Apis Insights
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Apis Insights

Cryptocurrencies and How They Work

Blockchain Technology

How blockchain works

Distributed nature

Immutability

Security

Types of Cryptocurrencies

Tokens

Bitcoin

Altcoins

  • Networks (known as“Layer 0”): Once the infrastructure is in place, and the nodes are setup to communicate with one another from a hardware standpoint, the next objective is to ensure each one of these nodes can engage with one another. In practice, the network layer is what enables fundamental operations on the network such as node discovery, device authentication, block propagation and synchronisation across all nodes.
  • Protocols (known as “layer 1”): This layer outlines the “rules” of how the parties will operate the blockchain itself. An example of such rules includes how the consensus algorithm will operate (i.e. how nodes will come to agreement) or even how miners will be rewarded for solving cryptographic puzzles.
  • Services (known as “layer 2”): This layer opens up a new level of sophistication for the technology. Indeed, the service layers refers to an additional set of tools that can be setup onto the blockchain to enable new “features”. This is the layer in technology that enables “digital asset” properties to emerge. A host of other features, such as data storage or communication, also become possible in this layer. In more concrete terms, this is the layer that enables the storage of cryptoassets on Coinbase, for example.
  • Applications (known as “layer 3”): Another level of sophistication is enabled by the third layer, known as the application layer. This layer is what allows end users interact with the blockchain and deploy the services contained in Layer 2 towards a specific end. These ends can take endless forms, ranging from games (e.g., CryptoKitties) or even compliance solutions (e.g., KYC-Chain). Applications on this layer are commonly referred to as “dApps” and can be compared to mobile phone apps in our mobile analogy.

Stablecoins

Non-Fungible Tokens (NFTs)

Other Tokens

Benefits of Programmable Assets vs. Traditional Instruments

Disintermediation of the financial system

Programmable (composeable) money and financial assets

  • Oracles: One of the first capabilities to highlight is the ability to bridge the on-chain and off-chain worlds. Oracles — known as blockchain “middleware” — are the medium that allows information that is off-chain be incorporated into on-chain transactions. This ensures that external information, such as the price of a particular commodity for example, can be incorporated in an autonomous and real-time way. Through these Oracles, blockchains can transcend beyond their virtual context and effectively be used to operate in concert with the “real world”. This makes it possible for a host of data points, such as the price of a commodity or even flight status data (as explored in the next point), to be brought onto the blockchain in real-time. As shown, Figure 10: Comparison of Partners Using Oracle Technology, Chainlink (LINK) and Band (BAND) are by far the most prominent protocols in this regard. In fact, the founding thesis of Chainlink was to greatly enhance blockchain capabilities by “enabling access to real-world data, events, payments, and more without sacrificing the security and reliability guarantees inherent to blockchain technology”.
  • SmartContracts: Another feature to highlight is the programmability, and therefore the versatility, of the technology. Much like smartphone apps have revolutionised how we use our phones and lead our lives, dApps enable the embedding of intelligence within cryptocurrencies towards an endless range of use cases. SmartContracts are a useful illustration of how revolutionary the ability to build intelligence into an asset really is. Suppose two parties have agreed to perform a transaction on a given date and at a given price. By building a SmartContract on the Ethereum blockchain, the two parties in question can effectively program the terms of the agreement, ensuring that it is executed in the way they have agreed, without any third-party intervention and without any tampering. The company Etherisc provides a useful illustration of how this concept works in practice. In 2017, the company started offering blockchain-based insurance for passengers wanting to protect themselves against flight delays. The product — unsurprisingly named Flight Delay — which was developed using Ethereum SmartContracts, allows passengers to receive an indemnity payment should their flights be cancelled or delayed. As mentioned above, flight status data can be synced into the contract in real-time through the oracles. While the product is conceptually simple, it illustrates the depth of the capability of Ethereum SmartContracts: in this particular instance, the technology is used to price risk, act as a transaction mechanism, and administer the contract, without third party involvement.
  • Automated Market Makers: Automated Market Makers (“AMM”) represent yet another example of how the programmable nature of cryptocurrencies can be leveraged in practical financial applications. Typical exchanges work by having order books that are used to record all “buy” orders and all “sell” orders. External parties, known as market makers, are then involved to “make the market” by always being available to take the other side of a “buy” or a “sell” order, earning a margin on each trade by buying at a slight discount and selling at a slight premium. Without these market markers, exchanges would become illiquid and could not function, making them an essential third party between traders. In contrast, AMM are exchanges that are setup to automatically provide liquidity for certain crypto trading-pairs, for example ETH/BTC. Liquidity pools are set up, with a proportion of each asset from the pair invested in the pool. The trading price for the pair is determined by an algorithm that evaluates the quantity of each asset in the pool: in our example, the more ETH there is relative to BTC, the lower the price of ETH becomes, and vice versa. Trades are executed via SmartContracts, eliminating the need to have an external market maker. AMMs are also permissionless, thereby ultimately increasing the size of the market that they create. Indeed, by not having any hurdles to entry, more participants can enter the market. For any market, liquidity is fundamentally a key challenge to overcome, but through AMMs we can appreciate how the creation of the relevant blockchain application can address the liquidity challenge for crypto assets. The first AMM to be created was Bancor, which went live in 2017, though more popular ones — such as Uniswap, Sushiswap, and Balancer — have since emerged.

De-dollarisation

A reliable store of Value

Digital Coordination Layer

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