Author: Jay Jiyuan

The best way to know is to read my thoughts on the blog site: Ideabins.blog. I have been a managerial consultant for 10 years and then college teaching for 12 years. Entrepreneur in heart, interested in financial leteracy

Cryptocurrencies & NFTs Financial talks at dinner table

Merkle Tree & Double Spending

Post author By Jay Jiyuan
Post date May 29, 2022

The family today will wrap up the technical issues and move on to big picture issues associated with cryptocurrencies and blockchain.

Greg: Okay, last time we talked about Merkle Tree but did not find the time to talk more about it. To begin, I think the key is to understand different hash values. We have transaction level hashes, meaning each transaction has its own hash, although we barely talk about that.

Emily: Yeah, why is that?

Greg: Because the “block hash” steals the show. In fact, we talk about block hash so much that we may even believe there is only one hash in each block. But if you think about it, that can’t be true because we want to make sure every transaction is immutable, not just immutability for the entire block.

Jason: That’s true. I remember watching that video you recommended, and it shows every time the guy typed something in the data column, the hash changes. It’s not like the hash only changes once at the end when all data are entered.

Greg: It has to be that way. If anyone can mess around each and every transaction inside a block without any change in hash, what does it mean to have a secure block? It means nothing. A secure block must make sure all the records it contains to be secure. We can think of a block as a movie theater, which is not safe unless all movie-goers are safe. If one were to be kidnaped in it, nobody could claim the theater safe.

Lily: The key is to link record level security to block level security I think.

Greg: Exactly! And that’s where Merkle tree fits in. Let me show you a picture of that tree.

Merkle Tree, Merkle Root & Block Headers

Emily: It looks complicated.

Greg: That’s because it shows more than a Merkle Tree. It has three blocks, or more accurately three block headers. Merkle Tree is shown for the middle block. Let me show you another picture from Investopedia that contains only Merkle Tree, no block headers:

Transactions (T), Hashes (H), Merkle Tree & Merkle Root

Emily: What’s the basic idea of the picture?

Greg: The tree keeps pairing up transaction’s hashes, called “leaves hashes,” to combine them all into one single “root” for all transactions. In the pictures the root is called “Tx_Root” or H_abcdefgh where “Tx” or “T” stands for transactions. Most people call it Merkle root to honor the author who invented it. “H” is always for hash.

Kimberly: It’s funny that you call it a tree, but the root is at the top.

Greg: I was gonna point that out. Yes, the Merkle Tree is always upside down with the “leaves” at the bottom and “root” on the top. Furthermore, it is the same fingerprint machine, SHA256, that is used to build the tree. It starts by creating one hash for each transaction and then retains the hash, no need to keep transaction details, which saves space.

Lily: Let me guess: The fingerprint machine keeps pairing up hashes until there is just one hash, which will be the Merkle Root hash, right?

Kimberly: Also, once we have linked all records in a block, we then link blocks. This is done by each block header always containing the block hash of the preceding block, like its parent, which has its own parent block. That way once a block is added to the blockchain, it cannot be easily changed.

Greg: Both of you guessed right! A couple details. First, if the number of hashes is an odd number, we will simply duplicate one hash to ensure all hashes will be paired up. Secondly, the Merkle root hash is always 32 bytes, whether it’s for one transaction or one thousand. Finally, SHA256 actually hashes block header twice, which is why sometimes you will see notions like SHA256-2 or SHA256 Squared (SHA256²).

Emily: Why is that?

Greg: I don’t think we need to worry too much about it, but the most popular theory is that hashing twice helps protect against the so called “length extension attacks.”

Emily: What’s that?

Greg: According to this Wikipedia page, it’s a risk where a hacker can use the output hash and the length of input messageto calculate another hash controlled by hacker, without needing to know the content of input message. By the way all SHA-2 algorithms, which include SHA256, are vulnerable to this but the future generation like SHA-3 won’t have the problem.

Joy: We probably should only remember that the reason behind hashing twice is to increase the security of the hash.

Greg: That’s right. Now to wrap up, here is a pretty good overall picture from Tutorialspoint.com:

Emily: This one has all the six fields in a block header.

Greg: Yes, it does. One terminology issue: The level of difficulty is sometimes called “Bits” like in this picture. Just so you know.

Kimberly: I have had a question for a while but did not get to ask: What exactly is the “double spending” problem. Almost all discussions on mining mentioned this.

Joy: There is an article by Investopedia that offers a good explanation. It says the problem is mostly for digital money, not paper money. Spending the same $20 bill twice is virtually impossible, just like you can’t have a cake and eat it. After you hand your $20 bill out to the cashier for a 16’’ pizza, you can’t get that bill back, unless the pizza had the wrong topping, like you ordered mushroom, but you got meatball. You can demand for a refund and get the $20 back — but then you didn’t get the pizza.

Jason: It is possible though that the store manager may let you keep the meatball pizza for free and give your $20 back. A friend of mine told me a story like that before.

Greg: Good try, Jason! But that is not a “double spending” case. Instead, it’s “no spending” because you did not spend a penny in the transaction.

Kimberly: But why do cashiers in supermarkets or stores constantly check every dollar bill from the customers?

Joy: I was thinking of the same thing. Supermarkets are looking for fake money, but fake money is one feasible way to double or even multiple spending. It uses one real dollar bill to produce thousands or millions of fake bills. To be sure, fake paper money is only possible with the right printing equipment and paper. With central bank’s monopoly power, it is impossible to produce fully authentic paper money. Cashiers with a simple device can quickly tell the difference.

Kimberly: So is it true that digital money is more vulnerable to double spending than paper money?

Greg: Let me first make a quick comment that we need to separate digital money from cryptocurrency. The former is centrally issued just like the paper money but only exists in digital format, while the latter is decentralized, encrypted and distributed.

Kimberly: Wow, up to this point I thought “cryptocurrency” and “digital money” were different names of the same thing!

Greg: I recommend this article of Investopedia entitled “Digital Currency.” The authors correctly point out that all cryptocurrencies are digital currency, but not all digital currencies are cryptocurrency. Digital money has three types. The first is cryptocurrencies like Bitcoin and Ethereum; but we also have the so called “virtual currency” like casino tokens; and finally Central Bank Digital Currencies or CBDC, issued by central banks.

Joy: I remember reading this article from Times of India that says one of the striking facts of life is that an estimated 92% of the world’s currency is digital. I believe that estimate is right because all transactions between banks, between banks and firms, between firms and firms, they happen more often in digital form than in paper money. The bigger the transaction size, the more likely it is in digit form.

Greg: That’s right. If you expand the definition of digital currency to those frequently but not necessarily exclusively existing in digital form, then we can totally believe more than 90% of money today belong to that group. They are simply digital tokens. Yes, they can be printed out if needed, although I have a hard time imaging why we would want to do that.

Kimberly: Perhaps not printing out but cash out from an ATM machine. Like someone receives her monthly salary in digital form to her bank account but may need to take out a $5 bill to pay the toll if she does not have a FasTrack device.

Greg: That’s true.

Kimberly: So what does it mean for the double spending problem?

Greg: Is digital money more vulnerable to double spending than paper money? I would say no. In fact, I would say the double spending problem for digital money is overstated. There is an important technical reason for that: Digital money is much easier to be copied than paper money. However, just because it’s technically feasible does not mean it’s inevitable, because we already have powerful means to control and prevent the problem.

Kimberly: What are the means you have in mind?

Greg: Because digital currency is centrally controlled, the same central authority becomes the means to fight double spending. It will have detailed ledger to track down every digital dollar and nobody can escape from that monitoring and central auditing — unless the kind of double spending approved by the central authority.

Kimberly: We can have legitimate way of double spending?

Greg: Oh yeah, it happens all the time. All commercial banks are required to have certain amount of money in reserve but can make commercial loans above its limit. This is a legitimate way of double spending the reserved money. Say a bank only has $1 million in cash but can make $1.5 million loans. We just don’t call it “double spending” but “leveraging.”

Joy: On the other hand, like we talked about earlier, paper money is not any safer than digital money. Fake paper money can happen to every one of us on a daily basis. Just because one cannot spend the same dollar bill twice does not mean double spending is impossible for paper money. It is possible, mostly through fake dollar bills.

Lily: What about cryptocurrency? Are they more vulnerable to double spending?

Greg: Once again, the possibility of double spending for cryptocurrency is exaggerated. If anything, the blockchain has made double spending very difficult — even without a central controlling authority. There is an article in Investopedia that says that the “likelihood of a secret block being inserted into the blockchain is very slim because it has to be accepted and verified by the network of miners.” In fact, “it is more likely that a cryptocurrency is stolen from a wallet that wasn’t adequately protected and secured.” In conclusion, it says “(t)here isn’t actually any recorded instance of double-spending. The cryptocurrency community believes that all double-spending has been thwarted.”

Emily: We still have not touched on the comparison between Proof of Work and Proof of Stake yet. Looks like we will get to that another day.

Tags block hash, Digital currency, Double spending, Merkle root, Merkle tree, Transaction hashes

Blockchain Cryptocurrencies & NFTs Financial talks at dinner table

Digging Deeper into Crypto Mining

Post author By Jay Jiyuan
Post date May 22, 2022

The Kingstons continues their intellectual journey on blockchain in relation to cryptocurrency. The previous days were on foundational topics like the cryptocurrency algorithms, decreasing reward to miners, and most importantly the cryptography that sits behind all cryptocurrencies. Today they are ready to talk about details of mining itself, finally addressing Emily’s question from days ago.

Greg: So does everyone have the chance to watch the video I recommended? Don’t mean to put pressure on you guys.

Jason: I did. You are right and I was able to understand the show most of the time. Now I have something to brag about in my school to other kids.

Emily: It looks like the thing called “nonce” plays a crucial role in mining, Am I right?

Joy: That’s right. To mine is to play with numerous nonces. Similarly, to win in the mining game is to find the “Golden Nonce” that leads to a hash that fits the criterion or the standard hash.

Emily: But what exactly is “nonce?” The video did not tell us, it just shows up like a magic number.

Greg: Nonce stands for “number used once,” where the first letter “n” is for “number,” and “once” for “one time.” It’s 32-bits — or 4 bytes because one byte is 8 bits and 32 divided by 8 is 4. This is a good size because it’s much smaller than SHA-256 that’s 32 bytes, again 256 divided by 8 is 32, yet big to generate a large number of combinations. Anyone wants to guess how many possible combinations there will be for nonce?

Jason: Let’s see: 32 bits and each bit has two values “0” and “1,” the possible combination will be, let me get it from my phone. “Hey Google, what is 2 to the power of 32?” Wow! It’s 4,294,967,296 or more than 4 billion different values.

Greg: Great! We need that many nonces because each one can be used only once. I hope we can get to the point later that even these many nonces sometimes may not be enough.

Joy: Now we can finally answer Emily’s questions what mining is: It is a process in which miners enter different nonces into the SHA-256 the digital “fingerprint machine” to produce different hashes and one of them may be a or acceptable for validating the entire block of transactions.

Greg: More accurately SHA-256 does not work just with nonce but with the whole block header.

Emily: What is that? I’ve heard block in a blockchain but never block header.

Greg: A block header is a “headshot” of the block with 80 bytes of 6 fields. Sometimes you see people writing down fewer than 6 fields, but they should really have listed all as all are useful. These fields are “software version” that has 4 bytes, “previous block hash” of 32 bytes, “Merkle root” of 32 bytes, “Timestamp” of 4 bytes, “Difficulty target” of 4 bytes, and finally “nonce” of 4 bytes.

