresponding the public key. For Bitcoin, the authority is a decentralized set of miners and the message are bitcoin transfers. Each private key holder on the Bitcoin blockchain can send bitcoins to all other Bitcoin users corresponding public key. The private key must therefore always remain secret. Not even the US government can control the Bitcoin wallets of users. The idea of censorship resistant money has resulted enormous user adoption of Bitcoin wallets with over 106 million users in 2022. Nation state governments argues that secret digital identities are bad and  cryptography is now  a battle between libertarian absolute right to privacy activists and big government proponents leveraging all tools disposable to prevent technology like Bitcoin from criminals. Although almost holding polar opposite views of cryptography both big government and libertarian maxis share one thing in common and that is to achieve the objective no matter the cost. For example, the PGP founder Phil Zimmerman was almost jailed for life in 1995 by the US government for releasing an RSA based encryption product that leverage highly advanced modular cryptography for public use via internet, which was a product that essentially ensured private communication remained private and in 1998, the Swiss firm Crypto AG built backdoors to internet products for the American government. Following launch in January 2009, it is therefore not surprising that a cryptography product like Bitcoin has been attacked continuously as a threat against national security emphasizing Bitcoin’s climate change impact and use by money laundering criminals by not only Biden’s White House administration including SEC chair Gary Gensler and Treasury Secretary Janet Yellen, but also the European Union’s Central Bank chief Christine Lagarde and other world leaders such as President Xi. However, the Bitcoin blockchain is the first technology that can execute decentralization. The concept of a censorship resistant immutable database according people with libertarian leaning is therefore a life changing technology perhaps equivalent to inventions like wheels, harnessing fire, electricity, nuclear power, solar power and the Internet. 

 

The Fiat Illusion

Satoshi’s problem with central banks is deeply correlated to issues arising from the relationship between nation state economic policies and money. The fact is that money like fiat currency is imagined by citizens to have value. No nation state or world empires in history has maintained for longer than a couple of hundred years. The pure fiat based US dollar system launched in 1971 when former  US President, Richard Nixon, declared that the greenback no longer converts to fixed amounts of gold. Since Nixon’s announcement, the belief in paper money, also known as the fiat currency system, has established itself as the dominant monetary force in western economies. This great experiment has increased wealth inequality to record amounts and the middle class of developed nations feels left behind. Like previous periods in  history, the decline of the reserve currency is often a sign of revolutions. In 2022, the western hemisphere is witnessing populist and nationalist ideas taking root across              globe at a faster pace than the Black Death in 14th century Europe. Among these populist ideas is Modern Monetary Theory (MMT), which is a short term monetary solution to long term problems in the financial markets. Most investors today underestimate the likelihood of MMT being implemented and given the consistently low interest rate environment of developed nations across the world; the next great monetary experiment may already have begun.   Just ask yourself when was the last time you used ancient Roman empire money to buy ice cream? Although the economic policy of nation states varies from almost communist to capitals, the general consensus in terms of fiscal and monetary policy is that undesired behavior is rewarded via economic subsidies, while desired behavior is taxed. In the purest sense, wealth distribution is well intentioned. However, nation states production falls drastically if governments promote too much undesirable behavior, which is why most nations in the west are liberal rather than purely communist. In addition to promoting undesirable behavior, nation states that provide less value per dollar taxed may suffer from losing its most productive member to competing nation-state. The era of Internet and Blockchain is lowering the threshold for Sovereign individual to move to other countries. Unlike nation states, the goal of Bitcoin is to promote desirable actions and disincentivize undesirable actions. Bitcoin is narrow in scope compared with nation states, but the objective of Bitcoin is to create immutable digital property via incentivizing user to hold, protect and verify Bitcoin transaction through bitcoin rewards and price appreciation. The Bitcoin objective is more similar to the goal of central banks than nation states. The main responsibility of central banks is setting the interest rate for the most creditworthy institutions. The interest rate charged large banks by the central banks is considered the risk-free rate because the central bank can always repay loans by printing money. As banks may earn the risk free rate by depositing money with the central bank, the risk free is considered the price of money. In 2009 Satoshi created Bitcoin because the risk-free rate is to low and constantly declining. However, before understanding how money works and evolves as a medium of exchange, store of value and unit of account over time The first true monopoly over currency emerged with the Roman empire

 

-        Free banking Era in the US

-         

 

 

 

 

 

Sovereign Individuals vs Nation States

If blockchain applications like Bitcoin proves superior to traditional applications, then nation-state developed applications must improve and compete organically because in the Information Age traditional taxation, regulation and military force cannot shut censorship resistant decentralized applications. If sovereign individuals live under the laws of government A where the income tax rate will increase from 30% to 40%, while government B will keep the 30% tax, then in the Information Age, all else equal, sovereign individuals living in A can place all bitcoin money in a decentralized censorship Web3 wallet and move to B. If country B has bilateral agreement with country A, then these sovereign individuals pick country C instead. Unlike the industrial age, where lack of  technology, information and wealth distribution restricted physical movement across borders, the Information Age allows for freedom of movement by for example working online jobs from home rather than work in a coal mine. In addition, the Information Age makes it much easier to learn new languages via cheap language programs online that may accept bitcoins for a fraction of the fee traditionally paid to book companies and expensive teachers.  Since blockchain based schools will leverage economic incentives to lure both the best teachers and student via cryptoeconomic incentives, then sovereigns must allocate more resources to improve schools or if people prefer cryptocurrencies like bitcoin over fiat currency like the US dollar, then Central Bank institutions like the Federal Reserve must conduct more efficient and honest monetary policy. Blockchain When individuals are allowed to take control of their own lives, the temporal discounting equation balancing the present with the future shifts forward or backwards depending on the objectives of various sovereign individuals. Perhaps certain genius Sovereign individuals can skip all together by raising Bitcoin to create new types of blockchain technology prior to turning fifteen years old. Empowering individuals simply taps into the creative genius of all mankind to create unimaginable innovations to improve life outside the traditional innovation system.

 

Bitcoin is Money and Money is Bitcoin

Due to the innate relationship with Bitcoin and money, the history of money requires special attention, especially now that blockchain technology is becoming the foundation for facilitating trades and also storing both digital wealth and information via encrypted Web3 wallets rather than banking and cloud computing platforms. The history of money therefore deservedly has its own chapter later om in the book., we shall first explore both the birth and early days of Bitcoin plus Ethereum respectively and how these two largest blockchains differ ideologically from each other and later also investigate the enormous value that decentralization can potentially release in 100% centralization dependent societies through blockchain technology. At first one might ask why Bitcoin’s creator prefers going by the now legendary pseudonym rather than receiving recognition for the historical so far one trillion dollar invention, but given the massive Bitcoin critique since the 2009 birth from some of the most powerful leaders and institutions around the globe, my bet is that many of us like Satoshi would choose anonymity over the dangers arising from challenging a government monopoly on the creation of money[11].

 

 

The White Paper

The importance of anonymity holds especially true to Satoshi who taunted both the Bank of England Chair and British Prime Minister when launching Bitcoin’s version 0.1 on open source software Source Forge in January 2009 by permanently embedding the below line of text in addition to offering a mining reward of 50 BTC in return for leveraging computing power to solve Bitcoin’s first cryptographic mathematical puzzle and generate the so called ” Bitcoin Genesis Block”.

 

“The Times 03/Jan/2009 Chancellor on brink of second bailout for banks”.

 

The humiliating taunt of central banks depicted in the 2009 Genesis block text demonstrates Satoshi’s confidence in a vision that Bitcoin’s native currency BTC will for all futures be censorship resistant to all types of monetary policy manipulation and with expanding probability over time shows that money can be designed outside of the government monopoly, which was the vision outlined in Satoshi’s 2008 white paper, Bitcoin: A Peer-to-Peer Electronic Cash System. As a result of creating money by typing 31,000 lines of software code plus using limited fiat spending on Internet advertising instead of leveraging the traditional government approach like bills, bronze, or gold, Satoshi successfully bypassed governments and forever changed the world by adding competition to the global government monopoly over money. Without following monetary policy outlined by government authorities, the market value of BTC therefore becomes the money equivalent to a thermometer that measures the value of fiat currency instead of measuring heat.All else equal, minor increases in BTC value against fiat currencies over time indicates that Satoshi’s novel Bitcoin blockchain technology is creating real value for society, while simultaneously perhaps revealing that fiat currencies are suffering from slight inflation colds treated with some interest rate hike medication. Surprisingly, however, Bitcoin’s total market value expanded from 0 in 2009 to over 1 trillion USD dollar in 2021 and that exponential increase in value demonstrates not just the value of novel blockchain technology, but also proves that fiat markets suffer from severe dislocations with inflation as represented by the consumer price index surpassing 8% in a majority of developed nations in September 2022, which is a problem likely requiring monetary surgery like haircuts or enormous tax increases on the top 0.01% rather than just simple interest rate hike medication to fix.

 

 

The First Cryptoeconomic Approach

In addition to taking the temperature on how governments are managing monetary policy, Bitcoin’s blockchain was a first principle Cryptoeconomic approach for distributing software and consensus via the Internet rather than through a centralized database, which allows miners of BTC to account for all historical transactions on the Bitcoin network via the same database. The Bitcoin’s distributed database accounting for all transactions also updates simultaneously with new transaction creating new blocks, which are mined and chained to old blocks. Bitcoin’s distributed database can therefore be pictured as a giant evolving excel spreadsheet where rows and columns are added and subtracted continuously with new transactions and users acquiring or selling BTC. Since an exact replica of the Bitcoin excel spreadsheet is held by a million different computers simultaneously, the government is unable to shut down the Bitcoin network unless they confiscate all million computers at the same time. It is therefore safe to say that Bitcoin money cannot be controlled by any government or central bank, which makes Bitcoin’s monetary policy immutable to change unless there is an agreement among the 51% majority of Bitcoin holders.

 

Measuring Bitcoin Growth

Measuring Bitcoin Growth

·      Not only Market Cap[12]

·      2015 Market values of areas where Bitcoin Technology might directly compete with the existing infrastructure depicted by Tuur Demeester[13]

o   $2 trillion annual market for electronic payments

o   $1 trillion annual e-commerce market

o   $514 billion annual remittance market

o   $2.3 trillion hedge fund market

o    $7 trillion gold market

o   $4.5 trillion cash market

o   $16.7 trillion offshore deposit market

·      First technology since credit card in 1960 to radically modernize money

o   Bitcoin

§  BTC there digital currency and clearing network is open source

·      Mobile

·      P2p

·      Protected cryptographically

·      Privacy oriented and native to internet

§  Fusion is unprecedented security and efficiency in banking

o   Four risks

§  Better currency -> Ethereum stealing market lead

§  Better currency is possible but like…

·      TCP/IP for the internet

·      Network effects and critical mass of BTC has generated adoption

§  Undetected Backdoor/bug

·      Any system this is pos

·      sible

·      Bitcoin is open source though and patched by volunteers who may also structurally update the code

·      Perhaps compare to have an Iphone backdoor

§  Hard fork -> making the network incompatible and split in two

·      Explain what hard fork mean with Block size wars

·      Block size wars

o   7 transactions per second

o   Needed larger block sizes as the chain scales

§  Gold or Cash

·      Big blockers = more transactions = electronic cash

o   Miners liked big blocks more money

·      Small blockers = store of value = gold = 1mb limit is fine

o   Larger blocks mean only large computer can handle bitcoin

o   XT Gavin Anderson and Mike Hern

§  Released 2mb and 24 tps

§  Bitcoin XT software

§  Small blockers saw this as a betrayal

§  Failed, even if miners liked the bigger block

§  DoS attacks occurred

·      Mikes entire regional ISP dos attacked today

§  All XT nodes were DoS attacked

§  Possible foul play – no mass adoption

·      Bitcoin split

o   Segwit

§  Segregated witness activated in 2017

§  More data can be fitted on each block

§  Remove the cryptographic signature so more data can fit on the block (Only leaving the sender)

·      Store transaction data off-chain (smarter)

o   Bitcoin Cash

o   Bitcoin SVX

 

·      Value will flow the better version of of the fork after a period of fear and doubt

§  Sustained attack by resource incentivized governments

·      Expencive and mechanism in place for protections

o   On Chain Analytics

§  Beside traditional finance metrics, like market value or the dollar value per BTC, it is possible to analyze Bitcoin network growth by leveraging so called on-chain features.

§  All Bitcoin transaction data is stored in a decentralized database, which is used by historians and traders as a method to measure the economic value and future price of BTC

·      Details of every block (timestamp, fees, miner rewards, block weight, addresses, users, etc.)

·      Details of every transaction (sending and receiving addresses, the amount transferred in each transaction, the remaining addresses, block time, etc.)

·      Smart contract invocation and usage (mostly for Ethereum and Ethereum-based tokens).

o   Bitcoin Transaction Data

§  Number of transactions per day

§  Transfer volume

o   Bitcoin Adress Data

§  Active users

§  Total users

§  Large users or so called whales

o   Bitcoin Blockdata

§  Block size

o   Block Height

·       

·      All of these on-chain measures together with metrics from TradFi are showing a secular adoption trend

 

Not only Market Cap[14]

 

 

Deducting Satoshi’s Identity

Even if advanced cryptography is leveraged to protecting Blockchain technology against cryptanalysts  bootstrapping to achieve sufficient decentralization remains a problem. Methods used by cryptanalysts to decode blockchain is finding single attack vector weaknesses and in the early days of Bitcoin a major weakness was Satoshi Nakamoto while bootstrapping the network as Bitcoin had not yet achieved sufficient decentralization, which is one of the main reasons why Satoshi likely chose anonymity. The Occam razor/the or most likely answer to how created bitcoin was the government. However, unless it is a government agency under full secrecy behind bitcoin, then the frequent anti-cryptocurrency rhetoric contradict the Occam razor thesis government Although blockchain technology generally is used to secure peer to peer financial transactions and protecting information earlier forms of cryptography in history was generally leveraged to protect military and other sensitive government information from reaching adversaries, the cryptography world was still filled with mystery identities. One of these mysterious and enigmatic historical figures is the Man in the Iron Mask who was imprisoned by king Louis XIV  in the French fortress Pinegrove, Savoy. Basically, one can view Satoshi Nakamoto as the 21st version of the Man in the Iron Mask. Rather than relying on crypoeconomic incentives like Bitcoin to secure information, historical cryptographic encryption was often based on various types of mono and polyalphabetic ciphers where letters, numbers and symbols were interchanged to scramble messages, but not tied to any form of monetary reward. Scrambling made written communication readable only to people knowing both the codeword and type on scrambling method leveraged to encipher that particular message. One of the most famous enhanced monoalphabetic ciphers was the Great Cipher invented by Antoine and his dad Bonaventure Rosignol in 17th century France on behalf of king Louis XIV to secure important communication. The great cipher lost after father and son Rosignol passed away was also believed to protect communication that could reveal the identity of the Man in the Iron mask. Both French philosopher Voltaire and American scientist Benjamin Franklin tried to figure out the person hiding behind the Iron Mask without luck and the Iron mask has inspired  both Hollywood movies and theatre production.  In Chapter 4, our journey will take us through cryptography history, but unknown identities Just like These hackers are constantly trying to find attack vectors and vulnerabilities in the code. Although Satoshi’s true identity remains unknown to the public in 2022, the blockchain community including journalists, bitcoiners and even regulatory institutions have without luck spent enormous amount of time trying to deduce the true identity of the man behind Bitcoin’s iron mask that happens to be responsible for executing the world’s first decentralized crypoeconomic blockchain network. All those blockchain community hours spent trying to remove Satoshi’s iron mask to  reveal the true identity means that many potential Satoshi’s have been named. Maybe describe some famous people trying to find Satoshi

 

§  Challenges the government monopololy

§  Taunted Central banks through genesis block

·      The only way to read satoshi’s message was to use encryption

·      Press the transaction hash that start with 4a5e

·      Look for coinbse

o   Coinbases are special type of data only included in transactions for newly minted bitcoins

§  Coded into hexadecimal form

§  Hex to ASCII

o   Try yourself [15]

·      Create security problems

·      Shows Satoshi confidence and importance of security

·      Launched Bitcoin version 0.1 on open source software Source Forge on January 9 2009[16]

§  In addition, the American PGP founder Peter Zimmerman was accussed of exporting weapons when he leaked the RSA based PGP technology via internet

·      Check out PGP it has a funny meaning

·      There is also a lot of cool rulings

o   US being stricter than Europe

o   Balancing bad people with privacy rights

§  If he had used a disc to transfer the code across land borders he is a terrorist but if he used a book then it would be educational

§  FBI dropped the charges

§  Zimmerman was a libertarian that believed in the absolute right to privace

·      The code book

 

 

First: Likely Satoshi’s

Out of these potentials, no one has identified as Satoshi except for Australian computer scientist, Craig Wright. In December 2015,  two separate magazines back believed Craig’s claim to be the Bitcoin equivalent to the man behind the Iron mask, which is a famous cryptographic cipher that if solved reveals the identity of the Iron Masked man that was imprisoned in a tall tower in the middle of France by Napoleon. Unlike most people in the crypto-community, the Australian authorities believed both Craig and the magazine and therefore raided Craig’s home for tax fraud following the magazine publications. However, despite being a computer scientist and successfully filing the US copyrights to Satoshi’s white paper and early Bitcoin code, the magazine stories were discredited and the real Satoshi is likely someone else. Two more likely candidates as potential Satoshi Nakomotos is the founder of Bit Gold and computer scientist, Nick Szabo, and also the first recipient of the first ever Bitcoin transfer, Hal Finney. Bit Gold is a digital currency as outlined by Nick in the Bit Gold white paper 2005 and shares many common factors with Bitcoin, which means many people including Elon Musk believe Nick is the most likely Satoshi candidate. Despite strong opinions from heavy weights like a Tesla, Starlink and SpaceX mogul, Nick has consistently denied being Satoshi. However, even if Nick truly is not Bitcoin’s man behind the iron mask, he has at least inspired the real Satoshi Nakamoto with the early work on Bit Gold. Considering Nick’s strong denials, my opinion is that so far it is Hal Finney that is the most likely Satoshi candidate.  Hal was part of the original libertarian cyberphunk crew and worked for the PGP founder Phil Zimmerman who famously gave away PGP cryptography for free because of his belief in the technology and the individual right to privacy above all else.  PGP leverages RSA cryptography, which was designated as weapons grade technology by the US and British governments. The free PGP drop therefore almost caused the US government to place Phil in prison for exporting weapons grade technology across US borders via the Internet. RSA is perhaps still considered weapon technology and a noteworthy fact is that RSA cryptography was created independently by a British spy organization and three American computer scientists in the late 1960s early 1970s. While RSA is now encrypting almost all information on the internet with varying degrees of strength, RSA also happens to utilize similar asymmetric key cryptography as Bitcoin, which strengthens the case that Hal as a PGP cyberphunk believing in absolute privacy rights and echoing the blockchain ethos of autonomous control of finances in combination with a vendetta against central banks could be Satoshi. The main problem with believing that Hal is the man behind the iron mask is that he died in 2014 from ALS, which is a serious disease of unknown origin causing nerves to break down until the host dies.

 

 

So who is Likely Satoshi – Final candidate

o   Adam Back[17]

§  According to Charles Hoskins founder of the xxx Cardano chain and an early contributor to Ethereum said on a Lex Friedman podcast that Adam Back is Satoshi and he also have some interesting opinions for why[18]

·      In the podcast Charles denies himself

o   Adam Back is occamz and has a chip on his should knew of Hal Finney, Phil Zimmerman

§  Right time

§  Right place

§  Right age

§  Right skill

o   Fourth the scripting language common in 80s and 90s for a stack based assembly

o   Created hash cash

§  PoW

o   Grew up with cyberphunks

·      Hal was to talented Unix Linux Game[19]

o   Bitcoin was developed on a windows machine

o   The code was very academic needed to be cleaned up

o   If Hal, less lets use sec p256 k1

§  More protocol design later and engineering now

o   Stinks academic old

§  Great brain came in and cleaned up the language

o   No overlap between satoshi and Adam

·      US army Code Stylometry

o   a technique leveraging ML to develop a finger print for anonymous code,

o   Take original BTC source code and open source repos and match the two

o   Match it to weaker opsec

o   94% accurate stylometry is

Written Satoshi is Nick Szabo

However, the main reason for Hal being Satoshi is that he was the first person that downloaded the Bitcoin client and he was also the first BTC recipient in a Bitcoin transaction. As a result, many people argue that Hal is the Bitcoin creator because why would Satoshi not send BTC to himself to test out the Bitcoin network. However, Hal denied being Satoshi until death and unless someone can prove that Hal held the private key to Satoshi’s Bitcoin account, we will never know if the true identity of Satoshi was Hal Finney.

 

 

 

 

 

Second: Unlikely Satoshi’s

Bitcoin basically combines properties of cryptography, economics, game theory and computer science in a way that fits the legendary investor Peter Thiel description of a zero to one creation, which are inventions powerful enough to reshape society. [20] Peter even outlined in front of 1000s of bitcoin maximalists at the Miami Bitcoin Conference in 2022, why the unique censorship resistant properties provided by combination of game theory incentives and cryptography makes its native cryptocurrency bitcoin (BTC) the truest and most honest market in the world.  The combination of economic incentives rewarded to miners for leveraging computing power to verify that all transactions included in each Bitcoin block and then chaining that block via cryptography to the previous block secures the Bitcoin blockchain and prevents anyone from double spending. With summed total value of BTC surpassing well past 1 trillion dollars on November 2022, the financial market seems to agree that Bitcoin is an idea enough to unleash powerful change in our world. The powerful list of Bitcoin sceptics ranging from government agents and institutions to C-suite members of  large corporations suggests that credible Satoshi candidates like Craig Wright, Nick Szabo and Hal Finney have an incentive to deny that they are in fact Satoshi. However, outside these more credible candidates, the rampant public speculation driven by the curiosity to demystify Satoshi Nakamoto’s true identity has led to some funny people being outed as Satoshi including Dorian Nakamoto who is an engineering trained Japanese American with libertarian leanings and both PayPal buddies Elon Musk and Peter Thiel. Other than sharing the same last name with the pseudonym Satoshi Nakamoto, Dorian like Hal and Nick outrageously denies being Satoshi and although the Ethereum blockchain is founded by wizkid Vitalik Buterin who was sponsored by the Thiel fellowship foundation to create Ethereum, I think it’s safe to say with 99% certainty that neither Thiel nor Musk is Satoshi, their ideals, intelligence and entrepreneurial approach suggests that both PayPal founder could part of the group that crated Satoshi.

·      Smartest move by Satoshi is to not reveal identity

o   Libertarians vs Government

§  Historical Battle

§  Privacy rights vs criminal use of cryptography

§  Polar opposite views

§  Share the no matter the cost attitude

·      Phil Zimmerman

o   Example of Libertarian that was almost jailed because he believed that cryptography protect privacy and is human right

·      Crypto AG

o   Provided backdoors to the US government

·      Following bitcoin launch in 2009 to describe the dangers of cryptography and Bitcoin’s founder Satoshi if his identity is revealed

o   Government hates immutability

§  Yellen, Biden, Lagarde and XI

§  The whole government world is against the crypto

·      Counterargument and why Bitcoin is more powerful than the government worries

o   First technology to execute on decentralization

o   Immutable database means people privacy and financial transaction can be stored securely and is peer to peer

o   To a libertarian BTC is therefore like the invention of the wheel

§  (Describe Bitcoin importance)

·      Bitcoin combines a bunch of different technologies fitting Peter Thiels classic zero to 1 slogan

o   Game theory, economics, math etc…

o   Thiels 2022 bitcoin conference

o   Cryptoeconomics

·      In a piece written by Joshua Davis in the New Yorker year 2011 Outlines following about the inventor

 

·      First of all, the question of who created Bitcoin is still unknown, which must be considered as one of the greatest mystery’s in the world

o   Started developing Bitcoin code in 2007[21]

o   Registered bitcoin.org in 2008[22]

o   White paper published in 2008 Halloween

o   Who is the inventor or inventors?

·      Used a pseudonym

o   Satoshi Nakamoto

o   Wrote flawlessly in English

o   Used British Spelling

 

 

 

 Bitcoin and PayPal

Note that after Confinity changed names to PayPal when merging with Elon’s X.com, the newly branded PayPal team pivoted from the original online banking business model to become a centralized payment processing platform instead. The narrowed focus can only be explained by the relationship between money and cryptography. Based on immense Bitcoin critique from powerful politicians 20 years after PayPal was sold to eBay, the idea of a cryptographically yet centralized PayPal online bank probably was not a popular idea among the Bush administration officials. The original idea to dominate banking shows how much Bitcoin has influenced the libertarian minded group behind Satoshi. In 2022, Bitcoin is competing with  fintech firms like PayPal. Peter Thiel’s public critique of central banking is also something that Satoshi’s shares as show by the massive critique of central banks and government bailouts outlined succinctly included in Bitcoin’s Genesis block via the text about the UK 2008 bank bailout and finally the technology and English writing skills reveals something about the entity behind the Satoshi pseudonym. The fact is that Satoshi started writing Bitcoin code in 2007 and after at least a year registering the internet domain bitcoin.org in 2008, which shows how careful and methodical Satoshi was in development leading up to launching Bitcoin in 2009 makes sense given how the novelty behind merging economic incentives with cryptography to secure a database over the internet challenges the centralized narrative of current world order. First of all,  the Bitcoin blockchain is designed to be transparent, scarce and censorship resistant. The Bitcoin code caps the total circulating supply of BTC at 21 million and the Crypoeconomic incentives in combination with cryptography makes it impossible to manipulate the Bitcoin blockchain’s monetary policy by a single user, which inherits some properties of gold that libertarians prefer over central bank controlled fiat currency.  Second, the Bitcoin Genesis block text taunting UK’s chancellor block was likely aimed at emphasizing the damage done to society via Moral Hazard when governments without repercussion has monopoly over picking winners and losers in the short-term via stimulus packages to prevent systematic collapse, which further proves that Satoshi is a person with libertarian beliefs.

 

Before there was Bitcoin There was PayPal and Ideas

o   Peter Thiel and Elon Musk

§  Creator of PayPal payments systems

·      This explains Anguilla from his interview Cosm

·      PayPal was a decentralized dream from the crypto currency book [23]Sovreign individual by Brexi reese moggs dad lord reese mog[24]

§  Thiel loves to talk about Bitcoin and is behind Ethereum

·      EGOLD on a beach in aguadilla

·      EGOLD on a beach in Aguadilla[25]

·      Wage a war against the Central Bank

·      Indictedd in 2007 by US justice department

Who killed PayPal

·       The Gauseback-Levchin Test

o   The “Gausebeck‐​Levchin” test imposed an image of black letters set against a yellow background with crisscrossing lines, and asked the new user to enter the letters he saw on his monitor to proceed. Human customers could discern the letters easily, but programs pretending to be human couldn’t. The test is still in wide use today among e‑commerce sites plagued by automated fraud.[26]

o   Outcompeted Native EBAY fintech Billpointy

§  50% of Ebay transactions

§  Debit Cash back to attract new users when billpoint partnered with Visa

o   Public on October 2021

§  PayPal consequently decided it was time to begin filing for its initial public offering. That’s when the regulators, lawyers, and politicians moved in.

§  Shots from media

·       hile one Silicon Valley lawyer wrote in the California legal publication The Recorder that PayPal was an ideal money laundering mechanism for “drug dealers and domestic terrorists,” despite the successful anti‐​fraud devices concocted by Levchin’s tech team. Having already entered the mandatory pre‐​IPO “quiet period”—a relic of Depression‐​era reforms—PayPal was prohibited from responding to its critics.

§  PayPal 10K[27]

·       October 26 IML Finance terrorist act Bush

o   PayPal banned by Bush friend Governor Mike Foster LA in October

o   Every transaction above 2K must be reported to Treasury

o   March 2022

·       NY Attornet Eliot Spitzer

o   Unclear user agreement

o   PayPal was used for online gambling websites which violated the US Patriot Act

§  Processing gambling was 6% of revenues in 2002[28]

o   To much regulation

§  PayPal sold to Ebat

·       Setttled with Justice Department for MUSD and agreed PayPal was not allowed to be used for online gambling

o   Ebay Skype

§  EBay failed to integrate Skype into the company's mission. EBay bought Skype hoping to take advantage of its promise of online phone service and its innovative P2P -- peer-to-peer -- technology. Think of the music downloading model popularized by Napster and Kazaa, in which clients interact without the use of a central server, so that information travels directly to and from "nodes," or users. Skype added a communications level on top of an existing P2P technology called Global Index. That allows the company to provide service to millions of users without having to build and host a centralized server.[29]

o   Why did Skype sell to Ebay?

§  Zennstrom called Ebay the first web2 company[30]

·       No other company had Encrypted VoiP

·       NSA could not monitor VoiP

o   Skype Encryption

§  Skype calls whip around the Internet encrypted with ‘‘keys,’’ which essentially are very long numbers. Skype keys are 256 bits long — twice as long as the 128-bit keys used to send credit card numbers over the Internet. The security is much more than doubled — in theory, Skype’s 256-bit keys would take trillions of times longer to crack than 128-bit keys, which are themselves regarded as practically impossible to break by current means.

o   VoiP

§  Skype was Luxembough company not US so gave freedom of communication

§  Ebay paid 4 billion for a 60 million dollar company

§  VoiP existed but not decentralized VoiP[31]

§  Skype is a hybrid of centralized and decentralized[32]

§  SEC Ebay to aquire skype[33]

o   We need to bring this in under Kazaa

 

 

·       Egold and Aguadilla to tie this to PayPal

·       Satoshi tries to create competition with central banks because he is sick and tired of shadow banks

·       Here we need a paragraph that ties Bitcoin to central banking and why it measure the temperature of monetary policy.

·       Worth revisiting Peter Thiel and Elon Musk

·       After the critique move onto money and its relationship with money

·       Bitcoin was just an idea of how to create programmable money because after programmable money other ideas started popping up including programmable decentralization, trust and privacy, which leads us to Ethereum.

·       PayPal is now becoming centralized

o   Charging users 2500 USD for spreading misinformation in accordance with their rules

o   People removed their PayPal accounts in numbers

 

·      All of the above brings back the potentiality of PayPal associated person being behind bitcoin

·       Egold and Aguadilla to tie this to PayPal

o   EGold

§  Founded in  1996 by Douglas Jackson and Barry Downey in 1996[34]

§  Digital currency backed by grams of gold

§  US government believed that EGold worked had flawed KYC by allowing people to register accounts without restrictions and allowed illegal money to flow between borders per a side chan narrative

 

·       Satoshi tries to create competition with central banks because he is sick and tired of shadow banks

·       Here we need a paragraph that ties Bitcoin to central banking and why it measure the temperature of monetary policy.

·       Worth revisiting Peter Thiel and Elon Musk

·       After the critique move onto money and its relationship with money

·       Bitcoin was just an idea of how to create programmable money because after programmable money other ideas started popping up including programmable decentralization, trust and privacy, which leads us to Ethereum.

·       PayPal is now becoming centralized

o   Charging users 2500 USD for spreading misinformation in accordance with their rules

o   People removed their PayPal accounts in numbers

 

o   With @elonmusk now buying Twitter here are some nuggets that help you know what may happen going forward...

§  1. In early 2000, #PayPal tried create #Bitcoin before Bitcoin

§  2. PayPal was created by merging the firms X (Elon) and Confinity (Thiel)

§  3. X was online bank created by Elon Musk

§  4. Confinity was created in part by Peter Thiel as a cryptography and payments company

§  5. One of the VC backers for Confinity was a founder of #Cybercash  in William Melton and a coworker of CTO Steve Crocker in 1995

§  6. slight side turn, but Steve Crocker worked at Darpa  (US Defence technology) and likely had both the connections and inside knowledge of early encryption technology of the internet to create the first #crypto yet he did not...

§  7. #PayPal did not/ was not allowed to create #crypto either and sold to Ebay in 2001

§  8. Thiel understands social media power and that governments like centralized encryption. he is so sure of Facebook that he uses taxfree pension money to buy facebook stock at like 1 cent each

§  9. Despite facebook, Thiel likely wanted a #decentralized social media in reality

§  10. Thiel was in Aguadilla and part of the group that wanted to create a version of #EGold (hacker libertarian group against #CentralBanks ) at some point before #BITCOIN  launch in 2008

§  11. In 2008, #Satoshi creates Bitcoin by leveraging #cryptoeconomics and #blockchain technology in a novel way making a hack of #Bitcoin extremely resource intensive, which is what Thiel wanted to do with PayPal

§  12. Thiel foundation sponsors #bitcoin magazine writer @VitalikButerin to drop out from university to create #Ethereum  in 2014

§  13. Musk repurchases http://X.com in 2017

§  14. Musk Puts #bitcoin in on Teslas balance sheet in 2021

§  15. Musk build solar powered giga factory in Austin that can mine #BTC in 2021/2022

§  16. Thiel comes out and says he was underinvested in #BTC

§  17. Musk now buys social media twitter in 2022

§  18. Texts between @elonmusk and Kimbal talks about making tweets cost money to prevent spam and #blockchain to make twitter censorship resistant...That sounds like #cryptoeconomics and above all else a mix between #bitcoin and #Ethereum to me

§  19. Well making #twitter coin based on a ERC 20 token  on a Thiel sponsored and censorship resistant #Ethereum where there even exist an ENS naming service already sounds like a logical move

§  20. In September 2022 #Ethereum merges and becomes 99.99% more #environmentally friendly by moving to proof of stake, but it also makes it harder for governments to censor both #ETH and #BTC - why?

§  21: Well #BTC uses Proof of Work still, which is resource incentive. But in the future all Bitcoin will be mined using solar and be used as a transfer pricing mechanism for #electricity

§  22. If government thinks #ETH is now a security then #Bitcoin still survives and vice versa

§  23. Conclusion: Musk creates http://X.com the everything app and thiel gets his libertarian viewpoint

§  24. Musk and Thiel have reconstructed PayPal/ merge of Confinity and http://X.com again after 25 years...

o   Truly amazing stuff... #ETH #BTC

 

 

Computation, Bitcoin and Real Economy

Before Satoshi launched Bitcoin, Precious Metals are two assets whose value is controlled by supply and demand and not buy any sovereign nation. It was society xxx back in time XYZ that came up with the idea of using precious metal coins based on bronze, copper, silver and gold. Naturally people were drawn to precious metals because they were hard to fake. However, of all existing precious metals, gold was and remains considered the optimal hedge against inflation by both traditional financiers and libertarians. While traditionalists believe in gold, its mostly technocratic libertarians believing that Bitcoin and some other cryptocurrencies have emerged as an alternative to precious metals for the purpose of hedging against inflation.  Just like gold, bitcoin is a definitely scarce resource meaning that bitcoin value is controlled by market forces such as human behavior driven supply and demand rather than backing by a sovereign nation like the US dollar. hile the amount of gold that exist in the world is unknown, (perhaps insert how to find gold), only 21 million bitcoins will ever exist no matter how much wants to manipulate bitcoin suppy. Historically, gold outperforms only when real yield fall except in exceptional circumstances where interest rates are extremely high (check this).  Real yield equals nominal yield like the the interest set by the Federal reserve minus the inflation rate (In 2022 real yields are record negative). If nominal yields increase more than the inflation rate then the real yield will increase, which in turn means that gold and also Bitcoin doesn’t always perform well under inflationary environment. However, a low nominal yield is a natural function of MMT so in this inflationary scenario gold and Bitcoin would perform exceptionally as hedge. In xyz year (insert footnote from blog) I recommended for historical reasons it’s better for most portfolios hold a greater percentage of gold than Bitcoin. However, I also said that the minimum amount of Bitcoin that should be allocated to crypto is 1% of the total portfolio. As a hedge gold has both strengths and weakness compared to Bitcoin. Gold has a longer history, is more durable and more fungible. Bitcoin, however, is more portable, verifiable, divisible and censorship resistant. What then drives inflation?

 

The typical Budget of an average US Household

The signs that economic fragility would emerge after Covid-19 were significant, perhaps even understood by most, yet global monetary and fiscal policy suggests  global ignorance. Most economic recessions result from complexity. The 2008 great financial crisis emerged as banks overleveraged complex investment products. There is no need to hold a PHD in physics to understand that sending stimulus checks, closing businesses and restricting movement on a global scale would have an obvious negative impact on the economy. Global supply chains depend on movement, business drive economic growth and workers drive businesses. The driver of reactionary policy is our lizard brain and herding behavior.  Virtue signaling and short-term economic solutions superseded  the temporal discounting approach that weighs the pros and cons of a global lockdown. Instead of strategize how sending stimmies to people would effect inflation,  global leaders scrambled to close down borders when China locked down. Instead of transparent public policy, US decision makers behind closed doors partnered with centralized social media sites to regulate information on the internet.  Instead of free market capitalism, US economic policy depended on a CDC public health policy that preferred totalitarian command approach to economics by shutting down businesses and sending stimmies to millions of Americans. As a result, US consumers are experiencing the Covid-19 inflation tax in 2022. The  household budget numbers in 2021 shows  a deep sensitivity US inflation tax. The average household income in 2021 was 61,000 dollars and that income was spent on different parts in the economy like energy, rent, mortgage, clothes and entertainment. The table in Figure 1 outline scenarios in which household salary increases by 3% and inflation by 10%, 20% or 30% spanning 2022-23. The very last row of Figure 1 illustrates that consumers earning 3% more per year must decrease consumption between 14-59% relative to income in this example. A 10% increase in inflation for 2022 will especially create demand shocks for entertainment and apparel. That demand shock will generate hardship for certain business sectors directly and others indirectly, which could potentially bring the US economy into a recession. Inflation is now mainly caused by supply chains and will have a disproportionate impact on transportation, food, housing and energy production. These areas also represent a majority of household consumption. Proactively or in response to inflation, the FED and Treasury may send checks or impose price controls so that US consumers can maintain their standard of living. Otherwise, there may be a great deal of instability in the upcoming two years. The Treasury will most likely also raise taxes on the very rich to shift wealth from those least impacted by inflation. The income tax during WW2 for those earning over 200,000 USD was 94% in 1944-45, we might see taxes approach those levels again as politicians will call the tax a patriotic duty in the fight against inflation.

 

 

 

Shadow Banks, Inflation and Why BTC matters

Not printing money when holding the central bank power to print is emotionally difficult if the purpose of printing is to avoid economic disaster stemming from crisis events like Covid-19. To prevent politicians from basing monetary policy on public emotion instead of rationality, the US congress established the Federal Reserve as an independent from government central bank. Despite FED independence, US monetary policy like most other countries has generally remained easy since the famous Bretton Woods decision to drop the USD to Gold peg in 1971 to promote fiat currency flexibility and in the US, fractional banking got its biggest boost since the 1931 FDIC government insurance program that still protects bank deposits up to USD 200,000. Moral hazard created by FDIC insurance incentivizes banks to move packaged loans from the internal balance sheet’s liability side to off-balance sheet legal entities called special purpose vehicles (SPVs). These SPVs are shadow banks created to avoid traditional banking regulation and allows traditional banks to take more risk with depositors’ money (not their bank capital) to earn higher profits and bonuses, while on paper still following government regulation. Unlike traditional banks, there is no direct deposit insurance for off-balance sheet products like SPVs, but the growth of SPVs and other financial innovations is massive and the derivatives industry is now so systematically important that SPVs therefore enjoy an implied deposit insurance. Imagine running businesses that cannot fail! These shadow banks extend credit through SPVs based on semi scientific gaussian statistics such as normal distributions, correlations and standard deviations, which convinces regulators that SPVs are safe. In normal markets, statistical approaches  are appropriate, but in extreme market conditions asset relationships break down and fat tail catastrophes transpire. For example, the Corona Crisis led to significant unemployment and without stimulus borrowers would default on mortgages even with low interest rates! IMAGINE NOW! Like in the 2008 banking crisis, SPV debt is backed by a diversified portfolio of loans on the asset side and if mortgages start to default due to systematically higher interest rates, then these massive SPVs are unable to repay loans. An increase in mortgage defaults leads to further house price declines as SPV sponsors must cover losses by fire selling at discount prices and now defaults spread systemically through the economy like the corona virus itself similar to a traditional bank run. In 2008, the TARP bill created by President Obama prevented the subprime liquidation cycle from destroying the economy. However, TARP further increased moral hazard by sending signals to shadow bank SPVs that the government prints bail out money.

 

Inflation and The CARES Act

the CARES stimulus like TARP incentivizes shadow banks to extend more risky loans on the asset side, which then increases the systemic importance of the SPVs. The problem with stimulus  is currency debasement. The value of the dollar will perhaps decrease relatively to fixed assets such as gold and consumer products, which leads to inflation. Given the divergence between the real economy and the stock market during the middle of 2020, asset inflation is already taking place. The question is when prices on consumer goods starts to increase. The first central bank was Stockholm Banco, created in 17th century Sweden with the aim to lend government money. Not surprisingly, the firs CEO, Johan Palmstruch, was jailed when the bank issued excessive amounts of promissory notes. When the inevitable bank run occurred, Stockholm Banco went bankrupt. Ever since the first “central” bank insolvency,  the banking system has evolved to prevent future defaults. The current US banking system started with creating the FED in 1913 and has resulted in enormous absolute life improvements for US persons. However, in the last 30 years massive money printing by central banks have created record levels of wealth inequality. Up until 1913, the main objective of central banks was to maintain price stability, but since then many steps have been taken to stimulate the economy at all costs. In combination with information asymmetry between lenders and borrowers,  FED, and FDIC, the US government have created enormous moral hazard problems in the global economy.  The drop of the gold peg and increasing political interference in central banking policy further increased the moral hazard problem during the 1970s, as the termination of the Bretton Woods system led to a faith-based fiat currency system. Ever since 1971, shadow banks have gathered massive amounts of debt through financial innovations such as packaged mortgage obligations, which has increased shadow bank balance sheets to record levels. These shadow banks use SPVs to extend credit like banks use fund deposits to profit. My worry is that inflation is not a question of if, but when. 

 

 

 

Chapter 4: Idea and Execution

 

 

Bitcoin Time

The key difference between Web3 and current technology is spreading power across a range of nodes creating a combined consensus of new and existing data stored on the blockchain. Without decentralization, blockchain technology is still both faster and more secure than web2 databases, but not as revolutionary as the internet. The future of blockchain technology is likely an interoperable combination of  modular and monolithic ecosystems rather than just one monolithic Bitcoin network. The interoperable blockchain ecosystem offering a full range of decentralized application services will complement or replace current Internet technology. The modular blockchain approach is perhaps the same level of decentralized and slightly less secure, but modularity creates much faster execution. In Web3, private rather than institutionalized ownership of capital may limit current political powers. Anti-crypto lawmakers may therefore suggest that bans and strict regulations against decentralized blockchains will prevent what they consider shit products from reaching consumers. Computationally intensive cryptography only underpins proof of work, not other types of consensus mechanisms in blockchain technology like proof of stake, but proof of work tokens like bitcoin should incentivize a renewable energy push, which at the same time solves lack of energy issues in other areas of our economy. Web3 criminals use crypto for illicit activities, but these criminals use USD as well. Unlike current fiat system, blockchain based currencies may create a system where those engaging in illegal behavior are unable to transact with people adhering to laws and regulation. Blockchain becomes a source of truth that disincentivizes undesirable behavior like fraud and other types of  criminality. The Bitcoin blockchain is software representing the equivalent of a decentralized Swiss watch. Just like a Swiss watch relies on physical mechanics to move its arm according to a repeatable pattern in seconds, the Bitcoin network unlocks a precise amount of bitcoins to miners for verifying transactions according to the predetermined schedule outlined in the software. Instead of measuring time in seconds. the predetermined schedule cuts the amount of bitcoins release for the next 3 years and 9 months in half in relation to 21 million bitcoins. For example, if 20 million bitcoins have been released, then over the next 3 years and 9 months miners will be rewarded with 500 thousand bitcoins for verifying transaction. If bitcoin increases in value, more Bitcoin participants are incentivized to start mining. The ingenious part of Bitcoin is that difficulty of mining bitcoins expands in proportion of the number of miners. To successfully mine bitcoins during periods with increased demand to mine bitcoin therefore requires miners to spend more energy to successfully mine bitcoin. The miners therefore look for geography where cheap energy exist, and do not be surprised if that ends up being a renewable sun energy bitcoin factory in the Sahara over the coming decade. Note that if demand for mining remains high when the next halving begins, then mining bitcoins becomes even more difficult. In our example, the halving pattern repeats in accordance with Bitcoin time, and thus more miners compete to earn a share of the 250 thousand bitcoins released. Due to the nature of the continuous halving pattern, Bitcoin will never reach exactly 21 million bitcoins, but will like a Swiss watch continue to counting time infinity until the world ends.  

 

The Idea: A Visual Analogy For How Bitcoin Functions

Satoshi’s motivation to create programmable trust, money and privacy is clear, but the technical aspects are complex. The fact above all facts in cryptographic money is that the Bitcoin blockchain has never been hacked. In a Bayesian world for which probabilities updates with facts, the so far impenetrable Bitcoin blockchain is therefore marginally adding blockchain trust on a daily basis. The proof for expanding trust in cryptocurrencies is in the pudding with the recent adoption of digital assets by public large institutions combining for a market value easily surpassing trillions of US dollars in financial payment, bank and technology firms like PayPal, Venmo, J.P Morgan and Facebook. Although these public companies are generally still just getting their feet wet by simply offering cryptocurrencies to users, other traditional firms are leveraging blockchain adoption to drive financial market innovation.  For example,  on September 6th 2022 one of the largest most well-regarded US private equity firms managing over USD 447 billion in assets, KKR, partnered with the 2017 launched SEC regulated broker dealer Securitize Capital to launch a partially tokenized health care growth fund. Digital asset partnerships like those between KKR and Securitize have the potential to revolutionize private equity and hedge fund markets by offering paths for smaller investors to access deals provided only to large institutions and also provide liquidity to illiquid markets on par with public markets like S&P500 and I will talk more about that later on in the chapter about Tokenization.  Although repeatedly hearing how the Bitcoin blockchain is super secure, decentralized and ownership proof from annoying Bitcoin maximalists like MicroStrategy founder Michael Saylor or loud Bitcoin podcaster Anthony Pompiliano, you may perhaps wonder why Bitcoiners like Michael and Tony feels so strongly about BTC replacing USD as the World reserve currency and as a result keep repeating that maximalist Bitcoin mantra. On the other side of the Bitcoiners and equally annoying are traditional power centers claiming via almost propaganda like methods that the Bitcoin network  is some sort of super Ponzi scheme not backed by any real economic value, terrible for the environment and a great method for criminals to avoid banking regulation. However, as usual, the truth of Bitcoin somewhere in between and the goal of the next section is explaining the most integral components of a blockchain with the hope of facilitating why Satoshi created the 21st century equivalent of the steam engine during the 18th century industrial revolution.

