Governance determines how the rules of the underlying network are set and maintained. The more parties that are able to contribute to governance debates, the more decentralized the governance. While participation measures active contribution, transparency measures the visibility of discussions affecting rule making. If such discussions are only visible to a limited group, it centralizes decision making in ways that Evaluators and users cannot easily see.
Is the governing authority for the DID Method innately centralized? Is the Method governed by a single entity, who could make arbitrary changes to the governance? Or is it governed by a closed set of parties, without fully open access? Or is there a legitimate effort to open the decision making process to multiple, competing and cooperating parties?
If the goal of a Method is to enhance or support a certain group, then there may be centralization focused on that group and their interests. In the most centralized extreme, a Method may be created explicitly to establish a monopoly market that it can extract rent from. The opposite extreme is a Method created explicitly for the public good. Governance takes resources, which can limit the ability of interested parties to influence rulemaking.
Generally, the more expensive it is to participate, the more governance centralizes to those parties most able to make the investment. Permissioned operation impacts the availability of the network to various participants, which can affect inclusivity with regard to underserved or vulnerable populations. Permissioned networks also expose the permission giver to legal or other attacks.
Similar to Governance, financial accountability reflects the integrity and sustainability of the DID registry. The more open, transparent, and accountable the system, the greater the confidence a DID controller may have that it will remain stable and operational, and therefore continue to provide service.
Does the DID Method restrict access or functionality to particular wallet implementations per the specification? Whether or not any given wallet works with the resolver or registry is covered elsewhere. Vice versa, limited capability to work with other Methods and registries restrict usage.
How much memory is required for DID resolution, without relying on authoritative intermediaries e. We consider the amount of memory required to fully resolve a DID of the method, whether that memory is stored locally or processed ephemerally via communications. Whether or not one can resolve a DID directly on a resource-constrained device affects the granularity at which smaller devices can be part of the ecosystem. If small edge devices, such as a smart watch, smart speaker, or even a mobile phone, are incapable of directly resolving a DID of the DID Method, then the method will lead to cloud-based services like blockchain explorer APIs, which themselves become a point of centralization.
Many find this option an acceptable engineering trade-off. Others would prefer solutions that allow even the smallest devices to be fully capable of resolving DIDs in an authoritative manner. What are the minimum resources required to create a trusted DID without relying on intermediaries? Being able to create a DID in constrained situations enables certain types of decentralized applications that otherwise are not possible.
On the edge, many devices rely on gateways to manage compute-, memory-, and bandwidth- intensive tasks. For example, while a smart lightbulb might use ZigBee or 6LowPAN, it will typically use a hub to connect to the Internet, even for access from devices within the local IP network. The more resources it takes for small devices to participate in registration, the greater the percentage of those that will need to rely on centralizing factors like hubs and gateways.
Different Methods enable different scopes in which a DID might be considered usable or valid. Contextual DIDs are a middle ground that allow a set of parties to use DIDs, while those outside that group cannot meaningfully do so. Trustlessness is a prerequisite of a decentralized system. If you have to trust the source of a DID Document i. If, instead you have a cryptographic audit trail, then the current state of a DID cannot be compromised by an intermediary or central party.
The matter of enforcement is a tricky question, one that the authors did not have sufficient time to explore and resolve. Although we are forced to leave this section for future collaboration, we want to share some of our insights. In state-level governance, enforcement is an operational matter for the police and a judgmental matter for the courts. In other words, the police and the courts constitute the enforcement powers of governance.
For distributed systems, especially those like Bitcoin and Ethereum, enforcement is a function of both social and technical functions. Technical enforcement could include such notions as which cryptography is used to ensure proper authentication of transactions or the details of a consensus mechanism such as proof of work POW or proof of stake POS.
Should a given cryptographic technique prove to be compromised, that would affect the ability of the system to enforce its own rules, making the specific cryptography used by a given Method a significant factor in evaluating the suitability of a given Method. Further, understanding the decentralized nature of a given POW or POS mechanism requires an Evaluation of both the means for executing the mechanism as well as a profile of those parties who could potentially influence or even undermine that mechanism.
Social enforcement mechanisms rely on community or institutions. For Methods that have explicit governing bodies, like did:sov, presumably enforcement is a matter under their jurisdiction. Nodes on the network that operate outside the guidelines of the governing bodies can presumably have permission revoked as a means of enforcement. Methods that do not have formal governing bodies may, nevertheless, have a strong enough community to correct violations, as Ethereum did in response to the DAO hack.
Finally, all Methods operate in and across one or more geographic jurisdictions, each with potentially distinct laws and mechanisms of enforcement. Identifying the potential enforcement mechanisms that could apply to the Method, to those using a Method, or to the operators of a Method, is almost certainly going to be relevant to certain Evaluator s.
We have already seen GDPR and various US laws being applied based on where different servers are physically located, with lawsuits brought against server operators. It is inevitable that similar actions will eventually be brought against DID Method operators at various levels.
In short, understanding the process for identifying violations and enforcing the rules as set by the rulemakers is vital to a complete Evaluation of the decentralization of a DID Method. We regret that we were not able to sufficiently explore these issues for this rubric and we look forward to working with subsequent collaborators to flesh out criteria that can provide suitable guidance for enforcement criteria. For each major software component Wallet, Resolver, and Registry , ask each of the following questions.
In this section, because DIDs are so early in the development lifecycle, most DID methods in production have only one implementation and some have none. Therefore, we have not standardized the responses nor provided examples. Consider these open-ended essay questions for consideration. As the market matures, this subset of questions will improve. If there is one dominant implementation, how many programmers would need to be compromised to get a back-door into distribution?
Similar to the alternatives section, this section is limited because DID methods are just beginning to reach production, and so we have minimal knowledge of current adoption. As the market matures, we anticipate this section improving. Security has a strong influence on overall trust in the ecosystem. Different DID methods offer different security guarantees, or guarantees of different strengths.
What is the lowest security level "bits of security" provided by the combination of algorithms and key types that the method requires its implementations to support? A DID method that requires implementations to support something weak e. Does the system use cryptographic and security primitives that are well vetted by technical experts, and battle hardened in the school of experience?
Exotic crypto and other security mechanisms without expert review and a production track record is likely to contain hidden risks. How friendly is the system to adopting post-quantum crypto, larger hashes, or other measures that upgrade its security?
A DID method that is hard to upgrade with respect to crypto creates incentives to remain with deprecated algorithms beyond their useful lifespan. To what extent is the entropy used to create an identifier demonstrably connected to the party that created its inception key? An identifier that has a predictable or manipulable value, or that has inception keys that anyone could have created, is an attack vector.