Emily: Wow, lots of information here. Do fields with more bytes more important than others?

Greg: Not necessarily. Nonce for example only has 4 bytes but as the video shows it plays a crucial role in mining. The 6 fields in a block header are divided into three types. Nonce is the only one that miners have control. Others are either predetermined like previous block hash or controlled by the system like software version, difficulty target and the Merkle root, or controlled by nature like timestamp. I have a table from the book “Mastering Bitcoin,” 2^nd edition by O’Reilly Media Inc in 2017. But we don’t have to understand all the details for each field, just focus on difficulty target and Merkle root and Nonce.

Size	Field	Description
4 bytes	Version	A version number to track software/protocol upgrades
32 bytes	Previous Block Hash	A reference to the hash of the previous (parent) block in the chain
32 bytes	Merkle Root	A hash of the root of the Merkle tree of this block’s transactions
4 bytes	Timestamp	The approximate creation time of this block (seconds from Unix Epoch)
4 bytes	Difficulty Target	The Proof-of-Work algorithm difficulty target for this block
4 bytes	Nonce	A counter used for the Proof-of-Work algorithm

Block Header the Headshot of the Block

Jason: Just a curiosity: what exactly is Timestamp? The description says seconds from Unix Epoch.

Greg: The Unix “epoch” timestamp is based on the number of seconds elapsed from January 1, 1970, midnight UTC/GMT.

Emily: After watching the video I think I have an idea of what mining is. You click a button and computer quickly runs through different nonce until it finds one that fits the target of difficulty. What I still don’t understand is how the target hash is set.

Greg: The target is set by the algorithm. Remember we talked about how the level of difficulty is set every two weeks? The reason behind the difficulty target is also simple: We just want to keep the pace of releasing new Bitcoin at ten minutes per block. The Mastering Bitcoin book said it very well: That ten minutes per block is the “heartbeat” of Bitcoin.

Joy: That is a good expression.

Greg: The fun comes when we put nonce and target together to get a complete picture. I find this article by Kirill Eremenko in 2018 that does a fairly very good job explaining how. Another article by Blockchain Council also explains nonce well. I specifically like the simple math classroom analogy it uses.

Jason: I like math. Sowhat is the analogy?

Greg: Very simple and yet very interesting, it says in a math class the teacher gave the following problem for students to solve, and whoever gets the answer first win some award: 315 + ? = 319.

Jason: That’s it? That number is 4! 315 + 4 = 319. I bet even Cleo can solve it.

Greg: Theproblemiseasy, but it offers hints to several important concepts in mining. Turns out that “4” is nonce, “319” is the target of difficulty, and “315” is previous block hash or anything that nonce is added to for mining. Mining is to find the piece of the cryptographic puzzle — the nonce and hash value — to meet the level of target difficulty. Take a look at this picture I draw to see how nonce and target work together to produce acceptable hashes for Proof of Work. This is inspired by a similar drawing in this article but with changes.

How Level of Difficulty Controls Proof of Work

Kimberly: What changes have you made from the original?

Greg: The biggest one is to make the target hash an area rather than a single line. This reflects the changing level of target difficulty, called “retargeting,” because a higher level of difficulty means a smaller target hash. So of the two yellow broken lines the one below is harder than the one above.

Emily: It’s never clear to me how to control target hash or level of difficulty. I heard someone saying the other day that it is controlled by the leading zeros in the target hash. Why’s that?

Greg: Because with any number of a fixed length, more leading zeroes always make it smaller. Let’s compare two 5 digit numbers, one is 01234 and the other 00123, which is smaller? Of course the second one with two leading zeroes. I can even change the second number to 00987 and it won’t make a difference. This is why the number of leading zeroes controls level of difficulty. If the algorithm needs to raise the level of difficulty, just add more leading zeroes. Do the opposite and drop at least one leading zero to lower the level of difficulty.

Emily: Oh, that’s it? It sounds so easy.

Joy: It is easy. You often read people saying that mining involves solving complicated math problems. Not true. The math is easy and simple, the solution however requires more computing resources. That’s why I said that both Proof of Work and Proof of Stake are Proof of Resources.

Emily: But I still don’t see how a smaller target hash will make mining more difficult than a larger target?

Greg: Because a smaller target squeezes the space for finding acceptable hashes. Look at the picture again and if the target hash was the yellow broken line above, not below, there would be more acceptable hashes to be found, mining is easier.

Joy: Think of a room with a high ceiling versus another room with a very low ceiling, which room can hold more stuff? The one with high ceiling, right? A larger target hash is like a larger room to accept more hash values.

Greg: Chapter 10 of the book Mastering Bitcoin I mentioned earlier has an excellent analogy I believe would help us all. It tells a dice rolling story. Someone rolls two dice, and the goal is to show a number of dots below a target, just like our proof of work problem. Now, one dice has six sides with 1 to 6 dots on each side. Jason, if I roll two dice at the same time, how many possibilities of dots there will be?

Jason: Well, each dice has 6 possibilities, and two independent dice will have 6 x 6 = 36 possibilities.

Greg: Right. Now let’s say the target is to show 12 dots on two dice rolling together. Is it easy to get a “Golden Nonce,” meaning the right nonce to solve the mining problem of finding acceptable hash value?

Jason: Very easy! The only time one would loss is when she has (6,6), meaning both dice have “6” dots. All other combinations are winning.

Greg: Right! Now let’s lower the target to 11 dots. That would still be easy, as long as they show up anything below 11 dots. Keep lowering down the target until it’s 5 dots, then it’s harder, because most rolls will show up above or equal to 5 dots. Jason, how many rolls would meet the target?

Jason: Let’s see: (1,1) for both dice showing one dot; (1,2) for one dice 1 and the other 2 dots, (1,3) for one with 3 dots and another 1 dot and finally (2,2) for both showing 2 dots. I guess only 4 out of 36 possibilities qualify. 4 divided by 36 is roughly 11%, so nearly 90% of the time one loses.

Greg: How about a target of 4 dots? Only (1,1) + (1,2) = 2 possibilities to win. For target 3 it drops down to (1,1) = 1 winning possibility.

Emily: I see your point: The smaller the target the harder to get the required nonce to produce satisfied hash values.

Greg: I’m not done yet. Let’s go down to a target of 2 dots on the same pair of dice, then we will see a really tough game, because nobody can win no matter how many times she rolls the dice.

Emily: Interesting! Are you sure about that?

Greg: I’m positive. The book I am citing from claims one possibility of (1,1) will win but that’s not true. Remember the challenge is to go below — not equal to — the target of 2 dots. The only “chances” to win are (1,0) + (0,0) = 2 possibilities but those are impossible since no dice has 0 dot as the minimum dot is 1. That’s why for two dice to show dots below 2 is impossible. Game over and nobody win.

Lily: So does it mean sometimes we will have no winner and no new Bitcoin will be released?

Greg: Of course there will be winner and a new block of transactions will be verified and added to the blockchain. It just means sometimes we will run through all the 4+ billion nonces and still find no acceptable hash below the target.

Lily: It’s amazing that even 4 billion nonces are not enough to solve the mining problem.

Greg: It’s understandable if you know how powerful computers are today. The article by Kirill Eremenko tells us that “even an average mining device can calculate up to 100 million hashes per second, and therefore will go through the Nonce range in 40 seconds. And that’s an average miner. Mining pools and industrial scale mines are able to go through the Nonce range in fractions of a second.”

Lily: Okey, I can see that 4 billion nonce is not that much in the eyes of modern computers. But what we do to make sure we find the right hash to verify the new block of transactions?

Greg: That’s why Proof of Work is not just a game of nonce, we must utilize other things in the block header I was talking about earlier and then use the SHA-256 fingerprinting machine to make sure we get Proof of Work done.

Kimberly: The block header contains a total of 6 fields, we’ve used nonce and previous block hash, what else would we use?

Greg: The first extra field to be utilized is Timestamp. As Eremenko points out, “all we have to do is wait until the timestamp increases. A change in the timestamp will mean that the combination is now different and if we try all 4 billion Nonce values again, every time we will get a brand new hash value.”

Kimberly: Sounds like we solved the problem once and for all.

Greg: Not really. Turned out that even the timestamp, which increases by second, is not updated fast enough. The mining pools, where miners form a club to mine together, can finish running through 4 billion nonce in a fraction of one second. We need other ways to help find the Golden Nonce.

Emily: Wow! Now what?

Greg: If there is a will, there is a way. Turns out that we can use Coinbase transaction to solve the problem.

Emily: What’s that?

Greg: Let’s first find out what Coinbase is. According to this Wikipedia page, Coinbase is “an American company that operates a cryptocurrency exchange platform.” “It is the largest cryptocurrency exchange in the United States by trading volume.” What makes Coinbase transaction special is that it is always the first transaction in each block, and it is created by miners who use it to collect the block reward and other transaction fees.

Emily: How does it work for solving our problems here?

Greg: It may sound complicated, but the idea is simple: We use the Coinbase transaction data as extra space to hold extra nonce.

Lily: How much space can we get from the Coinbase transaction?

Greg: Quite big, it can hold anywhere between 2 and 100 bytes of data. That space is called “extra-nonce space,” which provide an extra nonce mining solution. Say we use 8 bytes of the Coinbase data space, plus 4 bytes of “standard” nonce space, there would be 12×8=96 bits, or “2 to the power of 96” instead of “2 to the power of 32” as previously with the standard nonce.

Lily: Wow, with this much space we don’t have to use the Timestamp.

Greg: That’s right. The other good thing is that Coinbase transaction always enters Merkle Tree, so anytime there is a change in Coinbase transaction, it will change the block hash.

Emily: What’s a Merkle Tree?

Greg: That’s the question for another day. We will also talk about encryption and compare Proof of Work and Proof of Stake.

Tags block header, Coinbase transaction, Crypto mining, Extra nonce, Merkle tree, nonce, Timestamp

Blockchain Financial talks at dinner table

All About Cryptography

Post author By Jay Jiyuan
Post date May 20, 2022

The Kingstons agreed to dig into more details of cryptocurrency mining asked by Emily. Although the issues are more technical than all the previous conversations the family has had, the conversation style keeps the text short and pointed because anyone can ask any questions along the way. At the end of day, however, they did not go any further than talking about hash, hash function and cryptography.

Greg: Let’s consider the mining question Emily raised at the very beginning. Remember we were talking about a decreasing reward for miners? Turns out that the Bitcoin algorithm also has a changing level of difficulty for mining, which can either go up or down, depending on the number of miners in the game and how active they are mining.

Joy: That’s right. Please don’t feel overwhelmed Emily because this issue is directly related to what mining is. We’ll get there to answer your questions.

Emily: Thank you for telling me that. Meanwhile, I’ll keep asking questions along the way if you don’t mind.

Greg: Of course not! Let me begin from one concept called “difficulty epoch” as discussed by a CoinDesk article. Each epoch corresponds to 2,016 blocks of transactions, which in turn correspond to roughly two weeks. After the current difficulty epoch is reached, the difficulty level will be updated either up or down, based on the number of miners and their activities in the last two weeks.

Joy: Yeah, the goal in the algorithm is to finish verifying a block in ten minutes. If last two weeks have seen less than ten minutes the difficulty level will be up, otherwise down.

Lily: So it looks like not only the entire supply of Bitcoin will reach 21 million coins in 2140 but the pace of releasing new bitcoins is also determined by the algorithms at 10 minutes per block.

Joy: Yeah, the whole process is transparent. You can prove it with the numbers. 10 minutes per block means 6 blocks in one hour, 144 blocks in one day of 24 hours, and 2,016 blocks in two weeks or 14 days because 2,016=144 x 14.