 

Blockchain vs Internet Protocols

In technical Computer Science terms, the Bitcoin blockchain solved the Byzantine general’s problem by doing things on distributed systems that up until 2009 only could be done on centralized systems. By solving the Byzantine general’s problem, Bitcoin became the world’s first tool to create programmable privacy, trust and money and allowed users to send money to other users without paying fees to white collar middleman bankers, which is essentially the financial equivalent of a steam engine to the horse and buggy. In an omnipresent  2013 Bitcoin talk spearheaded together with Coinbase CFO and Network Sate author Balaji Srinjavisan, Naval Ravikant equated the Bitcoin blockchain with HTTP by saying how most Internet users leverage web applications and cookie approvals for their businesses without knowing that all these protocols run on top of the foundation of HTTP, which in turn is a special case of TCP. In the same 2013 Bitcoin talk, Naval goes on to outline the 4 technologies that for the first time in history solved the Byzantine problem and allowed Bitcoin to become the first API for programmable cash allowing hackers with transparent software code to create digital wills, escrows, dividends, payouts and crowd funding. In addition to combining those 4 technologies, Satoshi added game theory and economic incentives, which invented cryptoeconomics. I urge you to reread the below example because knowing the novelty of executable distributed ledgers in 2023 is equivalent to understanding the impact of TCP and later HTTP for the creation of the world wide web.

 

 

1. Digital Signatures in a clever way

I wonder if David Chaum knew when he created the first blind signature in 1983 that his cryptographic invention was the start of a monetary revolution. The blind signature was the foundation of a new type of money that securely connects users monetarily through a blockchain network, perhaps similarly to how internet connects a network of people informationally. Way before the internet, Chaum understood that combining cryptographic proofs with record keeping could create a secure system for sending money peer to peer at super low costs without revealing the identity of transaction counterparties involved and censorship resistant to outside third-parties. Just 15 years ago, the market capitalization for the entire cryptocurrency market was 0 and as of 2021, the total market cap topped 2 trillion dollars.

 

2. Distributed Blockchain Ledger

The second special component of bitcoin and other cryptos is the blockchain ledger. The idea behind the ledger is derived from time stamping legal documents. The reason legal documents get time stamped is so that the person viewing a specific legal document knows when the document came into existence. Like reviewing legal documents, the bitcoin ledger records the time of a transaction, which establishes the order of transactions in its blockchain. In addition to creating order, the ledger also creates a hash pointer to the previous transaction to make transactions more secure. If someone messes with the data of this pointer or so called hash function to the previous transaction then the current transaction becomes invalid, which means that a previous transaction ensures the integrity of the next one: there is no screwing with the blockchain. The bitcoin ledger is more technical than a linear pointer to the previous transaction and instead collects transactions in blocks and trees. This reduces the amount of time needed to certify the previous transaction and speeds up the network. Basically, the ledger creates a decentralized system for authorization of peer to peer transactions. For most centralized databases, there is an administrator that is responsible for validating that the records are accurate in the database. For example, in social media and banking, the administrator could be Facebook and Bank of America respectively. In a transparent decentralized database based on cryptography, the administrator is replaced by a distributed network of validators that is  unable to change records without consensus. The Bitcoin blockchain is therefore a distributed self-governing ledger controlled through consensus used to keep track of how much bitcoin people hold. Distributed consensus essentially means that everyone participating in the Bitcoin blockchain update the database by agreeing upon the network state. Through unique logins – public and private keys - all participants therefore have access to the exact same database. The control of the network – the distributed ledger – is divided between thousands of users, which replaces trusted third parties for updating, maintaining, deleting and approving transactions on the blockchain. Basically, what consensus does is that it makes sure transactions on the blockchain are fair, reliable, in real time, efficient and transparent.

 

 

 

3. Peer to Peer Network

Like a bank account storing transaction history or any other type of centralized database, the main purpose of the Bitcoin blockchain is to record, verify and store data for transaction that are via Bitcoin addresses directly without depending on any type of third-party intermediary. Imagine therefore that the Bitcoin blockchain equal a two dimensional Excel spreadsheet distributed, but instead of only storing information centrally on one main database stores information on a distributed identical database on all computers globally  simultaneously. The information displayed in the two dimensional Excel spreadsheet is all the owners of BTC in column A and the corresponding amount of BTC owned in column B. For every new transaction, the bitcoin spreadsheet updates information on all computers simultaneously, which means  that all spreadsheets on all computers everywhere shows identical bitcoin owners matched with equivalent ownership amounts at the same time all the time. Since, the Bitcoin blockchain relies on Nakomoto consensus and mathematical cryptography, governments or institutions  are unable to change the transaction history of that so called immutable bitcoin spreadsheet. Column A will therefore always show current owners of bitcoin and column B will always show corresponding amount owned, which is an extremely useful tool to protect against property theft in finance and first principles use case of blockchain technology. However, security is not enough for blockchains to expand the technology and replace traditional payment systems because banks fulfill the same functionality as blockchain and people trust banks (until they don’t). Blockchains must therefore become useful, fast and reliable without sacrificing security for people to trust them in everyday life.

 

 

 

 

4. Proof of Work

Bitcoin leverages  Proof of Work consensus mechanism secure a distributed blockchain by providing validators with cryptoeconomic incentives via Bitcoin rewards in exchange for computer powered security provision. The main purpose of the consensus mechanism is verifying  that all Bitcoin network participants holds a verifiably accurate and identical database. The idea behind Bitcoin is to leverage energy and algorithms to prevent fake uses of computing power like double spending. Blockchain networks are comprised of blocks and each block is a list of transactions within a certain time period. The blockchain for bitcoin is immutable because PoW consensus prevents bad actors from changing anything in the blocks. The word chain comes from the fact that new blocks are attached to the previous blocks. These new blocks are created by miners using their computers to add new blocks through executing PoW. It takes around 10 minutes on the bitcoin network for miners to find the accurate PoW hash function to validate transactions. Basically, PoW involves a ton of computer nodes around the world engaging in guesswork to solve a puzzle. Guessing involves a hash function, which is basically the password to a block. As reward for finding the correct password for a block in the bitcoin blockchain, miners are rewarded with bitcoin. The transactions are then validated on the blockchain with everyone receiving the updated record on the new block. Projects that use PoW includes Litecoin, Z-cash and Minero. Like most things in life there are some weaknesses with PoW, which opens up for competing cryptographic consensus mechanisms to take over the pole position for blockchain validation. All blockchain based consensus mechanisms must balance the holy trinity of security, scalability and decentralization. Bitcoin and Ethereum are level 1 protocols meaning that they are foundational base layers. In terms of scalability, both ETH and BTC are slow meaning that they cannot process a high number of transactions per second, but in return, they are secure and decentralized. Blockchain decentralization refers to the meaningful distribution of computing power and consensus throughout a network, while security reflects a blockchain protocol’s defenses against malicious actors and network attacks. Bitcoin, for example, has not been hacked since its inception in 2009, which is an incredible feat by itself! In a perfect world, all three pillars of the holy trinity offer 100% security, scalability and decentralization at the first layer. However, to solve the scalability problem, ETH have many level 2 protocols that intends to increase transaction speed, while lowering gas fees. There are four main approaches for forming layer 2 contracts on Ethereum including channels, sidechains, plasmas and roll ups. These different approaches all have strengths and weaknesses and it will be up to the market to decide which approach is the most efficient. Sadly, achieving more scalability – faster transactions – on a blockchain means sacrificing decentralization and security. There are also other layer 1 projects like Solana and Algorand that attempt to scale faster than Ethereum, but these protocols are less secure and decentralized. In the end, the market determines the optimal balance between these three pillars, which is the reason for why there are so many different tokens that can be traded in the crypto world. The other leading consensus mechanism is proof of stake (PoS).

 

 

 

5. Economic Incentives

In addition to following the Nakamoto consensus mechanism, a functioning decentralized Bitcoin needs motivated security, which Satoshi solved via economic Game Theory incentives. The technology that secures bitcoin and other cryptocurrency transactions is also part of the blockchain to protect against malicious attacks The current purpose of bitcoin is debated heavily by the blockchain community. Like normal money, Bitcoin’s original objective – per its white paper – was to function as a medium of exchange, unit of account and store of value. In addition to fiat money, BTC eliminates the need for trusted third parties like banks to validate transactions; the last part is what makes bitcoin an alternative to fiat currencies. However, as BTC has now been around for around 10 years and with the rise of alternative crypto currencies, BTC has now established itself more as a pure play alternative to gold. Just like gold, BTC is a scarce asset with only 21 million in total existence. Compared to gold, bitcoin is more portable and divisible so many experts argue that BTC will replace gold as an inflation hedge by a large margin. In terms exploring the crypto world, BTC has most likely grandfathered most of us into the cryptography community, which leads us to blockchain.

 

 

Block Wars

Although Satoshi envisions Bitcoin as money like the US dollar, the majority of the Bitcoin community believe the transaction speed of bitcoin is to slow and the price to volatile in the short-term to be anything but a store of value like gold. The debate cumulated in what is now known as the “Block Wars”.

 

 

 

 

The Key Problem For All Blockchains: The Trilemma

PoW was the first consensus algorithm that ingeniously created a secure blockchain by providing validators with bitcoin rewards in exchange for computer powered security provision. Like most things in life there are some weaknesses with PoW, which opens up for competing cryptographic consensus mechanisms to take over the pole position for blockchain validation. All blockchain based consensus mechanisms must balance the holy trinity of security, scalability and decentralization. Despite the development of the Lightning network on top of Bitcoin to increase transaction scalability, the anonymous yet influential Ethereum researcher Polynya believe Bitcoin is incapable of achieving resiliency as a medium of exchange. Polynya believes instead that the Ethereum blockchain is the ultimate solution for increasing blockchain transaction speed without sacrificing security and decentralization. In the many research papers written by Polynya, he outlines how and why a modular blockchain is the winning approach. In computer science, modularity is the degree to which a system's components like the different aspects of a blockchain may be separated and recombined to increase flexibility and efficiency. Modularity therefore seems like an excellent approach to increase blockchain speed while maintaining security and decentralization. Modular blockchains transforms a two dimensional bitcoin blockchain spreadsheet into a multidimensional spreadsheet, which is what creates that additional flexibility. Modularity implies nothing negative about the importance of two dimensional spreadsheets, but imagine using Excel without short-cuts, tabs and macros to automate calculations.

 

 

Bitcoin and Ethereum are level 1 protocols meaning that they are foundational base layers. In terms of scalability, both ETH and BTC are slow meaning that they cannot process a high number of transactions per second, but in return, they are secure and decentralized. Blockchain decentralization refers to the meaningful distribution of computing power and consensus throughout a network, while security reflects a blockchain protocol’s defenses against malicious actors and network attacks. Bitcoin, for example, has not been hacked since its inception in 2009, which is an incredible feat by itself! In a perfect world, all three pillars of the holy trinity offer 100% security, scalability and decentralization at the first layer. However, to solve the scalability problem, ETH have many level 2 protocols that intends to increase transaction speed, while lowering gas fees. There are four main approaches for forming layer 2 contracts on Ethereum including channels, sidechains, plasmas and roll ups. These different approaches all have strengths and weaknesses and it will be up to the market to decide which approach is the most efficient. Sadly, achieving more scalability – faster transactions – on a blockchain means sacrificing decentralization and security. There are also other layer 1 projects like Solana and Algorand that attempt to scale faster than Ethereum, but these protocols are less secure and decentralized. In the end, the market determines the optimal balance between these three pillars, which is the reason for why there are so many different tokens that can be traded in the crypto world. The other leading consensus mechanism is proof of stake (PoS).

 

 

 

Idea

On January 27th, 1880, legendary Thomas Edison patented the lightbulb. Ever since that patent, the evolution of manipulating electricity has been the driving force behind the technological revolution. Elon Musk is currently spearheading the path to a world with self-driving sustainable electric cars and a net zero emission future. With visionaries such as Musk, the world now seems to move from Zero to One in some sort of none-linear leaps. The expression “Zero to One” is derived directly from Peter Theil’s book about entrepreneurship. In Zero to One, Theil details that creating value is not enough if the creator is unable to reap some of the company profits. That is why the global economy must allow entrepreneurs to benefit by creating effective monopolies. Being a rent seeker is not an object of effective monopolies, as this implies a static world where nothing changes and where the goal for founders is to corner markets. Instead of being traditional monopolies, effective monopolies must be incentivized to continuously come up with new products that lacks competition and opens up unopened doors. This line of thinking explains the logic behind time limits on patents, which was for example given to Thomas Edison by the US government to incentivize other inventors such as Musk to execute on important ideas in the future. For entrepreneurs to succeed in creating a Zero to One idea, they need to start companies and this is where venture capital investors enter the story. Add BTC text

 

Execution

After idea generation comes execution, which is achieved by forming a company. Today, creating companies is relatively inexpensive, but access to capital is still important and somewhat more difficult to attract. Certain products including software is less capital intensive, as there is no upfront investment other than time, while other types such as cars require investments in expensive machinery. That is why technology companies such as Apple, Spotify, Facebook and Amazon are “garage” stories, meaning that these tech giants needed less funding than a more traditional business of equal size. Nevertheless, even tech companies need start-up capital, which must be sourced from somewhere. If family and friends lack funds, then entrepreneurs are likely to pitch their product to venture capitalists (VCs). However, becoming a VC also requires access to large pools of money. Add Ethereum Text

 

Ethereum’s mission

As the world’s first programmable cash, the Bitcoin creators was most likely inspired by libertarian ideals. Money is perhaps the most foundational control mechanism for nation-state other than an army because the power to tax in a strong native currency is an excellent method for government to both ensure law abiding citizens and raise funds to improve society. Creating  programmable money outside of the nation-state fiat system therefore goes against the traditional education curriculum approved by most governments in the world, especially when the foundation of Bitcoin is underpinned by a libertarian ideology that governments cannot be trusted. Libertarianism does therefore not attract individuals with political ambition. Launching a libertarian political party in industrialized nation-states is therefore difficult in democracies where an elected congress, court system and President represent the people’s desire to govern nation-states like the U.S. and absolutely impossible in autocracies like Singapore. The closest path to achieve libertarian ideals the typical nation-state democracy is by following the concept of direct democracy, which is a system where elected politicians must obey the outcome of a particular vote and is difficult system in practice. However, the rapid technological advance Information Age is forming technologies like the Internet and Blockchain that is returning power to the sovereign individual. In 2022, people can state their opinion on Twitter, send money via Bitcoin, work from home and easily move to new countries if they don’t like living under certain condition set by a particular government.

 

Like Bitcoin was inspired by the libertarian that freedom from big government abuse, Bitcoin in turn inspired Ethereum and its key creator, Vitalik Buterin. In a personal anecdote that is quoted by Camilla Russo in the excellent book outlining the Ethereum journey, Infinite Machine, Vitalik mentions remembering that the libertarian capital of world, New Hampshire, did not require mandatory seat belts for anyone over 18. Although seat belt laws are generally good, the idea of saying fuck no to seat belts is something that we can clearly see is still influencing the libertarian minded Vitalik Buterin. The Libertarian leaning undertones is perhaps also sone of the major reasons for why Vitalik knew Bitcoin was the path forward. Vitalik’s journey in digital assets actually began as a writer for the Bitcoin Magazine. And thanks to the experience writing for the Bitcoin Magazine, many people in the crypto industry began appreciating Vitalik’s ability to break down complex topics in relatively simple writing. With more and more people reading the writing in Bitcoin Magazine, Vitalik successfully expanded his network in the early day of the crypto industry around 2012.

 

Through that expanded network, Vitalik tried to get his hands on projects within the cryptocurrency industry. One of these projects was assisting the team at Mastercoin with various tasks, which was a team trying add smart contract functionality to Bitcoin. [35]However, it was the project after Mastercoin that would change the cryptocurrency industry forever, which was a project introduced to Vitalik after Yoni Assia in 2012 when visiting Israel. Vitalik asked Yoni who at the time was  known for  heading up the traditional stock and foreign exchange company Etoro if there were any interesting projects in cryptocurrencies that Vitalik could help with. Yoni knew that Vitalik was capable of breaking down complex cryptocurrency topics and offered Vitalik bitcoin in return  for writing the white paper for Google venture Color coin. The rest is history because while writing the white paper on color coin, Vitalik understood that Bitcoin’s currency application could be extended to maintain ownership of basically anything that only one person can own at the time and be represented as a digital asset like a physical painting, music, bank account or an insurance contract.

 

After the initial white paper on Color Coin, Vitalik though more about how Mastercoin idea of creating features to an existing blockchain was  sub-optimal, when creating a new more flexible chain like Ethereum was possible. In the book Infinite Machine, former Bloomberg journalist turned full time author Camilla Russo outlines how Vitalik from spiritual standpoint spearheads a  group of young libertarian men to create the Ethereum blockchain by overcoming unparalleled levels of entrepreneurial and regulatory challenges that comes with creating a decentralized open source product that challenges power centers of the traditional finance.

 

Unlike Bitcoin, the idea of Ethereum is ultimately creating a censorship resistant world computer, which challenges the 21st century power dynamics of the and above all else the nation-state, which amassed power thanks to the Industrial Revolution. As a result of the potential conflict with powerful interests,  the unicorn loving billionaire selfless genius Vitalik Buterin and the  remaining founders of Ethereum decided to follow the traditional of forming a company as a necessary centralized evil to overcome regulation and dynamics put in place by the establishment.  Vitalik Buterin and fellow co-founders of the Ethereum Foundation launched their mission to develop the world computer via designing a blockchain for programmable computers, they outlined a vision of creating a generalized version of Bitcoin Ethereum’s yellow and white paper, which spanned five major technological epochs. Although continuous marginal improvement is always necessary to reach the next epoch of Ethereum’s evolution, the yellow paper showed that Vitalik and the co-founders understood that what is safe today might not be tomorrow. Perhaps, Vitalik and the gang read up on history, which outlines the battle  between cryptography and cryptanalytics like ancient Greece vs Persia or Julius Caesar versus the world.

 

Ethereum Foundation

Just like the Industrial Revolution allowed the nation-state to challenge and overcome the power of the church, the Information Age is allowing a group of nerdy libertarians with a utopian fantasy for creating a world based on decentralized consensus to challenge both the democratic and autocratic the nation-state. However, perhaps to Vitalik’s despair, the Ethereum co-founders still needed to create a nation-state approved traditional company So together these young men launched a company called Ethereum Foundation LLC and choose the crypto friendly nation of Switzerland as home base in 2013. The utopian group of individuals includes co-founders Vitalik Buterin, Charles Hoskinson, Anthony Di Iorio, Joseph Lubin and finally, after some heavy debate among the original’s founders given the title co-founder despite joining the Ethereum project at later stage, also developer Gavin Wood. The Ethereum Foundation was the beginning of wild still ongoing journey on how cooperation from Russia to Canada only guided by economic incentives as outlined by the transparent Ethereum blockchain and without any central management  leads to the development of a multi-purpose decentralized world computer based on Network cooperation principles in the Information Age instead of principles preached by God and State.

 

 

Programmable applications

In the second line of Ethereum’s white paper, Gavin Wood refers to Bitcoin to make the point that peer to peer value transfers are technologically possible to accomplish at low cost without depending on any sort of trusted bank like third party. If the second largest cryptocurrency with a market value surpassing 200 billion dollars mentions another cryptocurrency in the second line of its founding document, then it’s clear that the successful application of Bitcoin must have inspired the entire digital asset space, which is valued above USD 1 trillion in 2022. In the paragraph following the second sentence, Gavin refers to Bitcoin as a transaction-based state machine or in more simple terms a currency application that allows users to securely transfer bitcoin to other users. My interpretation of Gavin’s explanation is that programmable money, trust and privacy were the key objectives with Bitcoin, but that Satoshi could have done more than just creating a currency application. one of these hints was the possibility leveraging smart contracts on the Bitcoin blockchain. That hint to add smart contracts  was the foundational component when Vitalik Buterin first proposed to create a more generalized version of Bitcoin or as is quoted in the yellow paper, “The key functionality of a blockchain with a Turing-complete language and an effectively unlimited inter-transaction storage capability remains unchanged.” [36].

 

The Ethereum team have various views on Bitcoin, but they all agree that monolithic blockchains like Bitcoin are sub-optimal. By sub-optimal the Ethereum team that Bitcoin is too slow to become an all-purpose blockchain as all key functionalities like consensus, settlement, data availability and execution take occur on a singular layer,

 

The goal of Ethereum is to become a modular blockchain that splits key functionalities into separate layers per Figure xxx. When Bitcoin was created in 2009 accuracy was prioritize above over speed and cost. If Ethereum wants become the base layer in a blockchain based network of computers for programmable application the speed and cost per transaction needs to needs to be high and low respectively. As a result, Ethereum needs high accuracy, cost efficiency and speed. Improving Ethereum takes time and that is why Ethereum is going through a marginal improvement process across five stages.

 

In the original 2014 Ethereum white paper, Vitalik describes how Ethereum aims to leverage smart contracts to become a foundational network for all types of programmable applications in Web3 similar to how TCP,IP and HTTP protocols are the foundational networks in Web2 for centralized Internet applications on iPhones. In addition to adding smart contract capacity on-chain, Ethereum also wanted to leverage a different consensus mechanism in Proof of Stake to solve more efficiently solve the trilemma of scalability, decentralization and security. By adding smart contract functionality and PoS consensus mechanism into the programming language instead, Ethereum aims at creating an invariant base layer for new decentralized applications allowing for high security, speed and decentralization, while maintaining low cost per transaction.

 

Although Bitcoin made it possible to execute a blockchain for programmable application, the macro idea behind Ethereum is derived from Alan Turing.  was that users with private wallets that connected to ethereum can create, purchase or use decentralized applications like banking, social media or any traditional applications apps on their smartphones without requiring pre-approval from centralized third-party stores like Amazon, Google and Apple. In other words, a decentralized censorship resistant cloud based world computer functioning as a base layer platform for any type of web based application.

 

o   In the book introduction we talked about how developers must balance pros and cons of consensus mechanism depending on the objective

o   Although Bitcoin is aiming to leverage the lightning network, Bitcoin was never built to handle more functions than sending money peer to peer with censorship resistance

o   Ethereum wanted to create a blockchain that on top of sending money peer to peer could do more.

 

To overcome Bitcoins 2 dimensionality, Ethereum leverages smart contract technology. The smart contract allows users of the ethereum blockchain to sign a contract that outlines the rules of the game in advance can therefore interact peer to peer without necessarily trusting each other or worrying about government involvement. Ethereum therefore expands upon the foundational principles of the Bitcoin blockchain; immutability, accuracy and censorship resistance.

 

As of 2022, the Ethereum project is an unparalleled success with hundreds of billions in market value, millions of users and thousands of decentralized applications. Even if Ethereum fails to become the number one blockchain in the Network State, the objective of a small group of Greys to create a censorship resistant world computer that is owned and used by everyone, I believe, was achieved successfully beyond the wildest dreams of anyone.

 

 

o   If bitcoin is an excel spreadsheet with unlimited rows and 2 columns, Ethereum is a spreadsheet with an infinity amount of columns, rows, tabs, functions and macros, which can be used to create any type of application

§  Ethereum wants to be the world computer

§  And decentralized web3 was born via DeFi application were born!

·       Ethereum Statics

o   Market cap

o   Number of Dapps now

o   Compare addresses to BTC

 

 

 

Key Players of Ethereum[37]

Outside of the cofounders, there are several key players that made Ethereum happen.  Draw inspiration from some more recent people and not just history. Refer to Vitalik the splurge merge…etc…. use Infinite machine.

 

 

From Proof of Work to Proof of Stake[38]

Both PoW and PoS blockchains follows the ethos of incentivizing desirable behavior and punish undesirable behavior to form absolute consensus on a blockchain. If PoW is the father, then PoS is the son. Like fathers, the PoW mechanism is time tested, but requires more energy to function properly, while the PoS mechanism is younger and have energy to explore and challenge the status quo.  In comparison to Ethereum, Bitcoin mining requires expensive investment in hardware with high GPU processing power and access to cheap energy is beneficial. Pro PoS maximalists believe that the expensive nature of running Bitcoin nodes benefits the wealthy. Ethereum is cheaper and its decentralized consensus mechanism that allows anyone to participate. As a result, the Ethereum team early on decided that Ethereum at some point needed to switch from PoW to PoS, but switching took much longer than anticipated.and largest consensus mechanism for cryptos, then PoS is the largest competitor. PoW is number one because both BTC and ETH still use PoW. However, the plan is for ETH to migrate over to PoS to limit energy usage when verifying blocks on the blockchain. In a PoS world, miners use the underlying token for staking rather than computing power and in return earns a reward. To prevent powerful miners from attaining too much power there is often an inverse relationship between staking and return. If a miner stakes a lot of coins, then the return is lower, which disincentivizes centralization. Other than a lower environmental impact and perhaps a greater amount of decentralization, PoS also removes some of the other main issues with PoW. A great analogy for comparing PoW and PoS is done by the educational YouTube channel, Whiteboard Crypto, and we will extend that analogy via the first edition of Consensus Mechanism Olympics.

 

Consensus Mechanism Olympics

The 100 times 100 meter flagship event competition of the first ever Consensus Mechanism Olympics. Unlike a traditional 100m event, only 8 participants are competing in total and the race require runners to compete 100 times. Perhaps unfair, but the 8 participants have no idea if event rules follow the proof of work or proof of consensus mechanism. The winner of each race receives a reward in the form of Bitcoin if the race follows the proof of work and Ethereum if the competition follows proof of stake. After participants completes the 100 races, the participant with the most reward is crowned the first ever Consensus Mechanism Olympian. With the objective set at winning many races, the uncertain rules mean that participants must prepare to compete both in a Ethereum and Bitcoin race. Keep in mind that the participants are selected from a random group of people with some of them poor and athletic and others are fat and rich. Poor and athletic participants can work hard at accumulating Bitcoin by selling Ethereum, while fat and rich can

 

For a proof of work race, participants should use all resources to get fit. For participants running the PoW race, the goal is to reach the finish line first to get a reward; there is no second place or participation trophy.

 

The person who wins the first race is most likely to win the next race so in the PoW system the people who are most athletic earns all rewards. However, it might be the case that 7 participants in the race gets sick so sometimes the person who is the least athletic might win the race. In reality, the runners in PoW are miners competing to solve a computational puzzle. With a strong computer the miners are more likely to solve the puzzle and earn the mining rewards. Worth noting is that more participants means a more difficult the puzzle to make sure that blocks are not solved to quickly or slowly; in fact, it always takes 10 min to solve for a block in the BTC blockchain. In PoS, there are still 8 runners, but only one runner gets picked to finish the race. However, in order to be on that starting line all 8 runners must have staked something – putting up collateral like a mortgage – so if they get picked and don’t finish the race they will lose some of their stake as a punishment; this is called slashing.

 

PoS algorithms have different factors that in combination chooses who becomes the validator validating the block. Some PoS algorithms give a higher likelihood of being a validator to those participants who have staked more coins. Other PoS models considers the amount of time participants have staked their coins. Finally, almost all PoS models also take randomness into consideration. To figure out a factor combination, reading the white paper for each blockchain token using PoS is a must.

 

 

 

 

Why I am bullish on ETH

The Ethereum blockchain is miles ahead of competitors when it comes to the creation of a well-executed decentralized database in a modular fashion. The biggest risk is OFAC compliance, which was supported by major players in the crypto space. However, many of them are looking for regulatory capture and among those that are pro OFAC is the now disgraced crypto king and former owner of the digital asset exchange FTX and hedge fund Alameda research Sam Bankman Fried. Despite threats against decentralized blockchain like OFAC, I expect that a decentralized-applications leveraging the unique properties of Ethereum in combination with a great user interface to be the canary in the coal mine for blockchain adoption among the general public.What is modularity in Blockchain actually though? We now know that modular blockchains may separate core functions of the blockchain into different layers to speed up transaction capacity while maintaining the highest level of decentralized security that is possible. Modularity also exist in outside of the digital world. For example, famous entrepreneur Ingmar Kamprad brought modularity to the furniture business. Instead of selling a completed couch, Ingmar created a furniture empire by separating the components of the couch and then package these components to build the same couch, which simplified the shipping process while maintaining quality of the end-product lowering costs to both IKEA and customers.  A monolithic blockchain is basically furniture packaging before IKEA introduced modularity to the furniture business. Transforming a monolithic blockchains into modular blockchains is therefore similar how IKEA transformed the process of ordering furniture.  Instead of making blockchains like Ethereum incorporate high security, decentralization and speed all at once in a singular execution layer, the modular blockchain approach layers these most important to generate faster and cheaper transactions cheaper without sacrificing quality. Where Monolithic Blockchain may Fail: The Blockchain Trilemma and Congestion. The blockchain trilemma states that blockchains have to sacrifice security, speed or decentralization to achieve the other two components.  In my opinion, achieving decentralization is by far the most important objective in the trilemma because without decentralization blockchains are just marginal improvements to our current centralized application system. The remaining hurdle to overcome is then increasing both speed and security without negatively impacting decentralization.  The bitcoin blockchain has already proved blockchain security, which leaves speed as the remaining objective to achieve for our two most decentralized blockchains, bitcoin and ethereum, to generate blockchain adoption.  In addition to expanding highest speed, blockchain networks must also maintain high minimum speeds, which occurs when blockchains are maximally congested. Network congestion is triggered by mass use at the same time overwhelming the network. Blockchains are not unique when it comes to suffering from network congestion. For example, websites may become congested when new products are released. In a modern society, network congestion creates a blockchain user experience comparable to traffic jams during rush hour in a big city. However, instead of driving like a snail or inability to buy new sneakers, blockchain congestion prevents transaction settlements or creates super expensive transactions.Developers are working extremely hard on approaches to solve blockchain congestion because if transactions are slow or expensive compared to centralized application users will stop using Daps.

 

 

Solving Congestion

Computer scientists focused on decentralization favor lowering network transaction costs and congestion by bringing IKEA’s furniture approach to the blockchain space. These developers want to separate consensus mechanism, execution and data availability – all core blockchain functions -  into different layers with Sharding, Rollup and ZK proof methods so that more decentralized blockchains like Ethereum executes transactions quicker than fintech platforms while remaining censorship resistant to negative political influence. Note, system developers with a centralization preference are willing to sacrifice decentralization and censorship resistance for faster transaction speed. These developers prefer monolithic blockchains like Avalanche, Near, Solana and Binance. The difference between these monolithic blockchains and current technology giants is marginal, but these centralized blockchain apps are capable to create some of  the most user friendly Dapp/web3 network in the world. Monolithic blockchains have flexibility to add more core blockchain function into each layer compared to modular blockchains. By relaxing decentralization requirements, monolithic blockchains require fewer validators, which make validators sensitive to pressure from influential politicians and powerful institutions. I believe the modular blockchain is the superior approach simply because modular blockchains are at least as fast as their monolithic cousins without sacrificing decentralization, which I consider the core concept of blockchain technology. The easiest approach to understand the application of blockchain modularity through sharding, rollups and ZK proofs is through a visualizing example. Sharding, rollups, and ZK proofs is the equivalent to solving congestion during rush hour traffic by creating a new highway that only allows self-driving electric taxi cars or niche vehicles needed to transport goods or lots of people like trucks, busses and tractors. Through improving technology, applying careful regulation and increasing highway options, commuters can reach their desired destination safer, faster and cheaper, while conserving energy and reducing the number of cars on the road. How Sharding, Rollups and ZK proofs solve rush hour congestion in blockchain: Sharding opens new highway lanes, which conserves energy and limits congestion. Rollups equal new regulation by providing flexibility for niche blockchain use cases. ZK proofs cryptographically enhance security similar to self-driving car technology. I will write a separate one pager that in depth analyze the technical aspects of Sharding, Rollups and ZK proofs. Knowing the technology behind these three modular foundation pillars is great, but understanding why and what each pillar achieves for blockchain technology is most important.  Specially, for early adopters or those investing in crypto.

 

The Ethereum Merge

The September 15/16th 2022 Ethereum merge is perhaps the most significant event for Ethereum since launching the native ETH token, which emerged from an initial coin offering raising around 31,000 BTC equating to around USD 18.3 million in capital at a price of around 0.31 USD/ETH. Considering that Ethereum’s 2022 market value now surpasses USD 235 billion making Ethereum the second largest blockchain in the world behind Bitcoin, the upcoming merge is of historical significance not just for Ethereum, but for the entire Blockchain industry. The aim of the merge is switching from Ethereum’s current cryptographic based consensus mechanism Proof of Work (PoW) to Proof of Stake (PoS), which is a switch supported by a majority of Ethereum users noting that some dissenting opinions exist from network participants like miners prepping to mine ETH Classic. The merge basically reduces some of the costs and problems associated with the monolithic PoW crypto trilemma, which is a trilemma similar to the impossible trinity problem in traditional markets. Just like mandating fixed exchange rates, free capital flows and at the same time conducting independent monetary policy is impossible for governments to achieve, the monolithic crypto trilemma prevents blockchains from efficiently maximizing scalability, security and decentralization in the same layer necessary to outcompete centralized institutions like Visa, Goldman and Mastercard from a user perspective. (1) Scalability is the transaction speed. (2) Decentralization is meaningful distribution of computing power and consensus throughout a network. (3) Security reflects a blockchain protocol’s defenses against malicious actors and network attacks.By moving away from the monolithic approach used by blockchains like Bitcoin where core functionalities including consensus, settlement, data availability and execution occur on a singular layer to instead rely on a multi-layer core functionality approach, the merge increases Ethereum’s modular capacity, which reduces energy consumption, clears the path for proposer-builder separation and cuts ETH token issuance by more than 90%. The Merge expands access to institutional investors with environmental energy concerns, democratizes the maximal extractable value (MEV) through holders staking ETH, reduces transaction costs of level 2 roll ups by an order of magnitude, and makes ETH 90% more deflationary (1.6K ETH issued daily instead of 16K) Currently, Ethereum miners earn around 14,400 in ETH rewards daily for securing transactions on the PoW network profiting miners with superior hardware the most. In addition, MEV bots and arbitrageurs extract an excessive premium from Ethereum users in return for providing liquidity and post merge that value is transferred to stakers, which will generate more Ethereum adoption. The transition to PoS also paves the way for future transaction fee reduction on both the main network and level 2 roll ups like the EIP-4844 proposal. Finally, although difficult to predict, the likelihood of institutional capital flooding a more ESG friendly Ethereum network expands vastly post merge.

 

How Ethereum Will Share the Liquidity Premium

Blockchain technology enables decentralized trust keeping by relying on cryptography and consensus algorithms instead of institutions. Ethereum is therefore emerging as a low cost high security alternative to centralized institutions as a tool for users and business to exchange goods, services, communication and information via Internet. Ultimately, the merge is a major step for Ethereum to create a blockchain network that minimizes the institutional capacity to extract network value from small users, which is what I call harvesting the liquidity premium without taking appropriate risks and is all too common in the centralized economy of today. Basically, internet technology has allowed large centralized monopoly institutions to extract excessive fees and information from consumers and business in return for facilitating transactions and providing information security, which drains money from society to a few leading institutional stakeholders.  There will always be a liquidity premium, but the problem is how capitalist oligopolies and governments are incentivized to extract that small fee from users and citizens. The liquidity premium includes profiting from harvesting user and citizen information indirectly or money directly. The main problem is that the incentive to not take risk means that sometimes there is no risk associated with the service that is provided by third-party institutions in return for harvesting money.The true definition of liquidity premium is compensation for taking risk, but harvesting money is providing liquidity without taking risk. For example, banks extract liquidity premiums in the form of charging interest for providing services like lending money to homebuyers, which is why the interest rates are higher for homebuyers with bad credit scores. If a homebuyer does not repay the loan then the bank lose money. The key to the definition of the liquidity premium is therefore taking risk, but when incentives are misaligned money is just harvested, which is defined as moral hazard. The Great Financial Crisis in 2008 is a textbook example of moral hazard, as bad mortgage loans by big banks got bailed out by the US government through the trillion dollar TARP bill when housing prices dropped so quickly that it threatened the survival of the US economy. That fiscal put money was then in essence harvested by bankers, while US tax payers took all the risk.  Over time, harvesting small fees is like how wasting time lowers economic output For example, experiencing slow internet at work one day may lead to a 10 minute productivity loss per worker that day, but if it's 10 min everyday over 20 years, the cumulative productivity loss equals 41 days per worker, which is essentially equivalent to the harm caused to society from the harvested liquidity premium by banks through charging consumers 0.001% for every transaction. On an individual level those fees are barely noticeable, but scaling that transaction fee to account for a global population of 8 billion people, you can see why bankers generate excessive profits for just owning government licenses, some software and a central database. In an efficient decentralized blockchain economy, users share the excess liquidity premium profits proportionally to the amount of tokens staked together with the creators of decentralized applications established on top of the Ethereum network making everybody participating an owner and liquidity provider. In a pure decentralized Proof of Stake blockchain based economy, these monopoly institutions must therefore develop decentralized services via the Internet on top of blockchains like Ethereum. By providing good services, these institutions will still make money, but they will not harvest a simple liquidity premium like in the past.

 

 

Consensus Mechanism Difference Between Proof of Stake and Proof of Work

The market extractable value on Ethereum pre-merge totaled around 650 MUSD. Out of the total MEV, ethereum arbitrage players filtrated out over 64%, while miners extracted less than 36%. That means before Ethereum flipped from PoW to PoS, pure arbitrage traders received almost 400 MUSD from not providing much value other than liquidity. Those figures account for less than what middlemen extract in traditional finance, but the aim is to lower that number significantly via proof of stake. By managing the Casper PoS protocol both for Ethereum’s “main chain” and all future chain shards post the September 15 ETH-merge, the Beacon chain becomes the core consensus layer for Ethereum. The transition from PoW to PoS means transferring Ethereum’s entire 0.5 to 1 TB of blockchain data history to the Beacon Chain, which is why the ETH merge is such a huge event. Note that prior to enforcing the rules per Ethereum’s PoS consensus mechanism post-merge, the Beacon Chain has already attracted a significant amount of validators by offering staking yield and block proposal power in return for these validators supplying 32 Ethereum as collateral via a smart contract on Ethereum 1.0. The Beacon Chain therefore allows the PoW to PoS transition to flow smoothly. Without going into much complex detail, a racing competition is a great analogy for understanding differences between PoW and PoS consensus mechanisms. Imagine that 8 cars of different quality are provided with the opportunity to participate in two separate racing competitions. The first format is a PoW race and second is a PoS race, but in both formats the winner is awarded with crypto tokens for finishing first. In a PoW race, the car with the most resources likely wins both the first race and future races, which means the best car likely earns almost all rewards. However, in a few instances spanning many race iterations, the fastest cars might all break down at the same time during a race, thus letting slower cars earn rewards in a few instances. These PoW racing cars are like miners racing/competing against each other to solve a computational guessing puzzle race. However, instead of fast cars, Ethereum PoW miners use strong computers meaning the strongest computer miners earn all rewards just like the best racing cars. Although PoW mining might use renewables to power cars in the future, PoS racers believe having all 8 cars racing incentivizes faster cars is both unfair and increases energy consumption, which pollutes the environment. In addition, PoS racers believe the PoW takes too long to complete a race and is also too expensive hence slowing and making the PoW blockchain centralized. To limit energy consumption, increase speed and provide equal opportunity, the PoS racing competition therefore only allows 1 out of 8 cars picked randomly by a randomization algorithm to finish the "short" race. In PoS, the cars are generally chosen based on staking a higher token amount for a longer time and with a high capacity to actually finish the race if chosen. In PoS, staking tokens means fronting collateral like a mortgage in return for yield – so chosen cars failing to finish a race will lose part of their staked token as punishment, which Vitalik Buterin refers to as the slashing incentive. “The Beacon Chain becomes the equivalent of a FIA referee if above racing competition was Formula 1”. After PoS goes live, the Beacon Chain’s most important management function therefore becomes ensuring that validators validate and propose blocks accurately. If a validator misbehaves, the Beacon Chain will respond by taking some of that validator’s 32 Ethereum held as collateral through slashing or tossing them out entirely.

Ethereum’s Watershed Moment

The Ethereum watershed moment is movement to decrease the market extractable value to 0. The idea is to create the equivalent of biological ecosystem where economic growth fuels the network. One can picture the Ethereum watershed as a sunny sky with water filled mountains. Due to gravity, the water from the peaks flow downstream first to the hills, then to the flatland and finally into the groundwater. At some point  water evaporates due to the heating of the sun into clouds refilling the water resources on top of the mountain and the system repeats. The mountains represent Ethereum’s kinetic potential, the hills are blockchain layers, the flatlands the dApps, the trees the developers, the allocators are tree keepers and, the clouds are MEV bots, the leafs are ideas that are growing and the groundwater the ethereum blockchains (the Ethereum Stakers). Although the beacon chain ensures the integrity of the Ethereum network, the largest benefit of PoS is not increased integrity or reduced energy efficiency, but rather the democratization of the miners’ extractable value with liquidity premiums proportionally flowing downstream to end-use stakers. Just like physical products undergoes a supply chain process refinement starting with raw material and ending with a finishing touch prior to being sold, the blockchain refines ETH transactions through transaction supply chain process for which each step of the supply chain adds marginal value to end-users. As described earlier, Ethereum’s PoW supply chain process extracts excess value from end-users to certain key stakeholders and is therefore blunt and inefficient. Currently, all transactions in the PoW system is first submitted to a memory pool, downloaded and saved by Ethereum miners, then arbitrage bots fight each other for arbitrage opportunities by bundling transactions and placing them in an order to benefit the owner of these bots and finally miners collects all transactions to build a block and earn a reward for doing so. However, these bots and miners can extract value through sandwiching, replay, liquidation and arbitrage from users and that is not good. Just like raindrops trickle-down to watersheds due to gravity, the liquidity premium trickle-down to Ethereum stakers thanks to the laws of economics as MEV searchers and Block Builder fight each other to have their transactions included by the block proposers by bidding competitively. These competitive bids lead to fee compression, which allows economic surplus raindrops to flow downstream to the Ethereum Staking watershed. Bankless Co-founder, David Hoffman, points out in a blog called Ethereum’s watershed how the move PoS flips the liquidity premium from large platforms with access to expensive hardware and private networks to Ethereum stakers, which are us the end-users.

 

1.Transaction Origination – memory pool

When users transact using Ethereum there is an extra fee added to incentivize settlement after the transaction is broadcasted to the Ethereum Network nodes.Before being accepted, the data associated with that transaction is downloaded by the Ethereum nodes in a so-called memory pool, which is a limbo state for transactions that have yet to be settled on Ethereum’s blockchain. If users pay a priority fee, a form of bribe, or if the transaction is picked up and bundled by a MEV searcher, the transaction is more likely to be accepted and included in a block quickly.

2. Maximum Extractable Value Bots – micro arbitrageurs

These MEV searchers in turn arrange their transaction bundle in a specific order with the aim of paying the block builder the most attractive fee for transaction inclusion. In PoS, the block builder will capture more than 99.99% of the MEV, as these arbitrage MEV seekers compete with each other to have their bundle included by the block builder.

3. Block Builders – macro arbitrageurs

Block builders then combine bids from bundled MEV searcher transactions and priority fee paying users to pay the block proposer. Before including a bundled transaction by MEV searchers and priority fee paying users, the block builder will simulate all possible transaction bundles to find the most profitable combination and then fill the remaining block space with memory pool transactions. In this step, block builders compete through using superior hardware to find the most profitable memory pool transaction and private network order flows, which means Block Proposers capture 99.99% of block builder MEV.

4.Block Proposers – ETH Stakers

Ultimately, the block proposer accept block builders offers with the highest bid. These block proposers are the Ethereum stakers – end-users – and all stakers do is basically choosing the block builder offering the most profitable block! Stakers then sign off on the best bidding block builder’s proposal by validating it and collateralizing that signature with a corresponding Ethereum stake!

 

 

Ethereum Future

·       Ethereum Roadmap

·       Verge Merge..

·       What does each of these updates actually mean

 

 

 

 

 Data Structure for the Ethereum Blockchain

The main purpose of cryptography is to validate that all information contained in the new block is accurate and also protecting information in historical blocks from manipulation methods like protecting relationships of  private keys  with  public keys through cryptanalytic reverse engineering. Vitalik states above that efficient cryptography minimizes need for data availability while keeping the same level of data integrity, which may require using slightly more energy, storage and difficulty for approved network users to open and verify messages, but makes it more difficult across all aspects for anyone without keys to solve or circumvent the cryptographic proof. That is why Polynomial Proofs are necessary for the “wider” Verkle Trees implementation. Ethereum’s main focus with both moving from PoS to PoW in the coming merge is mostly on improving decentralization and reducing energy consumption by distributing rewards proportionally in return for verifying transactions to lightnodes (small smartphone users) on the Ethereum network. However, to maintain decentralization and security for post-merge development to become a data availability and consensus layer for DApp developed on top of Ethereum, the underlying cryptography of Ethereum needs added complexity to remain scalable when execution and settlement for a majority of transactions for cost and efficiency reasons transitions to layer 2 applications and blockchains like ZK Sync. Post-merge, Ethereum aims to become a world computer by allowing layer 2 applications to leverage Ethereum for decentralization and securing transactions via provision of data availability and consensus.

 

Understanding Cryptography Using an Historical Analogy

Say that I am a knight in charge of a town bordering the enemy and I want to send a message to my King about a pending enemy attack. For security reasons, I can use a form of stenography by shaving my messenger's head and write on top of the head that “the enemy will attack”. After the hair grows back, I send the messenger to the king who knows the message is written beneath the hair and if the messenger is caught by the enemy, the enemy won’t know about the message on his head.  However, instead of just sending the plain message beneath the hair, I can therefore use a monoalphabetic cipher to protect the message against the enemy by moving every character in the message three steps to the right so that letter “A” becomes “D” and “E” becomes “I. If the enemy has never accounted for ciphers or does not understand what cipher method being used, the enemy needs to spend energy to break the cipher, while the cipher only requires slightly more complexity for the king to read the message. Although a Merkle tree relies on complicated math instead of stenography, the Verkle adds a cipher to the stenography used by the Merkle Tree, which in this case is polynomial mathematical proofs rather than vector commitment proofs optimizing the cryptography!