How robust are protections against attempts to suppress information flow, whether legal cease and desist or technical denial of service? Control over an identifier is far less valuable if the propagation of that control can be limited by someone else. Availability is the "A" in the security evaluation acronym CIA. Is the current state of a DID document provably correct from a history that's visible to anyone who can resolve the DID? It's possible to tamper with systems that don't actively prove the correctness of their current state.
Such tampering is not easy to discover. Is the code of the method published, does it have many contributors, and does it have a published vulnerability reporting responsible disclosure mechanism? Security vulnerabilities tend to be found and fixed best in code that has many active contributions and a strong history of correctly handled responsible disclosure. To what extent does the system support mechanisms where DID control is distributed across multiple parties m-of-n control, threshold signatures, etc.
Diffuse trust makes hacking harder and recovery more robust but maybe more complex. Does the system use cryptographic mechanisms that satisfy legal requirements in relevant jurisdictions e. When DIDs are used as identifiers for people, it becomes important to consider what tools a DID method offers to operate at different levels of privacy.
Use cases that focus on IoT or institutions may not feel that this dimension is especially important though institutional privacy may sometimes be desirable. Privacy tends to surface some interesting tradeoffs. For example, DID methods that score very high in the "transparency" dimension may score low in privacy, and vice versa. What provisions are made for restricting visibility of DIDs to audiences other than the general public? Restricting the audience for a DID is a way to discourage crawling and secondary, possibly abusive publication.
Inferring relationships between Bitcoin addresses allowed law enforcement to track down the operators of Silk Road, even though those operators believed they had privacy. To what extent does the method incentivize due to cost, hassle, etc.
People will often trade away privacy for a low price or ease of use. Methods that encourage this tradeoff are less optimal from a privacy perspective, even if their privacy features are theoretically reasonable. How are mistakes corrected, and how is the right to be forgotten addressed? Note how this creates a tension with immutability, which may be valuable in 2.
Does the method acknowledge privacy risks in service endpoints and other forms of DID document data, and provide technical, policy, or explanatory safeguards? We reviewed a lot of proposed criteria for inclusion in this rubric. Not all of them turned out to be a good fit, often because they were simply not related to decentralization.
They were useful criteria for evaluating a DID Method, but we specifically limited ourselves to ONLY consider those criteria that specifically capture some notion of decentralization or its related benefits. We've included a list of additional considered criteria in. Maturity was one of those categories of criteria that we liked, but just wasn't related to how decentralized a Method is. We considered the maturity of the specification, such as how long it has been published.
We considered the organizational maturity of the lead proponents of the Method: is this Method backed by a major player that has been around a while or is its only advocate a small startup? We even considered the operational maturity of the Method: how long had the Method been live, in production? These are all excellent questions to ask when considering supporting, adopting, or contributing to a particular DID Method, but they do not capture anything about how decentralized a Method is.
A system simply doesn't become more or less centralized just because it is around a long time. What can happen over time is that a given Method might improve in its adoption or diversity, as more institutions, users, and platforms add support in various ways, and these aspects of a Method can shift how decentralized a Method might be, but maturity itself does NOT affect centralization. The authors had similar discussions considering security, privacy, and reliability criteria.
All of these are important, but not directly related to the question of decentralization. While decentralization can improve reliability, it can also undermine it if done poorly. Similarly, security and privacy don't necessarily impact decentrality and vice-versa. We encourage everyone using this rubric to consider it as one tool for evaluating only the decentralization aspect of DID Methods. Other Evaluations will also be necessary to make a fully informed decision about adopting, supporting, or contributing to any given Method.
It offers a set of criteria which can be used selectively by Evaluator s to better understand and document their considerations when deciding to support or adopt a given DID Method. Today, comments are welcome in the Rebooting Web of Trust repository in which this document is published.
Our intention is to move this conversation to the DID WG, should the group accept this contribution as a starting point for future work. DID git Spec. It can use any communications channel between parties. Only those two parties are privy to the decisions made about communications and recordation. The spec is openly developed on github by a listed set of contributors and issues may be raised by anyone. The git network is the git source code, which is controlled currently by 16 people. They do not have a public issues process.
Each registry is controlled by potentially unknown parties as negotiated in "meatspace". Changes to the bitcoin protocol are chaotic and uncertain. They use BIPs, but the path to adoption is uncertain and the relative power of developers, miners, and users is open to debate. The Sovrin Foundation has an open community governance model but has not yet had open elections of trustees.
The network is Ethereum, which evolves through EIPs proposed by anyone, discussed by "the community" and ultimately adopted by Ethereum core devs. The spec is published on GitHub with issues open to the public. The smart contract for the registry is immutable. Jolocom's network is Ethereum. Decisions over Jolocom's smart contracts are made by an unknown group within Jolocom.
Rules for accepting changes to the business rules are bilaterally negotiated between the peers, subject to conformance with the specification. The controllers of the git repo are a limited set, but their decisions are "meatspace protocol" and hence not explicitly transparent. The spec is maintained by volunteers, operating in an open fashion but without formal processes for announcements and meeting notes.
The network and registry are bitcoin, which has a fairly public but messy innovation process, without formal meetings or votes. The Sovrin Governance Framework actually requires all minutes of Sovrin governance discussions are public with a handful of exceptions for legal reasons e. There is only one editor to the did:peer specification, but the repository itself lists 14 contributors with actual commits.
The network and registry rules are ultimately decided by the parties participating in each did:peer context a closed set of peers. There is only one editor to the did:git specification, with a total of three contributors with actual commits although more are listed. The network is git controlled by an unknown population and the registry is a particular repo under the control of potentially unknown parties. The spec lists 4 editors and the repo lists 4 committers.
The network and registry is bitcoin, which relies on an informal process of any number of parties. All three layers are ultimately under the control of the Sovrin Foundation, which itself has a governance framework to coordinate input from multiple parties. A shared characteristic of many truly decentralized cryptocurrencies and many ICO tokens is that they generate their values intrinsically — their values are what everyone agrees their values to be.
In contract, there is another variety of cryptocurrencies called asset-backed cryptocurrencies, which, as the name suggests, generate their values through a pool of collateral e. Stablecoins are a class of cryptocurrencies that seek to maintain price stability with respect to an asset with a stable value, such as U.
There are two main varieties of stablecoins: collateral-backed coins and algorithmic coins. Collateral-backed coins rely on collateral to back the value of the coins. Collateral can be U. The collateral is placed in an account, with a bank or other financial institution, and is subject to audit to ensure that the collateral truly exists and is sufficient to cover the amount of the outstanding obligations.
