Intro 2.0 to Smart Contracts (Very High Level)

I read an old blog post this morning called Intro to Smart Contracts. After spending the last year learning about blockchain technology, I realized that this article brought no value to anyone that read it. I apologize to the 14 people that did.

The point of this article is to actually explain what smart contracts are at a very high level.

When you buy Ether or Bitcoin, the coins that you buy are sent to a unique address. With Bitcoin, no coins are actually held at this address. The address acts as a unique identifier, like a bank account number, that allows the total of the transactions to and from this address to be calculated. Bitcoin can be thought of as a ledger that records the deposits and withdrawals from accounts. When you send a transaction via the Bitcoin network, your old balance is reduced by some amount and another account’s balance is increased by this amount. But no physical value is ever moved.

Ethereum works a bit differently. Ethereum stores a number of coins you own at an address in something called a smart contract. The ability to store information at these addresses is called the Ethereum State. Whereas Bitcoin only stores transactions that have been sent in the Bitcoin blockchain, any type of data can be stored in the Ethereum state and thereby the Ethereum blockchain. The information that is stored could range from the amount of Ether you have to the type of life insurance you own.

A smart contract is an address that holds computer code. Transactions can be sent to this address that will trigger specific functions. For example, a user could program and deploy a smart contract that holds the name of a person. When a transaction is sent to this function with a name, the state of the smart contract will be changed so that it now stores the name that was sent to it. Another person could send a different transaction to this smart contract that will return the name that is stored in this smart contract. While this is a very boring example of what smart contracts can do, smart contracts enable Ethereum to operate as a universal computer. Due to the decentralized nature of Ethereum, there are smart contracts that anyone can send transactions to. (You can also create smart contracts that only execute functions when certain people send transactions to it).

Slock.it is using the functionality that smart contracts enable in some very cool use cases. They are developing a mini Ethereum computer that allows physical objects such as bike locks, door locks, or electric charging stations to be operated by a smart contract. You can send the bike lock a transaction with a specified amount of Ether that would allow you to use it for a duration of time. This is different than a Hubway station because the only infrastructure that would be required is a blockchain enabled bike lock.

In my previous article, I stated that smart contracts use conditional statements like a contract in a bet. While smart contracts execute certain functions if a transaction containing some data is sent, smart contracts aren’t only used to write conditional contracts. Many of the use cases regarding conditional contracts, such as the Patriots winning, are difficult to implement on Ethereum. The reason for this is that the Patriots winning is an off chain event, and the Ethereum blockchain needs to be notified of this event somehow. There must be a certified off chain authority that can inform the smart contract of this condition when it occurs. Every node in the blockchain needs to receive this same exact information so that consensus can be reached. Gnosis, a prediction market platform, has developed a solution to this hurdle, but it requires a certified off chain person informing the blockchain what the outcome of the result was.

Transferring Assets via Blockchain Technology

Another feature that has generated lots of excitement within the Blockchain 2.0 realm is the ability to transfer assets using the blockchain. While bitcoins have provided people with the ability to send money through the Internet, without the fees of middlemen such as banks, the ability to transfer assets through the blockchain would allow people to trade their houses, cars, or shares of stock without using traditional middlemen such as realtors, stock brokers, or auto salesman. This would also mean that assets would transfer immediately after they were purchased, which would prevent incidents like this from occurring. Colored coins and Counterparty are two technologies that I found that seemed to be the most talked about among Bitcoin and blockchain forums.

Colored coins function as regular Bitcoin transactions. To create a colored coin that represents some asset, all one has to do is take a bitcoin and add metadata to this “coin.” This added data would represent some asset such as one share of Ford or a house in Florida.¹ (Bitcoins do not actually exist because Bitcoin is really just a ledger of inputs and outputs into somebody’s Bitcoin wallet. When computers check to see if an account has enough bitcoins, they are just searching for previous inputs into that account. Adding data to a bitcoin is really adding data to some bitcoin transaction in which all parts of that transaction are colored with this added data.²) This new coin functions just like a regular bitcoin transaction. Here is a link if you want to learn how to add this metadata to create a colored coin.