 

Ethereum Benefits from Verkle Trees and Polynomial Commitments

Merkle Patricia Tree

Verkle tree

• Efficient with width 2 (Binomial Merkle Tree)
• Rely on hash function
• Average proof size is 18 MB
• Path includes all sister nodes must be included at each step in the tree until reaching root hash (Expensive and slow)

• Wider
• polynomial commitment shrinks average proof size to around 200 bytes per account
• Lower proof generation time (quicker processing)
• Path is proof (leads to greater width and shorter path)

 

 

 

Modularity

The objective of the blockchain technology is to make Web3 user friendly, which drives adoption. Before Steve Jobs drove adoption of smartphones via creating an exceptionally user-friendly smart phone interface, computing power and hardware technology needed to scale.  When scale was sufficient to create  smartphones, Jobs created the first platform Web2 Internet applications via the iPhone. For Web3 to advance, decentralized applications must first overcome the blockchain trilemma. After overcoming the trilemma, inventors like Vtialik Buterin will create the “Apple” platform decentralized applications via blockchain modularity. The goal of modularity is to delegate security and decentralization to the fundamental layer one blockchain. Examples of fundamental blockchains include Ethereum, Near, Solana and Cosmos. When security and decentralization is established on layer one, developers can use various cryptography tool to build layer 2 and  layer 3 chains that allows much faster transaction speed. The 4 core blockchain functions for both monolithic and modular blockchain are, Data availability Consensus, Settlement, and Execution. There are different  Ethereum wants  except data availability and consensus to separate layers the more modular and in my opinion the better the chain. The measure of scalability is how fast a blockchain can create new blocks, which is measured by transaction speed per second. Each block of blockchain is created to store information. Larger blocks and the less information verify that the information is accurate means a speedy transaction throughput. With more transactions per block and higher storage, the user experience of the blockchain greatly increases. Worth noting here is that base layer blockchains may be slow, but shift scalability to other layers. The creator and validator of new blocks earn rewards in return. For tokens and cryptocurrencies, the cost per transaction for users should be low, while maintaining security. Not that the average cost does not always reflect optimal cost. For example, there was huge volatility cost spike for both Ethereum and Bitcoin with exponential price increases right after the COVID drawdown in 2021. Costs should both be low on average and not vary much from the average to reflect good pricing. Ethereum wants to decentralize mining reward to everyone via a concept called stateless clients. For a blockchain to be truly decentralized across the whole ecosystem from block miners, validators, users to bot operators, MEV extractors and block builders, the decentralization and final decision maker must be the underlying users. Otherwise, the game theory incentives will allow large monopoly players like in the traditional economy to monopolize the blockchain and extract a liquidity premium from end-users. The stateless client approach means that anyone on the blockchain can use a smart phone to perform the consensus function of the chain. This is not possible in PoW blockchains, but it is in PoS chains. Measured by cost of running a node and minimizing processor, memory, storage and amount staked by clients generates a lower hurdle for being a block proposer and a block builder

 

Low User MEV

Market extractable value is often referred to as the invisible tax to market participants in both traditional and digital markets. The blockchain uses cryptoeconomics to run software programs and verifying transactions on the network. The game theory behind cryptoeconomics incentivizes miners, validators, users and speculators to invest in technology for maximizing return. Whenever a transaction is performed on a network there is a fee charged and that fee is provided to miners or validators for verifying the transactions contain in a block. However, the order of blockchain transactions, off-chain activities between sophisticated participants, network congestion and arbitrage bots may shift the fee charged up or down, which often extracts value from the blockchain and thus penalize simple end-users. Lower user market extractable value is therefore bad all else equal. MEV attacks include: (1) Front Running algos across the memepool of tranaction (2) Sandwich attacks Buy right before large transaction by paying extra fee Sell after large transaction completed (3) DEX arbitrageBuy tokens from pools where lower priced and sell them in higher price pools (4) Liquidation Liquidate the capital of insolvent user and earn a liquidation fee

 

 

Summary

Blockchains aim to maximize (1) security, (2) speed and (3) decentralization by blending economic incentives with cryptography, but all three objectives are not possible to maximize globally on the same Layer, which is a problem referred to as the crypto trilemma. The Ultimate goal of solving Ethereum’s blockchain trilemma is to remove third-parties from extracting excessive liquidity premiums. The implications of the trilemma for Ethereum is that marginal improvements to goal (1), (2) and (3) sometimes negatively impact the other 2 goals, but marginal improvements are generally beneficial to the chain overall. The current Ethereum State is just a database recording and remembering all account balances and smart contracts deployed and running on its EVM, but the problem is that with each new state, the global state size expands causing block verification (reading and updating from State root) time to increase, which can create decentralization, speed and security problems. The merge leaps Ethereum in the right direction by solving some trilemma issues and flips the liquidity premium from miners and bots earning excessive returns for owning expensive hardware to ETH Staking validators! In the future, the merge also allows Ethereum to update its data/state structure/tree cryptography from a hexary Merkle Patricia tree structure to possibly a binomial Merkle tree, but most likely a polynomial Verkle tree to make Ethereum Stateless, as Ethereum goes modular by becoming a data availability and consensus layer, as depicted in the Ethereum roadmap above!

 

 

 

Chapter 5: Battle of Cryptographers Beyond the age of Internet

 

Bitcoin Incentivized Public Adoption of Cryptography

The history of cryptography boils down to a technological arms race between the information attacking code crackers against the information defending code creators. Stealing important enemy information is key to warfare success. Code cracking cryptanalysts using simple methods like frequency analysis is now replaced with advanced computer hacking to steal information from nation-states. The most important information is protected by cryptographers first using monoalphabetic ciphers and now perhaps even quantum cryptography. Despite the ginormous positive impact of cryptography in history as a tool protecting both physical and more recently virtual information, nation-state fear of weaponization has likely prevented school curriculums in all nation-sates from promoting cryptography to students via education. Although most historic cryptography inventions were created to defend military information, Bitcoin was released publicly. Bitcoin became immediately consumed by sophisticated Internet participants and spread to less sophisticated users over time. The main consequence following wide-spread public adoption of Bitcoin is that nation-states must now teach students the risks and rewards of cryptography to compete with other nations on Web3. The introduction of cryptography into the education curriculum will spark adoption and likely unleash the decentralization of the Internet that functions more like markets than the Web2 big-technology led command market. In Web2, encryption protects all nation-state secrets in centralized databases so some current advancements in cryptography remain nation-state secrets. These  secrets are kept for at least 30 years to protect against future code cracking attempts, which means that intelligence agencies like NSA are likely developing cryptography beyond imagination of the general public in 2022. As a result, the dangers  of cryptography demonstrated by its violent nature explains why Satoshi used a pseudonym when launching Bitcoin in 2009.

 

The Science of Secrets

Cryptography is basically the science of keeping secrets secret and secure. When Peter Thiel launched Confinity, security of the  peer to peer payment application was number one. No one will trust sending money to unknown counterparties unless transactions are 100% secure.  Although encryption underpinned early Internet Protocols before Confinity, the US government must have warmed up to idea of encryption to grant a team of software dudes with pre-approval of weapons designated technology. Nothing represents public ignorance better than the Oscar’s academy, as physics defeated cryptography in 2015 yet again. This time actor Eddie Redmayne won the Oscar for the best male actor by portraying the brilliant physician Stephen Hawking in the Hollywood biopic, The Theory of Everything. Eddie stole that golden statuette from fellow UK actor Benedict Cumberbatch who portrayed the cryptography expert and computer inventor Alan Turing in the "Imitation Game." Although Eddie symbolizes why physics remains the Michael Jordan of science, Benedict represents why that may soon change as the world goes virtual. While machines developed in the Industrial Age unleashed a physics renaissance with loadstars like Newton and Einstein by expanding time spent on science rather than digging coal, the exponential growth in computer power during the Information Age transferred time spent dealing with real Industrial Age constraints to the virtual world. With more relative time spent online than in the natural world, sciences like physics are no longer attracting the brightest minds like back in the Industrial Age.

 

 

The First Cryptographer

Cryptography was a game changer long before Bitcoin hype created over USD 2 trillion in digital asset value. Just like Rome, cryptography was not created in one day. Although cryptography methods were laughably simple in the beginning,  cryptography always was and is the premier approach to prevent third parties from gaining access to privileged information. The first known cryptography user was the ancient Greek writer Herodotus who authored how the Greek army used simple stenography to prevent Persians from intercepting military communication. However, unlike securing military communication, the Bitcoin blockchain leverages cryptography to transparently ensure accurate transaction reconciliation and prevent database manipulation from any type of central party. It’s kind of funny how all cryptography needed to generate bestselling Netflix documentaries was to become synonymous with money by creating a decentralized database securely facilitating transactions and storage of a limited supply of bitcoins. The main difference from ancient Greece and now is the existence of powerful computers, which are used to decrypt sensitive information that is protected by cryptographic encryption. Important information stored on databases ranging from military and infrastructure data to bank accounts and even private user information are almost always protected by cryptography. The main problem is that much of that information is stored on a centralized platform, which creates a single attack vector for hackers. Imagine, for example, the chaos that would ensue if a bad actor was able to shut down the US PowerGrid or access the US nuclear codes. Blockchain is a tool to decentralize the database to protect against these single point of attack vectors. In addition to offering protection against hackers, much of private user information is stored for profit purposes by centralized big technology platforms via the Internet, which are corporations that monetize or sell user information to third parties. With the internet still experiencing user adoption, more and more power is resting with these big technology platforms, which can be seen in the trillion dollars in market values of Amazon, Google and Apple. These platforms do provide good stuff like iPhones, instant messaging, tele-health, delivery, banking and much more, but the internet is also eroding privacy piece by piece every day and concentrating all that power with a few giant technology platforms is becoming a problem. Ultimately, I believe people should decide for themselves how private information should be used and blockchain is the best tool for making privacy on the internet private again. By relying on cryptography, user information can still be accessed by firms trying to provide great services without tying that information to a specific user.

 

Cryptography Now and How Cryptography Improves Over Time

Famous mathematician Chris Bernhart describes the most exciting advancement in mathematics and cryptography when writing, “Quantum computation includes all of classical computation. It is the more general form of computation. The qubit is the basic unit of computation, not the bits, [39] In 2022, Cryptography is an applied sub-field of pure mathematics, which is the study of obscenely abstract shapes, quantities, numbers and spaces. Pure math is generally beyond use in real life, but applied math like cryptography is perfect to solve real world security problems. When engineers successfully apply pure math that has been developed by pure mathematics revolutionary technology often emerge. Example of pure math changing the world includes quantum mechanics, nuclear power and calculus. Cryptography is the premier application of quantum mechanics because quantum ciphers are mathematically unbreakable and later in this chapter you will find out why! However, Cryptography emerged as a result of securing military communication through Monoalphabetic, Polyalphabetic and Vigenere ciphers, which are all forms of cryptography based on simplistic usages of text, symbol and number to hide messages in plain sight. 500 BC, the Greek father of history, Herodotus, describes how the application of simple Stenography and ciphers led to military victories for ancient Greece in battles against Persia. One particular example of stenography used by the ancient Greeks, according to Herodotus, is writing on a messenger’s shaved head and then letting the hair grow back before allowing the messenger to deliver the message. If the messenger is captured, the message is kept hidden beneath the hair on the scalp. The success of secret writings by the Greeks therefore became an area of military research and the field of cryptography is even derived from the Greek word Kryptos, which is a word that describes something hidden and secret. After years of marginal improvement of the secret messaging developed by the Greeks, the famous Roman emperor, Julius Caesar, created slightly more advanced monoalphabetic ciphers through writing letters to Roman generals where every character in the message corresponded to a character three steps to the right in the Roman alphabet. For example, the letter “A” became “D” and “Z” became “C, which safeguarded communication with generals simply allowing Caesar to send messages in plain sight, which became a huge strategic advantage for the Roman military. One approach to decode less advanced ciphers was applying frequency analysis, a1s certain letters appear more frequently in text like “e” and “a’ in English. Even if “a'' is decoded as “d”, the frequency analyst knows that “d” represents “a’ in the cipher because “d” shows up next to certain letters and also appears with the same frequency as “a” would in normal text.

 

Introduction of Key Word Cryptography

After Caesar, the world continued the marginal improvement in cryptography because on the side of the cryptography coin are cryptanalysts who seek to decode and decipher secret messages. Marginal improvement in cryptography is derived from the historical battles between cryptographers to secure information from cryptanalysts, which is the main reason why blockchain technology exists today. As of August 2022, no cryptanalyst has yet successfully hacked the Bitcoin blockchain! However, unlike the blockchain ciphers, the deciphering techniques used to crack monoalphabetic and polyalphabetic ciphers improved rapidly in the 17 to 18th century, cryptographers needed to invent new methods to secure important communication from cryptanalysis, which is why the Vigenere Cipher became a popular cryptography method. 16th century cryptographer, Giovan Battista Bellaso, must have foreseen the coming cryptanalytic evolution when designing the first more advanced Vigenere Cipher in the 1550s. If you are a history junky, then perhaps the most famous Vigenere cipher was the cipher revealing information about the French man in the Iron Mask; Napoleon's twin maybe? The Vigenere cipher added complexity to polyalphabetic ciphers by also including mandatory keywords, which were must haves for decoding a Vigenere cipher. Most importantly, these keywords made frequency analysis obsolete, as keywords shuffled the message by changing the number of times “a” or “e” showed up in a specific text. Although more secure, the problem with Vigenere is that both sender and receiver must commit the keyword to memory, which creates coordination problems and that is why it took 200 to 300 years for cryptographers to actually adopt the Vigenere cipher method.

Mathematical Cryptography – Early Beginnings

The history of cryptography is split into the classical era and the modern era. The turning point from classical to modern occurred in 1977 with the introduction of both the RSA algorithm and the public key exchange algorithm. These algorithms were revolutionary by being the first viable cryptographic schemes where security was based on the theory of numbers to enable secure communication between two parties without a shared secret. Cryptography went from being about securely transporting secret codebooks around the world to being able to have provably secure communication between any two parties without worrying about someone listening in on the key exchange. Relative to the 18th and 19th century, more advanced ciphers were required to remain secure against code breakers in the 20th century, which in turn required more memory and sophistication by both messengers and senders. Cryptographers therefore marginally started shifting from memory based ciphers to algorithms on computing machines, which is also the kind of cryptography that underpins the trillion dollar blockchain industry today in the 21st century. The foundation for mathematical cryptography actually started with the 19th century English polymath, Charles Babbage, who became obsessed with the puzzle solving nature of cryptography and cryptanalytic. From Babbage’s passion to develop systems that systematically decrypts ciphers, he invented the first technique to break the Vigenere Cipher. Thanks to the cryptographic passion, Babbage also invented the first computing template through the analytical engine. As a computing machine for solving a variety of mathematical problems, the analytical engine included classical computer science terms such as memory and processor to apply software commands like THEN FOR and IF. The techniques invented by Babbage were used by both the Germans and Americans spanning the World Wars and applied cryptography and as the bombs expanded size, cryptography became an even more important matter of national security. Although texts, keywords and symbols remain important in both the 20th and 21st centuries, cryptography continuously dove deeper into the realm of probability, statistics and mathematics with improving computers.

Cryptography is Even More Important on the Internet and Blockchain

If the public key and RSA algorithm was the set up for a blockchain Big Bang, the actual explosion occurred when Bitcoin was created by merging the internet with cryptography. Together, the internet and cryptography enable and improve the execution of permissionless trust among a group of untrusting parties via a network of computers. The internet facilitates information flow of data on railroads between computers connected through train station miners responsible for verification and storage of transactions, while cryptography protects the information flow against third party manipulation. Cryptography is therefore a combination of security tools used for protecting blockchain databases, contracts and transactions against manipulation by hackers, governments and any other centralized third parties. Just like museums use advanced security to protect billion dollar paintings against theft, blockchains leverage cryptography to guarantee billion dollar database integrity. While greater museum security increases protection against theft, too much security limits the user experience. Imagine therefore being Head of Security of the Louvre museum in Paris and that your responsibility is protecting the famous multibillion dollar DaVinci painting, Mona Lisa, against thieves or damages, which equals deciding over a large budget for investing in a number of security measures such as installing high fences, new alarms and AI security cameras. Some tools like a high non-transparent fence blocking the view of Mona Lisa or requesting excessive amounts of personal information from customers are strong “nevers”, as excessively limiting user experience will decrease museum profits; I mean why even display Mona Lisa. If Visa and Mastercard provides greater user experiences than blockchains for payments, then blockchain adoption will likely fail even if certain properties of blockchain technology are unachievable by centralized players like Visa and Mastercard. Like museums, blockchains must also balance the type, degree and amount of cryptography to apply for security purposes without hindering or limiting a great user experience. Hash functions look similar to Vigenere!

Main Objectives and Components of Blockchain Cryptography

As described by the word “blockchain”, the blockchain is an evolving and appending decentralized database where new pieces of data or information individually or in combination leads to the creation of a new block chaining new to old information contained in the previous block. The ever evolving blockchain process in turn requires a type of cryptography that achieves below five objectives in order to remain accurate and immutable to protect against malicious actors. (1) Avalanche effect a slight change in the data can result in a significantly different output. (2) Uniqueness every input has a unique output. (3) Deterministic any input will have the same output if passed by the same hash function. (4) Quickness the output can be generated in a very small amount of time. (5) Reverse engineering output cannot generate the input. The main purpose of cryptography is basically validating that all information contained in the new block is accurate and also protecting historical blocks from manipulation by preventing reverse engineering. For Bitcoin, cryptography ensures that miners responsible for creating new Bitcoin blocks every 10 minutes and accurately verifies new information receives bitcoin currency as a reward.

The three main components of blockchain cryptography used to achieve Avalanche, Uniqueness, Deterministic, Quickness and Reverse Engineering Resistance are the following. (1) Asymmetric-Key Cryptography (AKC)  unique public-private key pairs are generated by an encryption algorithm to shield owners of private keys from others. The private key is generally a random number and the public key is calculated by executing an irreversible algorithm so that Web3 users may securely transmit money via unsecure channels without releasing private key information. (2) Digital Signature (DS): key use case of above ensuring blockchain validity and that data is verified correctly. (3) Hash functions (HF): make sure that all participants share the same view of the blockchain by securely linking blockchain blocks together and maintaining the integrity of all data stored inside each block. If the database is altered, the hash-algorithm returns an invalid call through a property called the Avalanche effect so that validators disregard faulty information when updating the blockchain. There is no public or private key for hash functions. Instead, the hash function relies on a cipher to generate a hash value of fixed length from the plaintext, which cannot be crypt analytically reverse engineered from the cipher-text. HF, AKC, and DS all come in different flavors, which mean blockchain developers can choose from an exponential set of cryptographic combinations to achieve network security. For example, in the upcoming Ethereum merge, Ethereum’s blockchain will switch from Proof of Work (PoW) to a Proof of Stake consensus mechanism for agreeing on Ethereum’s network state. Although a truly decentralized PoW consensus algorithm is considered more secure, the decentralized PoS approach provides almost the same level of security with the added benefit of being less energy intensive and allowing for faster transaction throughput on the network (read up on PoW vs PoS. Another example of specific design choice in cryptography is the kind and amount of user identity that is revealed when sending and receiving cryptocurrencies via the network. The Bitcoin blockchain relies on pseudonymous cryptography hiding user identity, but not making users entirely anonymous. However, certain blockchain enthusiasts prefer to be completely anonymous when transacting and are therefore developing anonymous alternatives to Bitcoin like Zcash and Monero. With the recent ban on Tornado cash in the US, which is a mixing service that Ethereum’s users leveraged to hide identities on the otherwise transparent Ethereum blockchain. If you are wealthy or a public person, it makes sense to hide your transaction, but it also makes sense for criminals. Cryptographic design choices and the type of algorithms used to secure blockchains therefore matter a great deal and we shall see what the future of blockchain technology has in store.

 

 

The Wild West Freedom of Cryptography

Most brilliant people of our age are instead figuring out approaches to handle the complex rules of the Internet. Online complexity, like economics and politics, is influenced by human emotions and imaginary orders rather than natural laws. Traditional nation-state-based fictitious orders like violence, fiat money, and language are humanity's best methods for generating trust in the physical economy. Still, the standard trust mechanism fails in the Virtual society due to the emotional complexity behind interactions between online users with millions of different faiths, cultures, and languages. An alternative approach to traditional nation-state imaginary orders is to use cryptography-based economic incentives like blockchain technology to incentivize desirable behavior by the Internet user. Suppose Web3 users know that financial transactions on the Bitcoin blockchain are verified by an unbiased, decentralized, and censorship-resistant third party. In that case, Internet users can trust each other on the Internet. Cryptography is the required trust-generating method in blockchain technology. As a mathematical science, cryptography studies techniques for securing communication in the presence of undesirable behavior. In combination with economics, it generates online trust. Just like physics is the branch of science that deals fundamentally with the natural world, cryptography deals with the virtual world. Therefore, cryptography inventions like Satoshi's "Bitcoin" are as fundamental to the online world as physics inventions like  Einstein's  "special theory of relativity equation" are to the natural world.

 

2015 Oscar: The Last Time Cryptography Beats Physics?

If we experience exponential growth in blockchain technology, the public may in 50 years question why Benedict failed taking home that Oscar statuette.  Unlike the scientific discoveries often made in physics, the British and global public were still unaware of Turing’s cryptography and computer science accomplishments during WW2 for more than 30 years after the end of World War 2.  Just like Oppenheimer and Fermi’s nuclear bomb, the technology invented by Turing extremely powerful. The difference was that cryptography works in silence and secrecy so US and UK military determined that cryptography was a threat to national security and should remain hidden. Unlike cryptography, hiding nuclear technology from the public was never an option because all of us have seen the destruction of Hiroshima and Nagasaki by Fat Boy and Little Man. The significant positive impact from the horrific attack by US on the Japanese was that nuclear energy became rapidly possible to harvest only a couple of years after war. As a result, nuclear power plants began popping up all around the world starting with the 1954 launch of the Obninsk Nuclear Power Plant, in the Soviet Union. Compared to nuclear power, the secrecy of cryptography meant that US and UK intelligence services hid Turing’s blue print of modern computers from the publicly for the next 30 years for national security reasons. The Internet was therefore funded and developed by the US government at a much slower pace than what could be achieved by the private sector. Despite the open source release of Bitcoin,  physics is still taught to students starting in early childhood, while cryptography remains relegated to nerdy classes at top Universities, at least in the US.

 

 

Napster and Kazaa

Before Bitcoin launched the world’s first cryptographically secured decentralized peer-peer monetary network application, one of the most famous centralized file sharing firms was Napster, which allowed users to share music peer to peer virtually over the Internet rather than using physical CDs. Although a great idea, the music was stored in a central database owned by Napster and after the music was downloaded, Napster users often distributed music without paying its owners. As a result of suffering a number of copyright infringement lawsuits from big music companies, Napster later had to reinvent itself as a pay per download service. However, despite all of Napster’s problems with the law, Kazaa saw an opportunity in 2000 to become Napster 2.0. Like Napster, Kazaa would allow users to exchange copyrighted material without paying royalties to the owners, but the main separation from Napster was leveraging decentralization to avoid copyright infringement. The unique idea behind Kazaa was to provide a service for users to store and share files privately, but never actually storing files in a database owned by Kazaa. If files were stored with individual users instead of Kazaa, then the Big music industry would have to sue users not the owner of a decentralized software program. Kazaa simply expanded upon the Napster idea by creating a more general and decentralized file sharing firm where users could search and download all types of media files owned by other Kazaa users. Like Bitcoin, Kazaa used cryptographic encryption to distribute files, but unlike Bitcoin, the Kazaa software was centrally owned. Kazaa was first created by its Estonian programming creators BlueMoon Interactive including Jaan Tallinn and later sold to the Uppsala, Sweden, native entrepreneur Niklas Zennström and Danish programmer Janus Friis[1]. Note that the technology behind Kazaa also served as the foundation for Niklas and Janus when creating Skype, which in turn is the software used by Microsoft teams. Like Musk’s and Thiel’s PayPal being sold to E-bay, Niklas and Janus problems with the law led to a sale to a company named Sherman.

 

PGP and Turing

In addition to companies wanting to leverage cryptography to decentralize storage and ownership, historically successful cryptographers of the past, like the person behind computers Alan Turing and the PGP creator Peter Zimmerman, have experienced issues with the governments, which we shall expand upon later in the chapter, but  Napster and Kazaa show that the idea of abstracting away cryptography when creating applications like Bitcoin is nothing new. Similar to Napster and Kazaa, the Internet HTTP protocol is abstracted away when users interact with the user interface of Internet websites, the cryptography component of blockchain is abstracted away when users transfer bitcoins peer to peer via Bitcoin’s currency application. Thanks to Satoshi’s cryptography application breakthrough, the global public first became generally aware of cryptography, in 2009, successfully combined politics, mathematics, computer science, economics and hardware technology to invent the first globally adopted cryptography based Bitcoin blockchain, cryptography has played a key part in deciding historical outcomes like WW2 and also the expansion of the Roman Empire.

 

Nation State Authority

Nation-state authority emerges from obedience derived from a combination of fear and shared sense of beliefs.  Trust in enforcement of domestic laws and conduction of fiscal capacity, which ensures sovereignty is well respected by large corporate institutions and other nation-states. The law and fiscal capacity of a nation-state is ultimately based on efficiently using monopoly on military violence to ensure order within and outside borders. Before Internet and Blockchain developments sparking the Information Age, nation state ability to leverage violence to enforce laws and taxing corporate profits in native fiat currency peaked, as large US newspapers and television channels like New York Times and ABC controlled all flow of information within the US. If the President disliked a specific article or show, he could call up the corporate executive in charge and tell that person to shut down the article or episode without any problem. Pre-Internet, citizens could not complain about something they do not know. However, as Internet became popular, the number of newspapers, tv-channels and other sources of information grew exponentially. With all that information, the government could no longer control the flow of information therefore decreasing the efficacy of using violence.

 

First Money Outside the Traditional Financial System

In early history grain equaled money, then commodities like gold and finally fiat money. The latter facilitated public, business and private spending, while nation-state taxation became much easier to enforce. However, when the group or person created Bitcoin in 2009, Satoshi purposefully taunted central banking and fiscal policy institutions because if bitcoin ownership spreads virtually via users located in different nation-state borders, then bitcoin is beyond the reach of the monopoly power to enforce violence by any single nation-state.  Via cryptography, Bitcoin became the world’s first currency outside of the traditional financial system and  eliminated the nation-state monopoly on money creation by the capacity to remove bitcoin via taxation or violent enforcement. Before Satoshi used cryptography as a key ingredient preventing users from double-spending, cryptography was leveraged to protect applications on Internet Protocols against hackers, maintain privacy and above all else the most the important military tool in history, which was an Information Age prediction in the book Sovereign Individual by Moogs and Dale. Cryptography is such an important component in both Blockchain and Internet technology that governments designated the first encryption protocols as weapons of mass destruction and is also the reason why blockchain money is called cryptocurrencies. Bitcoin emerged because of advances in cryptography meaning that applied cryptography to secure blockchains and create both world money and computers in Bitcoin and Ethereum respectively is the biggest technical invention in the 21st century.

 

Quantum Computing in the Future

In the  quantum computing is the most exciting current application of cryptography, we must start simple with early history, as the field of cryptography needed continuous marginal improvement for at least over 2500 years to break free from the backwaters of mathematical sciences. And cryptography  began with the Greek Father of history, Herodotus, who was the first person documented to mention how soldiers leveraged secret writing to win battles in epic stories about the Greek military 500 BC. Following Herodotus, Julius Caesar  who outside of Satoshi is the most famous cryptographer in history by leveraging Caesar cipher cryptography to secure troop movement communication with roman generals. The fact that Caesar used cryptography, means that cryptographers have played a significant power balancing role in history long before the Internet and Blockchain by protecting sensitive sovereign military and even more importantly Internet database information.

 

Blockchain and Quantum Entanglement

Tie this to section above! interaction between quantum entangled phenoms is faster than the speed of light, which is paving the way for a potential quantum computing and cryptographic revolution. A quantum state describes the smallest unit of a phenomena and is often depicted by electrons/photons in physics; the smallest unit of electricity and light respectively. Quantum entanglement therefore means that two or more phenomena like electrons/ photons have a special bond that makes all entangled phenoms update simultaneously when one phenomenon is measured no matter the location of the other quantum entangled phenoms. Entangled photons and electrons can therefore not be described independently from each other, which is king of similar to the connection between a public and private key in cryptography! Quantum entanglement is derived from the study of Quantum mechanics, which is perhaps the most exciting area of physics. In Quantum mechanics, determinism used in Classical mechanics is replaced with probability based randomness or so called true randomness to explain the unexplainable interactions in our world, which ranges from the energy released by colliding atoms to the gravitational pulls by massive planets and stars. Worth noting is that Albert Einstein failed to accept true randomness until his death and even famously stated this objection to true randomness by declaring that God does not play dice with his creation. Einstein who was an ardent follower of Classical mechanics in physics believed in sensitivity to initial conditions — meaning a small change in the input can get amplified and produce an entirely different outcome — rather than true randomness. He thought that there was some undiscovered hidden variable explaining why physicists needed probability theory to explain outcomes of interactions between atoms, but Einstein was wrong and proven so by John Stewart Bell’s theorem in 1964. The prevailing theory is now that quantum entanglement exists, meaning that certain events like explaining why the measured spin of an electron or photon can change randomly in repeat experiments with the exact same underlying conditions are truly random. The benefit of quantum mechanics is the application in cryptography. All cryptography is trying to do is using computation to protect information. Well, quantum mechanics allows for quantum computing, which means parallel computation. In fact, quantum computation is so fast that it will crack everything that is encrypted in our society ranging from nuclear codes to Facebook accounts. The good news is that quantum mechanics, as shown by the Ekert Protocol for Quantum Key Distribution, also may generate unbreakable cryptography!

 

Short Review (have not included the Quantum Part last or Ethereum which maybe should be moved)

Starting in 500bc, Herodotus first wrote about simple cryptography called stenography where information was hidden in plain sight. After Herodotus, came the Caesar ciphers, which leveraged monoalphabetic ciphers to encrypt messages and protect military information from being intercepted by the enemy. Following Caesar ciphers, a bunch of other types of cryptography ciphers including polyalphabetic ciphers were developed to stay ahead of hardworking cryptanalytics charged with the responsibility of breaking the now more and more difficult ciphers. When frequency analysis became a commonly used technology to break mono and polyalphabetic cryptography, the Vigenere Cipher became popular among cryptographers because it added keywords that made frequency analysis a much less effective cryptanalytic tool. However, even the Vigenere cipher failed the test of time when Charles Babbage came up with computing methods to break the Vigenere Cipher. After Charles Babbage, cryptography entered the mathematical realm and as a result public key cryptography was invented in the 1970s, which is what blockchains use today in hash functions, digital signatures and asymmetric key cryptography. The problem is that public key cryptography is not quantum resistant so blockchain must now continue to evolve in order to stay ahead of the code, cipher and now blockchain hacking cryptanalysts.

 

 

 

 

Chapter 6: Decentralization vs Centralization

 

“A network state is a social network with a moral innovation, a sense of national consciousness, a recognized founder, a capacity for collective action, an in-person level of civility, an integrated cryptocurrency, a consensual government limited by a social smart contract, an archipelago of crowdfunded physical territories, a virtual capital, and an on-chain census that proves a large enough population, income, and real-estate footprint to attain a measure of diplomatic recognition.”

 

The Cyberpunks

The optimal blend of decentralization and technology in Web3 and the Metaverse is the loadstar for the next step in the digital evolution. Ethereum founder Vitalik Buterin  and tech philosopher believes that architectural, logical and political design are the main independent axes behind software decentralization. Architectural design is the number of computers/worlds that makes up the system/Metaverse and how sensitive these computers/worlds are to influence. Logical design is how the data structure and interface are maintained by the system/metaverse. Finally, political design is who controls the system/Metaverse. The decentralization philosophy described by Vitalik first emerged among the cyberpunk’s community in the early 1990s. The cyberpunk community is best described as the antithesis to dystopian futures often described in science fiction novels like ,1984, authored by George Orwell. The cyberpunk community formed with the key objecting of promoting online freedom for individuals and groups. As the first Internet group, the cyberpunk community envisioned a system based on decentralized reputation rather than centralized credit scores. The main idea was to leverage cryptographic technology like ZK-proofs and consensus mechanisms to facilitate the freedom of speech. [40] The decentralized technology promoted by the cyberpunks enables anonymous communication on the Internet. To incentivize desirable online behavior by users, the cyberpunks wanted the Internet to be a reputation rather than government enforcement based system. Although Vitalik promotes a balanced approach between government centralization and individual decentralization, the most extreme cyberpunk ideology was summarized in, The crypto anarchist manifesto, by the founding cyberpunk member and form Intel worker Timothy C May. [41] In the cyberpunk summary, Tim describes how cyberpunk maximalism believes in freedom of speech above all else, even if humans begin behaving according to the darkest. The ideas outlined by Tim is a none-starter, but preventing an Orwellian future is super important. Although cyberpunks tried to create decentralization technology, the first execution of decentralization was Bitcoin.

 

Year 2022

The use of the Internet is revolutionizing the nation-state world order promoted by Industrialization. In 2022, we see evidence of geopolitical uncertainty similar to some of the worst crisis periods in recent history. As the Biden administration is  preparing for the midterm election, the western hemisphere is experiencing ex-ante geopolitical uncertainty similar to 1939. As a cherry on top of geopolitical instability, the US recorded a 40 year high 8% CPI print to jumpstart 2022. The deflationary impact of offshoring manufacturing in combination with advancing information technology,  enabled global central banks to subsidize the unemployment associated with offshoring manufacturing industry by printing money. With fragile supply chains globally in 2022 and increasing expense of importing goods from countries like China, inflation is again becoming an economic reality. In addition to high inflation, gold is no longer backing the dollar like it was back in 1939, which was the year before WW2 began in Europe and also the year that Federal Reserve started purchasing treasury bonds to finance government fiscal deficits. By becoming the US Treasury’s personal piggy bank in 1942, the FED dropped its mandate to promote price stability[1]. In the decade leading up to 1939, compounded US growth was negative including a -2.0% CPI the year before, which probably encouraged FED to purchase bonds[2]. However, from August 1939 until August 1948, inflation spiked and the dollar monetary base increased by over 149%. Despite the often negative relationship between interest rates and inflation, the 1942 FED pegged government long and short term interest rates at 2.5% and 3/8%, which yielded full control of monetary policy from FED to the US Treasury. With newfound monetary power, the US Treasury issued more debt, imposed price controls, raised reserve requirements and increased taxes during the war years. Unlike in1939, the current US monetary system is purely fiat based and thus allows wiggle room for more money printing a la MMT. If we study history of geopolitical uncertainty, a wise move is to not underestimate the possibility of increased taxes and a reversion to low interest rates despite high inflation perhaps in combination with price controls and higher reserve requirements until the Ukraine conflict de-escalates and global supply chains are fully restored. Even with de-escalation and higher interest rates, isolationism may lead to continued supply chain issues and higher prices as production across the world shifts domestically.

 

Biological and Market Ecosystems The Lung is Fractal to Protect against Disaster
Bachelier brought Gaussian statistics to the financial world. Through his analysis of French bond prices based on assumptions such as normal distribution, price independence and stationarity, Bachelier influenced future orthodox financial economists such as Markowitz, Sharpe, Black and Scholes. These gentlemen went on to form foundational economic theories guiding investment decisions and risk taking that we see today. However, their elegant models are not always perfect and perhaps even dangerously flawed, as Gaussian statistics fails to incorporate the real risk of tail events, which definitely played a part in the creation of The Tech Bubble in 2001, The Great Financial Crisis in 2008 and the Corona Crisis in 2020. Mandelbrot formed a complementing theory to orthodox finance in his book, The Mispricing of Markets, which suggests a fractal approach attacking some of the underlying assumptions in Gaussian statistics. Unlike conventional theory suggests, Mandelbrot states that market prices are dependent sometimes creating persistent price trends according to the long-term dependence variable H. He also proves through his cotton price analysis that tail events occur more often than suggest by a normal distribution. In fact, Mandelbrot concludes that α in the power law guides market movements at the tail, although he realized that different markets seem to have varying value of α. Important to note is that his analysis of the cotton prices also demonstrated that the power law is time invariant meaning that large price moves over longer time are scaled smaller fractals over shorter time periods.

Meritocracy and Blockchain
The Bitcoin Bockchain network is worth over 500 billion dollars and has never failed or been hacked since inception in 2009 proving that blockchain with a foundation in solid compute code is more secure and reliable than any centralized server based network ever been in history. Bitcoin incentivizes miners to mine bitcoin accurately and the best miners receive the most bitcoins.  Just like Bitcoin, governments of traditional nation states promote the idea of meritocracy via diversity. The problem is that meritocratic systems with centralized leaders are inherently biased. The design of the political system in both socialist and capitalist systems either incentive short-term solutions to long-term problems for re-election purposes or long-term solutions envisioned by authoritarians. However, Blockchain technology creates a system where meritocracy incentives can be created for real. Imagine a world where our monetary system and its rewards is driven by merit; those rewarded with power and economic goods are those who are talented and hardworking instead of those that are wealthy or in a high social class. The blockchain version of a meritocracy does not mean a system that is driven by a sense of competition where losers receive nothing, but rather a system creating an improved world where people are yielded an equal opportunity to succeed via diversity of thought irrespective of background. Over the past fifty years – as markets increasingly have become more efficient – the economic pie has grown larger. I believe, the pie will continue growing larger more rapidly if society follows transparent, fair and meritocratic rules. In addition to a growing pie, the pie must also be split in a just fashion by eliminating baseless hierarchies and corruption, which are core pillars of a compassionate fair society. Limiting dangers means holding large institutions or so called gatekeepers accountable by using meritocracy to call out wrongs and thus keeping centralized parties from attaining excessive power. Access to internet and the freedom of speech is therefore so important to decentralize the narrative spread by governments, banks and news organizations. Just like internet decentralizes the information narrative, cryptography decentralizes the value of money. While internet lessened gatekeepers’ like newspapers and governments power of information, blockchain technology will lessen banks’ and governments’ power over our monetary infrastructure by providing a transparent alternative. If governments and central banks across the world engage in moral hazard behavior – like bailing out insolvent banks, printing money and widening wealth inequality – cryptographic based digital currencies through consensus could provide a financial infrastructure alternative. Centralized and decentralized systems can live in symbiosis in order to create the best world possible.

 

 

Consensus Mechanism Decentralization

The concepts of decentralization and centralization adds another dimension to the traditional capitalist right and socialist left political ideologies. Unlike traditional political ideologies, decentralization and centralization is conceptually invariant meaning that the level of decentralization for socialist and capital policies depend on application. In US politics, both yielding power of abortion rights to women and right of gun rights to adults are decentralized  ideas, while their inverse is centralized. The extreme versions of traditional political ideologies are both centralized, which is the fascist right and communist left. No wonder that a common description of communism and fascism is as a half-circle meeting at the bottom as a completely centralized society. If God created the moral structure needed to conquer Earth and the State generated law structure needed for reaching Space, then the Network may be the cooperation structure taking humanity interplanetary. Pure maximalism is bad, but the Leviathan Network based society is a rival to both God and State nations, as outlined in the Network State. Well-executed Networks depend on co-ownership/operation and time-stamped history, beyond manipulation by God and State. If Bitcoin unleashed decentralized asset ownership and Ethereum smart contract platforms, then decentralized apps with superior UI providing its users with tools to store information with absolute privacy might be the key for driving an explosion in blockchain adoption. A society that is 100% centralized needs at least 1% decentralization just like a 100% capitalistic society needs at least 1% socialism to prosper. By just getting behind the above, you will understand how a quadratic relationship between central and decentralization generates high prosperity in society, which means you are ahead of 95% of the world population. Perhaps in the information age, God, State and Network are now together propelling humanity forward like three Leviathans.

 

Tribal Decentralization

Prior to domesticating of grains causing the agricultural revolution 12,000 years ago, society consisted of small tribes spread across large swaths of land and survival depended on a combination of hunting animals and gathering fruit, vegetables and other plants.  The size of these hunter gatherer tribes ranged from extended family to bands consisting of less than 100 people, which exemplifies the ultimate anarchist decentralized society, as survival depended on oneself and cooperation with a small group of independently from other tribes, not on centralized security provided by government. Instead of laws, tribal customs were followed, which is a form of social contracts between tribe members ideologically similar to smart contracts for blockchain members. Just like violating smart contracts on blockchains leads to both legal problems and a damaged reputation for Web3 users, those hunter gatherers that break tribal customs like overhunting or under sharing food generally experienced tribal ostracization. Although the life of  decentralized societies is unimaginable way for Information Age technologists with constant Wi-Fi access, the early societal way of life came with some functional benefits like incentivizing limited ownership of resources like land or food and imaginary structures like governments for security, corporations to facilitate credit issuance, or money to exchange goods and services. Instead of institutions, farms and machine, the  hunting and gathering society required personal reputation, cooperation skills and flexibility to travel vast distances, share resources and  provide food. Resource ownership for hunter gatherer is like an astronaut carrying extra weight without purpose on a spaceship that is going to the moon.

 

How Agriculture Upended Tribal Decentralization

The largest benefit of not depending on resource accumulation and landownership, is the lack of incentives to steal resources from other tribes and thus decreasing the economic gains from using violence against human beings, which prevents the unnecessary resource wars often sparking conflict during both the agricultural and industrial age. However, when domestication of grain became technologically possible 12,000 years ago, the incentive to use violence instead to generate economic gains increased exponentially. With more and more farms, warriors banded together and started charging farmers a protection fee in the for of a certain % of the harvest almost like the wardrobe fee charged by the mob for protecting restaurants from other criminals. As a result of expanding capacity to more efficiently harvest grains on plots of land, society began transforming from decentralization to the centralized 9 to 5 society we live today. As farms grew larger and larger and resource accumulation increased and the incentive to commit violence expanded exponentially. When farmers began accumulating resources that surpassed a critical amount, the demand for fruitful land increased so much that small farms for protection became small villages and these small villages then became large cities spearheaded by kings that in return for taxing farmers enforced law and provided large scale military protection against other cities.

 

 

How the Information Age Upended Industrial Centralization

Although the agricultural revolution began the secular shift towards the centralized nation-state society based model that likely peaked during the industrial revolution, at least for the foreseeable future thanks the development of Internet and Blockchain, society has experienced periods of increased decentralization like the dark ages after the fall of the Roman empire. However, during the agricultural age and prior to both feudal mid-evil times and the industrial age, the Roman empire ruling current Europe from 700 bc until 600 ac, was the perfect and most well-known example of a centralized mega nation-state with the capacity of taxing a majority of the living population spanning 100BC living on land ranging from what is currently Egypt in the south, Lebanon in the east, UK in the west and almost all of Europe except for ottoman empire countries like Germany and a small portion of Scandinavia in the north. The Roman key to such success in war was just not capacity to organize a large army, but also the ability to leverage technology. In addition to minting coins leveraged for trade and creating a sophisticated centralized economy to generate economic growth leading to inventing superiors’ armor and swords needed for battle, Rome via the perhaps most well-known user of cryptograph, the Roman emperor, Julius Caesar, leveraged the monoalphabetic ciphers for securely communicating with Roman Generals fighting wars in  distant lands as described in chapter 3.

 

hunter gathering society

 

Diversity of Thought Information and Money

Internet decentralizes information, which in turn inspires diversity of thought necessary to inspire new ideas across education, politics and business. Just like internet inspires diversity of thought, blockchain decentralizes money, which promotes diversity of resource allocation. Together Internet and Blockchain is making physical geography controlled by nation states obsolete. Bitcoin is a censorship resistant piece of software that only cares about incentives. Bitcoin does not care about right or wrong. As long as a majority of users are good, Bitcoin is a net positive. Democracies should therefore educate citizens about decentralization and suggest decentralized wallets for storing decentral digital assets. When Russia attacked Ukraine to defend the Russian population in February 2022,  both the Ukrainian zloty and Russia rubble crashed in value due to war uncertainty.  As a result, Russians and Ukrainians rushed to exchange domestic to foreign cash, which is demonstrated by long ATM outside bank office in both countries.  However, for the first time Bitcoin decentralization also showed strength as Ukraine began receiving crypto donations totaling over 100 MUSD in value over just a month. The invasion of Ukraine demonstrates the complementary power of decentralized software and the fragility of absolute reliance on a centralized fiat currency. Refugees that stored a small part of their wealth prior to escaping in a decentralized wallet remained possession of their digital currency no matter what, which like fire insurance for the housing market makes global pooling of decentralized money an insurance tool against total wealth loss. Perhaps Satoshi Nakamoto should be awarded with the Nobel Peace, Economics and Mathematics prize (if there was one).

 

 

 

Vitalik, Marshall and Ellenberg together…perhaps some antifragility also.

Outside of working on Ethereum, Vitalik is a frequent contributor aimed at educating the public about complex philosophical solutions and problems arriving from blockchain .points to certain things being convex and other concave where a concave predespoition is preffered [42]

 

 

Why Decentralization Matters

Using Vitalik’s definitions of decentralization digging deeper into what decentralization really means is possible. For example, Governments and traditional companies have one President/CEO, congress/head office and country/company that is impossible to split in half. These governments/companies are therefore not politically, logically or architecturally decentralized. Common law on the other hand has logical centralization, but architecturally common law is decentralized since there are many judicial-courts that rules with discretion. Language, however, is logically decentralized, as there is no institution or person controlling the Spanish language. The Metaverse includes language, law, economics and governance and these components must follow a system that is flexible and decentralized. The Metaverse cannot be the rules of one country, judicial court, economy and government, as the virtual world extends beyond borders. Obviously, more advanced technology like VR glasses and holograms are needed, but we also need multiple virtual currencies, economies and worlds to create a decentralized virtual environment for users. If technology advances enough, then perhaps the world is entering a player one future in which people increasingly interact virtually rather than in reality. Outside of the virtual gaming world, I see a future where meetings, shopping and dating is done in virtual reality. Fifth avenue in New York will therefore be complemented by a virtual mega avenue in the most popular land of the metaverse. In a way, time spent in the metaverse through social media, video games, video chats and email already surpass physical interaction for a majority of western civilization

Example of decentralizations

 

 

 

Blockchain Superiority

Deep within heart of hearts, politicians know that decentralized blockchain based applications may replace centralized applications transferring some influence and oversight over the financial system from politicians to open source computer software. The economic uncertainty emerging from decentralization like how a world without middlemen impacts political influence is the Occam razor explanation for why lawmakers are increasingly suggesting stricter regulation and bans on various crypto projects. One thing is clear, politicians always prefer using market forces rather than laws to destroy threats to their influence. Why would Blockchain be different if the technology threatens political Power and financial influence? The reality is that Dapps threaten central power clusters similar to how the renewable energy push have crushed oil and gas companies. The difference between oil workers and politicians is that the former lost jobs in a justifiable democratic fashion, while politicians use rule of a law as a tool to peddle power. Mass adoption of Dapps likely decrease revenues for middlemen like banks, credit card companies and stock exchanges. In return for political favors, these middlemen rent seekers benefitting from economic status quo use a portion of revenues to lobby politicians that expand laws which creates an economic environment that further expand profits. For example, if consumers send money peer to peer via Dapps instead of banks, politicians supporting banks will stop receiving donations. Slimmer middleman profit margins therefore mean decreasing political donations, which in turn limits political power and influence. Similar to how the evolution of internet and open source software provided individuals with a voice and ability to execute new ideas without going through big gatekeepers for capital to fund ideas, advances in cryptography and computer hardware expands power and economic pie for individuals at the cost of limiting power and pie for decision makers. The final step for decentralized blockchain applications to outcompete their centralized brother is scaling blockchain networks without sacrificing security to increase both transaction speed and public trust. Achieving rapid adoption means decentralized application must generate a truly superior user experience. Despite blockchain bans and regulations across China, EU and US, decentralized application adoption is likely to explode average smart phone users understand its power.

