13 Nov, 20
Ethereum Network Primer – The protocol for globalisation
Before the Ethereum network there was Bitcoin: The concept of Ethereum was conceived after the creation of Bitcoin, the world’s first global and decentralised peer-to-peer currency. The creation of a digital currency that could facilitate secure and globalised exchanges of value without an intermediary has made waves in the financial sector. Created as a response to the US government’s bailout of the banks in 2008, Bitcoin is a currency that has no central bank, meaning it is free from potentially harmful monetary policies such as quantitative easing. It has already proven itself to be a safe haven in countries such as Argentina and Venezuela, which suffer from hyperinflation. It has made changes to global equity raising, improved international remittances for emerging economies, has given traditional banking institutions new competition, and has introduced a new class of financial assets. A digital asset for a digital age, an instantly transferable currency powered by a globally decentralised network, free from manipulation from any entity.
However, Bitcoin’s purpose is that it functions as a currency, a medium of exchange and a store of wealth. Inspired to decentralise more than the monetary expression of blockchain, the concept of Ethereum was born in 2013. Trading financial assets, lending money, selling artwork, gambling on a soccer match, etc, could all be decentralised and globalised via Ethereum’s smart contract and application functionality that is built on top of a peer-to-peer network. To put it simply, while the internet facilitates communication around the world, Ethereum facilitates the exchange of value around the world.
Since then, these attributes and development of Ethereum have made it the second largest cryptocurrency network in terms of market capitalisation, as many tout the potential for Ethereum to change the way individuals and businesses interact with each other. Much of the success is credited to the visionary co-founders of Ethereum; Vitalk Buterin, Mihai Alisie, Anthony Di Lorio, Charles Hoskinson, Amir Chetrit, Joseph Lubin, Gavin Wood and Jeffrey Wilcke.
In this article, we explain how:
- Ethereum facilitates transactions without a third-party administrator
- Its Smart Contract functionality;
- The implications of the technology.
To explain the problem of undertaking financial transactions without a trusted third-party, imagine you had a group of 5 friends where you lend and borrow money between each other, with all transactions recorded on a ledger. One day, John claims that Sue has tampered with the ledger, and that she actually owes him $100 more than what is written. Since there is no bookkeeper and your ledger is your only way of verifying transactions, how do you find the truth? Even if there was a bookkeeper, how do you know if the bookkeeper has not tampered with the ledger and split the money with Sue? What makes Ethereum valuable is that it applies a system of consensus, where it can validate all transactions without a central administrator.
The Consensus System
The consensus system is about finding an agreed and correct state of a ledger. When you have a decentralised, pseudo-anonymous and global network, where no one entity has control over the ledger, this issue becomes highly complex. Malicious actors in the network may create fraudulent transactions that allow them to spend money they do not have, and the absence of a trusted entity is not available to monitor and disqualify these transactions.
The Ethereum network, like Bitcoin, solves this issue by using proof-of-work consensus, where independent computers act together to distribute a synchronised version of a ledger. This network of CPUs commits their computing power to process transactions in blocks, which are chained in sequence, coining the term “blockchain”. Whenever a CPU processes a block, they get rewarded with the network’s native currency, hence the name “miner”. The end-user just has to wait for the miners to broadcast these blocks and update their ledger. Now, what if a rogue miner broadcasts a fraudulent block? Since the speed of processing blocks is relative to the amount of CPU power committed, the blockchain with the majority of CPUs would create new blocks faster and have a longer blockchain. This longer blockchain has the “proof-of-work” of the majority of CPUs, and the end-user would just defer to this chain, knowing the majority has agreed that this chain holds the correct state of the ledger. Hence, we have created a peer-to-peer network that allows for decentralised consensus, and transactions can take place without an administrator or risk of fraud.
A smart contract is a digital program that can autonomously facilitate transactions and contracts via the rules it was programmed with.
Here is an example of how a smart contract can be programmed to work:
Person A wants to borrow $100 at 10% interest from Person B, due for payment in one month. Person A sends $150 worth of gold certificates as collateral to a smart contract. Person B sends $100 to the smart contract, and the smart contract transfers the $100 to Person A.
If A deposits $110 back to the smart contract in one month, B gets $110 back and A gets the gold certificates back. If A does not deposit $110 back to the smart contract by the deadline, B receives the gold certificates and A loses their collateral.
A real-life example of a smart contract is the good old vending machine. Let us say that the vending machine only dispenses Coke for a dollar. If you put in 50 cents, it will not dispense anything. If you put in two dollars, it will dispense a coke and give you back a dollar. The vending machine replaces a third-party, the cashier, operating autonomously for 24 hours a day. Now imagine if you could extend this functionality to every transaction in the world. Transactions such as the trading of securities, creation of loans, exchange of goods and services, would all be facilitated by a smart contract instead of a third party such as stockbrokers, bankers and PayPal.
