Web3 for TradBiz — Web3 and Crypto Foundations (4 of 14)
Crypto and Web3 basics
Understand how blockchains work, the role of crypto keys, passwords and wallets, blockchain design tradeoffs, and the Web3 tech stack
Before exploring Web3 use cases and business implications, it is important to start with a few foundational basics. These include understanding conceptually how blockchains work, the role of crypto keys, passwords and wallets, tradeoffs in blockchain designs, and the emerging Web3 technology stack. If you’re already familiar with these topics, feel free to jump ahead to the next chapter, Advanced Web3 topics.
Let’s start with the blockchains and other distributed ledgers that provide the foundation for cryptoassets and Web3. Think of a blockchain as a ledger containing transaction data and account balances, much like any other spreadsheet or database, but that are replicated, shared, updated, and synchronized across a distributed network of computers, or nodes. The key breakthrough is that blockchains provide mechanisms for ensuring that everyone using them agrees on the value of all the transactions, without any one entity owning or controlling the network. Blockchains solve the so-called double-spending problem, preventing any specific cryptoasset from being used more than once.
A blockchain like Bitcoin works when a transaction is initiated by a user holding some of the blockchain’s cryptoassets, or tokens. The requested transaction is broadcasted to a distributed, peer-to-peer network of nodes, which run an algorithm to authenticate the transaction. These validated transactions are then combined with others to form a new block, which is added to the end of the blockchain. Each block records the permanent, time-stamped transaction transparently in an immutable, or non-changeable manner. In this way the requested transaction is completed, with any changed balances recorded in the appropriate users’ addresses. Many blockchains also provide additional functionality enabling smart contracts, other kinds of digital assets, and the wide variety of use cases that we will explore later.
Blockchains can be public, private, or a hybrid blend of both. Public blockchains like Ethereum and Bitcoin are permissionless, meaning that anyone with the appropriate technology and resources can participate. Blockchains can also operate privately, such as when organizations adopt technologies like Hyperledger to enable industry-specific supply chains and other processes. Still others, like Ripple, operate as hybrids, with transactions processed privately, but relying on a public blockchain for finality.
Users interact with blockchains using wallets, crypto keys, and backup seed phrases. Private and public cryptographic keys determine the digital identity of users in crypto ecosystems, enabling them to complete transactions which are recorded on the blockchain. These keys are stored in software or hardware based crypto wallets. For a basic value transfer transaction, a sender signs a transaction using their public key, which is then validated by the network, transferring the value to the receiver’s public address. Wallets increasingly allow users to recover their private crypto keys using a series of 12–24 simple words generated by the crypto wallet, providing users with back-up access to underlying private keys, even if the wallet is destroyed or lost.
Every blockchain makes tradeoffs between scalability, security, and decentralization. The Crypto Trilemma refers to how blockchains can only maximize two of three dimensions — scalability, decentralization, and security — which forces trade-offs in network design. Scalability is determined by network throughput, typically measured in the number of transactions per second. Security is the ability to ensure immutability of the data that has been recorded on the blockchain, as well as resistance to attacks from malicious actors. Decentralization is the degree of diversification in ownership, influence, and value in the blockchain.
Every blockchain’s design has made tradeoffs that provide different profiles of scalability, decentralization, and security. For example, Bitcoin is arguably the most decentralized and secure blockchain, but is limited to an average of five transactions per second and a 10-minute transaction confirmation time. Ethereum, an open source blockchain with smart contract functionality launched in 2015, is the second largest cryptoasset in market capitalization and provides the foundation for many Web3 use cases. Ethereum performs a bit better than Bitcoin, at 12–25 transactions per second with a six-minute confirmation time, while still providing good decentralization and security. On the other hand, Solana, a competitive chain to Ethereum, processes about 2,800 transactions per second with an average processing time of less than one second;¹ however, the Solana network is far more centralized than either Bitcoin or Ethereum, with just 1,861 validators² compared to Bitcoin’s 15,75²³ nodes and Ethereum’s 407,550 Beacon network validators.⁴
Blockchain teams continue to evolve solutions to address the crypto trilemma trade-offs. These solutions include developing more recent consensus mechanisms like Proof-of-Stake, enhancing layer one protocol performance with sharding to split blockchains into smaller partitions, and increasing block sizes to store more transactions. Newer innovations include creating layer two solutions like state channels, off-chain computing, and side chains that increase transaction volumes while leveraging the underlying security of an existing layer one chain.
