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 Singapore University of Social Sciences - World Scientific
Future Economy Series
ISSN: 2661-3905

Series Editor
David Lee Kuo Chuen (Singapore University of Social Sciences, Singapore)

Subject Editors
Guan Chong (Singapore University of Social Sciences, Singapore)
Ding Ding (Singapore University of Social Sciences, Singapore)

Singapore University of Social Sciences - World Scientific Future Economy Series

introduces the new technology trends and challenges that businesses today face, finan-
cial management in the digital economy, blockchain technology, smart contract and
cryptography. The authors describe current issues that the business leaders and finance
professionals are facing, as well as developments in digitalisation. The series covers
several increasingly important new areas such as the fourth industrial revolution, Inter-
net of Things (IoT), blockchain technology, artificial intelligence (AI) and many other
forces of disruption and breakthroughs that shape today’s realities of the economy. A
better understanding of the changing environment in the future economy can enable
business professionals and leaders to recognise realities, embrace changes, and create new
opportunities — locally and globally — in this inevitable digital age.

Published*

Vol. 4 Blockchain and Smart Contracts: Design Thinking and Programming

for FinTech
by Lo Swee Won, Wang Yu and David Lee Kuo Chuen

Vol. 3 Artificial Intelligence, Data and Blockchain in a Digital Economy,

First Edition
edited by David Lee Kuo Chuen, supported by Singapore University of
Social Sciences and World Scientific, in support of Singapore Digital (SG:D)
and in collaboration with Infocomm Media Development Authority

Vol. 2 The Emerging Business Models

by Guan Chong, Jiang Zhiying and Ding Ding

Vol. 1 AI & Quantum Computing for Finance & Insurance: Fortunes and
Challenges for China and America
by Paul Schulte and David Lee Kuo Chuen

*More information on this series can also be found at

https://www.worldscientific.com/series/susswsfes

(Continued at end of book)

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 Published by
World Scientific Publishing Co. Pte. Ltd.
5 Toh Tuck Link, Singapore 596224
USA office: 27 Warren Street, Suite 401-402, Hackensack, NJ 07601
UK office: 57 Shelton Street, Covent Garden, London WC2H 9HE

Library of Congress Cataloging-in-Publication Data

Names: Lo, Swee Won, author. | Wang, Yu (Fintech research fellow), author. |
Lee, David (David Kuo Chuen)
Title: Blockchain and smart contracts : design thinking and programming for fintech / Lo Swee Won,
Wang Yu, David Lee Kuo Chuen, Singapore University of Social Sciences, Singapore.
Description: New Jersey : World Scientific, 2021. | Series: Singapore University of
Social Sciences--World Scientific future economy series, 2661-3905 ; vol. 4 |
Includes bibliographical references and index.
Identifiers: LCCN 2020041556 (print) | LCCN 2020041557 (ebook) |
ISBN 9789811223686 (hardcover) | ISBN 9789811224867 (paperback) |
ISBN 9789811223693 (ebook) | ISBN 9789811223709 (ebook other)
Subjects: LCSH: Financial engineering. | Blockchains (Databases) |
Cryptocurrencies. | Computer security.
Classification: LCC HG176.7 .L62 2021 (print) | LCC HG176.7 (ebook) | DDC 332.4--dc23
LC record available at https://lccn.loc.gov/2020041556
LC ebook record available at https://lccn.loc.gov/2020041557

British Library Cataloguing-in-Publication Data

A catalogue record for this book is available from the British Library.

Copyright © 2021 by World Scientific Publishing Co. Pte. Ltd.

All rights reserved. This book, or parts thereof, may not be reproduced in any form or by any means,
electronic or mechanical, including photocopying, recording or any information storage and retrieval
system now known or to be invented, without written permission from the publisher.

For photocopying of material in this volume, please pay a copying fee through the Copyright Clearance
Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, USA. In this case permission to photocopy
is not required from the publisher.

For any available supplementary material, please visit

https://www.worldscientific.com/worldscibooks/10.1142/11919#t=suppl

Desk Editors: Balasubramanian Shanmugam/Yulin Jiang

Typeset by Stallion Press

Email: [email protected]

Printed in Singapore

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December 24, 2020 14:18 Blockchain and Smart Contracts: Design Thinking. . . 9in x 6in b4043-fm page v

This book is dedicated to

Prof. Cheong Hee Kiat, President of SUSS,
and
Prof. Tsui Kai Chong, Provost of SUSS.

v
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December 24, 2020 14:18 Blockchain and Smart Contracts: Design Thinking. . . 9in x 6in b4043-fm page vii

Preface

Digital economy, cryptocurrency and blockchain have been popular

keywords in the news, social media, research articles, investment
and strategies for companies and nations over the past few years.
Technology is more than just a future trend — it is happening now,
developing fast and has a huge impact on every aspect of the society,
including the governments, corporations, educational institutes and
individuals.
The finance industry has witnessed dramatic changes in the
products and services provided in the markets, owing to the rapid
developments of new technologies and innovations. At SUSS, we are
devoted to becoming the bridge between industry and students. We
have organised dozens of meet-ups, seminars, workshops, conferences
and summits and invited experts from industry, government agencies
and academia to share their thoughts. We are also one of the
earliest institutes that provide training and courses on blockchain
and cryptocurrencies.
Through these events and other collaborative research projects
with industry partners and government agencies, we have learned a
lot about the latest development and trends, and such knowledge
can then be incorporated in our teaching materials and curriculum
design.
To ensure that our curriculum is relevant to the industry devel-
opments, the Finance Programme at SUSS has gone through several
rounds of curriculum revamp. With a strong industry connection,

vii
December 24, 2020 14:18 Blockchain and Smart Contracts: Design Thinking. . . 9in x 6in b4043-fm page viii

viii Preface

we were able to invite industry veterans to become our SUSS Fellows

to advise on our curriculum updates and give students exposure to
the fast-changing finance world. By July 2020, we have appointed
more than 100 experts in FinTech and blockchain areas from all over
the world to be our SUSS Fellows.
In addition, the Finance Programme at SUSS has developed a
series of new courses in the curriculum to equip students with relevant
knowledge and skills to meet the needs of the new roles that have
been evolving in the finance industry for the past few years. These
courses cover areas in business analytics, programming, blockchain
technology and the latest developments in financial technology as
well as business innovation. The objective is to give students rigorous
training in the areas of programming and analytical skills, which
are greatly needed in the new economy. Various levels of options
are available at SUSS. For example, we offer FinTech minor for
the undergraduate, the Master of Finance (MFIN) programme, the
Graduate Diploma in FinTech (GDFT) programme, the Graduate
Certificate in FinTech (GCFT) programme for professionals who
wish to acquire professional advancement and deepen their knowl-
edge of finance, financial technologies and financial innovations, and
the Doctor of Business Administration programme for people who
further seek sophisticated problem-solving skills required to tackle
complex business problems and drive innovations.
Therefore, in this new book, as the 4th Volume of the SUSS-WS
Future Economy Series, we discuss both the design thinking ideas
and technical details in blockchain and smart contracts to provide
in-depth analysis of the conceptual framework of the Bitcoin and
Ethereum blockchains and help the readers understand more about
the token economics. The content is developed based on several
courses at SUSS, to name a few, Financial Cryptography, Financial
Technologies and Innovations, Blockchain Security and Privacy, and
Hands-On Lab with MultiChain.
Our goal is to equip the students with the following three skill
sets in the workplace after they graduate. The first skill is technology
analysis. We hope to train more people to know what technologies
are about and what the underlying technical details are so that they
December 24, 2020 14:18 Blockchain and Smart Contracts: Design Thinking. . . 9in x 6in b4043-fm page ix

Preface ix

can truly understand and appreciate the technologies and familiarise

themselves with the application and useful scenarios.
The second skill is business strategy. Knowing what tech can and
cannot do is important, but what is more important is to choose the
most suitable technology for your business. So, the second important

Mr. Vitalik Buterin, Co-Founder of Ethereum, delivering the keynote at the

Inclusive Blockchain Conference in 2017.

Mr. Zooko Wilcox-O’Hearn, CEO and Founder of Zcash, conducting the

Blockchain Privacy Workshop in 2018.
December 24, 2020 14:18 Blockchain and Smart Contracts: Design Thinking. . . 9in x 6in b4043-fm page x

x Preface

Dr. Xiao Feng, Chairman and CEO of Wanxiang Blockchain, giving a keynote
address at the Global Inclusive Blockchain Conference in 2018.

Ms. Hester Peirce, Commissioner of the U.S. Securities and Exchange Commis-
sion, delivering a keynote address at the SUSS Convergence Forum in 2019.
December 24, 2020 14:18 Blockchain and Smart Contracts: Design Thinking. . . 9in x 6in b4043-fm page xi

Preface xi

Mr. Sopnendu Mohanty, Chief Fintech Officer, Monetary Authority of Singapore

(MAS), giving a keynote speech in our very first online summit, China–Singapore
Blockchain Leaders Summit 2020.

skill related to technologies is to understand the business strategy —

what is the case for your company, what your business can or cannot
do and how technologies can help achieve your objectives. Knowledge
about the technologies alone is not enough, one must be aware of the
companies’ strategies such as the KYC, business philosophy, market
environment, regulation and compliance, and the firms’ competitive
edges to make sure the business is sustainable in the long run.
The third skill is project management. Effectiveness of planning
and vision depends largely on the execution, so project management
also plays an important role. It is the step to bring ideas to the
market. Regardless of the decisions on which technologies to use
or the level of reliance on technologies, students shall be able to
contribute to the company as employees and make the projects work.
Therefore, we consolidate some of the course materials and
incorporate them into this book, hoping to provide readers with some
insights about the design thinking and technical details behind the
blockchain technologies, and to employ the knowledge or the mindset
in your future study or work. Like the spirit of decentralised and
distributed blockchain, we are happy to make our course materials
December 24, 2020 14:18 Blockchain and Smart Contracts: Design Thinking. . . 9in x 6in b4043-fm page xii

xii Preface

open-sourced to encourage peer-to-peer learning and we look forward

to seeing more people recognising realities, embracing changes and
creating new opportunities in this inevitable digital age.
Feel free to visit the SUSS-WS Future Economy Book Series page
(https://www.worldscientific.com/series/susswsfes) for our existing
books on other relevant topics such as AI, data and quantum comput-
ing and more upcoming books, or our website (www.sussblockchain.
com) for the latest news on workshops and publications available at
SUSS FinTech & Blockchain Group. Enjoy the journey to learn!
Last but not least, we would like to thank the President, Provost
and Dean of SUSS for supporting us on this project. Also, without
the contribution by the SUSS Fellows to the workshop series and
conferences, we would not have accelerated the preparation of these
materials. Many students have contributed in one way or another in
the preparation of this book by providing feedback and our fellow
academics have been very forthcoming in their criticism to enhance
our presentation. We will not name everyone but thank all of you for
helping us.
December 24, 2020 14:18 Blockchain and Smart Contracts: Design Thinking. . . 9in x 6in b4043-fm page xiii

About the Authors

Professor David LEE Kuo Chuen is

the founder of several companies including
California-based Left Coast, Singapore’s Ferrell
Group and BlockAsset. He is a non-executive
director of two listed companies. He is the
founding investor in Zcash, Qtum and a few
other blockchain companies. He is an advisor
to Financial Inclusion Institute, and was the
director of the Sim Kee Boon Institute for
Financial Economics at the Singapore Management University. He
graduated with B.Sc., M.Sc. and Ph.D. from the London School
of Economics and Political Science. He was the Group Managing
Director of OUE and Auric Pacific. He founded and managed one
of the most successful hedge funds in 1998 for property invest-
ment in Asia with several commercial buildings and more than
100 units of residential units. He founded Premium Land and
was the property developer for Ferrell Residences, a high-end 24-
storey residential building, in 2006. His operation and managing
experience includes F&B, manufacturing, hospitality, hedge funds,
stockbroking, property management, property development, REITs,
medical plastic components, listing and de-listing of companies,
startups and multinationals. He is the editor and an author of
the American Library Association Outstanding Award Reference

xiii
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xiv About the Authors

Book titled Digital Currency by Elsevier and the LASIC model

for scalable technology companies. He has been nominated by the
Internal Consulting Group as a Global Thought Leader for Fintech
and Blockchain.

Dr LO Swee Won is a lecturer at the

School of Business, Singapore University of
Social Sciences. She graduated with a Ph.D. in
Information Security & Trust from Singapore
Management University, where her dissertation
focused on the security of online distribution of
multimedia codestreams. She teaches financial
cryptography, FinTech, and blockchain secu-
rity and privacy courses to postgraduates and
undergraduates. She is a content provider and validator for the IBF
Future-Enabled Skills series and a member of the Blockchain and
Distributed Ledger Technologies Technical Committee (BDLTTC) at
ITSC. Her primary research interests include data/user security and
privacy, and risks and complexities in blockchain. Her publications
include book chapters and papers in top conferences such as WISA,
ICME and ESORICS. She serves as a referee for The Singapore Eco-
nomic Review and IEEE Transactions on Intelligent Transportation
Systems, and is a member of the Editorial Board of Cybersecurity
and Privacy (specialty section of Frontiers in Big Data) as a Review
Editor.

Ms WANG Yu (Cheryl) is a fintech research

fellow at the School of Business, Singapore
University of Social Sciences. Her main research
interests are FinTech, ICO, Financial data anal-
ysis and Asset pricing. Prior to SUSS, she
worked at the National University of Singa-
pore Business School as a research associate
on corporate governance and sustainability. She
graduated with an M.Sc. in Applied Economies
December 24, 2020 14:18 Blockchain and Smart Contracts: Design Thinking. . . 9in x 6in b4043-fm page xv

About the Authors xv

from Nanyang Technological University and a B.Sc. in Financial

Engineering from Huazhong University of Sciences of Technologies.
She has written multiple journal papers, including an empirical study
on sustainability reporting and firm value published in the SSCI
journal, Sustainability, and one investigating cryptocurrency as a
new alternative investment published in the Journal of Alternative
Investments that has been cited over 150 times and recommended
by CFA Institute Journal Review. She also serves as a referee for var-
ious journals such as Singapore Economic Review, Quarterly Review
of Economics and Finance and Journal of Alternative Investments.
 b2530   International Strategic Relations and China’s National Security: World at the Crossroads

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About the Contributors

Edwan CHIAM is the founder and CEO of

HelloDime. From his early days as a student,
Edwan has always marvelled at revolutionary
technologies and how they can revolutionise
and impact the future in which we live. Right
from the very basics of our lifestyle through to
the tools we communicate with, he is curious
about the developments of such technologies.
Upon graduation, Edwan’s fascination grew
in the area of Financial technology, which led him explore the
fintech industry further. He has experience in various blockchain
projects in the areas of Asset tokenisation, Enterprise blockchain
implementations on use cases for Finance, Medtech and DTM. He
constantly challenged himself by translating his area of interest
for laypeople. That eventually gave rise to a new product named
HelloDime, which aims to garner early curiosity in the area of
blockchain technology and the future. More information can be found
at www.hellodime.com, the HelloDime website.

xvii
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xviii About the Contributors

GUO Li is an Assistant Professor in Finance

at Fudan University and a Principal Investiga-
tor at the Shanghai Institute of International
Finance and Economics. Before joining Fudan
University, Dr. Guo obtained his Ph.D. in
Finance from Singapore Management Univer-
sity. His research work has been published in
one of the top-3 journals in finance — Journal
of Financial Economics. He also serves as a
reviewer for multiple leading SSCI/SCI journals, including Financial
Analyst Journal, Journal of Empirical Finance and Journal of
Financial Econometrics. He has also won several best paper awards
in international conferences, such as the 2019 WRDS Advanced
Research Scholar Program (WARSP) Best Paper Award, the 26th
SFM Best Research Paper Award in 2018 and the Best Young
Scholar Paper Award in 2017 Frontiers of Business Research in
China International Symposium. Li’s research has been selected in
the “Chenguang Program” and “Pujiang Talents Plan” supported by
the Shanghai Education Development Foundation and the Shanghai
Municipal Education Commission. He is also managing a research
project as the Principal Investigator funded by the National Natural
Science Foundation of China (NSFC).

Roy LAI, founder of Sentinel Chain, is

a veteran in the technology, financial and
blockchain industries. In 2015, Roy established
InfoCorp Technologies to provide infrastructure
for accelerating financial inclusion to unbanked
communities through the use of blockchain
technologies. In 2018, Roy was announced as a
winner of the Entrepreneur of the Year Award
in Singapore. In the same year, Roy founded
December 24, 2020 14:18 Blockchain and Smart Contracts: Design Thinking. . . 9in x 6in b4043-fm page xix

About the Contributors xix

Sentinel Chain, a Blockchain-based International Consortium mar-

ketplace for cross-border business-to-business financial services and
the world’s first platform to accept the use of livestock as collateral.
Sentinel Chain was cited by the World Economic Forum as an
“exciting and practical” real-world use case for blockchain in their
May 2018 report, “The Global Financial and Monetary System in
2030”. Roy is also a fellow at the Singapore University of Social
Sciences where he teaches Blockchain programming and Smart
contracts.