Greg: Not meant to confuse you, but there is another milestone related to the decreasing coin reward to miners. Remember we learned yesterday that four every four years the reward will decrease by half. That four years correspond to 210,000 blocks created or confirmed.

Emily: How do the algorithms control levels of difficulty?

Greg: The key is to change the number of leading zeros in the target hash function.

Emily: Wow, what’s a hash function?

Joy: We talked about hash function before when we were discussing NFTs. A hash function is best to be called a “fingerprint machine.” In math terms, hash function is nothing but algorithm that accepts different inputs or data or messages and then produces uniform sized “fingerprints” that can be called “hashes,” “hash values,” “hash sums” or “message digests.” I can show you a static picture here, but the guy named Haseeb Qureshi does a better job in a blog showing a really neat dynamic cartoon picture.

Hash input, hash function and hash digest

Greg: Haseeb Qureshi did a good job but this video is by far the best I’ve ever seen after reading, searching and watching many other pieces and sources. It explains a whole bunch of concepts like block, blockchain, hash, hash function, nonce, distributed network, tokens and Coinbase and nicely put them together with a little demonstration that clearly and visually get the ideas crossed. It’s so intuitive that people as young as Jason can understand because everything is right there in front of your eyes. It’s about 18 minutes long but I guarantee that it won’t waste a single minute of your time.

Emily: Wow! I’ve never seen you so excited before. We sure will watch it later.

Greg: Just a bit background information for the video. At the beginning of the video you will see the term “SHA-256,” that means “Secure Hash Algorithm” that produce hashes that are 256 bits long. Bear in mind that when it comes to computer terminologies, we don’t count “words” but only “bits” and “bytes.” One byte is 8 bits. So 256 bits is just 32 bytes.

Emily: Why should we care about these details?

Greg: You don’t have to. We could sit here talking about bits, bytes and hexadecimal numbers all day. But the important thing to keep in mind is that the SHA-256 is a hash function, or more accurately a cryptographic hash function — the machine that makes hashes or “fingerprints.” There are other hash functions but SHA-256 is the most popular one. If you must know one hash function, SHA-256 would be it. Bitcoin uses SHA-256, for example. I learned from this article by n-able.com that “The US government requires its agencies to protect certain sensitive information using SHA-256.”

Kimberly: What make SHA-256 so much liked?

Greg: That article by n-able.com again offers a good summary: (1) one way function from input data to hash and almost impossible to figure out what the input data is even if you know its hash because “A brute-force attack would need to make 2²⁵⁶attempts to generate the initial data.” (2) Uniqueness of hash, once again because the “2²⁵⁶possible hash values (more than the number of atoms in the known universe), the likelihood of two being the same is infinitesimally, unimaginably small.” (3) the avalanche effect that “a minor change to the original data alters the hash value so much that it’s not apparent the new hash value is derived from similar data; this is known as the avalanche effect.” These are the major ones; I will add more later when we compare hash function with encryption.

Joy: Now that you mention encryption, I remember reading somewhere that cryptocurrency needs both hashing and encryption.

Greg: That’s true. The nice thing though is that encryption and decryption, hash functions, and digital signature algorithms are all parts of cryptography. This is why Bitcoin and others are all called “cryptocurrencies” because they all use the same foundational technologies of cryptography.

Emily: What does the word “cryptography” mean?

Greg: Good question. This article from Investopedia offers a good explanation. I have it downloaded to my phone. Here it is: “The word ‘crypto’ literally means concealed or secret. ‘Cryptography’ means ‘secret writing’ — the ability to exchange messages that can only be read by the intended recipient.”

Emily: Sounds like cryptography is all about security and confidentiality of information or data.

Greg: More accurately it’s a decentralized way of keeping information, data and transactions secure, a way that does not require a third party or a central authority. Furthermore, the technologies not only provide security but also efficiency. If you watch the video I recommended, you will see that we can put in all the stuff from the Library of Congress and the hash function still produce one hash digest that is only 256 bit long!

Lily: What about encryption and decryption? What are they and why we need them?

Greg: They serve different functions for cryptocurrency. So far we have been talking about cryptocurrency mining, which relies on the hash functions. But when we get to the transactions between digital wallets, encryption and decryption become the key tool.

Kimberly: How do hash function and encryption differ?

Greg: That’s a hot topic and much discussion surrounding it. The first key difference is that encryption is a two way process, meaning you first encrypt the plaintext data to make it secret or unreadable, which is called “ciphertext”, and then you need to decrypt to make it readable.

Joy: This is like sending and receiving a telegraph in the old days.

Greg: Exactly. Say someone’s grandma is seriously sick, she’d rush to the post office and writes down the words “Grandma sick, come home!” to be sent to her brother. The post office worker would first translate, encrypt that is, the words into a bunch of codes, and then send to her brother. Once the telegraph arrives at the receiving post office near where her brother lives, someone else in that post office will translate, decrypt this time, the codes into plain English.

Kimberly: How is the hash function different?

Greg: Hash function always works one way, meaning there is no decryption. Once the input data, messages or transactions were hashed, we don’t want them to be decrypted or to make the hash readable by a human. For a hashing function, such a reverse process — if succeeded — would be a disaster because it means the hash function failed to do its job.

Kimberly: But why is that a good thing? It’s like sending a telegraph out that no one can read and understand, right?

Greg: I thought about that for several days by asking myself the same question as you just did: What if someone needs to read and understand the original input, not just the hash? I searched online using that question and could not find any answer.

Kimberly: So do you have an answer now?

Greg: Suddenly it came to me yesterday that it’s not the right question to ask, because it failed to take the purpose of blockchain data into consideration. When people put transaction records in a blockchain, they want two things: One, keeping those records in the chain permanently and remain unchanged forever. Two, making the authenticity of all the records in each block easily and quickly proven. For those purposes a one way hash function works out perfectly.

Kimberly: Could you elaborate on that?

Greg: It is directly related to a very nice property of the hash function. Not only is it a fingerprints machine, but the machine is extremely efficient. Remember I talked about earlier that even if we put all the books and journals from the Library of Congress into one block — I know that’s impossible given the 1 MB per block data limit set by Satoshi — the SHA-256 hash function would still produce just one hash that is 256 bit long?

Kimberly: Yeah, why is that relevant here?

Greg: Well, keep using the Library of Congress example, and still assume the entire collections were fit into one block, with the hash function working properly, even if I changed one comma in one book — and there are 167 million items when I checked it last night — to a period, the hash will be completely different.

Joy: Yeah, even a tiny change in the input will certainly lead to a completely different hash. This is called “Avalanche Effect.”

Kimberly: Those are impressive, but I still don’t see their relevance with our discussion here.

Greg: Think of it: How would you make sure that none of the records in a block has been tempted? Checking all the records one by one, or just look at the hash function to see if it has been different?

Kimberly: Oh, I see! A hash function makes it very easy to find out any changes made to any record in a block. I can buy that, but what about encryption? Does it do the same thing as a hash function?

Greg: Smart question! If I say “yes,” then we can use encryption to still get what we want. Unfortunately, the answer is “no.” You see, the output from encryption varies, depending on the size of the input. That means longer inputs or “plaintexts” will have longer outputs or “ciphertexts.” This is just like telegraph, the more words you send, the longer the telegraph and more money it costs you.

Joy: Very interesting. The other reason we can use hash function for blockchain is that all hash functions are deterministic, meaning that given the same input, only one hash digest will be produced. Therefore, while it is virtually impossible for anyone else to reproduce the input from hash, whoever owns the input record knows perfectly well what the input is. She does not have to do the “reverse engineering” like a hacker would have to.

Emily: You say, “virtually impossible,” is it still possible to find the input once you have the hash?

Joy: It is possible but highly unlikely. The way to do it is through the so called “brute force attack,” meaning to run through all the possible combinations until hitting the target. This requires great resource with very low chance of success. Remember the reason we were told earlier: A hackers would have to make 2²⁵⁶attempts to generate the initial data.

Lily: I am thinking of passwords that we use every day. They are usually not very long, so which function is best for protecting passwords, hash function or encryption?

Greg: Good question. The answer is still hash function but for a different reason. Can you guess what it is? It’s because decryption — the process that makes an unreadable text readable — is a bad idea that is asking for trouble. This article correctly points out that “it’s more secure to store the hash values of passwords instead. When a user enters a password, the hash value is calculated and then compared with the table. If it matches one of the saved hashes, it’s a valid password and the user can be permitted access.”

Joy: Speaking of passwords, I’ve read an interesting story that is almost funny: Turns out if you limit the passwords to a four-digit number, the choices made by many people are highly predictable. I still remember that the top choice is “1234,” followed by “1111” and “0000.” Those made the “top three” list.

Lily: So is encryption any good at all for cryptocurrency? It sounds like hash function is all we talk about.

Greg: That’s a question for another day.

Tags Avalanche effect, Crypto mining, Crytography, Decryption, Digital fingerprints, Encryption, Hash function, SHA-256

Blockchain Cryptocurrencies & NFTs Financial talks at dinner table

Blockchain & Cryptocurrency

Post author By Jay Jiyuan
Post date May 18, 2022

After yesterday’s talk on editable blockchains, the family comes back today to continue their conversation on blockchain and cryptocurrency mining. The conversation is mostly between Emily, who believes she is not good at technical details, and her parents.

Greg: I hope you all had the time to find something related to blockchain. Yesterday we talked about philosophical issues of absolute or relative immutabilities, today I think the issues may be more detailed and more technical.

Emily: I guess I’m not good at technical stuff. Can you help me with “Proof of Work?” versus “Proof of Stake?” I know one of the top cryptocurrencies, Ethereum I think its name is, is moving toward “Proof of Stake” while Bitcoin stays with “Proof of Work.”

Kimberly: That’s right. I read a report from the Fortune magazine that Ethereum is currently running both “Proof-of-Work” and “Proof-of-Stake.” But when they finish the highly expected upgrade, which we don’t have a set date yet, it will be “Proof of Stake” only.

Lily: And I read an article published by Bitcoin magazine that says Bitcoin will not, and could not, switch to “Proof of Stake” because Bitcoin code is immutable.

Joy: It’s important to remember that first of all, “Proof of Work” and “Proof of Stake” are different ways of doing cryptocurrency mining. Perhaps even more importantly they are both “Proofs of Resources” in the sense anyone possessing more resources has a better chance to become a winner in crypto mining.

Emily: You said “a winner” so there is just one winner? Also what is cryptocurrency mining? Why are so many people interested in mining?

Joy: Let’s begin from the last question, which is the easiest: People want to mine crypto for the same reason today as people came to California during the “gold rush” in the 19^th century. They want to win something big.

Emily: How big is “big?” I mean the size of miner reward.

Joy: Let’s find out. Jason, could you Google today’s Bitcoin price for us please?

Jason: Sure. “Hey Google, what’s the price for Bitcoin today?” Here it is: $31,119.80 for one bitcoin on May 15, 2022.

Joy: Thank you! Just to be clear, a winning miner will get far more than $31,000 because she receives more than one bitcoin, 6.25 coins to be accurate for now, every time she successfully mined one block of crypto transactions. We multiply the unit Bitcoin price of $31,119.8 Jason just found for us by the number 6.25, which is $194,498.75.

Emily: You said, “for now.” So 6.25 coins are not constant all the time?

Joy: No, how many coins the winner gets are not constant but keep decreasing by half roughly every four years, until it goes to zero in 2140 when there will be 21 million Bitcoin in total.

Emily: How does the decreasing reward work?