There are some companies such as Overstock.com that have received SEC approval to issue their publicly traded stock as colored coins.¹ Most colored coins are not backed by a legal contract and are based on trust that the other party has the physical asset to back their colored coin.

             From scrolling through Reddit and Quora forums, it seems that many people are opposed to colored coins because they believe they will cause blockchain bloat. Blockchain bloat is classified as transactions within the Bitcoin blockchain that are not used for currency transactions, like colored coins.³ While the added data to Bitcoin transactions will increase the amount of information being processed on the network, which could slow processing speeds down, miners who process colored coin transactions are still receiving a processing fee from these transactions.⁴ This view that blockchain bloat is akin to email spam is held among some purists that believe that the Bitcoin blockchain should be kept for only pure Bitcoin transactions.

Another downside of using colored coins is that if one sends a colored coin to an address that does not have colored coin capabilities, the colored coin will be lost forever. There are specific computers within the blockchain that can understand which bitcoin transactions are colored coins. This is how colored coin wallets operate as well.⁴

            In an article by Richard Gendal, he discusses how the exchange process of colored coins works. When someone agrees to buy a colored coin from another party, there needs to be a system in which the buyer is guaranteed that they will receive this asset coin when they send their money. Colored coin technology ensures this by having the seller put their asset coin into a escrow account of sorts, which functions outside the blockchain.⁵ This goes against Bitcoin ideology because there is now a third party that the individual must put their faith in. The problem with trusting a third party is that if this company failed while holding someone’s assets, those assets could be lost.

Counterparty, a competing technology to colored coins, uses a bid/ask system to complete the exchange process. A seller will make an ask price, and a buyer will make a bid price. When these two offers are matched, the seller is required to honor the price they said they would sell the shares at, and the buyer must honor the price they stated they would pay for the shares. Like stock exchanges, Counterparty locks these assets into place until the offer has expired. Coded into the protocol is an automatic exchange system that forgoes a party outside of the blockchain. But Richard Gendal states that the problem with this system is that all these bid/ask prices are stored in the blockchain, meaning that temporary transactions are stored permanently.⁵

            Unlike Colored Coins, Counterparty uses its own currency to digitize assets onto the blockchain. This native currency is called XCP. XCP came into existence when individuals sent bitcoins to a Bitcoin wallet in return for XCP. The bitcoins that were sent to this wallet were destroyed, so that Counterparty and the creation of XCP would not be viewed as a get rich quick scheme.¹² The Counterparty website likens this to the process of mining bitcoin as “Bitcoin miners also destroy one resource [Energy] to get another [Bitcoins].”

            While Counterparty has its own currency, the transactions within Counterparty are merged onto the traditional blockchain network. There is special computer code that recognizes Counterparty transactions and establishes an independent Counterpary ledger. Since the same nodes that mine bitcoin process Counterparty transactions, there is a bitcoin fee for every transaction within Counterparty. Besides the bitcoin transaction fee, it costs 0.5 XCP to create an asset token. This 0.5 XCP that is used to create an asset token is burned (See issuance strategy above), causing XCP to be deflationary.⁷

Bibliography:

1) Digiconomist. "Adding Metadata to the Blockchain, Part 1 - Digiconomist." Digiconomist. 2015. Accessed August 09, 2016. http://digiconomist.net/adding-metadata-blockchain-part-1.

2) "How Do Bitcoin Transactions Work? - CoinDesk." CoinDesk. http://www.coindesk.com/information/how-do-bitcoin-transactions-work/.

3) Wagner, Andrew. "Ensuring Network Scalibility: How to Fight Blockchain Bloat." Bitcoin Magazine. 2014. https://bitcoinmagazine.com/articles/how-to-ensure-network-scalibility-fighting-blockchain-bloat-1415304056.

4) "Beginners." Coloredcoins. 2015. Accessed August 03, 2016. http://coloredcoins.org/inner-page-3-1/.

