Understanding Crypto — Part 1

I love the energy with which crypto is growing. I’m not talking about the price action, but the technology and applications. This entire space has exploded and there are a lot of new things to learn like dApps, DAOs, Web3, NFTs, etc. It is a challenge to keep up. My goal with this two part series is to create a guide for myself to come back and review my learnings in a quick and organized way. The intent is to write summaries for key topics focusing on the high level idea followed by references to learn more.

I hope this helps others get started on their crypto learning journey.

First order of business, what is a blockchain?

The best way to describe blockchain is to think of it as a database of immutable records. These records can be a lot of things, transactions, photos, videos, text, etc. For the two big names:
1. Bitcoin — these records are transactions
2. Ethereum — these records are transactions and smart contracts

Ok, but what is the big deal about blockchain storing transactions?

To answer this, imagine you want to transfer $100 to a friend. Today, you would go to your bank and ask them to transfer the money to your friend. The bank would subtract your account balance and add that amount to your friends account balance. The bank ensures you are sending what you have and the money is transferred to the right account. We use these 3rd party institutions as a trusted intermediary and depend on them for book keeping of our transactions. What blockchain does is remove this dependency and allows us to maintain our transactions amongst ourselves and we do not have to depend on this third party.

Why would anyone record these transactions?

The blockchain has in built incentives for people (a.k.a. miners) to record the transactions. They do this by doing some computation (a.k.a. proof of work) and getting rewarded with the blockchain’s cryptocurrency for successful completion of said computation. This required computation is the magic sauce that authenticates transactions without the need of a third party. It also makes it difficult to alter any aspect of the transactions preventing individuals or organizations from tampering with the decentralized database. One fascinating thing I want to point out is that all the transactions on the bitcoin blockchain are available for everyone in the world to read, making it one of the most transparent financial systems the world has ever seen.

When does this fail?

If majority (> 50%) people running the computations plot together to cheat the system. Or the reward + transaction fee i.e. the incentive is not large enough for people to do the required computation. Both these scenarios are extremely unlikely but theoretically possible.

Aside: Blockchain is a decentralized database that can store things. It wouldn’t work without a cryptocurrency. The value of the cryptocurrency is the incentive that attracts people to do the required computations and maintain the blockchain network.

References:
Easiest way to understand blockchain
Blockchain in depth

What is Bitcoin?

Bitcoin is the first successful implementation of a cryptocurrency. The bitcoin blockchain stores peer to peer transactions with no central authority — transaction management and currency issuance are carried out collectively by the network. It is the first shared incentive network that reached mass adoption.

References:
Bitcoin Official Docs

What is Ethereum?

As bitcoin gained in popularity, people realized that blockchain could be used for things other than just money. In 2015, Ethereum was created as a general purpose blockchain that can be used to power applications that everyone can use and no one can take down. It’s called the world’s programmable blockchain. Ethereum enables its users to build decentralized networks with memories for a whole lot of other applications and not just peer to peer digital currency.

How does it work?

In the Ethereum universe, there is a single, canonical computer (called the Ethereum Virtual Machine, or EVM) whose state everyone on the Ethereum network agrees on. Everyone who participates in the Ethereum network (every Ethereum node) keeps a copy of the state of this computer. Additionally, any participant can broadcast a request for this computer to perform arbitrary computation. Whenever such a request is broadcast, other participants on the network verify, validate, and carry out (“execute”) the computation. This execution causes a state change in the EVM, which is committed and propagated throughout the entire network.

The above is copied from Ethereum website’s official documentation. Ethereum is built on top of the bitcoin blockchain concepts: the validators are the miners and they are incentivized to perform the computation by collecting ether, the native cryptocurrency of ethereum. Additionally, Ethereum allows application developers to upload programs into EVM storage. Users can then make requests to execute these code snippets with varying parameters. These programs uploaded to and executed by the network are called smart contracts.

Anyone can create these contracts and make it public to the network, using the blockchain as its data layer, for a fee paid to the network. Any user can then call the smart contract to execute its code, again for a fee paid to the network.

References:
Main components of Ethereum system
Ethereum in 25 minutes
Ethereum Official Docs

What are Decentralized Applications (dApps)?

Smart Contracts and dApps are used interchangeably but most times dApps refer to applications built on a decentralized network that combine a smart contract with a front end user interface.

A dApp has its backend running on a decentralized peer to peer network. The front end can be written in any language making calls to this backend.

Aside: dApps can host the frontend code on decentralized storage such as IPFS

A well-designed decentralized application user experience may not seem so different from a typical web app, but it differs from the latter in that it lacks servers, HTTP, and potential censorship.

dApps development is attracting a lot of talent and evolving at a tremendous rate. Some big dApps like UniSwap(crypto exchange), CryptoKitties (gaming), OpenSea (NFT marketplace) are already being used by millions of people. The strongest use case for a dApp today is perhaps Decentralized Finance (DeFi), more on this below.

References:
dApps — visual explanation
State of dApps — 2021

What is Decentralized Finance (DeFi)?

DeFi is an application that runs on the blockchain and has capabilities to act as a traditional bank. These applications are pieces of code that runs a program on the blockchain and are open for everyone to read. The service fee of these applications are generally much less compared to traditional financial institutions.

Unlike a bank or brokerage account, a government-issued ID, Social Security number, or proof of address are not necessary to use DeFi. More specifically, DeFi refers to a system by which software written on blockchains makes it possible for buyers, sellers, lenders, and borrowers to interact peer to peer or with a strictly software-based middleman rather than a company or institution facilitating a transaction.

DeFi applications provide users with more control over their money through personal wallets and trading services that explicitly cater to individual users instead of institutions. Below are some important concepts to know when discussing DeFi:

  1. Stablecoins are cryptocurrencies matched to a real world asset. Examples: USDC, Tether, DAI are all stablecoins whose values are pegged to the US dollar. By being backed by a reserve asset like the US dollar, stablecoins provide the volatility free valuations of fiat currencies to the cyrptocurrencies market.
  2. Lending and Borrowing is supported using smart contracts. These contracts provide the framework by encoding the terms and activities necessary to conduct transactions between the lender and the borrower.
  3. Decentralized Exchanges (DEXes) allows users anywhere in the world to trade crypto without an intermediary. “Code is the law” is the phrase everyone accepts in the crypto community. Unlike the traditional centralized exchanges like Coinbase, Binance, etc. DEXes are not regulated by anyone. These applications operate based on the open source code that is accessible to everyone. Some very popular DEXes you might have heard about are Uniswap and PancakeSwap.

Resources:
Introduction to Uniswap

Conclusion

I really enjoyed wring this. I hope you find this overview useful. If you find any errors or mistakes, please let me know in the comments.

Part 2 of this post can be found here.

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Piyush Sharma

Piyush Sharma

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