The Gemini Dollar and the Paxos Standard are both examples of collateral-backed stablecoins. Both are pegged to the U. Algorithmic stablecoins rely on a liquid market of digital bonds to expand and contract the stablecoin supply, thus creating price stability in the stablecoin. NOTE: This dynamic is similar to that used by securities market makers, with the notable difference that market makers are intermediaries that make a market in an instrument issued by a third party.
In contrast, in the case of an algorithmic stablecoin, the stablecoin algorithm itself is responsible for expanding and contracting the supply of the stablecoin. Algorithmic stablecoins substitute monetary supply policy dynamics for collateral as the mechanism for maintaining a stable coin value. The potential benefits of the algorithmic approach include a scalability and automation that may not be feasible with the collateral approach.
Examples include Basis, which pegs its value to the U. Given the variety of cryptocurrencies, it is important for financial institutions and other service providers to understand how regulators view cryptocurrencies and what those views mean from a risk perspective. Howey Co. The factors of the Howey case are: 1 whether purchasers of the instrument contributed money or valuable goods or services ; 2 whether purchasers invested in a common enterprise; 3 whether purchasers reasonably expected to earn profits through that enterprise; and 4 whether the expected profits are to be derived from the efforts of others.
Most of the analysis to date under the Howey case as applied to cryptocurrencies has focused in particular on whether token purchasers rely on the efforts of others with respect to any expectation of profits by those purchasers.
To date, the SEC has demonstrated a very careful and nuanced application of the Howey case to cryptocurrencies that shows an appreciation for the variation among cryptocurrencies. As mentioned above, the SEC staff has distinguished between what it has determined to be truly decentralized cryptocurrencies, bitcoin and Ether, which it believes are not investment contracts and therefore not securities and other types of cryptocurrencies. As a result, decentralization could develop over time, even after an initial token sale launch, and therefore a token that starts its life cycle as a security could at some point become a non-security.
NOTE: This concept of mutability has been expressed in the reverse for example, a loan may start its life cycle as a commercial instrument but end its life cycle as a security , but until now, mutability has not been expressed so as to turn a security into a non-security.
The SEC and its staff have yet to apply Howey or any alternate security analysis to the context of a stablecoin. Under a Howey analysis, it is not clear that stablecoins should be deemed to be securities. A purchaser of a stablecoin has no such expectation; rather, a purchaser of a stablecoin expects the value of the stablecoin to remain constant. We predict, therefore, that stablecoins, as described above, will not be determined to be investment contracts under the analysis in Howey , although it is possible that stablecoins could be deemed to be securities under other rationales.
Interestingly, the NYDFS approval of Gemini Dollar and Paxos Standard makes no mention of securities law and in no way indicates that New York State thinks that the issuance of the collateral-backed stablecoins constitutes the issuance of a security. Whether or not a cryptocurrency is determined to be a security, the Commodity Futures Trading Commission CFTC takes the position that all varieties of cryptocurrencies are commodities for purposes of the CEA.
Perhaps more importantly, however, by virtue of being deemed a commodity, cryptocurrency transactions imbue the CFTC with anti-fraud and anti-manipulation authority. As a result, even when securities law anti-fraud and anti-manipulation authority does not reach a particular transaction, commodities law authority now does. Financial institutions and other service providers that are considering providing cryptocurrency-related services — such as custody, valuation, and lending, among others — will need to consider not only the variety of cryptocurrencies, as discussed above, but also the relevant regulatory treatment of each variety.
For example, a bank that is considering providing custodial services with respect to ICO tokens would want to understand whether the tokens in question are securities, and, if so, what securities regulatory requirements apply to their safekeeping.
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Bitcoin is the original cryptocurrency; the first truly decentralized network for sending and receiving value over the Internet. Irrespective of terminology, the fundamentals of these new tokens can vary, and some may functionally resemble securities when marketed and sold to investors. Cryptocurrencies and tokens, broadly, are truly innovative. That is to say, they present an arrangement of technological components that is so novel and varied as to defy categorization as any traditional asset, commodity, security, or currency.
At root, units of a cryptocurrency are scarce items that can be exchanged and may have market value despite the fact that they have no institutional issuer or legally-promised redemption. In this sense, cryptocurrencies are somewhat like valuable commodities e. However, unlike gold or platinum, cryptocurrencies are entirely non-tangible.
That is not to say, however, that they exist only in the minds or promises of men and women. In a literal sense, a bitcoin is a unique answer to a math problem and proof that you solved that problem 2 or else had the unique record of the solution transferred to your control.
The decision to value these finite solutions and therefore make the effort to uncover them can also be analogized to gold. Men and women need not seek gold. The value placed on gold by society is largely a sort of mutually shared desire or—less charitably—illusion. We could, instead, seek platinum or silver for use as a medium of exchange, store of value, or decorative object. Similarly, those interested in cryptocurrencies could seek answers to alternative math puzzles.
A particular cryptocurrency, say Bitcoin, could even change its underlying math puzzle. However, such a change would be more like the collective actions of gold miners choosing to instead mine silver, and less like a single government choosing a different asset, or no asset, to back its paper currency. Regardless of the particular analogies used to explain the technology, regulators will continually look at how a token is employed, what work it helps a user accomplish, and they will thus classify these activities as within or without their regulatory purview.
Blockstack 12 , automobile loans by e. Visa 13 , document notarizations by e. Proof of Existence 14 , machine-to-machine messages on the Internet of Things by e. IBM 15 , and more. And even if the Bitcoin blockchain is being used for these alternative purposes, some amount of bitcoin will always be involved in order to write to the ledger, even if it is a nominal amount.
These projects may simply use the scarce, fungible, and transferrable nature of a Bitcoin-like token to represent a legal right. Many of these issuer-backed tokens may, transparently, be securities. Other token projects seek to decentralize an online service, just as Bitcoin effectively decentralizes online money transmission, and the tokens that power these networks may more closely resemble valuable commodities used within the ecosystem.
At a conceptual level, Bitcoin is a network of strangers who provide an online service — electronic money transmission and value storage. The bitcoin software specifically its consensus mechanism and its verifiable public ledger the blockchain ensure that participants perform this service faithfully, thus obviating the need for service-users to trust any particular service-provider within the network.
This scarce unit is algorithmically and automatically awarded to the participants based on their efforts to power the service, thus incentivizing and rewarding honest participation in the open network. The scarce unit is also the medium of exchange that users of the service must obtain and then utilize in order to pay for that service. That conceptual model can then be applied to other online services beyond money transmission.
For example, a network of strangers organized through software and public ledgers could be incentivized to provide cloud storage services or cloud computing services, and a scarce unit inherent to that network could be used as a medium of exchange and an automatic reward for honest participants who help provide the service by offering storage or computational power to the network.
