Understanding Ethereum: A Global Value Exchange Network in a Trustless Economy

Original author: Naly

Original Translation: DeepTech TechFlow

Trustless Economy - Understanding Ethereum

The functioning of human society fundamentally relies on trust. From personal relationships to the global economic system, trust is the bond that connects us together.

The key issue is whether this bond is strong or not?

In a small-scale environment, trust can be very strong. This is because trust is based on relationships, knowledge, and direct responsibility, and a person’s reputation directly affects the relationships they establish.

However, as the number of interactions increases and expands, the relative strength of trust becomes very fragile. Why? The larger the crowd, the fewer interpersonal relationships established, the less impact of reputation, the better the incentive measures must be, and the better the system must operate.

Table of Contents

• Trustless Economy - Understanding Ethereum
• Trust Story
• Big Game
• The Birth of Ethereum
• Decentralized Stablecoin
• Loan Market
• Decentralizationexchange
• 流动stakeprotocol
• The Power of Numbers
• Trustless Code
• BTC and ETH
• World Computer
• Economic Security
• Programmability Economy
• Decentralization Applications
• Decentralization Finance
• Decentralization organizations
• Trustless Economy

Case

In the book “Sapiens”, Yuval Noah Harari explains that trust can be maintained in groups of up to about 150 people, a number known as the Dunbar’s number. When the size of the group exceeds this number, humans rely on the development of shared myths, religions, and ideologies.

In the present era, as relationships scale to larger organizations, companies, or global markets, the societal solution is to institutionalize trust. Essentially, it is to weave a narrative that certain individuals within the system are ‘trustworthy’ in reputation.

The following figure shows a visualization method.

Although it sounds simple, it doesn’t always work.

In the 2008 financial crisis, the financial products that these ‘trusted’ banks and credit rating agencies considered to be very safe (AAA rated) turned out to be the opposite. Banks wrapped low-quality assets in fancy packaging and sold them as high-quality assets. Once people realized this, the system collapsed catastrophically.

The stock market experienced a big dump, with global stock market capitalization evaporating approximately $30 trillion. Housing prices in the US real estate market fell by 30%, and over 3 million trapped houses were repossessed.

To grasp the immense scale of 30 trillion dollars, consider this: if you stack one-dollar bills, the height would reach about 2 million miles, which is eight times the distance from the earth to the moon. Alternatively, if you spend one million dollars every day, it would take more than 82,000 years to spend it all!

The 2008 financial crisis was just one example of many catastrophic failures of trust that led to system paralysis.

• Enron scandal (2001): Enron’s fraudulent accounting practices led to its bankruptcy, eroding trust in corporate governance and auditing standards.
• Wells Fargo account fraud scandal (2016): Wells Fargo employees created millions of unauthorized bank and credit card accounts, leading to significant financial losses and loss of trust in the bank.
• Facebook-Cambridge Analytica Data Scandal (2018): The behavior of Cambridge Analytica collecting personal data from Facebook users without their consent highlighted the risks of centralized control of personal data.
• Equifax data breach (2017): A major data breach at Equifax exposed sensitive information of 147 million people, undermining trust in centralized credit reporting agencies.

Great game

Why do these trusted entities continue to betray our trust?

Is this a natural greedy behavior of all human beings, or is there a mathematical reason? In fact, both are true.

Life is a big game. You roll the dice, move forward on the board, buy houses, collect $200 when you pass go, improve skills, establish alliances, make enemies, and ultimately build and break trust. It’s an endless cycle.

To quantitatively analyze major decisions in life, we can refer to game theory - a mathematical study of strategic interactions.

The most common entry in this field is the “prisoner’s dilemma” - a game where two people are arrested and imprisoned. They can choose to cooperate and remain silent or betray each other.

If both sides remain silent, they will serve a short prison sentence. If one betrays and the other remains silent, the betrayer will be released, while the silent one will serve a longer sentence. If both betray each other, they will serve a moderate prison sentence.

This dilemma illustrates the conflict between individual rationality and collective rationality, demonstrating how the pursuit of self-interest by individuals can lead to worse outcomes for the society as a whole.

If we map this mechanism to multiple iterations and calculate the probability of success (cumulative score), you might think that a traitorous society would increase; as the ancient saying goes, good people never win.

In fact, the results are quite different. Once this game is programmed into a computer through iteration and allowed to run thousands of times, accumulating scores, some interesting discoveries are revealed.

The most successful computer program is called ‘tit for tat’ and has the following characteristics:

• Friendly: Not the first to betray
• Retaliation：If the opponent betrays, retaliate immediately
• Forgiveness: revenge but not holding grudges

(For more long game theory content, please refer to the video.)