Ernie TEO is an economist and game the-

orist with a focus on technology, fintech and
blockchain. He co-founded Dedoco, a document
process solution that is built on blockchain to
prevent tampering of documents and create
an audit trail for authentication and valida-
tion (signing). Ernie is also Vice Chairman of
Blockchain Association Singapore and Adjunct
Senior Lecturer at the National University of
Singapore Business School where he teaches FinTech and Blockchain.
Ernie is active in the blockchain community in Singapore, giving
talks and seminars both in the industry and at universities. He has
also published in the area of Blockchain and FinTech, most recently
in the 2018 IEEE International Conference on Cloud Engineering.
A pioneer of blockchain education in Singapore, he conceptualised
and taught the first blockchain course as part of a degree program
at the National University of Singapore. He received his Ph.D. in
Economics from the University of New South Wales, Australia, and
also held academic positions in Nanyang Technological University
and Singapore Management University.
December 24, 2020 14:18 Blockchain and Smart Contracts: Design Thinking. . . 9in x 6in b4043-fm page xx

xx About the Contributors

YU Yinghui heads the Master of Finance pro-

gramme and the Graduate Diploma in Financial
Technology programme at the Singapore Uni-
versity of Social Sciences (SUSS). She obtained
her Ph.D. in Finance from the University of
Hong Kong in 2006, and before joining SUSS,
she was a derivatives trader with a global
investment bank for eight years. Dr. Yu’s
research interests include asset pricing, alterna-
tive investments, risk management as well as financial technologies
and innovations. Her research has been published in journals such as
the Journal of Finance.
December 24, 2020 14:18 Blockchain and Smart Contracts: Design Thinking. . . 9in x 6in b4043-fm page xxi

Acknowledgements

We would like to thank our researchers Davina Tham, Sherman Low

Wei Dong and Yiheng Liu, as well as Balasubramanian Shanmugam
and Jiang Yulin for their tremendous help in the completion of this
book.
We are also especially thankful to the Dean of the School of
Business, Associate Professor Allan Chia Beng Hock, and the former
Dean of the School of Business, Professor Lee Pui Mun, for their
support. Thanks are also due to our colleagues Professor Leslie Chew
and Dr. Daniel Seah from the School of Law, Associate Professor
Ding Ding, Dr. Caroline Lim, Dr. Hung Yuchen, Associate Professor
Joseph Lim, Associate Professor Linda Low, Associate Professor
Phoon Kok Fai, Dr. Ren Jing, Sherry Li Ying Ying, Dr. Tan Chong
Hui, Associate Professor Tan Yan Weng, Dr. Wang Yue, Dr. Xu
Weibiao and Dr. Yu Yinghui from the School of Business.
Special thanks also to our close partners and collaborators
Professor Zhao Xiaoju, Professor Hou Wenxuan, Professor Liu Liya,
Professor Chen Yun, Associate Professor Cindy Deng Xin and
Assistant Professor Min Min of Shanghai University of Finance and
Economics (SUFE), Professor Pei Sai Fan of Libai Academy, Dr. Yan
Li of Nanyang Technological University, Associate Professor Zhang
Junwei of Xidian University, Sopnendu Mohanty, Tay Su Hui and
team from MAS, Thomas Ho of NRF, Veronica Tan, Koh Wee Siong
and team from IMDA, Law Chung Ming, Teh Kai Feng, Low Yue
Wen and team from ESG, Juanita Woodward of CTD, Anson Zeall

xxi
December 24, 2020 14:18 Blockchain and Smart Contracts: Design Thinking. . . 9in x 6in b4043-fm page xxii

xxii Acknowledgements

of IDAXA/ACCESS Singapore, Chia Hock Lai of Singapore Fin-

Tech Association/Global FinTech Institute, Tan Bin Ru, Yeo Guat
Kwang, Tome Oh and others from Blockchain Association Singapore,
Dr. Naseem Naqvi from British Blockchain Association, Daphne Ng,
Dr. Ernie Teo, Edwan Chiam and team from Dedoco, Paul Neo of
SAL, Peter Douglas and team from CAIA Association, and Addy
Crezee and team from Blockshow. We are indebted to Emma Cui
and her team from LongHash, Wang Lei and his team from 8BTC,
Dr Xiao Feng, Du Yu and team from Wanxiang Blockchain Labs,
Selina Lin and her team from DRC and Niu Zhiyan and her team
from Shanjun Culture Media.
We would also like to thank our SUSS Fellows, workshop
instructors and invited speakers for sharing their insights with us.
There are so many to thank and their names are all on www.
susssblockchain.com but especially to Dr. Aleksandra Bal, Dr. Alex
Baranovskyi, Andras Kristof, Anish Srivastava, Anju Patwardhan,
Professor Anne-Laure Mention, Anthony Lim, Armen Harutyunyan,
Ben Cessa, Ben Chan, Benjamin Soh, Bobby Ong, Dr. Boyd Cohen,
Dr. Chan Onn, Charlie Lee, Chua Tju Liang, Clay Lin, Danny
Lim, Dave Appleton, Dr. David Hardoon, Debbie Watkins, Diego
Gutierrez, Dmitriy Budorin, Edward Tan, Gary Loh, Gongpil Choi,
Harry Smorenberg, Henry Wang, Commissioner Hester Peirce, Ian
Myles, Jack Lee, James Gong, Jason Lim, Jeff Garzik, Jehan Chu,
Jerome Eger, Joseph Thompson, Justin Newton, Dr. Justo Ortiz,
Karen Teoh, Prof Kung Chen, Lesly Goh, Lisette Cipriano, Liz
Steininger, Joseph Lubin, Dr. Loi Luu, Matthew Tan, Mike Lloyd,
Dr. Miguel Soriano, Niall Dennehy, Nicola Paoli, Nizam Ismail,
Patrick Dai, Paul Schulte, Dr. Peter Yan, Ramon Vicente, Remington
Ong, Renqi Shen, Robert Greene, Roberto Capodieci, Robin Lee,
Roland Schwinn, Roland Sun, Roy Lai, Roy Teo, Shaun Djie, Shen
Bo Siew Kai Choy, Professor Silvio Micali, Stanley Yong, Sunny Lu,
TM Lee, Tomicah Tillemann, Tony Lai, Tony Yeoh, Val Yap, Vitalik
Buterin, Associate Professor Wan Zhiguo, Dr. Wang Xinxi, Wijitleka
Marome, Dr. Yan Qiang, Yusho Liu, Yvonne Zhang, Professor Zhang
Bohui, Zhang Yifeng, and Zooko Wilcox.
Lastly, Cheryl Wang Yu and Lo Swee Won would like to express
their thanks to Guo Li and Li Feng.
December 24, 2020 14:18 Blockchain and Smart Contracts: Design Thinking. . . 9in x 6in b4043-fm page xxiii

Contents

Preface vii
About the Authors xiii
About the Contributors xvii
Acknowledgements xxi

1. Cryptography and Blockchain Technology 1

2. Bitcoin Mining and Python Programming

Demonstration 73

3. Consensus for Blockchain and Distributed Ledger

Technologies 99

4. Token Economics and Valuation 121

5. Cryptocurrency as an Alternative
Investment Class 155

6. A Look at Security and Privacy: Bitcoin,

Cryptocurrencies and Blockchain Networks 171

7. Introduction to Blockchain Smart Contracts

and Programming with Solidity for Ethereum 189

xxiii
December 24, 2020 14:18 Blockchain and Smart Contracts: Design Thinking. . . 9in x 6in b4043-fm page xxiv

xxiv Contents

8. Hands-On Lab with MultiChain 217

9. Hands-On Guide to Bitcoin Layer-2

Lightning Network Node Setup 305

10. Architecting and Designing Your Own

Blockchain Solution 337

Index 351
December 24, 2020 14:17 Blockchain and Smart Contracts: Design Thinking. . . 9in x 6in b4043-ch01 page 1

Chapter 1

Cryptography and Blockchain

Technology

1.1 Introduction
In this chapter, we discuss the fundamentals of information security
and cryptography that undergird blockchain technology. Information
security and cryptography are highly intertwined fields of study.
Information security concerns the protection of data from unautho-
rised access or modification, while cryptography concerns the study
of mathematical techniques used to achieve information security
objectives when facing adversarial attacks.
We will begin by examining different objectives of information
security, and the concepts in modern cryptography that have evolved
to meet those objectives. We will then look at different cryptographic
techniques used to secure information in blockchain and financial
technology. These include hash function, digital signature, public
key infrastructure, encryption and privacy techniques. Throughout
our discussion, we will make references mainly to the Bitcoin
blockchain for application examples. We note that the usages of the
above cryptographic techniques in other blockchain are essentially to
achieve similar security objectives.
If we look up cryptography in the dictionary, a definition we are
likely to find is “the art of writing or solving codes”. This definition
accurately describes the historical evolution of classical cryptography
up until the 1970s and 1980s. Classical cryptography has been around
for millennia — the earliest known uses of codes have been recorded

1
December 24, 2020 14:17 Blockchain and Smart Contracts: Design Thinking. . . 9in x 6in b4043-ch01 page 2

2 Blockchain and Smart Contracts

as far back as ancient Egypt. What made classical cryptography an

art was the fact that there was little theory behind the construction
or decryption of codes, and no systematic way of thinking about the
requirements a secure code had to satisfy. Its purpose was primarily
to achieve secrecy, and because of the great expense involved, its
use was limited to governments and military organisations. Perhaps
the most famous example is the Enigma machine invented by the
Germans in the early 20th century, and used by Nazi Germany to
encrypt military communications during World War II.
The field of cryptography has evolved a lot since then. Unlike
classical cryptography, modern cryptography is not just an art but a
science and a mathematical discipline. Instead of ill-defined, intuitive
notions of complexity or cleverness, the field now relies on rigorous
proofs of security. We can think of modern cryptography as a suite of
algorithms based on the intractability of difficult problems, which are
problems that cannot be solved in a “reasonable amount of time” by
an efficient attacker. This phrase is deliberately vague, as the speed
of computing and therefore the requirements of what we consider to
be a code that is secure enough are ever-changing.
Compared to classical cryptography, modern cryptography is
also much more pervasive. Its use now extends beyond secret
communication to the protection of the user, data at rest (in storage)
and data in transit (sent over a network), and it is integral to nearly
all computer systems. In one form or another, most of us are users
of cryptography on a daily basis, whether we are sending an e-mail
or paying for a ride with our transportation card.

1.2 Security Objectives

The goal of cryptography is to achieve information security. Before
discussing how to achieve our goal through cryptographic techniques,
we first need to know exactly what we are trying to achieve. Since
the inception of this field, the three main objectives of informa-
tion security have been known as the “CIA triad”: confidentiality,
integrity and availability. However, with the evolution of computing
and technology such as cloud services and the peer-to-peer network,
December 24, 2020 14:17 Blockchain and Smart Contracts: Design Thinking. . . 9in x 6in b4043-ch01 page 3

Cryptography and Blockchain Technology 3

the CIA triad is no longer considered sufficient to ensure protection

against attacks on the data and user. Security practitioners are now
also expected to address two additional security objectives: authen-
tication and accountability. It is important to keep in mind these
five objectives, as they guide the design and use of cryptographic
techniques. Let us look more closely at what each objective entails.

1.2.1 Confidentiality
Confidentiality extends to both data confidentiality and user confi-
dentiality (also understood as user privacy):

• Data Confidentiality: There are two primary aims of data confi-

dentiality. The first is to shield data from all unauthorised parties.
This is similar to the original objective of classical cryptography,
and is achieved through data encryption. The second is to shield
data from unauthorised parties who are differentiated on the basis
of access rights. For example, a patient’s hospital records will
contain different types of data, such as identifying information, test
results, diagnoses, treatments, prescriptions and medical insurance
coverage. To protect the patient’s privacy, hospital employees
should only have access to the records on a need-to-know basis.
Doctors, nurses, pharmacists, hospital administrators and medical
social workers should all have different access rights depending on
the information they need to carry out their respective roles. The
records management system will therefore need an authorisation
protocol that gives users different levels of access based on their
identity.
• User Privacy: There are two primary aims of user privacy, in situ-
ations where there is reason to expect that a user remains uniden-
tifiable. The first is to ensure untraceability. We should be able
to conceal the routes of goods, money, data and other operations,
so that an observer cannot follow the trail to deduce identifying
information about a user. The second is to ensure unlinkability. We
should be able to conceal the connection between multiple pieces
of data from the same user, so that they appear unrelated to an
observer. For example, given multiple pseudonymous transactions
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4 Blockchain and Smart Contracts

on the Bitcoin blockchain, it should not be possible to deduce the

real identity of the user who performed the transactions, nor to
deduce that they were performed by the same user.
High-profile cases of compromised data confidentiality have made
news headlines in recent years, from the unauthorised harvesting of
Facebook users’ personal data by Cambridge Analytica to the data
breach of Sing Health medical records in 2018. In contrast, there
are almost no publicly disclosed cases of compromised user privacy,
which largely remains an area of theoretical concern in academia but
is also gaining more attention as big data, Internet-of-Things (IoT)
and the usage of blockchain become more pervasive.

1.2.2 Integrity
We cannot trust a message unless we know that its content has
been secured from the point that it leaves its origin to the point
that it reaches its destination. Data integrity is concerned with
ensuring that data are not tampered. Though often conflated with
confidentiality, integrity is a distinct objective. It is sometimes
assumed that encryption is sufficient to ensure data integrity, in the
sense that since encryption conceals the real content of a message,
the content cannot be modified in any meaningful way. This is a false
assumption as it is possible to manipulate a piece of encrypted data
in ways that simply invalidate its content. In this case, the recipient
has no idea if the encrypted data are received with errors or were
maliciously modified. We therefore need tools specific to integrity
protection to secure data from unauthorised modifications.
Integrity is achieved through the use of hash function, message
authentication codes and/or digital signature. Integrity is closely
associated with authentication and accountability — two security
objectives that have evolved above and beyond the traditional “CIA
triad”. It is important to be able to distinguish the subtle differences
among all three.

1.2.3 Availability
Data and online services are of no use if they are not available when
authorised users need them. Availability as a security objective is
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Cryptography and Blockchain Technology 5

closely associated with a malicious activity known as a Denial-of-

Service (DoS) attack. As its name suggests, a DoS attack is when
an attacker attempts to overwhelm a server with a flood of bogus
requests that render the server so busy that it is unable to process
normal traffic, and becomes unavailable to other users.
In this era of the IoT, a DoS attack has evolved to a Distributed
DoS (DDoS) attack, which uses a network of distributed devices
connected to the Internet to carry out the attack. In a DDoS attack,
an attacker first injects malicious software (or malware) into any
vulnerable devices connected to the Internet. These devices could
be mobile phones, routers, personal computers, network printers and
Internet Protocol (IP) cameras. Once infected with malware, these
devices become bots that can be remotely controlled to send bogus
requests to the target server, even down to a stipulated date and
time. Availability is usually addressed through good system design,
such as intrusion detection or intrusion prevention systems. It is also
important to note that provision of availability is closely related
to how susceptible a system is to single point of failure, i.e. how
decentralised the system is.

1.2.4 Authentication
Authentication extends to both data authentication and user authen-
tication:

• Data Authentication: The aim is to verify that the origin of a piece

of data is what it claims to be. One of the most common ways
of ensuring data authenticity is through message authentication
codes and digital signatures.
• User Authentication: The aim is to verify that a user is who they
claim to be. It can be achieved by providing authentication factors
to a login system, based on what you know (e.g., username and
password), what you have (e.g., access card) or who you are (e.g.,
biometric information). Similarly, the cryptographic techniques
involved are message authentication codes and digital signature,
where users are required to demonstrate something they know (i.e.,
the secret/private key).
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6 Blockchain and Smart Contracts

1.2.5 Accountability
Accountability aims to thwart a user from falsely denying that they
have sent or received a particular communication. It is analogous
with the concept of non-repudiation. Imagine that we have ensured
data integrity and authentication; that is, we have secured a piece of
data from tampering while in transit, and we have verified the origin
of the data. Accountability goes a step further by creating a digital
artefact that makes it impossible for the sender to deny having sent
the data. It draws an undeniable link between the data and the users
who have processed it, ensuring accountability for actions performed
on the data. This is achieved through the use of a digital signature.
With the rise of “deepfakes” and disinformation, and eroding public
trust in news media, ensuring accountability is increasingly becoming
a matter of social and political stability.

1.2.6 Attacks
Know thyself, know thy enemy, and in every battle you will be
victorious.

— Sun Tzu, The Art of War

To respond effectively to a threat to information security, we

must know what we are up against. Understanding possible attack
strategies enables us to put in place the appropriate safeguards to
ensure the security of a system and its cryptographic techniques. We
will briefly look at two types of attacks here:

• Active Attack : The attacker performs aggressive and often blatant

actions with the aim of affecting or altering a system’s operations.
Examples include e-mail phishing, modifying data in transit
between users, mounting a DDoS attack and mounting a brute-
force attack (trial and error) to guess a username and password
combination. An active attack is easy to detect but difficult to
defend, involving a thorough analysis to close all loopholes in
a system or cryptographic technique. By the time an attack is
detected, the damage may already have been done or underway.
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Cryptography and Blockchain Technology 7

• Passive Attack : The attacker uses covert methods to tap into

a network and eavesdrop on or record communications. The
objective of a passive attack is usually to gain access to a system
or steal information surreptitiously. Examples include surveillance,
man-in-the-middle attacks and keystroke logging. Designed to
avoid detection, passive attacks are difficult to detect but easy
to prevent. One of the most straightforward methods is to encrypt
communication between users.

1.3 Cryptography
Earlier, we briefly discussed the idea of what is considered secure in
cryptography. We stated that cryptography is a suite of algorithms
based on the intractability of difficult problems that cannot be solved
in a reasonable amount of time. In this section, we will examine the
concept of security in cryptography in greater detail, and identify
the key properties of a secure cryptographic scheme.

Key Terms: Bit, Scheme, Algorithm, Function

A bit (short for binary digit) is the smallest unit of computer

data. Each bit has one of two binary values, either 0 or 1. 4 bits
of data therefore have 24 or 16 possible combinations:

0000 0100 1000 1100

0001 0101 1001 1101
0010 0110 1010 1110
0011 0111 1011 1111
In the following sections, we use certain terms to talk about
parts of a security system. A cryptographic scheme is an overall
description of how a security system works. Schemes consist of
one or more algorithms, which are sets of instructions defining a
sequence of operations to be carried out by a computer. For
example, an encryption scheme may consist of a secret key
generation algorithm, an encryption algorithm and a decryption
algorithm.
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8 Blockchain and Smart Contracts

A function is a process or relation between values that takes

some input and produces some output. For example, the secret
key generation algorithm has a KeyGen() function that takes
as input the security parameter n, and produces a secret key k
of n bits. The encryption algorithm has an Enc() function that
takes as input a secret key k and a plaintext m, and produces a
ciphertext c. The decryption algorithm has a Dec() function that
takes as input a ciphertext c and a secret key k, and produces a
plaintext m.

Cryptographic techniques cannot be proven unconditionally

secure, as that would require breakthroughs in the analysis of
computational complexity that are not yet within our reach. In fact,
almost all cryptographic techniques can be broken given enough time
and computing power. We still consider them secure because what
is “enough” is generally not achievable in our lifetime or several
lifetimes. Instead of unconditional security, we aim for cryptographic
techniques to be computationally secure.
Refining our earlier statement, we say that a cryptographic
scheme is computationally secure if no efficient attacker is able to
break it in a reasonable amount of time. An “efficient attacker” can
be understood as an attacker with a reasonable amount of computing
power, while “a reasonable amount of time” can be understood as a
time frame during which the ability to solve a problem has ceased to
be useful or interesting. Cryptographic techniques that meet these
conditions have a negligible probability of being broken.
For example, to break a secret key of 4 bits, an attacker needs
to try only 24 combinations, with the probability of guessing the
right key being 1/24 . This is easily done through a brute-force
attack. A 4-bit secret key is therefore not computationally secure.
In contrast, if the key is of 256 bits, mounting a brute-force attack to
try 2256 combinations would take an attacker several lifetimes, even
with a supercomputer. That makes a 256-bit key computationally
secure.
Intuitively, it seems that we could make cryptography schemes
more secure by setting the highest requirements, such as assuming an
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Cryptography and Blockchain Technology 9

attacker with unlimited, rather than reasonable, computing power.