Joy: It’s called “block halving event” and let’s show it with numbers. I will quote this website called bitcoinblockhalf.com that does a good teaching job. I have it downloaded to my phone. Here it is: “When Bitcoin first started, 50 Bitcoins per block were given as a reward to miners. After every 210,000 blocks are mined (approximately every 4 years), the block reward halves and will keep on halving until the block reward per block becomes 0 (approximately by year 2140). As of now, the block reward is 6.25 coins per block and will decrease to 3.125 coins per block post halving.”

Emily: I understand these numbers but why the decreasing rewards. That’s not fair to later miners don’t you think?

Joy: This is a good time to tell the entire crypto rewarding story, or why miners get rewarded in the first place. Let me ask a question first: Who do you think is authorized to issue the paper money?

Lily: The central banks. In the US that’s the Federal Reserve.

Joy: That’s right. Now, who has the authority to issue Bitcoin, Ethereum and other cryptocurrencies?

Lily: No one. They are decentralized currencies I believe.

Emily: Wait, what are “decentralized currencies” versus “centralized currencies?”

Lily: The dollar bills we use every day are centralized money because every dollar bill is issued and controlled by the Federal Reserve, nobody else can do that. That monopolistic and central control makes the dollar centralized currency.

Greg: Now that we are on the topic, centralized versus decentralized is not the same as distributed. I read an article talking about how the three systems differ. Briefly, centralization or decentralization refers to mode of control, while distribution is about location.

Joy: Yeah I heard about that, too. Bitcoin, or more accurately its blockchain, is decentralized but also distributed: “Decentralized” because decisions are made not by a central authority but by consensus; “distributed” because the nodes in a peer-to-peer computer network are all over the world.

Greg: Here is a picture of the three systems I found online. Centralized has all links pointing to a single center, kind of like the Chinese political system where everything is eventually determined by Beijing. Decentralized does not do that, although it may contain hubs of links, kind of like the federation system this country has, where hubs are different states. Distributed has neither a center nor hubs. It is like “direct” or “pure” democracy if you will, getting rid of the representatives altogether.

Lily: I don’t know you guys but if we were treating all three systems as modes of control for decision making, I will pick the one in the middle, the decentralized mode, although I understand the “distributed” system is for locations, not exactly for controlling.

Kimberly: I feel the same! Decentralized has advantages from both sides, just like “representative democracy” is better than centralized dictatorship and distributed “direct democracy.”

Three Systems of Decision Making & Location

Greg: Going back to cryptocurrencies, they are all issued and controlled by algorithms, not by government agencies.

Emily: What are algorithms?

Greg: An algorithm is a predetermined set of rules for computing. In this country we have rule of law for governing human behaviors. Algorithms are the rule of law for governing computer behaviors.

Emily: Interesting. I did not realize how important algorithms are in our lives.

Greg: Bear in mind though algorithms are initially designed by humans. Once started, an algorithm can obtain its own life, or works by the designed logic until we decide to change the rules later.

Joy: I really want to comment on the algorithms in cryptocurrency, more specifically Bitcoin, has been well thought of. Let’s ask ourselves this question: Why was the algorithm designed to reward miners? This is highly relevant to Emily’s question of why the miner rewards are reduced by half every four years.

Lily: From what I have read, it’s all economics. When Bitcoin first started, it must compete with the monopoly power of central banks. The way it competes is through mobilizing as many people as possible, to get them involved in creating and owning cryptocurrencies. Offering reward in Bitcoin — not in dollars — is the best way to go, because miners would have their personal interests lined up with increased value of Bitcoin, or all cryptocurrencies for that matter.

Joy: That’s right! Decentralized power comes from having a large number of people all working for the same goal with shared interest. The economic reasoning behind cryptocurrency rewarding is to give higher reward at the beginning, when Bitcoin was a brand new “startup money” and not many people knew about it.

Lily: It also reflected the lower value of Bitcoin in terms of dollars back when it started in 2009.

Joy: Exactly! The priority back then was to attract more miners to join the digital “gold rush,” to make some “cryptocurrency noise,” to increase decentralized power, which all add up to benefit the value of Bitcoin or other cryptocurrencies.

Kimberly: I see the logic now: The algorithm assumes the value of Bitcoin will get higher and higher as time goes on, so there is no point in keeping the same number of rewarding Bitcoin for the winners.

Emily: I see it, too. Even though the number of Bitcoin rewarded goes down from 50 in 2009 to 6.25 today, the dollar value is perhaps higher than 2009 given the current Bitcoin price. The miners today can take home much more than earlier miners.

Greg: That’s exactly what happened. One thing I love about this country is that you can always find the information you want. I was searching for the price history of Bitcoin and came across this article from Investopedia called Bitcoin’s Price History. We can see Bitcoin had a price of zero when it was introduced in 2009. That changed on July 17, 2010, when its price jumped to $0.09. So indeed the 50 bitcoins received by the first miner meant nothing in 2009, while 6.25 bitcoins are enough to bring six digit income now, even with the recent cryptocurrency price crash.

Joy: This is why I had a hard time believing Warren Buffett actually said that he would not buy all the Bitcoin in the world for even $25, because he said he could not find any use of Bitcoin. He seems to have forgotten what he has been doing for all his life: investing in something for better returns. That’s exactly what one can do with Bitcoin. Let’s say someone sold Buffett 50 bitcoins back in 2010 at the historical price of $0.09 per coin, and he kept those until today, he would have gained how much? Jason, could you do the calculation for me?

Jason: No problem. 50 bitcoins times the unit price of bitcoin today at $31,119.8, that’s $1,555,990, more than $1.5 million! Let’s take out his historical cost of $4.5 in 2010, his net profit would still be $1,555,985.5!

Greg: Let’s calculate his rate of returns. Divide his gain of $1,555.985.5 by his cost of $4.5 and then multiply 100 to make it a percentage figure. What do we have, Jason?

Jason: Wow! That comes out to be 34,577,456%!

Greg: That was phenomenal, and I doubt if Buffett’s other investment records can beat that.

Emily: I still have a concern for miners after 2140, when the algorithms will stop paying reward as there won’t be new Bitcoin released once the algorithm reaches its goal of 21 million Bitcoins.

Joy: I won’t worry too much about that. Miners are still capable of charging fees against Bitcoin users because transactions will still need to be audited by miners. Miners have other privileges like voting for Bitcoin rule changes as well.

Greg: I think we’ve had an interesting discussion on things like decreasing mining reward, centralized versus decentralized currencies, distributed nodes and the value of cryptocurrencies as “investible assets.” But we have yet to answer Emily’s questions about what mining is in any details, about “Proof of Work” versus “Proof of Stake.” We’ll have to stop here as it gets late. Do I have everyone’s consensus to continue the talk tomorrow?

The answer is “yes” and that marks the end of conversation for today.

Tags Bitcoin, Bitcoin price history, block halving event, Blockchain, centralized vs decentralized, Cryptocurrency, distributed nodes, Proof of stake, Proof of work, Reward to miners, ROI to Bitcoin

Blockchain Financial talks at dinner table

Blockchain & Relative Immutability

Post author By Jay Jiyuan
Post date May 8, 2022

It has been weeks since the Kingstons had a conversation on NFTs, Bitcoin and Blockchain based on the blog post written by Devin Finzer, co-founder of OpenSea the largest NFT marketplace in the world. Greg has been busy writing a research paper, and the rest of family had to mind their own business. But today is a good day as everyone feels the need to catch up where they left off last time.

Kimberly: I feel like we should talk more about blockchain. Last time we briefly touched on it, like how a blockchain keeps ownership of NFTs or transactions unique or “non-fungible.” But there must be more to blockchain, right?

Jason: Wait, what is a transaction that you guys keep talking about? Is it buying or selling something, like I paid my friend Lee $1 yesterday to buy two sweetest apples from his family trees?

Joy: Yeah, business transactions are the most obvious that involve at least two people and usually money changing hands. But not all transactions involve two people nor money. If your friend simply gave you an apple for free, that could still be called a transaction.

Emily: Some transactions do not involve different people, either. If I change my weekly budget to cut down food spending and increase book spending, those changes are recorded as transactions, too.

Greg: To answer Kimberly’s question, of course there are more, much more to blockchain. Last time we were mostly talking about NFTs, the stuff that Devin Finzer and OpenSea focus on. We can go deeper into blockchain today if you guys want.

Joy: Let’s do that. To start, I remember reading this interesting article from Investopedia with a flashy title of “Forget about Bitcoin: Blockchain is the future.” It basically calls Bitcoin a small side show and the blockchain the big drama.

Lily: I’ve seen that, too. Somehow I feel the article is exaggerating the case. Some people are only interested in Bitcoin and know little about blockchain, while others believe blockchain represents the future technology, or the greatest invention since the Internet.

Joy: I agree. we don’t have to forget about Bitcoin in order to remember blockchain. Historically, blockchain came to us much earlier than Bitcoin did, so in that sense blockchain is the “chicken” and Bitcoin the “egg.”

Kimberly: It is also true though that many people discovered or became aware of blockchain only because of Bitcoin. It’s almost like they ate the “egg” first to then realize the value of the “chicken.”

Emily: Yeah, like I did not know much about the Titanic ship tragedy until the other day when I watched the movie Titanic with Kate Winslet and Leonardo DiCaprio in it.

Jason: So you are saying the Titanic movie is your “chicken,” the real Titanic ship is your “egg?”

Emily: I’m saying it can go both ways. A “chicken” for someone can be the “egg” for someone else. We don’t have to settle down on one order and put that in stone.

Joy: You have a good point. If I were to write that Investopedia article, I would use a title like “Appreciate Bitcoin but Understand Blockchain.” People use flashy titles all the time to catch more eyes and ears, and I get that. But everything has a limit, we should not go too far on that.

Greg: I like the way Emily said it: putting something in stone. That old expression now may have a new way of saying it. Some people may stop saying “set in stone.” They’ll probably say, “set in blockchain!”

Kimberly: Interesting. I assume it is because blockchain makes everything in it immutable or, to put it in plain English, permanently unchangeable. But how exactly does blockchain do that?

Greg: First thing first, I don’t want you guys to think blockchains are absolutely immutable. Everything is immutable with the right amount of resources, like money and time.

Lily: Are you saying the stuff inside a blockchain is changeable? I have never heard anyone saying that before, everyone seems to be saying a blockchain is immutable database.

Greg: There are two kinds of thinkers in the world. Some just see further than the rest of us, not necessarily because they are smarter — they usually are — but more because they ask the right questions, assign themselves more challenging jobs and do not blindly follow others’ thinking trail just because it’s popular.

Joy: You are talking abstract. Any example please?

Greg: I’ll cite this article by Dr. Gideon Greenspan who works on private blockchains, and I believe it raises some excellent points. I’ve downloaded it to my phone.

Emily: Wait! What is a “private blockchain?” Are you talking about different ownerships of blockchain? So a private blockchain is privately owned by someone?

Joy: Public or private blockchains are not exactly about ownership. A private blockchain for example can be owned by governments just as likely as by private firms. I think it is better to call them “permissioned” or “membership” blockchains, meaning you need permission or membership to get into them, much like you need a valid username and password to enter your email accounts.

Greg: That’s right. Since Bitcoin started on a “permissionless” blockchain, most blockchains are in that category, meaning they are open for any strangers to see all the transactions inside. They are “open to public” but not necessarily owned by public.

Jason: Unlike the public library we visited last weekend that is open to public and is owned by the city government.

Joy: Correct. Speaking of “permissioned” blockchain, I’ve read something from Investopedia that says some banks claim they build blockchain but they’re not, because their blockchain is private or requires permission, which according to the author, has little to do with the innovation behind Bitcoin.

