Blockchain, Cryptocurrency and Web3 - Part 3

Intro

This is the third part of a 3-part read by Rajesh Bhat that aims to uncover some of the mystery and confusion about blockchain,?a technology that is quickly becoming a necessary element of our daily lives. Part 1 and Part 2 are available at KnowESG.

Web3

Within the city walls of each city state there are different vibrant activities carried out by its builders and citizens (users). There are all kinds of folks that make up this digital community within a blockchain. There are long term thinkers and builders, there are the brightest and smartest makers - those who build civilisational projects, and then there are grifters and outright thieves as well. There are people who are motivated by culture and values. There are others motivated by making money. There are outright speculators who want to buy into the next best thing and cash out at the peak. There are grifters and nomads that keep moving across different city states looking for the next best thing. There are engineers and there are artists. There are the technical-minded and there are the creatives. There are the Youtubers and content creators who try to make sense of this digital reality unfolding in front of us, some of whom sell their audiences for money. Then there are financiers who go around funding projects of promise in exchange for ownership, with the hope of multiplying their money. They sell themselves to the community to win the confidence of the best builders. There are bag holders, common citizens that shill their project to the moon and defend it from all criticism. There are collectives of citizens and contributors who work for projects and get paid for their time spent. There is collaboration here, there is also collusion. Industries get created overnight. Some fold, yet some endure for a long time.?

There is finance. There is art here. There is communication media. There are governance mechanisms (that solve how to manage projects fairly). There are a thousand different experimental projects in newer application areas by visionaries and novices alike. There are shady builders who cash in on any hype to sell ponzis, pyramid schemes and MLM marketing scams to gullible citizens who fear they lost their opportunity to make money. There are cycles of economic activity within these walls. There are economic booms when everything and everyone is doing well, there are tonnes of money to be made (and lost in scams) and frenzied activity, followed by years when everyone is poor, builders, financiers and citizens lose generational wealth, and countless businesses die, hardly anything moves, many lose hope souring on their dream of making money or finding a value-aligned community, and walk away from this digital civilisation back to the real world.?

This is web3.

In web3, key real world activities are getting and will be reinvented for the internet-native world of blockchains. Once a sector from the real world gets replicated on the blockchain, it is very likely going to offer much better performance (more efficient, more powerful) than the same sector in the real world.?

Finance was the first major activity that was successfully invented in web3.

Decentralised Finance

The fundamental activities in finance are:?

1) Lending/borrowing.?

2) Buying and selling of assets.

3) Native assets that mirror real world currency, such as US dollars (because any spending that crypto people do in the world is in a real world currency) and also blockchains have a very large interface (contact surface area) with the real world.?

4) Derivatives - to hedge risks in buying and selling of volatile assets.

These activities have been successfully solved on the blockchain today and are collectively called ‘decentralised finance’. Decentralised emerged on the Ethereum blockchain during 2019-21. The key development in the creation of finance on the blockchain was the creation of an asset standard on the blockchain called ERC-20 (Ethereum Request for Comment), a standard that allowed the creation of a fungible asset on the Ethereum blockchain. A fungible asset is something like a currency or an equity share (where they can be atomically split endlessly and also each unit is exactly equal to any other unit).?

Consequently, the key elements of the decentralised finance infrastructure have come up in web3.

Lending and borrowing

You can borrow any ERC-20 token (or a cryptocurrency like Ethereum or Bitcoin) using a different ERC-20 token (or cryptocurrency) as collateral. In the process you pay interest to the project which provides you the facility. The project in turn offers interest to lenders who offer their asset as deposit (lending) to earn the interest.

A web3 application that solely runs with a smart contract on the blockchain as a backend is powerful and is called a protocol. The biggest lending protocols in web3 are Aave and Compound.

There is an explosion of ERC-20 tokens (over 100,000 ERC-20s) and cryptocurrencies and a real need for users and projects to be able to swap between different ERC-20s and the cryptocurrency. This is done on the blockchain by the invention of the decentralised exchange. In terms of an analogy, you want to be able to swap potatoes for wheat, and apples for oranges in your city state.?

Decentralised Exchanges (DEX)

A decentralised exchange allows you to swap any ERC-20 token (or cryptocurrency of the blockchain) to any other ERC-20 token (or cryptocurrency of the blockchain). To enable this for traders, a DEX has liquidity providers who offer liquidity on the exchange (ERC-20 pairs or ERC-20 cryptocurrency pairs) and earn fees from the swaps. A decentralised exchange ensures there is liquidity for almost all ERC-20 tokens in existence (provided there is a liquidity provider for that token).

Uniswap, Sushiswap, and Curve Finance are some DEXes.