So, are friendliness and trustworthiness beneficial to society?

My point is, it makes a lot of sense - in almost all life situations, cooperation is more advantageous. This is evident in team sports, interpersonal relationships, and business. Those who cooperate well are often the best!

What I find particularly interesting is that when mapped to longer time spans and mapped to the field of biological evolution, another pattern emerges.

(Please refer to the video for the content about evolutionary game theory.)

As cooperative societies grow, they reach an unstable point, because any individual with a tendency to betray will immediately disrupt the balance and drop interpersonal relationships (see Dunbar’s number). This is evident in the formation of cooperation within nations or corporations, and the rise of an empire continues until it reaches maturity, at which point its inevitable decline begins once internal betrayal and imbalance begin.

In short, in a team of good people, all it takes is one bad actor to take advantage.

Evolutionary selection tends to favor strategies based on the recipient’s previous reputation to determine whether to help. This is possible in small-scale environments, but as the group exceeds the 150-person limit we previously discussed, there are failure points in reputation-based central authority.

In order to make a wide and advanced cooperative society possible, there must be a supporting structure. I and many others believe that the livelihood of every member of the global financial system and society cannot rely solely on the “sweet talk” of those who are economically motivated to manipulate the truth for their own benefit.

The urgent need to redefine financial trust.

The Creation of Ethereum

The Power of Numbers

In 2009, BTC was born; it is a financial model aimed at eliminating trust issues in the financial system through an unforgeable currency asset.

BTC achieves this goal by introducing the Block chain. Block chain is a Decentralization database protected by a large number of computers and driven by a finite currency unit - BTC (BTC).

BTC is a peer-to-peer network that is secure through encryption. It allows all users to custody their own funds and is managed by an issuance plan that cannot be arbitrarily inflated by a single authority. These factors have earned BTC the reputation of digital gold.

Check the article below for an overview of the BTC network.

Image: Unlicensed Economy - BTC

Trustless Code

Six years after the birth of BTC, Vitalik Buterin envisioned a more versatile blockchain. This blockchain not only allows users to hold and transfer digital assets, but also utilizes the immutability of the blockchain to create trustless applications and build decentralized sub-economies.

These statements may seem confusing at first glance, so please be patient.

The key innovation of Ethereum is Smart Contract.

Smart Contract is a digital protocol that automatically executes and enforces the predefined conditions of the protocol through code, without the need for human intervention.

The implementation of these contracts relies on some key blockchain features.

• Immutable Ledger: Once the contract is deployed, its terms cannot be changed.
• Economic Security of Decentralization：The network ensures security through economic incentives and a large number of network participants (rather than a single central entity).

You can think of Smart Contract as a cookbook, which automatically prepares delicious food when all the ingredients are ready. Once the code (in this metaphor, the recipe) is provided, there is no longer a need for manual intervention.

This recipe is Open Source, which means that everyone can see what will be made (and how to make it) before agreeing to the contract. It is also immutable and cannot be changed once deployed.

BTC vs ETH Square

From a macro perspective, BTC and Ethereum can be compared to a very secure calculator. Just as a calculator performs arithmetic operations, the BTC network efficiently processes peer-to-peer value transfers.

While Ethereum can be likened to the Apple App Store - it provides a foundational platform for developers to build and run applications.

Just as the App Store provides a secure environment for applications on the iPhone, ETH Block provides a decentralized and programmable blockchain environment for creating and executing Smart Contracts and decentralized applications (dApps).

Continuing with this analogy, while BTC is a transaction network, Ethereum is like a whole computer.

World Computer

Unlike traditional computers, the state of a traditional computer is implemented internally (i.e., the specific state of the system or software at a specific point in time), while the Ethereum computer, also known as the Ethereum Virtual Machine (EVM), runs by executing contracts in a vast computer network.

When a transaction is executed on the ETH blockchain, the EVM ensures that every computer (or Node) in the network processes and approves the transaction in the same way.

Each time a new set of transactions is added, it is called a “Block” - hence the name Block chain. Public Block chains like Ethereum allow anyone to add data, but cannot delete data.

The network is powered by Crypto Assets Ethereum (ETH) to pay for the computational resources of transactions. Each transaction requires ETH to execute, which means if BTC (BTC) is digital gold, then Ethereum (ETH) is digital oil.

