The Basics of Bitcoins and Blockchains: A Book Review
Intro
And here it is — a brief review of “The Basics of Bitcoins and Blockchains” by Antony Lewis, who is currently a blockchain investor with Temasek in Singapore, and a professional with previous experiences with R3 (I’ve encountered the Corda blockchain in my digitalisation experience at work), and Traditional Finance.
In a phrase, I thought that this was the most proficient text that I’ve read on the subject so far, with an evident effort to approach the fairly-complex field of DeFi from first principles as much as possible. The argumentation is so intuitive that in some senses I regret not starting with this text as my introductory book to the field.
As per other Blockchain-focused and DeFi-centred books, Lewis covers most of the essential themes worth understanding for beginners: TradFi, Cryptocurrencies, Tokens, Cryptography, Blockchains and Tokenomics. Where he particularly excels I think is articulating very clearly the complications of Traditional Finance (inspired likely by his experience in conventional banking as spot FX trading) and how those problems set the stage for “DeFi to eat TradFi” as industry pundits would put it.
The sharp exposition on traditional finance balanced against a nuanced description of blockchains and cryptocurrencies gives way to a powerful articulation of the potential of this technology to engulf the world of TradFi.
As the text covers many foundational concepts written about previously in this blog, for this iteration, I opt to write down some brief thoughts on 3 main innovations I found particularly interesting: DeFi as the next evolution of monetary concepts, Ethereum as a world-computer and a Deeper Look at Tokenomics.
DeFi as the next stage of Money
Part of the joy of this text is Lewis’ capacity to articulate the nuances of conventional banking and finance — and then to weave it with the technological potential of Blockchain to describe a type of ‘evolutionary journey’ of money: from physical cash, to middlemen-mediated digital cash to intermediary-less digital cash (e.g., Bitcoins).
Physical Money. According to Lewis, the history of “money” is extensive but for the sake of simplicity we can consider as a first stage the use of physical money. We might envision physical money as bank notes (for example, a note of $10 Singapore Dollars — or “fiat dollars”). For the most part, transacting physical money is straightforward — when I pay SGD$5 for a meal, no one takes a commission for that transaction, it is patently-recognisable that I am no longer entitled to that SGD$5 and the vendor is incrementally-entitled to SGD$5 more.
Where physical money fails is “at a distance”. Whilst it is straightforward to use physical money for local economies, for example, what happens when you need to transfer USD$50 to the company Steam for a new AAA game? You might perhaps consider taking a flight to the States to pay the USD$50 note to the company’s HQ. Or you might resort to “digital money” — which enables transfer of value from one party to another over the Internet.
Digital Money. But the problem with digital money, however, is that it is conditional on the workings of middlemen (so-called “M3 Money”) — who bookkeep the amount of value you have in your account today, and keep track of how much you are entitled to transfer to others or withdraw from your account. The analogy would be to a DBS iBanking App. This app (and your associated account with DBS) makes it straightforward to transfer value from Alice to Bob at a distance — but results in a host of associated problems that come with centralised bookkeepers.
Lewis’ argument is that it is hard to operate a digital money-based system without centralised bookkeepers governed by regulators. Because digital money is easily-replicable — this creates a “double spending” problem where it is hard to validate if money has been spent more than once. The conventional solution to this problem was faithful bookkeeping by centralised intermediaries — who would be punished if they did anything other than this faithful bookkeeping. But this also leaves a great deal of authority in the hands of such intermediaries (commercial banks) who can extract a fee from users simply for transferring value from A to B. (E.g., A credit card commission)
DeFi as the next evolutionary stage of money. This brings us to Bitcoins and Blockchains. According to Lewis, Bitcoin is a genuine innovation because it is the first instance of a “censorship-resistant digital cash for the Internet”. Prior to this innovation, it was not straightforward to transfer value from Alice to Bob directly over the Internet without an intermediary. With Bitcoins and cryptocurrencies — it is.
With DeFi, neither Alice nor Bob needs to open an account with an intermediary bank to transfer value. Alice needs a private key (which can then be converted into an ‘address’ and ‘public key’) and Bob needs the same. With a crypto-wallet software, Alice can bundle information about the value she incontrovertibly owns (e.g., the quantity of tokens she wants to transfer) alongside Bob’s address to create a ‘transaction’. This transacted is recorded and broadcasted over the underlying blockchain — a distributed ledger stored on multiple user-nodes in the network — and is deemed effective once confirmed and ‘mined’ by block-creators.