Whereas protocols like Uniswap are DEX that can swap any asset to any asset, Curve Finance is a stable swap, i.e., it can swap two assets that have 1:1 value (like two USD-stable coins)

Stable coins

Citizens, builders and other stakeholders in the digital city states of blockchains have a large surface area of contact with the real world, hence a large number of spending for them is in real world currencies like the US dollar and Indian rupee. This includes daily livelihood expenditure, raising funds from investors, diverting funds from their other income, bringing their real world wealth into crypto investments, and diverting to real world investments like cars, houses, etc.?

Therefore, it is very important to have an asset native to blockchains in web3 that mirrors the value of real world currency like the US dollar. Such an asset on the blockchain is called a ‘stable coin’. A USD stable coin by default mirrors the US dollar at all times.?

Some of the biggest stable coins are USDT (USD Tether), USDC (USD circle), Dai, BUSD (Binance USD), LUSD (liquity USD) and RAI (reflexer USD).

Stable coins have different mechanisms of maintaining the peg (keeping their value=1 USD):

1. Fiat collateral, maintaining at all times a reserve of 1 USD (real US dollar currency, also called ‘fiat') for every 1 stable coin minted. These are the simplest stable coins and hence the least risky (as long as the reserve of fiat USD is maintained).

2. Digital collateral. For every 1 stable coin (1 USD worth), have an equivalent value (1 USD worth) of crypto collateral, such as ETH, in reserve (LUSD does it, so does Dai and Rai). These have low risk of default too.

3. Undercollateralised stable coin. This kind of stable coin claims that it can maintain the peg algorithmically through some exotic mechanism. Note:ALL algorithmic stable coins so far have collapsed. UST (Terra USD), USDN (USD neutrino) are some examples. There are some others that have been created recently (USDD for example) which are likely to collapse too.?These are not durable stable coins.

How does a stable coin know what the price of the US dollar is at any given time? A blockchain does not know or recognise any data outside itself, so this is a large technical problem with major security implications. A service that can offer accurate real-time prices on the blockchain is called an ‘oracle’. Providing prices from outside the blockchain (like real world currency prices, real world temperature, real world gold prices, etc.) is an even more difficult oracle problem. Today, this is provided by a blockchain service called Chainlink, which provides US dollar prices to stable coins created and managed on the blockchain.?

Derivatives

If you own a large amount of apples, but you buy some wheat on a weekly basis as a critical item, you want to protect yourself from a situation where apple prices drop steeply one month from now and you are not able to buy any wheat from selling apples. You will then use an arrangement like options, when you make a deal with a third party of having the ‘option’ of buying 1 kg of wheat for 1 kg of apples one month from now for a small fee. If the price of wheat drops below that, you don’t exercise the option, and the third party gets to keep the fee.

In reality you have many such instruments (like the option) that protect a user from adverse price action in a future scenario. Such instruments are called hedging instruments. They are called derivatives.

There are many such derivatives protocols in web3. It is still an evolving area, and the winning technology for different derivative instruments is far from established. Some interesting web3 (decentralised) derivative protocols are dYdX, Primitive, Lyra, GMX, Opyn, etc.?

Other DeFi areas

Yield optimisation is another area of DeFi (decentralised finance) that is significantly large. Providing liquidity for exchanges, lending, etc., is a major requirement in DeFi. It is valuable for a liquidity provider to route their liquidity to the right protocol that earns the highest yield. Such a protocol is called a yield optimising protocol.?

Yearn Finance is such a protocol.

Finance forms a big part of the projects in the city state. It would get very boring if there was no culture to go along with all the finance, wouldn't it?

Non-Fungible Tokens

In any large enough human community, art, music, creative pursuits, entertainment, games and interest groups play a big role. In the digital city state that is the blockchain, there are all of these pursuits and more. Moreover, to have a thriving cultural scene, you need to have an entire thriving section of businesses around these objects, things like a marketplace (where collectors may buy from artists and other collectors), minting facilities (where these objects may be created), lending (where collectors may borrow money against their objects), etc.

On the blockchain, all of the above are made possible by the creation of an asset standard called ERC-721. Unlike the ERC-20 standard, which allows the creation of only asset per smart contract (asset is divisible and has max token supply), with the ERC-721 standard with a token supply of n, each token is indivisible and has a unique token ID. Each token is associated with metadata like url, text, attributes, etc. There is a smaller token standard called ERC-1155 which is also associated with these kind of assets, where there may be tokens which are each identical, but are indivisible and have metadata associated with them. Assets created complying to these token standards - ERC 721 and ERC-1155 - are together called Non-Fungible Tokens (NFTs). Other than these unique properties, NFTs have the most common properties of ERC-20s, such as transfers from sender address to buyer address.?