5) Brown, Richard Gendal. "A Decentralized Securities Trading and Settlement System Is Being Built Hidden in Plain Sight." Richard Gendal Brown. 2014. Accessed August 02, 2016. https://gendal.me/2014/06/10/a-decentralized-securities-trading-and-settlement-system-is-being-built-hidden-in-plain-sight/.

6) "Why Proof-of-Burn." Counterparty. March 23, 2014. Accessed August 06, 2016. http://counterparty.io/news/why-proof-of-burn/.

7) "Assets." Counterparty. Accessed August 05, 2016. http://counterparty.io/docs/assets/.

Intro to Smart Contracts

I first became interested in smart contracts after reading the book The Age of Cryptocurrency: How Bitcoin and Digital Money Are Challenging the Global Economic Order.  The book doesn't explain how smart contracts work well, but I was fascinated by the future Blockchain 2.0 technology.  

Smart contracts function like regular contracts that are created when two people make a bet or a customer takes out a loan from a bank. There is some variable term, such as if the patriots win or if you fail to make your interest payments, and a consequence, then you owe your friend ten dollars or the bank can take ownership of your house. But what’s unique about smart contracts is that they are based on the blockchain. The essence of the blockchain is that it creates a way to establish trust among untrusted parties. First, the blockchain creates a system in which there is no central authority that controls the servers that data is stored on because the blockchain is run off of thousands of independent computers around the globe. This means that nobody can corrupt stored data or change the terms of a contract without the other party knowing, since each computer’s ledger must agree with the other computers’ ledgers in the blockchain. Second, the blockchain publishes a public ledger of all transactions that have taken place within its network. This allows people to verify that a person actually posses the assets they claim to have.

Smart contracts could be very beneficial to underprivileged groups such as the unbanked. Unbanked people are not able to receive service by traditional financial institutions such as banks. This means that they are restricted in their ability to get loans and other forms of capital. By using smart contracts, the unbanked could digitize their assets* and post them as collateral to loans that individuals make to them. When the smart contract is being established, the person receiving the loan would place their asset token into an independent escrow account that is controlled by the smart contract code. The loan provider would do the same with the money being loaned, and this money would be sent to the customer. But if the customer failed to deposit their monthly interest payment into an escrow account managed by the smart contract code, this could trigger the escrow account to move the asset token into the loan provider’s account. Smart contracts on the blockchain provide a secure and unbiased way for people to enter into agreements, contracts, or bets.

Many people use the example of a bank being able to take control of a borrower’s home if they neglect to pay their loan payments as a great use case of smart contracts. People believe that this would greatly reduce litigation costs and efforts because the code would automatically process the change in ownership of the house. But if this change in ownership of the owner’s house takes so much time and effort to conduct after the customer defaults in the traditional system, I believe using smart contracts would just shift the workload of this litigation process to the front end when the contract is being created.

The Bitcoin blockchain cannot support smart contracts due to the fact that it does not allow “computer language to carry out a wider array of more precise instruction” beyond Bitcoin transactions, which is known as Turing completeness.¹ Firms such as Ethereum are developing a blockchain that contains these Turing completeness capabilities that would allow for the programmability of programs like smart contracts.²

Here is a link to an interesting article on why the absolutism of smart contracts is an undesirable feature.

*See next post for description of asset tokens on the blockchain

1) DeRose, Chris. "'Smart Contracts' Are the Future of Blockchain." American Banker RSS. 2016. Accessed August 06, 2016. http://www.americanbanker.com/bankthink/smart-contracts-are-the-future-of-blockchain-1078705-1.html.

2) DonaldMcIntyre. "What Is Ethereum? How Does It Work? • /r/ethereum." Reddit. Accessed August 07, 2016. https://www.reddit.com/r/ethereum/comments/3krr3s/what_is_ethereum_how_does_it_work/.

