53 In an unbundled ICO Upfront Ventures blockchain and crypto deck

1 A Guide to Blockchain and Cryptocurrency Mark Suster, @msuster

The problem with understanding cryptocurrencies and blockchain is that people conflate too many issues. 2 • Will Bitcoin price keep going up? • Will the fed crack down on Bitcoin? • Will cryptocurrencies disrupt governments? • Will ICOs replace venture capital?

Anti-Authoritarians • Libertarians • Emerging Market Citizens 3 And to understand anybody making arguments in Crypto you of course have to understand their role / biases in evaluating the potential or risks. Incumbents • Governments • Banks • VCs Disruptors • Technologists • Crypto funds Crypto

4 I. What is Bitcoin II. What are Ethereum, alt coins, and Internet 3.0 III. Unresolved problems

5 Bitcoin 2008

6 Bitcoin Bitcoin Blockchain 2013

7 Bitcoin Bitcoin Blockchain “Gold” Software “contracts” Bitcoin Ether Bitcoin Blockchain Ethereum Blockchain 2014

8 Bitcoin Bitcoin Blockchain Bitcoin Ether Bitcoin Blockchain Ethereum Blockchain ICOs Ether Ethereum Blockchain 2015-16 Ethereum’s biggest “use case” to date seems to be helping other coins create a market.

9 Bitcoin Bitcoin Blockchain Bitcoin Ether Bitcoin Blockchain Ethereum Blockchain ICOs Ether Ethereum Blockchain New currency, “alt coins” New Blockchains 2017-18 • Stellar • Tezos • Stratis

10 I like to think of the topic as three distinct layers that are related but need to be understood in their own rights. ICOs Cryptocurrencies / tokens Blockchain

11 Historically digital assets on the Internet have been freely copied and distributed. This obviously doesn’t work when it’s money. Pictures CDs DVDs • Napster • BitTorrent

12 The goal of blockchains is to: P2P computer nodes • Make each digital asset identifiably unique (through cryptography), • Create a record that is trusted (a ledger), • Without a central issuer (decentralized), • And form consensus among computers of which transactions are valid.

13 The foundational concept that underpins digital property rights is cryptography. Input Output Algorithm 6e812e782R52Bx Long string of transaction data, sender, recipient, quantity, amount, etc… “Hash” of fixed length

14 Algorithm Hash Data Data Data Any computer can run the same data through the algorithm and will always get the same hash. This is critical for verification.

15 Algorithm Hash Algorithm Hash A Hash B Data Data Data Data A Data B If you get different hashes, then you know the input data wasn’t identical.

16 Algorithm Hash Algorithm Hash A Hash B Data Data Data Data A Data B Algorithm Hash ? ? ? ? There is no way to run the hash in reverse to figure out the original data, making anonymity & security possible.

17 Cryptographic hashes are just data and can be combined. Hash AB Bob 0.5 Bitcoin debit, Mary 0.5 Bitcoin credit Steve 2.2 Bitcoin debit, Susan 2.2 Bitcoin credit SHA-256 (Secure hash algorithm) Hash A Hash B SHA-256 This hash is a digital fingerprint that represents both sets of transactions. SHA-256

18 Most importantly you can create a single hash that represents all the transaction data. The “root hash” that represents the entire dataset is still just 256 bits. Root Hash ABCD Hash AB Hash CD Hash A Hash B Hash C Hash D Used to efficiently compare large datasets Transaction A Transaction B Transaction C Transaction DTransaction data “Merkle Tree”

19 A “block” is just a row of data that has a hash calculation from an underlying Merkle Tree, so it ensures that the underlying data haven’t been changed. Transaction Data Block Header Root hash of current transaction data + hash of previous header + nonce + timestamp, etc) Components of a block (simplified)

20 A blockchain is a sequence of blocks that stores every transaction and each links to the previous block, so that anyone can easily confirm that the entire data structure is accurate. Rest of headerRoot Hash Current block Genesis block Data Hash of Prev Header Root Hash Rest of header Data Block Header Hash of Prev Header Root Hash Rest of header Data Hash of Prev Header Root Hash Rest of header Data

21 The next big concept is to understand how a trustless and decentralized P2P network works. Historically we required trusted, central authorities. Store of value Transfer of value KYC 3rd party Bank or You Another person Business Financial intermediary Custody, Remediation

22 In a decentralized system you have peer-to-peer nodes that interact with each other. This is how Napster & Skype worked and how BitTorrent works. Decentralized data transfer: • Each user is a “node” that can use the network for free. • The only catch is that while your client is open, the network uses your computer & bandwidth to transfer video files, music files or complete phone calls.(BitTorrent, Napster, Skype) User’s Computer = Node

23 Bitcoin created a P2P network in which nodes were servers attached to blockchain databases. Every node stores every transaction that has ever happened so that a central authority doesn’t need to.