In 2017, the utilisation of smart contracts to distribute equity gained traction. Smart contracts were programmed to distribute tokens which represented a stake in a company or project, executing when a buyer sent money to the smart contract. These were called “Initial Coin Offerings” (ICOs), which are similar to the traditional fixed price IPOs. However, these ICOs were accessible to anyone in the world, with little to no requirements. No signing up with a brokerage, no minimum capital, no country restrictions. We had seen the total equity raised in 2017 reach a staggering $10 billion USD and $11.4 billion USD in 2018. Although smaller than the US’ $63.4 billion USD raised in IPOs in 2018, for an emergent technology that started in 2014, this was a massive win for Ethereum. People began to realise, since you could create tokens to represent a stake in a company, why not everything else?
Tokenisation of Assets
An important functionality of the Ethereum network is the ability to create “tokens” on the blockchain. Tokens can be created by anyone and are inherently valueless, however, these tokens can be used to represent ownership of an asset. For example, you could create a token called GOLD, each representing one redeemable ounce of gold backed in your safe. Or let us say you own an apple plantation in your yard, and each APPLE represents one apple. Maybe you want to expand your apple plantation’s production, but you require funding for this process. Now you sell each APPLE for a 1% stake in your business. See the idea?
Some examples of tokenised assets are:
- PAXG: Each PAXG “is backed by one fine troy ounce of a 400 oz gold bar stored in a London vault.”
- USDC: Each USDC is backed by fully reserved assets and are redeemable for one USD.
- UNI: Each UNI entitles you to voting rights on the Uniswap platform, an Ethereum. powered exchange. These tokens may be entitled to fees from the platform in the future.
- Mata Capital’s tokenisation of real estate, namely a hotel in Paris.
- Godsunchained, where cards are tokenised and required to play the game.
- WiV, a company that tokenises collectible wine.
Bitcoin has shown that we do not need a slow, expensive, custodial intermediary to transact from anywhere in the world. Within this new digital economy, we no longer need to pay $30 to wire money overseas and wait 3-5 business days for it to clear. With Bitcoin, all you need is a phone or computer to receive money, creating a globally accessible payment network, breaking down the inefficiencies of global borders.
With the Ethereum network, we can build entire financial systems on top of a globalised platform due to its ability to facilitate peer-to-peer transactions, the functionality of its smart contracts and the tokenisation of assets. There are already smart contract-enabled lending services, exchanges, marketplaces, insurance, investment funds, etc., on Ethereum and tokenised assets such as gold and USD to use on these platforms. Combining these three capabilities of Ethereum, we have created globally accessible liquidity of financial assets that is available 24/7. Australians can trade with Americans without a broker, lend money without a bank, trade goods without an escrow. Anyone can conduct IPOs using a smart contract, with global access to liquidity and without the need for a broker. This sector of Ethereum is called Decentralised Finance (DeFi), which introduces a cheaper, faster, more secure and globally accessible way of providing financial services.
Decentralisation also means that once smart contracts are deployed onto the blockchain, no person, no institution, no country is required to run them. Even if the smart contract has a switch built into the code to shut it off, the open source nature of Ethereum allows for anyone to copy and deploy the same smart contract without the power switch. This means that the anti-competitive nature of banking institutions cannot be extended to Ethereum. Brokers cannot charge you oligopolistic fees because you can just trade peer-to-peer. DeFi operates globally, so that even Argentinians, Venezueleans, and Iranians who want freedom from their broken monetary policies can trade for other financial assets free from interference and censorship. A decentralised financial system where power is distributed to the users instead.
The services provided by the Ethereum network are not entirely free. In order to perform actions on the blockchain, such as creating tokens or using a smart contract to trade apples for oranges, you would have to pay a “gas” fee. Gas fees are paid in ether (ETH), Ethereum’s native currency. Think of it like gas to power a car, but in this case, it is gas to power a network.
The value of ETH is based on the value of the financial and non-financial services provided on the Ethereum network, as it requires ETH to be accessible. The Ethereum network conducted its initial distribution by crowdfunding through BTC, where 2000 ETH was exchanged for 1 BTC. The duration of the crowdfund was 42 days, with the price of ETH linearly increasing until it reached 1,337 ETH for 1 BTC. Each ETH was ultimately sold at around 0.31 USD each.