Greg: The voices against private blockchain are louder than that because, like Greenspan puts it: “immutability has become a quasi-religious doctrine – a core belief that must not be shaken or questioned.” Imagine the response when someone’s religious belief was challenged.

Lily: Interesting. I did not see immutability as a religious doctrine for blockchain but did take it for granted. So what does Greenspan say about blockchain immutability?

Greg: He challenges the common wisdom and calls the blockchain immutability a “myth.”

Joy: Is he trying to use a flashy title to make news?

Greg: I can’t read what’s on his mind, but he does make several convincing points. First and foremost, he answers the fundamental question by critics of private blockchain: What is the point of developing a blockchain if its contents can be changed or edited? Would anyone guess what his answer is?

Joy: I don’t know what he would say but I would argue that we humans want different things. Sometimes information security or immutability is the top priority, for that blockchain immutability serves us the best; but other times controllability is the king, meaning we want to keep the capability to change things as we see fit. At the end of day, no matter how powerful our computers are, we still want control them, not they control us.

Kimberly: I agree. For financial transactions it makes perfect sense to keep all the records straight and not to be modified or edited once they enter a blockchain. We also don’t want our passports, our driver’s licenses or our tax returns to be changed, especially not by anyone else.

Emily: I see what you mean. But mom is right, some records or transactions we do want to make changes from time to time to fix human errors, frauds. The law changes, too, which means legal contracts sometimes need to be updated.

Joy: That’s right, even smart contracts may need updates.

Lily: I think part of the problem is that blockchain was made popular by Bitcoin. Some people only see the Bitcoin side of the blockchain story. I don’t know if this is a good analogy but to me blockchain is like the gunpowder: We can use it to make fireworks for the Fourth of July, but the same gunpowder can be used to make weapons. A kid only knows the former, but a terrorist is only interested in the latter.

Emily: So to ask why anybody wants an “editable blockchain” is like a kid asking why anybody wants to use gunpowder for anything other than fireworks.

Lily: Something like that. But dad, you haven’t told us what the answer from Greenspan is.

Greg: Well, his answer is long and although I like the points he makes, he does sidetrack himself a bit and spends much time telling us why no immutability is perfect even with “permissionless” blockchain. His point is well taken there because it is true immutability depends on the tradeoff between what we want and what resource we have. So immutability is a relative thing, not an absolute one.

Lily: So he did not tell us why an “editable blockchain” is needed.

Greg: Not really. Your mom actually does a better job in answering that “why” question. There is also this webpage by Accenture called “Editing the Uneditable: Blockchain Needs to Adapt to an Imperfect World,” which essentially says the same thing as your mom did. Let me see if I can find the page.

Kimberly: The title seems to offer a clue to the answer: We need editable blockchain because the world is not perfect and static.

Greg: Yeah. I’ve found the page and here it says: “In most instances, immutability is an obvious benefit. But it’s also increasingly apparent that instances will arise where absolute immutability is a hurdle standing in the way of blockchain’s adoption.” Then it goes on to list areas where editability or mutability is good and needed, like in data storage, illegal actions, operational errors, permanent mischief and regulatory concerns.

Kimberly: I can understand why relative immutability is good and necessary, but I have a more basic question: Relative or absolute, how does blockchain ensure immutability?

Emily: I want to ask that question, too. How about you, Lily?

Lily: Same here.

Greg: I think this is a good place to stop for today. Why don’t we all do some homework on that and come back tomorrow to share our findings?

Everyone agrees and the talk comes to an end.

Tags absolute vs relative immutabilities, Blockchain, permissioned vs permissionless, private blockchain

Cryptocurrencies & NFTs Financial talks at dinner table

A Deep Conversation on Fungibility

Post author By Jay Jiyuan
Post date March 22, 2022

After the second family conversation yesterday, the Kingstons are anxious to talk more about NFT after doing their homework reading of the “NFT Bible” by the co-founder of OpenSea (the largest NFT marketplace in the world), Devin Finzer.

Emily: I’m glad dad recommended this reading; I feel I know so much more now about NFTs than before.

Greg: So what is the number one thing that impressed you guys the most?

Kimberly: I would have to say it is the point of “non-fungible assets are the norm; fungible assets are the exceptions.” The more I think of it the more I agree. We have seen far more unique things in the world than identical things.

Greg: I would be careful about calling fungible things “identical.” In the business world “fungible” essentially means “interchangeable” or “tradable” — even though two things may not be identical in every possible way. To borrow Lily’s term, things are “commonsense fungible” enough to be interchangeable or tradable.

Joy: I wonder if we should put “interchangeable” and “tradable” together, even though they sound similar. It seems to me that being identical is the least forgiven and most strict. Even identical twins are not exactly identical to the extent they expose to different environments. Being interchangeable is more forgiven because similar things are interchangeable even though they may or may not be identical, like two apples from the same tree in the same season. Tradable is most forgiven because we can arrange to trade so many different things, some of them not deemed interchangeable at all, like Russia exports oil and natural gas and imports iPhones and iPads.

Greg: Anexcellent point! Yes, many fungible things are interchangeable, but both fungible and non-fungible things are tradable. Perhaps international trading involves more non-fungible stuff given the different levels of development.

Lily: One advantage of focusing on “tradeable” things is that trading always involves negotiation. I think many things have fungibility that is also subject to negotiation.

Kimberly: An interesting thought that’s in line with Devin Finzer, who also emphasizes the relative and subjective nature of non-fungibility. Here it says “fungibility is relative; it really only applies when comparing multiple things.” And he goes on by saying two business class sets on an airplane is more fungible than a “first class” and an “economy class” tickets.

Fungible is exception; Non-fungible is the norm

Greg: I agree fungibility is relative but disagree that it is only useful for comparing multiple things. You can compare two things meaningfully for fungibility, just remember their fungibility is not fixed or absolute but changeable or conditional, depending on scenarios, contexts, time, people and history.

Emily: In theexample used by Devin Finzer you can see he is thinking of the same way. He talks about someone preferring a window seat would not trade his window seat with an aisle seat. But for someone else who does not care as much, the two seats are more fungible.

Lily: Yeah, the same goes to the idea of “semi-fungible”: Items within the same class are more fungible than items between classes, like two box seats in a football stadium are more fungible than one ordinary and one box seat, just like two Teslas are more tradable than one Tesla and one Ford.

Emily: Oh, that’s what “semi-fungible” means? I was wondering about that. What about the name of non-fungible tokens? I was thinking that if non-fungible was the norm, then non-fungible tokens literally mean “normal tokens,” not really an exciting name.

Lily: “Normal tokens” are not exciting I agree, but if we switch to the other side of the same coin and just call tokens “unique” that should be more appealing, as we all like things that are unique.

Emily: That’s true and in that sense, the name “non-fungible tokens” defines the nature of things pretty well because all tokens are unique in the NFT world, and each is different from others.

Greg: Yes, you may even say being unique is the only common feature shared by all NFT items on a blockchain.

Joy: Speaking of uniqueness, it just hits me that the whole idea for companies to develop brands is to make their products or services unique, not interchangeable with non-brands or other brands, even from the same category of goods or services.

Kimberly: Good point. And companies are not the only ones doing that, buyers do, too. I have a Chinese friend who once told me that the Chinese prefer the number “8” because it sounds similar to “Fortune” in Chinese. If that’s true, a Chinese customer may think a gold bar with the ending serial number of “8” is more valuable than an otherwise identical gold bar with a different ending number. I bet she would refuse to trade her “8” numbered gold bar with another.

Greg: Interesting points you’ve all brought up. We have been told in schools that commodities, money and gold are textbook examples of fungible or interchangeable things. Now we know even textbook examples do not always hold and are subject to negotiation. Both sellers and buyers have the power to turn interchangeable things into non-interchangeable.

Emily: What about the opposite direction? Like can we turn non-interchangeable into interchangeable?

Joy: Your question sends us back to the “tradable things” I said earlier. T-Shirts and airplanes are normally not interchangeable, right? But international trade did just that: Developing countries export T-shirts, tea, coffee, banana, raw materials so they afford to import airplanes from developed countries.

Kimberly: That happens every day. The fungible money plays a crucial role here: Anything can be tradable as long as they all have values measurable by money.

Lily: I’m thinking that the reason non-fungible becomes the norm is because we all want to be unique, like I won’t trade my pants, jackets, skirts and shoes with Emily or Kimberly, even if they were the same brand, size or color. All my stuff has my name on it, and I don’t want to trade them with others.

Kimberly: I think it also depends on level of economic development. My Chinese friend told me that in the days before China opened its door to the world, some families in the rural area of China were so poor that the entire family had only one pant or one jacket. Whoever needed to get out of the bed got to wear that pant, others all hided under a family comforter. These people had no choice but to share the same “family pant.” Non-fungibility was not even on the agenda.

Emily: Shocking and sad story but good for China to put those days behind! I was wondering if and how the blockchain has changed things around.

Lily: Yeah, I was wondering about that, too. We should expect at least some changes, right?

Joy: We do, one big change has been pointed out by Devin Finzer that although we’ve had digital assets since the internet age, we’ve never really owned them like in the sense of physical world. That digital ownership story is changed by the blockchain technology.

Kimberly: That’s right. Devin talked about how blockchain makes it possible not only to prove who owns what in the digital world, but also for owners to move their digital assets around, like we do in the physical world.

Emily: Iwish there were more details, like how does blockchain make things different in the digital world?

Greg: There are many discussions on advantages and usages of blockchain, like Bitcoin, digital ownership, immutability or unchangeable, enhanced security, distributed ledgers. But all these I believe are based on non-fungibility of things. Digital ownership, digital credential, immutability, security, these things are baseless without digital assets being unique.

Emily: How does blockchain ensure non-fungibility then?

Greg: We can look at it at two levels. The first is at the block level. We all know blockchain is a chain of blocks. Each block of information has a unique timestamp and more importantly a unique “hash function,” which according to this Wikipedia page, is “any function that can be used to map data of arbitrary size to fixed-size values.” This guy named Haseeb Qureshi has a better way to put it: The hash function is a “fingerprint machine.”

Joy: Yeah, I remember reading that piece. He has a neat cartoon picture to show how different inputs to the hash function come out as a fixed sized “fingerprints.” So if the input is “Hello!” the output will be some combination of letters and numbers. But if the input is “I love dogs!” then the output will be something different. They all will have the same size, like 256 bits. If the NFT is your passport, it will come out uniquely, never the same as someone else’s passport.

Lily: So a hash function is as unique as a fingerprint.

Greg: More accurately a hash function produces unique fingerprints, depending on unique input data. This is how each block in a blockchain will be earmarked by its own unique fingerprint.

Joy: The article compares “normal” hash functions with “cryptographic” hash functions. The latter come with more security features and more robust than the former. It adds three more features like one-way function, avalanche effect and collision resistant.

Greg: That’s right. But even a normal hash function is nice and powerful. One of its features is deterministic, which ensures that if you give the same input, the hash function will always produce the same output. Fungibility in the physical world is retained in the digital world.

Kimberly: But there are numerous records, transactions or NFT pieces within each block. How do they remain unique?

Greg: Let’s get the name straight first. In the physical world things are three dimensional existences, but in the digital world I believe everything becomes a token, whether you have Bitcoin, transaction records, personal credentials, driver’s licenses or passports, deeds, contracts, NFT artworks, games or cartoons.

Kimberly: Okey, so how do we keep tokens unique?

