web3 in 420

*This is part 2/2 of a series on accounts & wallets, [read part 1 here](https://paragraph.xyz/@nichochar/blockchain-accounts).*

*Wallet* is an important yet confusing web3 term. That is because the name refers to multiple concepts depending on context: the `wallet client`, the `passphrase`, `account manager software`, or a `public account address`. Let’s dig in and disambiguate.

 ![Metamask (eth wallet) does a few things](https://storage.googleapis.com/papyrus_images/7370473e0cd444935794508e5779810a)

## Wallets

A wallet is software for managing [web3 accounts](https://paragraph.xyz/@nichochar/blockchain-accounts).

Wallet clients are responsible for private key management, application UI, and transaction/asset management. However the boundaries of what a wallet *is* are blurry and still evolving. Some have described wallets as the operating systems of web3, or the browsers of web3. Neither analogy is perfect, but the idea is correct: wallets are a powerful and foundational piece of the web3 ecosystem.

From an end-user’s perspective, a wallet is the software needed to interact with blockchains:  and help with the experience of performing transactions (send tokens, sign using private key, interact with smart contract). Since the data is public, they typically also list token balances, and the transaction history.

Wallets, unlike the physical wallets in our pockets, don't hold tokens directly (that analogy is misleading). Rather, they are a mechanism in which the owner can prove (s)he owns custody by signing transactions with the private key. The *blockchain* stores the token ledger (a mapping of wallet addresses to their respective balance). This is why transferring tokens is so cheap, we're not moving anything around, simply debiting from one account and crediting another in our global, shared ledger.

## Custody

When the end-user is directly responsible for the private key (by memorizing the seed phrase), the wallet is called **self-custodial** or **non-custodial** (Metamask, Ledger, Rainbow). When a company or other 3rd party manages the private key for the end-user, it is called a **custodial wallet** (Coinbase, Binance, Magic Link). This is where the adage "not your keys, not your coins" comes in: it is referring to the custody property: whoever controls the private key controls the wallet.

It is hard to exchange fiat money (like dollars) for cryptocurrency tokens without going through a [centralized exchange](https://paragraph.xyz/@nichochar/crypto-exchanges-and-decentralization), and use a custodial wallet in the process. Most users therefore have multiple wallets, some custodial and others not, and transfer tokens from the custodial ones to the self-custodial ones to gain custody.

## Architecture

Just like web browsers allow users to interact directly with the web through URLs, wallets allow users to interact directly with web3 nodes through [JSON-RPC calls](https://ethereum.org/en/developers/docs/apis/json-rpc/), which are handled by providers (Infura, Alchemy).

 ![](https://storage.googleapis.com/papyrus_images/7ca80eb910726a9b63fac5b5dbd14378)

Wallets

*This is part 1/2 of a series on accounts & wallets, find [part 2 here](https://paragraph.xyz/@nichochar/wallets).*

[Blockchains](https://paragraph.xyz/@nichochar/blockchains) introduce new software constructs and paradigms. One difference with the web2 world is how accounts are defined, registered, and controlled.

## Accounts

Blockchain state –  at its simplest –  is a set of account balances and the transactions between them. Each account has a publicly known address, a public key to which also exists a counterpart private key. The public key is shared publicly, while the private key should be kept securely by the account owner. Examples of public addresses are `0x1dA4FDf7029bDf8ff11f28141a659f6563940642` on Ethereum or `bc1q3yz87mhky7c30y9v38aggypw8jrda7ettefxgr` on bitcoin.

There are 2 types of blockchain accounts:

* Externally Owned Accounts (EOAs)
* Contract Accounts (only exist on smart contract chains like Ethereum & Solana, not bitcoin)

## Externally Owned Accounts (EOAs)

EOAs are not registered to blockchains like you’d register a gmail address to a centralized provider (google). Instead, they simply already exist: there is a space of trillions of billions of public keys, and “creating” an account means generating a new random private key, and then deriving its public key (or address). Knowing the private key allows to sign transactions (proving ownership) and therefore control the account.

 ![](https://storage.googleapis.com/papyrus_images/00494c5d184fcb94acecc517fbc5f285)

*Note: Losing the private keys means that controlling that account is no longer possible, and the currency in it is inaccessible forever.*

How does one know how to generate a new random private key? With conventionally adopted standard cryptography algorithms, that have been proposed and approved by the community. This approach avoids the need of a central authority in charge of account management in favor of shared cryptography methods (which is **permissionless** and **censorship resistant**). Most of these algorithms went through the **BIP** (bitcoin improvement proposal) mechanism.

 ![](https://storage.googleapis.com/papyrus_images/8679c442282ab92515b483391865af17)You might have heard of “seed phrases” or “mnemonics”, these are from **BIP39**: a proposed method of generating private keys in a more human friendly way. From the **seed phrase** (12 to 24 english words), we derive a **private key** (optionally using an extra passphrase), then from that **private key** we derive a **root key**. Finally, we can create multiple **public/private key pairs** (accounts) from this single root key. This technique was proposed in **BIP32**, and is called Hyper Deterministic (HD) wallets.