 

 

Difference Between Decentralized and Centralized Applications

Decentralized applications run on a distributed peer to peer blockchain network rather than on a single server controlled by a corporation. Compared to centralized technology, decentralized networks therefore have no single point of weakness. Without an Achilles heel, decentralization limits the ability of malicious corporations to manipulate information stored on central servers without transparency. Imagine a politician using Bank of America debit and credit cards to buy drugs. If the same politician enjoys a professional relationship with Bank of America a conflict of interest may arise. For example, the politician may create beneficial policy for Bank of America in return for having transaction history hidden or deleted from Bank of America’s central server.  Conflict of interest that may create political moral hazard behavior is impossible on immutable blockchains without democratic approval among elected blockchain validators. It is true that decentralized applications rely on cryptography, which allows some users to conduct criminal activity while remaining anonymous, while identification is almost mandatory on centralized apps like Facebook and Gmail. Anti-blockchain evangelists therefore argue that cryptography based applications is a tool for criminals to circumvent justice, which in combination with blockchain’s environmental impact is why many politicians pose that blockchain technology is a danger to society.  However, the arguments used by politicians against blockchain used against internet in the beginning of the 1990s. The fact that politicians are worried about blockchain’s criminal and environmental impact on society in combination with blockchain’s current adoption timeline makes the technological adoption of blockchain based application almost identical to that of the early Internet. Unlike blockchain technology, the Internet was created through public funding. Although lawmakers actually outlawed Internet in the beginning, they later accepted public use of internet with the caveat that no private person or company was allowed to make money on internet by selling goods and services. It therefore took many years for the public to trust the internet with personal information like credit card information. Imagining life without Internet today is impossible. Developing public trust and convincing lawmakers that blockchain benefits outweighs consequences is therefore super important and understanding why some stakeholders like politicians may want to limit adoption requires investor patience. If blockchain adoption follows in Internet’s footsteps, the road to adoption will be bumpy, but ultimately a life without blockchain may soon also be difficult to imagine.

 

 

Mandelbrot And The Mystery Of Cotton

Before diving into Benoit Mandelbrot’s financial research, we will first investigate the man himself. Like most other Poles born in the 1920s, his early life was heavily impacted by WW2. In 1936, his family moved to France where he ended up studying mathematics at the famous Ecole Polytechnique University. After graduating from Cal Tech in the U.S with a Masters in Aeronautics, he returned to France for a PhD in mathematics at University of Paris. This was also where he began a career in research and as a polymath he worked on problems within mathematics, information theory, and fluid dynamics. Mandelbrot’s introduction to finance came while working on income distributions at IBM in the 1960s where his edge was IBM’s advanced computers. His wealth research at IBM intrigued economists around world and resulted in an invitation to present by Professor Houthakker at Harvard University. While preparing for the presentation about his findings on income distribution in a Harvard classroom, Mandelbrot noted that someone had forgotten to erase a convex v-shaped graph on the blackboard showing a similar pattern to income distribution. That diagram happened to display the price of cotton, which the New York Cotton Exchange had kept exact daily prices records of for more than a century. As almost a mad scientist, Mandelbrot wanted to find out if a deeper relationship between the price of cotton and the income distribution existed.

The Father Of Modern Finance

Prior to disclosing Mandelbrot’s financial parallels between the income and cotton price distribution, we must first introduce the brave man responsible for modern finance. That brave man’s name is Louis Bachelier and he shaped the future of orthodox financial theories in the beginning of the 20th century by using a combination of probability theory and Gaussian statistics as foundation for his research. According to Mandelbrot, Bachelier was the first person to bring statistical modeling into finance as Bachelier’s PhD thesis involved analyzing the movement of French Bond prices through a comparison of its price swings with how heat diffuses through an object. Heat diffusion and bond price dispersal are both complicated stochastic processes, as analyzing all relevant factors impacting how energy particles and the bond prices move is nearly impossible. To simplify the analysis, he viewed the market as a fair game similar to a coin flip. Just like the coin has a 50% chance of landing on heads, the French bond price has a 50% probability of going up or down on any given trading day if price moves are independent and no new information is added. Bachelier therefore concluded that French bond prices follow a random walk fluctuating around its average price. In fact, he showed that a month’s worth of bond prices printed on a graph would spread out just like the famous bell curve as predicted by the Gaussian normal distribution. By being able to use Gaussian assumptions such as price independence, stationarity and normal distribution, he could apply heat diffusion equations on financial data. His forecasts were successful as he almost perfectly identified the probability of profiting from call options and he therefore concluded that the market obey the laws of probability. However, Mandelbrot believed that Gaussian assumptions were imperfect and suggested that life is more complex. Mandelbrot’s research demonstrates that price dependence exists, extreme events occur more often than Gaussian theory suggests and asset price time series’ are not stationary.

 

This distribution represents a 1000 trials of a 1000 coin tosses with number of heads on the x-axis and total heads given each trial on the y-axis. The distribution is bell shaped and centered around 500, which is predicted by the Gaussian normal distribution. http://pi3.sites.sheffield.ac.uk/tutorials/week-9

 

 

Back To Cotton Prices - Plus Power Law, Income And Meaning Of α

Thanks to Mandelbrot’s position at IBM, he was one of the first economists monitoring economic data using advanced computers. In his 1962 cotton analysis, he could therefore study more than 100 years of daily, monthly and yearly price moves without problems. For Houthakker, the constantly changing volatility of those price moves made the analysis of the cotton time series unfit for the Gaussian Bachelier model. To improve upon the findings of Houthakker, Mandelbrot’s approach involved combining power laws and the mathematics of stable distributions. The former is a common pattern in science. For example, the number of earthquakes varies by a power law with their intensity as small quakes are common and big ones are infrequent. Power laws are also common patterns in finance and Mandelbrot labeled such patterns fractal scaling because they are time invariant. To understand the power law of a time series, one should draw the power relationship on graphing paper using log scales such as 1,10,100 instead of numbering the axis using a regular scale such as 1,2,3. For example, as we learned from junior algebra, there is a clear relationship between the area and the side of a chessboard square. The area is the length of the side raised by the power of 2. In a log-log graph format as in Figure 2, the area to side relationship turns out to be a straight line as the area of a square with length 2 is 4, 3 is 9 and 4 is 16. The slope of that straight line in a log-log graph is therefore going to be 2, which is precisely equal to the length raised by the power of 2. The linearity observation is extremely awesome because it is then possible to detect a power law distribution if one plots unknown observations of a time series in a log-log format. With wealth, Pareto stated that all income distributions follow approximately a 3/2 alpha (α) power law. This means that one can calculate the probability of anyone’s place on the income distribution curve. For example, if minimum wage is USD 15 per hour and the average workweek is 40 hours, the annual salary is about USD 32,000 per year. The percentage of people making approximately 100 times USD 32,000 is then (1/ 100)^1.5, which is around 0.1%. A 1000 times minimum wage is then around 0.003%. With fractal geometry there is a limitless range of powers for different types of time series and later you will see that there is a different value of α. Above figure is a log-log graph with α equal to 1, 2 and 3. The figure is graphed by Mandelbrot and the center line shows the slope of a tile area to its side length relationship, which is similar to the chess square example.

 

Mathematical Distributions

The final touch to analyze cotton price came from the study of mathematical distributions. A stable distribution is robust when adding errors from two independent sources does not change the nature of the beast being analyzed. Sure, if you add the height of people from New York to an analysis of height in New Jersey, the average and variance height might change, but that change can be explained by the Gaussian normal distribution. However, as we identified earlier, the price of cotton follows a more skewed distribution, but thanks to the French Mathematician, Cauchy, the power law distribution is stable as well despite being more mathematically complicated. The difference between the Gaussian and cotton price distribution is that the former is egalitarian, while extreme data points dominate the latter. By that Mandelbrot means that adding another cotton price point might dominate the crowd, while adding the height of New Yorkers to a height analysis of New Jersians will not dictate the statistical outcome.

This graph depicts Pareto's income distribution result with rich people at the top and poor people at the bottom of the Y-axis and number of people at a given income level on the x-axis. Unlike the Gaussian bellcurve depicted in Figure 1, this picture demonstrates how skewed the income distribution is in reality. The top of the graph demonstrates the richest people in society, which is so far away from the mean that the Gaussian laws are unable to predict people that rich.

 

Putting It Together In Cotton Price

When Mandelbrot added new data points to his cotton analysis, the volatility floated between 0.4% and 3% instead of being constant. Adding new data points also included larger price jumps than the Gaussian model could explain. Mandelbrot thought that just like there are many poor people in the world and a few rich people, it seems like there are many small cotton price moves and a few extremely large ones. To test if price moves follows the power law, he needed to find the equivalent power to Pareto’s alpha of 3/2α. To complete his test, Mandelbrot graphed price moves on log-log paper and the plot was linear with a negative 1.7 slope, which displays the same pattern as the chessboard graph in Figure 4 This variation is slightly higher than Pareto’s 1.5α and slightly lower than a gamblers earnings from tossing a coin at 2.0α. Mandelbrot also showed that the pattern was time invariant meaning that prices showed an identical pattern across data with daily, monthly and yearly frequency. One can thus conclude that price variation of cotton is fractal! Daily prices behave like yearly prices and monthly prices like daily prices. Another conclusion drawn from Mandelbrot’s cotton research is that modern finance based on Gaussian statistics underestimates the likelihood of extreme events. Perhaps this underestimation is due to the fact that mass psychology has an enormous impact on finance markets when driven by fear.

 

 

Adding Long-Term Dependence - H

If you flip a coin 100 times, Bachelier’s Gaussian model suggests that the range between the longest hot streak and losing streak varies with the square root of flips. If your best winning streak was 5 heads in a row and worst loosing streak was 3 tails, the range from best to worst was 8. For a game with 10,000 flips, assuming that each coin flip is independent, the Brownian Bachelier model infers that the range from best to worst compared to just 100 flips is square root 100 times greater, which results in a range of 80. However, unlike coin flipping, the fundamentals impacting asset prices such as inflation, unemployment and production are not independent events. Take the shut down of businesses across the U.S. amid the COVID-19 crisis as an example. This shutdown has caused an unemployment rate that is serially correlated, as around 30 million people have filed for unemployment in the first quarter of 2020. It is then possible that the sharp drop will have a long-term effect if people are unable to go back to work. One possible long-term consequence is that video conferencing might make traveling sales people redundant as meetings could take place via videoconference rather than booking expensive flights and hotel rooms. This in turn will have a severe future impact on the travel companies, hotel industry and economy. Long-term dependency can also take place in time series analysis. For example, the historical analysis of cotton price shows that asset prices can trend further than predicted by the Brownian square root of time law. Mandelbrot labeled this trending tendency “Fractional Brownian Motion” or so called long-term dependence “H” in honor of the hydrologist Harold Hurst and mathematician Ludwig Otto Holder. The value of H can be anywhere on a scale from 0 to 1. If a variable dependent on time tends to swing further than suggested by the Brownian law then the H is greater than 0.5 and the price trend is persistent. Perhaps this explains why human behavior generates price trends in markets such as equities. If prices went up yesterday it might give humans a false sense of confidence that this will occur again and they then extrapolate this pattern into the future by purchasing more stocks. This also explains why Hedge Funds running a trend following strategy generates a high risk adjusted return. However, as displayed by Pareto’s α, at any point the market can swing in the opposite direction and that is why risk management and running a diversified portfolio is so important in the investment industry.

 

Bringing Together H and α

If α measures discontinuity of events and H measures long-term dependence then how do these factors impact the underlying variable such as cotton price? For H or long-term dependence to exist according to Mandelbrot, order of events matters. However, for α, order is not important as the discontinuity pattern depends on relative size of the event. To test how impactful the long-term dependence is on the underlying variable, one can shuffle the data used for forecasting like a stack of cards. After shuffling the data, the relative size of events will still be visible, but the order of events will change. If there is a large difference in result before and after the reshuffling, one can conclude that there is a form of long-term dependence impacting the underlying variable. In certain circumstances these two variability causing variables has a dual relationship such as in the tossing of a coin where H=0.5 and α = 2, which yields the Brownian relationship H=1/α. Mandelbrot does generally not believe this relationship holds true in markets, but the fact that variance relationships in the market guided by power laws and persistent trends exists defies the laws of Gaussian statistics. Using logarithms rescales everything so that a1% change in 1915 equals a 1% change in 2003. Two noteworthy changes here is the flash crash in 1987 and the clustered volatility during the Great Depression in 1929. These particular moves are way outside the scope of Gaussian statistics. The existence of α and H also opens up the possibility of recurring anomalies in asset prices, which can be harvested by investors with a quantitative mindset. When it comes to evidence for α and H the results are varied. According to Mandelbrot, industrial heavy weights such as Alcoa and General Foods have values of the former closer to the Gaussian 2α, while more volatile high beta technology stocks are lower than cotton’s 1.7α meaning that the α distribution is more uneven than the Gaussian bell curve would suggest. Similar to α, the latter is also range bound with research suggesting a range of values from 0.5H to 0.63H for the USD relative to other currencies and a range of 0.53H to 0.74H for the S&P 500. Both of these H-ranges signals a higher persistency for trends than suggested by the random walk value of 0.5H. The lack of clear patterns in H and α among financial instruments means that more research needs to be done on fractal analysis to fully confirm Mandelbrot’s theory. Finally, if the markets are long-term dependent and follow power laws, they are much more risky than predicted by the Gaussian normal distribution. As an example, one can look at the historical equity risk premium, which according to the standard financial model should be around 1%. However, in practice, the equity risk premium ranges between 4-8%, which is much higher than the conventional theory’s 1%. This is because market participants either demand a higher compensation because markets are risky or they demand a higher compensation because they fear that markets are risky. The fear of financial ruin as suggested by conventional wisdom is a powerful force and explains why many investors prefer holding a sub optimal amount of investible assets in cash. Mandelbrot is most famous for his work in fractal geometry. Above depicts the now famous Mandelbrot set. https://en.wikipedia.org/wiki/Mandelbrot_set

 

Virtual Competition

“Conflicts and recessions are currently being ineffectively treated with painkillers rather than cures; knowingly or unknowingly doesn’t matter.”

 

The fact is that economic policy is not a tool that widens rivers, reshapes mountains, decreases temperatures and eliminates desserts to improve harvests and supply chains necessary for both efficient price discovery in stocks and commodities, which are needed to achieve basic standards of living. Just like a snake sheds its skin to remove harmful parasites, the economy needs bankruptcies to remove harmful companies. By allowing bad companies to fail during recessions, more capital reaches good companies in periods during economic growth so that humanity can invent itself out of geographic and climate dependencies. To create sustainable economies, society should therefore leverage decentralized blockchain technology to compete with the current centralized system Just like socialism competes with capitalism to maximize prosperity. Decentralized capital lets democracy decide how to decrease the dependency on polluting sources of energy and poor geography through community cooperation in a cross border fashion to hopefully increase life quality for the poorest humans. Improving technology requires investment which in turn needs price discovery, but markets never experience price discovery if central banks continue printing money to prop up dying assets. In addition to inhibiting investments made based on accurate information, poorly executed monetary and fiscal policy may lead to re-allocation of resources perceived to disproportionately impact certain parts of a population negatively, which can spark revolutions, election of populist leaders or even hot wars.If technology can be used to de-escalate conflicts by expanding cooperation across borders through decentralized communities?

 

The Network State

In the book the Network state, entrepreneur and blockchain philosopher, Balaji Srinivasan, defines in one sentence the network state and how an internet community may form through decentralized blockchain technology;

 

 

Without technological competition, which may allow communities to form across borders based on self-identified attributes as described by Balaji above, lack of beneficial geographic location creates sovereign competition that may escalate to hot wars meaning that geography is currently perhaps the most important factor for a nation’s economic success. However, by adding digital/virtual realms that potentially achieve diplomatic recognition by cross border community formation, real land like desserts, oceans and mountains for strategic security and protection, lengthy rivers without waterfalls for superior trade routes and natural resources like precious metals and abundant energies for monetary power and industrial production, become marginally less important, which decreases the probability of hot wars and increases the likelihood of cooperation between nations to create more sustainable economies.

 

 

 

Risk of Current Economics

After the global Covid-19 pandemic, the so-called developed countries are experiencing record levels of inflation, interest rates and housing declines. Inflation in US, Germany and UK is surpassing 8% on a year over year basis, which is forcing central banks to raise interest rates after a period of zero to negative interest rates over a 10 year period. Amidst all of the economic uncertainty, the US dollar is challenged by the Chinese Renminbi similar to how the US dollar surpassed the British pound as world’s reserve currency since World War One. With 6 trillion in economic stimulus spanning 2020-2022, the US has printed more money for economic recovery in response to Covid-19 than the combined GDP of Canada and Japan in 2021. China has also printed money, but given their centralized state model, they have a greater control over how printed money is spent. China could for example tell companies making perhaps too great of a profit to return that money to the state coffers, while in the US windfall taxes from excessive profits require approval from a democratically elected congress. Unlike Chinese economic policies where poor companies may be shut down by the government, the FED’s action to print money in response to economic crisis periods like 1971, 1992, 2001, 2008 and 2020 has therefore prevented true price discovery of financial assets and commodities over an extremely long time period, which in a capitalistic market has allowed poorly run companies to stay alive despite delivering inferior products and services. Although the USD has strengthened against the EUR, SEK and GBP by 30% in 2022, there is long-term potential dollar devaluation resulting from continuous FED and Treasury stimulus is similar to the currency devaluations that collapsed UK and Spain when they respectively were the dominant world power. In the Prisoners of Geography, Tim Marshall demonstrated how the geographic lottery explains why a US that includes warm water port access to the Pacific and Atlantic oceans and friendly neighbors like Canada and Mexico remains as the dominant world power since around World War 1. Like US, Chine is in possession of a karge abundance of natural resources due to geographical luck. In 2022, China is the primary threat to US domination from a game theory perspective by teaming up with other world powers like Russia to both limit the US and expand their own progress. Note, economic policy never creates nations, but short-sighted economic policy destroys them. Every single world power in history spanning silver mining Spaniards in the 1500s to a great British empire of the 19th century lost world dominance due to rampant inflation, which is directly correlated with an economic policy to print money.

 

China the AI challenger

The economic best approach for some, may be the worst for others, which results is the result of all the biases that arise from being human. With a vast range of varying importance of imaginary orders, the optimal method for how to best allocate resources is therefore up for interpretation. However, the two most extreme methods of resource allocation are 100% communism and 100%  free market capitalism, which are more achievable then ever in the Information Age. In 2022, AI and Internet allow communist countries like China to be one step closer to achieve full control of their centralized fiat based economy, while permissionless blockchain and Internet technology allows libertarians to create network economies outside the government controlled financial system based on 100% free market capitalism. Most people prefer neither the 100% communistic nor a 100% capitalistic approach to resource allocation, but rather a blend of government control and unleashing the creative genius of sovereign individuals and the Information Age is for the first time since the fall of Rome transferring the power of economic resource allocation from nation-states to sovereign individuals. China is now salivating at the possibility of overtaking the US position as number one and is using a blend between economic policy and foreign soft-power to increase influence in South America and Africa through investments like building a giant canal in Nicaragua and a super dam in Ethiopia with the hope of establishing political influence. These two areas are potential hot zones for future conflicts because the US does not like the fact China is pursuing influence in the west. Capitalism and Geography Legendary investor Howard Marks often states when he is interviewed on podcasts and financial tv that capitalism without bankruptcy is like Catholicism without hell. Howard believes that economic recessions are necessary in capitalism as a method to flush out viruses from the system similar to antiviral medication. His argument is that great companies survive tough times, while poorly managed companies with poor business models collapse. According to Howard, economic hardship therefore allows market participants like himself to buy companies with bad management, but with a good business model, and install good management teams instead to create profit. Although the US is considered capitalist and China socialist, China has benefited immensely relative to the US and other western countries from free trade. In return for shipping deflation to the western world by producing goods and services for pennies on the dollar, China has created import dependency. Western consumers now demand cheap products similar to a drug addict looking for heroin and with supply chain problems China determines the price. In addition to being the largest exporter in the world of intermediary goods like computers, China contains vast natural resource wealth, natural borders, warm water ports and great trade routes. Markets main purpose is to efficiently allocate resources across the globe to benefit mankind, but defining what actions benefit mankind is impossible to answer and if Internet and Blockchain decreases the friction of moving to a new place, then nation-state power will decrease all else equal.

 

Chapter 7: Cryptoeconomics

 

 

The Last Straw

I believe that a weakening US dollar is a major Grey Rhino as Neil Ferguson argues in the book, Doom, which is the continuous devaluation of the dollar has certainly been the case since President Richard Nixon dropped the greenback’s peg to gold back in the 1970s. A follow up question is then asking what happens to our society if the dollar value inflates away to a point in which the greenback is no longer the world’s reserve currency? What happens to global markets if the dollar decreases in value by 100% over 5 years? Would the dollar replacement be a basket of global currencies agreed upon by the G20 or a decentralized currency that thrives on a transparent yet immutable blockchain technology? I am asking these questions now because time and again throughout history large empires have crashed and burned due to monetary mismanagement, including Spain in the 1600 century and the Great British Empire at the end of the 1900 century. What is to say that the money printing by the US Federal Reserve (FED) is different from that of the Spanish manipulating the silver price due to supply shocks or the 1900 century British treasury lowering amounts of silver in coins they minted. All of these actions lead to inflation. In the beginning of 2022, the market priced in five 0.25% interest rate hikes by the FED. If other central banks around the world also pursue contractionary interest policy together with an inability to decrease balance sheets, then there will be a push to alternative systems like blockchain based cryptoeconomics. But what is the tipping point turning Grey Rhinos or Black Swans into Dragon Kings? In Doom, Niall argues that revolutions are responsible for tipping points by using the industrial and technological revolution as examples. From an economic standpoint, we should ask if current inflation is a symptom of deep misalignments expanding in our economy. If so, will policy makers thread the needle or will the constant short-term price fixing turn into an inflationary Dragon king event? Is it possible for FED to shrink their balance sheet of 8.87 trillion dollars to a sustainable level? Or will continuous Grey Rhinos perhaps limit the impact of USD as the world’s reserve currency and lead to more decentralized solutions with the DEFI MATRIX as described in chapter 9, which like the internet is a potential Dragon King.

 

 

The Deflationary Power of Globalism means Isolationism is Inflationary

As described by Balaji in the Network State. The blockchain through the creation of virtual realms may create cross border communities to shake up a world where physical geography historically determined the economic faith of sovereigns, states, cities and towns. Decentralized communities spanning cross borders will increase empathy for people living on the other side of the world because people in different countries will share things that were not obvious previously. Two Liverpool fans are less likely to fight irrespective of location if they feel a sense of community thanks to the blockchain all else equal. That idea of coming together as a group across borders to create diplomatic states recognized by sovereigns is the future and will expand cooperation in our world. However, as China opened up with the economic policies of Hu Jiang (president).  western import addiction yields China an enormous power because what happens to the west if China becomes isolationist. From a game theory perspective, China will most likely handle trade embargos much better than most western countries other than the US due to the abundance of natural resources, which ensure survival from global financial hardship that a trade embargo may create. China’s technology sector has vastly improved and no longer relies on western software to run native computer networks. Through exporting deflation and becoming both technology and natural resource independent, China is now setting up a push to challenge the US dollar and become the world’s reserve currency. Inflation makes previously cheap goods expensive. In an isolationist world, goods are marginally produced within borders rather than relying on trade of goods produced through comparative advantage. For example, outsourcing production to China has dampened prices in the US to benefit the consumer, while the Chinese have expanded life quality for workers, but with China in power, they will set the price, not US. Geography plays a huge part determining a nation’s export and import of goods and services, as countries with abundant natural resources tend to be developing nations that export unfinished goods necessary to produce finished goods refined by developed nations like microchips and batteries to create powerful and expensive computers and electric cars. Moving goods requires beneficial geography, as difficult trade routes require higher consumption of energy and greater levels of cooperation. Despite accelerating advances, technology, up until recently, only allowed for centralized advances controlled by companies and governments thereby yielding immense to governments and companies in developed nations.  Even sea export, which is the most energy efficient method to move goods, benefits immensely from canals and straits that shrinks the distance between two trading partners like the Strait of Hormuz and Malacca as well as the Panama and Suez Canal may. However, often the location of these straits and canals are monitored by third party nations that are not global world powers like Egypt and Panama. For example, the Strait of Malacca is a preferred route for China to import oil from Russia, which means a blockade of oil in the Strait of Malacca could easily therefore escalate into hot conflict. In a centralized world, the spark to a conflict with China could be just one man deciding to invade Malaysia and stop all ships from passing. However, if we decentralize communities into states that span virtual and real borders, humanity spreads power and information to a larger group of people that together can de-escalate potential conflicts that may arise from blockades by sharing information and preventing propaganda. To expand cooperation, we must understand the meaning of money and then learn cryptoeconomics

 

The Method of Measuring Value

Fiat money is an imaginary myth used to facilitate trade by measuring the relative value of goods and services. If people are provided with value like food, housing, and education, then money matters less. Across the world, people are provided unequal amounts of social services and how people perceive money therefore varies with where they are raised. In capitalist countries, people must to a greater extent self-fund healthcare, education, and other personal expenses, so one may argue on average that citizens of more capitalist countries like the US place more value on money than less capitalist countries. Money matters in socialist countries like Sweden as well, but in socialist countries the goal of money is to be more of a pure consumption tool, as government taxation takes care of most healthcare and education related expenditures. In most economic textbooks, the big mac index is used to demonstrate the relative purchasing power of a currency. By using USD as base currency, as in the above chart, one can measure the strength of other currencies relative to USD by comparing actual vs implied exchange rates. Explaining why money is perceived differently in different societies is important because how citizens perceive money ultimately determines future inflation. Despite the importance of money as a relative value measure, countries across the socialist and capitalist spectrum fail to educate their citizens about money. For example, both American and Swedish education might teach kids about money through math and social studies, but classes focused on basic fundamentals of money and how it impacts personal finance, trade deals, transactions, resources, and disputes are rare in both countries. The truth is that decisions about how we spend our money are perhaps the most vital decisions in our personal lives outside of family; how else can we afford to feel safe and secure. The definition of money according to academia is that money is any verifiable and generally accepted item as payments for goods and services, debts, and taxes. If the value of money remains stable for a long time, then no normal person thinks about money, but when the domestic currency depreciates quickly (inflation) money is on everybody’s mind; just ask the Venezuelans. If history serves as a guide to the value of money, then what is generally accepted as money at one point in time might not be so in another. The fall of Rome around year 500, Spain’s fatal reliance on silver in the 1500th century, Germany after WW1, and even US in the 80s, exemplifies how inflation leads to economic instability and perhaps even fall of empires. To protect against a drop in the value of money, most governments across the world now yields increasing power to central banks to deal with financial uncertainty. The problem is that these central banks are repeating past errors, as they are currently printing more money than ever to boost the economy. The historical odd duck for money printing is current Japan, as Bank of Japan’s (BoJ) accommodative monetary policy has led to deflation rather than inflation, which is something worth investigating when inflation is a hot topic in the markets.

 

Money Perception with an Example

 

The perceived current value of money is perhaps the ultimate cost measure for living. A country where social services like healthcare and education is provided for through a more efficient use of taxes deemphasizes money as a necessity and as a status symbol relative to those countries with less efficient taxation. In Sweden, tax funded education on average creates a culture of respect. For example, intelligent Swedish students do not become doctors to make money, as the Swedish healthcare system provides low incentives to achieve wealth. Instead, the driving force behind becoming a doctor is influenced by a compassionately educated society where basic needs are taken care of to a greater extent and those who become doctors in Sweden simply earn respect. If you ask a typical US person if US should adopt a universal healthcare system, which most likely lowers doctor salaries, the likely answer is no, as a US person would argue that lower salaries disincentivize smart students from becoming doctors. No system is better or worse, but somehow Sweden and US are both known to educate great doctors even if Sweden’s education system comparatively deemphasizes the importance of money. The value of money also changes with decreasing or increasing faith in large government and private institutions. Zimbabwe is a great example, as their 100 trillion dollar bank notes show the distrust of their citizens in the banking system. No matter if a country is more socialist or capitalist, it is clear that humanity is entering a period in history when central banks will print money and maintain low interest rates in perpetuity even if a likely outcome is inflation. Therefore, understanding the societal function, purpose, and impact of money, has never been more important.

 

 

 

Re-deflating the Global Economy

The most significant consequence of cryptocurrency technology is that nation states no longer hold a monopoly over the process of creating money. By decentralizing the money creation process, small chunks of monetary power previously held by governments has shifted to Sovereign Individuals. With programmable money created outside of the control of central banks, the most coercive nation-states can no longer unilaterally freeze bank accounts of their citizens holding certain cryptocurrencies to enforce desirable behavior. Holding cryptocurrencies supported by a vast decentralized blockchain network like Bitcoin is therefore similar to an insurance policy that provides protection against authoritarian property theft. Owning just a small slice of digital blockchain property like Bitcoin is the best alternative in history to money as a medium of exchange, store of value, and unit of account.

 

Fiat vs Crypto

At the most fundamental level, cryptos come in two forms; tokens and coins. Tokens represent ownership, while coins represent what investors could potentially own. Bitcoin is a crypto coin meaning that bitcoin behaves more like currencies than equities. Bitcoin’s original function was to facilitate peer to peer transactions similar to dollar transactions, but at a much slower and expensive rate and is therefore not a great replacement for fiat. However, in addition to peer to peer transactions, bitcoin also behaves like gold because there is a limited supply of 21 million bitcoin. Unlike fiat, no government can control the bitcoin supply or print more bitcoin. Instead bitcoins are created as a reward to puzzle solving blockchain miners. These miners also validate transactions on the network. All crypto coins like bitcoin operate on their own blockchains. Ethereum, for example, is also coin, but unlike bitcoin, the Ethereum blockchain allows for smart contracts, which can be used for a range of tasks including DeFi yield farming and token creation.

 

 

Crypto is more than just Fiat

A smart contract is a form of immutable code that creates trust between two or more untrusting parties for purposes other than simple peer to peer transactions. Most crypto projects and companies are built on smart contracts and as a result, the digital token ecosystem has exploded. Unlike coins like bitcoin or Ethereum, tokens like Uniswap, IMX or NFTs do not own a blockchain. Tokens are actually more similar to equities as tokens represent ownership. The difference is that equity ownership is stored centrally with a broker, while tokens are registered in an immutable wallet address. Uniswap is a governance token for a DeFi platform and IMX is a token used to purchase NFT’s on the ImmutableX network. The ImmutableX network is built on top of the Ethereum blockchain and IMX is therefore a level 2 token. Like Ethereum, holders of IMX can stake their coins to earn a share of the transaction fees generated by all NFT’s bought and sold on the ImmutableX platform. If users love NFT projects on the ImmutableX platform, then transactions will generate a higher yield to holders of IMX, which increases the value of the ImmutableX platform. NFTs traded on platforms like ImmutableX are unique and some of these NFT projects like bored apes are valued like Van Gogh paintings. Basically, tokens represent ownership, while coins represent what the owner could potentially own. Coins and tokens including NFT’s can also be placed in collateral with DeFi lending platforms like Aave. In return for lending out tokens, the lender earns a token yield similar to a legacy market fixed income instrument. Corporations or individuals needing liquidity can tap into these DeFi pools instead of the debt market to raise capital for projects. Like Commodities, cryptos can be divided into subgroups based on economic objectives so even within the digital asset space there is a great deal of idiosyncrasy. Given all the new use cases developed through coins, tokens and blockchains, the underlying return drivers in the crypto space are unique when compared to factors driving legacy markets.

 

 

 

Digital Assets - The 5th Asset Class

In the beginning of 2022, the world is experiencing record high inflation, debt levels and geopolitical instability, which in combination with extremely negative real interest rates means that investors must review their strategic asset allocations. Common for all investors is balancing risk and reward to achieve an investment objective, which can range from a consumer saving for retirement to a firm maximizing shareholder value. The main tool for balancing risk and reward is leveraging asset allocation by spreading risk across asset classes, which include equities, fixed income, currencies and commodities. In addition to the big four legacy markets, there are derivatives, alternative investments and real estate, but I argue that derivatives and alternatives are layers on top of traditional asset classes and that real estate is a form of commodity. Since bitcoins creation in 2008, the digital asset space has grown exponentially and as of February 2022, the crypto market capitalization was valued at over 2 trillion dollars, which is large enough to be considered as a new asset class. However, before cementing crypto as a new asset class there are other thresholds that also needs surpassing. The first step in cementing crypto as an asset class is to find out what defines an asset class. The second step is comparing regulation between digital and other asset classes. The third step is measuring statistical relationships between the digital and legacy markets and the final step is analyzing performance drivers behind digital assets.

 

Governments

Under normal circumstances money beyond fair taxation  is not used by governments to enforce citizen control, but rather plays a significant role in the economy by pricing goods and services and incentivizing economic productivity by workers intuitions and entrepreneurs. In return for creating superior goods and services that sell for a higher price all else equal means certain producers are generally rewarded with more fiat currency. However, in countries with high levels of corruption certain producers that create inferior or even illegal goods may get rewarded handsomely. If these bad acting producers happen to conspire with, for example, an authoritarian government that would mean unlimited support by the printing presses of that government’s fiat currency. Even in less corrupt countries like the US, large firms hire lobbyists to manipulate senators and congressmen via monetary reward to vote for legislation that may benefit the shareholders of firms at the expense of the majority of US citizens. However, if cryptocurrency leverage software to become incorruptible, then the incentives of that cryptocurrency is finding the hands of the absolute best producers in the economy rather than pushing producers that are easy to manipulate. The value of money generally depends on two factors and that is the capacity of violence by its creators and the conduction of fiscal and monetary policy to ensure economic stability. The interest rate charged on money is the opportunity cost of spending money today. Interest rates of different fiat currencies can differ a great deal between nation-states and higher interest rates is associated with more expensive money all else equal. However, for the past 30 years starting with the Clinton administration, the secular trend of most fiat currencies in developed nations is decreasing interest rates to facilitate the creation of credit to create new business, buy new homes and prop up the value of financial assets.

 

Governments are Bad

In the past,  governments have banned goods they consider undesirable even if their people like those goods. For example, both coffee shops were banned for a period of time by governments because the leadership associated coffee with drugs and a place where undesirable people could meet up and conspire against the economy. A more modern example is how the Bush administration accused PayPal of violating the Patriot Act by supporting terrorist financing via providing payment services to users of online gambling companies located outside of US. Despite that transaction revenues from online gambling only accounted for 6% of PayPal’s total revenue in 2022, a quick analysis of PayPal’s income statement in their public 10K filing from the same year show the serious risks associated with the reporting restrictions placed on PayPal by the US government. The Louisiana governor who happens to remain close friends during the following three Presidents with then President Bush decided to approve a ban on PayPal from doing business in the entire state of Louisiana. Ultimately, the legal troubles were to much for PayPal and the firm was bought by eBay. Decentralized currency is an invaluable tool for people suffering from an abusive government or inflationary monetary policy by a short-sighed central bank. The most significant consequence of censorship resistant and programmable money is that criminals can buy and sell illegal drugs and weapons, while remaining anonymous. The anonymity aspects of cryptocurrencies are so problematic that some authoritarian nation-states like  the Chinese  regime is banned all crypto mining and trading in 2021. Deep inside the hearts of the Chinese leadership, they can feel the unpopularity of the Chinese government’s coercive methods among Chinese citizens. With access to Bitcoin and if Chinese government violence escalates, the most dissatisfied part of the Chinese population can transfer assets out of the country much more easily with bitcoin. If assets are easier to move cross nation-state borders then that could facilitate a vote by foot from China escalation to less authoritarian countries. In addition to facilitating frictionless movement between across nation-state borders,  cryptography is already used by the worst kind of criminal. Not even total global bans on cryptography would prevent criminals from sending encrypted information and money peer-to-peer since privacy enhancing technology is open source and transparent.  Although technology like the Internet, asymmetric key cryptography, computing power and hash functions were necessary technologies to create the first version of Bitcoin, the revolutionary part is derived from blending advanced cryptography with game theory and economics to create decentralized money. Just like the blinking computer mouse inspired technology entrepreneurs including Mosaic’s Marc Andreesen with endless opportunity, the first peer-to-peer Bitcoin transaction to Hal Finney showed that any two Bitcoin users can exchange resources without the approval of intermediaries.

 

 

The Economy in an Information Age

If technology is the fundamental driver behind the Information Age transition, then fear of total economic collapse has always been the historical accelerator, which includes wars (nuclear), pandemics (Covid-19),  technology (crypto and artificial intelligence) and geography (climate change). For example, the amount of work that can now be done from home across nation-state borders means that the Covid-19 pandemic partly proved that acceleration to the Information Age hypothesis and that land owned by powerful nation-states in a work online economy is less important. However, the Covid-19 pandemic also demonstrated the power of centralized news sources and governments lockdown and vaccine mandate power. For example, at the onset of the Covid-19 pandemic in 2020, New York Times journalist Sheri Fink wrote an article that predicted the severity of Covid-19 infection by quoting data from the US Center for Disease Control (CDC). In that article, Sheri quotes that CDC is expecting that 2.4 to 21 million people will require future hospitalization in the United States as a result of Covid-19[3]. In the same article, Sheri writes that the U.S. only has around 925,000 hospital beds, which is clearly not enough to support millions of COVID-19 cases. When hearing this information from Sheri and her journalist colleagues in the MSM, people get scared and fear can then turn into a mass panic and that allowed governments to enforce lockdowns and vaccine mandates.  However, an improved use of resources around the world leads to higher global growth and a higher growth creates increasing market valuations. As a result, market participants in executive positions have a stronger confidence in the economy and will then have their companies invest in R&D and hire workers to create new products and services, which obviously further grows the economy as the goods are consumed. This is an example of a positive feedback loop, but the loop never continues forever as the market has historically moved in cycles. These business cycles are changes in economic activity experienced by economies over certain time periods. One can then draw a conclusion that there must be negative shocks to the system that reverses a positive feedback loop. These negative shocks are either caused by endogenous factors such as regulation and a change in monetary policy or by exogenous factors such as a virus and a natural catastrophe. Both The Dotcom Bubble in 2001 and The Great Recession in 2008 were endogenous crises as the former was caused by excessive speculation on tech stocks and the latter by irresponsible borrowing and speculation on house prices. However, COVID-19 is different from both The Dotcom bubble and The Great Recession as the virus is the textbook definition of an exogenous shock.

 

Incorporating Web3

General agreement between economists is that economic productivity is great when a wide distribution of society reaps the benefit, but how to optimally generate economic productivity evolves with technology and the cryptography based Web3 Internet via creating a virtual economy is therefore revolutionizing the economic equation for the Information Age relative to the Agricultural and Industrialized Age. On  the opposite and most extreme sides of the economic spectrum is the libertarian free market and the communist central planning economic philosophies. The libertarian anarchistic philosophy dominated the early hunter gather society, but since the advent of farming the secular trend with cyclical hiccups has been towards central planning and the dominant form of society during the Industrial Age has been autocracy and socialistic democracies, which ranges from nation-states with full government control like China to more decentralized state based societies with a federal overlay like the US. However, despite technologies to expand government control and surveillance like AI is rapidly improving, the booming Internet and Blockchain industry decreases friction for Sovereign Individuals disagreeing with their governments about financial, social and legal issues like taxes, gay-rights or free speech with a tool to just leave for another nation-state, which allows the economic pendulum to swing back to the free market. In broad terms, economics is the study of scarcity with a fundamental assumption that players making up the economy such as governments, institutions and individuals have unlimited wants constrained by limited resources. Most economists agree that economic growth depends on the number of workers and productivity per worker, but how to best generate that economic productivity depend on some fundamental assumptions of an economist proffered economic theory. Unlike physics, economic theory does not seem follow a neat set of laws, but varies with assumption and technology. However,  even nation-states following great economic philosophies with robust assumption will receive dissent from the public that changes the temporal discounting equation of how to optimally balance present economic resources with alternative future returns from other approaches, which could lead to intelligent individuals leaving. For example, the only negative impact of war like the 2022 Russia and Ukraine is not only dying soldiers, but also the escape of intellectual capacity to grow economic productivity in the future. And, Internet and Blockchain is expanding the ability to move somewhere else. While farms, factories and offices required worker to be physically present in the centralized economies of the Agricultural and Industrial Age, the Information Age allow workers to earn their living online. Countries waging wars are therefore likely to lose some of the most productive workers in the economy. And advancements in Internet and Blockchain technology is therefore decreasing the importance of nation-state geography and countries must therefore compete to attract individual talent via economic incentives, money or valuable resources like a powerful currency, superior infrastructure, lower taxes or better utility per government per dollar rather than just nice weather or beautiful women. Ultimately, the Sovereign Individual is attracted by some sort of general utility that is maximized by the unit of effort necessary to create that utility, which is money. So how do nation-states create money that optimally allocates resources?

 

How The Economy Began

Let’s begin with first principles before diving deep into money, central banking and credit by imagining how to start an economy for a remote village in Amazonas. The natural question that that entails designing a new economic system is how. My design would first focus on taking care of absolute core needs such as food, safety, healthcare and education. I believe that if the system takes care of these hierarchical life necessities, then your fellow villagers can in the future spend more time on leisure, passion and self-actualization. When people have more time to focus on other things than base necessities, the world evolves and with evolution comes new inventions that in turn create even more free time. At some point in history, this thought experiment was how society functioned and the progress shows how our world is a process of continuous marginal improvement ultimately leading to the complex and interconnected economic system of today. In fact, economic growth first exploded during the industrial revolution because more people could provide for their families by using their brains when machines took over manual labor. Today, most western governments rely on economists to optimally apply collective brain power. The guiding principles of these western economists update with time, but there is one thing that is constantly on their mind when it comes to allocation of resources: money. I therefore believe that he most important function of a society is money and it is the job of our economy to distribute the money in a meritocratic fashion.

 

 

Classical Economics: Adam Smith

In year 1776, famous classical economist Adam Smith wrote the now world renowned book, Wealth of Nations, which underpin classical economics. All students of economic theory have at some point learned about both Smith and his literary masterpiece. Above all else of Smith’s contributions is his legendary invisible hand theory, which remains popular among capitalists today. The invisible hand theory states that equilibrium prices are determined by natural forces in our economy. These natural forces are driven by people acting in their own self-interest by freely producing and consuming, which in turn creates balanced trade flows and natural price movements. The invisible hand theory is part of a laissez-far economic approach meaning that lesser government involvement equals a greater economy. The classical economic school of thought dominated the western world during the 18th and 19th century and evolved many western countries from monarchic rule based systems to capitalist economic democracies with self-regulation. Under monarchic rules, a top-down approach where one supreme ruler decided upon resource allocation often with protectionist tendencies was considered optimal. However, classical economists including Ricardo, Malthus and Mills used academia to promote free trade through basic supply and demand analysis, which slowly changed the views of those in power. If correctly applied, free trade maximizes the pie and increases life quality for both rulers and their subjects, which is why classical economics transformed society in the 18th century. Economists still expand upon theories that were introduced by classical economics and as a result, classical economics remains a dominant force in our society.

 

 

 

Neo Classical Economics: Irving Fisher

In the beginning of the 20th century, the leading school of thought was neo classical economics. While classical economic theory believed that equilibrium prices were based on the summation of underlying cost of materials plus labor costs, neo classical economic theory expanded upon classical theory by mathematically conceptualizing the idea of the rational economic human. In a stereotypical fashion, the neo classist believes that all individuals are utility maximizing robots and that all firms are profit maximizing machines. Before an action, however, both the consumer and firm with full information must first carefully weigh all possible options against each other and then select the optimal action at all points in time. These optimal actions in turn drive demand and equilibrium for goods and services. Neo classists therefore believe that equilibrium prices are a pure function of consumer and firm preferences, which obviously includes the cost of production. The biggest deviation from classical economics is that neo classism includes the concept of perceived value. Producing Coke and Pepsi might cost the same, but if people prefer Coke, then Pepsi’s price might be lower to compensate for its lower usefulness. This idea of rationality made neo classical economics attractive to mathematicians as well because they could start using math to find optimal solutions to all types of micro and macroeconomic problem. There are many famous neo classical economists including Kenneth Arrow, Paul Samuelson, and Irving Fisher. The latter is the most famous and pioneered work in intemporal choice in markets (theory of capital and interest rates), utility theory and econometrics. Fisher also has many famous concepts named after him. These concepts including the fisher hypothesis, fisher equation and international fisher effect are still taught to economic students today. Finally, Fischer’s research on quantity theory of money inspired Milton Friedman and monetarism, which is another branch of economics that is held dearly by many current economists.

 

 

 

Keynesianism: John Maynard Keynes

Keynesian economics is named after perhaps the most famous economist of all time in John Maynard Keynes. It is a beloved style of economics spanning both the 20th and 21st century, as it increases power to politicians by being an open proponent of fiscal and monetary intervention. Keynes grew up in the beginning of 20th century England, but surprisingly this famous economist graduated university with a degree in mathematics rather than economics. According to writer Zachary Carter’s book, The Price of Peace, Keynes interest in economics developed when he began his career in British civil service for the India office, which resulted in his first book, Indian Currency and Finance. Keynes colleague in the India Office, Basil Blackett, was impressed with Keynes mind for economics and therefore asked Keynes to assist him at the treasury department when a financial meltdown was looming on August 1st, 1914. Following the experiences at the treasury department, Keynes earned his respect in government by continuously coming up with solutions to various economic problems. What separated Keynes from neo classists is that he believed fiscal and monetary policy was needed to save the economy during severe hardship, while the neo classists argued that economies would stabilize naturally through supply and demand forces. In Keynes legendary economics book, The General Theory of Employment, Interest, and Money, he argues that the economic damage suffered during the 1930 Great Depression proved that monetary and fiscal policy action was needed to restore the economy. In this book, Keynes also argues that supply and demand equilibrium functions well at the microlevel, but not at the macrolevel, so it separated economics into micro and macroeconomics. His reasoning is that supply and demand forces will fail at the macro-level with the added complexity of total spending in the economy, which has an ultimate impact on output and inflation. Government spending should therefore be used as it can quickly revert the economy to its normal level by increasing the money supply, as inflation lags behind. Keynes referred to this as price stickiness. Another example of price stickiness according to Keynes is that workers would refuse to lower their wages despite it being rational (classical economics argued the opposite).

