Reader question roundup!

A collection of reader submitted questions and author submitted answers, lightly stirred.

In this issue:

  • What is ETH2? (reader submitted)

  • What is DeFi? (reader submitted)

  • What are exchange tokens like BNB/FTT? (reader submitted)

  • What is the Hedera hashgraph? (reader submitted)

  • What is a tokenized security? (reader submitted)

The constant flow of news has been crowding out reader submitted questions, so this in issue of Something Interesting we take some time out to work through a bit of the backlog! If you have questions of your own let me know in the comments!

What is ETH2?

“I read this announcement about ETH2 and I was confused what it meant. Can you explain? I hope you aren’t disappointed in me for holding ETH!” -IS

Ethereum isn’t part of my portfolio but I don’t think it’s ethically problematic to own ether, unless you are using it to do crimes somehow. Probably don’t do crimes! This is not financial advice.

ETH2 is a sweeping set of planned upgrades to the Ethereum platform that are intended to address scaling issues, lower fees and also move Ethereum from a proof-of-work (PoW) platform like Bitcoin where miners prove their honesty by burning electricity and computation power to a proof-of-stake (PoS) platform where miners prove their honesty by putting money at 'stake' that they will lose if they get caught cheating. Advocates for proof-of-stake hope it will provide the security benefits of proof-of-work without the environmental impact. I personally am skeptical.

Ethereum has been working on the migration to ETH2 since 2014 and is nearing the first major milestone, where they are asking interested users to migrate their ETH by burning tokens on the ETH network in exchange for ETH2 tokens locked in a staking contract. Withdrawals from staking contracts are not yet implemented but are planned for a future upgrade. If I did hold ETH I personally would probably wait a while before migrating!

What is Decentralized Finance (DeFi)?

"What the heck is this DeFi stuff?" - SS

People often refer to the collective set of products and platforms built on top of Ethereum as Decentralized Finance or DeFi for short. The idea is that everything that has been built in the traditional finance world has an implicit decentralized counterpart that can be built with cryptocurrencies.

There is a whole exotic pantheon of strange financial products you can play with but to a first approximation they allow you to create tokens, trade tokens or lend/borrow tokens. Those are powerful primitives so they can do interesting new things like create flash-loans that are borrowed and paid back within a single (complex) transaction, allowing infinite credit for the borrower and zero-risk returns for the lender.

Right now it is difficult to ascertain which of these new tools (if any) is creating genuine value because speculation is so rampant in the space that it dominates actual usage signals. Nominal yields on DeFi financial products are very high - but so are the risks. Crazy exploits happen in the space all the time. And there is reason to be worried about how well a market that is so deeply built on leverage will handle the inevitable down turn in the next bear cycle. Caveat emptor.

What are exchange tokens like BNB/FTT?

“Can you explain stuff like the Binance tokens and FTT?” - SS

Sure! As far as I can tell the first exchange token originates with a hack at BitFinex in 2016 where the hackers stole ~120k Bitcoin. Rather than declare insolvency BitFinex decided to socialize the losses across all users and give them each "Return Rights Tokens" (RRT) corresponding to the USD value of the loss. That wasn’t an especially legal strategy but it worked surprisingly well? RRT tokens traded for between $0.05-0.20 to the dollar and people kept using BitFinex and they were eventually able to pay back the USD lost to token holders by 2017.

These days a bunch of the major exchanges have launched exchange coins: Binance has Binance Coin (BNB), FTX has FTX Token (FTT), BitFinex has LEO. You can think of them like airline miles or casino chips - they function as an in-house currency. You can usually use them to pay trading fees on the exchange, and often they will offer a small discount for paying with the in-house token to incentivize you.

Most exchange tokens are functionally an attempt to sell users equity in the exchange company while avoiding pesky securities laws. Binance for example has pledged to use 20% of its profits to buy BNB from the open market and destroy it - more or less exactly like a stock buyback. So many holders of BNB are functionally investing in Binance as a business but Binance can plausibly claim they are just hoping for discounts on their trading fees.

What is the Hedera hashgraph?

“Was wondering if you have investigated hashgraphs, especially Hedera's hashgraph?” - SM

I don’t generally spend too much time investigating individual "ETH killers" because there are so many and they are often deliberately dishonest and confusing to keep people from understanding their sleight-of-hand. A good rule of thumb is that if someone tells you they have improved the scalability of blockchains what they basically always mean is that they centralized the system somehow.

In the case of Hedera what they are doing is being dishonest about what kinds of security guarantees the system can actually offer. Eric Wall has a good teardown for the curious, but mostly this is just another scamcoin:

What is a tokenized security?

“Can you do a breakdown of tokenized securities?” -SS

A bearer asset is a type of asset where whoever holds it (i.e. the "bearer") is by definition the owner. A good example of a bearer asset is physical cash - when someone hands you a $20 bill, you now have $20. Bitcoin is also a bearer asset - the very first digital bearer asset.

Stocks and other securities are almost exclusively not bearer assets. When you own a stock what you actually own is an IOU from an exchange that owns an entry in a clearinghouse maintained by a corporation called the DTCC. When you buy or sell stocks what is actually happening (eventually) is that the DTCC is updating its record of who owns how much. Nothing is actually changing hands.

There are advantages and disadvantages to this system. One of the disadvantages is that it is slow - stocks trade on what is called T+2 settlement, which means stocks you buy today generally don’t clear until two days later. Some folks are very excited about the idea of speeding up trading settlement by transforming all securities into bearer assets, where there is no difference between trading and settlement.

One way to accomplish that might be tokenizing those securities on a blockchain as digital bearer assets. That’s usually what people mean when they talk about "tokenized securities" - storing equity records on a blockchain somehow. It’s an interesting idea, but I’m not convinced it’s especially practical - blockchains are expensive! I also haven’t seen any sign that it is happening yet.