In a recent report, the world’s largest bank, Industrial and Commercial Bank of China (ICBC), praised the rise of Ethereum and BTC. The bank compared BTC to gold for its scarcity, while referring to Ethereum as “digital oil,” highlighting its role in “providing a powerful platform” to support numerous innovations in Web3. - FXStreet

It should be noted that when we talk about transactions, unlike the BTC network, we do not only refer to the sending of funds. On the Ethereum network, a transaction refers to any operation that changes the network state, which, due to the creation of smart contracts, could be any operation from deploying new contracts to voting governance or purchasing new items in on-chain games. (We will discuss this in detail later).

Economic Security

Image: Over 30 million ETH is staked on the Ethereum network

When it comes to the Ethereum network, one of the first concerns that comes to mind is security. How do we ensure the security of these Smart Contracts?

Ethereum is economically secured through Proof of Stake (PoS) Consensus Mechanism.

In PoS, the network state is changed by validators - these participants are responsible for storing data, processing transactions, and adding new blocks to the blockchain.

To become validators, users must lock Ether (ETH) as collateral and run the necessary computing hardware to maintain and update the network status. To illustrate how to add new blocks, let’s assume that two simple transactions occurred within a block.

• John sent 1 ETH to Betty.
• Developer Bob spends 2 ETH to create a new Smart Contract.

The work of all validators in the network is to verify these two transactions and update the network state accordingly. In this example, validators need to ensure that John’s account decreases by 1 ETH, Betty’s account increases by 1 ETH, and a new Smart Contract is created and recorded on the on-chain Block.

Validators in the network update the status on local hardware. Once the majority (over 50%) of validators agree that the transaction is valid and the status change is correct, the next Block will be added. This Consensus Mechanism ensures the integrity and accuracy of the network’s status.

If validators are dishonest and misreport the network state (e.g., updating their local computer to show that John sent 1 ETH to George instead of Betty), and more than 50% of the network participants disagree, they will face the risk of being slashed and losing part or all of their stake ETH.

Image: There are over 1 million validators on the Ethereum network

validators are rewarded with newly minted ETH and Money Laundering, which provides them with economic incentives to act in the best interests of the network.

Simply put, participants are economically incentivized to secure the Ethereum network.

This 50% rule means that if someone wants to tamper with information or deceive the system, they need to control more than half (51%) of the computers on the network. Currently, this requires approximately 10.3 billion dollars.

It is almost impossible due to the following reasons:

• Market Liquidity: The Ethereum market lacks sufficient liquidity to handle $103 billion in purchases without causing extreme price fluctuations.
• exchange limits: No single exchange or combination of long exchanges can handle such a large-scale purchase in a single transaction.
• Regulatory and Compliance Issues: Such a large-scale purchase will attract the attention of regulatory agencies and require compliance with extensive Anti-Money Laundering (AML) and Know Your Customer (KYC) regulations.
• Counterparty Risk: It is almost impossible to find enough sellers to meet the demand of 103 billion US dollars worth of ETH.

Programmability Economy

We have learned that Ethereum not only allows for the trading and storage of financial value, but also enables the creation and execution of trustless protocols based on predefined instructions.

This means that while BTC has created a limited Decentralization currency unit, ETH has created the possibility of a new financial system.

Previously, the financial system required intermediaries such as banks and lending agents, but Smart Contracts make it possible to program Decentralized Applications (dApps) that no longer require human intervention once deployed.

Decentralization Applications

So, what kind of Decentralization applications can be created?

Almost anything that needs protocol, intermediary, trust, and centralized points of failure can be decentralized and unpressured using blockchain technology.

The potential design space is unlimited, from Supply Chain management and healthcare to gaming and digital identity. In addition to being able to eliminate manual intermediary, Blockchain technology also enhances the efficiency and connectivity of data. Today’s isolated and outdated databases are evolving towards a more efficient and connected technological layer.

• Blockchain, the digital record technology used for BTC and other cryptocurrency networks, is a potential disruptor in the financial world. However, it also has great prospects in Supply Chain management. Blockchain can significantly improve the Supply Chain by speeding up and cost-effectively delivering products, enhancing product traceability, improving coordination between partners, and helping to obtain financing. - Harvard Business Review

So far, the most attractive area has been Decentralized Finance, abbreviated as DeFi.

Decentralization Finance

The on-chain lending market allows anyone with internet access to provide tokenized assets and earn interest by lending out these assets. These transactions are not intervened by a middleman, and the interest rate is predetermined by a mathematical model based on the supply and demand mechanism through an encryption code.

The emergence of stablecoins provides users with tokenization versions of national currencies (such as the US dollar and the euro)—this is a $1610 billion industry that has already attracted the adoption of TradFi giants like Visa and Paypal.