 

 

Monetarism, MMT and 21st economics

Monetarism and MMT are two economic styles that on many levels oppose each other. The latter takes Keynesian reflation to the next level by arguing for even more stimulus in economic recessions, while the former believes that central bank policy contributes to manipulated markets and inflation. According to Stony Brook economist, Stephanie Kelton, the central idea of MMT is to give governments with a fiat currency system the power to create money to fund important government projects in education, health care and infrastructure, as long as these projects do not create extreme inflation. MMT is actually not that much different from the Keynesian system because both theories assume that 1), loaned money pays for itself through growth and 2), the government won’t go broke because it is borrowing from its own central bank in its own currency. The difference between the two theories comes down to the supply and demand analysis of money. Under the current Keynesian system , governments levy taxes to pay for their liabilities. If the government is unable to pay its liabilities through these taxes, the politicians will then borrow money by issuing bonds. Issuing bonds increase the demand for loans, which in turn increase interest rates. When interest rates increase, private businesses and consumers are crowded out because if interest rates are high then businesses and consumers are unable to borrow money. However, MMT believers argue that interest rates do not have to increase when the economy receives an excessive amount of stimulus as the government can raise taxes to reduce excess money rather than raising interest rates. On the other side of the inflation argument is legendary monetarist economist, Milton Friedman. He is for an economy without discretionary/excessive monetary policy. Monetarists argue that excessive stimulus can have negative unintended consequences, which is worrisome given the amount of stimulus that governments have infused into the economy for a stabilization purpose during the corona pandemic. This could potentially explain why government debts in western economies are at record levels (Central banks hold most of this) and interest rates are at zero despite a stock market at record highs. However, the monetarist view is less popular among politicians because it means market forces decide where allocation of money should flow and thus decrease the importance of government.

 

 

 

 

Cryptoeconomics: Satoshi

The idea of merging cryptography with economics is defined as cryptoeconomics, which is a radically different method of imaginary orders to generate trust in our current centralized economic system. Just like the catholic church and nation-state are trust generating entities between Catholics and citizens respectively, the cryptoeconomic approach allows a network of untrusting individuals to trust each other. However, rather than relying on traditional imaginary orders outlined in the bible or constitution to generate trust, blockchains use economic incentive based software with game theoretic mathematical proofs to enforce rule following users interacting on the blockchain. These blockchains are protected by cryptography and users have incentives to not include fraudulent transaction.  By combining Internet, Blockchain, and Game theory, cryptoeconomics is revolutionizing market dynamics by replacing traditional third party financial and government institutions with decentralized software to create liquid markets, which will have huge ramification on the macroeconomic landscape in the Information Age compared to previous epochs. Just like cryptography as perhaps the most foundational component of blockchain from a technology perspective deserved chapter investigating its history, so does economics and game theory by serving as the most foundational and revolutionary component from a trust generating imaginary order perspective. The economic incentive structure of blockchain is the engine that propels user adoption by rewarding users that verify new blocks honestly and punish users that cheats, which together with cryptography eliminates fraud completely for well-designed blockchain. Via economic incentives anonymous users can therefore trust that new blocks are conceptually accurate, while cryptography ensures and secures that users abide by the rules technologically and protects the blockchain from outside interference.

 

Blending Centralization and Decentralization Economics

While nation-states like the US government enforce the strength of their monopoly to create and maintain the value of fiat currency via flexible imaginary orders  blend violence with fiscal policy and monetary policy capacity, blockchains are guided by censorship resistant software. Fiat money is like law, chivalry and religion an imaginary concept that allows a network of untrusting people to in this case allow strangers exchange goods and services. The strength of the US dollar fiat currency does not necessarily come from being backed by the full faith of the US government, but rather from the fact that most international trade settles in USD and the fact that USD is backed by the world’s strongest army, but a strong army cannot protect against governments that create too much domestic fiat currency via printing. Other nation-states and citizen will lose trust in governments conducting irresponsible monetary and fiscal policy, which means that the imaginary orders underpinning nation-state fiat is flexible. For example, if the return to violence is lower which , then nation-states that are conducting careless monetary and fiscal policy is likely going to experience currency devaluations.  The main point is that there is no single approach that is the correct path to follow for our economy. Instead, the economy evolves continuously and adapts to overcome temporal challenges by balancing the present with the future. The same way that a villager sets the economic path for his village, Adam Smith learned his path from older economic sages. Smith then paved the road for future economists including Fischer, Keynes, Friedman and Kelton. From what I have learned, there is no right or wrong in economics because all of these economists are smart, but rather there is progress. Sometimes stimulus might be the right action and other times it is not. There is no way to test alternative histories in economics and this uncertainty makes economic so darn difficult, which is something that humanity must accept. What I do know is that great things are ahead. We must blend common sense with economic theory and then our world will prosper!

 

 

The Evolution Of Central Banking

To understand why the emergence of a decentralized financial system via building web3 inventions like stablecoins and platforms providing decentralized banking services like custody and liquidity is breaking the nation-state monopoly of money creation, one need to understand the system during the Agricultural and Industrial Age. Jerome Powell is the current Federal Reserve chief and is the 16th person with the job. He is in a difficult position in 2022, as he must navigate the toughest crisis since World War 2.  One the battles is negating favorite media topic is the battle of main street versus wall street. For many main streeters, the latter is synonymous with greed, which is a group that includes banks. Before discussing modern issues with the banking system, noting that main street sometimes forgets the importance of banking throughout history is paramount. For the past 200 years, banking has provided extreme value to society by facilitating trade and credit transactions, which in turn fueled economic growth. Without banking, fundraising for infrastructure projects and costly machines would be near impossible, especially during the industrial revolution, as corporations often invested in long-term projects and therefore borrowed great amounts over long time periods. The business of lending money is risky and optimally banks invest in projects that have low risk with high expected returns. The problem is that extending credit in a digital world is so profitable, which is why shadow banks have multiplied in size almost to the point where they have replaced traditional banks. These shadow banks deploy a more complex lending process through structuring and off-balance sheet transactions, and they do it outside of the scope of central banks and regulators. Government experts that have pointed to the increasing reserves at large banks as a sign of economic health have failed to incorporate shadow banking in their analysis of credit. Given the vast amounts of credit circulating in the economy, the banking system is now so systematically important to society that governments and central banks will not allow banks or shadow banks to fail. This creates moral hazard, which means that banks and shadow banks are incentivized to invest in risky projects. There is no doubt that we need institutions that facilitate trade, monitor payments and handle credit extension, but in the digital world, society must solve the moral hazard problem to avoid future depression and perhaps even hot war.

 

Moral Hazard

The underlying cause of moral hazard in lending are information asymmetries. Borrowers possess an information advantage over lenders, as borrowers use money with a purpose. Before lending money, lenders must therefore monitor borrowers credit histories and previous investments. The borrower must sometimes also post collateral that is forfeited to the lender if the borrower is unable to repay the loan. For example, collateral for a mortgage loan is the borrowers house. With verification of the borrower’s trustworthiness and collateral, the information asymmetry decreases between lender and borrower to the point where the lender feels comfortable to transact. If the borrower defaults in a normal situation, the lender will lose money. However, banks today have the implicit full guarantee of the central bank, which means banks are invincible: either banks win by investing in risky projects or they receive central bank stimulus if the risky projects fail. Despite this government guarantee, the bank will still care about the borrower’s ability to pay back, but ultimately government insurance allow banks to engage in risky behaviors.

To exemplify moral hazard, Sven will invest in one out of two projects: project “risky” or “safe”. Project risky has a 50% probability of success, while project safe is guaranteed to be successful. There are no interest rate assumptions in this example.

• Risky: success = 30% return / failure down 30% (130% or 70%)

• Safe: success = 5% return (105%)

• Expected return of (Risky) = 0%

• Expected return of (Safe) = 5%

Clearly, project safe is a greater investment, as expected return (safe) > expected return (risky). However, investing in project safe only holds true if you risk your own money, as the risky project involves similar odds to betting on black in roulette. For example, imagine that Sven sets up a limited liability company called Sven INC with $2 in equity and $8 debt. As a result, Sven INC’s asset side then has $10 in cash. If Sven invests in project safe, he is guaranteed to make 0.5$, while the upside profit for project risky is 3$. However, if Sven loses 3$ on project risky, then he only loses 2$ in equity, as the remaining 1$ is covered by Sven INC’s lender (debt). The expected return on project risky for Sven in the limited liability example is therefore 1$, which is greater than project safe’s expected value of 0.5$. The structuring of the liability side of Sven INC’s balance sheet creates moral hazard, as the limited liability status protects against downside risks. Similarly, to the Sven example, governments protect downside risk for banks, which introduces moral hazard in banking. The difference between banking and the Sven INC example is that debtors investing in the latter understand the risks, while bank depositors might not. Even if depositors understand the risks, they do not care, as the government bails them out if the bank goes insolvent.

Figure 1

 

 

Why Banks Exist and Fractional Reserve Banking

Borrowing lots of cash spanning vast time horizons is a difficult goal to accomplish, as few lenders are willing to risk great sums of money for a single investment opportunity. Instead, most lenders prefer storing wealth safely with high liquidity, despite lowering their investment return. Traditional banks were therefore created as financial intermediaries to facilitate lending by transforming and pooling short-term deposits by private individuals into loans for long-term projects. Through these liquidity transformations, banks are indirect architects of electric grids, highways and schools in society. Unlike modern banks with a complex credit generation process, traditional banks create money out of credit as taught in schools, which means direct deposits are pooled for investment purposes. Banks can then lend out more money than is deposited by their customers. Lending out more money than exists is called fractional banking. While fractional banking has helped plenty of people from poverty, the weakness of fractional banking are bank runs. If all depositors withdraw money at the same time there will not be enough cash in a bank’s vault to cover the withdrawals. To remain in power, the bankers bank (central bank) and governments cannot allow these types of bank runs to occur so the role of the central bank has therefore shifted dramatically in the 21st century. Also, in the digital revolution, political interference in the banking system has increased. Figure 2 demonstrates why a bank is able to extend another loan to Stan, which further expands both credit in the economy and the bank’s balance sheet. Stan is also purchasing a camera for an influencer business and the bank believes that the cash/equity buffer on the bank’s balance sheet is enough to ensure against a bank run. However, at some point the bank will feel that the cash/equity buffer is not enough. However, if there is no deposit insurance a bank will be more careful to lend money to stan, as bank run like Stockholm Banco can therefore occur.

 

 

Banks and Credit Extension

Before describing the role of central banks, discussing how corporate banks profit is important. With substantial funds, banks are able diversify their portfolio by investing in many large projects to avoid losing money on just one bet. The large banks today engage in many different activities, but traditional banking consists of two objectives; act as a custodian for client money and extending credit. Prior to the industrial revolution, extending credit was considered immoral and even illegal in many countries to protect people from debt burden. However, lending became more acceptable, as the industrial revolution increased investments in expensive machinery. As a custodian, banks stored currency in their vaults translating naturally to loans, which is the most common approach to extending credit. The term credit comes from the Latin word creditum and refers to the trust required between two counterparties to trade over time. For deferred payment transactions trust is necessary. The more credit created by banks, the more profit they are likely to earn. However, this leaves banks vulnerable to bank runs. As a result, governments have established deposit insurance to protect consumers and prohibit these bank runs.

 

Figure Excel money

 

Lending money to Rose for a social influence camera is an investment. If Rose purchases that camera, but fails to earn money, she will not repay her loan. If Stan is unable to repay as well, then the bank’s equity/cash buffer will not cover the withdrawals. If central banks do not bail out Honest Abe’s bank then the bank’s equity would be negative and the bank itself insolvent. This could happen if social media turns out to be a bad industry to invest in. With deposit insurance banks can continuously expand their balance sheets, which invokes moral hazard. In Figure 3, however, the store subscribes to Rose social media account and money is moved from store deposit back to Rose’s deposit. As a result, Rose repays her loan and the bank’s balance sheet is smaller, but the bank does not fail.

 

First Central Bank

Sweden’s Riksbank is generally considered as the oldest operating central bank in history. Prior to becoming a central bank, the Riksbank was founded as a joint stock company in 1657 by Johan Palmstruch under the Stockholm Banco banner. The bank first functioned as a private bank, but king Charles IX of Sweden had ultimate power of the bank’s management, so despite shareholders being liable for the bank’s debt, Stockholm Banco could still lend government funds and act as a clearinghouse for commerce. In 1668, the Swedish Riksdag (parliament) overtook Stockholm Banco after the bank failed to cover its customer’s withdrawals and its main shareholder Johan Palmstruch was jailed. The bank run on Stockholm Banco is a powerful lesson that issuing to many promissory notes without adequate capital is a dangerous game to play and yet the same game is being played today at the cost of taxpayers. After the foundation of the Riksbank, other joint stock central banks followed suit such as Bank of England, which was originally established to purchase government debt. Later on, the United States Federal Reserve Bank (FED) was established, which is currently the most powerful bank in the world. The FED arose from two separate U.S. central banks in 1913 and remains privately owned by a group of membership banks, which is unknown to the general public. These 12 membership banks include Goldman Sachs, Lazard and Rothschild Bank of London.

 

 

 

 

History of The Federal Reserve

Prior to FED’s creation in 1913, it was hard to separate certain physical commodities from money, as commodities such as gold or silver served as economic monetary anchors for paper money. Until 1971, FED kept the dollar value relative to the price of gold constant. This meant that the amount of money and credit in the system was constrained by gold reserves. In the 1920s, the central bank mandate expanded, as politicians became worried about real economic stability and unemployment. FED’s objective then evolved to also promote a smoother US economy by providing services such as supervising the banking system, acting as a monetary regulator and conducting monetary policy. Even with a role expansion, FED’s main focus remained on managing gold reserves, which led to lax monetary policy and excessive speculation in equity markets through cheap loans provided by banks. When FED closed the speculation loophole with the Real Bills doctrine in 1928, interest rates increased due to monetary tightening and the markets came crashing down in 1929. The ensuing bank runs between 1929-1933 resulted in the necessary yet dreaded deposit insurance with the creation of the Federal Deposit Insurance Corporation (FDIC). The creation of FDIC in 1933, was necessary for people to trust the banking system, but the FDIC creation has some really long-term consequences that governments are still fighting today, especially because the FDIC incentivizes bank consumers to remain ill informed. Problems with Deposit Insurance of bank consumers are not worried about their bank deposits, they do not research how banks invest their money. As a banking supervisor and regulator, FED therefore monitors banks and set reserve requirements so that banks are unable to overextend credit to risky counterparties. In 1944. Bretton Woods of monetary management agreement was established to organize the western financial system. The agreement tied western currencies to the US dollar, which was ultimately tied to the gold price. However, to spur on economic growth and prevent unemployment, central banks printed more money than there was gold supply. In 1971, the Bretton Woods agreement was therefore terminated by the Nixon administration. By removing gold as a nominal anchor, the dollar became a fiat currency without intrinsic value and currency became worth what people think it is worth. Starting in 1971, the FED is now able to create money from thin air by pressing a button. The termination of Bretton Woods in combination with digitalization has allowed shadow banks to emerge and circumvent banking rules through regulatory capture.

 

Shadow Banking

Not printing money to solve problems is emotionally difficult for central bankers, especially when the purpose is to avoid economic disasters such as the Corona Crisis. To prevent politicians from impacting monetary policy decisions, the FED therefore established itself as an independent institution. The US President is, for example, unable to fire the FED’s chief executive, but the rules do not prevent the FED chair from political pressures and tweets. Political pressure often forces central banks to conduct bank friendly monetary policy, which in combination with fractional banking and fiat money allows shadow banks to extend massive amounts of credit through regulatory capture. To avoid banking regulation, banks move packaged loans from their liability side on their balance sheet to off-balance sheet legal entities called special purpose vehicles (SPVs). Creating credit through SPV’s is a complex process, but the end result is the same as for traditional banking; moral hazard. If shadow banks are not allowed to fail, then they will lend money to risky projects. There is no direct deposit insurance for off-balance sheet products like SPVs, but the growth of SPVs and other financial derivative innovations is massive and the derivatives industry is now so systematically important that SPVs have their own implied deposit insurance. Imagine running a business that cannot fail. That is precisely what is happening to our banking system.

 

 

Further Problems with Shadow Banking

Ever since 1960, the amount of shadow banking liabilities have increased drastically and these shadow banks extend credit through SPVs based on semi scientific gaussian statistics such as normal distributions, correlations and standard deviations, which convinces regulators that SPVs are safe. In normal markets, the statistical approach to lending functions well, but in extreme market conditions, statistical relationships break down and fat tail catastrophes transpires. The SPV is usually a limited liability company without employees. The equity and junior tranche owner of the SPV is usually a sponsoring entity such as a bank. If the SPV loses money, the sponsoring entity takes the first hit, so when banks establish these SPVs, their balance sheet risks are transferred to the SPV, but the risks are not removed. Currently, the amount of credit circulating in the economy is massive and the fat tail problem increases exponentially with credit extension. For example, the Corona Crisis has caused significant unemployment. Without central bank stimulus, people might default on their mortgages, which increase the odds of mortgage SPV defaults. Just like traditional banks lend out money deposited by their customers, the SPV issues debt by pooling together millions of mortgages on the liability side of the balance sheets. The SPV debt is then backed by a diversified portfolio of loans on the asset side. If only a few mortgages fail then the SPV survives, but if most mortgages default, then the SPV is unable to repay loans on its issued debt. An increase in mortgage defaults leads to house price declines and the SPV sponsors must then cover losses by fire selling mortgages at discount prices. This process then turns into a liquidation cycle, as defaults spread systemically through the economy like the corona virus itself, which is similar to a traditional bank run. In 2008, the TARP bill created by President Obama prevented the subprime liquidation cycle from destroying the economy. However, the TARP bill further increased moral hazard because it sent a signal to shadow banks that when shit hits the fan, the government prints money and bails them out.

 

 

Inflation and The CARES Act

Despite a ten-year bull market, the US passed the CARES act to prevent record unemployment from destroying the economy. The CARES act provides businesses and consumers with economic stimulus payments and unemployment checks. Ultimately, these payments equal an FDIC type of insurance to shadow banks, as people continues paying down mortgages. As a result, house prices remain high and business insolvencies are prevented. The CARES stimulus also incentivizes shadow banks to extend more risky loans on the asset side, which then increases the systemic importance of the SPVs. Loans on an SPV’s asset side is payed for by its liability side and if the asset side decreases in combination with mortgage defaults an economic depression will occur. However, this crisis is prevented if the FED and governments decides to print money. The problem with a printing approach is currency debasement. The value of the dollar will perhaps decrease relatively to fixed assets such as gold and consumer products, which leads to inflation. Given the divergence between the real economy and the stock market during the middle of 2020, asset inflation is already taking place. The question is when prices on consumer goods starts to increase.

Lockdown

Current geopolitical uncertainty escalated with the global Covid response, which was a response fueled by fear mongering and lockdowns to prevent death and hospitalizations without regard for economic and political side-effects. Sadly, millions of people with co-morbidities like obesity have passed away with or maybe from a Covid infection. I want to make it clear that Covid is a dangerous disease and that vaccines are probably more beneficial than harmful, but the lockdown strategy was a policy error. The idea of using lockdowns to prevent sick people from overwhelming hospitals ex-ante was well-intended, but the fact is that lockdown policies failed balancing scientific and economic trade-offs. While some researchers argue that lockdown saved lives, other studies, like a well-known study from John Hopkins, argue that lockdowns in addition to unintended consequences including hurting the global economy failed to prevent excess hospitalizations and death. Long-term, the economy and geopolitical instability was impacted negatively by lockdowns because global central banks and governments launched historical economic programs containing unimaginable amounts of monetary and fiscal stimulus to prevent an economic crash. In US alone, FED printed around 80% of the dollar supply existing today and the US Government provided over 4.15 trillion dollars in different fiscal stimulus packages. As a result , risky assets like stocks and crypto went to the moon during Covid, which was great for rich asset owners. However, while the rich experienced excess, the average US consumer simply maintained their standard of living by spending stimulus checks on housing and food, while at the same time dealing with covid. In addition to causing inflation and mental health problems, lockdowns disrupted global supply chains. Poor supply chains in combination with money printing led to more money chasing fewer goods, which is why prices prior to the start of the Russian invasion were higher in 2022 than 2021.

 

The John Hopkins study - https://sites.krieger.jhu.edu/iae/files/2022/01/A-Literature-Review-and-Meta-Analysis-of-the-Effects-of-Lockdowns-on-COVID-19-Mortality.pdf

Cause of Inflation

The high inflation print in March 2022 is also direct consequence of continuous reliance on short-term fiscal and monetary policy to stimulate the economy since 2008. Specially in 2019, as the global response to the Covid pandemic with lockdowns and direct checks destroyed supply chains and added excessive amounts of money into the system. Pouring gasoline on a souring global economy was the ineffective secular global coordination push for climate change, which created division among nations. Instead of pragmatism, politicians have gambled on deflation and a net-zero carbon future by imposing lockdowns and relying on authoritarian energy sources. Students of history know that inflationary pressure experienced by the likes of the Roman empire, Spain in the 1500s, Germany in the 1920s and US in the 1940s is a precursor for change. Higher prices are basically a tax on the middle class, which is the portion of the population needed for political stability. If the middle class is unable to attain basic needs like food, energy and housing at a decent price then trust in large institutions is vaporized. Internally, uprisings may take place and externally, wars may happen. The Russian invasion of Ukraine will most likely shift the world from globalization to isolationism, which leads to an even higher cost of production and increased prices. However, a Ukraine versus Russia war escalation is likely to cause even further price expansions.

 

Russia and Ukraine with Resulting Sanctions and Climate Change

The 7.9% inflation print in March 2022 excludes the price shocks on energy, rare metals and food resulting from the invasion of Ukraine by Russia. With responsibility of over 12% of global oil/gas exports and 20% of wheat exports, Russia is one of the largest producers of energy and food. With escalating sanctions imposed on Russia by Europe and NATO, Russia has surpassed Iran and is now by far the most sanctioned nation in the world. In response to accelerating sanctions, Russia is likely to eliminate energy and food exports to Europe. In addition to energy and food export, Russia is also one of the largest exporters of rare earth metals like 28% of global nickel exports, which are used as components when generating battery, solar and wind power.[43]The energy sector and transportation sector for the largest polluter in Europe, Germany, accounted for 33% and 22% of emissions respectively in 2020. In their mission to move to climate friendly substitutes, Germany outlines the need for smarter grids, improved charging stations and more efficient batteries to achieve the net zero carbon objective by 2045.[44] The German net zero carbon strategy does not include the possibility of a global war that would eliminate import of rare earth metals from the largest producers in the world. The push for a net zero carbon future is one of the reasons behind inflation and therefore have a perverse consequence in slowing down the western transition a net-zero carbon future. Building up supply chains or finding substitutes to replace energy, food and metals shortage is dangerous because it causes further inflation in the west. Higher inflation means that a strained middle class will hurt even further.

Modern Central Banking

In centralized nation state economies, the requirement for perceiving money as valuable is having trustworthy institutions responsible for governing its value. As a result, these institutions including central banks are forced to become more transparent to increase public trust. Despite trust levels differing vastly between countries, most central banks across the world follows Japan’s lead when conducting fiscal and monetary policy. While Japan conducted what I call new school monetary policy in a vacuum in the 1990s, western central banks including ECB, BOE, and the FED now seem to coordinate across borders. Together, through trial and error, these players have created a monetary policy roadmap to avoid economic depressions after economic crashes and this roadmap includes different steps. The first step in new school monetary policy to prevent a depression is lowering interest rates to encourage borrowing and investment. When nominal interest rates like the US federal funds rate hit zero or perhaps even negative in response to undesired outcomes, the second step is to monetize treasury bonds so that governments can create bailout packages to prevent systemic risks in the economy. When these bailout packages lead to unintended effects like asset bubbles, the third step is to provide stimulus directly to the people, which has not directly been done by BoJ. The main danger when going from the second to the third step is populism. The owner of assets are typically the wealthy and in asset bubbles they make lots of money, while the commoners are left behind. A strong leader can say that these bailout packages should go straight to the people creating a dangerous precedent, as cash power can be used to manipulate votes short-term. However, what worries me the most with the money handouts is how that money impacts prices in the real economy. In the new digital economy, it is much easier for business to raise prices with the click of a button. For example, many restaurants now show their food menu via a QR code instead of a physical menu, which means restaurants are theoretically able to charge dynamic pricing. If, for example, the price of food or raw material increase, restaurants and other businesses can immediately push the cost to consumer without changing prices physically. Just like Japan printed money to fight of multiple crisis’, the western world has entered into a period of unbounded money printing. This money printing has not lead to the kind of inflation that is measurable by the FED, but rather it has led to a potential twin asset bubble in the equity and fixed income markets. Fixed income instruments have an inverse relationship with rates so when FED lowers the federal funds rate, which is a rate charged to banks for borrowing from the FED, the price of bonds go up all else equal. It also leads to a lower yield on bonds so it forces investors with cash on hand to look for alternatives in order to generate a rate of return. That is why a lot of these investors have turned to the equity markets, which has reached peak valuations in a period when the world has suffered from a global pandemic. Many smart people now believe that this will lead to an overheated economy.

 

 

 

 

Summary of the Chapter

 

Central banking

The first central bank was created in Sweden to lend government money. The institutions chief officer, Johan Palmstruch, was jailed because the bank issued to many promissory notes. When the inevitable Swedish bank run occurred, Stockholm Banco was unable to cover withdrawals. Ever since this “central” bank insolvency, the banking system has evolved to prevent future defaults. The current US banking system has ruled since the creation of the FED in 1913, which has resulted in enormous absolute life improvements for US persons. However, in the last 30 years massive money printing by central banks have created record levels of wealth inequality. Up until 1913, the main objective of central banks was to maintain price stability, but since then many steps have been taken to stimulate the economy at all costs. In combination with information asymmetry between lenders and borrowers and digitalization, the FED, FDIC, and US government have created enormous moral hazard problems in the global economy. The drop of the gold peg and increasing political interference in central banking policy further increased the moral hazard problem during the 1970s, as the termination of the Bretton Woods system lead to a faith-based fiat currency system. Ever since 1971, shadow banks have gathered massive amounts of debt through financial innovations such as packaged mortgage obligations, which has increased shadow bank balance sheets to record levels. These shadow banks use SPVs to extend credit much like a bank uses fund deposits to make a profit. There is currently a high appetite for borrowing money, as interest rates are kept artificially low by central banks. Despite low returns from lending, shadow banks have an incentive to lend as much as possible because of the implicit guarantee from the central bank. This was demonstrated both in 2008 with the TARP bill and in 2020 with the CARES act. The cycle of money printing will end when inflation takes place. My worry is that inflation is not a question of if, but when.

 

When all Bets are Off

War has no rules. Economic sanctions against Russia by the west will disrupt supply chains perhaps enough for the FED to fix yield curves at low rates and for US Treasury to impose price controls on energy and food. In addition, increased isolationism may ensue as seizing of assets from foreigners imply that property right is an illusion empowering western companies and governments for both good and bad. For example, how will countries rely on Visa for credit and debit cards, Facebook and Instagram for social media and Swift for international payments when US companies can remove services with the push of a button. As a result, nations must expand domestic production. In turn, costs will go up and the net zero carbon future is jeopardized. Combining isolationism and disrupted supply chains with dovish monetary and fiscal policy will drive further inflation. There is certainly a possibility that FED will raise interest rates a number of times in 2022 as stated continuously, but I wonder if they can do that when already slammed US consumers are now forced to experience higher rates on a mortgage, credit card loan and car insurance. Historically, periods of inflation generate political uncertainty and a craving for strong men. In the US, we all know what that implies with a guy claiming that the last election was stolen from him.

 

 

 

Chapter 8: Decentralized Applications and Metaverse

 

Online Sovereignty

Bitcoin is not last technology  to create a trusted medium of exchange, unit of account and store of value without government backing. All Bitcoin showed was decrease the importance of nation-states and corporations by proving ownership and identity via immutable software code on a network of distributed databases on computers located invariantly in relation to  geographic borders. By expanding upon the first principle ideas behind bitcoin, an achievable future vision of DeFi, Web3 and Metaverse starts to form.

 

In Web1, users could read (think reading newspapers)

In Web2, users could read and write (think writing blogs)

In Web3, users can read, write and own (think monetizing content)

 

Among interesting areas: NFT, Privacy, Stable coin, Currency, Commodity backed, Remittance, Platform, DeFi, Exchange, DAO, Metaverse

 

Web3 equals digital autonomy, which allows individuals to virtually socialize, earn, play and work in real time like in the physical world. Obviously, DeFi, Web3 and the Metaverse requires advancement in both hardware and software to create a digital world that allocate resources efficiently among users like in the real fiat world. In addition to improving technology, discussing the amount of decentralization is important to facilitate Web3 and Metaverse development. The developments in Web3 is more similar to how no nation-state have power to enforce law on the global oceans. By replacing expensive manual processes for large corporations similar to how machines made farming more efficient with fewer farmers, the next generation of workers will leverage coding, business and marketing skills to scale the upcoming Web3 plumbing system, which involves replacing inefficient old Web2 pipes and railroads with automated blockchain based software. These new Web3 pipes leverage a blockchain’s ability to generate programmable trust, privacy and money and was first invented when Satoshi Nakamoto combined ideas derived from game theory, law, economics, cryptography and computer science to create Bitcoin, which has grown into a trillion dollar digital asset market. Positive externalities will be unleashed when the global economy lessens dependency on manual white collar functions like approving, updating and processing centralized database information and removing single attack vector threats to information across our economy in industries including finance, healthcare and government. Three of these positive externalities include lowering costs of existing products, increasing human capital on new products in blue ocean markets and improving work life balance, which creates a happier and more productive workforce on a net basis.

 

Future of Web3

There are many paths for investing and make money in Web 3.0. The first way is to directly purchase cryptos like Ethereum and Bitcoin for the sake of price appreciation. The second way is to earn a yield by validating transactions through solving puzzles in PoW or staking in PoS. The third way is to lend and borrow through liquidity pools like Aave. The fourth way is to buy NFT art or yield farm in DeFi. The fifth way is to pool together capital and provide insurance. The sixth way is to pool capital in a DAO like Klima Dao and buy assets that provide a yield. The seventh way is to invest in companies that provide Web 3.0 services like Coinbase. Personally, I believe we are in the early stages of a digital revolution and that the total market cap of all things crypto will increase so the most important thing is to stay long. However, to invest in the best ideas within Web 3.0, it is up to each individual to do their own research. For a virtual world to function properly a virtual economy needs to be created. Like the physical economy, the virtual economy will facilitate transactions and allocate resources between users and companies. In addition, a virtual economy will reward creators for creating new games or virtual worlds. Friendships usually lost in the past because people moved apart for school and work instead remain through social media and video games. Status signaling by owning fancy artwork is now done through NFTs and video game skins. Work meetings and conferences in person has been replaced by video software such as Zoom and Microsoft teams. Content is distributed by individuals rather than large news and content gatekeepers. Decentralized wallets allow people to lend, borrow, wire and transfer money outside of the traditional banking system, which means awesome projects to solve problems in India can be supported by someone in Peru. New projects and DAO’s launched on blockchains allow for censorship resistant democratization of information and pooling of resources. Frankly, the Metaverse allows for a more equal playing field as long as people have similar access to the internet. Passion makes GameFi a more attractive area for innovation within the Metaverse than does DeFi. Many talented developers love video gaming. As a result, GameFi has great potential to attract contrarian obsessionistas.  Unlike a majority that may love gaming, these developers understand blockchain at a technical level, which is setting the stage for a merge between gaming and blockchain. In GameFi, entrepreneurs with contrarian obsession can become game developers and at the same time incorporate finance into actual game play. The economic network effects from potential GameFi inventions are huge and only time will tell if GameFi becomes the next big thing.

 

 

 

 

 

Moore’s and Metcalfe’s law

In a way, Web3 can exist without the Metaverse, but not the other way around. Web3 is concerned about who owns the internet of tomorrow. If the owner is a centralized institution, then Web3 is not really different from Web2. The development of the Metaverse will therefore reflect Web3 advancement. Metcalfe’s and Moore’s law are the two most powerful ideas behind the internet boom and they provide a framework for the future adoption rate of Web3 and the Metaverse. The former states that the value of a communication network is proportional to the square root of its number of users, while the latter refers to the fact that the number of transistors in microchips doubles every two years. Computers and microchips go hand in hand and transistors in integrated circuits of microchips are the electric railroads. If the railroad conducts electricity faster, then computing power magnifies. The exponential increase in computing power is why computers today are so tiny that they fit in our pockets. These flexible computers made it possible to establish huge networks like social media and internet itself. Improving technology that is more user friendly leads to adoption, which means that services built by the technology becomes more valuable to the community already using that technology. The Metaverse requires powerful microchips to become immersive. Qualcomm has, for example, teamed up with Microsoft to create custom microchips allowing users with augmented reality glasses (AR glasses) to beam a realistic likeness of themselves into the headset of another user so that it feels like the two people are in the same room. Per Moore’s law, the Metaverse is no longer science fiction and per Metcalfe’s law the value of the Metaverse should increase exponentially like the internet. I have no idea what the Metaverse will look like, but depending on Moore’s law there are some really exciting potential outcomes. Let’s discuss these potential outcomes.

 

 

 

Idea and Execution

Around 6 years after Bitcoin became the first decentralized application, Ethereum unlocked blockchain based applications via the smart contract functionality. The rapid adoption of Bitcoin and Ethereum further incentivized the smartest people in the world to start building decentralized application to solve problems in the real world. The lowest hanging real-world problems were financial in nature, as the combination of smart contracts and cryptography are perfect technologies to leverage for storing money and secure financial transaction. Among the lowest hanging fruit in the DeFi industry became collateralized borrowing. Mortgages in traditional finance are perfect examples of collateralized borrowing. The house functions as the borrower’s collateral to ensure trust.  If the borrower fails to pay interest rate on the mortgage, then the bank lender may seize that mortgage In  DeFi, the borrowers replace mortgages as collateral with cryptocurrencies. These cryptocurrencies are stored in a smart contract in return for borrowing more or other types of cryptocurrencies. If the value of the cryptocurrency collateral falls, then the smart contract allows the “bank” lender to seize the cryptocurrency collateral from the borrower automatically. The smart contract simply ensures trust between two untrusting parties in a financial transaction. These simple DeFi solutions to financial transactions based on smart contracts have evolved and there are now a wide range of real world problems can be solved by blockchain technology. As a result, the cryptographic based computing revolution will generate exponential economic growth by expanding labor demand for developing blockchain based products, while also reducing excessive societal costs associated with corporate red tape labor.

 

 

MakerDao: The First DeFi Application for Creating Collateralized Stablecoins

Not surprisingly, blockchain adoption occurs at an accelerated pace in software intensive lower hanging fruit industries responsible for efficiently allocating economic resources and information in the global economy,  which is the Internet and financial industry.  That is why Bitcoin is the first principle application for programmable money/trust and Ethereum the equivalent for a programmable world computer. After Bitcoin and Ethereum, the MakerDao application, developed by Rune Christensen in 2015[1] as a layer 2 online banking protocol leveraging the smart contract function on Ethereum, was the first successful DeFi application[2]. With over USD 7.7 billion in total value deposited as of October 2022 per Defillama[3], the MakerDao protocol’s original business model profited from issuing token equivalent fiat currency transparently similar to central banks by allowing users to deposit Ethereum and a range of other tokens and cryptocurrencies as collateral and in return for locking up cryptocurrencies mint the DAI stablecoin pegged at a 1 to 1 value with fiat like the US dollar. For example, users can supply 1000 USD in Ethereum to a MakerDao vault and 700 DAI (700 USD), which removes the insane volatility associated with cryptocurrencies like BTC and ETH and therefore simplifies purchases on Web3. In addition to benefits associated with minted DAI coins, users also receive interest on their deposited ETH collateral. For providing the stablecoin service, MakerDao like any traditional financial company profits from the deposited collateral via lending and borrowing ETH to traders and large financial institutions in need of financing for projects or investments. The emergence of Stablecoins in combination with decentralized price oracles may revolutionize ownership and trade in our global economy by functioning as a railroad for transporting information to digital assets from the real world. Decentralized web3 applications for which users own and monetize personal information will then replace freemium models utilized by centralized cash apps, debit cards, exchanges and social media platforms.

 

 

What is DeFi?

The DeFi industry has expanded dramatically since 2015. According to Defillama, DeFi holds around USD 55 billion deposits and the DeFi industries estimated market value in 2022 is USD 22 billion. DeFi is just open source algorithms utilizing smart contracts built on top of blockchains to circumvent intermediaries. DeFi was possible due to the creation of stablecoins. These stablecoins allowed rational investing based on temporal discounting in Web3. (1) Interoperable No arbitrary restriction such as wealth, nationality, age or bank. No middlemen and rent seekers control the system (2) Programmable
Smart contracts that are transparent and can be permissionless. (3) Composable Like Lego, a composable system of pieces that when combined can build anything

 

The main benefit of DeFi creating decentralized immutable databases, which democratizes access to capital markets. DeFi will boom if rent seekers and gatekeepers in traditional markets are not allocating capital effectively. Unlike government currencies where taxation generates adoption, Stablecoin adoption is generated by providing users with an edge. Stablecoin emergence started with Tether, which was backed directly by fiat in the Tether treasury.  Tether is still the largest Stablecoin in the world, but the risk associated with key man decisions has forced many people to turn to alternatives. A range of collateralized Stablecoins like MakerDao, PaxosGold and Terra therefore emerged as competitors too Tether. Perhaps the most exciting of these alternatives is the Algorithmic Stablecoin, Terra, which uses a system of arbitrage incentives, open market operations and dynamic protocol levers collateralized by the native cryptocurrency Luna and Bitcoin to maintain peg stability. The biggest risk associated with Terra is a bank run, which could cause fiat pegs to deviate similar to the Iron Finance Stablecoin debacle. The bank run risk is most likely why Terra purchased Bitcoin to maintain price stability in times of emergency. However, there are a lot of benefits with Terra and that is why more than 100 Dapps have been built on top of the now 48 billion dollar Terra and Luna ecosystem. The atomic swap function for cross-border payments, the low fees charged to merchants for transactions and the Dapps built on Terra is why Terra might become the number one blockchain in the future, while the bank run risk might become its downfall.

 

 

Stablecoin Deepdive

Stablecoins are crypto tokens pegged 1 to 1 with fiat currencies and are a dream for the transformation of our society into a digital economy, as the human brain desires stability. As discussed earlier, the financial system needs stability to function. The Bitcoin price swings might work for certain types of applications, but stores and other firms cannot price their goods and services in such a volatile currency.

That is why nation-state governments created stable fiat currencies backed by central banks where long-term inflation is sacrificed for illusionary short-term price stability. Like magic, equity analysts, consumers and businesses can then discount future values to the present and consider opportunity costs satisfying the needs of the prefrontal cortex. In fact, currency stability is so treasured by our society today that many people consider crypto maximalism as a sacrilegious act against the church of stability. In addition to enhancing criminality and climate change according too many politicians, bitcoin’s price volatility violates Newton’s first law of prefrontal cortex science.

 

Stablecoin purpose

Without short-term price fluctuations in the crypto space, Stablecoins serve as a medium of exchange, unit of account, store of value and method for discounting the value of future digital currency projects.

Unlike transactions made in fiat currency, Stablecoin equivalents are secured and cleared by blockchain technology rather than expensive banking and third party intermediaries. These intermediaries are known to charge high fees for custody and facilitation of transactions. For example, with Stablecoins there are no extra fees for immediate settlement of international cross-border payments if both counterparties own digital wallets. The perhaps main purpose of Stablecoins other than just providing stability in a volatile crypto space is enhancing blockchain developments for Decentralized applications (Dapps) by simplifying access to asset raising and liquidity provisioning. To connect with the real economy, most Stablecoins are pegged 1 to 1 with the largest fiat currencies in the world like USD, EUR, GBP and Yen. These Stablecoins maintain their peg by collateralization similar to how banks collateralize mortgages with underlying houses.  Stablecoins are generally collateralized by storing exchanged fiat currency used for minting/creating new Stablecoins in a vault like Tether or by holding cryptocurrencies and commodities in a treasury like Terra and PaxosGold. Inflationary yet stable currencies allow businesses and consumers to plan for the future. In addition, the human brain’s prefrontal cortex is the future planner and the prefrontal cortex needs illusionary certainty to feel calm for the world to function. As a result, the instrument used by businesses and consumers as medium of exchange, unit of account and store of value must be stable. Currency stability is a religion so powerful that when Cryptopunks argue that Bitcoin equals money a majority of the world’s western prefrontal cortexes simultaneously breaks as Bitcoins price volatility violates the law of stability. The truth is that short-term stability is a powerful but necessary illusion, which is difficult for Bitcoin to solve without a FED printer. In a perfect world, merchants should have access to liquidity when currency volatility explodes, but instead society chooses to exchange short-term volatility for long-term inflation (volatility), which is the cost of transacting using a government backed stable fiat currency. Fiat stability is why the crypto developers are solving crypto volatility problems by creating Stablecoins using the four different forms of underlying collateralization such as USDC, Tether and Terra.

 

 

The First Widely Adopted Stablecoin

The first widely adopted Stablecoin was Tether created in 2014 by a Hong Kong based team. Tether is a fiat collateralized crypto token (USDT) with an objective to remove cryptocurrency volatility and serve as a bridge between traditional and digital markets. Each Tether was first pegged 1 to 1 with USD, which means that in theory for every Tether in circulation there should be an equivalent amount of fiat in the Tether treasury. Tether is a business and the parent company generates profits from fees on deposits and investments. For example, a minimum deposit of 100,000 USD is needed to interact directly with Tether’s treasury and withdrawing balances from Tether costs at minimum a 1000 USD. When depositing fiat directly into Tether there is also a 150$ account verification fee. Finally, instead of just holding cash in the treasury, Tether lends out money to companies (risky).  In 2019, the Tether team updated the financial disclosure statements no longer claiming a 1:1 USD deposit backing. These cash equivalent reserves held are instead high quality yield generating papers with low risk, but anything that generates a return still involves risk.  The updated financial disclosures therefore imply that Tether’s peg might break if the value of Tether’s treasury reserves drop. Given the volatility of the crypto market as a whole, it is not surprising that a lot of shady decisions have been made to keep Tether alive, like preventing customers from withdrawing Tether in 2017.[45] Despite controversy, Tether is the third largest crypto token in the world with over 80 billion USD in market cap benefitting mostly from the 2017 bull crypto bull run when there were no stable coin alternatives. In 2017, a stable coin explosion took place, and other Stablecoins like Terra were created. Sharing some history about the Terra project is important before demonstrating in detail how Terra maintains a fixed 1:1 price to fiat with algorithms and cryptos rather than a fiat reserve treasury like USDT.

 

Different Kinds of Stablecoins

Terraform Labs was founded in 2018 by Korean computer scientists Do Kwon and Daniel Shim to compete with traditional and other crypto payment systems. [46]As of March 23 2022, The combined market value for the Terra ecosystem which includes Luna, Terra and now also some Bitcoin is over USD 48 billion. Rather than the Ethereum or Bitcoin approach, Kwon and Shim began with creating a Stablecoin to promote stability over volatility to underpin the Terra ecosystem. In the now legendary Terra White paper, Kwon and Shim outlined their vision of scaling a practical blockchain payment network to generate user adoption. The Terra Stablecoin bet paid off, as there are now more than 100 projects built on Terra platforms across DeFi, NFT and Web3. Unlike fiat backed Tethers, Terra Stablecoins are algorithmically pegged to fiat currencies including USD, EUR and KWR and uses a system of arbitrage incentives, open market operations and dynamic protocol levers to maintain peg stability. The algorithm controlling the Terra system is designed to destroy/burn and create/mint the collateral coin Luna to prevent peg deviations against fiat currencies. Minting or burning in crypto speak is the process of creating or deleting tokens algorithmically through a smart contract to increase or decrease the value of the tokens already circulating in the open market. These Luna tokens are held in the Terra Treasury similar to how a traditional bank puts collateral in a bank vault to enforce repayment when lending out money to borrowers. Since Luna tokens are either burned or minted to maintain Terra price stability, the supply of Luna is elastic and volatility is pushed from the Terra Stablecoin to the price of Luna. While the Terra Stable coin remains pegged to fiat, the Luna token has increased by over 600% in 2021.  The Terra ecosystem founders wanted their flagship token to have a stable price so that developers on the Terra blockchain could focus on creating Decentralized applications (Dapps) without questioning the future value of the native Stablecoin. The main benefit of algorithmically backed Stablecoins like Terra over traditionally cash backed Stablecoins like Tether is that peg and collateral governance is handled by immutable open source code rather than key man decisions of a board or CEO. For example, the Tether team decided to hold commercial paper in the treasury rather than full cash reserves to back Tether. These key man biases may violate Stablecoin stability in the long-term, which are avoided when stability is instead maintained by algorithms.

 

How are algorithmic stable coins stable? Are They?