Greg: Simple, they all belong to different owners, creators or developers, and they have public and private keys in digital wallets. You can check out more information for the keypairs and how they work online. Essentially you can send transactions to public key, but you need private key to unlock them and prove you are the owner.

Joy: This validation process using private keys is why Devin Finzer says the blockchain finally solved the ownership problem.

Greg: Plus moving tokens around anywhere and anyway owners want. Once we have non-fungibility established, things become more fungible — no pun intended.

Joy: Maybe we should stop here and save more topics for another day.

All: Good idea!

Tags Cryptographic, Hash function, Identical, interchangeable, International trade, Relative & subjective fungibility, Semi-fungible, Tradable

Cryptocurrencies & NFTs Financial talks at dinner table

Why Some NFTs Have Shocking Prices

Post author By Jay Jiyuan
Post date March 15, 2022

After the first family conversation on NFT ended with an open question, today everyone is anxious to get back together at the dinner table because they have something other than foods in mind.

Greg: So did anyone want to share the thoughts on Lily’s question of why some NFT products having a shocking price tag?

Kimberly: Well, I think the key is to remember the NFT market is not just a buyers’ market, but also a new market. We have never seen such a market before because the whole blockchain technology was simply not there.

Joy: Excellent point! That definitely has something to do with the skyrocketing prices that Lily was talking about. What people do in a brand new market? They speculate because nobody knows exactly where the market is heading even in the short future.

Greg: I agree. This always happens: When we do not have solid facts to back up our thinking one way or the other, we use our imaginations to fill out the gap left by weak or scanty evidence.

Lily: But I still don’t understand how speculation pushes up the price of some but not all NFTs.

Kimberly: Well, in a buyer’s market only buyers have power, the sellers are left to suffer from low price. But in a new market both sellers and buyers are allowed to speculate, and both can shape the market through speculations, making the game fair and more interesting.

Greg: What Kimberly is saying is that although the NFT sellers lost the traditional monopoly power of scarcity like Picasso had, they gain the power of speculation in a time of high uncertainty.

Lily: I understand that part. But why only some but not all NFTs receive astonishing price?

Emily: I think I have an answer. In a way the NFT market is like the California Gold Rush that we learned in history class. Everyone had high hopes, and everyone was trying to get rich quickly.

Greg: Interesting comparison. The Gold Rush showed us how powerful speculations was. Let’s be honest, without the Gold Rush there won’t be 300,000 people moved from all over the world to California; without the Gold Rush the city of San Francisco and the state of California would not have been born so early.

Joy: That’s true. Never overlook the power of speculations because changes made by speculations are just as real as those driven by full facts.

Kimberly: One important lesson from the Gold Rush — the one that helps answer Lily’s question: Only a few people ended up getting rich from the Gold Rush, most earned little more than they had started with. Remember the Charlie Chaplin movie “The Gold Rush?”

Lily: Oh yeah, a great movie! So this NFT market is like the Gold Rush Déjà vu all over again.

Greg: Well, yes and no. NFTs are way more sophisticated than digging gold in the old days. For example, all gold miners were competing with each other to find gold, not to create anything that nature did not directly provide. NFT market is full of creators and creativities.

Joy: The gold miners also only needed to find gold and never worried about finding buyers, because everyone wanted to buy gold once the miners found it.

Kimberly: We also did not hear stories like how the miners coordinated to form any brand. Basically zero branding power from miners.

Emily: Yeah, the gold buyers were not much better. They just sit there waiting for the miners to come to them. Today the NFT buyers are highly developed but also highly divided. Some are willing to pay big ticket price for items that others couldn’t care less.

Lily: So you are saying it is the divided buyers who pushed up the price of some but not all NFT items.

Emily: I think so. The article from the Washington Post I was talking about yesterday described how a few NFT marketers like “Bored Apes” and “CryptoPunks” managed to win big from selling NFT collectables.

Kimberly: I have a feeling that the current NFT market emerges more by design than by random events.

Emily: You are right on that. According to the article, the cryptocurrency and blockchain community wanted to use NFTs to help them gain market traction and acceptance. “They want to create a sensation, to whip up publicity for NFTs in particular and cryptocurrencies in general.”

Lily: No kidding. Nothing else is more powerful than the headline news that some people became overnight rich from NFTs.

Emily: A good example is this NFT artist named Mike Winkelmann, who called himself Beeple, flew to the art fair in Miami in private jet — this is the same guy whose entire wardrobe used to be worth about $600, and by the time he landed in the airport, his bank account received $56 million from the record sale at Christie’s. It’s like a jackpot.

Lily: Cases like that add fuel to more speculation.

Emily: It sure did. Let me quote the Washington Post article again: After the “Beeple sale” on March 11, 2021, the total NFT sales reached $12 billion by early December last year, up from $546 million in the first half of 2021.

Joy: In the worst case scenario we may even see “winner takes all,” when a few winners can charge any high prices they want while the rest receive almost nothing.

Greg: We have had a wonderful conversation so far, but we may want to go deeper than talking about a newspaper article. I believe we can learn a lot from the industrial insiders. I came upon this wonderful blog last night that I have not finished reading yet. It had an interesting title of “The Non-Fungible Token Bible: Everything you need to know about NFT,” published in January 2020 by this guy named Devin Finzer, the co-founder of OpenSea, the largest NFT marketplace in the world. How about we all read that blog and come back to talk more tomorrow? I can send the link of that blog to your phone if you are interested.

Everyone except Jason and Cleo agrees to read the blog and that is the end of the second family conversation on NFT.

Tags Beeple sale, Big ticket prices, Buyers market, Gold rush, New market speculations, NFTs

Cryptocurrencies & NFTs Financial talks at dinner table

First Family Conversation on Non-Fungible Tokens

Post author By Jay Jiyuan
Post date March 13, 2022

Three days had passed since the Kingston family last had a long chat at the dinner time. Today Emily raised a question that interested everyone.

Emily: So has anybody heard about the thing called NFT?

(All except Cleo raised hands)

Emily: Jason, you heard about NFT, too?

Jason: Yeah, why, you found it hard to believe? A friend of mine was a big fan and he kept telling me all the stories about NFT, like some kid in Asia sold his selfies for more than a million dollars.

Kimberly: Oh I heard crazier stories than that: This Seattle based teenager artist built a collection of NFTs valued at more than $26 million.

Emily: Yeah, I heard that one, too. The funny thing is that the kid was selling stickers and prints for $5 a piece online just one year ago.

Kimberly: So who can tell us what NFT stands for?

Lily: I know the first letter “N” means “Non” and “T” for “Token” or Tokens. Someone once told me the meaning of “F” but I forgot it now.

Emily: “F” means “Fungible,” which means “replaceable” or interchangeable with something identical. So “Non-fungible” basically means not replaceable or not identical to something else. But if something is non replaceable, it must be unique. That’s what it says.

Lily: How do you know so much about NFT? Are you gonna create your NFT and sell it?

Emily: Not really. Our arts teacher asked us to write an essay on NFT.

(Turning to Greg), speaking of the essay, dad, what do you think of NFT? Do you see much value in it?

I look at some NFTs and I don’t understand why someone’s selfie deserves more than a million dollars.

Greg: It’s natural to feel that way, and I am sure you are not the only one with questions. I myself have been thinking of it a lot lately.

Kimberly: Do you look at it more from a financial perspective or a commonsense perspective?

Greg: It’s interesting you put that way, but I believe both ways are needed to fully understand NFTs. In fact, not only financial and commonsense but we may even need an artistic perspective. After all, those non-fungible tokens are mostly seen as arts.

Joy: Wow. This conversation is getting more interesting! I have a nonprofit client who is familiar with arts and museums. We were chatting the other day about NFT, and I asked her opinion. She said the same thing you just said that it is easier to understand NFTs if you know arts.

Emily: Oh good! I’m glad you guys mentioned that. I came across this interesting and fairly recent article on Washington Post published last December that talked about just that. It’s pretty long but let me pull it out on my phone to give you a few highlights.

Greg: Is the one written by a journalist who went to Miami, Florida to cover American’s most prestigious art fair, I forgot what is called.

Emily: Yeah. It is Art Basel Miami Beach, which attracts the world’s art collectors.

Greg: That’s a good piece and I liked it. It has lots of information in it and brought us the latest stories in NFTs, crypto, blockchain and the art world.

Emily: I think so, too. Anyway, the first section of the article has a definition that says an NFT “is a unique digital representation of a good — for our purposes, a work of art. It’s akin to a certificate of authenticity or a deed and it’s recorded on a blockchain.”

Jason: I have heard the name before but what exactly is a “blockchain?”

Emily: I’ve learned a lot this time from writing my essay. The best way to define a blockchain conceptually is a “distributed and decentralized database.” In case you did not know, a database is just a bunch of data stored in a computer that allow people to access for information.

Jason: Well, how do they make database “distributed and decentralized?”

Emily: The key is to create “information redundancy.” Before blockchain, databases are separated and isolated from each other, each owned by a different organization.

Jason: What’s wrong with that?

Emily: Well, to see what’s wrong, the first thing is to recognize that those databases are centralized because no matter how big a company or a government agency is, it only has one database.

Kimberly: Yeah, now that you mentioned it, a good example is IRS, the government agency that collects citizens’ taxes. Pretty much everyone pays taxes, right? And the IRS has a huge database for all taxpayers’ transactions, not just this year but way back. Think of how many records there must be in the IRS database.

Emily: Exactly. The danger with centralized databases is that they attract hackers. But even without hackers there are natural disasters like fires, earthquakes, floods, power outages and lightening hits. It is called “a single point of failure” for all centralized databases.

Jason: So blockchain stores the same database with multiple copies in multiple places.

Emily: Exactly. Multiple databases are decentralized because there is not a single database that controls all others. All duplicated databases are equal and if one database is hacked or corrupted, others won’t, and we can quickly find out the bad copy and kick it out of the system.

Greg: What you said is a nice conceptual definition of blockchain, I want to add a technical note to it: Anything registered in a blockchain is truly non-fungible, meaning unique or unreplaceable because it is designed to be that way. A blockchain is a bunch of blocks each with a unique time stamps with information in it and these blocks are connected to form a chain.

Kimberly: So let’s see, that means no two Bitcoins are identical because they each will have a unique trace on the blockchain, right?

Greg: That’s exactly right and that’s the beauty of digital currency, unlike fiat currency, where one dollar is just one dollar, the one dollar bill on my left hand is fungible or identical with the one dollar bill on my right hand.

Jason: What is fiat currency?

Greg: Oh, it’s just a fancy way to call the traditional money issued by government, like the American dollars we use every day, or Japanese Yen, or the Euros.

Joy: Speaking of fiat money, I’m thinking that no two dollars are identical, either. I bet the one dollar on your left hand will have a different serial number than the one on your right hand. However, the two dollars do have identical value, just like two Bitcoins.

Greg: That’s right, I forgot about the serial numbers. Good point!

Jason: I have a few dollar bills left from my lunch money. Let’s see: Yeah, this bill has a serial number F30022163M, the other one says K61556364C. They are different.

Kimberly: If blockchain can make two units of the same digital currency, like Bitcoin or Ethereum, non-fungible or unique, it certainly will make all NFTs unique, right?

Lily: I think we should separate two kinds of uniqueness. Yes you are right to say that on a blockchain everything is unique, and nothing is identical with anything else, even between two bitcoins or two dollar bills. But do we really care about that kind of technical or trivial uniqueness? I doubt it.

Emily: That’s an excellent point. I was thinking along the same line but with NFTs. One big problem with NFTs is that people can always make copies of the same popular NFTs for themselves. If they all registered their individual copies on a blockchain, they will be unique in some ways, like when they were entered, and who the owners are. But from commonsense perspective, that kind of uniqueness is really no big deal, as these copies are all identical except for the blockchain generated uniqueness.