Any object that is of a certain type, is indivisible and in each instance is unique and has unique metadata (for example, for type: houses, each instance is unique and has unique metadata such as address, photos, latitude/longitude, etc.) can be represented on the blockchain using NFTs.?

After creation of the NFT asset standards in 2018, there has been an explosion of uses for them in web3. Art was the first exciting use case. Many digital and generative artists have created art in web3 and minted them as NFTs. Art Blocks and Fxhash are some of the popular art projects using NFTs. Profile Pictures (PFPs) are another popular use of NFT tokens. PFPs are images with properties that a person may identify their personality with, and use it as digital identity on the internet. Cryptopunks, Bored Ape Yacht Club, and Doodles are some popular PFP projects. Gaming has also come up on the blockchains using NFTs, Axie Infinity is a great example. Loot, Blitmap, Chain Runners, Treeverse, Forgotten Runes Wizard Cult are some other projects that are building immersive games using NFTs. Metaverse is another use of NFTs (Sandbox, Crypto Voxels), where users may own digital land, hang out in virtual spaces like bars, and participate in virtual concerts, etc. Interest groups for developers, called Developers DAO, for analytics called Flipside Crypto, exist too. Projects in music such as Beat Foundry and many photography projects like Twin Flames, Quantum have come up. Digital collectibles like Rare Pepe cards are a big use too. Decentralised naming services like ENS (Ethereum Naming Service) are big. Unique experiments like Nouns DAO also use NFTs. Some decentralized finance projects have also uniquely used NFTs such as Uniswap and Solidly. It is very clear that NFTs as a token standard will find very wide use in different industries going forward.

An ecosystem has emerged around NFTs, making it easy for the applications using NFTs. NFT marketplaces like Opensea/ Looks Rare/ Known Origin/ Super Rare, borrowing protocol like NFTFi, minting contracts like the Manifold smart contract, fractionalisation protocols like [Fractional.art](https://Fractional.art) , NFT metadata storage protocols like IPFS and Arweave, virtual galleries like Deca Art and onCyber, and Club NFT for users to back up their NFTs are all important parts of the NFT ecosystem.

NFTs have the benefits that come with any tokens on the blockchain, such as native transferability (across addresses). They also offer provenance (clear and irrefutably established title of ownership and proof of originality). These properties can be used easily by ecosystem projects to offer additional services.??

Being a relatively new asset class and having a lot of growth associated with them, there is much hype around NFTs. There is also an attempt at price discovery of NFTs where the market tries to assess their value correctly (by invariably underpricing and overpricing different use cases). Over the next couple of years, clear and strong uses of NFTs and their value should be established as it takes building for years for value to irrefutably emerge in a new space.

Given the explosion in types of projects and assets in web3, how do these projects manage/govern themselves?

Decentralised Autonomous Organisations

There is a very large and expanding diversity of projects building within the ‘city walls’ of the blockchain, namely web3, in finance, art, music, gaming, photography, and an ever expanding list of areas. Some of these, like finance (and gaming), have started to grow huge, in terms of hundreds of billions of dollars in size. Now, all the different parties who have interests in a project, the builders, the service providers, the users, etc., need to coordinate to take the best actions for the project. The way the different individuals associated with a project align themselves and contribute to the projects is called Decentralised Autonomous Organisation (DAO).

To understand DAOs, we reintroduce our asset type ERC-20 as explained in decentralised finance! The folks who already hold the ERC-20 tokens for a project are the investors (money bags who gave money to the builders at the start, in return for a say in future money made by the project), the builders, the service providers, and the users (who may be rewarded by project tokens). Thus, the ERC-20 tokens of the project approximately weigh who has how much ‘skin in the game’ when it comes to the project. So, the DAO allows the token holders of the project to vote on any actions and decisions on the project, in proportion to the number of tokens they hold. These results of voting are captured on the blockchain, and are therefore very durable.

The kind of decisions and actions a DAO has to grapple with are varied. First is the matter of funds (profits from services offered to users of the project) collected. Billion dollar projects have billions of dollars in ERC-20 tokens and cryptocurrencies to manage (typically held in a multi-sig wallet called Gnosis Safe). The DAO decides how it is spent (pay contributors, grants to new projects that benefit the current project, etc.). How to assess the output of contributors and how much to pay them is another set of decisions. Approving future directions of the project (what blockchains to be present on, what features to build), and what new assets (ERC-20s) to support, etc., are some of the other decisions. Since all the decisions are on the blockchain, which is 100% public, all the discussions and decisions of a DAO are viewable, residing within the public domain. Technically, a web3 project can be entirely driven by a DAO without even needing to incorporate a legal entity in the real world! Maker DAO is one such prominent example.