After reading the entire White Paper on Terra, my first reaction is that Terra’s minting process is complex and perhaps not simple enough to understand for people with a normal life, but I love challenges so let us try breaking down the Terra White Paper.[47] On June 16 2021, Iron Finance suffered a coding design flaw and Iron USD lost its soft peg to the dollar. The design flaw allowed the value of the collateral backing the governance token Titan, which is equivalent to Luna, to drop to 0. Although some people believe Iron Finance was a scam, Ivan Kuznetsov wrote a paper arguing that the design flaw in Iron Finance stabilizing mechanism failed to appropriately incentivize arbitrageurs to protect Iron USD’s peg during a swift drop (bank run).[48] The same could happen for Terra. Basically, Terra outlines how growth generation is centered around incentivizing network effects by effective algorithmic monetary and fiscal policy to maximize stability and utility. While a government incentivizes adoption by enforcing taxes payable in the government currency, Stablecoin adoption is generated by edge provisioning. Simply put, merchants and friends will use Terra if a noticeable edge over fiat and competing Stablecoins exists.  Terra has already achieved adoption by luring in the largest payment processor in South Korea, Chai, to accept Terra Stablecoins. The Chai-Terra partnership is probably behind the 2022 increase in market value of Terra despite that crypto is in bear market territory. Terra’s edge over competitors was seamless transactions across borders at low fees and a giant ecosystem spanning DeFi, gaming, borrowing, lending and the metaverse. In addition, a maximum of 1% in transaction fee is charged to merchants.  Seamless cross border transactions remove time consuming bank settlements from days to seconds and low fees provide merchants with greater revenue as the maximum fee charged by using the Terra ecosystem is much lower than the 2-3% typically charged by Visa or Mastercard.  Lower merchant fees are made possible by utilizing the Terra blockchain algorithm, which is a combination of elastic monetary policy to create a stable yet censorship resistant currency and efficient fiscal policy in which multiple Dapps compete for financing from the Terra Treasury.  The main Terra peg is not to the USD or EUR, but to the international monetary fund special drawing note, (IMF SDR), which is a weighted-basket of major international currencies. The Terra SDR allows for all underlying Terra currency pegs to enjoy shared liquidity in order to maintain individual peg stability to all pegged currencies simultaneously. Shared liquidity also allows for the atomic swap function. For example, if user B wants to receive Terra EUR from user A holding Terra USD, the Terra Swap function allows user B to receive Terra EUR at the prevailing USD/EUR exchange rate although user A is sending the payment to user B in Terra USD. Exchanging Terra pegged to different currencies is therefore as seamless as a Venmo payment.

 

Difference Between Iron Finance and Terra

Iron Stablecoins was backed by USDC and Titan rather than just Luna, which makes Terra and Iron a bit different. Also, in response to a scenario putting downward pressure on Terra similar to that experienced by Iron Finance, Terra’s algorithm will rapidly offer Luna SDR for Terra SDR at huge discounts, which incentivizes arbitrage traders to buy 1 Luna SDR for around 0.9 Terra SDR’s until the Luna-Terra ratio and pegs are back to 1 again.  In addition, the Terra System will increase transaction fees and burn of Luna collateral to further remove supply of Luna.  Higher fees and burn rates increase the marginal value of each Luna held by validators as they receive more rewards for validating transactions in a now smaller Terra ecosystem. The Terra treasury has also implemented a nuclear stability option by using bitcoin as collateral. In March 2022, the Terra Treasury started purchasing bitcoin with the goal of amassing a total of 10 billion dollars in BTC to back Terra Stablecoin stability. Unlike Iron Finance, Terra is therefore becoming the first stable or fiat currency in history that is using the bitcoin standard. The best part of Terra is not necessarily the Stablecoin itself, but the protocol’s objective to create long-term value through algorithmic investing in decentralized applications, which will hopefully assist in creating the best Stablecoin possible as well.

 

Why Terra monetary policy also does not work

Terra is a family of Stablecoins pegged to major fiat currencies and collateralized by native cryptocurrency Luna to create a stable yet censorship resistant method of exchange compared to bitcoin and other volatile cryptocurrencies. The hope is that currency stability incentivizes adoption of Terra, which in turn accelerates demand increasing both transactions and value of the Terra ecosystem. More demand imbalances the Terra SDR and IMF SDR peg, which is unacceptable for a Stablecoin. In response to imbalance, the Terra system rebalances the peg by varying transaction fees and supply of Luna according to a predetermined and transparent algorithm.

 

Mining Profit = Luna rewards/Luna supply – unit minting cost

 

In a Terra expansion, the price of Terra SDR is likely pushed below 1 against the IMF SDR. Note that 1 Terra SDR can always translate into 1 Luna SDR by transacting with the Terra Treasury. When 1 Terra SDR purchases more than 1 IMF SDR, traders will exchange 1 Luna SDR for a higher valued 1 Terra SDR from the Terra Treasury, which equals risk free money! In return for aggregating and verifying all transactions on Terra’s Proof of Stake blockchain, Luna holders or so called miners stake Luna tokens to earn extra yield from all transaction fees generated by interactions between users of Terra.  Miners holding larger Luna stakes are more likely to become validators responsible for ensuring transaction accuracy and timeliness, which means larger stakes earn more yield! In our example, a demand shock pushes the Terra SDR below 1 so observant Terra ecosystem traders will therefore send 1 Luna SDR to the system and receive back 1 Terra SDR, which generates a small arbitrage profit for traders as 1 Terra SDR is valued more than 1 IMF SDR by the open market. In return, the Terra SDR peg value is brought back to 1. The holders of Luna are also happy because the Terra ecosystem burns/destroys a part of the Luna SDR upon receipt. Fewer Luna tokens increases the value of Luna in a growing Terra ecosystem as market forces drive up the price for each individual Luna. Note that the Terra SDR will experience economic contractions pushing the exchange rate above 1 IMF SDR in the future so the Terra ecosystem monetary policy algorithm is continuously smoothing mining profits across both good and bad times. To maintain stable long-term mining profits, the change in the rate of Luna burn and Terra transaction fees therefore decreases with accelerating demand.

 

 

Issues With Stablecoins and Cryptos in General

Money laundering is a common problem cited frequently with regulators because of laxed third-party monitoring in the crypto space. Regulators argue third-parties like banks are beneficial because of KYC or know your customer checks.  Although KYC in theory prevents money laundering, the USD is undoubtedly the largest currency used for nefarious activities; just ask the infamous Pablo Escobar who, rather than hiding money, used billions of dollars in profit as firewood.  In the end, KYC is an educational challenge that the crypto and stable coin community must overcome for regulators to feel comfortable with peer-peer transactions.  My hope is that with education regulators will hopefully understand that a permissionless blockchain is essentially an immutable database that records all transactions on the network.  I would therefore suggest future Escobars to not launder money on a permissionless blockchain.  Note that even if blockchain based Stablecoins is a great tool against money laundering, irresponsible monetary and fiscal policy by central banks and governments generally remain problematic as long as the Stablecoin is pegged to fiat. We should also investigate the price paid for the pleasure to transact in a stable algorithmic currency.

 

Terra and Algorithmic Stablecoin Dangers

Trust in fiat currency pegs by Stablecoins depend on the value of the underlying collateral stored in treasury and on the system/bank/vault/treasury holding the collateral. For Stablecoins like Tether maintaining a fiat peg is relatively straightforward as each Tether is backed by an equivalent dollar securely held in the Tether Treasury. The main risk is that the collateral custodian is devious. For example, if Tether’s Treasury is not holding a proportional collateral amount of Tether’s total market value in its vault, the Tether Treasury may suffer a bank run. Algorithmic Stablecoins like Terra can also suffer bank runs. Unlike people, however, transparent immutable software cannot be manipulated. A potential Terra bank run scenario is if merchants stop accepting Terra Stablecoin payments and if Terra users then respond by switching payment method and selling Terra, which in turn leads to a rapid contraction of Terra money supply. As a result, the value of the Terra SDR may rapidly decrease below 1 to the dollar, which puts enormous pressure on the Terra algorithm to stabilize all fiat currency pegs. Remember that if the value of Luna is 0, then Terra is no longer able to maintain currency pegs, which actually happened to Terra’s Stablecoin competitor Iron Finance.

Terra Fiscal Policy

Like validators of the Terra blockchain, the Terra treasury earns a portion of the seigniorage/profits generated by Luna burn and transaction fees. The Terra treasury then uses those profits in combination with an algorithmic and decentralized approach based on economic activity to invest in new Terra Dapp projects.  Investing in Dapps, means that the Terra treasury functions like a Venture Capital arm of its blockchain like a normal investor allocating resources. Terra’s investment in Dapps is achieved through a mathematical equation optimizing funds sent to Dapps based on both current and future Dapp economic activity.  Investing in decentralized application platforms that create practical solutions for social media, borrowing/lending, gambling and more aims to create future growth of the Terra Ecosystem. The more economic activity that a Terra Dapp is generating, the more fiscal stimulus that Dapp will receive from the Terra Treasury. Efficiency of funding is measured by comparing current economic activity with previous periods economic activity. Accelerating economic activity will lead to more funding from the Terra treasury. For the math behind the proportion of funding received by a specific Dapp, I will delegate to the white paper. [49] However, by using a programmatic approach to funding Dapps based on past success, the Terra treasury aims to without bias create the best possible Dapps to grow the Terra ecosystem more than competing blockchains.

 

From Stablecoins Decentralized Finance Emerged

One of the most interesting areas for Web 3.0 is decentralized finance. The goal of DeFi is to remove middlemen like bank, payment and insurance providers that extract value from the system. To outcompete centralized finance – whether it involves lending & borrowing, custody or simple peer to peer payments – a decentralized system must handle transactions faster, safer, and cheaper. Currently there are two cryptographic ecosystems – Bitcoin and Ethereum – showing promise and frankly outshining all other alternatives. Both BTC and ETH demonstrate proven security and decentralization, which is key with the advancement of rollups. BTC and ETH are blockchains, which means they are decentralized computer networks. A decentralized computer network is made up of many nodes that verifies transactions on the network, and they can either be computers solving puzzles like in a proof of work consensus mechanism or they can be stakers like in proof of stake. The problem with a centralized system is that all nodes are in one central location. If there is an attack on that central location then the entire network goes down. The nodes making up the decentralized network, however, exist in several geographic locations, which removes the main weakness of a centralized system. The entire decentralized network for both BTC and ETH is updated on all its nodes at the same time, which means there are multiple copies of the transaction history on each network. In other words, there are as many copies of the transaction history as there are nodes. For example, if there is an internet shutdown in US, the nodes verifying the decentralized network in Europe can pick up the slack, as they share the exact same database/information as the nodes in the US. The difference between BTC and ETH is that the former is arguably more of a pure store of value play like gold, while the latter is showing promise as a general purpose blockchain.

 

DeFi Liquidity Pools

It will take time before businesses tap into the DeFI market, but the fact is that running a business always requires capital. When companies raise capital to fund new projects or operations they historically either turn to equity or debt markets. The participants in equity and debt markets include venture capital firms, retail investors, governments and large institutions. Issuing debt through loans or bonds is generally cheaper than issuing equity because debt require full repayment to the lender. In return for having first claim on a business’ assets, debt lenders therefore generally earn lesser returns than equity holders. However, equity capital providers receive a claim on future cash flows of the business in form of stock appreciation or dividends. That means issuing equity for a business comes at the cost of upside from stock appreciation, but without the promise of repayment. For example, start-ups have no current income so they often issue equity in return for potential future profits for investors. Up until recently, most companies would fund operations with a combination of debt and equity, but a new avenue has opened up; blockchain funding. One of the biggest providers for blockchain funding is Aave. As an open source liquidity protocol, the objective of Aave per its website is to be a non-custodial liquidity protocol for earning interest on deposits and borrowing assets. Currently, Aave has over 27 billion dollars flowing through their platform. In the future, companies may use liquidity protocols to raise assets, as an alternative to debt markets. To access these liquidity protocols, companies must create decentralized wallets, which means there might be a growth in decentralized wallet providers. For individual investors, however, Aave is now a great platform to make money through yield farming.

Aave

Aave is a great liquidity pool, as the platform consists of many participants and supports a wide range of cryptos and stable coins on many different blockchains, as depicted in Figure 1. However, before using Aave, the first step for yield farming is to download or access a centralized or decentralized exchange to purchase cryptos. Coinbase Pro is an excellent choice for a first time user, but there are other alternatives in the digital currency space with exchanges like Kucoin and FTX. When fiat funds have been deposited and used to purchase cryptos, the next step is to move those cryptos to a decentralized wallet. This decentralized wallet should support blockchains like Ethereum or Polygon, which both work with Aave and are widely favored among people in the digital currency space. Ethereum is much more secure and has been around for a longer time, but is expensive, and Polygon – although less secure – is much cheaper. The two decentralized wallets that I use is Coinbase Wallet and Metamask. A decentralized wallet allows users to store, send and receive crypto anywhere on the planet through a public and private key. The public key is used to receive funds, while the private key is used to send funds. The private key should remain private otherwise anyone could access your cryptos in the decentralized wallet and defraud you. The public key is what I used for depositing funds into Aave through connecting Aave with my decentralized wallet in the top right corner as per Figure 1. After Metamask or another decentralized wallet has been connected to Aave, the tokens that are suitable for yield farming should be deposited. These suitable tokens should offer great upside through price appreciation or great yield given risk. Note, to use the Polygon blockchain, the Ethereum tokens must be transferred to the Polygon blockchain through a bridge. The bridge I use is called the Polygon Bridge. To complete the bridge transaction, Metamask swaps Ethereum tokens for the Polygon equivalent through the bridge. Metamask mainly supports Ethereum, but the Polygon network can be added in the account settings. After the cryptos are deposited on Aave on either Ethereum or Polygon, the tokens can be lent out for a fat yield.

Yield Farming

An interesting way to make money in cryptos is yield farming, which is a way to maximize the rate of return by leveraging different DeFI protocols. This is accomplished by switching between different strategies using different protocols including Avee, Compound, Synthetix and Uniswap. These yield farmers move their funds from low yielding to high yielding protocols and swap existing coins for new ones with higher yields. The concept of yield farming comes from crop rotation in actual farming. Three well known yield farming strategies is lending/borrowing, supplying capital and staking LP tokens. Lending is an easy way to earn an APY and it involves supplying stable coins such as DAI and USDC to one of the lending platforms and start getting a return on capital with liquidity mining and leverage super charging this APY. Compared to savings accounts generating around 0.1% APY, the yield farming world can deliver over 100% APY; what is the catch? Well, any form of investment that delivers a high rate of return comes with lots of risk including liquidity mining, leverage and risk. Liquidity mining is the process of distributing tokens to protocol users. One of the first protocols was synthetix where liquidity miners got rewarded for adding liquidity to seth/ethpool on uniswap with SNX tokens. The liquidity mining process doubles the reward because in addition to the yield generation, you also get rewarded with increased values of tokens. These incentives can be so high that farmers may be willing to lose on initial capital to get rewarded through the distributed tokens. The Compound protocol for example incentivized farmers to borrow high yielding assets because they provided comp tokens as a reward, which was higher in return than the borrowing cost. Leverage is another way to generate high returns, which basically means you use borrowed money to increase return. The farmers can use their coins as collateral to borrow new coins and then repeat that procedure. Leverage is also the biggest risk, but all the loans are overcollateralized. If the collateralization ratio drops below a certain threshold, the loans are liquidated. In addition, there is smart contract risks like bugs, platform changes, systemic risk and admin keys. Most of these protocols run on Ether so there is a risk that Ether would drop sharply in value. Finally, there is DeFI specific risks such as an attack on liquidity protocols.

 

Ethereum Sidechains and Rollups

Ethereum is a general purpose blockchain that has built up enormous network effects through a grassroots movement. As a result, Ethereum is now the second largest crypto currency per market capitalization and holds the most underlying real value projects. For example, Ethereum allows its network participants to use Ethereum based tokens to borrow and lend money without banking intermediaries on DeFi platforms like Aave, and Ethereum’s smart contract capability also powers big NFT markets. As of June 2021, Ethereum hosts more than 200,000 ERC tokens on its network and many of these tokens are among the top 100 cryptos per market capitalization like Polygon and Shiba Inu. Ethereum, however, has some scalability problems meaning that the network is unable to sufficiently process transactions in relation to transaction demand on the base layer. As of now, the Ethereum network can process up to 30tps, which is less than both VISA’s 45,000tps and competing blockchains such as Cardano’s 250tps and Solana’s 65000tps. The slow transaction throughput leads to sky-high gas prices because users have to bid against each other to be one of those 30 transactions verified on the blockchain. For a 1000 USD transaction on the Ethereum network, the gas price easily surpasses USD 100, which means a 1000 dollar send costs 100 dollars for a total cost of 1100 USD. Solving the scalability issue is therefore the top priority for the Ethereum community. Luckily, Ethereum is a general purpose blockchain so Ethereum developers are launching multiple projects on top of the Ethereum network to create faster transactions. These projects include layer 2 solutions such as Polygon and ImmutableX, which both improve transaction efficiency. Polygon is a layer 2 scaling platform using proof of stake. Basically, Polygon is the same as Ethereum, but with lower gas fees. As a result, over 3000 Dapps now exist on Polygon to for example connect lenders and borrowers. Polygon’s weakness is its own PoS consensus mechanism used to validate transactions, as Polygon money can be stolen in 51% attacks if the network is not sufficiently decentralized. That is why many layer 2s instead use rollups like ZK Snarks and Starks (zero knowledge proofs) to increase transaction speed, while benefitting from Ethereum’s great security and decentralization. Like Polygon, Immutable X is a layer 2 solution, but ImmutableX use ZK rollups instead of PoS. ImmutableX is an NFT project launched in 2021 with a goal to outcompete other NFT platforms like Open Sea. The objective of ImmutableX is to create the cheapest marketplace for carbon free NFT projects to be traded among users. The ImmutableX platform launched with its native 9000tps token IMX, which started trading on decentralized exchanges on November 5th. The coolest things about ImmutableX it is the use of Starkware technology.

 

Base Layer Competitors to Ethereum

There are many base layer blockchains competing for developer resources and investor capital. These competitors often argue they are general purpose like Ethereum, but more efficient. For example, some competitors use PoS directly on the mainchain instead of using Polygon sidechains or ZK rollups like Immutable X to improve transaction speed. The PoS consensus mechanism is extremely popular for base layers, which can be demonstrated by the over 100 billion dollar combined market cap of just Polkadot and Cardano. However, the PoS methodology deviates slightly between the different blockchain networks. One example is Solana, which uses Proof of History within its PoS network. PoH itself is not a consensus mechanism, but by integrating time into the PoS algorithm, all validators in the Solana network receive full information on the order of transactions without needing to communicating with other validators, which allows for faster sequencing validation. The nodes/validators in a blockchain network are actually computers and these computers are unaware of time in for example Ethereum. In PoW and normal PoS, the computers therefore waste precious time when communicating with each other to establish transaction times in the network. Say that you are communicating with your family by posting letters. If you want to save the letters from your aunt, uncle, and mom in an order based on time. It is better to beforehand agree upon a time when a letter should be received. However, each family member might use a different postal service like UPS or Fedex so there will always be a delay. If a letter that was supposed to be received on January 5th is received January 7th and another letter that was supposed to be received on January 6th is received on time, it might create some trouble to organize in Ethereum. However, if the letters are timestamped, it is then possible for you as the recipient to reorganize the letters so that they are placed in order of receipt. In terms of a blockchain network, it means that people with different internet speeds in Solana can all validate transactions without having to communicate time, as the PoH algorithm will make sure that all of the nodes have the same historical transaction ledger organized based on time. Founder of Solana, Anatoly Yakavenko, explains PoH more in depth in his extremely technical white paper for Solana. The block-time for Solana is 400 milliseconds, which you can compare to Bitcoins 10 minutes and Ethereum’s 10 seconds. Through using PoH, Solana says they can handle up to 710,000 of transactions per second, which is 30 times what VISA currently handles. The problem with Solana and other alternative base layers is that they tend to be highly centralized.

Other Decentralized Protocols that Are Interesting Arweave

Sunvia uses decentralized tech for private ownership of information essentially replacing SSN. For example, imagine entering a bar without showing excessive information address or easily transfer health data to a new doctor. Audius is a decentralized competitor to Spotify. The MV of streaming services is around 400 BUSD and the big issue is the principal-agent misalignment between creators and companies. With NFT ownership, creators are in control of content and with that the 400 BUSD market.

Metaverse

If the power of Moore’s law slows down, the Metaverse most likely becomes a three dimensional videogame and communication platform, which is an extension of Xbox and Zoom. However, if Moore’s law growth continues, the Metaverse will replace Web2 social media giants and also yield to users in the immersive and decentralized virtual Web3 community power to monetize their own data. The most obvious future is that the Metaverse becomes a place for leisure and videogaming, which means people spend between 1-2 hours a day online. A slight addition to the most obvious potential future is that companies use the Metaverse to create virtual office space and stores. Imagine, for example, having a virtual boardroom meeting where the discussion flows like an in person meeting or using an XR device to shop at the virtual Amazon store. Instead of looking at a screen for the latter, consumers test the products directly in virtual space before purchasing them for physical delivery. The most immersive future is when the Metaverse exists in parallel to the real world. If the most immersive version of the Metaverse comes true, the potential market size per some analysts is over 10 trillion dollars. Well respected crypto asset manager Grayscale, for example, believes that the Metaverse space should surpass over 1 trillion dollars in future annual revenue. To access that revenue, talented developers are necessary, as more talented developers obviously increase the probability of creating the preferred Metaverse platforms, smart googles and XR devices for consumers. That’s why FANG firms like Apple, Facebook and Google invest heavily in recruitment for new Metaverse projects. Keep in mind that FANG companies are centralized players with an objective to monopolize hardware or platform access for Metaverse applications, which is an extension of Web2 rather than the democratized Web3. However, less well capitalized decentralized companies including Somnium Space (SS), Decentraland (DC) and Sandbox (SB) are competing and are building extremely popular worlds and important infrastructure for the Metaverse.

The Younger Generation

In 2022, gaming is super popular activity among high and middle school students that gamers and social media savants are piece by piece stealing popularity from athletes. With exponential improvement in computing power leads to high speed Internet, quality graphics and capacity smartphones and therefore also explains why an already 130 billion dollar gaming industry continues to experience rapid growth. Some of the leading decentralized companies like SS, DC and SB aim to create the most immersive Metaverse future that is practically possible, which is a future often depicted in Hollywood movies like Ready Player One (RP1). The plot of RP1 takes place in an online and digital world called the Oasis. In RP1, humanity prefers the online world over the real world because individuals have the autonomy to be whoever they want and do whatever they like. Like in the real world, RP1 characters enjoy feeling all five senses like touch, vision and smell. For the Oasis to become a virtual reality, one of the most important components besides advancements in technology is who sets the rules. There is no doubt that conservative people believing in the importance of physical interaction will refrain, but my guess is that many of us will choose virtual over actual reality due to the unbound nature of the internet; virtually we can be anyone we want! Revolution and adoption of new technology is often driven by the younger generation. The next contrarian obsession explosion in crypto is GameFi, which is a fusion reaction involving popular gaming with an unpopular blockchain industry. By fusing blockchain and video gaming, the release of energy, just like our dear sun, is endless. The professional gaming leagues for games like LOL, Counterstrike and Fortnite, are worth billions of dollars and status is now no longer an athletic monopoly, but also a virtual game!  Thanks to natural progression in society, gamers are now in positions of influence either as chief executive officers or as entrepreneurs. With newfound power comes capital, which implies money will likely continue flowing into gaming.  The contrarian obsession entrepreneurs with a passion for gaming that, although against the belief of the majority, also believe in the revolutionary properties of blockchain technology is setting up a potential fusion reaction between unique areas that the world has ever seen before. That is GameFi!

 

Web3 vs Web2 Games

GameFi is the result of fusion between video gaming and decentralized finance as blockchain technology allows connection of digital economies with the real world without dependence on the traditional financial system. In GameFi, creators can leverage blockchains to set up incentive systems for gamers without relying on banks for custody, payment providers for transaction settlements or property laws for ownership. In GameFi, users earn tokens, NFTs, virtual lands, skins and avatars in return for achieving tasks, beating other players in battle or progressing through various game levels. Before blockchain technology, all in-game features were owned by game developers through centralized servers rather than by individual players, which remained isolated on a game by game basis. However, since decentralized blockchains lets users prove digital property ownership, the in-game features can be transferred between games and create a Metaverse. The property ownership is represented by NFTs, so in-game features like virtual lands or avatars can also be sold to users on markets like Open Sea. For Web3 videogaming to become more successful and provide superior user experiences than Web2 video gaming, GameFi products must carefully develop a plumbing system that allows for an intuitive user interface with high quality graphics, speed and security. A great plumbing system will generate both user adoption and long-term sustainable profits.  The foundational pipe in the Web3 GameFi plumbing system is the blockchain. I believe, only flagship blockchains like Bitcoin, Ethereum, Solana, Thor, Avax and perhaps some others meet the requirements regarding speed, security and flexibility necessary for a great user experience in GameFi. Successful GameFi growth also needs decentralized blockchain for censorship resistance purposes. Otherwise, Web3 is no different than Web2. Currently, only bitcoin and ethereum are decentralized enough to maintain censorship resistance. Developers are ultimately responsible for generating games in web3 that are sustainable. In addition to great plumbing and decentralization, GameFi games therefore need developer activity, which is driven by profit incentives. Profit incentives are currently funded by VC’s and public initiatives to attract talented developers on their preferred blockchains. Centralized blockchains like Solana or Near are mostly funded by VC’s, while more decentralized chains like ethereum depend perhaps slightly more on public initiatives. I prefer the latter, but it’s hard to know currently what chain is the best. Successful GameFi projects will lean on tokenomics that incorporates long-term sustainable rewards to both prevent fraud and incentivize talented developers to remain, which is explained in chapter 9. Web3 games built on top of the best blockchains will likely attract the best game creators so it all comes down to plumbing!

Immutable X

ImmutableX is GameFi project developed by the creators of a game called Gods of Unchained. For this investment, I purchased both the ImmutableX token and two additional NTfs without really considering anything other than that the NFT designs looked dope and that these two projects had the lowest floor price at the time of purchase. My hope is that the IMX token and the value of the two purchased NFT’s will increase exponentially in value as Immutable X expands as both an NFT market platform and as a videogame creator.  The value of the IMX token will hopefully increase by earning a higher return through capturing some of transaction fees through staking as people expand trade on Immutable’s NFT marketplace. Secondly, my purchased NFT’s may soon be incorporated into games using Immutable X scaling solution for cheap and carbon efficient facilitation of goods and services, which should increase their value. Currently, Immutable X is used by firms like GameStop, TikTok, and ESL for NFT collectibles and crypto-powered video games, which means that ImmutableX already hold significant partnerships with large corporations in the videogame space. Immutable X is built on top of the Ethereum chain and is a layer two scaling solution, but not a sidechain like Polygon meaning the token does not have its own blockchain. The scaling solution is a Validium ZK roll up enabling Immutable X to process 9000tps at almost 0 fees compared to Ethereum’s current 30tps and up to 100 dollar transaction fees, while relying on the Ethereum blockchain’s superior decentralization and security. The Immutable X scaling solution therefore allows games using Immutable X to both verify and safely track historical ownership like anything else on Ethereum’s mainchain, which is useful for creating value. For example, just like Jordan shoes worn by Jordan are more valuable than other Jordan shoes, certain NFT’s will be more valuable if it’s possible to track famous previous owners. Immutable X was also the first project to launch using ZK proofs for quick scaling solution on Ethereum meaning that first edition NFT’s on Immutable X will at minimum have a value similar to first edition Pokémon cards if the Immutable X project is successful. Personally, I believe the first NFT collection on ImmutableX will be legendary if Immutable X reaches its potential. Especially, if Ethereum becomes the most adopted blockchain in the digital asset economy.

Near Future of Immutable X

Immutable X token holders may soon stake native IMX tokens to capture profits in proportion to transactions generated on Immutable’s platform. I believe that Immutable’s ecosystem provides excellent plumbing for game creators preferring ethereum over other blockchain competitors as a basis for developing video games. In terms of plumbing, native IMX tokens and NFTs are smaller pipes useful for connecting users in different games in a sort of Web3 spider network, while the ethereum is responsible for ultimate security and censorship resistance as the big pipe. Fungible tokens like IMX or ETH allow users to transfer value and secure the network, while NFTs, as proof of digital property ownership, serve as a mechanism to ensure fair trade.On June 6, 2022, the immersive role playing game lluvium sold land to investors and potential players for around 72 million dollars using the Immutable X scaling solution and the fact is that as more and more games use Immutable X, the more valuable the network should become for early NFT and token holders. Finally, outside of the already 100 million dollar fund launched in partnership with GameStop, Immutable X launched another 500 million dollar fund to boost web3 gaming adoption. The fact that Immutable X provides plumbing to developers on the most decentralized and secure Ethereum chain is a huge advantage when attracting talent outside of funding.  Building games in Web3 takes time, but as the Immutable and Ethereum world expands so should the value of my NFT’s and native IMX tokens.

Crypto Asset Class: Regulation

The perhaps most important factor for determining a stand-alone asset class is reviewing the characteristics driving performance of the underlying assets. So how are digital assets different from legacy assets from a performance perspective? Well, the digital asset space includes coins, tokens, projects and companies. These digital sub-asset classes listed below use technology to remove intermediaries, generate liquidity, pool resources, create communities, improve transparency, prove ownership and originate art. Regulations and laws in financial markets are used to establish trust between market participants and to protect against predatory or illegal practices. In the US, the SEC and CFTC regulates equity, fixed income, commodity and currency markets. CFTC and SEC in turn delegates some responsibility to NFA and FINRA, which are self-regulatory agencies. For example, self-regulation means that commodity market participants enforce regulation on themselves, as they are primary benefactors and have greatest understanding of commodities. The point of self-regulation is simply to make sure resources are productive. Unlike the digital asset space, the legacy market is filled with intermediaries. For example, in equities intermediaries include brokers, banks, underwriters, clearing corporations and mutual funds and for commodities there are CPOs, CTAs, FCMs, and IBs. These intermediaries are important for regulators because they store lots of data on market participants, which can serve as leverage and evidence against bad actors. Although there are centralized crypto exchanges like Coinbase, the digital asset space tends to remove intermediaries through the blockchain which worries politicians. In traditional markets, banks monitor dollar transfers, but in crypto, computers instead monitor transactions. The benefit of computers monitoring transfers is that they receive a fraction of the bank fee, as the bank must pay salary to its employees. The blockchain is a decentralized database consisting of many different computers in different jurisdictions making digital asset regulation difficult. The Chinese BTC ban in combination with El Salvadorian adoption, American regulation and Swedish division means that global regulatory bodies are out of sync on digital asset regulation. Simply put, crypto regulation will differ from legacy markets as the digital asset space is more decentralized. Future crypto regulation, however, will mature with education plus trial and error.

 

 

How Market View Crypto: Statistical Relationship

The holy grail for investors is maximizing Sharpe by generating as much money as possible with the lowest amount of risk by blending asset classes based on return, volatility and correlation. To achieve a high Sharpe, pension funds, individual investors and endowments develop a strategic asset allocation, which consists of uncorrelated return streams. At a high level, the typical institutional portfolio includes a large passive equity and fixed income portion in combination with a smaller portion of real estate/natural resources, PE/VC and hedge funds. Factors driving equity and fixed income markets therefore dominates the return profile of institutional portfolios, while commodities and currencies are generally used to lower the overall risk-taking based on statistical relationships with equity and fixed income factors. Besides appropriate regulation, institutional investors will include digital assets in a strategic asset allocation if the crypto coins, tokens, companies and projects either generate a high level of return or lower the amount of portfolio risk. To make the statistical analysis simple, bitcoin and the S&P500 serve as market risk proxies for the digital asset space and legacy market respectively (keep in mind that there is a wide range of coins, tokens, projects and companies that solve unique problems in legacy markets).

 

 

1. Return

Per the DQYDJ return calculator, bitcoin has generated a return of 265% annualized for the period March 2011 until March 2022 [1]. This return can be compared to the 12% annualized for the S&P500 during the same period. That means 1 USD invested in bitcoin is now worth 46,000 USD, while the same dollar is worth less in S&P500. Obviously, bitcoin compounding at 265% going forward is difficult to foresee as digital markets mature, but bitcoin’s large outperformance over S&P500 is an argument for the digital asset space as a unique asset class.

 

 

2. Volatility

Per the Marketmilk volatility calculator, the annualized bitcoin price volatility spanning the last 3 years was 163%, which is much higher than the approximately 15% realized historically by S&P 500[2]. Risk and reward of bitcoin likely means that the digital asset space is more of a return driver than risk mitigator in an investment portfolio.

 

 

3. Correlation

The final data point to analyze between bitcoin and the legacy market is historical correlation using different lookback periods, which depict how the digital asset space perform on a relative basis. Per the Yahoo finance calculator, the 14 day rolling correlation as of March 2022 between bitcoin and S&P 500 is 0.83, but spanning the past 5 years, the correlation has fluctuated between -0.5 and 0.8 suggesting a spurious relationship. If instead analyzing 30, 50 and 100 day lookbacks, the correlation fluctuates as well as per Figure 1. Per the 100 day lookback, however, the correlation between BTC and S&P is at a record high 0.86 as of March 2022. Despite the high correlation using a 100 day lookback, I would argue that the digital asset space is its own asset class based on the return and volatility of BTC compared S&P500. Obviously, history is not necessarily indicative of the future, as statistical relationships breakdown.

 

 

 

Other Risks

·      Why is it important to standardize metrics?

o   We need to compare apples to apples

§  Liquidity pool and lending platform are both exposed to smart contracts, governance and blockchain/currency risks

§  For liquidity pools the risk is mean reversion premium

§  For lending platforms it’s more credit risk premium

o   The  scoring system is not an absolute measure

§  28 % vs 40% just compares risks based on the definitions used in the risk scoring framework

§  Its not like volatility, correlation and moving averages

o   Relative risk is best measured using a form of z-score.

§  For example, take all protocols in DeFi that have existed for a certain period of time and calculate an average and a standard deviation

·      That way we can create relative scores

§  Same goes for volatility, return, APR of the rewarded token and performance of the rewarded token.

·      BTC backing of Terra

·      Time on mainnet since DeFi protocol started

o   Standardize this metric and not compare it to the original blockchain

·      Flash loans is the biggest risk

o   Public Audit

o   Smart Contract risk

·      Recursive Risk scoring

o   If a protocol had a centralized oracle but now switched, then the risk lessens etc…

o   The risk scoring should not be equal weighted.

§  Some metrics might matter more

§  In the risk scoring system, VaR and volatility is correlated so technically there is a higher weight to that metric already

·      Covariance matrix

o   On collateral and platform tokens

·      1 year data because platforms been around for 1 year

o   Longer data might be robust

o   Calculate over different time periods

·      Incorporating more On-chain analytics

o   Baked into Blockchain and Currency, but..

o   Adoption

§  Wallets numbers

§  Active adreses

§  Momentum how quickly are things changing

o   Decentralization

§  Whale Concentration

§  Nodes and validator geographic diversification

o   Security

§  How secure are the chains

o   Speed

§  TPS

o   Developer activity

o   Use case

o   Interoperability

Risk Management in DeFi

A risk-management framework is both a method and a tool in a toolbox for degens and normies to make informed decisions when investing in DeFi protocols. Unless you are 100% confident in your own ability to comeback or perhaps just enjoy living simply then never experiencing total loss is by far the most important objective in investing. The absolute simplest approach to prevent total loss is not putting all eggs in one basket, which is achieved through diversification. In Tradfi, sophisticated banks, investors and institutions have methodically developed and refined risk management frameworks relying on robust analysis including standard deviation, skew, counterparty analysis, credit risk, beta, kurtosis, volatility, correlation, covariance, factor analysis and basket approach to underpin prudent and diversified investment portfolios. However, although some of these measurements are useful in DeFi, digital asset risk management frameworks require additional methods and measurements to analyze risks specific to DeFi protocols including concentration, oracle, admin, governance, blockchain and operational risk. Some DeFi risks are idiosyncratic meaning protocol specific, while others are systematic meaning risks impacting the entire digital asset space. Analyzing impact of systematic risk in digital assets is therefore super important considering how a certain protocol is impacted by systematic and idiosyncratic risk, which I have done by comparing the risks for Anchor protocol versus a Balancer Stable pool. Keep in mind that all numbers and conclusion were made prior to the Terra Luna collapse.  DeFi is different than Tradfi because software code replaces functions like custody, exchanges, insurance and lending  provided by institutions like banks in Tradfi. Ultimately, DeFi is just a word for describing financial applications that use open source algorithms or so called smart contracts built on top of blockchains to circumvent intermediaries, which essentially creates functioning markets in a more transparent and democratic fashion. In current form,

 

DeFi involves manual risks that I do not want to analyze because advances in DeFi technology will remove those. However, these manual risks include inconveniences like creating multiple decentralized wallets for different blockchains, safekeeping passwords, high transaction fees and fat finger mistakes preventing institutions and high net-worth individuals from tapping into the DeFi market Despite above inconveniences normal to any new technology, DeFi protocols have some useful properties compared to Tradfi, as DeFi is (1) Interoperable No arbitrary restriction such as wealth, nationality, age or bank. No middlemen and rent seekers control the system. (2) Programmable Smart contracts that are transparent and can be permissionless. (3) Composable DeFi is built lego structures, but instead of lego pieces code is written to interact with existing code, which in turn creates new DeFi structures. DeFi democratize access to capital by allowing individual users to pool together resources and take on credit and market making risk instead of institutions. The analysis between Anchor and Balancer is a proprietary risk management scoring system as a tool facilitate informed DeFi investment decisions. With an agnostic framework for measuring DeFi protocol risk, investors can compare and invest in preferred protocols more easily.

 

 

Macroeconomic complexity

The first step when estimating risk in an ecosystem platform is asymmetric information honesty meaning no risk estimation method is perfect. Macroeconomic  shifts in inflation, unemployment and stock prices are often driven by fear of the unknown, which leads to herding behavior. People anticipating bad outcomes are therefore predictably irrational. For example, most will squeeze through the same exit rather than analyzing the situation to improve outcome if a building is on fire. In war, powering weapons  may produce a  scarce future supply of oil, which implies rationing and limiting current oil uses and  exports. In turn,  current oil rationing often  leads to a predictably irrational herding response by market participants to over-bid up the price of oil. A great risk system constantly update and manipulate exposure  agnostically across a large set of markets to position itself to profit ex-ante from these predictably irrational herding behaviors.   In traditional financial markets, economic theory and practice goes hand in hand when markets are normal. However, in periods of financial turmoil, practice differs from theory as cause and effect relationship between for example monetary and fiscal policy and economic variables like stock price, inflation, income and unemployment rate breaks down. When markets are normal standard risk estimation based on statistical normality  often utilized in academia works well because  economic variables are range bound around the efficient market equilibrium. However, convergent risk taking fails to include left-tail uncertainty, which may lead to total investment capital wipe out. In traditional finance that is a run on the bank caused by fear of foul play. As part of the macro economy, bank runs can happen in cryptocurrency markets as well, but so far such a bank run has never happened to true decentralized platforms.

 

DeFi complexity

The bank run  on FTX in November 2022 was caused by fraudulent behavior by Sam Bankman Fried.  As founder and CEO of FTX and owner of trading firm Alameda Research, Sam used client funds on the FTX platform to fund investments by the trading firm Alameda. When the public found out that the CEO was taking risky bets FTX suffered a flood of withdrawals from exchange customers and the assets backing the deposits could not cover all those withdrawals. The FTX debacle is no different than when Palmstruch created the first central bank in Sweden. Unlike traditional finance, true DeFi platforms are protected from fraudulent behavior of one person, but there are many unique quirks to various platforms. From those quirks we can estimate idiosyncrasies. The risk management system must above all else generalize DeFi so that platforms can be compared on an apple to apples basis. That means the risk system cannot rely solemnly on traditional metrics like volatility, correlation and moving averages. The  scoring system is therefore not an absolute measure, but is derived from a combination of heuristics and statistics.  For example, liquidity pool and lending platform protocols are both exposed to smart contracts, governance and blockchain/currency risks, but for liquidity pools the main risk is the mean reversion premium, while for lending platforms it’s more about the credit risk premium. Relative risk is best measured using a form of z-score. For example, take all protocols in DeFi that have existed for a certain period of time and calculate an average and a standard deviation. That way we can create relative risk scores. Same goes for volatility, return, APR of the rewarded token and performance of the rewarded token. The perhaps biggest risk in DeFi are flash loans. To identify Defi platforms sensitive to flash loan attack public software code audits and smart contract risk is key. The system should also depend on recursive risk scoring. If a protocol used centralized price oracle, but now switched to decentralized oracles the risk of fraud lessens all else equal. The risk scoring should not be equal weighted. Because some metrics might matter more and risk measurements suffer from collinearity. For example, traditional VaR and volatility metrics are correlated so technically there is a higher weight to that metric already. The should be a covariance matrix analyzing the collateral and platform tokens relationships. Longer time on main-net means data is more robust and calculate over different time periods. Adding Incorporating more On-chain analytics is important including adoption wallets numbers.vActive adreses.Momentum how quickly are things changing.v Decentralization Whale Concentration Nodes and validator geographic diversification Security How secure are the chains Speed  TPS Developer activity Use case Interoperability

 

 

 

Token Participation

Successful software products drive user adoption by solving new blue ocean or existing problems more efficiently. Raising assets in traditional finance generally requires the management team of software firms to convince wealthy private and institutional investors like VC funds why their product can overcome the cold start problem, which is a period when a new product has no users.  These startups need assets from investors to invest in both human and physical capital and also provide bonus incentives and sign up fees to generate user growth with the goal of reaching the critical mass needed for sustainability. For example, Airbnb and snap increases in user value with more users joining the application network.  Like traditional companies, DEFI firms may also seek private funding. But in addition to traditional funding and incentive structures, Dapps may also generate network growth through token issuance.  These issued tokens replace traditional utility with financial utility during the beginning phase when a DApp is not yet sufficiently large to support native user value.  Tokens issued to early adopters of Dapps require across a spectrum either active or passive participation. Although the crypto space has existed for a relatively short period, consensus and evidence is showing that passive token participation on the supply side dominates active participation. Active participation has shown to attract the wrong kind of users. For example, if you are a sportsbook and offer free bets many users might just use the free bets to earn free money and then never use the sportsbook again. Successful tokens require liquidity, which in turn requires recurring engagement with platform. Sportsbooks often use vampire attacks on competing sportsbook meaning to steal users away by offering bonuses to their high volume users. However, if vampire attacks often fail because ultimately sportsbook users care about the experience. Active tokens therefore generally need to align token incentives with network utility. (1) Incentivized referrals, (2) Curation (3) Core action. However passive participation like Arweave, which is a DApp where users offer to lend out excess computer storage to the Arweave network in return for earning Arweave tokens. Unlike an active toke, Arweave users require no continuous effort to earn Arweave tokens. In fact, earnings from lending scales with Arweave platform adoption. Passive tokens all else equal is therefore better.

 

 

DApp Activity

Before showing profit and besides launching products with ex-ante market fit, great DApps needs to generate user activity. More active users and assets deposited on the platform increases the likelihood that that the DApp is useful and can attract future users. DApp activity is best measured in relative terms on a total, delta and rolling delta for both active wallets, total value locked in the protocol and number of other projects taking place on the same blockchain. If the DApp is interoperable nor or can support operation in the future on multiple-chain that is better all else equal. It’s important that DApp activity signals incorporate active users. All else equal a higher increase in users over a monthly period is a bullish signal. As Dapps is new type of product, the best approach is to compare all the metrics on a relative basis rather than with other industries. DApp metrics that scores in the top 5% on a relative basis added to the overall DApp activity score is considered bullish. type of token requires a scheduled release of tokens to early adopters, VC investors, community, founders, key people, user growth, treasury, validators/miners, bug bounty rewards and much more. Fixed low supply of tokens in total increase token value all else equal, while a greater variable supply of tokens does the opposite. Deflationary monetary token policy increase value all else equal and inflationary does the opposite. Excessive distribution to founders, key people and VC investors is bad all else equal. One of the most important variables when evaluating blockchains and Dapps is the overall systematic risk to the industry. All Dapps and blockchains are exposed to systematic risks including regulation, inflation, beta to overall crypto market, interest rates and stock market. When creating a systematic analysis of all blockchain protocols its therefore important to outline the current systematic risk environment and how that impacts the DApp or chain under analysis.

 

 

 

 

Chapter 9: Fractionalization, Tokenization and the DeFi Matrix

 

The DEFI MATRIX

Newfound appreciation for orderbooks is a positive externality resulting from the emergence of all the different crypto currencies. In financial markets, the orderbook shows the intersection of supply and demand and is the ultimate tool for price discovery. Today, the majority of transactions are fiat based, but with a deeper understanding of orderbooks there is a higher likelihood for the DEFI MATRIX to become reality. The DEFI MATRIX is essentially an orderbook that through tokenization and blockchain technology shows everything priced in everything, which facilitates liquidity. In the near future, personal and institutional digital wallets can store stocks, bonds, NFTs and more, which in real time connects to the DEFI MATRIX. When each asset is continuously repriced against all other assets, the demand for cash/fiat currency decreases, adding pressure to traditional currencies already battered from inflation. In addition, cross collateralization of assets is made possible. . If central banks continue to money print then that will generate higher inflation, which also increases the likelihood of a future with the DEFI MATRIX. Soon tokenization and fractionalization will create the DEFI MATRIX, which is a potential next step in the evolution of our economy. If central banks and governments thread the needle with economic policy that will only slow down the transition to a more decentralized economy. There are currently so many products being developed by talented people in the crypto space and only time will tell when blockchain technology catches fire among us luddites. Investopedia defines an asset class as a grouping of investments that exhibit similar characteristics and are subject to same laws and regulation. Per Investopedia’s definition, equities and fixed income are different asset classes as equities and fixed income represent ownership and debt respectively. Ownership and debt involve two completely different risk profiles. For example, in the case of a firm bankruptcy, bond holders are paid first and equity holders last meaning that fixed income and equity return characteristics are different. Commodities are divided into market subgroups including energies, metals and agrarians, and each subgroup serve a similar economic purpose. For example, the economic purpose of electricity is to power a machine and that electricity in turn is generated by another commodity like oil. A precious metal like gold, however, is used to conduct electricity or as a store of value and is therefore in a different commodity subgroup than oil. To fit the definition of money, a currency must serve as a medium of exchange, unit of account and store of value. As commodities are physical goods and currencies is a tool for exchanging goods and services, the risk reward profiles between currencies and commodities are different. By defining asset class and reviewing how asset classes in the legacy market are different, we can now move forward to analyze crypto as a new asset class by comparing regulation, measuring statistical relationships, and analyzing performance drivers.  By breaking down the digital asset space into four components through defining asset class, comparing regulation, measuring statistical relationships and analyzing performance drivers, I conclude that the digital asset space deserves to be its own asset class. Investors that are looking to generate a higher Sharpe should at minimum allocate 5% of their portfolios to digital assets. If that means passively investing in bitcoin or utilizing a more complex DeFi strategy is up to the investor. The digital asset space performance and statistical relationship with legacy markets is too good of an opportunity for investors to pass up.

