The building blocks of crypto
Crypto purports to reduce the heft of intermediaries and has been described as a
broader movement toward decentralised finance and even a more decentralised
internet (“Web 3.0” or “Web3”). The touted benefit is to democratise finance,
granting users greater control over their data. Prior to the recent crash, the market
size of cryptocurrencies and DeFi had expanded rapidly (Graph 1).
Crypto has its origin in Bitcoin, which introduced a radical idea: a decentralised
means of transferring value on a permissionless blockchain. Any participant can act
as a validating node (see glossary) and take part in the validation of transactions on
a public ledger (ie the permissionless blockchain). Rather than relying on trusted intermediaries (such as banks), record-keeping on the blockchain is performed by a
multitude of anonymous, self-interested validators.
Transactions with cryptocurrencies are verified by decentralised validators and
recorded on the public ledger. If a seller wants to transfer cryptocurrencies to a
buyer, the buyer (whose identity is hidden behind their cryptographic digital
signature) broadcasts the transaction details, eg transacting parties, amount or fees.
Validators (in some networks called “miners”) compete to verify the transaction, and
whoever is selected to verify then appends the transaction to the blockchain. The
updated blockchain is then shared among all miners and users.
The history of all
transactions is hence publicly observable and tied to specific wallets, while the true
identities of the parties behind transactions (ie the owners of the wallets) remain
undisclosed. By broadcasting all information publicly, the system verifies that the
transaction is consistent with the history of transfers on the blockchain, ie that the
cryptocurrency actually belongs to the seller and has not been double-spent.
However, for a decentralised governance system, economic incentives are key.
The limits of the system are set by the laws of economics rather than the laws of
physics. In other words, not only the technology but also the incentives need to work.
Miners (or validators) are compensated with monetary rewards for performing their
tasks according to the rules so that the system becomes self-sustaining. Rewards,
paid in crypto, can come in the form of transaction fees but can also stem from rents
that accrue to “staking”
one’s coins in a proof-of-stake blockchain. The larger the
stake, the more often a node will serve as validator, and the larger the rents.
Since the advent of Bitcoin in 2009, many other blockchains and associated
crypto coins have entered the scene, most notably Ethereum, which provides for
the use of “smart contracts” and “programmability” (see glossary). Smart contracts,
or self-executing code that triggers an action if some pre-specified conditions are
met, can automate market functions and obviate the intermediaries that were
traditionally required to make decisions.
As the underlying code is publicly available,
it can be scrutinised, making smart contracts transparent and reducing the risk of
manipulation. An important feature of smart contracts is their composability, or the
capacity to combine different components in a system. Users can perform complex
transactions on the same blockchain by combining multiple instructions within one
single smart contract – “money legos”. They can create a digital representation of
assets through “tokenisation” (see glossary). As smart contracts cannot directly
access information that resides “off-chain”, ie outside the specific blockchain, they
require mediators to provide such data (so-called oracles).4
Newer blockchains, with Terra (before its collapse) being a prominent example,
have been touted as “Ethereum killers” in that they boast higher capacity and larger
throughput (see glossary). However, these changes bring new problems. Capacity is
often increased through greater centralisation in the validation mechanisms,
weakening security and concentrating the benefits for insiders, as explained below.5