Indeed, the study of information-theoretic security (or perfect secu-
rity) produces security systems that even an attacker with unlimited
computing power would not be able to break, as the encrypted
message provides no information about the original message. The
one-time pad, or Vernam cipher, which we will discuss in Section 1.9,
is an example of an information-theoretic secure scheme.
We can think of computational security as a practical balance
between security and efficiency. All computationally secure crypto-
graphic schemes rely on the provision of pseudorandomness. This
refers to the fact that the distribution of a string should satisfy
statistical tests of randomness, even though it is in fact not truly
random. Ciphertexts (encrypted texts) are not truly random; in
certain conditions, when enough information is known, a user can
know what ciphertext an algorithm will produce. However, to all
other users who do not have enough information, the ciphertext is
just a pseudorandom string.
Pseudorandomness is important because it prevents a ciphertext
from inadvertently disclosing information about the statistical dis-
tributions of the secret key or the original message. It does this by
ensuring that an attacker cannot distinguish one ciphertext from
another. Using the example of an encryption scheme, where an
encryption algorithm is denoted as Enc(), m is a message in plaintext,
c is the encrypted ciphertext and k is the encryption key,

c ← Enck (m)

A computationally secure encryption scheme requires that given two

ciphertexts c1 and c2 , or

c1 ← Enck (m1 )
c2 ← Enck (m2 )

Both c1 and c2 are indistinguishable to an efficient attacker. In other

words, both c1 and c2 have pseudorandom distributions, and do not
reveal any information about the statistical distributions of k, m1
or m2 .
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10 Blockchain and Smart Contracts

1.4 Blockchain
The concept of a blockchain first appeared in 2008 in a white paper by
Bitcoin inventor Satoshi Nakamoto. In the paper, Nakamoto proposes
Bitcoin as a peer-to-peer payment system, and “a chain of blocks”
as the structure for recording Bitcoin transactions in an immutable
and transparent manner.
The idea of using digital currencies for decentralised peer-to-peer
payment is not new. However, before Bitcoin, it had never been
realised because without a trusted central authority (such as a bank)
to oversee transactions, there was no practical way to thwart three
possible acts by malicious users: spending without authorisation
(i.e., without ownership of the account), spending without having
enough balance and double-spending (i.e., sending the same amount
of digital currencies to more than one receiver without deduction in
the account balance).
Consider the banking system that we are familiar with. To
initiate a fund transfer, users first have to log in to their Internet
banking account. The act of logging in proves a user’s owner-
ship of the account. When the user requests a fund transfer,
this involves the bank checking, among others, if the user has
enough balance to perform the transaction. If so, the request
will be approved. Immediately after, the amount transferred will
be deducted from the balance, so double spending will not be
possible. If a user were to copy and resend the transaction confir-
mation, this would not result in multiple duplicate fund transfers
to the same receiver, because the bank would prohibit fraudulent
transactions.
At its introduction, Bitcoin blockchain was the first sound
design of an open and secure Distributed Ledger Technology (DLT )
that thwarts these three malicious acts without the need for a
central authority. DLT is a method of record-keeping whereby
every person involved in the record-keeping possesses a copy of
the ledger. Whenever a new record is created, it is updated in
each and every user’s ledger. DLT is straightforward to imple-
ment in a trusted setting, which assumes either a trusted central
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Cryptography and Blockchain Technology 11

authority with no self-interest, or that all users will behave honestly

by

• not sending bogus or meaningless transactions that will consume

unnecessary computation and storage resources;
• updating the ledger in an honest and timely manner whenever a
new transaction comes in;
• not making unauthorised deletions, insertions or modifications to
transaction details on the ledger; and
• including only valid transactions on the ledger and rejecting all
invalid transactions.

A trusted setting without a central authority is unrealistic in

most real-life settings, however, given the self-interested behaviour
of individuals. Blockchain, specifically public blockchain like Bitcoin,
does not assume trust. Its significance is that it enables a decen-
tralised peer-to-peer payment system where the ledger recording
the transactions is maintained and updated by a group of users
who do not necessarily trust each other. It is able to bring the
community of users together to agree on a single version of the
truth through “crypto-economy”, which combines cryptography and
economic incentives. Cryptography records data on the transactions
in a secure manner and ensures that it is costly for a user to cheat
or perform unauthorised actions, while economic incentives reward
honest and trustworthy users who help to maintain the integrity of
the ledger.

“The Tragedy of the Commons” (Ostrom, 2015)

Blockchain can be considered as a modern solution to an age-

old economic problem known as the “tragedy of the commons”.
This term describes the scenario where, given a pool of a common
resource that is scarce, rivalrous (i.e. one person’s consumption
reduces the amount available to another) and non-excludable
(i.e., it is not possible to block access to the resource by people
who have not paid), individuals acting independently based
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12 Blockchain and Smart Contracts

on their own self-interest will behave contrary to the common

good of all, and deplete or spoil the common resource through
their collective action. Land, water and other natural resources
are prominent examples of such common resources, and the
“tragedy of the commons” often emerges in discussions about
environmental rights. Solutions to a “tragedy of the commons”
situation may be governmental (e.g., regulation, privatisation)
or non-governmental (e.g., collective social action) in nature.
In 2009, American scholar Elinor Ostrom became the first
woman to win the Nobel Memorial Prize in Economic Sciences
for her analysis of economic governance, particularly of common
resources. Her work identifies eight design principles for self-
organised governance of common resources, which turn out to
be very similar to those of blockchain:
1. Clearly define the group of common goods and the group of
entitled users.
2. Adapt the rules governing the use of common goods to local
conditions.
3. Allow users affected by the rules to participate in the decision-
making process.
4. Implement a monitoring system with monitors from within
the group.
5. Use graduated sanctions for users who violate rules.
6. Provide accessible and low-cost means for dispute resolution.
7. Ensure that the group’s rule-making rights are recognised by
any higher authorities.
8. In the case of larger pools of common goods, organise
governance through multiple, nested tiers of management.

1.5 Cryptographic Hash Function

We start with a simple definition of a hash function, namely that it
is a method of mapping input of arbitrary length onto an output of
fixed length. We call this output a hash value, also known as a “hash”
or “message digest”. A hash function, denoted as Hash(), takes as
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Cryptography and Blockchain Technology 13

input a message m of arbitrary length and produces a hash value

h of fixed length l:

h = Hash(m)

We can also write this process as

Hash(): {0, 1}∗ → {0, 1}l

Hash functions have many uses, one of the most common being
the generation of hash tables for indexing data to enable efficient
data storage and retrieval. However, cryptographic hash functions
are different as they possess rigorous security definitions. Crypto-
graphic hash functions can be used for file integrity protection,
generation of one-time passwords and digital signature computa-
tion, to name a few. We are concerned only with the family of
cryptographic hash functions, and will use “cryptographic hash
function” and “hash function” interchangeably in the remainder
of this chapter. Some examples of hash functions are shown in
Figure 1.1.
You might have heard of a blockchain being described as an
immutable ledger. This immutability is a result of the use of
distributed ledger technology coupled with hash functions, which
do not allow any modification to a block and its transactions to
go undetected. Informally, a hash function possesses the properties
shown in Figure 1.2.

Figure 1.1: Examples of hash functions.

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14 Blockchain and Smart Contracts

Figure 1.2: Properties of hash function.

Formally, the properties of pre-image resistance, second pre-image

resistance and collision resistance can be written as follows:

• Pre-image resistance (or one-wayness): Given h where

h = Hash(m1 ), it is infeasible to find out the value of m1 without
trying on average 2l − 1 times, where l is the length of the hash
value in bits.
• Second pre-image resistance: Given h1 = Hash(m1 ), it is compu-
tationally infeasible to find another message m2 , where m2 = m1
but Hash(m2 ) = Hash(m1 ).
• Collision resistance: It is computationally infeasible for an attacker
to find two distinct inputs m3 and m4 , such that Hash(m3 ) =
Hash(m4 ).

Many attacks against hash functions exploit the mathematical

underpinnings of collision resistance based on the “birthday prob-
lem”. In the original birthday problem, we are tasked to find two
people who have the same birthday out of a roomful of people.
Assuming that all 365 days in a year are equally probable for a
birthday (and ignoring leap years), we need at most only 23 people in
the room to have a 50% probability of finding two people who share
a birthday. It may seem counter-intuitive that a relatively small set
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Cryptography and Blockchain Technology 15

Figure 1.3: Number of pairs that can be formed out of four persons.

produces such a high probability of collision. However, consider the

following problem: How many pairs can we form out of four persons?
n!
The answer is six, given by the formula for n Cr = r!(n−r)! . Thus,
4 C = 6. See Figure 1.3.
2
As such, given 23 people in one room, the number of possible
pairs is given by 23 C2 = 253. This number is well over half of the 365
possible birthdays in a year.
An approximation can be devised in that given a function f () that
has x number of possible outputs, the number of tries after which
we expect to get two different inputs y1 and y2 where f (y1 ) = f (y2 )
√
is given by 1.25 × x. With respect to hash functions, the birthday
problem states that if the hash function produces a hash value of
length l bits, then a collision for that hash value can on average be
found in 2 l/2 tries. This probabilistic model is the basis for so-called
“birthday attacks”.
Aside from the sound design of a hash function, therefore, the
birthday problem reminds us that the length of the hash value is
also closely related to security. However, sound design is arguably
the more fundamental for security. The cryptographic community
witnessed this in 2017 when Google announced that it had achieved
the first concrete collision attack on SHA-1, having developed a
technique to generate a collision1 . SHA-1 produces a 160-bit hash
value, meaning that on average it takes 280 tries to find a collision

1
https://shattered.io/.
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16 Blockchain and Smart Contracts

Figure 1.4: Example of software integrity verification for ghostscript.

Source: https://github.com/ArtifexSoftware/ghostpdl-downloads/releases/dow
nload/gs952/SHA512SUMS.

through a brute-force attack, which is still computationally infeasible

given today’s computing power. However, Google was able to expose
a practical attack that exploited flaws in the design of SHA-1 that
paved the way for it to be phased out of use.
Hash functions form the basis of a myriad of cryptographic tech-
niques, including message authentication codes, digital signatures,
one-time passwords and checksums. For example, when downloading
software from the Internet, users should check their download against
the checksum, or hash value provided on the software’s official
website to ensure they have an uncorrupted version of the programme
(see Figure 1.4). Note that this act of checking software integrity is
based on the assumption that the official website is not compromised.
As we will see later, hash function is also used to protect integrity
of transactions and blocks; this is built upon the distributed ledger
technology. For the rest of this section, we will look more closely at
the application of hash functions in blockchain.

1.5.1 Merkle Hash Tree

Fundamentally, the Merkle Hash Tree is a binary tree; each parent
node has two children nodes. It is created using a bottom-up
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Cryptography and Blockchain Technology 17

Figure 1.5: An example of Merkle Hash Tree with data “P”, “Q”, “R” and “S”.

construction, where nodes at the bottom are called leaf nodes. Each
leaf node contains cryptographic hash of a piece of data and every
non-leaf node contains cryptographic hash of its children nodes. An
example is illustrated in Figure 1.5. Here, the data of each leaf node
are “P”, “Q”, “R” and “S”, respectively. Each leaf node thus contains
cryptographic hash of “P”, “Q”, “R” and “S”, i.e., hP , hQ , hR and
hS , respectively. The parent node (i.e., a non-leaf node) of “P” and
“Q” records the hash of hP and hQ , i.e., h2A = Hash(hP hQ ), where
“” denotes concatenation. Similarly, the parent node of “R” and
“S” records the hash of hR and hS , i.e., h2B = Hash(hR hS ). At this
juncture, we are left with only two nodes containing h2A and h2B ;
the parent of these nodes is called the Merkle Root and it records
Hash(h2A h2B ).
To take a closer look at how Merkle Hash Tree protects data
integrity, we notice how h2A is computed based on hP and hQ , how
h2B is computed based on hR and hS , and finally, how the Hash Root
is computed based on h2A and h2B . Consequently, any changes in
the data “P”, “Q”, “R” or “S” would always be reflected in the
Hash Root.
The construction of a Merkle Hash Tree allows efficient and secure
verification of data. If the Merkle Root, Hash Root, is published and
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18 Blockchain and Smart Contracts

immutable to changes (therefore, trusted to be the true representa-

tion of data in the tree), then one can verify whether the data “P”
is included in the Merkle Hash Tree by asking the Prover to supply
proofs consisting of {hQ , h2B }. The tuple {hQ , h2B } is called the
Merkle Path for data “P”.
The Merkle Path for data “P” together with the hash of “P” is
then sufficient for the Verifier to reconstruct its own Merkle Hash
Tree and compare the resulting Merkle Root with the immutable
Hash Root; if the hash values match, then the Verifier can be
ascertained that the data “P” is included in the Merkle Hash Tree.
If “P” is not, in fact, included in the Merkle Hash Tree but the
Prover lies that it is, the Prover needs to find a collision in the Merkle
Root hash. For simplicity, suppose the Verifier checks if data “N” is
included in the Merkle Hash Tree shown in Figure 1.5. To lie that
“N” is in the Merkle Hash Tree (instead of “P”), the Prover must
supply proofs that are in one of the following forms:
• {h1 , h2B }, where h1 is a hash value that will result in the same
h2A when computed with hN , i.e., Hash(hN h1 ) is the same as
Hash(hP hQ ).
• {hQ , h2 }, where h2 is a hash value that will result in the
same Hash Root when computed with the Hash(hN hQ ), i.e.,
Hash(Hash(hN hQ )h2 ) is the same as Hash(h2A h2B ).
• {h3 , h4 }, where h3 and h4 are both hash values that when combined
with hN will result in the same Hash Root that has been published
and immutable.
To supply either one of the proofs above, the Prover will have
to find a collision in the Merkle Root (Hash Root), an act which is
computationally infeasible due to the security properties of a hash
function. This has an important implication when one wishes to
verify if a transaction is included in a Bitcoin block.

1.5.2 Hash Function in the Bitcoin Blockchain

A blockchain is essentially a chain of blocks. It is a digital ledger, and
the “digital chain” is enabled by the use of hash function. Figure 1.6
shows the structure of a Bitcoin block. In the ith block, denoted as
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Cryptography and Blockchain Technology 19

Figure 1.6: Bitcoin block header structure.

Bi , there is a list of transactions. These transactions are integrity-

protected using a Merkle Hash Tree, and the Merkle Root is part of
block Bi ’s header as shown in Figure 1.6.
To integrity-protect the block header, Bitcoin does not employ
a straightforward calculation of the block header’s hash. Instead,
the proof-of-work (PoW) consensus algorithm in Bitcoin requires
miners to vary the 32-bit nonce and iteratively calculate the block
header hash until the resulting hash satisfies the difficulty target (see
Figure 1.7). Without loss of generality, we refer to the block header
hash that satisfies the difficulty target as the “valid block header
hash”.
As a secure hash function outputs a hash value that is pseudo-
random and it is infeasible to predict which nonce would result in a
valid block header hash, the PoW consensus algorithm is essentially
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20 Blockchain and Smart Contracts

Figure 1.7: Bitcoin calculation of block header hash (Proof-of-Work).

a lottery system among miners. Each miner can only vary the nonce,
recompute the block header hash and check if the block header
hash is valid. This effort constitutes proof of work. Each miner
has equal probability in finding a nonce that gives a valid block
header hash. When a valid block header hash is found, the miner
will broadcast the block in its entirety (referred to as “the solution”)
to the network. Other miners in the network will accept this block as
valid by checking that after hashing the solution, the resulting block
header hash satisfies the difficulty target. The value of a difficulty
target is part of the consensus rule globally accepted by miners in the
network.
To this end, we note that what constitutes a valid block header
hash is a hash value that satisfies the difficulty target. If the difficulty
target states that “A valid block header hash is one that starts with
at least four zeros in hexadecimal”, then, for a block Bi , any one of
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Cryptography and Blockchain Technology 21

the following hash values can be regarded as a valid block header

hash:

• 00004a89fd89403a36e19c5d67ffcc9bba626cf8dc9a2109bcdbb2471
b952683
• 0000ed4bf83abd0f4b4ce53ed89fe59285f1016ccf85d738d0f6aa9924
e368d4
• 000002eb9ddb8b6d986196f3bf4a3958b2605e917e734c0d9e24d800
dc3cbb6b
• . . . and the list goes on.

This presents an opportunity for an attacker who attempts to

revert a transaction.
For instance, Eve agrees to pay Bob 1 btc (bitcoin) in exchange for
a software license activation code. Eve creates a bitcoin transaction
that pays Bob the agreed-upon amount and this transaction is
recorded in block 500, B500 , with a block header hash value of
00006120ab0fbd24a1b61dbdca856c3795314945f405b4e90d9a1d3452b
85127. Upon seeing the transaction in B500 , Bob immediately sends
the activation code to Eve. At the same time, Eve creates another
block 500 without her transaction to Bob (denote this block as
B500 ’) and performs the proof-of-work to get a valid block header
hash for B500 ’. Suppose this block has a block header hash value of
000035a474b760c0d13ff431a806553a3364c302117ceff8e08ef5fe37b123
53. Eve broadcasts B500  to the network.
At this point in time, the network would observe two
blocks at height 500, namely B500 with a header hash value of
00006120ab0fbd24a1b61dbdca856c3795314945f405b4e90d9a1d3452b
85127 and B500 ’ with a header hash value of 000035a474b760c0d13ff
431a806553a3364c302117ceff8e08ef5fe37b12353. To other users in the
network, both blocks are considered valid. Bob’s fate would then
depend on which block is accepted by at least 51% of the users; the
block which is accepted by majority users and therefore belongs in
the longer chain will be considered as the final state of the ledger.
The discarded block is commonly called a stale block.
If block B500 ’ is included in the longer chain and block B500 is
discarded (because both share the same parent, B499 , thus only one
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22 Blockchain and Smart Contracts

would remain), Eve’s transaction of 1 btc to Bob would not be part of

the final state of the ledger. Therefore, in Bitcoin, transaction finality
is characterised by a concept called the six-block confirmation. The
idea is that a transaction will become computationally difficult to
reverse when it is buried at least six blocks deep in the blockchain.
The Bitcoin PoW’s difficulty target is set such that a valid block
header hash can only be found in, on average, ten minutes. In the
earlier scenario where Eve attempts to reverse her transaction to Bob,
the one-block confirmation of Eve’s transaction makes it possible
for Eve to create another valid block and possibly get the newly
created block accepted by majority of the users. However, if Bob
sends the activation code to Eve only after B500 is appended with
six additional blocks, it will make it practically impossible for Eve’s
attempt to reverse her transaction (for her to do so, she needs to
create B500 ’, B501 ’, B502 ’, B503 ’, B504 ’, B505 ’, B506 ’ and convince
the network to adopt her chain of blocks). Due to the security
properties of hash function, there is no faster way for Eve to create
the chain of B  blocks other than to run the proof-of-work algorithm
honestly and compute block header hashes iteratively. As long as Eve
does not possess majority hash power of the network, the six-block
confirmation ensures that Eve can never catch up with the rest of
the honest miners in her quest of creating the chain of B  blocks.

1.6 Digital Signature

Digital signature achieves user accountability, data authentication
and integrity protection. In cryptography, a digital signature is a
pseudorandom string that is created via arithmetic computation and
secured based on a computationally hard problem. A high-level (but
inaccurate) illustration of how a digital signature works is shown in
Figure 1.8.
In Figure 1.8, Alice attempts to send Bob a message “hi”. This
message is converted into its decimal equivalent (from ASCII codes 104
for “h” and 105 for “i” to the binary representation 0110100001101001
to the decimal representation 26,729). A digital signature scheme
takes Alice’s private key, that is the decimal number 3, and raises 26,729
to the power of 3. The result of the exponentiation is Alice’s digital
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Cryptography and Blockchain Technology 23

Figure 1.8: A high-level but inaccurate illustration of the working mechanism

of a digital signature.

signature. Subsequently, Alice sends her message and the correspond-

ing signature to Bob. Bob will verify Alice’s signature using her public
key, in this case, it is the number 1/3, by raising the digital signature
to the power of Alice’s public key. If the result of the exponentiation is
equal to Alice’s message, then Bob concludes that the message is
authentic and it indeed comes from Alice.
The above example is a high-level example to illustrate how
digital signature works, where essentially, signing requires the signer’s
message and private key and verifying requires the verifier to per-
form arithmetic comparison using the signer’s public key, message,
and digital signature. Actual implementation of digital signature
addresses the following practical considerations:

1. Our input messages to sign are usually much longer than a

statement such as “hi”.
2. Our public and private keys are long (around 1024 bits, i.e.,
a number that is around 309 digits, or 2048 bits) and their
relationship is not a simple a and 1/a. Instead, the relationship
between private and public keys is such that given a user’s public
key, it is computationally infeasible (due to computationally hard
problem) to find out or compute the user’s private key.
3. Modular arithmetic is used and we leverage many important
characteristics of modular arithmetic. This includes the ability
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24 Blockchain and Smart Contracts

to work only with integers, the provision of groups, rings and

fields, and the assumptions of computationally hard problems
when modular arithmetic is applied.