 

Tokenization and Fractionalizing

Tokenomics refers to a crypto asset’s qualities that make it appealing to both users and investors.  It refers to the supply and demand characteristics of the asset. Tokenization together with fractionalization will establish the DeFi Matrix to create everything liquitidiy. There is phone launched as an NFT… The DEFI MATRIX transition will accelerate under the current Keynesian monetary and fiscal system western society. In Doom, a book about the politics of catastrophe, Niall Ferguson demonstrates why governments and central banks manipulate the economy – albeit with good intention – to avoid expected negative shocks. Expectations fall within a probability distribution meaning that all economic outcomes considered prevented by fiscal and monetary policy action are not Black Swans. The expression Black Swan was coined by polymath Nassim Taleb to describe events that are perceived impossible based on human heuristics. Black Swans are often confused with their cousins – Grey Rhinos – which American author Michele Wucker defines as “dangerous, obvious and highly probable” events. Grey Rhinos like the 2008 financial crisis and COVID-19 are therefore confused for Black Swans – bolts from the blue – even if predicted by contemporaries; just watch the Big Short or consider why Coronavirus research exists. If Grey Rhinos are rare, then Dragon Kings are extremely rare. The French geophysicist, Didier Sornette, defined Dragon Kings as events so vast in magnitude that they fall outside of probability distributions including those with a fat tail like the Poisson and Power law distribution. (1) Type of token, Security, governance, currency. (2) Token model Pre-sale, vs fair launch. (3) Token allocation Less with insiders is generally good. (4) Supply How much is in circulation. (5) Lock ups. Instead of government and central bank controlled financial markets, the new decentralized market is emerging as a complement/alternative for storing value, lending and trading. As of 2022, the crypto market was valued at over 1 trillion dollars, which is still way behind its multi-trillion cousin. The decentralized market was spearheaded by Austrian minded blockchain developers like Vitalik Buterin, Satoshi Nakamoto, and Sam Bank Fried and exist on the internet using code instead of middlemen - like banks - to legitimize ownership and facilitate transactions. By utilizing smart contract technology, the decentralized market removes clearing houses and instead settles transactions on the blockchain. Smart contracts also prove ownership of goods and services, which has a lot of application. All users in the decentralized economy will have their own digital wallets connected to their own personal address where they store stocks, bonds, NFTs and cryptos. With the click of a button blockchain networks will be able to clear dollars against bitcoin, rare paintings against stocks and real estate against music rights. The DEFI MATRIX will make these transactions liquid. Each pricing pair should be considered as a submatrix and it is the sum of all these submatrices that forms the powerful DEFI MATRIX. Soon exchanges such as the stock, currency and crypto exchange will merge into our digital wallets freeing up an enormous amount of liquidity. With the DEFI MATRIX there is no longer a need to convert illiquid stuff into cash, but rather barter directly through digital wallets. Creating liquidity is super important for efficient allocation of resources. For example, an IPOs is considered a liquidity event, as it opens up the company to public ownership in return for providing capital to the firm, which decentralize ownership and hopefully creates happen in our economy.

 

 

 

 

 

Volcker

At 7.0%, the US experienced its highest inflation since 1982 and the FED must take action to combat excessive price expansion. The common definition of inflation – as a general price expansion – is outdated and I prefer Milton Friedman’s definition, which refers to inflation as an increase in money supply. Per Friedman’s definition, US inflation has been around since 1971 when President Nixon dropped the gold standard. Inflation is actually a part of the Fed’s dual mandate. To enforce the dual mandate, the FED must keep inflation stable at around 2% and maintain a so called natural unemployment rate of around 4%. Taking action against inflation means using the FED’s primary tool – the federal funds rate – to increase or decrease interest rates. In economics, there is a relationship between interest rates and inflation called the Fisher rule, which states that real interest rates equal nominal interests minus inflation. Per the Fisher rule, the FED controls the nominal interest rate to impact inflation and real interest rates. A higher FED funds rate slows inflation all else equal and no one knows the Fisher relationship better than perhaps the most powerful FED Chairman of all time, Paul Volcker. In 1980, the US inflation was so high that then Chairman Volcker was forced to drastically raise the nominal interest rate. In 2022, the inflation is once again reaching the persistent peaks of the 1980s and may force the current Chairman, Jerome Powell, to follow Volcker’s lead. A move to raise rates slows down inflation because borrowing costs increase and consumers are more incentivized to save. Higher discount rates also tend to lower equity valuations and expand market volatility. According to many economics experts, 2022 will be a year of rate hikes. I think that the FED should raise rates, but I do not think we are at an economic inflection point. The world is emerging from a pandemic with low labor participation, which means people are on edge. Slowing down the economy right now may slow consumption and put the economy into another recession. In addition, there are no investors that will buy the assets on the FED balance sheet, which may cause the bond bubble to burst. I would not be surprised if the FED tries to raise rates in March only to turncoat. I also think Biden will provide economic stimulus through his infrastructure bill. FED turning dovish in combination with economic stimulus will lead to further increases in inflation in the real economy.

 

What Prices Are Increasing and Where

Similar to the US and according to data from OECD, the consumer price index (CPI) for the 38 countries included in OECD rose by 5.8% in 2021. The high inflation number across OECD demonstrates that global and not just US specific factors are behind expanding prices. The CPI measures the cost of food, transportation, energy and housing, which are all key goods for the typical household. The rapid price expansion means governments and central banks are now on high alert, as low income families take the largest hit if goods and services become more expensive. There are certain things in life equaling human rights and inflation might remove some of the human rights away. People should have a home and food and they should not freeze if it is cold outside. For example, in Sweden the government has proposed 600 dollar subsidies on electricity costs to families impacted by higher energy prices, which is an inflation trade-off. However, inflation is also a double edged sword, as the wealthy tend to hold risky assets at a much larger percentage of their portfolio than those with less wealth. Higher prices therefore tend to lessen wealth inequality on a relative basis, as rising interest rates have historically correlated with equity and bond sell-offs. In my opinion, the consumer price index fails to capture the entire cost of living narrative. Per OECD, FED and other central banks, the definition of inflation is a general increase in the price level of the CPI. OECD economists argue that CPI is the optimal measure of inflation, as the basket of goods is directly tied to living expenses. However, the value of currency is not included in the CPI narrative. If country A prints money going into financial assets and not on goods included in the CPI, then inflation seems dampened based on a CPI measure despite a depreciating value of country A’s currency relative to foreign currencies. Also, central banks have tendencies as a group to exclude certain goods in the CPI to make the CPI seem lower than it actually is to justify money printing during periods of economic hardships. As a result of more money printing and fiscal stimulus in combination with CPI fixing and supply bottlenecks, we now see explosive acceleration in inflation as measured by the CPI. If continued, these price increases will have people ask for alternatives and that is where the crypto industry steps in.

 

 

Tokenization for Institutional Investors

In 2022, tokenization is one of the most interesting financial services in Web3 blockchain based finance. The process of tokenization involves digitizing ownership of traditional financial assets by  leveraging blockchain based database ledgers to create fast, cheap and secure access  to liquid secondary markets and tools that tailors investment portfolios for KYC and AML compliant qualified investors. Although tokenization structure can vary similarly to Class A shares with special debt conversion rights or normal Class B common shares, tokens generally represent proportional ownership to the number of tokens released. For example, if 1000 tokens represent an asset worth 1000 US dollars and the tokenized asset increases by 10% to 1100 US dollars, then the value of each token increases from 1 to 1.1 US dollars proportionally. Tokenization allows investment managers to leverage blockchain technology instead of expensive and time consuming traditional finance tools to fractionalize ownership of assets or bundle of assets on a digital ledger of often expensive real estate, fancy artwork, illiquid private companies and extensively regulated alternative investment funds. Tokenization also assists Web3 protocols overcome the J-curve associated with Venture capital investing in unicorn companies. Like startups, the beginning period for Dapps is all about survival. In traditional finance, Angel Investors and Venture Capitalists fund entrepreneurs to navigate the beginning period in return for a potential huge payoff in the future.

 

 

 

 

The First Tokenization of TradFi

 In September 2022, the private equity firm KKR with 447 billion dollars in assets under management partnered with the broker dealer Securitize Capital to launch a partially tokenized health care growth fund.[4] KKR is a leading traditional alternative investment firm and Securitize Capital is a US regulated broker dealer serving over 1.2 million investors and 3000 businesses offering SEC regulated exposure to alternative investment funds for retail investors via tokenization investment capital. The partnership between Securitize and KKR transforms assets into security tokens representing proportional ownership of the fund at fair market value prices and that like shares provide fund investors with verifiable and tradable in secondary market legal rights to profit proportionally to dividends and price appreciation arising from profitable private companies in KKR’s investment portfolio, while removing all costs associated with expensive custody and transfer agent middlemen, AML and KYC and fund structure regulation in traditional finance. The legal rights of token holders in the KKR and Securitize Capital fund is verified on the Avalanche blockchain as outlined via a predetermined legal smart contract. Prior to partnering with KKR, Securitize capital in turn has partnered with Arca Labs, which is crypto native firm that has written an extensive tokenization guide for alternative institutions interested in launching a fund for international and US qualified investors in accordance with the 40 act fund regulation for alternative investments[5]. Although secondary liquidity is one of the primary drivers for why private equity firms are the first alternative investment institutions leveraging blockchain, liquid alternative hedge funds like managed future CTA’s that already have the structure to provide daily subscription and redemption liquidity investors, but profits from investing in future derivatives considered as bad income and therefore requires special regulation from SEC, may also benefit by tokenization. The traditional 40 act set up for a managed futures firm that offers their advanced trading product to investors for performance and management fee is expensive. The current structure requires the CTA to set up an offshore sub-fund that is run by the investment manager and feeds trading profits into a investable onshore fund for qualified investors. The cost associated with the onshore-offshore feeder fund structure for traditional 40 act funds include a flat  40 basis point AUM expense to the regulated investment advisor providing the investment platform to access the onshore fund, a sub-adviser fee, distribution agent fee and on top of all those fees, the onshore fund can only invest 25% in the offshore fund, which requires application of leverage and therefore cause a performance drag of the 40 act structure to other funds structure running the same trading strategy in parallel.

 

Tokenization to Manage Risk

The key to create a holistic DeFi risk framework is to standardize risk scores so that evaluating risk between different types of DeFi protocols is possible. Developing a risk scoring method that is invariant to DeFi protocols requires both a macro and micro risk analysis. After the initial analysis, I categorize and breakdown risks into underlying components that becomes risk scores. Capturing all risks associated with a DeFi protocol is a herculean task, but the objective of my framework is to be as close as possible. To facilitate understanding risk in DeFi, I have designed a hypothetical risk-management framework that can guide us through the complex terms of DeFi. One of these protocols is a fraud, while the other one still exists. Both platforms are designed to provide investors with a fixed income like yield, which is generated taking on risk. These risks include systematic risk to the entire digital asset space and idiosyncratic risk from credit, market making risk among other risks. The the risk-management framework breaks down iditionsyncratic risk associated with DeFi protocols further . DeFi yields comes in the form transaction fees, staking profits and rewards from counterparties like borrowers or traders and platforms seeking to increase leverage, repaying liabilities without realizing tax on gains and losses or expanding userbase. The fraudulent DeFi platform in our example is the Anchor Protocol, which is a lending platform on the Terra Blockchain. The still sucessful platform is the Automated Market Making Polygon blockchain based stable pool on Balancer. Note that Balancer is a multi-chain Automated Portfolio manager and liquidity provider platform consisting of many different types of AMM pools. The Risk Scoring System is equal weighted and applicable across DeFi. Note that applications in DeFi lacks history to robustly quantify risks and the system is just one tool of many to quantify risks in DeFi . The system is designed so that protocol scores and weights adjust with new information emerging over time.

The blockchain based 40 act fund removes many of the fees associated with the traditional 40 act best described by the Figure 1 below and is accessible for qualified investors since the blockchain 40 act funds is Regulation D 506 (c) exempt.Benefits of tokenization include. (1) Automize KYC and AML compliance. (2) Reduce regulatory friction. (3) Lower transaction costs. (4) Automate delivery of tax documents. (5) Capacity to update offering documents in real time. (6) Increase transparency  In addition to removing fees, tokenization can provide investment managers with capacity to create tailored exposure to different investment programs and create a liquid secondary market to tailor exposure to the manager without being involved in the sales process. MakerDao grew to 7 billion in deposits by providing liquidity through creating a lending and borrowing market for collateral deposits like a traditional bank and tokenization is like the asset management version of MakerDAO

 

 

 

 

 

The Components of DeFi Risk

The Main Risk components out of 100 % with 100% being the riskiest, Systematic Risk , Operational/Smart Contract Risk, Financial Risk, Credit Risk and Centralization Risk. Each Sub-component rating between 1-10 to capture structural DeFi differences. Quantitative collateral analysis for all tokens is based on a 365 day timeseries from Yahoo Finance. Anchor and the Balancer Stable Pool both went live in 2021. Risk Scoring System uses monthly and daily data to capture both spikes and trends in Collateral (The 95-VaR is based on daily data, Rolling Volatility and pair Correlation is based on 30-days, Marginal VaR and Volatility is based simple additive math and Balancer uses a point in time method for marginal contribution). Systematic risk are factors that impact the whole DeFi space such as regulation and macroeconomics. DeFi protocols can be more or less exposed to systematic risk . Idiosyncratic risk is specific to the DeFi platform. DeFi protocols can be divided into smart contract risk, financial risk and centralization risk. The risk management framework is an 25% equal weighted scoring system across systematic, smart contract, financial and centralization risk for DeFi platforms.  The four equal weighted components are further broken down into equal weighted components. Holistic Framework and Risk Scoring Assumptions. DeFi investors earn Risk Premiums Holistic Framewor. Proprietary method to quantitatively and qualitatively account for Systematic, Operational/Smart Contract, Financial, Credit and Centralized Risks. Each risk component is divided into sub-components to standardize structural differences between investment platforms. The Risk Score is a method to standardize risks across DeFi applications. The Final Risk Score is relative and not absolute. Lower Risk Score is better.  A Risk protocol score of 40% compared to 60% means that for the same level of expected return the 40% protocol has higher risk-adjusted return even if the two protocols generate returns to investors from engaging in separate activities like Lending and Automated Market Making.

o   Systematic risk

§  Regulatory risk

§  Currency and Blockchain risk

o   Operational/Smart Contract risk

§  Time on main-net

§  Previous exploits

§  Public Audit

§  Recent Audit

§  Bug bounty program

o   Financial risk

§  Credit risk

·       Collateral Volatility

·       Collateral Makeup

·       Utilization ratio

·       Absolute Liquidity

§  Governance Risk

§  Market Making Risk

o   Centralization risk

§  Oracle risk

§  Admin risk

 

 

 

Category

Weight

Balancer

Anchor

Systematic risk

20

10

8

Regulatory risk

10

6

4

Currency and Blockchain risk

10

4

4

Operational/Smart Contract risk

20

15

16

Time on main-net since 2014

5

2

Previous exploits

5

3

5

Public Audit

5

5

4

Bug bounty program

5

5

5

Financial risk

20

13

10

Governance Risk

5

4

2

Market Making Risk/Price Impact

5

4

5

APR/Reward Level and Consistency

5

3

1

Concentration Risk

5

2

2

Credit risk

20

16

12

Rolling 30 day Collateral/Provider Volatility

5

4

2

Collateral/LP Makeup

5

4

2

Collateral/LP Ratio

5

4

3

Absolute Liquidity All else Equal

5

4

5

Centralization risk

20

18

14

Oracle risk

10

10

4

Admin risk

10

8

10

Total

100

72

60

 

 

 

 

 

Systematic Risk: Impacts all blockchains, DeFi protocols and currencies.

 

Regulatory Risk

Threshold

2

Under investigation across multiple areas (Platform, Blockchain, Token, Admin Team)

4

Partly under investigation in some areas (Platform, Blockchain, Token, Admin Team)

6

General DeFi regulatory risk

8

Regulated in more countries than normal

10

Regulated in any more countries than normal

 

 

·      Systematic DeFi risk decreases with general public acceptance. If a platform is regulated in many countries that means acceptance. However, if platform tokens, blockchains or admins are being investigated that is a risk to liquidity providers and lenders. The Anchor Protocol is under SEC subpoena, which is a risk. For Balancer, I could not find anything special so the regulatory risk is general in comparison to the DeFi industry.

·      https://www.theblockcrypto.com/linked/134758/judge-orders-terraform-labs-to-comply-with-sec-subpoenas

 

 

Currency and Blockchain risk

Threshold

2

Decentralized layer 2 and above, volatile

4

Decentralized layer 1 or not and volatile

6

Decentralized layer 1, stable (low collateral risk)

8

Decentralized layer 1, stable, large TVL

10

Decentralized layer 1, stable, large TVL, proven track record

 

·      All DeFi protocols are exposed to interconnected currency and blockchain risk. For example, stablecoins like USDC in the Balancer Stable Pool are used as collateral for minting DAI, which is an algorithmic stablecoin. On the Anchor Protocol, the APR received by lending UST to borrowers is exposed to price risk of Luna and Eth. Depreciation in Eth also impacts Ethereum based platforms like Balancer. Although though both Anchor and Balancer are two of the largest DeFi platforms in the world, neither of them has proven track records. The Balancer Stable Pool is on a layer 2 blockchain and riskier than a layer 1 pool due to the Polygon Bridge, which is a centralized attack vector for a hacker. Anchor is risky because the collateral has a high beta exposure to volatile cryptos like Luna.

·      https://defillama.com/protocol/anchor and balancer

 

Operational/ Smart Contract Risk: DeFi relies on software code. To minimize coding risks, a DeFi platform should have at least one public audit and also offer a bug bounty program to prevent future hacker attacks. Previous exploits demonstrate that the platform is insecure and more time on a mainnet shows long-term vitality.

 

 

Time on mainnet since 2014

Threshold

1

1.6

2

3.2

3

4.8

4

6.4

5

8.0

 

·      Anything DeFi before the first well-known DeFi platform Maker in 2014 is BC. Longer time on the mainnet is better because the risk score adjusts dynamically with time (the metric score dates back to 2014: 8/5 = 1.6). Balancer and Anchor launched on respective Mainnet in 2021, which means that in terms of long-term viability both are in the bottom 20% and have demonstrated almost nothing. If the two platforms survive over time, they will improve on the mainnet score.

·      https://dyor-crypto.fandom.com/wiki/Balancer\_(BAL)

·      https://dyor-crypto.fandom.com/wiki/Anchor\_(ANC)?so=search

 

 

Previous exploits

Threshold

1

More than 3

2

3 with additional rumors

3

1 to 3

4

0 with additional rumors

5

0.0

 

·      More exploits lead to a relatively worse exploit score. After doing some research, I concluded that more than 3 shows lack of coding skills, but this may change with time as hacker attacks increase. Anchor has not been hacked directly although it had an oracle mispricing in December 2021. Balancer suffered a pool drain of 535 KUSD and a dydx flash loan potentially draining unclaimed Comp token in June 2020.

·       https://dyor-crypto.fandom.com/wiki/Balancer\_(BAL)

 

 

 

Public Audit

Threshold

1

No

2

No, but in progress

3

1.0

4

1 and more in progress

5

More than 1 and within last year

 

 

·      More recent audits show code strength. Anchor, according to my research, only has one audit prior to launch on the mainnet so it fails to get the highest score. Balancer gets the highest score. 

·      https://dyor-crypto.fandom.com/wiki/Anchor\_(ANC)?so=search#Audits\_.26_Exploits

·      https://dyor-crypto.fandom.com/wiki/Balancer\_(BAL)

 

 

Bug Bounty Program

Threshold

1

No

2

No, but in progress

3

1.0

4

1 and more in progress

5

More than 1 and within last year

 

·      Bug Bounty Programs demonstrate the protocols willingness to prevent future attacks. Both protocols have massive bug bounty programs.

·      https://www.coindesk.com/markets/2021/04/20/balancer-labs-offers-2m-bug-bounty-to-spot-vulnerabilities/

 

 

Financial Risk: is the possibility of losing money from investing. To minimize investment loss in DeFi when making simple parameter tweaks and more complicated protocol maintenance updates, decentralized protocol governance is preferred over centralized governance to prevent whale accumulation, hacks and manipulation. APR and rewards should be consistent and based on fundamentals rather than just incentivizing short-term high trade volume. Borrowers should be overcollateralized and uncorrelated. Tokens in a liquidity pool should be correlated. In addition, the Stable pool and lending protocol should demonstrate market depth to limit market making risk.

 

Governance Risk

Threshold

1

Centralized

2

More than just autonomous computer code while considering whale concentration

3

More than just autonomous computer code while considering medium whale concentration

4

More than just autonomous computer code while considering whale concentration

5

Only programming risk with low whale concentration

 

·      Governance risk in DeFi refers to the probability that whales, admins or hackers manipulate or take advantage of protocol proposals for their own benefit. Both Balancer and Anchor use native governance tokens to prevent concentration of power by distributing the token widely within their respective community. Each governance token represents a vote. Holders of more governance tokens have a stronger voice when voting on proposals to improve the DeFi platform. Anchor is based purely on programming risk as no admin keys exist. This can be good if whale concentration is low, but sadly there is a large whale concentration in Anc. Balancer also has a large whale concentration, but admin keys allow at least some type of power balancing mechanism.

·      https://app.intotheblock.com/coin/BAL and Anc

 

 

Market Making Risk/price impact

Threshold

1

High relative volatility

2

Non-tailored AMM, staked token-token pairs, stable

3

Tailored AMM, staked token-token pairs, stable

4

Tailored AMM, stable

5

Pure Lender

 

·      Market making risk and price impact is basically impermanent loss, which is low for stable pools like Balancer even if the single vault model increases smart contract risks due to complexities. Balancer uses Stable Math, which is a tailored approach to liquidity provisioning that increases capital efficiency and liquidity around the 1:1 peg ratio, which increases trading volume and lowers fees. From a lending perspective, Anchor provides users with immediate withdrawal with no market making risk. The Anchor fee is high, but expected to decrease.

·      https://docs.balancer.fi/concepts/math/stable-math

 

 

APR/Reward Level and Consistency

Threshold

1

Purely reward driven

2

Lower APR, reward driven, but has some fundamental value

3

High APR, but likely to decrease due to competition

4

APR is fundamentally driven by staking APR or volume

5

Consistent fundamental APR

 

·      APR should be consistent and high. The Anchor Protocol holds around 4.4 billion of BLuna and 1.3 billion dollars of Beth in collateral. With current 19% APR and based on 11.3 billion in Anchor deposits, around 2.1 billion needs to be paid out to depositors in 2022, which means an underfunding of 1.5 billion dollars per year. The Anchor APR is derived from two components. Part 1 of the lending reward is distributed through Bluna and Beth staking rewards and part 2 is interest paid by UST borrowers. Anchor Protocol’s proposal 20 just passed so Anchor APR will drop by 1.5% per month until the equilibrium rate is achieved. Note that the Anchor protocol has a special treasury used to fund Anchor lenders, which recently received injected liquidity of 450 MUSD.

·      The Balancer DAI-USDC-USDT-MiMatic stable pool APR comes from 3 parts. Part 1 and 2 rewards are distributed in the form of Bal and Qi tokens, as Balancer partnered with QIDAO when launching the stable pool. These special rewards are likely to decrease over time, but hopefully the rewards increase volume and transaction fees generated to LP’s, which is the third and final part of the Balancer APR.

·      The Bal token is more fundamentally driven with all the updates coming to Balancer and I therefore see spillover effects including increased pool trading volumes across the board, while Anchor and Anc is almost purely reward driven.

·      https://wantfi.com/terra-luna-anchor-protocol-savings-account.html

 

 

Concentration Risk

Threshold

1

1

2

2-4 correlated

3

2-4 independent

4

4 proven

5

5 or more uncorrelated and proven

 

·      Concentration risk is related to correlation risks in supplied collateral or tokens invested in a liquidity pool. For the Anchor protocol investors, UST is the only asset deposited, but the correlation of Eth/Luna collateral provided by borrowers is 0.65 on monthly basis on data from Yahoo finance (not staked price) over the past year, which suggest high collateral correlation. Eth can be sold quickly, but Luna staking borrowers must wait 21 days for locked Luna to be sold, which decreases the likelihood of repaying UST loans in a flash crash. This means a high concentration risk and a potential haircut for Anchor lenders. In addition, over 50% of BLuna borrower collateral in Anchor is held by 4 wallets.

·      For Balancer the concentration risk is high due to off protocol use of USDC and USDT as collateral for DAI. In turn, DAI is used as collateral for MiMatic. If either USDC and USDT is a fraud or frozen, it will have a severe impact on all Balancer liquidity pools. That means the four stablecoins in the pool might not be as safe as one might think even if they are highly correlated.

·      https://wantfi.com/terra-luna-anchor-protocol-savings-account.html

 

 

Credit Risk: is the loss from failure to repay loans and is a big part of lending protocols like Anchor, while perhaps less so for Balancer.

 

 

 

30-day Collateral Volatility

Threshold

1

Extreme

2

Plus/minus 20% of Bitcoin over past year

3

Plus/minus 10% of Bitcoin over past year

4

1 to 5% over past year

5

avg below 1% over past year

 

·      Even if Bitcoin is deflationary, it makes sense to use the gold standard as a comparison tool for crypto volatility. The 30-day volatility metric aims to capture medium term trends in collateral volatility. Higher collateral volatility implies a higher likelihood for liquidations. Based on data from April 2021 until April 2022 from Yahoo finance with Luna accounting for 80% of collateral value and Eth only accounting for 20%s, Anchor’s collateral volatility is much higher than Bitcoin. Over the past year, Luna has had a monthly volatility of 46% compared to Bicoin’s 26%.

·      Balancer uses four stablecoins with very low individual monthly volatility. Balancer does not get the highest score because MiMatic’s rolling 30 day volatility looks strange (Look at graph in the presentation).

 

 

Collateral/Provider Makeup

Threshold

1

Extreme

2

Daily 95VaR higher than Bitcoin, 1 asset in collateral or whale concentration.

3

Daily 95VaR around Bitcoin with 2 or more assets in collateral,

4

Daily 95VaR lower than Bitcoin with 2 or more assets in collateral

5

Daily 95 VaR below 1%, with 3 or more assets in collateral

 

·      Unlike 30-day volatility, the daily 95VaR metric measures spikes in token price over a very short one day time frame. Having two different methods over two different time periods to measure price swings is important to evaluate the stability of a DeFi platform. Luna and Eth collateral on Anchor both have a daily 95-VaR that is much higher than BTC, but there are some correlation benefits, while borrowed UST has a low daily VaR. The Balancer stable pool consists of assets that have extremely low VaR. MiMatic daily VaR sticks out and prevents Balancer from a perfect score.

 

 

 

Collateral/Provider Ratio

Threshold

1

Extreme

2

LTV below 90%

3

LTV below 80%

4

Collateral correlation between stablecoins in the pool, LTV below 50%

5

Pure DEX

 

·      AAVE is perhaps the most tested DeFi platform existing today and sets the baseline for the Collateral/Provider Ratio risk scoring metric. Depending on existing market conditions, the highest LTV achievable on AAVE is 80% for some stables. In comparison, Anchor has a max 60% and 80% LTV for Beth and Bluna respectively, which is high for volatile cryptos. Current Anchor LTV is around 47%, but it’s concentrated with few holders. Unlike Anchor, Balancer is an automated portfolio manager meaning there is no LTV. However, some Balancer assets are used as collateral in LTV format on other chains, which adds some risk. USDC is for example locked up in the DAI protocol and that is why Balancer does not get the highest score.

·      https://docs.aave.com/risk/v/master/asset-risk/risk-parameters

 

 

Tailored Liquidity

Threshold

1

Illiquid

2

High gas fees, non-tailored liquidity pool

3

Medium gas fees, non-tailored liquidity pool

4

Tailored liquidity pool with low gas fees

5

Immediate withdrawal without impermanent Loss

 

·      Illiquidity with high gas fees leads to higher risks and unpopular DeFi products. Constant product pools are wasteful for coins with a stable relationship because it provides liquidity across an infinite spectrum rather than concentrating depth around the stable price. For Balancer, the stable price is 1 so Stable Math increases liquidity and market depth around 1, which in turn increases capital efficiency relative to constant product pools or concentrated pools with higher volatility assets. Anchor is a lending protocol offering immediate withdrawal and therefore gets the perfect score.

 

 

Centralized Risk: The whole objective of DeFi is to move away from centralized sources of risk. Admin risk and Oracle pricing risks are perhaps the two most important attack vectors to protect against in DeFi because they are difficult to decentralize!

 

Admin risk

Threshold

2

Bad admin key, no time-lock

4

Good admin key, no time-lock

6

Admin key, time-lock, multi-sig

8

Admin key, time- lock, more multi-sigs than 5

10

Decentralized governance

 

·      DeFi prefers democratic voting by governance token holders rather than yielding power to developers. In Balancer, 11 key community members have access to the admin key. However, a multi-sig access means that individuals have no decision power or custody control over Balancer protocol contracts. Balancer V2 allows multi-sigs to set protocol fees. Changes by Balancer admins is time-locked and a potential DAO decentralization governance is in the works. Anchor protocol relies on smart contracts and there is no admin key.

·      https://dyor-crypto.fandom.com/wiki/Anchor\_(ANC)?so=search

·      https://docs.balancer.fi/ecosystem/governance/multisig

 

 

Oracle risk

Threshold

2

Centralized oracle

4

Mix of protocol oracle and outside oracle

6

Decentralized oracles

8

Multiple decentralized oracles

10

No oracle needed

 

·      Oracles are responsible for pricing DeFi assets accurately either based on on-chain or off-chain data. These oracles can be centralized or decentralized and obviously DeFi prefers that latter as it lowers oracle risk. Anchor has traditionally used its own oracle and actually miscalculated the BLuna price on December 9 2021. If the change has not already happened there is a proposal to let an outside oracle like Chainlink for accurate pricing. The recent  oracle problem leads to a low score for Anchor on this metric. For Balancer, the price of the tokens is determined by the supply of tokens in the pool. If someone buys one asset in the pools with another asset. The price of the bought asset increases and the price of the remaining assets decreases. Balancer uses single deposit and stable math so Balancer is extremely efficient in terms of pricing.

 

·      https://twitter.com/anchor_protocol/status/1469416656824799233?lang=en

·      https://dyor-crypto.fandom.com/wiki/Oracle

 

 

 

 

 

 

 

 

 

Chapter 10: Lessons From Traditional Finance Applied to Web3

 

“Without price discovery, bad ideas never die and good ideas never thrive.”

 

Unleashing the Next Revolution (change it to fit digital asset narrative)

Before Edison and Musk was able to create groundbreaking products, humanity learned how to harvest electricity. The exact moment when electricity was manipulated equates to a singularity, as electricity continuously shapes our society precisely like the big bang still shapes our universe. The future of venture capital resides with successful entrepreneurs within the cross-space of technology and other sectors such as finance, health care and energy. The goal of a motivated technology entrepreneur is to create an efficient monopoly so that it is possible to extract some of the surplus generated by the company. To create motivation, VC investors must both provide capital and come up with creative ideas for the entrepreneur to capture the value being created. As a former employee of start-up companies, Chamath is spearheading the way a founder captures value from his company through the creation of SPAC for the purpose of entering the public markets. In finance 3.0, the SPAC is a great option for an entrepreneur to go public, as the set-up combines a final private round with a direct listing. The future is bright for VC. Most investors follow a convergent approach such as the classic 60-40 portfolio that profits in normal markets. Many of these convergent investors believe that markets are efficient, but AMH and the hedger-speculator hypothesis are alternative theories for why markets are not efficient. As a result, trends can occur when market participants overreact to new information. Historically, overreaction is more prone to occur when the market enters a new economic paradigm and when the market dynamic shifts correlation between asset classes tend to breakdown. When correlations breakdown, the convergent portfolio is unprotected even if the portfolio is diversified across asset classes. It is therefore smart for investors to allocate to investment strategies that are divergent in nature, which in turn truly differentiates how returns are extracted from within asset classes. Trend following is the textbook definition of a divergent strategy as markets must trend to find their new equilibrium price. Trend followers are often agnostic to which markets that will trend and it is therefore important to trade multiple markets. More complex trend followers are better suited to capitalize on trends than simple trend followers as complex trend followers incorporate more advanced measures to find optimal trend direction and strength while protecting against harm caused by noise, volatility, skew and kurtosis.

 

 

What farms I am invested in using a principled VC approach

·       First principle Look for Cool projects

o   Research DeFi Llama, listen to podcasts, follow twitter, discord

o   When I find something cool… next three steps

 

·       Second Principle: Mitigating risk through diversification across blockchains, tokens, liquid staking providers, Farms

o   Operational

§  Audit, White paper, team, size

§  Use DeFi Llama

§  DeFi Llama, which tracks 800 protocols over 80 blockchains, reported TVL at $234 billion yesterday afternoon (2022 -6%)

§  Avoiding impermanent loss (won’t get 100% apy).

§  Rug Pull

·       Third Principle is overweight good tokens, providers and farms

o   Big ecosystems that show growth

·       Fourth look at farms where underlying DEX shows future benefit

o   I don’t have time to claim and switch all the time, so I want to some price appreciation in farmed token

 

 

 

Entrepreneur vs Investor

Few doubts the importance of founding entrepreneurs including Daniel Ek, Stewart Butterfield and Mark Zuckerberg when creating unicorns such as Spotify, Slack and Facebook. However, behind every successful entrepreneur is an investor with capital. Usually, this investor is a VC who took risk by investing in the talented entrepreneur. Sadly, the VC is often forgotten. So, if the entrepreneur is the star basketball player like Jordan or Kobe, the VC is more similar to a Popovich (head coach). Just like Popovich motivates players and creates the optimal basketball team, the VC is a compass navigating the entrepreneur through the business landscape. Another similarity is that both a coach and a VC have often been a star player/entrepreneur in the past. My favorite example is Chamath Palihapitiya (Cham). At the age of six, Cham’s family moved from Sri Lanka to Canada to improve their life situation. According to Cham’s biography on Wikipedia, he used to sleep on a mattress in his family’s living room while attending Lisgar Collegiate Institute and at the same time working to support his family. I believe that these hardships taught Cham to work smart and value time, which made him the successful VC he is today. Although Cham never founded a company prior to becoming rich, he has been on the ground floor for multiple businesses. After graduating university, he started his career as a derivatives trader where he learned practical risk management skills. After leaving the job as a trader, he worked for AOL and then later for Facebook in 2005. While working at Facebook, Cham made venture capital style investments on the side in now huge companies such as Peter Theil’s Palantir.

 

VC Example traditional vs Digital Finance

For example, say that VC Lars runs a fund investing in technology startups. Lars is currently looking for new investment opportunities and it so happens that recently the up and coming entrepreneur, Lisa, pitched a really cool app idea in front of Lars. Lisa requires a 10 MUSD investment from Lars to market her idea so that it can spread on social media. Lars currently have 5 MUSD in free investment capital so he must find another investor willing to invest 5 MUSD in his VC fund. After making some calls to his network, Lars sets up a meeting with Henrik who is a CIO for a large pension fund. Henrik has an investment mandate to diversify a small portion of the pension’s portfolio to technology companies, but he believes that all technology companies in the public market are overvalued, which is why he agrees to the meeting with Lars. After the meeting, Henrik believes in Lars superior ability to invest in technology companies and invests 5 MUSD in the VC fund. In turn, Lars invests 10 MUSD in Lisa’s company at a 100 MUSD valuation. Lars now holds a 10% equity stake in Lisa’s company so if Lisa sells the company for 200 MUSD in 3 years, Lars would make 10 MUSD (100%) in total profit from that sale. However, Lars revenue share would be less than the 10 MUSD in total profit. That is because Henrik deserves his portion of that revenue. Henrik’s profit would be around 3.8 MUSD because he paid 2% in management fee over 3 years plus the 20% performance fee from the final sale. Lars final revenue is therefore 5 MUSD from capital appreciation and an additional 1.2 MUSD in fees from Henrik.

 

Stages in Venture Capital

Before exiting, Lisa’s company undergoes the traditional venture capital timeline (VCT). The stages of the VCT often blends together. Generally, the first stage of the VCT is the seeding stage. The financier at this stage is usually an angel investor, which is most likely to be family and friends or an accredited individual investor. The financier could also be a VC such as Lars who believes strongly in Lisa’s app idea. The financing at the seeding stage supports salaries, market research and business establishment. The following stage in the VCT is the startup stage. At this point, Lisa’s firm is likely to earn revenue. The startup stage financing is usually provided by VCs that prefer more information about the product prior to investment. These startup stage VCs will hopefully know if Lisa’s idea has the potential to generate lots of revenue in the future. Lisa in return will need more funds for product development and more marketing. Worth noting is that VCs entering at this stage generally does so at a higher valuation in return for receiving more information. A negative impact to Lisa and other early investors at this stage is that a VC could dilute ownership percentages and add another decision maker. Before accepting new capital, the value of the VC investment must therefore be weighed against ownership dilution. After these early stages in the VCT, Lisa’s company will enter the final financing stages. These second and third round financing stages supports Lisa’s company when the app is already generating revenue and provides capital needed for major company expansion. If Lisa is successful with the expansion, she should start preparing for her exit strategy. This strategy hopefully involves mezzanine financing, which is used to capitalize an initial public offering (IPO).

 

4 Ways to Sell a Firm

Not counting bankruptcy, entrepreneurs can usually pursue four exit strategies to liquidate ownership. These exits include merger and acquisition with and by another company, management buyout or IPO. The first three exits are likely if the firm is unable to IPO or if the owner of the firm is reluctant to fully let go of managing the company. For example, in a management buyout, the main principal might need liquidity to invest in other opportunities with the goal of maintaining control of the company. As a result, the principal sells part of the company to a familiar management team. However, an IPO is considered the holy grail, as an IPO involves honor and the highest profit for investors spanning the VCT. Traditionally, IPO’s are expensive, as they involve experts. These experts help setting up process and procedures dealing with SEC rules plus other responsibilities necessary to attract capital from public investors. Generally, the experts are investment banks and they also assist the IPO company by sourcing demand and setting IPO price and date. The IPO process is without a doubt a lengthy and costly ordeal, which is why Cham focused on the genius idea of starting holding companies or so-called special purpose acquisition corporations (SPAC) to short-cut the IPO process and provide more value for founders. These holding companies are created for direct listings rather than an IPO, but the end result is still a huge payout for the founder and all other investors in the firm.

 

SPAC on steroids

As an entrepreneur and founder of Pay Pal, Thiel wants to maximize profit for his stakeholders by creating efficient monopolies. However, for a founder to actually earn money after creating an efficient monopoly someone else needs to buy shares of the founder’s company. According to Cham, merging with a SPAC and directly listing the company on a public stock exchange is the optimal way for a founder to capture the largest risk adjusted slice of the company’s revenue pie. SPAC’s have existed for a long time, but have exponentially increased in popularity after Cham’s Social Capital successfully merged with Richard Branson’s Virgin Galactic in 2019. A SPAC is formed through an IPO to buy another company. The first line of investors in a SPAC is generally the sponsor. For example, Cham always invests a minimum of 100 MUSD in all of his SPACs so that he has skin in the game. After the sponsor comes investment banks and other institutional investors and finally private investors. A SPAC is essentially a blank check company meaning that the company itself does not pursue any commercial operations. Instead, the SPAC is formed by sponsors with industry specific expertise for the purpose of raising capital to purchase a company in an industry of their expertise. Generally, the sponsors have an idea of which company to target prior to creating a SPAC, but they do not disclose the target company to investors for the purpose of avoiding extensive disclosures during the IPO process. After raising enough capital, the money is first placed in an interest-bearing trust account. That money is then used to purchase the target company or is returned to investors if the SPAC is unsuccessful. Merging with a SPAC has gained popularity among founders of large firms including Spotify and DraftKings. The reason for SPAC popularity is founder optionality. A SPAC is essentially a combination between a direct listing and a private round so everything is set and done after the SPAC and the target company agrees to amount raised, valuation and percent dilution. For example, in 2019, Social Capital agreed to purchase 49% of Virgin Galactic for 800 MUSD. As of September 30, 2020, Social Capital’s 49% slice is worth around 2 BUSD, which is a 150% increase in valuation since directly listing on the stock exchange. In return for merging with Social Capital, the owners of Virgin Galactic ensured an 800 MUSD payout while keeping the upside of a direct listing. With a normal merger or management buyout the founder is likely to receive less profit and with an IPO the profit outcome is uncertain although the upside might be higher than directly listing through a SPAC.

1.https://www.investopedia.com/terms/s/spac.asp#:\~:text=A%20special%20purpose%20acquisition%20company%20(SPAC)%20is%20a%20company%20with,have%20been%20around%20for%20decades.

2. https://seekingalpha.com/article/4376539-chamath-palihapitiya-strikes-while-iron-is-hot-social-capital-iv-v-and-vi

 

 

 

 

Web 3.0, Liquidity Pools, Base Layers, Sidechains and Rollups

Within the next decade, decentralized networks under appropriate regulation are likely to provide almost frictionless transactions across borders in a Web 3.0 framework. A great example of Web 2.0 friction is when I moved to US for high school. As a student without a job, my parents sent money from their Swedish bank account to my US bank account for groceries, clothes and school supplies. I learned right away that moving money between countries in Web 2.0 is time consuming and expensive, as banks charge high fees, offer unfavorable FX rates and communicate poorly between jurisdictions. It is fair to state that moving money is much easier within jurisdictions. For example, after a meal with friends, it is common practice that one person pays with a credit or debit card and then charge others by individual Venmo (US) or Swish requests (Sweden). The problem is that Swish and Venmo are unable to communicate with each other on a global scale. When I go to Sweden, I cannot use Venmo and vice versa. Perhaps, Venmo and Swish can communicate in the future, but my bet is that decentralized wallets will revolutionize the finance game. The other day, I received 1 USDC – a stable coin pegged to the dollar – in a Web 3.0 transaction from a European Coinbase account in seconds without any fees. If enough people across the world download the Coinbase app, then maybe stores will accept Coinbase requests? The simple 1 dollar transaction is equivalent to a global Venmo/Swish transaction and doing so between two countries frictionless opens an ocean of possibilities. The battle with old institutions has begun.

 

 

 

Traditional Investing Tools

Quantifying investing success and explaining underlying drivers of asset returns are goals shared by most investment professionals. The first recognized academic theory that achieved quantification and measurement of return drivers was CAPM and this fundamental theory of finance is therefore one of the greatest research leaps in history. CAPM applies gaussian statistics on security returns to define market risk, which helps separating idiosyncratic from systematic risk. In the ensuing decades, new theories such as APT emerged, which expanded the universe of factors impacting asset returns. These new factors include quality, momentum, size and style. As a result of advancements in financial academia over the past 50 years, concepts such as systematic risk, beta and alpha have been dissected further to explain investment performance. These key statistics have now become regular terms thrown around by researchers and portfolio managers on quantitative trading floors. For some investors it is optimal to diversify across beta exposures through investing in mutual funds, ETFs, indices, asset classes, geographies and risk premias. A portfolio strategy applying a diversified beta approach lowers volatility while maintaining a reasonably high investment return. However, some investors seek higher returns than what is provided by risk premias and index funds and that is when active management enters the picture. The goal of active managers is to outperform beta risk premias or offer uncorrelated sources of return to the typical investor portfolio. These active managers earn a higher compensation and need to offer high information ratios in return for fees paid by their clients. Although the fundamental law of active management is far from perfect, achieving a high information ratio with many independent bets is currently the optimal way to measure performance of active managers.

 

Idiosyncratic and Systematic Risk

The foundation model for traditional investing is the capital asset pricing model (CAPM). The CAPM model analyzes expected return of assets in equilibrium based on a mean-variance framework. Gaussian concepts in probabilistic statistics such as normal distributions, Z-scores and correlations are foundational for mean-variance techniques. Within the area of financial analysis, CAPM is a key method for explaining investment strategy, asset class and security outperformance, as CAPM sets a baseline for measuring financial statistics such as systematic risk, beta and alpha. All securities in the market are impacted by both idiosyncratic and systematic risk. The former risk is geographic, asset class, industry and security specific while the latter involve general risks impacting all asset classes. If a manager optimizes a portfolio according to the CAPM framework, then that portfolio diversifies away all idiosyncratic risks. However, the CAPM portfolio fails to secure itself against systemic risks. The S&P 500 and Russel 2000 indices represent diversified market portfolios, as both of these indices include many securities from lots of different industries. Important to note is that both S&P and Russel are market cap weighted. If the airline industry is under attack because of a pandemic, then perhaps technology companies such as Amazon or Apple outperforms, as people rely on ordering food online instead of grocery shopping. The market cap weight for an index constituent is calculated by multiplying the number of shares with the price of each share. If Google consists of 1000 shares and the price of each share is 10$, then the market cap of Google is 10,000$. A market cap weighted index divides each constituents market cap by the summed market cap of all constituents represented in the index. In S&P, Facebook, Amazon, Microsoft and Apple represents 20% of the total market cap, which limits the diversification benefit of holding S&P. An undiversified index increases idiosyncratic risks and in S&P, technology specific risks dominate the index. Traditional long only US equity portfolios are often measured against S&P. As a result, long only portfolios often have a high equity beta against the S&P. The equity beta means that the US long only portfolio will move in the same direction of S&P regardless of market direction.

 

Betting in the Crypto Space

Investing in crypto is much like investing in early internet meaning that there is a few experts and therefore endless possibilities. Educating yourself within the space is super important to avoid scams if your goal is to gain exposure to Web 3.0 projects outside of Bitcoin and Ethereum. Viewing YouTube videos and reading blog posts about crypto is not enough, as you must also read up on economics, interest rates and fundamental financial concepts. Tying these traditional concepts into the more unique metrics of cryptos like tokenmoics, developer activity, vision and decentralization is key to generate a higher rate of return in Web 3.0. Tokens should be distributed widely, developer activity needs consistency, projects must have a clear vision and decentralization should be vast. Education also includes challenging yourself by creating a decentralized wallet like Metamask and start playing around with the UI and how it connects to Web 3.0 platforms like Aave. I recommend starting with low amounts of money and as you feel more comfortable maybe up the stakes. The winning cryptos will be those that provide real world economic value. These winners will not serve just as a means to barter goods and services like fiat currency, but they will also serve as a plumbing mechanism to the cryptographic infrastructure. To serve as a pipe in the plumbing system for crypto, the blockchain requires speed, security and decentralization. Leading blockchains like Ethereum, Solana, Cardano and Avalanche balance these three areas differently. They use their respective edge to attract capital and developers to build projects on their ecosystems. Capital and great developers are correlated because it is human nature to work on projects with the highest monetary incentives. More developers, means higher likelihood of creating successful projects, which leads to real world economic value. If I were to invest in the crypto space, I would therefore go with projects that attract the best developers because those are the areas where new ideas are executed. As of right now, Ethereum is the beta big daddy, but other blockchains may be the alpha generating sources of income.