Because cryptocurrency development is an open source movement, no one has the last say regarding what anyone of these things should be called, and several terms are used reflecting the various purposes that any particular scarce unit might service within a decentralized service, most prominently: cryptocurrency, token, or coin. These terms are used without precision and interchangeably. The particular term is immaterial as compared with the general idea represented: a scarce unit used as a medium of exchange and reward for participation amongst a network of strangers that collaborate to provide a service.
The second section will identify distinctions amongst various types of tokens and the risks suggested by these distinctions. Fundamentally, Bitcoin or any other token network is merely software running across a network of peers 20 that creates and maintains a shared ledger 21 accounting for holdings of a scarce token. These modifications can result in software that remains compatible with the parent network or ceases to be compatible. An example of a policy rule could be: refuse to relay transactions sending less than a certain amount of bitcoin.
Within a single blockchain, a transaction output cannot be double-spent. To give an example, if someone wants to develop new Bitcoin mining software that is compatible with the existing Bitcoin network but better utilizes her own particular mining hardware, then she may fork the original Bitcoin core software and take care to not alter the consensus rules. She is running forked software but her mining activity does not fork the Bitcoin blockchain.
Peers running this new software will recognize an alternative set of confirmed transactions as compared with the list of transactions on the parent blockchain on their own new network as authoritative. Whenever a group of networked peers persist in running forked software with alternative consensus rules that—therefore—create an alternative blockchain, then these peers will effectively be creating a new token network and new tokens.
The new blockchain will account for holdings of the new scarce token, and participants will be able to use the new network software to send these tokens to each other. Some varieties of forked token software recognize a common transaction history with their parent chains up until the moment of the fork.
For example, Ethereum Classic forked from Ethereum and Bitcoin Cash forked from Bitcoin and both forks recognize pre-fork transactions from their parent blockchains as valid. Other forked token software starts from scratch with a new blockchain that does not include historical transactions from the parent chain. Users can spend or use these new tokens without affecting the disposition of their tokens on the original network and vice versa. A notable example of a from-scratch cryptocurrency is Ethereum.
Alternatively, the developers of the new network could hard-code their own desired set of initial transactions and account balances into the first block. This could list certain amounts of tokens as belonging to addresses already generated by the developers as a reward for their work to develop the new network software, or it could assign new tokens to addresses created for investors who financed these development efforts. Developers could even set the first block to initiate with a transaction history copied from a moment in some other blockchain.
A developer could, for example, decide that the first block of NewCoin will have the exact same set of positive balances corresponding to addresses on the Bitcoin blockchain at midnight Jan 1, As with a forked blockchain, users of the parent chain can, if the so choose, freely spend or utilize the airdropped tokens without affecting the disposition of their tokens on the parent chain. The minting and transmission of these new tokens and their use is policed and described by the consensus mechanism and blockchain of the underlying network.
For example, a random Ethereum user can create 20 units of their own RandomCoin on top of the Ethereum network and send them to Ethereum addresses controlled by her friends. There is no RandomCoin blockchain; the original creation of RandomCoin by our random user and any subsequent transactions to her friends and beyond are recorded in the Ethereum blockchain.
Ethereum is not the only token network that has this functionality, but it is presently the largest. When token software is forked or developed from scratch many key attributes may change as compared with Bitcoin—the original cryptocurrency. What implications will these changes have for investor protection policy, for securities regulation, or regulation generally? Three key questions can help assess whether these changes pose heightened risks for potential users:. From these questions we can arrive at three key variables: distribution, decentralization, and functionality.
Each will be addressed in turn. Back in , the very first bitcoins made it into the wild through mining. Bitcoin represents a particularly special case when it comes to distribution. As the first cryptocurrency—really a first running proof of concept for peer-to-peer Internet cash—very few individuals knew about it, and many of those who did, approached it with hearty skepticism. It would not be until two years later that bitcoin would reach parity with the dollar.
Later, after losing interest in the technology, he spilled lemonade on the laptop that stored the private keys to his mined tokens. Unaware of the value he was throwing away, he broke his laptop down for scraps and took the hard drive out with the trash. Without online exchanges capable of matching interested buyers and sellers or being market makers themselves, the early spread of bitcoins was primarily through mining, gifting, and the occasional over-the-counter exchange.
This stands in stark contrast to how many tokens are, today, distributed. In short, today much of the early distribution of a token will often go to those intending to speculate on future value, rather than participate in the platform via mining or software development. Or, should we internally mine or create some number of the total tokens that will ever exist before releasing the software publicly by hard-coding an initial distribution in the first block of the blockchain? This latter strategy is known as pre-mining.
She may even sell tokens long before any mining, either private or public, takes place. This is referred to as a pre-sale. However, should the token network fail to develop into a useful platform, any initial investment can and will, of course, come to naught. In the most questionable examples of a pre-mined and pre-sold token, one will often find promises of a future guaranteed price floor for the token.
This may be rationalized or marketed by suggesting that each token is linked to some underlying reserve asset, perhaps a precious metal or partitions of a profitable fruit grove. Recognizing the community-wide reputational and regulatory risk posed by pre-sale offerings, 51 as well as the risk to users within token development generally, some cryptocurrency enthusiasts sought and developed alternative modes of initial distribution: proof-of-burn, airdrops, sidechains, private sales, and traditional capital formation.
In a proof-of-burn system, new tokens are distributed to those who provably destroy bitcoins by visibly sending them to a Bitcoin addresses known to have no known matching private key making them unspendable. It is believed that such a distribution scheme does not unfairly enrich the developers with speculative profits before any real progress on the platform has been achieved.
The most notable example of proof-of-burn came during the initial release of the Counterparty token XCP. The motivation behind this distribution, as described on the Counterparty website, was fairness:. By opting to distribute all XCP by proof-of-burn, the Counterparty developers eliminated any speculation that they planned to get rich quick or redistribute risk unequally. On the contrary, they put themselves in the same position as everyone else, backing their ideas with destroyed bitcoin to obtain XCP in the hope of eventually benefiting financially from their own project and hard work.
The strategy of taking on more personal risk than developers of competing projects and forcing themselves to produce results before they could see any benefits is already bearing fruit. Counterparty is the first and so far the only protocol to have a working distributed exchange, built in record time despite having no outside funding of any kind. There are, however, notable downsides to a proof-of-burn distribution. If the tokens obtained via bitcoin burning are the total supply of the token then the token economy will be inherently deflationary.
This static supply can mean that rapid shifts in demand can create large spikes in the price of the token, which could leave investors or users vulnerable to a pump and dump scam perpetrated by larger investors. Additionally, if the token fails, the user will be unable to recover her burned bitcoins; it is a total loss.