Image: Visa

Stable Coin is supported by transparent off-chain reserves (such as US Treasury bonds) or pegged to the US Dollar but backed by ETH, allowing anyone, anywhere to instantly access the online tokenized coin of their choice.

This technology is particularly important for countries where currency Inflation and devaluation are caused by greed and manipulation of centralized power.

For example:

• Venezuela: Due to rampant inflation, many Venezuelans are turning to Stable Coins such as Tether (USDT) to store value and conduct transactions, bypassing the unstable bolivar.
• Argentina: Faced with high inflation and currency controls, Argentinians are increasingly using stablecoins to protect their savings and promote international trade.
• Turkey: In the face of economic uncertainty and currency depreciation, Turkish citizens are adopting stablecoins to protect their wealth from the impact of the Lira Fluctuation.

Essentially, Stable Coin gives fiat currency the superpower of the internet, enabling it to circulate like other internet data. - Circle

Let’s take a closer look at some of the most famous Decentralized Finance (DeFi) protocols.

DecentralizationStable Coin

The first Decentralization application (dApp) built on the ETH blockchain is Maker DAO, which allows users to create and manage the Decentralization Stable Coin Dai. Dai is pegged to the US dollar but backed by ETH.

To obtain Dai, users need to provide Ether (ETH) as collateral in the Smart Contract. Once generated, purchased, or received, Dai can be used like other cryptocurrencies: it can be sent to others, used for payment of goods and services, and even held to earn interest through the Dai Savings Rate (DSR) feature in the Maker protocol.

Loan Market

Aave is a Decentralization non-custodial borrowing protocol, where users can participate as depositors or borrowers. Depositors provide Liquidity to earn passive income, while borrowers can borrow these assets for other Decentralized Finance applications.

Users can provide the assets and quantities of their choice and earn passive income based on market demand. After providing the assets, users can use them as collateral for borrowing.

Decentralizationexchange

Balancer is a Decentralized Exchange (DEX) protocol that allows users to exchange various cryptocurrencies directly from their wallet without the need for a central authority or intermediary.

Balancer uses the AMM (AMM) model, where Liquidity Providers deposit token pairs into the liquidity pool, and the price is determined by the ratio of tokens in the pool through a mathematical formula. Users are incentivized to provide liquidity to earn a portion of the money laundering generated in the pool.

Liquid Stake Protocol

Lido Finance is a Decentralized Finance (DeFi) protocol that provides liquid staking solutions for various Proof of Stake (PoS) blockchains.

Users can stake their assets in a liquid stake protocol like Lido, which will stake on their behalf and return a liquid asset instead of locking the cryptocurrency in a stake contract.

This method allows users to maintain asset Liquidity while enjoying stake rewards, thus achieving greater flexibility and participation in the Decentralized Finance ecosystem for a longer period of time.

Decentralization DAO

Thousands of financial applications have been built on the concept of Decentralization, removing the power hierarchy in TradFi and replacing it with Decentralized Autonomous Organizations (DAOs).

DAO is an organization that operates on-chain, and its rules and decisions are encoded by computer programs, rather than controlled by central authorities. DAO members typically hold governance tokens, giving them voting rights to propose and vote on matters such as fund allocation, financial management, and project development.

This Decentralization structure ensures transparency, as all operations and transactions are recorded on the Block on-chain, and allows for a more democratic decision-making process, with power distributed among all members rather than concentrated in the hands of a few.

Trustless Economy

We have discussed a lot of content, now let’s summarize and draw a conclusion.

Collaboration is a characteristic of every great society, but when the group size exceeds 150 people, the ability to build strong relationships weakens, and is replaced by reliance on narratives, stories, and centralized institutions.

Although the formation of these entities enables the group to expand and build complex social structures, it also creates very unstable organizations, allowing a bad actor to exploit the collective power for personal gain.

Game theory tells us that being a good person is beneficial to the growth of society. However, history also shows that a society full of good people is vulnerable to being eroded by bad actors.

In order to achieve the next wave of extensive and advanced cooperative society, a new supporting structure must be in place to achieve this goal.

The interesting thing about Smart Contracts is that they don’t try to build a structure around an imperfect model, but completely redefine this model.

The current society centralizes the power of trust in central institutions, while the introduction of Smart Contract provides a new infrastructure for society, supporting the development of next-generation trust-minimized applications and services. —— ChainLink

Many people, including myself, believe that the livelihood of every member of the global financial system and society cannot rely solely on the ‘sweet words’ of those who manipulate the truth for economic gain.

And you?

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