Kimberly: I like the term “blockchain generated uniqueness.”

Joy: So the issue is how we maintain “commonsense uniqueness” above and beyond the “blockchain uniqueness.”

Jason: But why does commonsense uniqueness matter?

Kimberly: Because we human beings all want to be unique; you don’t want to be just a carbon copy of someone else, even with someone you love or admire, right?

Greg: Going back to what Emily said, the problem we face today is not scarcity but the opposite of it: abundance. We can easily copy and paste anything digital that in a commonsense view are identical to each other. This is very different from the old days when making an identical copy of the masterpiece was impossible. The best one could do was to have a fake one that looks like the original, never identical.

Lily: Like back in the days for Picasso, Davinci or Monet, right?

Greg: Yeah. Today’s technologies allow us to produce identical copies so easily and in so large quantity that the “art hackers” in the old days could not even dream about.

Joy: So you are saying the big question today is how to restore or save scarcity in the age of abundance?

Greg: Exactly.

Joy: Well, one way to do that is through algorithms. Like the number of Bitcoin was programmed to be no more than 21 million ever. There, not only do we have scarcity but know exactly the size of supply.

Emily: The same logic works in NFTs. It turns out owning a free and identical copy is not enough for some people, they want to possess the one that is original and are willing to pay a big price for that.

Greg: So Bitcoin scarcity is created by the creator of the digital currency, but for NFTs scarcity is saved by some buyers on the demand side.

Kimberly: That makes sense, because there is always only one original NFT, regardless of how many free copies out there.

Lily: Not only that, but the more copies out there, the more valuable the original becomes. Whoever bought the original can always brag that she or he bought the one out of a million, which sounds much better than one out of 10.

Greg: This gets me to think that the basis of value today is different from Picasso’s time. In the old days, the value of artworks was attached to the artists, who were “the one and the only” to produce masterpieces that nobody else could match.

Joy: So only masters could produce masterpieces. Using the chicken-egg metaphor, the masters were “chickens,” masterpieces were “eggs,” and the chickens always came first. As long as there is only one Picasso in the world, the value of his artworks would be fixed, regardless of how many imitations there are.

Kimberly: But isn’t that always the case that a particular artist produces a particular piece of artwork, so the “chickens” always come first?

Greg: Well, yes and no. Different NFTs will be produced by different artists just like before but today’s artists do not have the same “monopoly power” as Picasso had. Think of what has changed?

Kimberly: Well, like you said earlier, there is an abundance of virtually identical copies today.

Greg: Yes. In the old days there was just one copy for each masterpiece of Picasso for the entire world. It’s a natural monopoly. If you wanted to see the masterpiece, you visited a museum. But nowadays everyone can have a personal copy of a NFT if she wants.

Kimberly: But that’s just easy accessibility, which does not kill monopoly power. There is still only one Picasso in the world.

Greg: There is only one Kimberly Kingston in the world, does that give you the same monopoly power as Picasso? Monopoly power is not about being the only one, but about your capability of changing or influencing the behaviors of others.

Kimberly: I see. Sounds like the abundance of identical copies shifts the power from NFT artists and sellers to buyers and we have a “buyers’ market” for NFTs.

Lily: But wait, in a buyers’ market the price goes down, why do we still see some skyrocketing prices in the NFT market?

Greg: Interesting question. But it’s getting late and let’s continue the conversation tomorrow.

Video highlight of what the family has learned on NFTs

Tags Abundance of copies, Arts, Blockchain, Decentralized database, Fiat currency, Info redundancy, NFTs, Picasso, Scarcity, Uniqueness

Financial talks at dinner table Securities Investment

The Howey Test & Investment Contract

Post author By Jay Jiyuan
Post date March 9, 2022

After their conversation yesterday on securities, Greg asked everyone, except Cleo, to do a bit of research on their own about the “Howey test” that the US Supreme Court used to define an investment contract, which in return will define securities. Today they come together at the dinner table again to present and trade their findings besides eating.

Security law & regulations this post focuses on

Greg: So, what did you guys find on the Howey Test? Who wants to tell us the background story behind the Howey Test?

Lily: Let me try it. According to the piece I’ve read, a Florida-based Howey Company sold land with citrus groves to buyers. They then asked the buyers to lease their land back to them, so they could grow and sell the citrus and split the money with the landowners.

Kimberly: I smell something strange. Why can’t Howey just use the land they own to grow and sell citrus? What’s the point of selling the land and then leasing back?

Lily: I wondered about the same. There must be something beneficial from doing the leaseback deal, most likely the company thought they did not have to register the transaction with SEC, and that was where their legal troubles started.

Jason: Wait! What is SEC?

Lily: Its full name spelt out is U.S. Securities and Exchange Commission. It’s a government agency in charge of regulating the securities markets and protecting investors. Right, dad?

Greg: You got it. It’s created 1934 by the Securities Act of 1933 and Securities Exchange Act of 1934, the two milestone laws in securities. Just remember this: Much of the securities rules and regulations didn’t exist until after the Great Depression in 1920s and early 1930s. They are the lessons learned by this country from the crisis.

Lily: Yeah, so in 1946, the SEC sued Howey because it believed the citrus deal qualified as an investment contract and therefore, Howey should have registered with SEC. The case went all the way to the U.S. Supreme Court.

Emily: I’m surprised that the Supreme Court agreed to hear it. To me it’s a small case.

Greg: Well, the Supreme Court in 1946 was not the Supreme Court today. What is important then is different from what is important now. It all changes by time.

Lily: After the court hearing it was decided that Howey should register with the SEC because the citrus business was an investment contract. The four conditions listed by the Supreme Court ruling then became one of the most famous case laws of this country.

Kimberly: I find it interesting that the whole definition of securities hinges on this single test. Mom was right when she called this Howey test “Almighty” yesterday.

Emily: That’s because the ruling of the Supreme Court was rich, containing four elements if I remember correctly.

Kimberly: You are right, I have written these elements down: The first is investment of money; the next is into a common enterprise; then investors must have expected profits and finally the profit is solely generated by efforts of others, not by the investors.

Greg: Since you’ve written it down, could you try to summarize the Howey Test for us?

Kimberly: It’s easy given the order I put the four elements down: Howey test says someone must invests money to a common enterprise or a company for the purpose of receiving profits that are solely generated from others’ efforts and time. If all four conditions are met, you have an investment contract and that defines a security.

Greg: Sounds good to me! Did anyone have questions?

Emily: I do! I have a friend whose dad invested in a farm — not with money but with a tractor he inherited from his father. Would that count as investment?

Greg: It would. “Invest money” has been later expanded to “invest asset” or valued resources. There is a catch, though, and not every book or article mentions it: Everyone will accept money, but not everyone will accept a tractor, depending on what the common enterprise needs. The investor would have to find out before investing.

Kimberly: What exactly is a “common enterprise?” We don’t hear that term often.

Common Enterprise that Kimberly asked about

Lily: From what I searched, that term has never been precisely defined. Most federal courts defined it as “horizontal,” meaning several investors pooling their money or assets together to invest in a project. A common enterprise is similar to a “shared project” in that sense. But other courts have different definitions.

Greg: I think it is important to keep in mind that the SEC was created to tighten the control and regulations of securities, cleaning up the mess left by the Great Depression. With that in mind, the Supreme Court cared more about substance than form in its ruling.

Emily: What do you mean “substance over form?”

Greg: Let’s use the Howey example, the leaseback deal that the Howey Company did with the landowners in Florida. There was never a stock or bond issued by the company. Would that count as investment contract? We all know now that the Supreme Court said “Yes.” The landowners were investing their assets in the Howey Company, and therefore must register with the SEC.

Joy: Yeah, speaking of substance over form, I found this other legal test called the “Forman test.” It’s quite interesting because it tells us what a security is not, even though the transactions involved names like “stocks” or “shares.”

Emily: Really, that’s interesting. Tell us more about it please!

Joy: You guys can Google it yourself by using “the Forman Test of securities.” But the basic story was that this nonprofit organization called United Housing Foundation developed some low-cost, government subsidized housing units and asked that anybody wanted to rent an apartment must buy eighteen shares of stock first. The shares were not transferrable — remember dad said ownership liquidity for securities, that anyone can buy or sell any number of shares at any time? Well, this one did not have any liquidity, and shareholders had no voting rights, either. When they leave the housing unit they must sell the shares back to the nonprofit organization at the original price they bought.

Low income housing units in the Forman Test of securities

Emily: How did the Supreme Court hear the case? I mean what happened that triggered Supreme Court hearing?

Joy: Like most legal battles, this one started when private interests were threatened. The nonprofits decided to raise the price for the units and 57 residents decided to file a lawsuit against the nonprofit. Interestingly, instead of accusing the nonprofit for simply raising price, these residents argued that the nonprofit violated the securities laws by issuing unregistered stock. The nonprofit argued back that the stocks it issued were not securities. That’s what the Supreme Court had to decide.

Kimberly: What’s the verdict of the Court?

Joy: Well, like dad was saying, substance over form. The Court basically agreed with the nonprofit and declared that just because it called its shares “stock” did not automatically make it an investment contract. The Court said something like when the transaction was motivated by consumption rather than investment for profit, the securities laws do not apply.

Lily: In other words, it is not how people call it, but what is really going on between investors and companies that matters.

Greg: Yeah. Some people get really creative with playing the names game just so they don’t have to register with SEC. It’s understandable because, let’s face it, it’s no fun to do the paperwork with government. Not just the paperwork but they must disclose all the crucial financial information to the public, like quarterly financial reports.

Joy: The Forman test was a big deal because it says you must separate consumption from investment.

Greg: Not all states agreed with the Forman test, though, despite the Supreme Court ruling.

Emily: Oh, really? Can states disagree with the Supreme Court?

Greg: Sure, there are federal laws and state laws, and if they disagree, your case will depend on which state you live or do business with.

Emily: Could you give us an example?

Greg: Yeah, I did my homework last night and found that there was one historical case right here in the Bay Area, in Marin County to be accurate. In 1959, let me quote this website, “some enterprising developers bought land in Marin County to develop a country club. To pay for some of the costs of building the club, they sold charter memberships in the club. The members would not share in the profits or ownership of the club but would have the right to use club facilities.”

Golf /Country Club in the Risky capital test of California

Kimberly: Let me see if I could put it in plain English: Some Marin County real estate developers needed money to build a country club. So they announced that anyone investing in money would receive a membership to use the club, not an ownership of the club.

Greg: That’s it, you did a good job in translation!

Kimberly: That to me is another “consumption but not investment” case like the Forman test says.

Greg: Exactly. By federal definition the membership would not count as securities because investors only get the right to use, not the right to own the club. But the California Supreme Court disagreed and came up with a new test called “Risk capital test.” It said even if investors only got the right to use, they invested money in a risky business that could not guarantee the consumption right in the future.

Emily: Very interesting! So cases like that will be counted as securities and must register with the state of California.

Greg: Yup.

Kimberly: That says a lot because almost all investment of money involves risks, and few if any enterprise would guarantee the return of profit.

Greg: It did say a lot. Instead of profits in the future, it looked backward to risk involved when investors wrote checks to business. The California Supreme Court apparently wanted to protect the public from risky investment schemes with uncertain or risky results.

Emily: Dad, I would like to return to Howey test. Why did the Supreme Court asked for having someone else’s time and efforts to qualify for a security? Why can’t it allow investors to take control of the company and be the managers?