A token airdrop is an alternative method of distribution that some believe can achieve a more equitable distribution of new tokens while avoiding any potential misaligned incentives between developer and user that might be inherent in a lucrative token pre-sale. Key to the airdrop method is the fact that the cryptographic addresses on a blockchain tend to be generated using well-understood cryptographic functions.
In that process the user also generated a corresponding private key. Making a successful bitcoin transaction necessitates digitally signing a message with the private key corresponding to the bitcoin address that will fund the transaction. Users should keep their private keys secret to ensure no one else can spend their bitcoin.
Developers who wish to airdrop their token at the start of their new network simply take a snapshot of some existing blockchain and use it to create the first block of their own blockchain. Now a Bitcoin user, should she choose to install and use the new AirdropCoin software, can import her existing bitcoin private keys into the new software and, from there, spend her AirdropCoins.
Networks that support consensus over multiple user-generated tokens apart from the foundational token, e. ERC20 tokens built on top of Ethereum, 56 may make airdrops even easier. The developer merely creates a smart contract on the network that allows anyone with a positive balance of the foundational token, say Ether, to claim some corresponding amount of the new token, gratis. Unlike proof-of-burn, however, token holders do not have to give anything up to obtain the new token.
Recipients of airdropped tokens would therefore lose nothing if the new network was to come to naught. Another method of releasing tokens into the hands of the public is via sidechain. To utilize a sidechain, a user need only send bitcoins to a special address which will temporarily lock those funds out of her control.
Simultaneously an equivalent nominal amount of sidechain tokens will be released into her control and she will have access to whatever functionality the sidechain offers. This peg works algorithmically through verification of cryptographic commitments on the blockchains of the two pegged tokens.
Therefore, the user of the sidechain does not need to rely on a trusted third party to guarantee the peg. Again, a primary motivation behind this innovation is fairness and the avoidance of volatility risk native to simple tokens. As described in the sidechains white paper, the developers also sought to create an interoperable ecosystem where several blockchains developed for different specialized purposes could be knit together:.
Unlike proof-of-burn or air-dropped tokens, sidechain tokens can always be redeemed for tokens from the parent chain likely Bitcoin. If the sidechain proves useless, users are not stuck with a valueless investment. The primary downsides to the sidechain approach are technical challenges. Ensuring that pegged bitcoins can be recovered by honest sidechain users, and never dishonestly recovered by interlopers, requires a sophisticated setup, 59 and—for the most secure implementation—minor adjustments to the Bitcoin protocol itself—something that will ultimately require the political will of the community or an economic majority at least to enact.
Rather than freely selling pre-mined tokens to the general public, a developer concerned with regulatory risk may choose to have a more limited sale. She may sell promises of her future tokens only to accredited investors or sell them to the public but only in dollar-value-limited amounts. Assuming full compliance with the relevant requirements in U. This approach concedes that the initial agreement between the developer and her purchasers is, in fact, an investment contract and, therefore, a security.
It, however, generally assumes that the token, once delivered to the investors pursuant to the terms of that investment contract, will not itself be a security. Future sales or re-sales of that token would not, therefore, be subject to securities regulation. Finally, some early stage token projects may eschew any of these public sales or distribution methods, choosing instead to raise funds solely from accredited private investors at least until the protocol is fully fleshed out, publicly released, and open for all interested users to begin mining or providing other such proofs of participation.
Rounding up these various distribution schemes we can imagine a hierarchy in terms of risk to the public. On the riskier end of that continuum would be pre-mined tokens offered for sale with attendant guarantees of future redemptive value or other hard-sell marketing tactics.
Less risky would be tokens offered to the general public without any promise of future value, and ideally with some transparency as to who is working on the project, what the project intends to build, and how new tokens will enter circulation. Less risky still would be tokens distributed using a proof-of-burn or airdrop system.
Finally, least risky would be a sidechained coin where users can freely move between the new currency and the long-established Bitcoin network at a known pegged exchange rate. Token projects that eschew public distribution during early development represent a different species of risk with an alternative mode of controlling for that risk. They are financed following the traditional venture capital method.
These projects have formal, accredited investors and are structured like any other early stage technology corporation. Token projects selling via a limited sale or SAFT agreement represent a hybrid approach. Initial investors are accredited or else capable of making only dollar-value-limited investments. This is a traditional approach to mitigating early-stage investor risk. If the project matures as planned, the tokens pre-sold in these agreements will ultimately be delivered and should be be functional and decentralized.
Their subsequent resale from the initial investors to the public at large removes the mitigating controls of accreditation or dollar-value caps, ideally in exchange for an asset that is less risky being as it is no longer merely a promise of some developer but, in fact, a functional token that can be used within a decentralized network. Decentralization is, perhaps, and overused term in the cryptocurrency and token community.
However, there are certain fundamental qualities that differentiate a service, such as money transmission, that is provided by a company, e. This section will explain varying degrees of decentralization as exhibited by various token projects, and it will highlight where risks to users do and do not exist with respect to a decentralized network. We will proceed with five subtopics: 1 Consensus , the rules that govern participation in a decentralized network and the process by which those rules are enforced by miners or validators; 2 Scarcity , a particular rule within any consensus mechanism that establishes key economic relationships between participants; 3 Transparency , the degree to which the software establishing the consensus rules is developed in an open and auditable process; 4 the Abundance and Diversity of Developers and Validators , whether several unaffiliated persons are developing the software or, merely, a select few; and 5 the Profit-Development Linkage , the degree to which a handful of developers or validators are incentivized to take quick profits by encouraging investment in the token.
As discussed in the first section, all cryptocurrency software will have policy rules and consensus rules. Policy rules are settings that an individual can choose to alter on her individual running instance of the software e. These are, in some sense, the constitutional rules of a cryptocurrency, setting fundamental variables like the total supply of the coin, rules for acceptable and unacceptable transactions, and rules for how the authoritative ledger of transactions—its blockchain—is assembled and maintained.
For Bitcoin, the consensus rules can be found in the reference client version of the software, which is publicly shared on a website known as GitHub, 64 and maintained by a loosely-defined group of unaffiliated developers colloquially known as core devs or core contributors. The actual binding rules themselves are whatever actual participants on the Bitcoin network say they are, effectively voting by running their choice of software.
The two factions recognize different and irreconcilable ledgers from the fork onward. Effectively, a contested hard fork is the creation of a new token that shares a common transaction history with the legacy Bitcoin network up until the point that consensus rules were changed.
This new network will include all users running the new software, and will not consistently recognize the contributions or participation of legacy users. Some may suggest that the legacy software represents the true Bitcoin and the new fork is a new currency that should brand itself differently. Others, however, might suggest that the new version is authoritative and represents the latest version of Bitcoin.
Still others may argue that the network with more computing power, mining effort, is authoritative. Ultimately, however, both networks will be judged by the purchasing power that they retain. Bitcoin relies on miners in order enforce constitutional rules because there simply is no other authority within the system.