1.6.1 Modular Arithmetic — A Brief Introduction

Before delving into the more specific RSA digital signature scheme,
we first need to lay out some fundamental concepts in modular
arithmetic.
A prime number is an integer that is only divisible by 1 and
itself. By convention, 1 itself is not considered a prime number. All
integers greater than 1 can be uniquely expressed as the product
of prime numbers. The greatest common divisor is defined as the
largest number that divides two numbers a and b. This is expressed
as gcd(a, b). If a is a prime number, then gcd(a, b) will be either 1
or a. If gcd(a, b) = 1, we say that a and b are relatively prime. For
example,
gcd(3, 9) = 3
gcd(290, 333) = 1
gcd(684, 1748) = 76
Modular arithmetic revolves around a number called a modulus,
denoted as N . Given integers a and N , we define the expression
(a mod N ) (short for “a modulo N ”) as the remainder after a is
divided by N . Thus,we can also write
r = (a mod N )
The integer a can be expressed as a = qN + r, where q is an integer,
r is an integer and 0 ≤ r < N .
For example,
Let N = 17
(6 mod 17) = 6
(17 mod 17) = 0
(425 mod 17) = 15
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Cryptography and Blockchain Technology 25

The concept of modular arithmetic is commonly used in the 12-hour

clock, in which the hour number restarts every time it reaches the
modulus of 12. So, when it is 15 hours past midnight, we compute
(15 mod 12) = 3, giving us the clock time of 3.
Given two integers a and b, we say that “a and b are congruent
modulo N ” if a ≡ b (mod N ). In this expression, the brackets around
“mod N ” imply that the modulus is applied to both a and b instead
of just b. When we say that a ≡ b (mod N ), it also means that
(a mod N ) = (b mod N ).
As an example, 36 ≡ 21 (mod 15) because (36 mod 15) =
(21 mod 15) = 6. When a ≡ b (mod N ), then it is also true that
a = b + kN for any integer k. By taking modulus on both sides,

a mod N = (b + kN) mod N

= b mod N + kN mod N
= b mod N + k(N mod N )
= b mod N + k(0)
= b mod N

With this in mind, a group is a set of elements with a defined binary

operation, denoted as ◦ . In mathematics, a group has the following
defined properties:

• Closure: For any elements a and b ∈ G, the result of a ◦ b is also

in the group, i.e., a ◦ b ∈ G.
• Identity: There exists an “identity” element e ∈ G, where for any
element a ∈ G, a ◦ e = e ◦ a = a.
• Inverse: For each element a ∈ G, there exists an element b ∈ G
such that a ◦ b = b ◦ a = e.
• Associativity: For any elements a, b and c ∈ G, (a◦b)◦c = a◦(b◦c).
• Commutative: For any elements a and b ∈ G, a ◦ b = b ◦ a.

A set of elements with the first four properties is a group. A group

that also fulfils the fifth property is called an Abelian group. The
order of a group, denoted as φ(), is the number of elements in that
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26 Blockchain and Smart Contracts

group. To decide the number of elements in a group requires certain

checks.
We are concerned with multiplicative group denoted as Z∗N , where
the binary operation is multiplication mod N . We can see that Z∗N
fulfils all the properties of a group:

• Closure: For any two elements a and b in Z∗N , (a × b) mod N will

produce an element of Z∗N .
• Identity: Z∗N has an identity element e ∈ Z∗N , such that (a × e)
mod N = a. For the group Z∗N , e = 1.
• Associative: For any three elements a, b and c in Z∗N , (a × b) ×
c mod N = a × (b × c) mod N .
• Commutative: For any two elements a and b in Z∗N , (a×b) mod N =
(b × a) mod N .
• Inverse: To ensure that each element in Z∗N has an inverse that
returns the identity element e = 1, we define the group as Z∗N =
{a ∈ {1, 2, . . . , N − 1}|gcd(a, N ) = 1}.

In other words, for each element in Z∗N to have an inverse, the element
a ∈ Z∗N must satisfy gcd(a, N ) = 1. In fact, it turns out that for a
group Zp∗ , where p is a prime number, the set of group elements is
always {1, 2, . . . , p − 1}.
As an example, suppose N = 12. Recall that any number modulo
N will always result in a number between 0 (inclusive) and N , so we
start with Z12∗ = {0, 1, 2, 3, 4, 5, 6, 7, 8, 9, 10, 11}. Let us check each

possible element in the group for its inverse:

Element a Inverse of a gcd(a,N ) Comment

0 Does not exist Invalid 0 is not in Z∗12
1 Identity element Identity element 1 is in Z∗12
2 Does not exist gcd(2, 12) = 2 2 is not in Z∗12
3 Does not exist gcd(3, 12) = 3 3 is not in Z∗12
4 Does not exist gcd(4, 12) = 4 4 is not in Z∗12
5 5 gcd(5, 12) = 1 5 is in Z∗12
(5 × 5) mod 12 = 1
6 Does not exist gcd(6, 12) = 6 6 is not in Z∗12
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Cryptography and Blockchain Technology 27

Element a Inverse of a gcd(a,N ) Comment

7 7 gcd(7, 12) = 1 7 is in Z∗12
(7 × 7) mod 12 = 1
8 Does not exist gcd(8, 12) = 4 8 is not in Z∗12
9 Does not exist gcd(9, 12) = 3 9 is not in Z∗12
10 Does not exist gcd(10, 12) = 2 10 is not in Z∗12
11 11 gcd(11, 12) = 1 11 is in Z∗12
(11 × 11) mod 12 = 1

∗ = {1, 5, 7, 11} and φ(12) = 4.

Therefore, Z12

As mentioned previously, where N is a prime number p, the set

of group elements for Z∗p is always {1, 2, . . . , p − 1} and the order of
Z∗p is φ(p) = p − 1. This is because for a prime number p, gcd(a, p) is
always 1. Suppose N = 7:

Element a Inverse of a gcd(a ,N ) Comment

0 Does not exist Invalid 0 is not in Z∗7
1 Identity element Identity element 1 is in Z∗7
2 4 gcd(2, 7) = 1 2 is in Z∗7
(2 × 4) mod 7 = 1
3 5 gcd(3, 7) = 1 3 is in Z∗7
(3 × 5) mod 7 = 1
4 2 gcd(4, 7) = 1 4 is in Z∗7
(4 × 2) mod 7 = 1
5 3 gcd(5, 7) = 1 5 is in Z∗7
(5 × 3) mod 7 = 1
6 6 gcd(6, 7) = 1 6 is in Z∗7
(6 × 6) mod 7 = 1

Therefore, Z∗7 = {1, 2, 3, 4, 5, 6} and φ(7) = 6.

Notice that by using modular arithmetic, all numbers that are

inverse of each other exist in integer form instead of fractional
form. This has important implications in public key cryptography.
Furthermore, certain mathematical problems are known to be hard
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28 Blockchain and Smart Contracts

in modular arithmetic, and this lays the basis of security for some
cryptographic schemes.

1.6.2 Scheme
A digital signature scheme comprises three algorithms:

The correctness requirement of a digital signature is as follows:

Given a key pair (sk, pk ) and the signature Sigm ← Signsk (m),
the verification algorithm Verifypk (Sigm , m) will always output 1.
In other words, a digital signature produced using the private key sk
corresponding to the public key pk will always be successfully verified
using the public key pk. Figure 1.9 depicts how a digital signature
algorithm works in Alice’s communication with Bob.

1.6.3 RSA Digital Signature (Textbook)

In more detail:

• Key Generation: On input of a security parameter n, the

KeyGen.RSA(1n ) function outputs a prime p and a prime q of
n bits; computes N = pq; an integer e that satisfies the relation
gcd(e, φ(N )) = 1; and an integer d that satisfies the relation ed =
1 mod φ(N ).

(sk = d, pk = N, e ) ← KeyGen.RSA(1n )
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Cryptography and Blockchain Technology 29

Figure 1.9: A graphical illustration of a digital signature scheme.

• Signing: Sign.RSA() takes as input the integer d (the private

signing key sk ) and a message to be signed m.
Sigm ← md mod N
Here, it is important that the message m is less than the value of
N for the verification to succeed.
• Verification: Verify.RSA() takes as input the tuple Sigm , m and
the integer e (the public verifying key pk ), and produces 1 (“true”)
if and only if
Sigem mod N = m
The correctness requirement of the RSA digital signature scheme is
Sigem mod N = (md )e mod N = m1+kφ(N) mod N
= m1 mkφ(N) mod N = m1 = m
The security of the RSA digital signature is based on the RSA
factorisation problem. By referring to the Key Generation algorithm,
the RSA factorisation problem states that given a very large number
N = pq, where p and q are both large prime numbers, there is no
known efficient method to find out its two prime factors p and q.
The reason that this RSA digital signature scheme in this section
is called a “textbook” scheme is because it is insecure for several
reasons. Initially, in one form of attack known as a no-message attack,
an attacker can arbitrarily choose a public key e of a legitimate user,
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30 Blockchain and Smart Contracts

generate a pseudorandom value as the signature Sig, compute m =

Sige mod N and produce the tuple Sig, m as a supposedly valid
signature of the user on the message m. By definition of how the
verification algorithm works, this tuple will also be verifiable using
public key e of the victim. In this case, the attacker does not need to
know the private key, and the message could just as well be gibberish.
One solution to the vulnerability is to hash the message before
signing it. The signature would therefore be generated on the hash
value rather than directly on the message. In this case, the security
of the solution now relies on the security of the underlying hash
function:

Sigm = Hash(m)d mod N

Furthermore, due to property of the hash function, signing on hash

value of a message is as good as signing on the message itself, as
any changes to the message will result in a completely different
hash value. Also, hash value is a compact representation of the
message, thus allowing more efficient signature generation compared
to operating directly on a potentially large message. Yet, we notice
that signing in the above manner produces a deterministic signature.
Actual implementation of the RSA digital signature is the RSA
Probabilistic Signature Scheme (PSS), which introduces a certain
amount of pseudorandomness to the message before signing it, so
that a different signature will be generated each time. A simplified
breakdown of signing and verification steps under the RSA-PSS is as
follows (Stallings, 2017):

Signing in RSA-PSS
S1. Given a message M , the signer performs a message encoding
process that takes as input M , padding1 , padding2 and salt:
a. Let M  = padding1 |Hash(M )|salt
b. Let H = Hash(M  )
c. Let DB = padding2 |salt
d. Using the mask generation function, transform H so that
|H| = |DB|
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Cryptography and Blockchain Technology 31

e. Let maskedDB = DB ⊕ HMGF , where HMGF is the

transformed H
f. Let EM = maskedDB|H|bc
S2. Using the private key d, compute a signature SigEM = EMd
mod N
Verification in RSA-PSS
V1. Given the possibly tampered message M ∧ , EM∧ and Sig∧ EM ,
∧ ∧e
the receiver verifies that EM = SigEM mod N . If yes, the
receiver proceeds to the next step. If not, the receiver aborts.
V2. The receiver performs a message-decoding process that
takes as input M ∧ , EM∧ , padding1 and padding2 :
a. Parse the string EM∧ and let maskedDB∧ |H ∧ |bc∧ , keep-
ing H ∧ for verification
b. Let DB∧ = maskedDB∧ ⊕ HMGF ∧

c. Parse the string DB and let DB∧ = padding2 |salt∧

∧

d. Let M ∧ ’ = padding1 |Hash(M ∧ )|salt∧

e. Let H ∧ ’ = Hash(M ∧ ’)
V3. If H ∧ ’ = H ∧ , accept the message as authentic.

RSA-PSS works on the principle that since the message EM∧ is

signed, if it has been tampered with, Sig∧EM would be invalidated and
step V1 would not succeed. In addition, the parsing at step V2(a)
would result in an incorrect H ∧ , and at steps V2(d) would result in
an incorrect salt∧ . Therefore, verification would fail.
In Python, this can be implemented using the RSA library in
Cryptodome. To generate public and private keys, we import the
RSA library as shown in Figure 1.10.

Figure 1.10: Python code for RSA keys generation.

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32 Blockchain and Smart Contracts

Figure 1.11: Example of RSA private key.

Figure 1.12: Example RSA public key.

The resulting private and public keys are shown in Figures 1.11
and 1.12, respectively.
Figure 1.13 shows how we can sign using the RSA digital signature
scheme in Python. Here, the message is sent as input to the signing
algorithm in bytecode and the user’s private (signing) key is assumed
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Cryptography and Blockchain Technology 33

Figure 1.13: Python code for RSA digital signature signing algorithm.

Figure 1.14: The resulting RSA digital signature in bytecode (upper part) and
UTF-8 encoding (lower part).

to be stored in a file named as “user privatekey.pem”. The resulted

signature (shown in bytecodes) is shown in Figure 1.14. If we
convert the bytecodes into UTF-8 representative, we will see that
the signature is essentially a pseudorandom string.
Recall that the verification of a digital signature requires the use
of the signer’s public key, message and the corresponding digital
signature. A successful verification indicates that the signer has
indeed created the message because no one else has access to
the private key to create the digital signature for that message.
Figure 1.15 shows the code that performs an RSA digital signature
verification. In this piece of code, we assume that user’s message
and signature are stored in separate txt files, and the user’s public
key is stored in a PEM file. Upon successful verification, a message
“The signature and the message are valid” will be displayed. In the
event that the message or signature has been modified, or if we used a
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34 Blockchain and Smart Contracts

Figure 1.15: Python code for RSA signature verification.

different public key from the actual signer’s, the signature verification
will fail.

1.6.4 Elliptic Curve Cryptography

Elliptic Curve Digital Signature Algorithm (ECDSA) is adopted in
Bitcoin and widely used in the blockchain system. It is the elliptic
curve analogue of the Digital Signature Algorithm (DSA), based on
the form of cryptography that is called the Elliptic Curve Cryp-
tography (ECC). ECDSA can be considered as an alternative, with
enhanced security, of the first-generation public key cryptography
methods such as RSA.
ECC uses third-degree and second-degree equation (resulting in
an elliptic curve, and thus the name). The general form is y 2 =
x3 + ax + b. In ECC, the private key is a random integer d selected
from {1, 2, . . . , n − 1} where n is the order of the subgroup, and the
public key is the point H = dG where G is the base point of the
subgroup (Corbellini, 2015).
Bitcoin uses Secp256k1 for parameters of the elliptic curves in its
public key cryptography. It is a recommended 256-bit elliptic curve
domain parameter over Fp associated with a Koblitz curve. Accord-
ing to the Standards for Efficient Cryptography Group (SEC)2 , the

2
http://www.secg.org/sec2-v2.pdf.
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Cryptography and Blockchain Technology 35

parameters are specified by the sextuple T =(p, a, b, G, n, h) and

the finite field Fp is defined as follows:
1. The prime modulo p = 2256 − 232 − 29 − 28 − 27 − 26 − 24 − 1
= FFFFFFFF FFFFFFFF FFFFFFFF FFFFFFFF FFFFFFFF
FFFFFFFF FFFFFFFE FFFFFC2F
The below is in hexadecimal form and basically it is an extremely
large number.
2. The elliptic curve E: y 2 = x3 + ax + b where a = 0 and b = 7.
3. The base point G in compressed form is
G = 02 79BE667E F9DCBBAC 55A06295 CE870B07 029BFCDB
2DCE28D9 59F2815B 16F81798,
and in uncompressed form is:
G = 04 79BE667E F9DCBBAC 55A06295 CE870B07 029BFCDB
2DCE28D9 59F2815B 16F81798 483ADA77 26A3C465
5DA4FBFC 0E1108A8 FD17B448 A6855419 9C47D08F
FB10D4B8.
Both are in hexadecimal forms.
4. The order n of G in hexadecimal form is the following number
and cofactor h is 1.
n = FFFFFFFF FFFFFFFF FFFFFFFF FFFFFFFE
BAAEDCE6 AF48A03B BFD25E8C D0364141
Public Key and Private Key
Therefore, for Bitcoin, the private key is a random number between
1 and the order n specified above. The public key is then calculated
through point multiplication based on the random number or the
private key as
public key P = random number k ∗ base point G
The equation will generate a new point on the elliptic curve, or
the public key, using the base point G. This process can be done in
Python with the ecdsa module as follows.
We first import the packages or modules necessary for our
calculations. The os module provides a series of actions that relates
to the operating system functionality. We use os.urandom() function
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36 Blockchain and Smart Contracts

to generate a string of bytes with random size, which is commonly

used in cryptography. The number in the parenthesis refers to the size
parameter — os.urandom(32) will generate a random 32-digit bytes
string. The ecdsa module is for us to conveniently use the ECDSA
algorithm in Python without the need to write all the equations
ourselves. The module will yield results using ECDSA. The binascii
module is used to convert binary and various ASCII-encoded binary
representations — hexadecimal, in our case. So, we use it to convert
binary numbers to hexadecimal representation or from hexadecimal
to binary for the purpose of function input.

Once we generate a random number to use as private key

in Python, we can use the SigningKey utility ecdsa.SigningKey
under ECDSA to get the SigningKey sk and then get our public
key from it. The from string before private key is needed as the
output of os.urandom() function is in string type. We specify the
secp256k1 parameters by including the curve=ecdsa.SECP256K1
command in the function. The public key is then derived from
the verifying-key.to string() function from the signing key sk.
The prefix 04 is added to represent uncompressed public keys,
while a prefix of 02 or 03 is used for compressed public keys.
The results are shown below. private key is a string so we
change it to hexadecimal representation using the binascii.hexlify()
function.
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Cryptography and Blockchain Technology 37

Do note that in cryptography the generation of a public key based

on a private key is one way only, meaning it is very easy to calculate
the public key of a given private key, but extremely difficult the other
way around — it is computationally infeasible to generate the private
key of a given public key. This feature forms the basis for security in
the digital signature or proof of ownership in Bitcoin, so owners of
the private key (secret) can easily generate the public key and share
it (public key) to the entire network for others to verify his or her
ownership of the secret without worrying about the leak of private
key (secret) information.

Sign and Signature

A signature will be generated after a signing operation takes place
and it is a mathematical process involving the message (what to be
signed) and the private key. Since it is a number, the signature is also
referred to as digital signature, as opposed to the actual handwritten
signature. ECDSA is a variant of the DSA that applied to elliptic
curves.
A digital signature allows others, such as the recipient of a
message, to verify the authenticity of the message (and other
information such as whether the message has been tampered with or
proof of ownership in Bitcoin’s transactions) using the sender’s public
key. Once we have the private key and public key, the signature can
be generated as follows:

1. To calculate the number r = xP mod n where xP is the x

coordinate of public key P .
2. If r = 0, a new random number k needs to be generated and r
needs to be calculated again (because r must be different from 0
to be valid).
3. Then, s is computed using scalar operations with message digest
m, the private key K and the random number k as inputs:
s = k−1 ∗(m + K ∗r) mod n where k−1 is the multiplicative inverse
of k mod n.
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38 Blockchain and Smart Contracts

4. If s = 0, a new random number k needs to be generated and both

s and r need to be calculated again (because s must be different
from 0 to be valid).