Blockchains also use different types of mechanisms to validate transaction and maintain consensus across their networks. Proof-of-Work (PoW) was the first consensus mechanism implemented for a blockchain, commonly associated with Bitcoin. With PoW, network nodes compete by solving mathematical puzzles in a process called mining, to earn the right to create the next block in the chain. PoW chains are often both decentralized and secure, but operate at low transaction speeds and high energy intensity, as miners need significant capacity of advanced servers to solve puzzles quickly.
Proof-of-Stake (PoS) was conceived to address some of the limitations of PoW. In PoS, validators are selected from a node pool based upon the amount of cryptoassets each has staked in the network. Transaction fees charged by the network are used to incentivize validators, with some platforms also offering block rewards. PoS networks have the advantages of being energy efficient, performing at higher throughput, and maintaining high security; however, they also risk higher centralization as the validators with the largest holdings have increased influence. Many newer blockchains use some form of PoS as their consensus mechanism. Importantly, Ethereum is currently in the process of transitioning from its original PoW mechanism to a new PoS model, which will make Ethereum far more energy efficient and pave the way for planned scalability enhancements.
Smart contracts are programs stored on blockchains that run when certain conditions are met. These programs consist of code, called functions, and data, referred to as state, that run when certain conditions are met and verified by the nodes.⁵ Smart contracts provide the building blocks for automating transactions and decentralized applications, such as transferring cryptoassets, rewarding users, and sending messages or notifications. Smart contracts are often coded in a dedicated programming language like Solidity, Ethereum’s JavaScript-like native language. Virtual machines are required to interact with and deploy smart contracts on a network. These are sandboxed programs that emulate an entire computer system, including CPU, memory, and storage.⁶ The Ethereum virtual machine (EVM) is the most widely used virtual machine. While native to the Ethereum network, the EVM has also been adapted to work on many competitive blockchains. Smart contracts enable blockchains to do much more than simply send and store units of value like Bitcoin does. In fact, the bulk of Web3 use cases discussed in this series are built on blockchains that make extensive use of smart contracts.
Many different types of crypto tokens have emerged, with associated token standards to ensure that smart contracts and applications are consistent and composable. For example, Ethereum tokens are referred to by their Ethereum request for comment (ERC) number. ERC-20 is the standard for fungible tokens, widely used in Ethereum-based projects in value, staking, governance, and other use cases. Non-fungible tokens, referred to as NFTs, often utilize the ERC-721 standard to develop and trade collectibles, profile pictures, art, access keys, and other virtual assets. A growing number of other ERC standards exist to meet a wide variety of use cases, such as preventing accidental burning of tokens (ERC-223), building more functionalities on top of tokens (ERC-777), bundling transactions (ERC-1155), and accommodating subscription models (ERC-1337).⁷ ⁸
Web3 ecosystems are categorized into four layers that we refer to as the Web3 technology stack. Let’s use what we’ve learned so far to see how this all comes together in the Web3 technology stack. It’s useful to think about Web3 ecosystems categorized into one or more of four layers: protocols, enablers, applications, and wallets and custody. Protocols, such as Bitcoin and Ethereum, are the underlying layer one blockchains and other digital ledger technologies that process and store transactions. Enablers are layer two solutions that improve protocol extensibility and scalability, including helping to address the crypto trilemma challenge discussed earlier. These include Ethereum rollups, state channels, sidechains, oracles, and bridges. Distributed applications, or dApps, are layer three solutions built on top of blockchains that cater to specific use cases and value propositions. As we discuss later, there are already thousands of dApps operating across nearly 100 use cases at various stages of development and user adoption. Finally, layer four is composed of the mechanisms for using and protecting cryptoasset keys and related data, including crypto wallets as well as institutional custody solutions.
Crypto regulations are lagging but catching up. We’ll finish up this chapter by briefly discussing how regulators are approaching the Web3 space. This is a complex topic, as regulations are in flux and different across jurisdictions around the world; however, we believe it is safe to assume that regulators will increasingly address crypto, and that a balance will emerge between enabling innovation while putting in place frameworks for taxation, fraud, securities, and consumer protection.