Book Review: The Age of Cryptocurrency: How Bitcoin and Digital Money Are Challenging the Global Economic Order

I recently finished a book called The Age of Cryptocurrency: How Bitcoin and Digital Money Are Challenging the Global Economic Order by Michael Casey and Paul Vigna. This book gives a complete overview of Bitcoin as a technology (the blockchain) and as a currency (BTC). It covers a very wide range of topics from the white paper published by Satoshi Nakamoto and his unknown identity to the regulatory hurdles that Bitcoin entrepreneurs have faced. (I have linked a website that I believe does a very good job of describing how blockchain technology works). The authors of this book emphasize the future implications of Bitcoin’s blockchain technology, which they refer to as the Blockchain 2.0. The Blockchain 2.0 is an umbrella term for all applications that are using Bitcoin’s core technology, the blockchain, in ways that go beyond transferring money. There were two main applications of the Blockchain 2.0 that the authors mentioned: smart contracts and asset transfers. I did not understand how these blockchain applications worked, after reading this book, and hope to explain them in following posts.

            The authors approached the challenge of explaining what Bitcoin is by first attacking the underlying question, “What is Money?” According to the authors, there are two contrasting views to this question. The ideology of metallism is founded on the belief that money has have some underlying value, think the Gold Standard, while chartalism is founded on the ideas that currency is an intricate network of trust and has value due to its characteristic as a medium of exchange.¹

I really enjoyed the author’s description of the Yapese monetary system. It is a great example of chartalist theory of currency, as well as an analogy for Bitcoin. The Yapese currency is based upon large round stones known as fei. Since these objects are so massive, it is very inefficient to transfer them to the new owner after each transaction, so they usually remain in the possession of the previous owner. But even while the physical stone may not move into possession of the new owner, the new owner is recognized as possessing the value of the stone. ¹ This example does a great job of illuminating how money is based upon a system of trust that other people will accept it as a unit of exchange and how Bitcoin is based on a public ledger where people acknowledge each other’s credits and debits, even though there is no physical asset.  

            While I don’t believe the authors do a great job of describing how the technology behind the blockchain and Bitcoin works, this book is a fascinating and informative read. I had very limited knowledge about Bitcoin and did not even know that the blockchain existed before reading this. Now, I am intrigued by both of these technologies and believe they will have a large impact on the future of financial networks. I also think Bitcoin is a fascinating experiment to think about in terms of a new monetary system. Bitcoin is deflationary and has no central bank, unlike most every other currency that we use today, and I am curious how this will impact monetary economics.

1) Vigna, Paul, and Michael Casey. The Age of Cryptocurrency: How Bitcoin and Digital Money Are Challenging the Global Economic Order. New York: St. Martins Pr.

What is Quantitative Easing and was it successful?

During the 2008- 2009 Great Recession, the Federal Reserve tried to create stability within financial markets and spur economic activity. To do this, the Federal Reserve lowered interest rates. But as the Federal Funds rate neared zero, interest rates remained high due to fears of insolvency within companies and illiquidity within financial markets. To solve this divergence in interest rate spreads, the Federal Reserve pursued unconventional monetary policy such as Quantitative Easing.

 Quantitative Easing works by the Federal Reserve purchasing assets, such as Mortgage-Backed Securities, long-term bonds, or treasuries, from banks in return for cash. This results in the bank holding excess reserves that can be loaned out to create economic activity. (When the bank’s supply of money increases, interest rates go down because banks want to be able to loan out their money to make a profit.) Quantitative Easing also allowed the Federal Reserve to create liquidity within financial markets, which freed up investors capital.  

Last week, the chair of The Federal Reserve Janet Yellen declared the end of Quantitative Easing, as the economy has improved and unemployment figures have lowered. Though the economy has improved and interest rates have been at near zero levels for the last four years, Quantitative Easing has become a controversial issue. Some people believe that this program has created a bubble in equity markets, and that it will lead to high inflation and a jump in interest rates after the program has been ended. The S&P 500 has returned over 130% since the start of QE1. Quantitative Easing may have helped make stocks an appealing choice to investors because businesses are able to take advantage of the low interest rates and bonds were had very small returns, but it is hard to say if Quantitative Easing has created a bubble in the equities market. The Fed has expanded its balance sheet by almost $3.6 trillion dollars through monthly asset purchases, but QE should be looked at as an asset swap rather than an inflationary program. (See link at bottom for more info) The last criticism, interest rates will jump after this program has ended, may become true, but the Fed has said that it will keep interest rates at similarly levels after the end of QE.