It facilitates a secure bitcoin transaction in the following way: the

sender can sign the hashed message m using the private key K and
a random number k. The receiver can verify that the message has
been correctly signed using the corresponding public key P without
the need of knowing the sender’s private key.
In Python, this signing procedure can be achieved by the following
lines. For a given private key (we use the output from the previous
Python section), we convert the string type to hexadecimal format.
Then, similar to the private and public keys section, we generate the
sk variable first using our private key and sign the message using
the sign function embedded in the Python ecdsa module. Again,
binascii.hexlify is applied to present the output in hexadecimal
format.

The signature and original message are shown below. The

hexadecimal string is the digital signature after signing the message
“hello” with the private key.

Verification
The counterpart of signature generation or computation is signature
verification. The receiver can easily verify the authenticity of the
message using the sender’s public key. Necessary inputs are the hash
value of the message, m, the public key P (corresponding to the
December 24, 2020 14:17 Blockchain and Smart Contracts: Design Thinking. . . 9in x 6in b4043-ch01 page 39

Cryptography and Blockchain Technology 39

private key that is used to sign the message) and the signature s.
The verification process consists of the following steps3 :
1. To calculate the integer w = s−1 mod n.
2. To calculate the integer u1 = (m ∗ w) mod n.
3. To calculate the integer u2 = (r ∗ w) mod n.
4. To calculate point H = (u1 ∗ G + u2 ∗ P )mod n.
If the x-coordinate of point H equals r, the verification is successful
and the signature is in fact signed or computed using the private key,
meaning the message is authentic or valid. In a bitcoin transaction,
this means the sender is indeed the owner of the bitcoin amount.
The mathematic logic behind the verification ensures its validity
in the following way (Corbellini, 2015):
1. To replace the public key P with private key k from the previous
equation,

H = u1 G + u2 P = u1 G + u2 kG = (u1 + u2 k)G mod n

2. According to the definitions of u1 and u2 , we can further rewrite

the equation to

H = (u1 + u2 k)G = (s−1 m + s−1 rk)G = s−1 (m + rk)G mod n

3. Since we define s as s = k −1 (m + kr) mod n, to multiply each

side by k and divide by s, we have k = s−1 (m + kr) mod n, and
substitute s in the equation above will yield

H = s−1 (m + rk)G mod n = kG

The “mod n” is omitted for brevity, since the cyclic subgroup

generated by G has order n, thus making “mod n” unnecessary.
Therefore, it proves that this is the public key paired with or
generated from the private key (or random number k).
The verification process in Python is shown as follows. We use the
public key and signature generated in the previous section. Since they

3
https://www.maximintegrated.com/en/design/technical-documents/tutorials/
5/5767.html.
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40 Blockchain and Smart Contracts

are in hexadecimal string format, we need to apply bytes.fromhex()

function convert to bytes before using them as inputs in the ecdsa
module.

The results will be true.

If we make changes to the public key or signature, even the slight-

est, the resulting outcome will not be successful and the Python mod-
ule will raise an Error message — “ecdsa.keys.BadSignatureError:
Signature verification failed” — to indicate the failure of signature
verification.

1.6.5 ECDSA vs. RSA

As we mentioned earlier, ECDSA serves as a next-generation public
key algorithm compared to the earlier one such as the RSA. The
main reason is that ECC is more secure than the RSA, that is
to say, the probability of the ECC algorithm being solved or the
risks of ECC being broken are much lower than that of the RSA.
The security of any public key algorithm relies on the size and
algorithm, so that having a public key, one cannot find the private
key; otherwise, it is not safe. The reverse direction is not impossible,
just computationally infeasible, because the possibility is very slim
given the extremely large number. Breaking an RSA key requires one
to factor a large number, but breaking an ECDSA key requires one
to solve the Elliptic Curve Discrete Logarithm Problem (ECDLP)
and the mathematical community has not made any major progress
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Cryptography and Blockchain Technology 41

in improving algorithms to solve this problem (Sullivan, 2014).

Therefore, using ECDSA will provide the same level of security as
RSA but with smaller keys (160-bit key length in ECC compared
with 1024-bit key length in RSA), which has the benefits of faster
signature generation, less data for the network and less comput-
ing power needed. More comparison is summarised in the table
below.

Aspect ECC RSA

Time ECC takes full RSA takes sub-exponential

exponential time time
Security and Same level of security Same level of security with
key size with smaller key sizes larger key sizes
Data size Smaller Larger
Encrypted Function of key size Function of key size and data
message and data size; size; encrypted message is
encrypted message is larger in RSA
smaller in ECC
Computational Smaller Larger
power

Source: Khalique et al. (2010).

1.7 Pay to Public Key Hash (P2PKH)

To illustrate how hash and digital signature are used in Bitcoin, we
look at the process of a method called Pay to Public Key Hash, or
P2PKH. Figure 1.16 shows the Bitcoin transaction fields and their
corresponding descriptions. Each transaction may contain more than
one input (e.g., 1 btc and 2 btc as inputs to make up for a 3-btc
spend) or more than one output (e.g., 1 btc as input and 0.4 btc,
0.6 btc to more than one recipients), or multiple inputs and multiple
outputs. Each transaction will also have a unique transaction hash
value based on its content; the hash value is recorded in the block
Merkle Hash Tree as detailed in Section 1.5.1.
We will use a fiat transaction example to illustrate how the
equivalent bitcoin transaction looks. Suppose there are four users,
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42 Blockchain and Smart Contracts

The equivalent bitcoin transactions’ flow can be modelled as

follows. In Round 1 (R1), the transaction of 5btc from Alice to
Bob will be formatted as shown in Figure 1.17 (we omit other
fields and the provision of transaction fees for simplicity). Sup-
pose this (Alice-to-Bob) transaction has a unique hash value of
7b844fe6a2ce9b1c7ea2f02bfb802a095ad3352a092ac83aef0562ee5952
b1d7.

Figure 1.16: Structure of a Bitcoin transaction.

Figure 1.17: Structure of the Alice-to-Bob transaction.

Alice, Bob, Charlie and Eve, and the flow of their fiat transactions
with each other is shown below.

Alice Bob Charlie Eve

Starting balance $5 - $1 $1
End-of-R1 balance - $5 $1 $1
End-of-R2 balance - - $5 + $1 $1
End-of-R3 balance $5 + $1 - - $1
End-of-R4 balance $1 - - $5 + $1
End-of-R5 balance $1 + $1 - - $5
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Cryptography and Blockchain Technology 43

Figure 1.18: Structure of the Bob-to-Charlie transaction.

Figure 1.19: Structure of the Charlie-to-Alice transaction.

In R2, as Bob sends the 5 btc he has received from Alice to

Charlie, he would formulate his transaction as shown in Figure 1.18.
As Bob intends to spend the 5 btc he has gotten from Alice, he must
specify that the input to this (Bob-to-Charlie) transaction comes
from a previous (i.e., Alice-to-Bob) transaction with the hash value
7b844fe6a2ce9b1c7ea2f02bfb802a095ad3352a092ac83aef0562ee5952
b1d7.
In R3, Charlie’s transaction to Alice contains two inputs (5 btc
and 1 btc), of which the 5-btc input comes from the previous Bob-
to-Charlie transaction. Thus, Charlie’s transaction is formulated as
shown in Figure 1.19.
In R4, Alice intends to pay Eve 4 btc. However, in contrast to
fiat currency transactions, Alice has in her wallet 6 btc instead of
5 btc +1 btc due to aggregation. Thus, in her transaction, Alice has
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44 Blockchain and Smart Contracts

Figure 1.20: Structure of the Alice-to-Eve transaction.

to specify that she intends to pay Eve 4 btc, and pay herself 2 btc;
this is the concept of “change” in bitcoin (see Figure 1.20).
Notice a few things in the example above. First, a bitcoin
transaction can contain one or more inputs and one or more outputs.
Second, once a previous transaction (e.g., Alice-to-Bob) has been
recorded on the blockchain, it effectively transfers the ownership of
the 5 btc from Alice to Bob. Third, when Bob intends to spend the 5
btc he has gotten from Alice, he must specify the source of the 5 btc
in the “prev out” field and provide his proof of ownership of the 5 btc
by stating his public key and digital signature on this transaction.
In order for miners to validate whether Bob has ownership of the 5
btc, they will do the following checks:
1. Extract Bob’s public key from the “scriptSig” field in the Bob-to-
Charlie transaction.
2. Calculate the hash of Bob’s public key obtained in Step 1.
3. Find the transaction specified in the “prev out” field in the Bob-
to-Charlie transaction, i.e., the Alice-to-Bob transaction.
4. Verify that the hash calculated in Step 2 is equal to the recipient’s
public key hash specified in the “scriptPubKey” field of the Alice-
to-Bob transaction.
5. If they are equal, use the public key obtained in Step 1 to verify
Bob’s digital signature in the “scriptSig” field for the Bob-to-
Charlie transaction.
6. If verification succeeds, conclude that Bob has ownership of the
5 btc and thus can spend the 5 btc.
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Cryptography and Blockchain Technology 45

7. Add the Bob-to-Charlie transaction to a block, and run the PoW

algorithm.

The fourth point to note in this process is that Bob’s public key
is not disclosed until he creates the Bob-to-Charlie transaction and
announces his intention to spend the 5 btc in his wallet. The usage of
public key hash to specify the receiver utilises properties of the hash
function — an attacker could not pretend to be Bob because the
public key hash reveals nothing about the pre-image. Consequently,
only Bob can provide the correct public key that hashes to the public
key hash specified by Alice.
Finally, once the miners verified that the hash of Bob’s public key
is equal to the public key hash specified by Alice, the miners will use
Bob’s public key to verify his digital signature on the Bob-to-Charlie
transaction. When the verification succeeds, miners conclude that
Bob has ownership of the 5 btc in the wallet.
To this end, note the relationship between a user’s private key,
public key and wallet address. For security purposes, private keys
are truly random strings. From the private key, a user’s public key is
calculated using a one-way (irreversible) and predetermined manner.
The public key is then hashed and encoded to form the user’s bitcoin
wallet address. As such, the conclusion that “Bob has ownership
of the wallet containing the 5 btc if his digital signature on the
transaction can be verified using his public key” is based on the
fact that Bob can only provide the (correct) public key if and only if
he has the private key to create the digital signature. Consequently,
only Bob can give Alice the (correct) public key hash. The act of
specifying the receiver’s public key hash in a bitcoin transaction is a
mechanism called “Pay to Public Key Hash (P2PKH)”.

1.8 Public Key Infrastructure

In a digital signature, the signature and message are verified using the
sender’s (i.e., signer) public key to prove that the message originates
from the signer. As the name indicates, a public key is widely
disseminated. However, the public key is a pseudorandom number
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46 Blockchain and Smart Contracts

Figure 1.21: Components of a public key infrastructure.

that by itself does not contain any identifiable information about its
owner.
This leaves a potential security loophole — how can a verifier
be sure that the public key belongs to the right signer? Without
a method of verification, an attacker could exploit this loophole
by intercepting the public key and replacing it with his own,
thereby compromising the objective of data authentication and
accountability in the digital signature. Therefore, there is a need
for us to ensure that a public key belongs to a specific user. Public
key infrastructure (PKI) solves this problem by providing a method
for associating a public key with a specific user in a secure manner.
As shown in Figure 1.21, the PKI framework comprises certificates,
certification authorities and certificate revocation.
A certificate is a digital document that serves as proof that
a particular public key belongs to a specific user (the subject).
A certificate contains the following information: version number,
serial number, type of digital signature scheme used, issuer’s name,
validity period, subject’s name, subject’s public key and issuer’s
signature. Aside from users, certificates can also state a website’s
information. A screenshot of Facebook’s certificate is shown in
Figure 1.22.
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Cryptography and Blockchain Technology 47

Figure 1.22: Example of certification path for facebook.com.

To obtain a digital certificate, we must approach a third-party

certification authority (CA, also known as the issuer). Certification
takes the form of the CA’s digital signature appended at the end of
the certificate. CAs are usually organised according to geographical
distribution. For example, Netrust is a CA that covers the Southeast
Asia region, and is the only accredited CA in Singapore. We know
which CAs to trust as one CA can vouch for another. This takes
the form of a hierarchical relationship, with a root CA at the top
vouching for intermediate CAs that issue certificates to end users (see
Figure 1.23). A list of such root CAs is hard-coded into our browsers.
Whenever we install a browser and visit a website, our browsers trace
the website’s certification path back to the root CA. Examples of root
CAs include Comodo, Symantec, GoDaddy, GlobalSign, DigiCert
and Verizon.
Certificates are revoked when they expire, if the user’s credentials
change or if the user’s private key is lost or compromised. To avoid
inadvertently sending confidential messages to a compromised user,
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48 Blockchain and Smart Contracts

Figure 1.23: The certification path for facebook.com.

we maintain repositories of revoked certificates to perform checks

on the status of a certificate. One way to do this is for root CAs
to maintain a certificate revocation list (CRL) that users can check
against. However, over time, the CRL may grow to such a magnitude
that it becomes either difficult to maintain or inefficient to perform
a search. Alternatively, the online certificate status protocol (OCSP)
uses IP to obtain the status of a certificate. This is a much more
efficient method that is supported in most browsers used today.
The PKI is a setting in which we can ensure user authentication
and build trusted, secure communication networks. Its usage can be
found in our daily applications as well as private blockchain settings
such as in Project Ubin.4 In public blockchain, however, a public key
is not associated with an identity in the conventional sense. Here,
we should note that public blockchain is typically pseudonymous,
meaning that it provides some, but not full, anonymity. In the Bitcoin
blockchain, all transactions are linked to public key hashes, which
on their own do not provide any identifying information pertaining
to the wallet’s owner. That said, it can be possible to prove a
user’s ownership of a wallet given certain information, such as her
possession of a private key corresponding to the public wallet address.

4
https://www.mas.gov.sg/schemes-and-initiatives/project-ubin.
December 24, 2020 14:17 Blockchain and Smart Contracts: Design Thinking. . . 9in x 6in b4043-ch01 page 49

Cryptography and Blockchain Technology 49

In the Bitcoin blockchain, the usage of public and private keys

to ensure bitcoin ownership in a decentralised manner is executed
through methods such as Pay-to-Public-Key-Hash (P2PKH), which
relies on the security of hash function and digital signature, as
detailed in Sections 1.5 and 1.6, respectively. Double spending is
prevented with a global view of the transaction hashes on the
distributed ledger.

1.9 Encryption
Encryption was an early component of classical cryptography and
continues to be an important part of modern cryptography, where it
is the means of achieving confidentiality. In this section, we will first
look at the concepts of perfect secrecy and computational secrecy,
and then discuss the distinctions between symmetric and asymmetric
encryption schemes.

1.9.1 Perfect Secrecy

A perfectly secret encryption scheme is one with a ciphertext that
does not leak any information about the secret key or the plaintext.
It therefore cannot be broken by any attacker, even with unlimited
computing power. The one-time pad (or Vernam cipher) is the most
prominent example of such a scheme. The Vernam cipher uses an
Exclusive-OR logical operation, denoted as ⊕, that only produces an
output of “true” (i.e., Boolean value of 1) when the inputs differ.
It is a bijective function, meaning that each bit in the plaintext has
exactly one corresponding bit in the ciphertext, and vice versa. There
are no unpaired bits. Given a plaintext m and a secret key k of equal
length, the truth table of the cipher is as follows:

Input Output
m k c
0 0 0
0 1 1
1 0 1
1 1 0
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50 Blockchain and Smart Contracts

To encrypt the plaintext m to a ciphertext c, we compute this as

c=m⊕k

Let the plaintext m = 1010111010, and the key k = 1100101100.

A sender will use k to compute ciphertext c as

m 1 0 1 0 1 1 1 0 1 0
k 1 1 0 0 1 0 1 1 0 0
c 0 1 1 0 0 1 0 1 1 0

To decrypt c, we compute this as

m =c⊕k

The receiver will use the same key k to compute the plaintext
m as

c 0 1 1 0 0 1 0 1 1 0
k 1 1 0 0 1 0 1 1 0 0
m 1 0 1 0 1 1 1 0 1 0

The Vernam cipher is a relatively simple scheme in that it is

based solely on the Exclusive-OR operation. However, it can provide
perfect secrecy because without knowledge of the key, which is
chosen uniformly at random, there are countless possibilities for the
plaintext. Specifically, if c has the length of l bits, then there are 2l
possible plaintexts, and each plaintext is equally probable.
As an example, suppose the secret key is given by k = A1 B1
C1 D1 E1 F1 AA BB CC DD EE FF 10 34. An illustration on
encryption of the message “I have 100 btc” using k, and decryption
of the resulting ciphertext using the same k, is shown in Figure 1.24.
Suppose an attacker is observing the network and intercepted
the ciphertext c. In the attempt to decrypt, the attacker will try
all possible keys to see if the decrypted text resulted in a coherent
content (this is known as a brute-force attack). In this process,
suppose the secret key tried by the attacker is k  = AC F0 C7 90
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Cryptography and Blockchain Technology 51

Figure 1.24: Vernam cipher decryption using the same secret key k used for
encryption.

Figure 1.25: Vernam cipher decryption using a different secret key k .

FF F5 F9 AA CE DD EE F8 10 3F, the resulting plaintext becomes

“Dan has 20 eth” (see Figure 1.25). In another instance, if k  = A9
E5 DD D1 F4 FF AA EB 88 CD AA FC 13 39, the resulting plaintext
is “Attack at dawn” (see Figure 1.26).
The Vernam cipher is perfectly secret without knowledge of
the secret key because the ciphertext leaks no information about
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52 Blockchain and Smart Contracts

Figure 1.26: Vernam cipher decryption using a different secret key k”.

the plaintext given the countless number of possible plaintexts. If

the Vernam cipher is so secure, why do we not use it all the time?
There are two major drawbacks to the Vernam cipher. First, each key
can be used to encrypt only one plaintext. Suppose the same key is
used to encrypt plaintext m1 producing ciphertext c1 , and plaintext
m2 producing ciphertext c2 . If an attacker has both ciphertexts, they
can compute the following:
c1 ⊕ c2
= m1 ⊕ k ⊕ m2 ⊕ k
= m1 ⊕ m2 ⊕ k ⊕ k
= m1 ⊕ m2 since k ⊕ k results in 0
This will leak information about the plaintexts.
Second, each key in a Vernam cipher must be truly random and
equal in length to the plaintext. Otherwise, it is vulnerable to a fre-
quency analysis attack and will leak information about the plaintext
as well. Certain alphabet or combinations of alphabet are known
to recur frequently in human communications. For example, in the
English language, “e” is the alphabet that appears most frequently
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Cryptography and Blockchain Technology 53

and “th” is the most common combination of two alphabets. If a key

is shorter than the plaintext, it will need to be repeated across the
length of the plaintext to encrypt the whole string. If the key happens
to coincide with the most common alphabet or words multiple times,
the attacker can then deduce information about the plaintext.
The requirements of no repeated keys and a unique and truly
random key that is equal to the length of each plaintext to be
encrypted make the Vernam cipher an inefficient scheme with a
high cost of construction. In any case, for most practical pur-
poses, it is not necessary to construct a perfectly secret encryp-
tion scheme as a computationally secure scheme will suffice. In
the rest of this section, we will look at computationally secure
encryption.