 ![](https://storage.googleapis.com/papyrus_images/7b7699ec4888b9b768876368cb2d3e57)The idea is that remembering mnemonics is hard, but one might still want many accounts for privacy and security reasons. This gives us the best of both worlds! This also allows interoperability, you can use the same passphrase in any wallet client for that ecosystem and everything works, and you can deterministically re-create all of your accounts from a passphrase.

## Contract Accounts

Contract Accounts are programs (smart contracts) which simulate EOAs. They can therefore only exist on smart contract chains like ethereum or Solana, as code.

What’s their purpose? Arbitrary functionality makes them safer, more powerful, and can improve the user experience.

For example, it allows techniques like “multisig”, requiring multiple confirmations before using the private key to sign transactions (similar to 2FA auth, in web2): see [Argent](https://www.argent.xyz/) or [Gnosis-Safe](https://gnosis-safe.io/).

A major drawback from Contract Accounts today (in Ethereum) is that they cannot sign transactions like EOAs can, making them less useful. This is an active area of proposed improvement for Ethereum, called **“Account Abstraction”** (see [EIP-2938](https://eips.ethereum.org/EIPS/eip-2938) and [EIP-4337](https://eips.ethereum.org/EIPS/eip-4337)), a sizable opportunity to improve web3 UX and security.

## Summary

 ![](https://storage.googleapis.com/papyrus_images/0753de34fc024c8fbc714d919aa9bf9f)

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Blockchain Accounts

Blockchains produce tokens, either by **mining** them or **minting** them. In order to get people to participate in the network, they need a solution to exchange tokens for money or other tokens: enter **exchanges**.
There are two types:
- centralized exchanges (CEX)
- decentralized exchanges (DEX)
## CEXes
*Examples: Coinbase, Binance*
![](https://storage.googleapis.com/papyrus_images/c3a438f4c5469e9c5c113b2e37205b9f)
 These are online trading platforms that match buyers and sellers via an **order book** (sellers are matched with buyers). They function the same way as online brokerage accounts, which is why they came first.
A trusted party (the CEX) handles customers’ wallets for them, matches buyers & sellers and settles the transactions. They leverage **centralized architecture** to optimize the order book.

These are registered licensed, businesses which enable their customers to convert fiat money (like US dollars) to cryptocurrencies and vice-versa. They handpick which tokens can be bought. They are subject to their country’s law & regulations, and **most countries impose Know-Your-Customer (KYC) rules**, which in turn require CEXes to only allow identified customers to use their services. This prevents anonymous trading (and prevents certain people from using the exchange: the **censorship problem**).

CEXes are typically highly liquid, and allow customers to buy and sell at any time.
Their business model is usually to collect a fee (~2%) on each transaction.
Their major disadvantage is **the custody problem**: *“not your keys, not your coins”* : customers don’t actually **control** the tokens until they extract them from the exchange into a wallet they control.
## DEXes
*Examples: uniswap, sushiswap.*
 ![](https://storage.googleapis.com/papyrus_images/43e09932256773523b35a57950f80887)
These are a newer and a more innovative concept: DEXes are **autonomous financial protocols powered by smart contracts** (typically on the ethereum blockchain and its derivatives). They enable crypto traders to *swap* one digital asset for another, with all transactions viewable on the blockchain. 

They leverage **Automated Market Maker** methods, where the price automatically adjusts based on real-time selling and buying. This is typically implemented with **liquidity pools** (sellers sell to a pool, buyers buy from the pool) rather than an order book.

Since their code runs on public blockchains: **anyone** with a funded ethereum wallet can interact with them **without limits **and** anonymously** (only the address is public knowledge, not its owner’s identity).

They still only offer primitive trading techniques, and lack advanced ones like margin trades, limit orders, futures, etc... 
Their efficiency is significantly lower than CEXes since they run on blockchains, which is more expensive and slower than off-chain architectures.
Their code being public doesn’t mean they’re necessarily safe: bugs can exist in the open that get uncovered over time.
Despite all of this, their popularity is increasing.

Crypto Exchanges & (de)centralization

## Consensus Algorithms

Consensus algorithms are used by distributed systems to reach agreement. This class of algorithms has existed since computers moved from single mainframe architecture towards a network-based one.
Historically, these algorithms were used in **non-adversarial environments** (bad nodes fail), and the most successful was [Paxos](https://en.wikipedia.org/wiki/Paxos\*(computer\*science)). Nowadays, with increased use of [blockchains](https://paragraph.xyz/@nichochar/blockchains), they are gaining adoption in **adversarial environments** (bad malicious nodes lie). The most successful is Proof-of-Work  (**PoW**), famously used by Bitcoin and Ethereum. However, Proof-of-Stake (**PoS**) is gaining traction, and Ethereum will be migrating to it later in 2022.