Joy: I have been thinking of the same question myself, and I think I have an answer: Separating investors from company managers helps the company grow and reach a scale.

Emily: Are you saying a security is not like a family business? You know, like mom and dad do everything themselves: investing their own money, working together to control everything in business.

Joy: That’s a good way of saying it.

Kimberly: I have a simpler explanation: Just think about borrowing money from a friend. If you own a business and wanted to borrow money from your friend, would you like to have that friend manipulate or manage your business, just because s/he lends you money? Of course not.

Joy: An excellent point. It reminds us that all laws are based on common sense.

Lily: I think the other reason is efficiency: Many investors know nothing about a particular business, and they may not be interested in it, but they are the ones with the money. Why not invest the capital and let someone else run the business. Everyone is happy and gets to do what they do best.

Joy: Another good point! I want to clarify one point about family business: At first they do everything by themselves but later when they grow bigger, they will hire someone else for managing the business. Some family businesses may also need more capital to grow. If they decide to go to public for funds, they turn themselves into the securities market.

Emily: If a family business stays private and never issues stocks and never lists itself on the stock market, would it qualify as a security?

Joy: It’s funny you asked. I came across this notion of “private securities” earlier. Apparently securities include both public and private types. It’s just that most securities we know are public.

Emily: So how the private securities differ from public?

Joy: A privately owned security does not issue any stock to the public. It is also not required to register with the SEC and do all the disclosures like public securities must. Of course, its downside is not to be able to sell stocks to the general public, only to accredited investors.

Emily: Who are the accredited investors?

Joy: I did some follow-up research and found that an accredited investor may be an individual or an entity like an organization, a firm, a bank, an insurance firm. Basically they are financially sophisticated, like a stockbroker or a licensed financial advisor, or with so much money that they do not need the protection by SEC.

Kimberly: I heard about accredited investors before. My school once invited a startup founder to speak to us and he mentioned that they prefer to get private funds from accredited investors, not through IPO …

Jason: What’s IPO?

Kimberly: It stands for Initial Public Offering, to raise capital from the public for new companies. The startup will sell shares of their stock to everyone who wants to buy. Of course, it’s public, so SEC will be involved. The speaker said they didn’t want to go through all the regulations and paperwork, so they chose to go private.

Joy: Speaking of startups, did you hear the term “Unicorn?” That’s a term used in the venture capital industry to describe a privately held startup company with a value of at least $1 billion.

Jason: Could you give me some examples of Unicorn?

Joy: This one I am sure you have heard: ByteDance, who owns TikTok, and SpaceX by Elon Musk.

Jason: Oh yeah! Let me check their valuation. Oh, ByteDance is valued at $140 billion, and SpaceX is at $100+ billion. By the way, how do they know the value of a startup?

Greg: The key is to separate two values: Intrinsic versus market. A startup is about to enter the market but not yet, so we don’t know its market value. But experts can come up with an estimated intrinsic value based on future earnings or some other company attribute unrelated to the market price of a security.

(At this point the dinner table conversation ends.)

Tags Accredited investors, Consumption vs investment, Family business, Forman test, Howey test, Investment contract, Private securities, Risky capital test, SEC, Substance over form, Supreme Court

Financial talks at dinner table Securities Investment

The Opening Conversation on Securities

Post author By Jay Jiyuan
Post date March 9, 2022

A quick reminder of the family members participating in the conversation:

It is a sunny day in the San Francisco Bay Area where the Kingstons live. Joy the mom usually has a busy schedule but today she came home early and prepared the meal for the big family. When she saw her husband, Greg, before the meal, she could not wait to ask him a question:

Joy: Honey I am glad you are home! Guess what, I was at a client meeting early afternoon and one of my clients asked me a question that was totally out of blue. She wants to know how to define securities, you know, stocks and bonds. I told her I’d have to ask my husband for more details. What would say to her if she asked you in person?

Greg: Interesting question! (Turning to Cleo and Jason, the youngest daughter and son both in primary school): Did you learn from the school about what securities are?

Jason: Not that I can remember. But I can Google it. (Jason pulls out his Pixel 5: “Hey Google, define securities.” Google returned entries from Oxford languages in four categories: “All,” “Politics,” “Finance” and “Police.”) Dad, you want the financial definitions, right?

Greg: Yes that’s right.

Jason: Here you go. It has two entries. The first one says: “A thing deposited or pledged as a guarantee of the fulfillment of an undertaking or the repayment of a loan, to be forfeited in case of default.” The second says: “A certificate attesting credit, the ownership of stocks or bonds, or the right to ownership connected with tradable derivatives.” Wow, a lot of strange words for me!

Greg: Well the first is basically saying the same thing as collaterals. Please check on the definition of collateral, C-O-L-L-A-T-E-R-A-L.

Jason: Hey Google, define “collateral.” Here it is: “Something pledged as security for repayment of a loan, to be forfeited in the event of a default.” It sounds similar to the definition of securities but what do all these mean?

Greg: Let me ask you a question. I remember last time your buddy, Michael I believe his name is, wanted to borrow your bike for one day. Why did you ask to keep his iPhone before lending your bike to him?

Jason: Because I was concerned that he may damage my bike, and I almost said no to him. Keeping his iPhone made me feel a little bit better or safer.

Greg: That’s it. You had something similar to a collateral from Michael.

Jason: Oh, really! That’s it?

Greg: Yeah — in spirit, not exactly in monetary term because you guys never agreed that if Michael broke your bike, you’ll keep his iPhone, am I right?

Jason: No, of course not! I did that just to make me feel better and safer.

Greg: So strictly speaking the iPhone is not a collateral but the basic idea is this: Someone wants something valuable from you, and you ask something valuable in return as a kind of guarantee, or a token that make you feel better and safer. Just remember the key difference is whether you can permanently keep the iPhone — that’s what the word “forfeit” means — in case Michael smashed your bike. If you could then it is a collateral or a security, otherwise it is not.

(Turning to Joy): Sorry we haven’t got to address your question. Your client was clearly asking about the second definition that Jason was reading out. Jason, could you read that second entry again?

Jason: Sure: “A certificate attesting credit, the ownership of stocks or bonds, or the right to ownership connected with tradable derivatives.”

Greg: That basically says securities are ownerships, either currently or in the future, either complete or fractional/partial.

Stock certificate for ownership that Greg talks about

Jason: I didn’t see anything that says future or partial ownership.

Greg: This is the tricky part of formal definitions. They tell you something you must know, but oftentimes you must possess additional knowledge to be able to completely understand the words. The more you know, the better you understand. In this case, I know securities involve future and partial ownership because that is what financial derivatives do.

Kimberly: So dad, do you think the definition is a good one?

Greg: It’s as good as can be stated in a few words. Securities are a full pack of knowledge points, impossible to be covered in one or two sentences. You really need a Wikipedia entry to cover them all.

Joy: Would you offer a more complete view to us, like what is the major parts that are missing? I want to impress my client, you know.

Greg: In that case, the definition Jason just read is not even remotely complete. It says nothing about risk, nothing about ownership liquidity, nothing about investment contract, nothing about common enterprises, nothing about profit expectation and passive income. It misses completely the legal test of Howey defined by the Supreme Court.

Joy: Wow, a lot of misses. let’s slow down a bit and say one thing at a time, shall we?

Greg: Sorry about that. Let’s begin with risk. Like many things in the world, securities contain value but also risk. In fact, we can say that the minute you take risk out of securities, they are no longer securities. I always like to add two letters “I-n” to the front, so that we say all securities are “insecurities.”

Emily: Interesting and I have never heard that one before. Could you give us an example of something that has little or no risk and not a security?

Greg: Sure. All standard insurance products carry no risk because as long as you pay your premium, you are guaranteed for the death benefits and cash value. We don’t call insurance products securities. For people who are retired, their annuities are also risk free. Not surprisingly, they are not securities. Finally, your savings and checking accounts in the bank are protected by FDIC, they are not securities.

Cleo: What is FDIC?

Joy: It is Federal Deposit Insurance Corporation, an insurance company that protects depositors. Say someone saves $2,000 in his Bank of the West account and one day the bank declares bankruptcy, the person will get his $2,000 back from the insurance firm even though his bank is closed for good.

Emily: Oh that’s good. I was watching the movie Something the Lord Made the other day on Netflix, it shows this great guy Vivien Thomas saved his tuition money for college in a bank and lost it all because the bank was closed for bankruptcy.

Greg: Yeah, they created FDIC in 1933 exactly because the Congress saw thousands of bank failures in the 1920s and early 1930s. Did you guys know that the money for FDIC is from the premiums paid by the banks? They are not paid by our taxes. It’s really one of the greatest programs in the world! If you look at the FDIC website, you will see that ever since the birth of FDIC “on January 1, 1934, no depositor has lost a penny of insured funds as a result of a failure.” That’s how safe your money is with the bank.

Jason: How about something that is risky but not a security?

Lily: Gambling is risky, but it is not security.

Kimberly: but I heard people saying investing in stock market is just like gambling at a casino.

Joy: I’ve heard that, too. Sometimes people just want to dramatically simplify things to make them easier to understand or to remember. But how long do you stay in a casino to gamble? One hour? Two hours? Whole day? An entire long weekend? For most people, it is less than three days. But investing stock market is typically much longer than three days, sometimes one’s lifetime.

Lily: Also most people know they will end up losing money in a casino but expect making money from a stock market.

Joy: Yeah, especially when you go long term in the stock market.

Cleo: But daddy took me to a horse racing the other day and told me horse racing was gambling.

Joy: That may not be completely true. Horse racing is a legitimate sport but can be a way of gambling. Not all racetracks allow betting on horses, though.

Greg: You are right. Note the gamblers on a racetrack are just like gamblers in a casino, they play the game quick and short.

Joy: So what’s the next thing that the definition missed?

Greg: It’s called “ownership liquidity,” basically a fancy way to say that one can buy and sell his or her securities to anyone else in the market upon a short notice.

Kimberly: And why is that important?

Greg: It makes securities more attractive than your savings and checking accounts in the bank. Here is why: You can cash your securities out almost as quickly and conveniently as you can from your bank accounts, but you expect much higher returns than what you earn in interests from a bank.

Lily: But money in the bank is safer with FDIC, right? You don’t worry about losing it like sometimes you do with securities in the stock market.

No risk, no gain. Some are willing to take more risks than others

Greg: True, and that’s the whole point of “no risk, no gain.” Securities have risk and bank accounts don’t, so securities bring higher gains than a bank account.

Joy: Okay, what’s next on your list of misses?

Greg: Let me see, I think it’s investment contract. This is fundamental and covers all the other issues like Howey test, expected profit, common enterprises and passive income.

Joy: Sounds like we are switching from business to law.

Greg: That’s because the US Supreme Court was involved and came out with a legal definition of securities that all come down to this thing called “Howey test.”

Joy: But when I invest our money into Google and Apple, I do not remember signing contracts with anyone.

Greg: The regulation is tight for security firms and also brokers and advisors but light for individual investors. You do not have to sign a formal contract, although the brokerage company may ask you to sign the paper to open your account. That has nothing to do with the Howey test.

Joy: So what is this almighty Howey test?

Greg: Instead of me talking all the time, how about we end here now, and everybody does his or her research online for the Howey test and we reconvene tomorrow to see what we get?

(Turning to Joy): Did you tell your client you will get back to her tomorrow?

Joy: No, I don’t get to see her tomorrow, we meet once a week.

Everyone agrees with the research idea and the conversation stops.

Tags Collateral, Derivatives, FDIC, Gambling, Howey test, Investment contract, Partial ownership, Risk, Securities