1.9.2 Symmetric Encryption

Modern encryption schemes belong to one of two categories: sym-
metric or asymmetric. A symmetric encryption scheme (Figure 1.27)
performs both encryption and decryption with the same secret key.
It is structured around three algorithms:

• Key Generation: The key generation algorithm has a function

KeyGen.SE() that takes as input a security parameter n and
produces a secret key k of n bits.

k ← KeyGen.SE(1n )

Figure 1.27: A graphical illustration of a symmetric encryption scheme.

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54 Blockchain and Smart Contracts

• Encryption: The encryption algorithm has a function Enc.SE()

that takes as input a secret key k and a plaintext m, and produces
a ciphertext c.
c ← Enc.SEk (m)
• Decryption: The decryption algorithm has a function Dec.SE()
that takes as input a secret key k and a ciphertext c, and produces
a plaintext m.
m = Dec.SEk (c)
The correctness requirement of a symmetric encryption scheme is
m = Dec.SEk (Enc.SEk (m))
In other words, for any m and k, Dec.SEk (c) = m if and only if
c ← Enc.SEk (m).
The Vernam cipher is a form of symmetric encryption as encryp-
tion and decryption use the same secret key. The most well-known
ones in use now are the Data Encryption Standard (DES) and
Advanced Encryption Standard (AES). DES and AES are block
ciphers, meaning that to encrypt a plaintext, both will partition the
plaintext into blocks of equal length and encrypt one block at a time
with the same key. The DES block cipher partitions data into blocks
of 64 bits, while the AES block cipher partitions into blocks of 128
bits. DES was published in 1975 and standardised by NIST in 1977,
while AES was published in 1998 and standardised in 2001. AES is
still widely used today, and underlies most applications that require
the provision of data confidentiality.
Earlier, we said that the key of the Vernam cipher is chosen
uniformly at random. We can regard the Vernam cipher as a truly
random permutation, whereas DES and AES are pseudorandom
permutations. In a simplified expression, whereas the Vernam cipher
encryption is given as
c=m⊕k
DES and AES encryption are given as
c = m ⊕ fk (x)
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Cryptography and Blockchain Technology 55

where fk () is a pseudorandom function producing an output with

a pseudorandom distribution. We will now look more closely at the
design principles underlying DES and AES.

1.9.3 DES and the Feistel Network

DES is one of many block ciphers based on a structure called the
Feistel network. The Feistel network is a multi-round cipher that
divides a plaintext m into blocks of 64 bits each, and further divides
each block into a 32-bit left half L0 and a 32-bit right half R0 :

m = L0 |R0

In each round of encryption, the DES round function swaps the right
and left sides, and applies a function fi (), also called a mangler
function, to one side. The mangler function uses a 48-bit subkey, also
called a round key, generated from a 56-bit master secret key. The
mangler function carries out four operations: expansion of the 32-bit
half-block to 48 bits; Exclusive-OR operation with the round key;
substitution using substitution boxes (S-boxes); and permutation.
Mathematically, we write this as

Li = Ri−1
Ri = Li−1 ⊕ fi (Ri−1 )

This process is repeated for the stipulated number of rounds

(16 rounds for DES). The ciphertext is the combination of both half-
blocks in the final round of encryption.
To decrypt the ciphertext, we use the same structure but apply
the round function in reverse. The plaintext is the combination of
both half-blocks in the final round of decryption. We invert the
algorithm by computing the following:

Ri−1 = Li
Li−1 = Ri ⊕ fi (Ri−1 )

This method of decrypting the left half-block works because of the

nature of the Exclusive-OR operation, which has the property that
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56 Blockchain and Smart Contracts

A ⊕ A = 0, since the inputs are identical. Similar to the decryption

of a Vernam cipher, we can see that

Given A = B ⊕ C
A⊕C = B⊕C ⊕C = B⊕0 = B
B =A⊕C

We can therefore effectively “cancel out” the round function from

the left half of the ciphertext:

Given Ri = Li−1 ⊕ fi (Ri−1 )

Ri ⊕ fi (Ri−1 ) = Li−1 ⊕ fi (Ri−1 ) ⊕ fi (Ri−1 ) = Li−1 ⊕ 0 = Li−1
Li−1 = Ri ⊕ fi (Ri−1 )

The table below illustrates how we compute a four-round encryp-

tion and decryption, with arrows indicating the order of computation:

Encryption Decryption
Input: m = L0 | R0 Input: c = L4 | R4
Output: c = L4 | R4 Output: m = L0 | R0
L0 R0 L0 = R1 ⊕f1(R0) R0 = L1
L1 = R0 R1 = L0 ⊕f1(R0) L1 = R2 ⊕f2(R1) R1 = L2
L2 = R1 R2 = L1 ⊕f2(R1) L2 = R3 ⊕f3(R2) R2 = L3
L3 = R2 R3 = L2 ⊕f3(R2) L3 = R4 ⊕f4(R3) R3 = L4
L4 = R3 R4 = L3 ⊕f4(R3) L4 R4

A notable feature of the Feistel network is that the entire

operation is invertible even though the mangler function fi () itself is
not invertible. The Feistel network therefore allows us to construct
an invertible algorithm from non-invertible functions. This is an
important security feature, as requiring a function to be invert-
ible necessarily introduces more structure, but more unstructured
behaviour will allow a cipher to appear more random, and hence be
more secure.
In DES, the mangler function fk i () is designed to have an
additional input of a subkey k i. DES requires a subkey because
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Cryptography and Blockchain Technology 57

the scheme’s 56-bit secret key is insufficient for the 16 rounds in

its Feistel network. In 1999, DES famously fell victim to a brute-
force attack that found the secret key in 22 hours and 15 minutes,
using a machine that cost US$250,000 to build. After this attack,
the use of DES with three subkeys, called triple-DES (3DES),
was proposed. In 3DES, three different subkeys, k 1, k 2 and k 3,
are generated from the 56-bit master secret key. The plaintext
is encrypted with k 1, decrypted with k 2 and then encrypted
with k 3. As long as the master key k is kept secret, then the
output of fk i () should be indistinguishable from a truly random
permutation. 3DES is still widely used today, but AES is now
considered a better choice for symmetric encryption using a single
secret key.

1.9.4 AES and the Substitution–Permutation Network

The current design of AES was selected by the NIST in 2000 after a
call for submissions in 1997. Also known as the Rijndael cipher, AES
is a block cipher based on a substitution–permutation network. As
we saw earlier, the Feistel network in DES also runs on substitution
and permutation operations applied to two halves of the plaintext.
The difference between a substitution–permutation network and a
Feistel network is that the former has to be invertible, while the
latter does not.
In AES, the plaintext is split into 128-bit blocks. The cipher
uses a secret key, the length of which affects the key schedule to
generate subkeys as well as the number of rounds — 10 rounds for
a 128-bit key, 12 rounds for a 192-bit key and 14 rounds for a 256-
bit key. The design of AES is very complex, as its round function
needs to be invertible. For our purposes, it suffices for us to have a
general idea of its operation. Similar to DES, the master secret key
first goes through a key expansion to produce a round key for each
round. Each round of AES comprises the following: Exclusive-OR
with the round key; substitution using S-boxes; permutation; and
further substitution using a matrix.
AES is the structure underlying the encryption schemes of many
applications we use today, such as file encryption on our hard disks
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58 Blockchain and Smart Contracts

(as well as ransomware attacks) and Secure Sockets Layer (SSL) pro-
tocol for secure communication. As forms of symmetric encryption,
DES and AES can be used to encrypt large plaintexts efficiently and
possess shorter key lengths than asymmetric encryption. However,
the main drawback of symmetric encryption is that the sender and
receiver will need to share the secret key prior to any encryption.
To communicate with n number of peers, a user will also need n
number of secret keys. These inefficiencies can be addressed through
asymmetric encryption.

1.9.5 Asymmetric Encryption

An asymmetric encryption scheme (Figure 1.28) is also structured
around three algorithms, but uses a public key for encryption and a
private key for decryption:
• Key Generation: The key generation algorithm has a function
KeyGen.AE() that takes as input a security parameter n and
produces a private key sk and a public key pk.
(sk, pk) ← KeyGen.AE(1n )

Figure 1.28: A graphical illustration of an asymmetric encryption scheme.

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Cryptography and Blockchain Technology 59

• Encryption: The encryption algorithm has a function Enc.AE()

that takes as input a public key pk and a plaintext m, and produces
a ciphertext c.

c ← Enc.AEpk (m)

• Decryption: The decryption algorithm has a function Dec.AE()

that takes as input a private key sk and a ciphertext c, and
produces a plaintext m.

m = Dec.AEsk (c)

The correctness requirement of an asymmetric encryption

scheme is

m = Dec.AEsk (Enc.AEpk (m))

In other words, for any pair of sk, pk and m, Dec.AEsk (c) = m

if and only if c ← Enc.AEpk (m). In asymmetric encryption, users
first choose a private key sk, which is used to compute the public key
pk. The computation of the public key is one-way only — given pk,
it must be computationally infeasible to compute sk. The resulting
sk, pk are always a pair that belongs to a single user. The sender
always encrypts the plaintext with the receiver’s public key, so that
the receiver can decrypt it with her own private key. Note that the
public key by itself does not contain any identifiable information
about its owner. In Section 1.8, we showed how certificates are used to
legally bind a user’s identity to a public key to prevent impersonation
by an attacker.
We use the textbook RSA encryption as an illustration of public
key encryption as follows:

• Key Generation: KeyGen.RSA() takes as input a security param-

eter n and produces a modulus N = pq where p and q are
uniform n-bit prime numbers; an integer e that satisfies the
relation gcd(e, Φ(N )) = 1; and an integer d satisfying the relation
ed = 1 mod Φ(N ).

(sk = d, pk = N, e ) ← KeyGen.RSA(1n )
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60 Blockchain and Smart Contracts

• Encryption: Enc.RSA() takes as input N , the integer e (the public

key pk ) and a plaintext m, and produces a ciphertext c.
c ← me mod N
• Decryption: Dec.RSA() takes as input N , the integer d (the private
key sk ) and a ciphertext c, and produces a plaintext m.
m = cd mod N
The correctness requirement of the RSA encryption scheme is
cd mod N = (me )d mod N = med modφ(N ) = m1 = m
Similar to the RSA digital signature, RSA encryption is backed
by the difficulty of solving the integer factorisation problem for N .
That is, it is computationally infeasible for an attacker to find the
two unique prime numbers p and q given only N . In asymmetric
encryption, only the public key tuple N, e is sent over an open,
insecure network, while p and q are kept secret. If the factorisation
of N were known, then (p − 1)(q − 1) = φ(N ) would be known, and
it would be easy for the attacker to break the algorithm and find the
private key d.
In RSA, the size of N is 4096 bits, which is around 1234 digits.
That said, the RSA encryption scheme described above is not secure
because it is deterministic — given the same plaintext, the resulting
ciphertext is always the same if the key pair (sk, pk ) is the same. An
attacker could intercept the ciphertext and replay it at a later time.
This is therefore a “textbook” RSA encryption scheme that should
not be implemented as is, as it is vulnerable to a number of attacks.
One solution to these attacks is the RSA Optimal Asymmetric
Encryption Padding (OAEP) scheme, which adds a pseudorandom
number to the plaintext in every instance of encryption, generating
a different ciphertext each time.

1.9.6 Hybrid Encryption

Apart from RSA encryption, other notable encryption schemes
include ElGamal encryption, based on the difficulty of the discrete
logarithm problem, and encryption schemes based on elliptic curves.
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Cryptography and Blockchain Technology 61

Although asymmetric encryption addresses the drawbacks of

symmetric encryption, it is much slower than the latter as it relies on
the algorithmic computation of large numbers. Asymmetric encryp-
tion schemes like RSA are therefore rarely used to encrypt messages
themselves. Instead, the hybrid encryption scheme is used in practical
implementation (see Figure 1.29 for a graphical illustration of hybrid
encryption).

Suppose Alice wants to send a confidential message to Bob:

1. Alice generates her pair of private and public keys sk Alice,
pk Alice and Bob generates his pair of private and public
keys sk Bob, pk Bob .
2. Alice encrypts the secret key k using asymmetric encryption
with Bob’s public key pk Bob.
ck ← Enc.AEpk Bob (k)

3. Alice encrypts her message m using symmetric encryption

with the secret key k.
cm ← Enc.SEk (m)
4. Alice sends ck , cm to Bob.
5. Bob decrypts ck using his private key sk Bob to obtain the
secret key k.
k = Dec.AEsk Bob (ck )
6. Bob decrypts cm using the secret key k to obtain the message
from Alice.
m = Dec.SEk (cm )

Because the secret key k for symmetric encryption is short — in

particular, it is likely to be shorter than Alice’s message to Bob — it
is more efficient to use asymmetric encryption to encrypt the secret
key. This also addresses the performance issue of having to pre-share
a secret key over an open, insecure network without a pre-shared key
prior to that.
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62 Blockchain and Smart Contracts

Figure 1.29: A graphical illustration of the hybrid encryption scheme.

Figure 1.30: Python code for hybrid encryption using RSA and AES.

Hybrid encryption using RSA and AES can be implemented

in Python using the RSA, AES and PKCS1 OAEP libraries in
Cryptodome. In the Python code shown in Figure 1.30, we assume
that the user has generated a pair of public and private keys and the
public key is stored in the file “receiver publickey.pem”. The result
of the encryption is shown in Figure 1.31.
To decrypt, we extract the ciphertexts of the secret key and the
message, use the recipient’s private key to obtain the secret (session)
key and then use the secret key to decrypt the message as shown in
Figure 1.32.
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Cryptography and Blockchain Technology 63

Figure 1.31: The resulting ciphertexts from hybrid encryption using RSA and
AES.

Figure 1.32: Python code for hybrid decryption using RSA and AES.

1.10 Privacy
User privacy in a blockchain rests on the untraceability and unlink-
ability of transactions. To recap, untraceability means we should
be able to conceal the details of a transaction so that an observer
cannot follow the trail. Unlinkability, in general, means that two
events occurring under observation of an attacker should appear
unrelated to the observer. Earlier, we said that blockchain technology
is pseudonymous, as opposed to anonymous. By simply observing
the blockchain, there is no identifying information linked to the
wallet addresses or transactions. However, we are able to trace the
source of every transaction, and therefore, able to obtain a graphical
visualisation of transaction paths.Through prior knowledge or social
engineering, it is possible to link an identity to a wallet address. We
therefore need security schemes in place to protect user privacy.
Furthermore, suppose an attacker observes the following transac-
tion traces (Figure 1.33) at time t.
At time t+1, a new transaction as shown in Figure 1.34 takes
place.
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64 Blockchain and Smart Contracts

Figure 1.33: Trace of transactions that can be obtained from a public

blockchain.

Figure 1.34: A new transaction that takes user inputs from three different
addresses may reveal user private information.

An observer can deduce, with certain probability, that addresses

2, 3 and 4 belong to the same user. In fact, such an attack is similar
to a dusting attack, where an attacker sends users tiny amounts of
cryptocurrencies to their wallets. After that, the attacker performs
analysis of these wallet addresses in an attempt to identify which
ones belong to the same user.
Understanding user privacy as a form of confidentiality might
lead us to consider encryption as a solution. The two main types of
data in a Bitcoin transaction are the transaction amount and the
addresses of the sender and receiver. Immediately, some problems
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Cryptography and Blockchain Technology 65

are evident with encrypting this information. Encryption alone

does not allow blockchain to function properly or securely as a
decentralised P2P payment system, and encryption alone does not
ensure untraceability and unlinkability. For example, encrypting
transaction data or wallet addresses does not provide untraceability if
the same wallet is reused. Furthermore, encrypting transaction data
and wallet addresses without providing additional information will
impede miners in the effort of validating transactions (e.g., check for
double-spending and proof of ownership).
Blockchain developers have managed to develop algorithms that
ensure user privacy while addressing these concerns. In this section,
we will briefly discuss five methods: CoinJoin, stealth addresses, ring
signature and Ring Confidential Transaction (RingCT) in Monero
and zero-knowledge proofs.

1.10.1 CoinJoin
CoinJoin is a trustless method that allows multiple bitcoin spenders
to come together and mix their input and output, so that observers
cannot easily trace how they are spending their bitcoin. Suppose
Alice has received 2 btc from Bob, which she now wants to spend.
But, Bob can easily track the 2 btc to see which addresses Alice pays
the amount to. For privacy, Alice decides to spend her 2 btc in a
CoinJoin transaction.
Alice finds at least one other user who agrees to spend the
common denomination of 2 btc. Among them, they identify a user
who will facilitate the transaction. They then provide their respective
input of 2 btc to the facilitator, as well as their respective public key
hashes specifying where their output should go. All the users then
sign the transaction and broadcast it to the network. This single
transaction spends the agreed common denomination of bitcoin from
each user at one go. Purely by observing the CoinJoin transaction,
other users, including Bob, will not be able to identify which
particular public key hash belongs to Alice. From that point onwards,
Bob will lose trace of Alice’s spending behaviour. In effect, CoinJoin
employs a mixing technique that gives users plausible deniability
regarding how they spend their bitcoin.
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66 Blockchain and Smart Contracts

The more users are involved in the CoinJoin transaction, the

more difficult it will be to trace the transactions of any one user.
This method depends on a mixture and obfuscation of data, but
does not involve additional cryptographic techniques. It therefore
retains certain vulnerabilities. CoinJoin does not preclude any of the
users involved in the transaction from announcing to the network
which public key hash belongs to them, thereby making it easier
for observers to deduce the public key hashes of other users in
the transaction. Furthermore, the users involved in the CoinJoin
transaction will know which public key hashes belong to the other
users. The solution to this is CoinShuffle,5 a method for encrypting
public key hashes.

1.10.2 Stealth Addresses

The concept of stealth address is used in many privacy coins. An
example is the Monero blockchain. The idea of stealth address is
used to hide the real recipient of a transaction. Instead of specifying
the public key hash of the recipient in a transaction, the sender
creates a random number r, and “randomises” the public key hash to
create a “one-time stealth address”. The manner of randomising and
creation of stealth address is designed in such a way that only the
real, intended recipient, can de-randomise the stealth address and
discover his/her own wallet address.6 We use Monero to illustrate
the usage of stealth addresses.
In Monero, every user holds four keys: a pair of private and public
view keys pv, PV , respectively, and a pair of private and public
spend keys ps, PS , respectively. The public keys are generated from
the respective private keys through elliptic curve multiplication:
PV = pv × G
PS = ps × G
Each user’s wallet address is made up of their public PV and PS.
Every time a user wants to carry out a transaction, a one-time stealth

5
https://bitcoinmagazine.com/articles/shuffling-coins-to-protect-privacy-and-f
ungibility-a-new-take-on-traditional-mixing-1465934826.
6
We use public key hash and wallet address interchangeably.
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Cryptography and Blockchain Technology 67

address for the receiver is generated. Suppose Alice wants to send

XMR (the Monero coin) to Bob. She obtains Bob’s PVBob and PSBob .
These two keys constitute Bob’s permanent wallet address. Alice then
chooses a random number r. She computes Bob’s one-time stealth
address XBob that will be used for this particular transaction only:

XBob = Hash(r × PVBob ) × G + PSBob

Alice also computes a random one-time transaction number R:

R=r×G

Alice includes both values XBob and R in her transaction to Bob.