24 New transactions are constantly broadcasted to the network. Every 10 minutes a new block is added to the blockchain representing the new transactions. All nodes update their databases (ledgers) accordingly. But how do they agree which transactions to include?

25 That is where mining comes into play. Mining is nothing more than the computers in the Bitcoin network validating all of the new transactions and competing to be the first node that gets to add the new block to the database. Input: Transactions in the past 10 minutes Output: Hash of fixed length SHA-256

26 Miners are given an output parameter for which they need to guess the input. The only way to get the right hash is for the computer to try billions of random inputs until it guesses the right answer. SHA-256 Input: Recent transaction data + Arbitrary number (“Nonce”) Hash Goal Must start with a fixed number of zeroes 000006e812e782R52Bx

27 This process is called “proof of work” because by iterating through billions of attempts you prove that you’ve dedicated computing resources to the network. 12345 12346 74623 SHA-256 Output Hash Input: Transaction data + Nonce Hash Goal 6e812e782R52Bx 28yB6zXuo87zS2 Iteratively guess numbers until one randomly produces the right result. 000006e812e782R52Bx

28 When Bitcoin started it was just some cheap computers deployed by college students, techies, etc. out of their homes. Easy to solve for the nonce, financial reward was small.

29 When more money could be made people put more CPUs at work and hosted them in faster hosting centers to solve the “proof of work” before others and win more Bitcoin. Many CPUs, higher power machines , professional hosting

30 With more money at stake, smart technical miners found that GPUs (for computer graphics) were faster than CPUs (for general computing) at the “proof of work” task. GPUs > CPUs

31 Eventually the largest miners built special-purpose ASIC chips that beat GPUs. We now have an arm’s race that favors the large & powerful. ASIC This also favors people in low-cost or subsidized electricity countries like China.

32 This first person to solve for the nonce gets Bitcoin (today 12.5 BTC or ~$150,000). With data + nonce other nodes can easily verify by running it through an algorithm. The one- way function is very easy to check. 00000… 74623 SHA-256 Output Hash Input: Transaction data + Nonce Hash Goal 000006e812e782R52Bx

When >50% of Hash power (miners computing power in the network) agree that the nonce is valid, consensus is reached without any authority (decentralized). 33 New block added New block added New block added

34 What should you know about Bitcoin? • Bitcoin is a digital fingerprint that can’t be repeated because two people can’t own it at the same time. • Its use case now is mostly gold (“store of value”). • It’s impractical for a $3 for a coffee due to energy use, transaction fees, latency & lack of price stability (not a great “transfer of value” today) • In the future, someone could create a stable coin whose value doesn’t change much—and which can be used more easily for transactions.

35 I. What is Bitcoin II. What are Ethereum, alt coins, and Internet 3.0 III. Unresolved problems

36 Ethereum’s big idea: besides exchanging money, wouldn’t it be helpful to find other trustless ways of doing business? “Smart contracts” were created. Bitcoin Ethereum Money Smart contracts Blockchains

What should you know about Ethereum? 37 • Ethereum is the most scaled platform where a large number of developers are competing to build infrastructure. • It differs from the Bitcoin use case (i.e. gold) and is more of a platform for software interactions (called smart contracts). • But it could emerge as a dominant platform for distributed apps (DAPPs) platform (time will tell).

38 As an example, businesses today are typically built by a centralized entity which concentrates power and profits. Example: Dropbox $ for storage $M UsersDropbox • Raise venture capital • Invest $$$ in servers to store your documents • Recoup money by charging users fees

39 Smart contracts allow you to build distributed businesses on top of the blockchain where third-parties provide the resources and are rewarded directly. Example: Decentralized Dropbox $ for storage UsersNetwork • Provide server space, processing power, bandwidth • Collect a currency / token • Pay a currency / token

40 What is an ICO? It is when an entity creates new coins and sells them to new buyers, today it is usually on top of the Ethereum blockchain. ICOs Cryptocurrencies / tokens Blockchain Initial Coin Offering on Ethereum • Avoid having to replicate the process of creating a whole new blockchain infrastructure • Most popular type of smart contract on Ethereum

41 Be careful of any ICO that doesn’t have an explicit reason to exist to incentivize network participation / resources (otherwise it is just another form of crowd funding and one that is likely to be highly regulated).