Quantitative Easing has not created economic wonders by creating a fast growing economy, but it may have helped make the Great Recession less damaging. Yet, there are still many economic side affects that may come of Quantitative Easing.

During the Great Depression, the Federal Reserve failed to pump liquidity into the system and help failing financial institutions. This led to a deflationary spiral and economic collapse. During the Great Recession, the Federal Reserve did many controversial things, but it fulfilled its duty of trying to create liquidity and stability within financial markets.

Here is the link mentioned above: http://pragcap.com/mechanics-qe-transaction

I am still unsure whether Quantitative Easing was a successful program. Please comment below on what you think or any information that has led you to view it in a certain way

The Rise of MOOCs

In an article I posted a few months ago, I tried to explain changes that are affecting our world, from the way we get information to how we create energy. The Internet has been one of the largest contributors to these changes, allowing people to communicate and share ideas with each other from across the globe.

In the field of education, the Internet has brought innovation by providing billions of people with the ability to explore any topic they desire, independent of their age or socioeconomic class. One creation that has stemmed from the Internet are Massive Open Online Courses or MOOCs. These are online classes that are taught by professors, available to anyone free of charge. Through university initiatives and startup companies such as Udacity, Coursera, and edX, colleges are able to distribute their courses to online audiences.

Finding a way to make MOOCs profitable has become a problem for these universities and companies. Udacity has partnered with large companies such as AT&T and Google to provide training for employees, while Cousera offers certificates of completion for a fee. Some universities have begun using online courses to teach supplemental programs to students. Harvard has begun using online classes to teach credit or degree classes through the Harvard Extension School, and Harvard Business School has begun offering online degrees through HBX. In 2013, Wharton was the first business school to publish MOOC versions of its first year MBA classes.

This summer, I was able to participate in a MOOC offered by Harvard called CS50. CS50 is an introductory to computer science class. Through filmed lectures, supplemental videos, and online coursework, I was able to participate in a class that was similar to what undergraduates at Harvard were taking. The CS50 staff has incorporated online chat groups, forums, and videos into the online class to allow students to interact with one another online, but there is still a large aspect of social interaction that is lost.

Though, I believe MOOCs are a great way to learn additional knowledge or refresh skills, I do not think that they are a replacement to a college education, yet. Peer interaction, study groups, and extra-help sessions are not very accessible when participating in a MOOC. San Jose State University recently found that their students who were taught via online courses received lower test scores than those who were taught in a classroom. Online lectures do provide students with valuable resources, as teachers are able to “flip” their classroom and students can watch lectures that they may have missed or not understood. In the future, I believe that more students will begin replacing college classes with MOOCs if universities are able to recreate an experience that is similar to what students in a physical classroom atmosphere experience.  

What is Monetary Policy?

The Federal Reserve was created in 1913 through the Federal Reserve Act.  The purpose of the Federal Reserve, or central bank, is to provide the country with a safe, liquid, and stable monetary system. The Federal Reserve does this by manipulating the Federal Funds Rate and changing the monetary supply..

In times of financial panic, the central bank tries to keep financial markets liquid and prevent the monetary supply from tightening. To keep the monetary supply from decreasing, the Fed can lower interest rates. When interests are low, individuals and businesses are more likely to borrow money, because it is cheaper. When businesses and individuals take out loans, they have money to spend, which can create economic growth.

 In the recent collapse, the Fed took many unprecedented measures to create loose monetary conditions. They created multiple programs that bought toxic assets from investors, which created liquidity within markets. (If a market is liquid, the asset can be converted to cash easily. This allows people to sell assets in return for cash, rather than being stuck with assets that they couldn’t sell.) Another program called Quantitative Easing was created to lower interest rates and increase the monetary supply. This was achieved by buying Treasury Securities.