 

 

Beta

If the long only portfolio outperforms S&P over a long-time span, then investors should probably purchase shares of the fund rather than investing directly in S&P. The paths to outperforming an index are many, but most common is holding a portfolio of stocks tilted away from S&P exposure. For example, investment strategies that caps total portfolio exposure at 3% for single securities automatically remove risk from large technology giants in a market cap weighted index like S&P. As a result, the annual return for such a strategy will most likely vary less than S&P, as technology stocks tend to have a relatively high beta. If technology stocks instead had a low beta, the conclusion would reverse. Now, Adaptive Alph defines beta as a statistical coefficient measuring the volatility of a portfolio of stocks or an individual stock relative to the systematic risk of a market portfolio such as S&P. The coefficient beta basically measures a stock or portfolio’s response to changes in the market as compared to S&P. If the portfolio beta equal 1.0, then the portfolio is expected to go up and down proportionally with the benchmark. If the beta ranges from 0 to 1 that portfolio is expected to increase or decrease in the same direction, but less than the benchmark. If the beta is greater than 1, the portfolio moves up and down more than the benchmark. Finally, if the beta is less than 0, the portfolio moves in opposite direction of the market. A greater negative number means a greater move in the opposite direction.

What types of Betas exist?

Up until the introduction of arbitrage pricing theory (APT) in late 1970s, CAPM was the leading theory among both financial academics and practitioners. These communities considered all non-market risk factors impacting firms as company specific events, which included factors such as CEO changes, accounting issues and earnings misses. Since the introduction of APT by Stephen Rose in late 1970s, investment research has evolved and new beta factors have emerged. Rose’s APT concludes that a multi-factor approach more accurately describes stock market return rather than a single market factor as demonstrated by CAPM. Furthering the conclusions of APT, researchers Fama and French added size and style factors, which are two systematic risk factors other than the market factor that can enhance portfolio returns. The size and style factors demonstrate how the size and valuation of firms drives stock prices. According to Fama-French research, the size factor demonstrates that small-cap firms tend to outperform large-caps while the style factor proves that cheap stocks relative to intrinsic value tend to outperform relatively expensive firms. Since the invention of the Fama-French factors, three other risk factors have been derived by the investment community; volatility, momentum and quality. Building a portfolio that diversifies across these risk factors have the potential of enhancing portfolio returns because it reduces volatility and thus enhances a portfolio’s return per unit of risk. Adding companies with low volatility involves investing in companies that vary less in stock price than the broad market. Low volatility companies often generate stable revenues and their accounting methods are robust without errors. Momentum involves investing in companies performing well over certain lookback periods and short those companies that have underperformed. The momentum premium exists over time because of fear of missing out. When Tesla’s stock price goes to the moon more investors jumps on the rocket ship, which drives the stock price even higher. Lastly, quality is factor debated heavily by the investment community, as defining a company’s quality is qualitative task. However, higher income, lower accruals and low levels of leverage signifies quality companies according to academic research. All of these five factors are betas meaning that they are risk factors shared by many companies and asset classes in the market. Investing in index portfolios involves beta exposure to size, style, momentum, quality and volatility. All indices with slightly unique constituents will have a different risk weighted exposure to these factors.

 

 

Alpha versus Beta

Finding an edge in investing is a complex and time-consuming process. For most individuals the task of portfolio management is overwhelming, as a typical person has a life outside of investing. That is why professionals recommend most individuals to invest in betas such as S&P rather than actively seeking to outperform the market by self-directing investments in individual stocks or actively managed funds. A key concept for these so-called retail investors is diversification, which involves spreading investments across uncorrelated return streams. A classic example is the 60-40 equity-bond portfolio, as represented by MSCI and JP Morgan bond index. The former and latter have a correlation of around 0.4. If the MSCI investment underperforms then the JP index should perform well around 60 percent of the time over long time periods. With factor, currency, geography and asset class diversification a strong portfolio may be created even if the portfolio solemnly relies on beta. That is because beta represents a risk premium, which is additional compensation received by increasing risk. When purchasing a bond that pays a coupon every month for 10 years, there is a risk that the bond defaults or that a similar bond is issued paying twice the coupon as the original bond. As a result, the investor receives a risk premium to compensate against default and liquidity risks. These risk premiums are generally higher for equities than bonds, as insolvent companies return money to all bond holders before equity holders when liquidating assets. A mixed portfolio of different uncorrelated risk premiums will reward investors with a higher return per unit of risk all else equal. If the risk premium is not high enough to satisfy investor appetite then pursuing active managers might be an option. The job of active investors is to earn alpha plus the beta. In other words, alpha involves capturing the risk premium plus additional return by outperforming a benchmark within a sector, asset class, currency, geography or factor.

Figure 5

Figure 5 is a timeline depicting the evolution of risk premias in finance. As new factors emerged, parts of what was considered alpha in the 70s is now considered beta. As a result, only top notch managers are able to deliver alpha to their clients.

 

Information Ratio

Earning alpha is the holy grail in financial investing. To earn alpha, investors must create an edge. Luckily, edges come in many shapes and sizes such as informational, technological, intellectual, emotional or relational advantages. In the end, alpha quantitively expresses the return generated above a benchmark. The concept of quantitatively explaining alpha through a multi-factor equation was made possible thanks to the single-factor model in CAPM. The return of any market portfolio is directly correlated to the market risk. The goal of many hedge fund managers is therefore to take idiosyncratic risk in equities to outperform the expected return of CAPM. For example, a US market neutral equity hedge fund might use a risk-free rate as a benchmark. Worth noting is that a market neutral hedge fund places long and short stock bets in the market to achieve a beta equal to 0. According to CAPM, a portfolio with 0 beta should have an expected return equal to the risk-free rate. If in our example the risk-free rate consistently has a return of around 3% and the equity fund has a return of 7%, the alpha is equal to 4% (7% -3% = 4%). However, only comparing realized returns between investments is a sub-optimal method, as the volatility of a typical market neutral hedge fund is greater than the realized volatility for the risk-free rate, which is close to 0%. Realized volatility measures the riskiness of an investment. A higher volatility implies higher risk, but not necessarily less return per unit of risk. A market neutral fund generally lowers the volatility well below a typical index investor to achieve a higher information ratio. The simplest definition of information ratio is to subtract benchmark return from portfolio return and divide the resulting difference by the standard deviation of difference in benchmark returns and portfolio returns over a period of time. A consistently high information ratio over long time signifies a manager that either invests with great skill by earning a high alpha or has chosen a terrible benchmark. Having a diversified portfolio with high information ratios and alpha is the holy grail for an active manager.

 

Fundamental Law of Active Management

The goal of all investment portfolios is to generate attractive returns while minimizing risk. The fundamental law of active management is a mathematical method used to measure the attractiveness of active managers by relating the expected information ratio of actively managed portfolios down to a few key parameters. These four parameters making up the fundamental law is the information coefficient (IC), breadth, transfer coefficient (TC) and benchmark tracking risk. When the parameters are multiplied, the fundamental law equation spots out a number that quantitively demonstrates the value add by the portfolio manager being analyzed. While benchmark tracking risk indicates a manager’s aggressiveness, the IC is defined as the level of correlation between forecasted returns with actual returns and measures a manager’s skill. Larger amounts of independent bets as per the breadth measurement in combination with a higher IC means that a great amount of value is added to the portfolio by the manager. The TC measures how much alpha information that is actually used in the portfolio, which is another way of measuring the success of a manager’s portfolio construction. A higher TC is better, but real-life constraints often lowers the TC. For example, if a portfolio faces short selling restrictions, then that portfolio’s TC is lowered all else equal, as all alpha information cannot be used. Like a short-selling ban’s impact on the TC, some drivers of the fundamental law parameters for a manager is outside of their control, which makes the job of analyzing a manager a difficult yet valuable job in the financial industry. Other factors that can impact a manager’s future performance are regulatory restrictions, transaction costs, and problems with mean-variance optimization. As a result, the realized information ratios tend to be lower than what is expected ex ante. In security selection strategies, the actualized information ratio has empirically been determined by research to be 45-91% lower than what was originally expected. However, investors such as Rentech, Paul Tudor Jones, and Stanley Druckenmiller, have proven that earning alpha is possible with an edge.

 

 

Divergent vs Convergent Trading Strategies

In reality, only two types of investment strategies exist. The first type of investment strategy is a convergent strategy that benefits from stable relationships between asset prices. Convergence is mean reverting in nature and could for example take place in the futures market when the future price of an underlying cash commodity moves towards the spot price or in the stock market when the value of a stock moves towards its true intrinsic value. The second type of strategy is a divergent investment strategy and it builds on unstable relationships between asset prices. Divergent strategies may be profitable when there is an underlying shift in the market that pushes the price of a stock away from its former efficient value and creates a new intrinsic value. This fundamental divergence is known as a paradigm shift and is due to a change in either endogenous factors such as regulation and a change in monetary policy or it is due to exogenous factors such as a virus and a natural catastrophe.

Above illustration demonstrates an important observation about convergent vs divergent investment strategies. In the blue graph, one can see that a convergent strategy profits most of the time, but not all the time. In the middle of the illustration, the convergent approach has two sharp 90 degree reversals in which losses occur. The divergent strategy, however, is almost the mirror opposite as it instead seems to trend negative in most periods and then has two sharp upswings in which the strategy profits massively. Holding a divergent strategy in periods when losses occur is psychologically difficult. One must fight instincts to sell in the frequent slightly bad periods and understand that divergency makes money in chunks.

Trend is an example of an investment strategy benefitting from the divergent factor

If investors placed all their investments on a convergence to divergence spectrum, my guess is that approximately 80-90% of a typical portfolio is based on a convergent approach meaning that if the markets are stable the portfolio performs well. The 90% convergent portfolio conclusion is accurate even if a portfolio diversifies across asset classes, as most trades tend to indirectly short volatility. For example, a traditional long only 60-40 portfolio is the textbook definition of a convergent strategy, despite diversifying across different sectors and maturities. This generally passive strategy generates a stable income in a normal market with low volatility through dividends from the growing equity portfolio and coupons from the fixed income portfolio. However, during a crisis period there is always a shock to the system and correlations across assets tend to approach 1 leading to most assets moving down together. If the crisis is prolonged, such as the dotcom bubble in early 2000s or the banking crisis in 2008, a divergent strategy like trend following drastically outperforms the market and therefore buffers the typical institutional portfolio. Adding trend creates a more stable overall portfolio, as the underlying approach to extracting return from inside asset classes must be balanced as well. Trend followers are generally agnostic to which markets that are most likely to trend and their portfolios can therefore trade more than 100 different markets across fixed income, equities, currencies and commodities.

Above illustration is from the CFA curriculum and depicts the performance of three different types of typical institutional investor portfolios. Portfolio D includes the CISDM CTA Equal Weighted Index, which is designed to broadly represent the performance of approximately 250 CTA programs in the Morningstar database that meet the inclusion requirements. As you can se, having10% of the portfolio invested in CTA's will enhance risk reward characteristics and shrink the max drawdown.

Why are trends caused?

According to the efficient market hypothesis, market prices reflect all available information. If markets are efficient then there is no mispricing and if there is no mispricing there is no investment strategy capable of extracting alpha. However, there are behavioral reasons for why prices are not efficient and Adaptive Alph believes there are two main reasons for why markets trend up or down. The first reason is explained through the adaptive market hypothesis (AMH), an alternative theory to EMH, which outlines human behavior as a cause for inefficient prices and trend. According to the AMH, markets overshoot or undershoot the equilibrium price when its participants adapt to new information. Two examples of behavior causing overreaction is herding and prospect theory explained in more detail below. Overreaction to bad news such as COVID-19 creates fear, which in turn causes significant up or down trends in the market that trend followers will then capitalize on. The second reason for why trend exist is that in the financial markets there are two types of investors - hedgers and speculators. The hedgers are willing to pay a premium to the speculators in order protect their assets. For example, a farmer could hedge the price of a physical asset such as wheat, on the futures exchange. On the other side of that transaction, there may be a hedge fund, such as a trend follower, speculating that the price will increase. In a so-called “normal” market, the spot price (current price) is less than the future price due to future price uncertainty and in exchange for absorbing the uncertainty the speculator demands a premium. That premium is an example of extracting alpha for taking on price risk in the market. If the uncertainty among farmers increases they are willing to pay a higher and higher price to protect their wheat and therefore causing a trending market.

 

The herd behavior by investors cause asset prices to trend.

Herding behavior is a bias making individuals follow the “pack”. For example, it is a status symbol to have the latest iPhone, which in turn drives up the price of the iPhone to irrational highs. This happens in the market all the time. The price of bitcoin, marijuana stocks and tulips in the 1700s are just a few examples.

Prospect Theory is a loss aversion bias that demonstrates how people respond differently to the prospect of losing and winning money. The prospect theory states that people are risk seeking and willing to gamble when there is a certainty of losing money. However, if there is a certainty of winning money then people are instead risk averse. This is best illustrated by an example. The expected return between winning 100 KUSD with certainty or 1 million USD with a 10% probability is the same at 100 KUSD. Most people would then choose to get a 100 KUSD with certainty. If you flip the experiment so that one will lose a 100 KUSD with certainty or have a 10% probability of losing a 1 million USD, then most people would choose to gamble. This difference in preference is dependent on how people emotionally respond to gains and losses. This type of behavior drives the markets away from the efficient price.

Above graph illustrates that we feel a loss of 100 GBP more than a gain of 100 GBP despite that the amount of gain and loss is equal.

How is a trend measured?

The simplest technique to measure a directional trend is the price break out strategy. For example, if the price of the S&P 500 is higher today than the price of S&P 500 3 months back, then the S&P 500 is in a positive trend. Another straightforward method to measure trend is to compare moving averages (MA) of the S&P 500 price with different time horizons or lookback periods. When the short 50 day MA is greater than the long 200 day MA of the S&P 500, then the S&P 500 is in a positive trend. The problem with these simple strategies is that they only measure the direction of the trend and fail to measure the strength of the trend. Pretend a comparison is made between the price curve of S&P 500 and Dow Jones. If the S&P 500 curve has a higher upward angle then a probable conclusion is that the S&P 500 is in a stronger trend than the Dow Jones. These elementary strategies also fail to measure the volatility and the full price history of the S&P 500 and Dow Jones price curves. If volatility is higher it means that the price curve fluctuates up and down at a greater pace and the trading cost of the simple system increase as the simple model will continue to quickly switch from long to short exposure. Also, only using one crossing MA lookback period such as a short MA of 30 days and a long MA of 100 days fails to account for the full historical price curve. As soon as 100 days have passed, the 101th day falls out of the trend analysis, which could have a great impact on trend strength. A more complex trend following model, however, will measure the strength of the price drift, estimate the volatility, incorporate skew, analyze kurtosis and account for the optimal historical price series of an asset.

What is a more complex trend model?

Instead of using MA filters to measure trend, a great start is to exchange the MA filters with exponential moving average filters (EMAs) and double exponential moving average filters (DEMAs). The EMA filters place a greater weight on more recent data points in the historical price curve used for creating forecasting signals. Some EMAs when bunched together also include the full history of a time series, which could make for more accurate forecasts. The weight parameter in an EMA filter is set by a quant and is a potential differentiator in model development. EMAs generally create a more reactive price curve without any sharp edges leading to lower noise in the signal and less trading on small trend reversals. Another additional complexity statisticians and more advanced trend followers incorporate when reducing noise in the signal is an ensemble technique. The ensemble is a multivariate approach to statistical analysis such as trend following incorporating multiple different EMAs assigned with different weight parameters and lookback periods that are then varied when training/running the model. The ensemble is an effective way to budget risk as it prevents risk concentration to just one parameter that in turn generates the trend signal. The ensemble can also add covariance matrices to the signal generation in order to see how markets move together. If market A and B have historically correlated then having a strong exposure in both of these markets might be suboptimal from a risk adjusted return perspective as these two markets have a high likelihood of seeing sharp trend reversals at the same time. An additional complexity that adds to a robust trend following system is to utilize portfolio optimization to take stronger positions in those markets that have a higher probability of trending.

What are some further complexities?

No matter the complexity of a trend follower, the goal is always to profit from riding optimal market trends. As a result, the trend following quant maximizes the probability of reaching the objective by deploying a complex statistical toolbox to locate trends. A recently developed technique for finding trends in the market is the basket approach. These baskets of instruments or markets are generally constructed so that the independent variables have a high correlation and consist of filtered historical market returns on the near future price development. Researchers then use dimension reduction techniques (DRTs) that in turn figures out the underlying factors that drive trend in markets of that basket. For example, a higher GDP growth in a country most likely boosts revenue for all companies in that country and GDP growth is therefore a principal component or underlying driver for equity markets. This example is called principal component analysis (PCA) and is a well established (DRT). By building baskets of instruments, the quant creates more favorable trend following characteristics than individual instruments or markets typically exhibit. Favorable means that the price curve is smooth, the direction of the trend is clear and other statistical moments such as skew and kurtosis have less of an impact. The exposure is then allocated to the markets that are being traded by that trend follower to imitate the basket exposure. This exposure is built based on the multiplication of the basket signals and their weights.

Finance 3.0 trend followers apply advanced statistical and mathematical techniques to capture momentum patterns in the market.

Talos the Automaton

Artificial intelligence and its guiding principles of evolution can be traced all the way back to the antiquity trough the Greek myths of Hephaestus and Pygmalion. Back in ancient Greece, storytellers’ orated epics about the intelligent robot and bronze giant Talos. As an automaton, the purpose of Talos was to protect Europa, the mother of king Minos of Crete, from foreign invaders. An automaton is a self-operating machine designed to follow a predefined set of rules fitting hand in glove with the definition of a quantitative trading system. The obvious difference between Talos and a systematic trading system is the objective function as the goal of a trading system is to generate high risk adjusted returns instead of protecting Europa from being assassinated. However, for Talos and the trading system to achieve their respective objective both of them must have a built in risk management system. Talos must differentiate friend from foe to prevent the wrong person from getting killed and the trading system must constantly balance reward against risk to avoid blowing up. Given recent developments in finance 3.0, the most advanced systematic trading systems now not only follow a pre-defined set of rules, but these superior systems now also recursively update their forecasting parameters to make enhanced predictions in the market. These adaptive quant systems are generally more complex than their finance 2.0 counterparts and to earn a higher risk adjusted return risk management is therefore more important than ever in modern quantitative investing.

Talos protecting Europa!

Uncertainty Management in Finance 3.0

Despite that the foundational mathematical theory of AI, spearheaded by cognitive psychologist (computer scientist) Geoffrey Hinton among others, have been around for over 50 years, it is recent advances in computing power and data gathering that are the main reasons for why there is now successful implementation of Machine Learning (ML) to financial markets. Through careful application of ML algorithms, high quality researchers combine a computer’s capacity to analyze data in infinitum with the dynamic ML model’s super human creativity to make optimal trade decisions. The ML model’s creativity is derived from recursive and complex mathematics to identify none-linear patterns in the financial markets. Whenever there is none-linearity involved the relationships between variables tend to move past the imagination of the human mind and when conducting abstract analysis a robust risk management system is extremely important to prevent the model from going haywire. For example, Adaptive Alph assumes that most of you readers would not want to sit in an AI powered car without a 99.999% guarantee of not crashing. Well, the AI investment process involves managing money, such as a worker’s future pension, and financial models must therefore equal the prudence of self-driving cars.

Risk vs Uncertainty

To create a prudent risk management system for a quantitative investment portfolio, we must first understand the meaning of risk management. Adaptive Alph’s definition of risk management is the practice of identifying potential risks in advance, analyzing them and most of all taking precautionary steps to curb the risks that are identified. There are basically two components to risk causing negative performance. The first component is the probability of a risky event occurring; for example, the probability of a recession. The second component is the performance impact of a risky event; for example, the depth of a drawdown if a recession occurs. Nassim Talib provides excellent illustrations of risk in his must read book, Black Swan, which Adaptive Alph highly recommends if you want to understand the complexities of risk. Nassim has many points in his amazing book, but maybe his most important point is the difference between risk and uncertainty. Risk is when the outcome probabilities are known in advance. For example, the chance of winning by betting on a black or a red number in roulette is around 49.8% as the casino added the green 0 to skew the odds to casino’s advantage. Playing roulette at the casino many times therefore guarantees a 100% probability of going bust. One conclusion from the casino example is that the probability of a black swan is 0% because risk is measurable. However, risk or rather uncertainty in the financial market is inherently different from risk at the casino as black swan events can strike whenever and the potential impact may be unimaginable.

LTCM

An unimaginable black swan event took place in 1998 when a group of genius “egg heads” at LTCM built models to capture arbitrage in the fixed income market. At first LTCM was the hottest hedge fund in the market and everyone wanted to invest as LTCM’s models kept racking up profits. To capitalize on arbitrage in the bond market, the LTCM models relied on capturing tiny anomalies in prices and to make money LTCM therefore needed to apply leverage on their positions. By applying leverage, LTCM essentially shorted volatility hoping that bond volatility remained within a predictable range. Myron Scholes coined the term “picking up nickels” and investors kept investing as they loved both LTCM and Myron’s elegant nickel analogy. However, picking up these nickels by applying leverage ended up being like a 100m sprinter using steroids to win the Olympic gold and then getting caught. LTCM’s risk management system completely underestimated their complex product, which contained many hidden risks that were also magnified by leverage. As a result, LTCM lost 50% of its value in August 1998 almost causing a global financial crisis. Due to LTCM’s popularity among investors, the fund was “to big to fail” so the central bank bailed them out to prevent a crash. In the end, LTCM is a black swan per Nassim’s definition because, 1) a ruin event took place when Russia devalued their currency and, 2) the event carried extreme impact. Risk management is therefore key for quantitative funds to prevent future LTCMs from happening. Given the low volatility over the past 10 years, I have a feeling that we have some current “eggheads” in the making. So what is then the solution for a quantitative hedge fund to protect itself from black swan type of events?

Risk Management: Portfolio Level

A successful systematic investor must take risks to profit, but unwanted risk must at all costs be avoided. To protect against unexpected shocks, the portfolio should therefore integrate risk management in its investment process, especially when it comes to machine learning. Integrating risk management means diversifying the portfolio while incorporating various risk measures such as max drawdown, volatility, VaR, skew and kurtosis that both monitors the trading system and controls the portfolio’s risk exposure. An ML trading system in finance 3.0 differs slightly from a finance 2.0 trading system despite that both of them relies on similar alpha indicators such as technicals and fundamentals. The reason for the difference is that an ML system dynamically evolves as new information enters the models. That means that the coefficients applied to the alpha indicators updates to hopefully make more accurate forecasts. One technique to prevent the parameters of a dynamic model from over adjusting is regularization. Applying regularization to an ML model is a combination of art and science. Only expert researchers who fully understand the data set and the objective function are able to appropriately optimize the rate of change of the parameters in the model. It is important to note that most machine learning models will make decision based on complex patterns generated by the market. Sometimes it is impossible for our human brains to understand patterns that are none-linear so having a robust risk management system is more important than ever to protect against black swan events.

To avoid risk concentration in a portfolio it is important to:

 When diversifying across markets and models one accounts for correlation. If the correlation of a market or model is less than 1 to the existing portfolio and the expected return is greater than 0 then adding these to the portfolio will increase the risk adjusted return.

Utilizing spread positions lowers the chance of taking a directional bet like LTCM. They used leverage on directional bets without considering volatility. A volatility that spikes causes margin calls.

 Lower exposures to those markets where the models fail to see opportunities.

Usually systematic funds set a target volatility to generate an optimal risk adjusted return stream and to prevent extreme negative events from impacting the portfolio. The systematic investment process should therefore automatically reduce exposure to markets lacking opportunity where volatility increases to achieve the desired target volatility of the whole program. There are some disagreements among experts here.

Following are statistical approaches that can be integrated in the risk management process:

 Volatility is the most common. The benefit is that volatility is easy to understand and can be calculated using simple statistical methods. The weakness is that volatility does not care about the direction of the risk. You need volatility to make money. Higher downside volatility indicates a lower Sharpe.

maximum drawdown (MDD) is the maximum observed loss from a peak to a trough of a portfolio, before a new peak is attained. Maximum drawdown is an indicator of downside risk over a specified time period. MDD measures the size of drawdown, but it does not account for the frequency of losses.

The above graph demonstrates that as there are more trials the underlying distribution is more likely to follow a normal distribution. Despite the above tendency, Markets are not normally distributed.

Risk Management: Model Level

Before launching a quantitative portfolio of models, one must also incorporate risk management at the model level. There are basically two approaches to manage risk, the top-down and bottom-up approach. Most funds use a combination of both top-down and bottom-up in their risk management process. In a bottom-up approach, each model in the portfolio acts independently from one another. If model A sees an opportunity in market X it will increase the exposure to market X without consideration of model B. To prevent the risk exposure of being too large in a single market or asset class in the bottom-up approach, one could then use a top-down limit framework by setting VaR limits. VaR calculates the maximum loss expected (or worst case scenario) on an investment, over a given time and given a specified degree of confidence. Unlike volatility, VaR measures the worst-case scenario so it is directional. The fund will likely have predetermined VaR-limits on each market and the portfolio as whole. The weakness of VaR-limits is that they do not measure the size of the breach. This is a big weakness as in finance the return distribution of any market tends to not be normally distributed. One must therefore incorporate other risk measures such as the possibility of margin calls, kurtosis and skew. In a top-down approach, however, each model in the portfolio considers the exposure of another model in the portfolio to prevent concentrated risk exposures. Usually this is done through a constrained mean variance optimization. In the end, both risk management approaches uses diversification and statistical methods to optimize risk to achieve the highest return possible.

Nonlinearity conclusion

From the story of Talos, the bronze giant, we learned that the idea of AI has been around for a long period of time and thanks to advances in computing power researchers can now successfully build dynamic models that adapt to the evolving economy. These models capture none-linear patterns in the market and are difficult for our human brain to comprehend. As a model increases in complexity risk management becomes more important and finance 3.0 models therefore require a more robust risk management system than the typical finance 2.0 model. A successful risk management system uses a combination of statistical measures such as volatility, max drawdown and VaR at both the portfolio and model level to protect the investment portfolio. The return distributions of markets are not normal so one must also account for skew and kurtosis. There are two risk management approaches, the top-down and bottom-up approach. In the bottom-up approach the models act independently and in the top-down approach a portfolio optimizer is used to account for correlation between the models. Finally, we learned that there is a difference between risk and uncertainty through Talib’s casino example.

//Stay Adaptive!!

 

Black Box:

According to the 2018 Preqin Global Hedge Fund Report, total AUM for hedge funds have now surpassed USD 3.2 trillion. Out of all these hedge funds, the top five largest, ranked by AUM, were all categorized as quantitative investment firms by the well regarded publisher, Pension and Investment. Despite all assets managed by quants, there are plenty of investors and people in general feeling that so called quant strategies are hidden, secret and complex black boxes making unexplainable decisions in the financial markets. Adaptive Alph is here to tell you that the quantitative investment approach or portfolio construction is not a black box. In fact, a true quant approach should be the complete opposite, as really successful quantitative investors must follow the same scientific approach as Newton and Einstein.

 

Turtle Experiment: Portfolio Construction Matters

To explain the significance of portfolio construction, we will start off with a famous quant story. Back in the 1980s, Richard Dennis and William Eckhert made a bet on the importance of nature versus nurture for becoming a great investor. Dennis, a legendary rules based and systematic investor himself turning USD 5,000 into more than 100 million, believed that he could train anyone to become a great investor, while Eckhert disagreed. To settle the bet amongst the two traders, they set up an experiment under the name “turtle trading”, perhaps the most famous experiment in history of finance, in which two separate classes consisting of around 13 people (turtles) learned the art of rule based trading. The main strategy of the program involved buying and selling a diversified set of financial futures contracts on 20 day highs and 20 day lows. The trading result achieved by the turtles varied despite the simplicity of this classic price breakout strategy. This is because a key component is portfolio construction as the rules must be followed 100% of the time, which is really tough when the market is moving against you. Adaptive Alph therefore believes it is important to define portfolio construction and, luckily for us, Rishi Narang does precisely that in his amazing book on quantitative investment, inside the black box. According to Narang, portfolio construction is the master chef blending the signals/spices generated by the alpha (moneymaker), risk and transaction models into an optimal mix in the portfolio. Successful quantitative investors must therefore have a complete understanding of portfolio construction.

Borrowed from Rishi Narang - Portfolio Construction

PS: Alpha model equals the moneymaker

Moneymakers

The goal for a quantitative analyst is to test a profitable hypothesis resulting from careful analysis of mispricing in financial instruments. Adaptive Alph calls the profit generating model the moneymaker, as its objective is to make money. One should consider the moneymaker as the optimist constantly scanning the investment universe for opportunity and as a result, feeding positive buy or sell signals into the portfolio construction part of the portfolio. A hypothesis for the moneymaker is either theory driven or it takes a more statistical, data driven approach. The former is relatively simple to understand involving the classic if “A” happens then “B” should happen reasoning. For example, if the market expects a company to report USD 10 million in earnings, but the company instead ends up reporting USD 100 million, a valid theory is to expect this particular company’s share price to increase. The latter, the data driven approach, is of higher complexity as it requires rigorous training in statistical methods and computer science to extract information emerging from the patterns, often nonlinear, in the data. Unlike the traditional approach, these nonlinear patterns that the quant is capturing do not fly under any theoretical banner, but rather they are patterns which are simply statistically significant. As an investor in a quant fund relying on a data driven approach, the fundamental truth of statistical science is simply something that the investor must believe. If believing in statistics is difficult, then Adaptive Alph does not recommend investing hard earned cash into a fund relying on the data driven approach.

Moneymaker Types and Successful turtles

In general there are six underlying known main factors (data driven models also capture factors difficult to give a name due to their complexity):

Factors that potentially drives the performance of a quantitative hedge fund

Three of these factors are fundamental factors and three of them are technical factors and all of them are different ways to drive the moneymaker. Fundamentals are factors derived from qualitative and quantitative information contributing to the economic value of a company, currency or asset, while technical factors are derived from human behaviors or sentiments driving the price of a particular asset. In the Dennis and Eckhert example above, the strategy utilize technical factors as the hypothesis is that if the price of a futures contract on, for example, gold breaks above its past 20 day high then the higher price trend is likely to continue and a buy order is therefore issued. If the price continues to increase further buy trades are sent into the portfolio construction optimizer until the price trend turns around and one must have a predefined strategy for exiting the trade. It turns out that Dennis hypothesis about traders being made rather than born was correct as at least six traders, listed below, made millions of dollars dating back to 1986.

 

·       - Jerry Parker (Chesapeake)

·       - Paul Rabar (Rabar)

·       - Liz Cheval (EMC)

·       - Howard Seidler (Saxon)

·       - Tom Shanks (Hawksbill)

·       - Jim DiMaria (JPD

Jerry Parker - You can listen to him on the weekly podcast Top Traders Unplugged

Risk Models

Generally, the moneymaker is the component that sends the strongest signal into the portfolio construction. The second strongest component is the risk management model, which is the pessimist carefully scrutinizing the moneymaker exposures. In Narang’s book, he separated the risk model from the moneymaking model, but Adaptive Alph believes sophisticated moneymakers tend to have a built in risk management function. Before explaining why risk management is important, we must first define the meaning of risk, which is simply the elimination of unwanted or unintended exposures. Many investors tend to define risk as volatility, dispersion or VaR, but all these measurements fail to capture the embedded risk in the portfolio such as tail risk, event risk, skew and kurtosis. Therefore, Adaptive Alph believes risk management is about careful position selection in regards to both selecting security as well as the position size in that particular security. For example, an exceptional moneymaker in trend following will allocate more risk to instruments with a strong price trend and less risk to those instruments that are whipsawing. This is an intuitive part of a trend following moneymaker. Important to note is that this type of dynamic risk taking is much more difficult to accomplish for a non quantitative trader relying on a more discretionary approach as the reaction time of a computer is multiples quicker at analyzing data than a human brain.

 

Balancing risk

Transaction Cost Model

Finally, there is the transaction cost model acting as a stingy CFO constantly measuring the trade cost of a signal generated by the moneymaker. The transaction cost model either feeds its own signal into the portfolio construction optimizer or it is a part of the moneymaker. Narang separated out the transaction cost model from the moneymaker to make it easier for the reader to understand its unique role within a portfolio context. Whenever a signal to trade is generated by the moneymaker there are two separate costs. The first cost is the cost of the trade itself and the second cost is the opportunity cost of trading something else. It could also be the case that two models are looking to make trades in the opposite direction and these trades are then netted against each other in some fashion, but this tends to be handled by the portfolio construction part of the portfolio. The job of the transaction cost model is to weight the strength of the signal generated by the moneymaker to its cost. If trade A is expensive with a super strong signal and trade B is cheap with a semi strong signal, the transaction cost model might shift the moneymaker to pick trade B. Important to note is that risk management potentially comes into play here as well and put strength behind trade A if trade A is perceived as less risky by the risk model. Despite the fact that most quant funds trade liquid instruments such as futures or public equities, frequent trading is still expensive and a large chunk of the performance can be subtracted by trading cost.

 

Portfolio construction = Masterchef

The Art of Portfolio Construction

When the moneymaker, risk and transaction models have generated a signal, the portfolio construction makes the ultimate decision on positioning. The decision is done using either a bottom up or top down approach often generating vastly different portfolios. In a bottom up portfolio construction, risk is allocated to moneymakers on a discretionary basis often through the vote of the portfolio’s investment committee. As a result, the moneymaking models act independently from another when generating forecast signals sent to the portfolio optimizer, which preferably includes the built in risk and transaction cost models. The portfolio optimizer is either based on optimization or rules based heuristics, the latter meaning that the ultimate position in each instrument is derived from human trial and error and therefore most often used in a bottom up portfolio construction approach. The advantage of using rules based heuristics is that one can identify precisely which model generates the return thereby allocating more risk to models that seem to perform better. Using heuristics one can also decide upon position limits on both different sectors and individual instruments preventing risk concentration without constraining an optimization process. A bottom up approach is essentially functioning as a fund of funds manager that instead of allocating capital to different fund managers distributes risk to different models. This means that if the hypothetical bottom up portfolio consists of three moneymakers it must be that three separate signals are sent into the portfolio construction. If moneymaker A is short gold with a strong signal and moneymaker B is long with a weak signal, assuming approximately equal weighted risk allocation, the portfolio will most likely short gold unless moneymaker C is strong long or if a rules based heuristic decision prevents the portfolio from further shorting gold as the risk exposure might exceed the system’s limit.

Top Down versus Bottom Up

Arguably, there are some weaknesses in the bottom up approach and that is why a top down portfolio construction is increasing in popularity with quant managers. The most obvious weakness of the bottom up approach is that the investment committee of a quant portfolio makes risk allocation decisions on a discretionary basis even if the outline guiding the decisions follows a systematic process. What Adaptive Alph means by a systematic process is that if model A performed well since the most recent committee meeting, then model A can at most receive x% higher exposure to avoid personal biases by any investment committee members. Just imagine the skewed allocation impact of endowment bias if one of the committee members created model A. Another possible weakness of the bottom up approach is that the models act independently, which might not be optimal from a risk adjusted portfolio return perspective. It could, for example, be that A and B in the above example are uncorrelated or even negatively correlated, which means that one could allocate more risk to each model for the chance of earning a higher return while lowering risk to ultimately increase risk adjusted return. In a top down approach, both the risk allocation and model independency issue is eliminated as each model in the portfolio is integrated with another. The performance of the quant fund would therefore no longer be attributable to model A, B or C, which is actually seen as a weakness of the top down approach by some investors. Instead, the models respective signal is now combined into one single tradable signal in the portfolio optimizer that is then executed in the market. The marginal contribution of each model to that ultimate signal in the portfolio optimizer is based on past success in identifying patterns in accordance with the portfolio optimization objective function and also its correlation to the signals generated by the other models in the portfolio. As you may have noted, allocating a higher weighting to a model with past success in the portfolio optimization step eliminates the need of an investment committee. This in turn has the benefit of preventing human behavioral biases causing deviation from the stated investment objective of the fund. After deciding upon portfolio construction methodology, the final signal is executed and trades are generated to get market exposure. This is the job of the execution algorithm, which is another blog as it is paramount to the success of a quantitative hedge fund.

Building Blocks Portfolio Construction Top Down

No matter if a quant fund uses a theory based bottom up approach or a data driven top down approach, investors in quant funds benefit from the quants ability to take risk dynamically and exploit nonlinear patterns. The top quants are those whom optimally combine data, science and art to create moneymakers, risk models and transaction cost models. The signals generated by those models are then forwarded to the portfolio construction part of the portfolio where they are mixed to create optimal market exposures. The art involved in the outline of the portfolio construction of the quantitative investment portfolio is paramount as it is the ultimate product differentiator for quantitative hedge funds.

Rishi Narang, Inside the Black Box

 

 

 

 

1.     Stable Systems

2.     Satoshi’s Mystery

3.     Battle of Cryptographers Beyond the age of Internet

4.     Finding a prosperity optimum: Decentralization vs Centralization

5.     Marrying Macroeconomics with Cryptoeconomics

6.     The Darwinian Impact of Human Psychology from a Game Theory Perspective

7.     Fascinating Founders

8.     World of Decentralized Applications and what may exist in the future

9.     Fractionalization, Tokenization and the DeFi Matrix

10.  Regulation

11.  The Network State

 

 

 

 

 

12.  The mystery of Satoshi

o   Who is he?

o   What di d he actually invent?

o   Why is it important and how is blockchain different?

o   What is it through an example?

13.  Battle of Cryptographers

o   Historical moments

o   Herodoutus

o   Caesar

o    

o   Mono and polyalphabetic ciphers

§  Definitions

·       Ciphers, Codes

·       Cryptanlytics

§   

14.  Decentralization vs Centralization

o   Political

o   Mathematical

o   Linear vs Quadratic

o   Prosperity

15.  The Marriage of Macroeconomics and Cryptoeconomics

o   Fiat vs Crypto

o   Fiscal and monetary policy

16.  Human Psychology 

17.  The Fascinating Founders

18.  Decentralized Application World

o   Metaverse

o   NFT

o   DEFI

o   Prediction Markets

19.  Fractionalization and Tokenization

o   Cold storage problem

§  Aligning token with incentive

·      Active vs Passive Users

·      Snap vs Arweave

o   Financial rewards stop network does not grow

o   Attract the right users

20.  Regulation

21.  The Network State

 

 

Appendix:

 

Investment Policy for Herodotus Investment Program

 

 

 

Strategy Details:

 

Overview:

The Herodotus Program is a broadly diversified long/short Digital Asset Program aimed at delivering a high absolute return over time, while maintaining a robust risk management framework controlling for both traditional finance and decentralized blockchain technology associated risks.

 

Performance Objective:

Although outperforming traditional equity indices over time is likely given the unique opportunity set provided by the nascent nature of the technology driving the digital asset space, the main objective of the Herodotus program is outperforming a basket consisting of the ten largest liquid crypto tokens per market cap in bull markets and avoid underperforming that same basket in bear markets, although a slight underperformance should be expected given the associated risks with investing in less liquid alternative digital token and protocol markets.

 

Target Investor:

The Herodotus program provides access to both emerging blockchain technology and a diversified revenue stream resulting in higher returning and more well-diversified investment portfolios for large institutional investors with limited experience in digital assets like pensions, family offices, ultra-high net worth individuals, banks and endowments.

 

 

Main Strategy:

The primary approach is discretionary macro applied on a broad universe of tokens and protocols across the GameFi, DeFi, NFT, Privacy and liquid token space. A  small portion of program risk in the portfolio is allocated to a complementary short basket of relatively overvalued liquid tokens which is mostly for risk management purposes, but also to generate alpha,. Although a majority of the risk is concentrated in what is considered the native crypto market, the discretionary nature of the mandate also allows for long/short investments in more traditional crypto companies across equities and fixed income if opportunities arise.

 

Main Strategy Techniques:

The Herodotus Program aims to leverage opportunities by leveraging a variety of discretionary techniques from fundamental to global macro analysis of the crypto market. The program attempts to identify opportunities across major macro and crypto economic themes with a time frame to hold  positions from a few days to many years.

 

Geographic Focus of the Strategy:

There is no geographical bias of the strategy. The evolution of geographic exposure will depend on the geographic locations of underlying tokens and currencies.

 

Blockchain Focus of the Strategy:

Ultimately, the performance of tokens and protocols depend on general risks associated with the evolution of the overall blockchain industry, which is known as crypto beta and perhaps best represented by the performance of bitcoin.

 

There is also a systematic blockchain risk related to capacity, security and usability for associated tokens and protocols leveraging a particular blockchain for security, data availability, consensus and execution. Note that the program may adapt a market neutral approach to certain blockchain’s  by identifying idiosyncratic difference in protocols and tokens in a pairwise fashion leveraging the same blockchain for security, data availability, consensus and execution.

 

Risk Management:

The Herodotus program has a portfolio structure that follows a strict set of maximum risk budgets based on financial heuristics developed from deeply analyzing data derived from both crypto and traditional markets.

·       No single position exposure in the portfolio may account on a leverage adjusted basis for more than 10%  of the program’s total NAV or 5% of market value on both an individual token and protocol basis.

·       The slippage % is proprietary information, but should be considered marginal given a relatively low frequency in discretionary macro trading.

 

The program accounts for changes in volatility in several different ways:

·      First, individual and combined position sizes in similar types of tokens and protocols are based on among other things contemporaneous market volatility. Meaning that position de-leverage position incrementally (Daily, weekly) basis in response to a combination between conviction, current volatility and risk budget.

·      In addition, Investments in tokens and protocols leverage volatility as an input into the actual investment position and changes in volatility may therefore trigger certain assets to become attractive from both an overvalued (short)  and undervalued (long) perspective..

·      Finally, volatility considered over multiple timeframes is a key input in the strategy’s traditional risk management where the value of risk limit is applied on both positions and a combination of position from a total portfolio perspective.

 

 

Operational Management:

The program relies on third party software for trade execution, risk and position monitoring, position reconciliation and Nav calculations.

 

 

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[2] https://theconversation.com/longing-for-the-golden-age-of-air-travel-be-careful-what-you-wish-for-34177

[3] https://world-nuclear.org/information-library/current-and-future-generation/nuclear-power-in-the-world-today.aspx

[4] https://www.brightfocus.org/clinical-trials/how-clinical-trials-work/fda-approval-process

[5] The Code Book (p. 228). Knopf Doubleday Publishing Group. Kindle Edition.

 

[6] https://www.nytimes.com/1975/09/10/archives/ibm-corp-introduces-a-50pound-computer.html

[7] https://www.youtube.com/watch?v=yJDv-zdhzMY

[8] https://venturefizz.com/stories/boston/decrypting-blockchain

[9] file:///Users/albinhoh/Downloads/FTNEA2022003.pdf

[10] https://www.history.com/news/seat-belt-laws-resistance

[11] https://shopx.medium.com/simple-decryption-of-satoshi-nakamotos-hidden-message-in-the-blockchain-42b5fe9b3c72

[12] https://cointelegraph.com/news/what-on-chain-analytics-tell-us-about-bitcoin-transactions-in-2020

[13] https://www.lopp.net/pdf/theses/How-to-Position-for-the-Rally-in-Bitcoin.pdf

[14] https://cointelegraph.com/news/what-on-chain-analytics-tell-us-about-bitcoin-transactions-in-2020

[15] http://dolcevie.com/js/converter.html

[16] https://www.newyorker.com/magazine/2011/10/10/the-crypto-currency

[17] https://coingeek.com/faketoshi-series-adam-back-the-men-who-are-not-satoshi-part-2/

 

[18] https://www.youtube.com/watch?v=lFw-3wynj-o

[19] https://cointelegraph.com/news/remembering-hal-finney-s-contributions-to-blockchain-and-beyond

[20] https://www.youtube.com/watch?v=ko6K82pXcPA&t=1299s

 

[21] https://satoshi.nakamotoinstitute.org/emails/cryptography/15/

[22] https://www.whois.com/whois/bitcoin.org

[23] https://www.cato.org/commentary/who-killed-paypal

[24] https://mindmatters.ai/2021/10/is-bitcoin-just-a-flash-in-the-pan-peter-thiel-responds/

[25] https://www.wired.com/2009/06/e-gold/

[26] https://www.cato.org/commentary/who-killed-paypal

[27] https://www.sec.gov/Archives/edgar/data/1103415/000091205702009834/a2073071z10-k405.htm

[28] https://www.cnn.com/2003/TECH/biztech/04/01/ebay.paypal.reut/index.html

[29] https://www.eff.org/deeplinks/2013/07/why-doesnt-skype-include-stronger-protections-against-eavesdropping

[30] https://www.theguardian.com/technology/blog/2006/nov/08/web20niklasz

[31] https://slate.com/technology/2004/02/how-to-tap-a-voip-call.html

[32] http://www.cs.columbia.edu/\~salman/skype/SkypeSecurity_1_5_garfinkel.pdf

[33] https://www.sec.gov/Archives/edgar/data/1065088/000089161805000726/f12571exv99w1.htm

[34]

[35] Russo, Camila. The Infinite Machine (p. 43). HarperCollins. Kindle Edition.

[36] https://ethereum.github.io/yellowpaper/paper.pdf

[37] https://www.theblock.co/post/166999/the-merge-10-key-people-behind-ethereums-biggest-upgrade-yet

[38] https://volt.capital/blog/the-merge

[39] Bernhardt, Chris. Quantum Computing for Everyone (The MIT Press) (p. 166). The MIT Press. Kindle Edition.

 

[40] https://academy.bit2me.com/en/quien-es-timothy-may/

[41] https://theanarchistlibrary.org/library/timothy-c-may-crypto-anarchist-manifesto

[42] https://vitalik.ca/general/2022/09/20/daos.html

[43] https://www.atlanticcouncil.org/blogs/econographics/beyond-oil-natural-gas-and-wheat-the-commodity-shock-of-russia-ukraine-crisis/#:\~:text=Accounting%20for%20more%20than%2028,exports%20respectively%20(Figure%206).

[44] https://www.mckinsey.com/business-functions/sustainability/our-insights/net-zero-germany-chances-and-challenges-on-the-path-to-climate-neutrality-by-2045

[45] https://productmint.com/tether-business-model-how-does-tether-make-money/#:\~:text=Tether%20is%20a%20cryptocurrency%20that,as%20well%20as%20through%20investments.

[46] https://jeiwan.net/posts/analysis-titan-fall/  

https://messari.io/asset/terra/profile#:\~:text=Terra%20was%20created%20in%20January,the%20world's%20major%20fiat%20currencies.

[47] https://assets.website-files.com/611153e7af981472d8da199c/618b02d13e938ae1f8ad1e45_Terra_White_paper.pdf

[48] https://www.sofi.com/what-is-terra-luna/

[49] https://assets.website-files.com/611153e7af981472d8da199c/618b02d13e938ae1f8ad1e45_Terra_White_paper.pdf

 

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