Alice’s transaction:
R=r×G
XBob = Hash(r × P VBob ) × G + P SBob
...
Other info

Since every transaction hides the receiver’s address, users do not

know whether they are the intended receiver of a transaction. This
means that every user will need to check every single transaction to
see if he/she is an intended receiver.
From the example above, given a transaction with X  and R ,
Bob will use his private view key pv and public spend key PS to
verify whether a transaction is meant for him. He would check if the
following equation is true:

Hash(pv × R ) × G + PS = X 

If Bob comes across Alice’s transaction, the calculation on the left-

hand side will be equal to

Hash(pvBob × R) × G + PSBob
= Hash(pvBob × r × G) × G + PSBob
= Hash(r × PVBob ) × G + PSBob
= XBob
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68 Blockchain and Smart Contracts

Thus, each time a user wants to send a new transaction, she will
choose a different r value, generating a unique stealth address. To an
observer, it will be computationally infeasible to work out which
addresses are meant for the same receiver, granting the receiver
untraceability.
However, suppose another user, Charlie, is also sending XMR to
Bob. On the blockchain, Alice’s and Charlie’s transactions to Bob
will not reveal that they are sending XMR to the same receiver.
But, if Alice and Charlie were to meet in real life and compare their
transaction details, it would be possible to deduce that both had
made transactions with Bob. To provide untraceability even in such
a scenario, Monero uses subaddresses. Bob can send different subad-
dresses to Alice and Charlie, which are not identifiable as belonging to
the same user. For more information about subaddresses, the reader
may refer to (SerHack and the Monero Community, 2018).

1.10.3 Ring Signature

To provide privacy to the sender, Monero employs a ring signature
scheme that is structured around a pool of unspent coins of the same
denomination belonging to multiple users. Recall that the scheme
of a digital signature comprises three algorithms: key generation,
signing using a private key sk and verification using a public key
pk. Given a group of n users, each user holds a pair of private and
public keys ( sk1 , pk1 , sk2 , pk2 , . . . , skn , pkn ). In the signing stage,
a user holding the key pair ski , pki uses her own secret key ski and
the public keys pk of all n users to generate a ring signature Sigm
on a message m. In the verification stage, the message and signature
pair Sigm , m can be verified using the pk of all n users.
A ring signature can be used to sign any transaction created by
a member of the group. This scheme allows the blockchain to specify
a set of possible signers without revealing which individual user
actually signed on a particular transaction. Ring signature inherits
all the security properties of a normal digital signature scheme,
with the additional property that it is computationally infeasible to
determine which user in the group has signed a particular message.
This anonymity cannot be revoked.
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Cryptography and Blockchain Technology 69

1.10.4 Ring Confidential Transaction

The RingCT method in Monero uses two ways to hide transaction
amount. First, it encrypts the transaction amount using the receiver’s
public key. Then, it uses cryptographic commitment and range proof
to prove that the transaction amount is valid. The proof is computed
to verify that the sum of all inputs is greater than or equal to the sum
of all outputs using commitments (thus, the sender is not creating
cryptocurrencies in a transaction), and the input values are non-
negative using range proof. For a deeper dive into Monero, readers
may refer to (SerHack and the Monero Community, 2018).

1.10.5 Zero-Knowledge Proofs

Zcash is the first public blockchain to implement a full privacy protec-
tion scheme on transactions. It encrypts all transaction data, and uses
a zero-knowledge succinct non-interactive arguments of knowledge
(zk-SNARKs) algorithm to provide user anonymity and transaction
untraceability and unlinkability in a more efficient manner than the
traditional zero-knowledge proof.
A good illustration of zero-knowledge proofs can be found
(Quisquater et al., 1989). Traditional design of a zero-knowledge
proof is interactive and requires multiple iterations to be convincing.
The non-interactive zk-SNARKs algorithm used in Zcash is more
succinct in terms of proof size and efficient in terms of verification
time.
Typically, when we want to convince someone that we possess
knowledge of a secret statement, such as a password, we do so by
exchanging the statement with a verifying authority or user who
also possesses knowledge of it. But, what if the user who is verifying
the information does not — and should not, for privacy — possess
knowledge of the secret statement itself? Zero-knowledge proofs allow
us to prove to a verifier that a secret statement we hold is true,
without actually revealing any information about that statement to
the verifier. Such proofs have three properties:
• Completeness. If the prover is honest, the prover will eventually
convince the verifier.
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70 Blockchain and Smart Contracts

• Soundness. The prover can only convince the verifier if the

statement is true.
• Zero-knowledge. The verifier learns nothing about the statement
aside from the fact that it is true.

We proceed with a high-level overview of Zcash based on the Zcash

protocol specifications (Hopwood et al., 2019). In a Zcash transaction,
the value of the transaction can be either transparent or shielded.
Transparent transfers are essentially the same as Bitcoin and shielded
transfer is the key differentiating factor for Zcash. There are two
types of addresses in Zcash, namely private (z-address) or transpar-
ent (t-address). Transactions can be between two t-addresses, two z-
addresses, or between a z-address and a t-address.
Transactions between two t-addresses are essentially the same
as Bitcoin transactions where the sender, receiver and transaction
amount are public information.
Transactions between two z-addresses are private, where the
sender, receiver and transaction amount are encrypted.
A transaction from a t-address to a z-address is a shielding
transaction, whereas a transaction from a z-address to a t-address
is a deshielding transaction.
In Zcash, each user possesses the keys as depicted in Figure 1.35.
In Zcash, the concept of JoinSplit Description is discussed. A
JoinSplit Description contains, among others, one or more encrypted
Notes for shielded transfers and values for transparent transfers
(Figure 1.36). It also contains nullifiers and commitments for shielded

Figure 1.35: Keys in Zcash.

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Cryptography and Blockchain Technology 71

Figure 1.36: Illustration of a JoinSplit Description containing encrypted Notes.

transfers, an ephemeral public key to derive encryption key used

to decrypt the Notes, and zero-knowledge proofs for all necessary
components. We will discuss these components next.
Shielded transfers are carried in encrypted Notes. Each Note
contains the recipient’s paying key apk , the value of transfer v, a
ρ to be used by the recipient to compute the nullifier when spending
the Note and a commitment trapdoor rcm.
When a sender, e.g., Alice, creates a transaction to Bob, the
output of this transaction must be accompanied by a commitment.
Commitment is calculated as Hash(10110000apk vρrcm), where
apk belongs to Bob and  denotes concatenation.This commitment is
also recorded on a Merkle Hash Tree.
As Bob intends to spend the output given to him by Alice, at
which the output is now the input to Bob’s transaction, Bob would
need to prove that the commitment of the input exists in the Merkle
Hash Tree without revealing which commitment it is. He would also
need to calculate a nullifier for the input. The nullifier is calculated
as Hash(1110ask ρ). This nullifier is added to the nullifier set and
used by the miners to verify if there is a double-spending. An input
where the nullifier exists in the nullifier set is a double-spending. To
this end, notice that because the Note is encrypted such that only
the intended recipient can decrypt, only the recipient will be able to
obtain ρ to calculate the nullifier.
Encryption of Notes is performed using an ephemeral secret key
that only the receiver can derive. Zcash uses a key agreement protocol
that allows only the sender and the intended receiver to agree on a
common secret without pre-sharing a secret key.
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72 Blockchain and Smart Contracts

With the above operations in mind, zk-SNARK is used in Zcash

for a sender of a transaction to prove that, among others,
• For the input — a Note commitment exists and the Merkle Path is
valid; the nullifier is computed in a correct manner so that double-
spending can be accurately detected.
• For the output — the Note commitment is computed correctly,
and the nullifier is unique.
The proof using zk-SNARKs is beyond the scope of this chap-
ter. It involves a multitude of techniques including homomorphic
encryption, arithmetic circuit constructions to model cryptographic
functions and secure creation of common reference string. Interested
readers may refer to a step-by-step introduction by the Zcash team
(Electronic Coin Company, 2020) and advanced readers may refer
to the Zcash protocol specifications (Hopwood et al., 2019) for more
details.

References
Corbellini, A. (2015). Elliptic Curve Cryptography: ECDH and ECDSA.
Retrieved from https://andrea.corbellini.name/2015/05/30/elliptic-curve-cr
yptography-ecdh-and-ecdsa/.
Electronic Coin Company. (2020). How it works | Zcash. Retrieved from Privacy
Protecting Digital Currencies | Zcash: https://z.cash/technology/.
Hopwood, D., Bowe, S., Hornby, T. and Wilcox, N. (2019). zips/protocol.pdf at
master. zcash/zips. Retrieved from GitHub: https://github.com/zcash/zips
/blob/master/protocol/protocol.pdf.
Khalique, A., Singh, K. and Sood, S. (2010). Implementation of Elliptic Curve
Digital Signature Algorithm, International Journal of Computer Applica-
tions, 2(2), 21–27.
Ostrom, E. (2015). Governing the Commons: The Evolution of Institutions for
Collective Actions (Canto Classics). Cambridge University Press.
Quisquater, J.-J., Quisquater, M., Quisquater, M., Quisquater, M., Guillou, L.,
Guillou, M.,... Guillou, S. (1989). How to Explain Zero-Knowledge Protocols
to Your Children. Advances in Cryptology — CRYPTO’ 89.
SerHack and the Monero Community (2018). Mastering Monero — The Future
of Private Transactions. LernoLibro LLC.
Stallings, W. (2017). Cryptography and Network Security: Principles and Practice,
(7th Global Edition). Pearson Education.
Sullivan, N. (2014). ECDSA: The Digital Signature Algorithm of a Better
Internet. Retrieved from https://blog.cloudflare.com/ecdsa-the-digital-sign
ature-algorithm-of-a-better-internet/.
December 24, 2020 14:17 Blockchain and Smart Contracts: Design Thinking. . . 9in x 6in b4043-ch02 page 73

Chapter 2

Bitcoin Mining and Python

Programming Demonstration

2.1 Getting Started

Decentralised as the bitcoin network is, the bitcoin mining process
may be difficult to understand for many. Basically, the underlying
blockchain technology is a distributed public ledger where bitcoin
transaction data are recorded. Each block in the bitcoin blockchain
contains transaction data and blocks of data are chained together
using cryptography (see Figure 2.1).
Transactions are grouped into a block that will be added to the
end of the current blockchain. The process is called mining and the
node that does it is known as the miner. As a reward, miners get
certain amount of bitcoins (currently 12.5 BTC) for every block
successfully mined and they can also collect the transaction fees of the
transactions included in the block. How to determine when a block is
successfully mined, or the consensus rule, in the bitcoin network is the
Proof of Work (PoW) algorithm. The bitcoin blockchain architecture
is summarised in Figure 2.2.
This chapter aims to provide a demonstration of mining in Python
and a better understanding of the mining process of bitcoins. Do
note that this is a simplified version and may differ from the real-life
bitcoin mining as we hope to provide you with some interactive and
programming experiences. When explaining the code line by line, we
will go through the bitcoin mining process step by step and illustrate
the meaning of each step as well.

73
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74 Blockchain and Smart Contracts

Figure 2.1: Blockchain structure.

Block structure, block rules

Block 1 Block 2 Block 3 Block 4 Merkle Hash Tree, orphan/stale block

• Proof-of-Work
• Block and transaction rules
Consensus Layer
• Difficulty

Miner • Choosing & validating transactions

• Transaction fees

Transaction pool • Orphan transaction

• Wallet; public and private key

Node
• Transaction (UTXO)

Figure 2.2: Summary of blockchain architecture.

2.2 Introduction of Python Programming

There are two ways to insert comments in Python: (1) to start
with “#” and whatever follows the hashtag in that line will become
comments or notes; (2) to start a line with """ and end it with """
so that whatever is in between will become comments for notes (see
Figure 2.3). The former is usually used for shorter comments such as
one line or a few words at the end of a line, while the latter is usually
used for longer comments such as several lines. These comments or
notes will not be run as codes.
In Python, there are many functions, codes or libraries readily
available for users to use, instead of writing one from scratch. Such
codes or scripts can be saved in a file named module. In order
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Bitcoin Mining and Python Programming Demonstration 75

Figure 2.3: Importing modules in Python.

to use an existing module or a set of libraries or modules (also

referred to as packages) in your Python IDE (Integrated Development
Environment) like PyCharm, you need to import the library first.
Importing a library means loading it into the memory and then
it is there for us to work with. “pandas” is an important module
in Python, especially for dealing with financial data. It stands for
“Python Data Analysis Library”, which is derived from the term
“panel data”. It allows us to see the data as a table format or
“series”/“data frame” type in Python. The code “import pandas
as pd” in Figure 2.3 means we can call the module using two letters
“pd” instead of the full six letters “pandas” for brevity. “pd” is widely
used as abbreviation for “pandas”.

2.3 Data Import

For the demonstration, we can use a simplified version of transaction
data and transaction ID, but the idea is the same: miners need to
import the transaction data first and select the transaction IDs before
they can proceed to the mining.
Assume that the transactions available, or the transaction pool
in bitcoin, are stored in a local file named “transactions.txt”. We
can use the “with open” command to import the text file into
Python (see Figure 2.4). We can include the full directory of
the file (e.g., “C:/· · · /transaction.txt”) or we can include the file
in the same Python project folder and use only the file name
“transaction.txt”. The “with open” command is also applicable if
the data are stored in other formats such as csv. We can also use
other methods such as the csv or pandas module to import a csv
file.
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76 Blockchain and Smart Contracts

Figure 2.4: Importing transaction data.

The data in the text file are then stored as a list in tx, with each
line as an element of the list (see Figure 2.4). To clean the transaction
data, we would like to store each row in different columns (similar to
Excel) and remove the line breaker “\n” at the end of each line. So,
we create a new list named tx list and leave it empty (“[]” refers to
a list). For each element t in tx, we delete the line breaker “\n” by
replacing it with an empty string. t.split will convert each line (t) in
transaction data (tx ) into different columns using the separator —
comma. Then, we store the separated line data in the list tx list with
each line as a list.
In the last line of Figure 2.4, we convert the list to dataframe
type by calling the pandas module, with the column names as “id”,
“content” and “tx fee” (here we use simplified transaction data;
the column names can be specified according to the data using
the following format). The transaction data are now well organised
with transaction id, transaction content and transaction fee data in
separate columns.
Next, with reference to Figure 2.5, we choose the transaction IDs
from the transaction data. The input() function allows users to use
the keyboard to key in data, which will be stored as strings. The
sentence in the parenthesis is what shows on the screen preceding
the cursor. The “\n” at the end of the line allows the user to key in
data in a new line. We can split the string input by space and get a
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Bitcoin Mining and Python Programming Demonstration 77

Figure 2.5: Selecting transaction IDs.

list of transaction IDs selected. There may be extra spacing in tx in

and thus instr list, so we delete the spacing from instr list. This will
generate a list of transaction IDs without extra spaces, but they are
still string type resulting from the input() function. So, we convert
the IDs to integer type using the int() function.
Transaction IDs that are not included in the transaction data
tx data should be removed from the list (see Figure 2.5). So, in the
for loop, for every element t or every transaction ID in the tx in list,
we use the if statement to skip the step of appending the transaction
ID to the ID output list instr list using “continue” (which means to
skip the following lines in the loop and continue to the next loop) if
that transaction ID is not in the ID column of the transaction data
(tx data[‘id’]). If all the transaction IDs selected are valid, all the IDs
will be included in the final ID output instr list.
Then, we create an empty data frame using pandas to store
the full transaction records for the transaction IDs selected
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78 Blockchain and Smart Contracts

using the “for loop” (see Figure 2.5). The for loop and
tx data[tx data[‘id’] ==id] return only the rows in tx data where the
ID in tx data[‘id’] appears in the instr list (the list that stores the
transaction IDs selected). The print output will be the list of valid
transaction IDs selected and the corresponding transaction data.
Printing 30 equation symbols is just to make the layout nicer.
Then, we can have the transaction data imported and nicely
presented in Python. This is a demonstration of data files import and
data clean in Python. In the following sections, we will use a simple
four-transaction example to further elaborate the mining process.

2.4 Transaction
Before we proceed to deal with the transaction data in Python, let us
run through the information contained in a Bitcoin transaction and
how it works. As mentioned earlier, transaction data will be recorded
in the bitcoin blockchain. Like any other conventional transaction,
a bitcoin transaction needs information on the receiver, sender and
the amount of money. First, a sender needs to have a certain amount
of bitcoins to spend, and he can initiate a transaction by specifying
a bitcoin amount and a sender. This transaction will then go to a
transaction pool for miners to validate and be included in a block
with other transactions. The Bitcoin blockchain ensures that trans-
action data included in a block cannot be altered. How can it achieve
that? The answer is the bitcoin blockchain structure and information
included in the transaction. Whether the transaction data included in
a specific block have been tampered with can be easily verified using
the Merkle Hash Tree method in the cryptography. Understanding
transaction, transaction data and Merkle Hash Tree is important to
understand bitcoin mining and blockchain.

2.5 Bitcoin Transaction

Similar to the bank account in a conventional online banking transac-
tion, each bitcoin transaction has a sender and receiver (Nakamoto,
2019). But, a bitcoin transaction contains more information and it
can have several transactions. So, the term input and output are used
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Bitcoin Mining and Python Programming Demonstration 79

Figure 2.6: Inputs and outputs in a transaction.

in Bitcoin and a bitcoin transaction may have one or more inputs

and one or more outputs (see Figure 2.6). Consider it as a one-way
flow of bitcoins. Input shows where the bitcoins came from (could be
multiple sources) and output points to where they are going (could
be multiple receivers). The number of inputs in a transaction is called
“Input Counter” and the number of outputs “Output Counter”, both
of which will be included in the bitcoin transaction data.
As we all know, a key aspect of blockchain is that once the
information is recorded, it is there forever and cannot be changed.
This spirit of blockchain can be viewed in a single transaction as
well. Although the bitcoins are non-fungible (meaning we do not
distinguish between different bitcoins), the sender needs to specify
the source of the transacted amount of bitcoins as part of the input
information in a transaction, and the concept of remaining account
balance is not applicable in bitcoin. Unlike a bank account, we can
see the balance left in a lump sum and we can spend it all together
without linking to previous transactions; the balance of bitcoins goes
by transactions. In each transaction, the input information will point
to previous transactions, to which a specific amount of bitcoins is
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80 Blockchain and Smart Contracts

Figure 2.7: UTXO and the concept of change.

linked. In this way, it would be very effective and easy for miners to
verify whether the sender owns the bitcoins.
Furthermore, the receiver information, or the transaction output
in bitcoin, is different from conventional online transactions. In a
bank transfer, we can simply transfer the money to another account
with the rest remaining unchanged as long as the amount we are
trying to send is no more than the total amount available, while in
bitcoin, we need to include the bitcoins left as part of the transaction
output. For each transaction, if there are unspent bitcoins left, this
amount will be sent to the sender’s address again as an unspent
transaction output (UTXO), which refers to bitcoins from a previous
transaction that has not yet been spent (or unspent) and can be
the input of another transaction in the future (Figure 2.7). All
transaction inputs in bitcoin are UTXOs and can be linked to
previous transactions that indicate the source of unspent bitcoins.
In summary, a typical bitcoin transaction contains the following
information as shown in Figure 2.8:

• Version that indicates the consensus rules to follow.