The blockchain is the authoritative state of the network and permission to alter that state in the next block roughly a ten minute interval of time is limited to the network participant who a solves an open-ended math problem by using guess and check, 68 b broadcasts that solution to the network, and c whose solution is then built on because some previous block solution must be used as an input to create future blocks by sufficient other miners such that this chain of new blocks is the longest chain—has the most computing effort dedicated to it—as compared with any possible alternative states forks of the network.
This is why a single individual, by marshalling as much computing power as the rest of the network combined, could, in theory, block future transactions by refusing to put them in new blocks or attempt to convincingly double-spend new transactions. While the revisionist miner may create new blocks that reward her with new tokens, if those tokens are not accepted in exchange for real goods or other currencies, then she will fail to profit from her actions.
Moreover, the cost of such an attack is, necessarily, massive. There is fierce competition amongst Bitcoin miners, and specialized hardware components—application-specific integrated circuits or ASICs for short—have come to dominate the field.
This focus on computing effort as the measure and gateway for legitimate participation is referred to in computer science terminology as proof-of-work. Two mechanisms warrant brief description here: proof-of-stake and permissioned distributed ledgers. Proof-of-stake systems do not require the mathematical calculations and costly hardware investments of proof-of-work systems. Permissioned distributed ledgers utilize merely the digital signatures of certain enumerated participants to determine who may write new blocks.
The advantage of this system is that no costly proof is needed to ensure honest and committed participation because participation is limited, ex ante , to a set of entities deemed trustworthy. Finally there is the possibility for hybrid consensus models. So long as this shift or co-specification is widely discussed and development decisions are made in a decentralized manner, this should not raise concerns.
More troubling, perhaps, are hybrid systems that combine elements of the permissionless models work and stake with elements from permissioned distributed ledgers. As previously described, Peercoin, an early proof-of-stake token, suffered a series of attacks that led developers to switch to a model where only certain identified non-attacker participants were allowed to submit proofs of stake. Even more worrying is the example set by a questionable fork of Peercoin called Paycoin.
Paycoin was nominally a proof-of-stake consensus system, like its progenitor Peercoin. With all of these consensus mechanisms outlined, what can be said for their relative risk to users or investors? One clear distinction can be made between the two permissionless systems proof-of-work and proof-of-stake and the permissioned distributed ledger.
In a permissionless system there is a going market rate for participation and an open competitive industry seeking to provide updates to the blockchain. In a permissioned system there is a closed group of individuals or institutions who have ultimate authority over the blockchain, and should these entities collude in order to block the transactions of particular users, little could be done to stop them.
Additionally, if—as would likely be the case—these permissioned users are also the developers of the software, then effectively any change to the protocol e. Such collusion is also, in theory, possible in a proof-of-work or proof-of-stake system.
This is particularly true if the user or group of users targeted for censorship offered large fees to a miner or stakeholder willing to break ranks and process the transaction or a new miner or stakeholder who enters the market and refuses to join the blocking cartel. She will have forked the network by mining these non-compatible blocks. The natural differences between commodities and securities may be instructive here. A group of individuals issuing a security have full control over the fundamentals of that investment vehicle: they can organize production within the firm, they can choose to offer more shares and dilute existing ownership interests, they have full control over the accounting internal to the organization, and the only external limits to these activities are legal—either through contract or regulation.
Another takeaway from this discussion of consensus is that within a proof-of-work or proof-of-stake cryptocurrency, there is only true resilience against fraud or manipulation when there is a large and competitive market for providing these proofs. Additionally, for permissionless systems, the cost of these attacks scale monotonically with the value of the underlying currency. In proof-of-stake currencies this is intuitive, if the value of the currency rises, so too do the costs of having a given required stake for selection as a transaction validator.
In proof-of-work, so long as we assume rational miners, a similar proportional increase in the cost-to-validate will hold. If the value of the underlying currency rises, the reward for mining a new block similarly increases. Rational miners will increase their capacity to mine new blocks until their marginal costs equal their marginal revenue.
As miners compete to find the new, more lucrative blocks fastest, the difficulty required to attack the network scales with the value of the currency it secures. A new permissionless cryptocurrency or one with fairly little adoption, by comparison, may have a sparse market for proofs, and, therefore, a few large entities may exercise outsized control over its maintenance.
This may be particularly true of proof-of-stake systems where a large portion of the currency is held by the initial creators of the protocol, and buying these units can only be accomplished via an exchange platform also controlled by the creators. In this scenario the creators can, in theory, reorganize the blockchain, block transactions, or change the underlying fundamentals e.
In proof-of-work systems, at least, the ability to take part in consensus is predicated on dedication of fairly uniform and ubiquitously available computing power and not on possession some exotic digital asset sold only by those already invested in the network. Because of this weakness, many in the community perceive proof-of-stake as a consensus method that can only be built on top of an existing proof-of-work currency: switching the consensus mechanism from work to stake once the currency is already distributed across the network.
Finally, hybrid systems present special challenges to a risk analysis. If certain addresses are enumerated as possessing special powers within the consensus mechanism e. Particularly worrisome are hybrid systems marketed as normal proof-of-work or proof-of-stake systems. In these cases, users will presume that rewards come in some fixed proportion to participation, that no special participants exist.
If this presumption is untrue, the user has, in effect, been scammed. She was led to believe that participation would grant her a pro-rata stake in the token, when in truth some other stakeholders may have the playing field tilted in their favor. The core software powering the Bitcoin protocol sets a maximum total bitcoin supply; accordingly, there should at most only ever be 21 million bitcoins in circulation.
New bitcoins are regularly created and awarded to the miner who dutifully works and finds each new block. On average, new blocks are calculated every ten minutes and the reward amount has been set, from the start in at 50 new bitcoins per block, to halve every , blocks roughly four years. As of today, the reward is at Various tokens may have a different total supply, or a different schedule for the creation of new tokens. If my understanding of the scarcity of some token is untrue e.
However, the actual implementation of a change will necessarily require acceptance of the new software code by the network of Internet-connected peers that allow the cryptocurrency to function—miners, message relayers, users, businesses etc. That network, built as it will be of thousands of already-invested incumbents, would likely prove resistant to any change that ultimately dilutes the value of its holdings.
The reverse, changes that decrease the ultimate total supply, may be less repugnant to incumbents. However, the mere fact that a known fixed supply has suddenly become flexible may be sufficiently unsettling as to make such adjustments unpalatable. The Bitcoin community generally perceives changes to the underlying scarcity of bitcoins as verboten. For example, the underlying scarcity of the token Dogecoin was originally specified as billion total tokens.