The U.S. currently treats cryptoassets as property, which means that the gains or losses from trades are subject to capital gains taxes. The U.S. Securities and Exchange Commission (SEC) has also issued guidance that the sales of tokens classified as securities must be registered, expanding the use of the Howey Test to determine when cryptoassets are securities. Exchanges offering security tokens trading must also be registered with the SEC. On the other hand, the U.S. Commodity Futures Trading Commission (CFTC) classifies cryptoassets as “commodities” under the Commodity Exchange Act, making them subject to the agency’s compliance oversight.
Cryptoassets are also subject to anti-money laundering (AML) and know-your-customer (KYC) requirements. For example, the Financial Crimes Enforcement Network (FinCEN) published in 2013 that crypto service providers fall under money services, making them subject to AML/KYC measures. Exchange users are therefore required to submit identity documents, addresses, credit cards, and bank account information as part of the registration or onboarding process.
With both the SEC and CFTC vying for control over cryptoasset regulation, the market is waiting for more explicit guidance from the U.S. executive and legislative branches that has yet to arrive. In March 2022, U.S. president Biden issued the Executive Order on Ensuring Responsible Development of Digital Assets, calling for an inter-agency exploration of crypto regulation, including user protection, financial stability, national security, innovation, financial inclusion, and technological support.⁹ As a response, the U.S. Treasury and Justice Departments released separate statements that they will be working closely with international partners to monitor and prevent illicit cryptoasset-related activity, bridge regulatory gaps across countries, promote inclusive access to financial services, and develop standards for digital payment architectures.¹⁰ ¹¹
From the legislative branch, the U.S. House of Representatives introduced the U.S. Virtual Currency Market and Regulatory Act in 2021, which would have required the CFTC to recommend enhancements to existing U.S. crypto regulations, but failed to pass in the Senate. In June 2022, the Senate began reviewing a bipartisan proposal, the Lummis-Gillibrand Financial Innovation Act, which aims to guide the digital asset space, including making cryptoassets transactions under $200 tax-free, defining most cryptoassets as commodities rather than securities, backing stablecoins with fiat reserves, granting the CFTC with exclusive spot market jurisdiction over cryptocurrencies defined as commodities, and confirming the SEC and CFTC as the main regulators of digital assets.¹²
Given regulatory treatment, there are significant differences between utility and security tokens. While these differences are subject to change based upon proposed regulations, they do provide useful guidance when evaluating the regulatory implications of different Web3 ecosystems. Utility tokens are a unit of account that provide access to the functionalities provided by a network. In many jurisdictions, utility tokens are exempted from laws and regulations governing securities, and therefore are accessible to everyone. Bitcoin has been classified by the U.S. SEC as a utility token given its fully decentralized nature and history. Ether is also considered a utility token by many, including the U.S. CFTC; however, some believe there is risk of security classification due to the initial coin offering (ICO) Ethereum’s founders used to launch the network.
Security tokens, on the other hand, are considered to represent a stake in an investment contract, such as the criteria outlined in the SEC’s Howey Test. These tokens may act like or represent other tradable securities, such as stocks, bonds, and derivatives. As such, security tokens may provide financial rights, such as voting, profit share or dividends. Depending upon proposed legislation, they may be subject to securities laws, such as U.S. SEC regulations and AML/KYC. Tokens classified as securities by the SEC may limit ownership to institutional and accredited individual investors. Some Web3 projects have even excluded investors in certain jurisdictions, such as the U.S., from investing in their tokens due to potential regulatory risk.
This distinction between utility and security tokens may be transitory, as innovation is leading to a wide variety of additional token types, including stablecoins, central bank digital currencies (CBDCs), governance tokens, non-fungible tokens (NFTs), and more. The hope is that a consistent set of frameworks will emerge from the changing regulatory environment, providing better guidance on how to classify and manage tokens across a wide variety of use cases going forward.