Some of the prominent DAOs are:

1. Decentralised finance

????- Maker DAO - governs the Dai stablecoin.

????- Curve DAO - governs Curve Protocol, basically a protocol for large scale stable coin swaps.

????- Compound DAO - governs the lending protocol Compound.

????- Aave DAO - governs the lending protocol Aave.

????- Uniswap DAO - governs the Uniswap’s protocol.

????- Olympus DAO - governs the defi protocol and reserves currency Ohm.

????- Index Coop DAO - governs collaboration.

2. NFTs

????- Nouns DAO - governs the NFT project Nouns, that has a very interesting funding and sale mechanism for the PFPs called Nouns

????- Ape DAO - supposed to govern the projects of Yuga Labs, namely, Bored Ape Yacht Club, etc.

????- Super Rare DAO - governs the NFT marketplace for art, Super Rare.

3. Other projects

????1. Gitcoin DAO - Gitcoin is an interesting funding protocol that uses quadratic funding to fund new bootstrapped projects on the Ethereum blockchain.

????2. Bankless DAO - runs media such as YouTube channel Bankless.

The DAOs are supported by a full stack of growing applications and infrastructure.

There are some well known shortcomings of DAOs. The biggest one is for kinds of projects that need 1 person 1 vote instead of 1 token 1 vote. This fails because there is no representation of a ‘person’ or a human being on the blockchain yet (any approximation of human today is vulnerable to sybil attacks). There are many such projects in real life, the most important being democracy (1 person gets 1 vote irrespective of the amount of wealth one holds). Thus, DAO decisions and actions are weighed in favour of the wealthy, which works for many projects that are structured like real life companies (where governance is weighed by equity holders: again, the more the equity you hold, the greater your say in strategic appointments).

For the governance of the entire city states themselves (namely the entire blockchain), DAOs are an improper tool (because we know from real world experience that governance, like democracy, is better suited for cities and countries). There are some interesting experiments in blockchain (and Layer 2 governance), most prominently by Optimism (a Layer 2 on Ethereum). Optimism has a combination of token governance (called Token House) and governance by human representatives (called Citizen House) enshrined in its governance.?

Now that you are convinced that a blockchain is a fascinating new digital realm and you want to participate in this world as a blockchain native citizen, I will show you how you become one.

How do you become a ‘citizen’ on the blockchain

You can identify yourself on the blockchain with a public address issued by the blockchain, to anyone, for free. You can do this by downloading the decentralised wallet that works with that wallet, and by following the instructions. A decentralised wallet like Metamask (works with all EVM compatible blockchains and Layer 2s, namely: Ethereum, Polygon, Arbitrum, Optimism, Starknet, zkSync, Avalanche, Fantom, Evmos, Moonbeam, etc.) or Phantom (for Solana) creates the unique address for you that you can subsequently use to participate on the respective blockchain.

The public address is the public part of the public/private key pair with the private key (also represented by a 12-word, 14-word or a 24-word passphrase) known only to you, to take actions on behalf of the wallet. Anyone who owns the private key (or corresponding passphrase) owns the address and the wallet. So, be careful with the private passphrase you are issued by the wallet.

Once you have your wallet address, you will need a small amount of cryptocurrency (of the respective blockchain), because for any action on the blockchain, you will need to spend the cryptocurrency (which gets paid to the security layer to execute your action while ensuring security of the blockchain). The bit of cryptocurrency that is needed to execute any action on the blockchain is called gas. You can get the cryptocurrency through any centralised exchange like Binance, Coinbase, WazirX, CoinDCX, etc., by spending Indian rupees, US dollars, or any other real world currency.?

With the decentralised wallet and the bit of cryptocurrency, you are all set to use any web3 application on the blockchain!

Other vital tools

A block scanner like Etherscan (or Polygonscan, Optimismscan, Arbiscan, etc.) is an important resource to use the blockchain. A blockchain is fully public, that is to say that all data there can be seen. A block scanner lets you see the entire blockchain data in an easy way. The kind of things you use a block scanner for are:

1. All the past actions on the blockchain (transactions) for any address with every detail, like smart contracts interacted with, transaction hash, address interacted with, gas paid, tokens used, etc.

2. To read smart contract code (almost all smart contracts are publicly viewable on the block scanner) and directly execute smart contracts.

3. Current gas for the blockchain.

4. Most used applications on the blockchain right now.

5. Current block, list of miners/stakers, node operators, and an exhausting amount of detail.

Analytics applications like Dune Analytics and Flipside Crypto offer open and free blockchain data for almost all web3 applications on the blockchain.