Dogecoin, once believed capped at billion, became a perpetually inflationary cryptocurrency. Regulators should not be primarily concerned with whether a given cryptocurrency is inflationary or deflationary, but, rather, how transparent the community is with regard to disclosing these relevant economic fundamentals and discussing any potential changes. These concerns will be revisited in the next section on transparency. Strong transparency is the hallmark of all legitimate cryptocurrency or token projects.
Three questions help a regulator to gauge the relative transparency of a given project:. Bitcoin provides a good model of transparency. As discussed earlier, this reference client need not be copied exactly in order to ensure compatibility with the network. Individuals can change some aspects of this reference software, sometimes referred to as policy rules.
For example, a user can alter the core software that she chooses to run on her hardware, in order to avoid relaying transactions below a certain size—perhaps because the user believes these tiny transactions are spam. Additionally, the bitcoin core software can be integrated into a larger software program that provides, for example, an alternative user-experience for a wallet, 97 versions compatible with smartphone operating systems like iOS 98 or Android, 99 more robust key management for highly secure systems, scalability for use in a data-center, and any number of other tweaks, changes, or derivative products.
As of this report there are: at least 15 versions of the bitcoin client, all with various design goals or device compatibility; at least 12 different software tools for integrating bitcoin payments into online shopping cart systems, libraries of bitcoin-related software functions and objects in no fewer than 7 different computing languages; and effectively too many mobile apps, browser plug-ins, and web-based wallets to count.
Much of this software is publicly shared and distributed using the online service GitHub. By looking through the Bitcoin Core repository on GitHub, an observer or security analyst can see the entirety of the current source code, as well as every change to and past version of that code going back to August As of this report, a look at the GitHub repository shows that there have been nearly 18, accepted modifications to the code from over different contributors since the repository was first created in As of this report, the Bitcoin Core repository has been forked over 20, times.
This means that it is unlikely that any backdoor or severe vulnerability exists in the protocol. Additionally, the authoritative record of all Bitcoin transactions, the blockchain, is entirely public. While it is the software that ultimately describes which mining rewards are and are not permissible, it is the blockchain that records the full history of mining rewards, i.
The blockchain also records the difficulty, i. To make another comparison to commodities and securities: just as a gold miner must, generally, reveal information about her highly successful operations in order to profit through the act of selling the commodity , a Bitcoin miner cannot be rewarded for proofs without leaving a publicly auditable record of her windfall.
To be clear, the difference is how controls are placed on would-be bad actors: in a public blockchain, the only way to become wealthier is to leave a public record. In a corporate setting, there may be similar records, but the fidelity of those records is based on legal compliance and honest accounting under the threat of regulatory sanction or shareholder prosecution should past malfeasance be revealed rather than a verifiable, public, and real time proof of rewards given for proven efforts made.
Aside from the relative transparency of the software utilized within the network and the transparency of the records generated by that software, there is a final area for analysis: the relative transparency of discussions and processes undertaken to update that software. Bitcoin, again, provides a useful baseline. Within the Bitcoin community, proposals to change the core software are always public.
Bitcoin Core is widely regarded as the authoritative version of the software, it is the reference client. However, any software that upholds the consensus rules is, by definition, compatible with the Bitcoin network. One can think of Bitcoin Core as a rallying point around which the community discusses and ultimately chooses how to modify the software on the larger network.
Small changes to the reference client, i. More fundamental changes to Bitcoin Core, e. It is a guide and baseline from which compatible software for the network can be made. Additionally, any new software that breaks the consensus rules the most important rules that prevent fraud would fork the blockchain, and, unless merchants and exchanges accept transactions listed on the new fork, the new version will produce nothing of value and be abandoned in favor of the fork with the original consensus rules.
To round up this discussion of transparency, there are several key aspects of Bitcoin that are public and easily auditable. The software is open source. Key versions of that software, the reference client in particular, are publicly displayed in an open, online software repository—GitHub—along with comments, proposed changes, and all accepted changes to that software.
The blockchain that the network generates is also, itself, public, and keeps records of all transactions as well as all new money entering the system as rewards for miners. Finally, discussions over major changes to the software are also had in multiple public fora both online and off.
The transparency exhibited by Bitcoin should be the model for all token projects. Several notable tokens follow this model. Proprietary software, private blockchains, or closed development communities who announce changes without public debate, engender greater risks to investors and users, because such practices conceal from the participants the very economic and technological fundamentals upon which the digital asset is built.
The resultant informational asymmetries are conducive to short-term scams and fraudulent marketing schemes. In such a new and rapidly evolving field, the norm will often be caveat emptor buyer beware ; buyers, or—at least—sophisticated proxies for their interests critics, security analysts, regulators , must have visibility into the community and the code it produces in order to form a clear picture of risks and rewards.
Additionally, the non-mining or non-validating participants on the network may or may not be a diverse group. Long-established cryptocurrencies or cryptocurrencies with strong, user-based development communities will generally have more diverse users. These platforms have multiple use cases and design goals in mind. These various use cases may conflict: for example a community of users who are primarily interested in censorship resistant payment technology e. When the class of validators and users is large and widespread, there is inherent inertia in the decision-making process.
This inertia prevents malicious or questionable changes to the consensus rules from being easily enacted. In a proof-of-work system this inertia is especially pronounced, because changes to the consensus rules could affect the return on investment of miners. Miners on the Bitcoin network must, for example, invest heavily in application-specific integrated circuits, or ASIC chips for short, in order to remain competitive.
These ASICs are not multi-purpose computing systems; they can do only one thing well: provide proof-of-work calculations to the Bitcoin network. Miners are, therefore, heavily invested in preserving the status quo of Bitcoin; any change that jeopardizes their future returns is often viewed with hostility. This inertia would not be present in nascent cryptocurrencies with a small or centralized mining or stake-based community.
In these communities, miners may also be the primary developers of the code as well its most ardent promoters and users. Without a competitive market of various stakeholders, monolithic changes to the protocol are more attainable—potentially even changes that benefit some core group at the expense of follow-on investors. This inertia would also not be present in a permissioned distributed ledger. In such systems a core group of enumerated individuals or groups is empanelled by the developers to enforce the consensus rules.
This group, acting together, can block any user on the network from transacting, double spend transactions, change the history of the ledger, and create new money from nothing. The best evidence of a healthy and decentralized community may be visible examples of disagreement, stalemate, and compromise between various stakeholders regarding proposed changes to consensus rules.
The long running debate between Bitcoin stakeholders over changes to the block size cap the maximum size, in megabytes, that a valid block to be added to the blockchain may be provides a useful example. The size of a block corresponds to the number of transactions included in that block; so a block size limit is also a de facto limit on the number of transactions that can take place per block i.