The crypto and Web3 basics that we’ve covered in this chapter provide the basis for understanding more advanced Web3 topics. As a review, we started by defining blockchains and distributed ledger technologies, explaining how users interact with blockchains use wallets, crypto keys, and backup seed phrases. You now know that the Crypto Trilemma causes every blockchain to make tradeoffs between scalability, security, and decentralization, and that there are significant differences between energy-intensive Proof-of-Work (PoW) chains like Bitcoin and Proof-of-Stake (PoS) chains like Ethereum 2.0. We explained how smart contracts programs are stored and run on blockchains, enabling a wide variety of functionality, token types, and distributed applications (dApps). We’ve seen how Web3 ecosystems can be categorized into a Web3 technology stack that includes layer one protocols, layer two enablers, layer three applications, and layer four wallets and custody. Finally, we reviewed how crypto regulations are lagging but beginning to catch up, including the debate about which tokens are classified as securities versus commodities. Equipped with this new knowledge, you are now ready to tackle a few more Advanced Web3 topics.
Monchester Macapagal and Kris Caigas of AcceleratingBiz contributed significantly to the research, writing, and production of this series.
Explore other Web3 for TradBiz insights and resources at acceleratingbiz.com.
Click on the links below to progress through the Web3 for TradBiz series:
[1] Web3 for TradBiz introduction
Web3 and crypto foundations
[2] Why embrace Web3 now
[3] Inevitable Web3 future
[4] Crypto and Web3 basics
[5] Advanced Web3 topics
[6] Using crypto wallets
Use cases and value propositions
[7] Web3 use case categories
[8] Decentralized finance (DeFi)
[9] Non-fungible tokens (NFTs) and the Metaverse
[10] Decentralized autonomous organizations (DAOs)
Web3 implications and opportunities
[11] Web3 impact on TradBiz market and business models
[12] Emerging Web3 investment opportunities
[13] Evidence of mainstream Web3 adoption
End notes:
¹ Disha Sinha, “Top 10 Cryptocurrencies with a High Transaction Speed in 2022,” Analytics Insight, accessed July 17, 2022, https://www.analyticsinsight.net/top-10-cryptocurrencies-with-a-high-transaction-speed-in-2022/.
² “Validators,” Solana, accessed July 14, 2022, https://solana.com/validators.
³ “Reachable Bitcoin Nodes,” Bitnode, accessed July 14, 2022, https://bitnodes.io.
⁴ “Earn rewards while securing Ethereum,” Ethereum, accessed July 14, 2022, https://ethereum.org/en/staking/.
⁵ “Introduction to Smart Contracts,” Ethereum, accessed June 8, 2022, https://ethereum.org/en/developers/docs/smart-contracts/.
⁶ “Virtual Machine,” Binance Academy, accessed June 8, 2022, https://academy.binance.com/en/glossary/virtual-machine.
⁷ “Token Standards,” Ethereum, accessed May 26, 2022, https://ethereum.org/en/developers/docs/standards/tokens/.
⁸ “Lesser-Known ERC Tokenization Standards On Ethereum,” Gemini Cryptopedia, last updated December 24, 2021, https://www.gemini.com/cryptopedia/ethereum-token-standards-erc777-erc1155-erc223-erc1337.
⁹ U.S. President Joe Biden, “Executive Order on Ensuring Responsible Development of Digital Assets,” The White House, accessed May 17, 2022, https://www.whitehouse.gov/briefing-room/presidential-actions/2022/03/09/executive-order-on-ensuring-responsible-development-of-digital-assets/.
¹⁰ Nikhilesh De, “US Treasury Develops ‘Framework’ for International Crypto Regulation,” last updated July 9, 2022, https://www.coindesk.com/policy/2022/07/07/us-treasury-develops-framework-for-international-crypto-regulation/.
¹¹ Jesse Hamilton, “US Justice Department Urges More Coordination to Combat Crypto Crime,” CoinDesk, last updated June 7, 2022, https://www.coindesk.com/policy/2022/06/07/us-justice-department-urges-more-coordination-to-combat-crypto-crime/.
¹² Jacquelyn Melinek, “Proposed bipartisan US crypto bill could be ‘sigh of relief’ for the industry,” TechCrunch, accessed July 15, 2022, https://techcrunch.com/2022/06/08/proposed-bipartisan-us-crypto-bill-could-be-sigh-of-relief-for-the-industry/.