Now, ETH is currently the second largest cryptocurrency in terms of market capitalisation. It is hard to quantify the current and potential value of ETH, much like any other tech stock. This has given rise to the speculative nature of its prices, which has appreciated from a low of $0.43 USD, and up to a high of $1,443.18 USD. However, we can see and explain the value of Ethereum, as will be outlined in our investment cases.
Ethereum’s Future – An Upgradeable Platform
The Ethereum network is moving from a “proof-of-work” model to a “proof-of-stake” model, where transactions are approved through validators who stake ether. Instead of following the blockchain with the most “work” done to validate transactions, you just follow the blockchain with the most ether staked to validate transactions. This is important for two reasons.
Firstly, we would like to partition the blockchain in order to scale more transactions into the network, which works because less data is required to be processed by each validator. However, partitioning the ledger means dividing the current miners into smaller groups, which will make it easier for a malicious entity to control the majority of this smaller group and input fraudulent transactions in the blockchain. By moving to the proof-of-stake model, the validators’ financial incentives are aligned with securing the network, and makes it easier to punish malicious behaviour. In the event that validators try to cheat the network, their stake will be directly punished, which is akin to being able to physically destroy a person’s mining rig in the proof-of-work model. The greater cost to attack the network tightens its security, allowing Ethereum to partition the ledger and scale to process a greater amount of transactions.
Secondly, rewards from validating transactions goes to stakers instead of miners. This means that Ether becomes not only a consumable asset, but also a yield bearing capital asset. With the addition of another upgrade proposal, called EIP 1559, there will be a base fee burnt every time a user performs an action on the network. This will reduce Ethereum’s current inflation rate, along with the potential of bringing it to negative inflation. This means Ether becomes a triple-point asset; a consumable asset, yield-bearing asset and a store-of-value asset.
Before coming to a conclusion, we would like to outline certain use cases we have gone through in this primer.
Outline of Ethereum network use cases
- Globalised peer-to-peer network that allows not only the exchange of value through currencies, but other financial and non-financial assets.
- Smart contracts facilitate transactions of any asset, eliminating the need for intermediaries in many use cases, such as lending money.
- Ethereum breaks down the barriers of both localised and global borders, allowing cheaper and more efficient transactions. E.g. Instead of borrowing from a bank at a 2.5% interest rate, you can be matched with a lender that charges 2% interest. Or the ability to raise equity from different countries easily.
- Ethereum provides globally accessible liquidity.
- Ethereum’s blockchain is a public ledger stored on a network of computers, meaning a record of transactions between businesses is untamperable and easily accessible.
Ethereum Network: Conclusion
The Ethereum network is the next generation protocol for facilitating the exchange of value in the internet era. A globalised protocol where physical distance between individuals, institutions or countries becomes irrelevant. Anyone with a computer or phone can access information, services and applications built on top of Ethereum, whether a person or organisation wants to verify historical transactions between businesses, exchange assets globally, or even access banking services that are not traditionally available in developing nations.
Key institutions such as Ernst & Young have started building the financial infrastructure to integrate Ethereum into businesses, allowing them to represent their operations on the blockchain using tokenisation and smart contracts. The finance, food and beverage, healthcare and even automotive sectors benefit from the automation of smart contracts and transparency of operations between different divisions in an organisation. For example, the city of Toronto has been testing the use of blockchain to better manage reconciliation and fund transfers between divisions of the government. By using Ethereum’s blockchain, information on historical transactions are always stored on an online ledger, where organisations can easily access information instead of fumbling through siloed document trails. Furthermore, being built on Ethereum means that the utility and value provided by Ethereum will be given to the users instead of being extracted as profits by monopolistic companies.
The use of information and financial management permeates through every business, and Ethereum is poised to disrupt current inter and intra business processes. We have stepped into the Internet era, but we still see inefficiencies in the ways individuals and businesses interact with each other. You can call your friend from the other side of the world, but sending money takes a few days. You call your bank for a loan, sitting on more than healthy collateral but it takes weeks to process your application. You can convince potential investors to fund your start-up, but you have to wait weeks or months for the deal to be brokered. Look around and think to yourself, are there inefficiencies I am dealing with that should not exist in this day and age? Is there a solution and does it exist? Then evaluate for yourself: is Ethereum the answer?
Zerocap provides digital asset investment and custodial services to forward-thinking investors and institutions globally. Our investment team and Wealth Platform offer frictionless access to digital assets with industry-leading security. To learn more, contact the team at [email protected] or visit our website www.zerocap.com
- Ethereum – The platform
- Ether (ETH) – The cryptocurrency used to run the network.
- Gas fee – The fee for transacting on the Ethereum network. Paid with ether.
- Ledger – A total record of transactions in a book or digital document
- Decentralised – Where no central entity has power over an organisation
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