The block size limit affects various stakeholders differently. Those focused on consumer adoption—exchanges and merchant processors—tend to want a larger maximum limit, because they do not want their users to suffer either delayed transaction validation or the larger fees that could be necessary to expedite validation if block space was scarce.
Those focused on mining or the stability of the network writ large, tend to want smaller blocks because A there may be bigger rewards to miners if block space is scarce and users compete for inclusion with fees, and B smaller blocks travel across communications networks faster and prevent potential problems associated with network latency like brief forks in the blockchain when two sides of the network disagree over which new block arrived first and is therefore authoritative.
The debate has generated some compromises. Rather than scale the blockchain by increasing block sizes many if not most in the Bitcoin community ultimately came to support a scaling solution called SegWit that compresses and truncates the transaction data such that more transactions can fit in the same size block. Ultimately, however, some big block partisans insisted that this was not a suitable way to address the scaling problem, and in mid some developers decided to fork the network by altering the block size consensus rule in a new version of the Bitcoin software that they developed and released.
This fork has persisted and the new resultant token has been named Bitcoin Cash by its partisans. The block size debate provides a useful example of decentralization because no single viewpoint or stakeholder has been able to easily and successfully advocate for the precise change they want. Instead, a variety of compromises and amicable separations have emerged.
The diversity of stakeholders is a naturally conservative force in the evolution of the network. This can be frustrating from the narrow point of view of a partisan in the debate, however it is a boon to the network at large and through the long term—rash changes, fraudulent amendments, and inequitable revisions stand little chance of survival in a highly decentralized community of stakeholders. The final question central to an inquiry into the decentralization of a token is: Are developers also holding and selling a large share of the scarce tokens, and are they substantially profiting from that activity in the short term?
The question is meant to determine to what degree the developers of a cryptocurrency are motivated by profit, and additionally, what the timescale of that profit-taking can look like. With a long enough time horizon, anyone could be characterized as motivated primarily by the prospect of future profits. We often cultivate hobbies and skills primarily because of an enjoyment of the work, a desire to participate in a community, or to solve some personal problem in our own lives.
If, however, as a result of our efforts we eventually make something of notable commercial value say, a work of art, an innovative design for a boat hull, a patentable invention for irrigating crops it would be unusual not to seek and take some profit from that work. Should we be particularly successful in monetizing our past passion, hindsight may make our otherwise tinker-like motivations appear to be driven more by greed than they really ever were.
Take, for example, the work of Satoshi Nakamoto, the pseudonymous inventor of Bitcoin. Bitcoins were frequently lost in buried hard drives, at the bottom of landfills, in laptops ruined by spilled beverages, or in thumb-drives misplaced and never found again.
Bitcoins were traded more for fun than profit and often at a great loss if we look at the future price , as in the case of alpaca farmers accepting bitcoins on websites in exchange for woven socks, or the case of a million-dollar pizza purchase through a friend across an ocean. And still to this day several blockchain-based projects are developed by a community of dedicated volunteers; individuals motivated more by the desire to see some cooperative process or service cloud storage, domain name registries, single sign-in identification, music production, and more automated and decentralized, rather than any expectation of huge future profits.
Others, however, plainly have less benign motives. Desiring quick profits, they hype their future technology, market it to trusting buyers online, promise future integrations and applications, all without developing much beyond a simple fork of Bitcoin or some other pre-existing open source token software.
But motives and intent can be a difficult metric for regulators or law enforcement to uncover and rely upon in prosecutions. Both the truly radical innovations as well as the scams will often be pitched with similar rhetoric and bravado, or have similar delays in development. Rather than look at the promises or claims surrounding a token, it may be better to look at how the development process is financed, and how the technology is structured to reward or not reward the developers.
Earlier, in the section on distribution, we discussed pre-mining as well as promises of a future minimum price floor. These are notable indications of a strong link between development and profit. Developers creating a pre-mined currency will often retain large amounts of the scarce coin.
These developers will often be the prime generators of hype surrounding the future promise of the network; the extreme example being a guarantee of a future price-floor for the token a promise to buy back tokens at a set rate. At this point the developers can walk away with large windfalls even if the underlying technology has yet to meet the expectations or promises of its marketing.
It may simply be a forked version of Bitcoin with different branding, produced and released at almost no cost. When the promised innovations fail to materialize the price of the token on third-party exchanges may plummet, leaving follow-on investors who bought at the height of the craze with nothing.
The clearest indication of an unhealthy link between network profits and development comes from the Paycoin example described in the previous subsection on consensus. In that example, Paycoin was marketed as a standard proof-of-stake based token. Paycoin was, in reality a hybrid consensus system utilizing concepts from both proof-of-stake and permissioned distributed ledger systems. Developers had enumerated certain network addresses within the code, identified with a public-private key pair, in order to grant those users disproportionately large rewards.
It is not unreasonable to assume that these addresses were, in fact, in the control of Paycoin developers and promoters. In this example, developers have a very strong profit motive, while Paycoin grows they are benefited by these oversized rewards at the expense of normal users who presumed they were equal participants. The software, in a case such as this, is effectively a bargain that has been fraudulently and materially misrepresented. These worst-case scenarios can be contrasted with a developer or group of developers who choose to distribute their new tokens only through open, competitive mining, or through a an airdrop or proof-of-burn system where bitcoins are sacrificed—not exchanged—by interested users wishing to obtain some of the token.
Similarly benign would be development utilizing a sidechain, where interested users will simply move bitcoins into the new project, retaining full ownership and control over those digital assets and offering nothing to the developer in exchange. In all of these benign examples, the developers have no means of taking quick profits from their network. Developers working on a token network that openly offers tokens, from the start, to competitive miners get no pecuniary benefit from each marginal miner that joins the network.
Developers working on a token that can be obtained by proof-of-burn, do not gain bitcoins from each new user—those bitcoins are simply destroyed in the process. And developers working on a sidechain do not gain control over the bitcoins pegged by users in order to obtain sidechain tokens. The tokens may be branded as something new, but they are perfectly fungible with bitcoins.
As the developers of Rootstock, a sidechain that seeks to replicate the smart contracting capabilities of Ethereum, explain,. The sidechain is a two-way mechanism, so when the miners receive the rootcoins in payment for contract execution, they can turn them back into bitcoin right away.
A securities regulator concerned with the Howey Test would likely choose different data points than a security researcher probing the network for holes. But different analysts also might hone in on similar points. For one, mining power concentration, or the concentration of miners whose computational efforts cryptographically secure proof-of-work blockchains, is a critical benchmark for any decentralization hawk. If all the key miners are geographically concentrated or grouped into a single pool, a blockchain may face mounting centralization and security risks, according to Ketsal.
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