## Description

Proof-of-Stake is a category of consensus algorithms for public blockchains that **leverages a node’s economic stake in the network**. Instead of rewarding good behavior, they penalize bad behavior, through economic value loss. Validator nodes deposit **stake** (a security deposit) into the network, through a smart contract. They now have 2 jobs: **minting** and **voting**.
For each block, one validator is **selected to mint** the next block, adding up all the transactions, collecting their fees, and signing the block. Then, the other validators **vote** to accept it. Voting power is linearly proportional to stake.
If the chosen minting validator lies, a portion of its stake is taken away (more than the total collected fees).
 ![](https://storage.googleapis.com/papyrus_images/ec72f9496d1a4e9cdca17ea29e72f5e7)
In Proof-of-Work, **miners** **mine the next block** by competing to solve a cryptographic puzzle. Only one of them wins, the rest of the work is discarded, which is wasteful.

In Proof-of-Stake, **one validator is chosen** and **mints the next block.** Once ready, other validators vote on the block’s correctness.


Different PoS algorithms vary in validator selection, validator reward distribution, and voting power mechanics. The two most popular variants are [chain-based](https://analyticslearn.com/chain-based-proof-of-stake-comprehensive-guide) and [BFT-style](https://en.wikipedia.org/wiki/Byzantine_fault).
If a node stops being a validator, it has to **wait a period of time before collecting** back its stake and transaction fees earned while minting blocks. This exit friction gives the network time to discover fraudulent behavior.

## Risks

- unproven in a high stakes environment
- if a single validator gains 51% of the market cap of the network, they can take over
- high stake validators increase centralization risk (voting power, selection power)

## Advantages

- consumes *significantly* less energy
- censorship resistant (harder to detect)
- reduces the economies of scale advantage, which reduces centralization risk

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Proof of Stake

## Definition

A [blockchain](https://papyrus-nextjs-8wnomxnrq.paragraph.xyz/@nichochar/blockchains) is a distributed, append-only database that is shared among the nodes of a computer network. It has no central authority, but rather relies on consensus between nodes to validate the chain of data as it gets built. The nodes all hold a copy of the data and can serve it independently.

Blockchains guarantee the fidelity and security of a record of data and generates trust without the need for a trusted third party (like a bank, a government, or a company).

Blockchains are best known for their crucial role in cryptocurrency systems, such as bitcoin ([2009](https://bitcoinwhitepaper.co/)) or ethereum ([2013](https://ethereum.org/en/whitepaper/)), even though they were [invented in 1991](https://link.springer.com/article/10.1007/BF00196791) for timestamping documents in a way that could not be tampered with.

## Blocks

The internal data structure of a blockchain is an ordered linked list of **blocks,** which are immutable data containers.

 ![](https://storage.googleapis.com/papyrus_images/c6ad5f5e253006f7bfc2dd8da3e590f9)

Blocks contain a nonce, new transaction data, the previous block’s hash, and the hash of the previous pieces, concatenated.

 ![](https://storage.googleapis.com/papyrus_images/9f1b976d8990910c1c56663d53858af0 "right-50")

Modifying the transactions (the data records) of a block will therefore invalidate not only its own hash, but all subsequent ones.

Once the block is approved through consensus algorithms, it is committed and written, and will forever be a part of the blockchain.

The hash function is public knowledge (usually, [sha256](https://en.wikipedia.org/wiki/SHA-2)), meaning anyone can validate the chain easily.

## Consensus

Because blockchains are decentralized, there is not central authority that can be trusted to know that the next block (containing all new transactions) is valid. Therefore, they require a consensus algorithm to build confidence about this validity.

This is actually a hard problem that peer-to-peer networks have struggled with, and bitcoin solved it cleverly by using an algorithm called **proof-of-work**, originally invented [in 1993](https://link.springer.com/content/pdf/10.1007%2F3-540-48071-4_10.pdf) to combat spam emails or other denial of service type attacks.

The intuition of this algorithm is that all nodes compete to be the creator of the next block. They all have the transaction data to put in it, and a hard puzzle condition (create an `output_hash` hash with multiple leading zeroes). They randomly try different nonces and compute:

```javascript
output_hash = hash(nonce, data, previous_block_hash)
```

Finding the right nonce is hard, but verifying it is easy. Miners get rewarded for winning this game, incentivizing more miners, and more miners means more security to the network.

There are other consensus algorithms, the most promising of which is called **proof-of-stake**.

Blockchains

# 👋 gm

I am [@nichochar](https://twitter.com/nichochar), a software engineer who has recently started dabbling and building things in web3.
As thrilling as it is, learning web3 can quickly get overwhelming. This is a whole new world full of technical and cultural jargon. There is a significant barrier to entry for crypto-curious and crypto-learners.
In this newsletter, I will summarize web3 concepts in 420 words or less (and maybe some diagrams 🙈). I’m a beginner myself so the goal is to learn together.

Welcome, thanks for being here, and I hope that you enjoy it! 

(if you do, subscribe!)

 ![](https://storage.googleapis.com/papyrus_images/3f9890dc99cf91bb3f2589ddfae7562e)

Wallets

Blockchain Accounts

Crypto Exchanges & (de)centralization

Proof of Stake

Blockchains

Introducing web 3 in 420