The description of this technology implies that in a world grounded by DeFi, individual users not only reclaim ownership over the value which they own, but are able to circumvent the failings and faults of a system predicated by centralised bookkeepers and authorities (single-point failures). It is a system of money grounded in individual autonomy — solving both the problems of physical and digital cash without extensive exposure to the risks of the each model.
Ethereum as a World-Computer
One fairly innovative takeaway for me was Lewis’ description of Ethereum as a type of ‘world-computer’. In previous readings and writings it seemed as though Bitcoin’s aim was to be a “censorship-proof digital cash for the Internet” whilst Ethereum’s was to be “platform layer for the running of decentralised applications and smart contracts”. The transfer of ETH can act as a transfer of value but that was not necessarily the “main point” of Ethereum.
Lewis’ description of the dichotomy is as follows: Whilst Bitcoin serves as a “data store of (transactional) information” — Ethereum goes a step further and serves as a “data store and processor of (not just transactional) information”. Therefore it is both a database and a processor of data stored on its blockchain.
We saw this in our brief description of dApps and smart contracts in a separate blog post. Whilst the Bitcoin Blockchain records and broadcasts transactions, Ethereum users can write smart contracts, upload them onto the Ethereum Blockchain for a “gas fee”, determine an address for this contract, and other users can interact with the contract like a juke box — send some tokens to this address and it does something in return.
The concept of a “world computer” comes in here because, just as how all Bitcoin nodes validate one another’s blockchain and “gossip” with one another, each Ethereum node running the Ethereum software runs the contract which is invoked and update their ledgers with the results of the invocation. In the words of the author — a fair way to describe this therefore is as an “unstoppable, trustless and censorship-resistant world computer”.
A Deeper Look at Tokenomics
Some words on Lewis’ approach to Tokenomics which he addresses in Part 8 of the book — Investing. We had briefly explored this concept in earlier writings where we spoke about potential demand-supply factors for Bitcoin and investing strategies in Cryptocurrencies. But I particularly enjoy Lewis’ discussion of the issue.
For Lewis, he cites that in Traditional Finance, a conventional method to understand the “right price” of an asset would be through pricing models that take as input some information about the thing (e.g., Discounted Cash Flows for a stock) and it spits as output a “fair price” for the thing based on certain calculations. We can do this for derivatives (options, futures etc.), bonds and equities for example. What is the equivalent concept in crypto-assets?
For Lewis, the problem can be approached from two angles: what factors are likely to change the price of asset and what ought to be the right price for the asset?
What things are likely to change the price of the asset? A useful first step to analysing Tokenomics is simply to write down a few factors which are likely to motivate price action: for example, sentiment on Twitter or macroeconomic factors like Rate Hikes for example. The presence of technical support and resistances might motivate the tactical price action of token. From a Macro perspective, if Bitcoin is correlated to traditional assets like equities and bond markets, and those markets are driven by macro factors undertaken by the Federal Reserve, by implication Fed actions are one “factor” that can motivate price action. A collation of these factors puts together a rough model of how price will move for an asset.
What ought to be the right price for the asset? There is a further, and deeper question, which is how do we know the “right price” for a crypto-asset. For Lewis, this field is currently too immature to make proper conjectures with fair-pricing models, not to mention structural limits to information collection.
For example, in a conventional asset pricing model, we would take as inputs information provided by the company — such as earnings, future business models, projected cash flows etc. — before translating that information-set into a monetary-projection of its ‘right value’. However, crypto-based projects, understanding that the very provision of such information anchors them to some arbitrary price — have an incentive not to provide sufficient information. (And currently there isn’t a set of regulation that would force them to provide this!) For this reason, whilst efforts to develop such models ought to continue to mature and develop, it is worth recognising the limits in place to developing effective pricing models in this space.
Final Words
In summary, I quite enjoyed this text and believe it sets a comprehensive foundation for any newcomer to this space. Its strengths in particular are in the description of the evolution from physical money, to digital money to the potential of DeFi, as well as the technical articulation of how Bitcoins and Blockchains work.