Company 42 Distributed applications (DAPPs) get most experienced venture capitalists excited. But what should a VC own—equity or token? Users who invest in tokens to fund development of the service Token ownership Value of tokens

43 • Illiquid  • Relatively stable, with few valuation fluctuations • Governance and shareholder rights; management lock up due to stock agreements and illiquidity • Liquid (unless new governance rules) • Potentially huge daily price fluctuations • Potential moral hazard without governing rules Equity Tokens

44 Why are alt coins created and what are they? • We’ve seen the emergence of Bitcoin and Ether. Those currencies represent > 50% of the value of all currencies. • There are companies creating new coins (ecosystems), which are known as “alt coins” (Litecoin, Monero, Ripple) • Alt coins can be built on top of Ethereum or you can create your own blockchain. • Whether any alt coins becomes valuable depends on the value they provide and how they incentivize network participants to participate.

45 Why do people refer blockchain networks as “Internet 3.0”? IP TCP HTTP HTML Open protocols beat proprietary “closed” networks. “Walled garden” The big Internet companies built on top of open protocols but then made each of their systems proprietary, making it hard for new companies to compete. Internet 1.0 Internet 2.0 Internet Protocols X

46 Big Company Protocol User identity User bank details Social graph (who you know, how well you know them) Interest graph (how they serve relevant ads) Reputation (am I a 5 or a 2 when I work with people?) Big companies establish a “network effect” and lock you in because through all of your data they are more efficient at serving you than any other startup could be.

47 • Google & Apple can charge a 30% tax on apps. • Apple can decide it doesn’t like fart apps. • Facebook can decide how to promote news & media. • Google can display shopping competitors, flight information, hotel booking and stop referring traffic. Big Company As a society we’re starting to see the consequences of this, which could get worse if power concentrates even further.

48 Internet 3.0 is a possibility to return to a decentralized web where the big companies have less control. If BigCo services were blockchain protocols then users could “port” their information more easily to new startupsIP TCP HTTP HTML Identity Banking Reputation Socialgraph Interestgraph

49 I. What is Bitcoin? II. What are Ethereum, alt coins, and Internet 3.0 III. Unresolved problems

50 Blockchains are showing signs of not scaling well today. A whole series of companies are emerging to perform work not completed by the core blockchain Side chains “Level 2” networks “Layer 2” networks Block N-1 Root hash Other info Block N-2 Root hash Other info … Block 1 Root hash Other info Block 0 Root hash Other info Root hash Other info 1

51 If hash power becomes centralized, then blockchain loses its decentralization properties. • Remember that consensus is achieved when >50% of hash power achieves consensus. • So if the nodes are concentrated (owned by a few players) then the system is less independent. • For example, what if state actors (Russia? North Korea? US?) decide to secretly put resources into a given network. 2

52 It’s one thing to have a trustless transaction with a person, but what happens when I can’t trust the code? The DAO project had a software wallet with a bug such that a hacker was able to exploit a bug to the tune of $50 million (later recovered). When dealing with “trusted” companies, there is at least remediation. Code Ethereum Trustless transaction 3

53 In an unbundled ICO world, how do you stop management teams from leaving with millions without even delivering value? ICOs Cryptocurrencies / tokens Blockchain • Need legal governance • Likely to see SEC oversight • How to stop pump-and-dump coin trading if coin owners are anonymous (especially since there are private groups now collaborating on encrypted messaging networks like Telegram & Signal)? 4

54 We are lacking mechanisms to enforce governance and world order. If the transactions are partially anonymous, then how do governments: • Track the flow of money to terrorists, white supremacists, criminal gangs? • Track the flow of illegal “money of influence” to state actors? • Manage large economies and not give up control of money supply? 5

55 In the end, the boom-and-bust of over-investment that also attracted a lot of innovation will eventually lead to a future wave of huge future investment off of the back of today’s ashes. We’ve seen this before: • Cable • CLECS/DSL • Wireless • Internet 1.0 We are somewhere here Time Euphoria / value

56 A Guide to Blockchain and Cryptocurrency Mark Suster, @msuster