            The Fed influences the money supply and interest rates by setting a target for the Federal Funds Rate. To reach this target, the Fed will either buy or sell large quantities of Treasury Securities. When the Fed sells Treasury Securities, they deduct the total cost the purchasing bank bought from that bank’s reserves. This bank is then required to borrow money from other banks so they have enough money to meet their required reserves. (The rate at which banks loan each other reserve money is called the Federal Funds Rate, which influences almost every interest rate.) The Federal Funds Rate will rise because there is more demand for borrowed reserves. The opposite occurs when the Fed sells Treasury Securities; interest rates decrease and the monetary supply increases. The Fed credits the bank’s account allowing the bank to lend out more of their deposits. 

Treasury Securities, such as bonds, bills or notes, are debt obligations issued by the US government. They a very liquid asset and are considered riskless because investors do not believe that the United States will default on their loans.

Why I am Bullish on Ford 2/2

Metrics and Valuation (All data came from Morningstar Inc)

This is the second part of my analysis of Ford Motor Inc (F)

Valuation:

Price/Earnings: PE ratio gives you the amount of money you are spending for $1.00 of a company’s earning. A high PE ratio means that the stock is expansive relative to its earnings and may be overvalued. Growth companies tend to have high PE ratios because investors are expecting large earnings growth in the future, even if the current earnings do not justify such a high price. The PEG ratio takes the growth rate into consideration. Any stock with a PEG ratio <1 is considered to be undervalued.

I tend to look at companies that have a PE ratio of 13.00 or below, but it can change dependent on the industry and company. Ford’s PE is 9.07 compared to the S&P 500 PE of 19.39. I believe that Ford is undervalued at this price.

Price/Book: PB ratio is the Price of the stock/Shareholders Equity. This is another valuation that can help investors find undervalued companies. There are some shortcomings to this metric because Shareholders Equity can be easily manipulated. If a company has a low PB ratio (<2.0 I think) then either the company is undervalued or may have financial problems.

Ford has a PB ratio of 2.5, which I think is still a semi undervalued rating.

Metrics:

Return-On-Equity(Net Income/Shareholder’s Equity): ROE is a metric that tells you how efficiently the company is using shareholder’s money. I usually look for an ROE greater than or equal to 18%.

Ford had an ROE of 33.81& in 2013, which means that Ford returned 0.3381 dollars in profit for every shareholder dollar invested.

Return-On-Invested Capital: ROIC is a measurement that shows the rate of return that the company is making off invested capital, such as common equity, preferred shares, and long term bonds. If the cost of capital is greater than the return on invested capital, the company is losing value and vice-versa. The equation for ROIC is: Net Profit after Taxes/Operating Capital

Operating Capital=Average Stockholder Equity + Average Debt Liability

Ford has an ROIC of 6.08% for 2013, while General Motors had an ROIC of 6.42%. Although I usually look for an ROIC between 15%-20%, automobile manufacturers tended to have an average ROIC ratio around 4% for fiscal year 2013.

Dept/Equity: This ratio helps investors determine if the company is actively issuing debt or issuing new shares of stock to raise capital. Ford currently has a debt/equity ratio of 2.9. Though this ratio is high compared to a computer company, auto manufacturers require lots of capital due to the capital-intensive nature of the business. These companies tend to have Debt/Equity ratios above 2.

When conducting financial research, it is important to learn about the financials of other companies within the same sector.

I believe that Ford is undervalued and has very strong growth potential domestically and abroad. China and Africa are two large markets that Ford has just begun to grow in. Ford is also developing innovative solutions to create more fuel-efficient cars. This is very important that a company of this size is still able to make such large changes. Ford is creating value for its shareholders, and I believe that it will continue to.

Disclaimer: I am just a kid with no proper financial training. This report will not guarantee investing success.