• Input counter that shows the total number of inputs.
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Bitcoin Mining and Python Programming Demonstration 81

Figure 2.8: Information contained in a Bitcoin transaction.

• Input information such as previous output hash (previous UTXO

identifier), previous output index (previous UTXO index), script-
Sig size (size of the sender’s signature), scriptSig (sender’s signa-
ture) and sequence number (currently disabled).
• Output counter that shows the total number of outputs.
• Output information such as amount (bitcoin amount to send),
scriptPubKey size (size of receiver’s public key) and scriptPubKey
(condition to spend the output which is the receiver’s public key).
• Locktime that suggests the time before the transaction can be
included in a block and added to the blockchain.

Among them, the inputs and outputs in a transaction provide

the information about the sender and receiver, including the sender’s
source of wealth, proof of ownership (see Figure 2.8) or proof that
the sender owns the bitcoin by a digital signature signed using the
sender’s private key, receiver’s address or public key, and the amount
to receive. The input counter shows the number of sources or previous
transactions linked (where the bitcoins come from) in this transaction
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82 Blockchain and Smart Contracts

and the output counter shows the number of outflows (where the
bitcoins go) with unspent amount transferred to the sender’s own
address.

2.6 Hash
Since there is a lot of information included in a transaction, bitcoin
adopts a more efficient way to incorporate the transaction data in
the mining while ensuring the integrity of the data at the same time.
Namely, the transaction information will then be taken into a hash
function and the generated hash value of the information will be used
as transaction ID that is used to identify the transaction. The hash
value of any input has the same length and any slight changes in the
input will cause the resulted hash value to be completely different
with no pattern. Such features of hash ensure that as long as we have
the same transaction ID, the data and information in a transaction
have not been tampered with.
What is hash and why is used in bitcoin transactions? Hash, or
hashing, refers to a function that takes data input of any length and
returns a value of fixed length (Sobti & Geetha, 2012). The value
returned by a hash function is also known as hashes, hash values, hash
codes or digests. We can create hashes of all kinds of digital content of
any length and form (e.g., numbers, letters, and symbols; documents,
images and music) and the output will be a value of fixed length, which
makes the calculation process neater and easier. The use of a hash
function can also easily suggest whether the transaction information
remains unchanged or not. This is because hashing the same input
will always generate the same hash values and any changes, even
the slightest, in the input will result in a totally different hash
value.
The hash function used in bitcoin is SHA-256, which returns a
fixed length of 256 bits (32 bytes). So, the transaction ID in bitcoin
would look like this:

B94d27b9934d3e08a52e52d7da7dabfac484efe37a5380
ee9088f7ace2efcde9
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Bitcoin Mining and Python Programming Demonstration 83

Now, that we use the hash values to represent a transaction (at

transaction level), is there an efficient way to aggregate multiple
transactions or hash values (at block level) as many transactions
may be included in a single block? In fact, for each block, the
transactions selected by the miner are aggregated by Merkle Hash
Tree and reflected as a single number, the Merkle Root.
The Merkle Hash Tree is a binary tree that would calculate the
hash value of every two transactions until the Merkle Root is reached.
The Merkle Root summarises all the transactions gathered within
this block and is used as an efficient way to determine if a particular
transaction is included within a block and to verify if all transactions
have not been tampered with (Merkle, 1980). A simplified version of
Merkle Hash Tree is shown in Figure 2.9. If the information within a
transaction is changed, the hash value of the transaction will change
(also known as the leaf) and the second layer (or the branch) will
change, leading to a different Merkle Root because any changes in the
input of a hash function will generate a completely different output
or hash values. We will demonstrate this process in Python using an
example of four transactions.

What does this imply? This means that if an attacker tries to

modify a transaction (say Alice to Bob: 1 btc), he is effectively trying
to find another transaction with the same hash value as Alice to
Bob: 1 btc in order to be not detected. This is not possible because
it is computationally not feasible as to find two different inputs

Figure 2.9: Structure of a Merkle Root.

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84 Blockchain and Smart Contracts

(or transaction data) with the same hash output (or hash values)
is extremely difficult with current computing power.

Same as earlier, we need to import the packages needed. Since

Bitcoin uses SHA-256 cryptographic hash function, we can import it
from the Python library available named “hashlib” (see Figure 2.10).
Note that if we use “import hashlib” instead of “from hashlib import
sha256” at the beginning, the code would be “hashlib.sha256()”
instead of “sha256()”, and if we would like to call the function as
Python, it would only recognise “hashlib” not “sha256” as a valid
function.
Next, looking at the functions in Figure 2.11, we define
two functions: dsha() and rev(). Bitcoin uses double hashing,
meaning for the input, we need to use the sha256() function
twice. In Python, “sha256(tx).digest()” returns the hash value,
or digest, of the input “tx”. So, for bitcoin, the code would be
“sha256(sha256(tx).digest()).digest()”. Instead of writing so many
strings every time, we can define a function named “dsha()” to return
the double hash results. Similarly, we can define a function named
“rev()” to reverse the elements in the input “buf”, which will be used
later in the calculation. “buf[::−1]” means to cover all elements (by
default as there are no numbers specified before each colon), from
the last to the first and one at each time (determined by the “−1”
after the second colon).

Figure 2.10: Importing sha256.

Figure 2.11: Defining functions dsha and rev.

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Bitcoin Mining and Python Programming Demonstration 85

Let us start with the following four transactions, A, B, C and

D (see Figures 2.12 and 2.13). The strings in the parenthesis are
the corresponding transaction IDs. The “bytes.fromhex()” function
converts hexadecimal, or hex, strings to binary strings.
The hash values of the four transactions can be calculated using
the following commands (see Figure 2.14). Note that output from
the “dsha()” function is binary, but it is easier for us to see the hash

Figure 2.12: Transaction A and B.

Figure 2.13: Transaction C and D.

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86 Blockchain and Smart Contracts

Figure 2.14: Calculating hash values of transactions.

Figure 2.15: Output of the four transactions.

Figure 2.16: Calculating the Merkle Root.

values in hex strings, so we present the result in hex strings using

“.hex()” function.
The output is displayed as follows in Figure 2.15.
Following the Merkle Hash Tree, the Merkle Root can then be
calculated as the hash of the sum of hab and hcd (see Figure 2.16).
The output is shown in Figure 2.17.
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Bitcoin Mining and Python Programming Demonstration 87

Figure 2.17: Output of the Merkle Root.

Therefore, the Merkle Root of our four transactions is

“c1f4106adf3afac4f2a443072058ebf0044c5859212865018
ed5c51403ad47e9”
This will then be used to mine a block and stored in the block
header.
Why do we need the reverse function for the Merkle Root?
Basically, this has something to do with how data is stored in the
computer and how we prefer it to appear. When considered as input of
the hash, or double hash, in the case of Bitcoin function, transaction
IDs need to be in binary strings and little endian machines, which
refer to an order that stores the low-order byte of the number (“little-
end”, or the least significant value in the sequence) first (at the lowest
address) and high-order byte (“big-end”, or the most significant value
in the sequence) last (at the highest address). But, the blockchain
explorers display the data in hexadecimal and big endian machines,
which store the ”big-end” first and “little-end” last. Therefore, we
need to reverse the characters in the hexadecimal Merkle root strings
to convert it back to big endian machines, thus the usage of reverse
function defined earlier on.

2.7 Block Structure

Each block consists of a block header and transaction data (see
Figure 2.18). Full transaction data are included in a block, but only
the Merkle Root is included in the block header as an aggregation
and presentation of the transactions in that block. Some nodes can
keep and sync merely the block header information, instead of the
full transaction data, to save space. The block header is crucial in
blockchain and mining as each block is cryptographically chained
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88 Blockchain and Smart Contracts

Figure 2.18: Overview of block structure.

Source: https://luxsci.com/blog/understanding-blockchains-and-bitcoin-technol
ogy.html.

to the previous block using a hash of the previous block header. It

contains the hash of the previous block header, timestamp, difficulty
target, nonce, Merkle Root and other information such as version
and block size.
The blockchain is designed in such a way that is constantly
appending new blocks of validated transactions to the end of its
chain. The chain can only grow and blocks cannot be removed or
amended once confirmed and appended. Since every block contains a
unique hash value of the previous block, if an attacker tries to change
content of the previous block, its hash value will change. Thus, the
attack will be detected because all subsequent hash values will not
match. Just as the hash of a transaction reflects the information
within the transaction and the Merkle Root reflects the transactions
included in a block, the hash value of the block header reflects all
the information in the block.
Here, looking at the codes in Figure 2.19, we include the version,
the hash value of previous block and time information, to be included
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Bitcoin Mining and Python Programming Demonstration 89

Figure 2.19: Given information to be included.

in the block header later. The above number for time is the Unix
epoch (or Unix time or POSIX time or Unix timestamp), which
is the number of seconds that have elapsed since January 1, 1970
(midnight UTC/GMT), not counting leap seconds (in ISO 8601:
1970-01-01T00:00:00Z). It is equivalent to 2019-07-07 08:08:08.

2.8 Mining
Mining refers to the process of finding a valid block to add to the
current blockchain and it follows certain rules or consensus rule,
which is Proof of Work (PoW) in bitcoin. Miners are the nodes
that do mining. Since there are no centralised parties like banks
or governments to control the issuance or validate the account
balance and transactions, the consensus rule, or PoW, is what the
bitcoin network relies on. The nodes in the bitcoin network reach
the consensus that a block is genuine through the block header’s
hash value — whether it satisfies a given condition or meets a given
target (Nguyen and Kim, 2018). Just like solving a math problem,
this condition is explicit and stated in the bitcoin protocol so that
everyone in the community must comply, which ensures trust among
the bitcoin community.
In Bitcoin’s Proof-of-Work mechanism, the blockchain that was
created with the greatest cumulative effort expended is the one
considered to be the latest and to which new blocks are attached.
That is to say, the longest blockchain in the system is the accepted
state of the bitcoin ledger as it requires the greatest effort to create.
Since the rest of the information included in the block header hash
value computation is more or less given, the most variable factor
is the nonce, so miners will keep trying different nonce values to
generate different hash values of the block header. That said, without
changing any other data in the block header (definitely not the
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90 Blockchain and Smart Contracts

transactions), the Proof-of-Work process is a competition among

miners to find “the Golden Nonce” that will result in a block
fingerprint (i.e., the hash value of the block header) that satisfies
a given condition or meets a given target.

2.9 Target and Mining Difficulty

In the bitcoin blockchain, the target is a 256-bit number that all
bitcoin nodes share. It is sometimes referred to as the difficulty target
as it measures how difficult it is to mine or generate a new block.
The SHA-256 hash of a block’s header must be lower than or equal to
the current target for the block to be accepted by the network. It is
usually expressed in hexadecimal. An example of target is as follows:
0x0000000000FFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFF
FFFFFFFFFFFFFFFFFF.
The more the leading zeros, the lower the target (meaning in
decimal the number is lower), and thus the more difficult it is to
find a block fingerprint that satisfies the condition or meets the
target. What is hexadecimal? The hexadecimal numeral system,
often shortened to “hex”, is a numeral system made up of 16
symbols (base 16). The standard numeral system is called decimal
(base 10) and uses ten symbols: 0,1,2,3,4,5,6,7,8,9. Hexadecimal
uses the decimal numbers and six extra symbols (see Figure 2.20).
We often see the block hash represented as hexadecimal numbers
(64 digits) which result from SHA-256 hashing. Each hexadecimal
number is four bits, so the output of SHA-256 is a 256-bit number
(64 hexadecimal digits × 4 = 256 bits), and thus the name.
Sometimes, a target is given in “bits” or a “compact” format of
the target such as “1903a30c” or 0x1903a30c. The exponent is 0x19
and the coefficient is 0x03a30c. The target can be calculated using
the following formula:

Target = Coefficient ∗ 28∗(Exponent −3)

So, for a difficulty bits value of 0x1903a30c, we have

Target = 0x03a30c ∗ 20x08∗(0x19−0x03)

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Bitcoin Mining and Python Programming Demonstration 91

Hexadecimal Binary Decimal

0 0000 0
1 0001 1
2 0010 2
3 0011 3
4 0100 4
5 0101 5
6 0110 6
7 0111 7
8 1000 8
9 1001 9
A 1010 10
B 1011 11
C 1100 12
D 1101 13
E 1110 14
F 1111 15

Figure 2.20: Hexadecimals, binary and decimal.

The target is then 0x0000000000000003A30C0000000000000

0000000000000000000000000000000.
What does “0x” mean? It simply means that what follows is in
hexadecimal, to avoid confusion with other data types such as decimal
or strings.
Since it is difficult to compare two targets using the hex strings or
decimal values as they are very large integers, difficulty can be viewed
as another representation of the target that makes the comparison
easier.
Difficulty is expressed as follows:
difficulty 1 target
difficulty =
current target
Difficulty 1 targets is defined as the easiest allowed target value,
0x1d00ffff, which gives us a hex target of
0x00ffff ∗ 2 ∗ ∗ (8 ∗ (0x1d − 3))
= 0x00000000F F F F 000000000000000000000000000000000
0000000000000000000
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92 Blockchain and Smart Contracts

Figure 2.21: Increase in difficulty of mining Bitcoins.

Source: https://www.blockchain.com/charts/difficuly?timespan=all.

Difficulty is a network-wide setting that controls how much compu-

tation is required to produce a proof of work. It is a relative measure
of how difficult it is to find a hash below a given target or to find a
new block. The bitcoin network has a global block difficulty, which
is adjusted periodically as a function of how much hashing power
has been deployed by the network of miners to ensure that it takes
10 minutes on average to add a new block to the bitcoin blockchain
(O’Dwyer and Malone, 2014).
How often does the network difficulty change? It changes roughly
every two weeks, depending on the network block generation speed
or the overall computing power (see Figure 2.21).
The formula for a new difficulty level is as follows:

New difficulty = Old difficulty

 
actual time taken for last 2016 blocks
∗
20160 minutes
Let us assume a simpler target to demonstrate how the target
is calculated using bits value in Python (see Figure 2.22). Exponent
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Bitcoin Mining and Python Programming Demonstration 93

Figure 2.22: Calculating the difficulty target.

Figure 2.23: Output of the target.

is the third and fourth digit in bits, so it is the second and third
element in the bits string since the number starts with 0 in a list and
bits[2:4] means the second and third in bits, which is 0x1e. bits[4:]
gets the 5th digit to the last digit in the bits value, which is 0x03a30c.
Then, we can calculate the target using the abovementioned formula.
While int(var) gives the integer of var in decimal, int(var, 16) tells
the program that this integer var is in hexadecimal.
The output will be as follows (see Figure 2.23). We can see that
the target in decimal is an extremely large number. It is much more
neatly expressed in hex strings, which is why hex strings are widely
used in the bitcoin blockchain. Without the zfill(64), the target would
be 000003a30c and the function fills the rest of the places so that the
final number is 64 digits.

2.10 Finding the Golden Nonce

If we recall the whole mining process again, once the miner selected
the transactions, the Merkle Root will be calculated and remain the
same as long as the transactions selected do not change. In previous
sections, we calculated the difficulty target. The next step is to put
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94 Blockchain and Smart Contracts

Figure 2.24: Process of Bitcoin consensus.

the rest of the information into the header and start finding the
Golden Nonce in the mining process (see Figure 2.24).
The target value in bytes is stored in target byte for block mining
later (see Figure 2.25). We can also prepare the partial header using
the information we have now, including version, hash of previous
block header, Merkle Root that aggregates the transactions included
in this block and timestamp. struct.pack(“< L”, x) returns the input
x as little-endian ordered unsigned long value. As mentioned in the
transaction section, the endianness is a convention that determines
in which direction a sequence of bits is interpreted as a number: from
(Big-endian) left to right, or from (Little-endian) right to left. This
is to follow the rules in bitcoin network.
From the partial header (see Figure 2.25), we can see that among
the information included in a block header, all the rest of the data
are given and can be easily obtained except for the nonce. So, to
successfully mine a new block is equivalent to finding a correct nonce
that makes the hash value of the block header equal to or smaller
than the target. Any change to the block header input (such as the
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Bitcoin Mining and Python Programming Demonstration 95

Figure 2.25: Partial header and block header information.

nonce) will make the block hash completely different. Since it is

believed infeasible to predict which combination of bits will result in
the right hash, many different nonce values will be tried and the hash
recomputed for each nonce value until a hash less than or equal to the
current target of the network is found. As this iterative calculation
requires time and resources, the presentation of the block with the
correct nonce value (known as the golden nonce) constitutes PoW in
Bitcoin (MacKenzie, 2019). The mining process can also be referred
to as the process of finding the golden nonce.
What is a nonce? In cryptography, a nonce is an arbitrary number
that can be used just once in a cryptographic communication (Gordon
and Jeffrey, 2004). It is similar in spirit to a nonce word, hence
the name. The “nonce” in a bitcoin block is a 32-bit (4-byte) field
whose value is adjusted by miners so that the hash of the block will
be less than or equal to the current target of the network. The rest of
the fields may not be changed, as they have a defined meaning. It is
important to realise that block generation is not a long, set problem
(like doing a million hashes), but more like a lottery. Each hash
basically generates a random number between 0 and the maximum
value of a 256-bit number (which is huge). If the corresponding hash is
below the target, the miner wins. If not, the miner needs to increment
the nonce (completely changing the hash) and try again. Therefore,
the process requires a huge amount of computing power.
The next step is to find the golden nonce, or to examine whether
the block hash meets the target using different nonce values. In
Python, we can start with a nonce that we choose by the input()
function. The while True loop ensures that the user can keep
keying in values if there are any wrong entries (see Figure 2.26).
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96 Blockchain and Smart Contracts

Figure 2.26: To input a nonce.

The nonce = int(user input) statement is necessary to convert the

user input to integer. Otherwise, what the user keyed in will be a
string type. It is possible that the user keyed in strings or other
symbols that cannot be used for the int() function, which will raise a
value error message. So, the “except ValueError:” statement is meant
for such cases and allows the user to key in again without the program
being ended by the error message.
Once we have keyed in a nonce value, we can start the trial with
this nonce value and keep trying to use a while loop. 0x100000000
in hex is 4294967296, so this is the max number of loops run if the
golden nonce is not found. With the nonce, we can have the hash of
block header (used to determine if the target is met). Do note that
in this example, we use a relatively easy target. In reality, to mine a
block in bitcoin is very difficult and the number of loops or the time
it takes to find the golden nonce is much larger and longer than our
example.
Generating a mining start time variable that shows the start time
is for us to see how long it takes to find a golden nonce or mine a
block with the target set compared to the time when we find the
golden nonce (see Figure 2.27). Current time minus start time is the
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Bitcoin Mining and Python Programming Demonstration 97

Figure 2.27: Finding the golden nonce.

time taken. We will show the nonce, hash of the block header and
the hash rate per second every 50,000 times the loop runs.
For every loop, we try a larger nonce value until the golden nonce
is found or nonce value reaches 4294967296 (can set to larger value
with smaller target). If the block header hash is smaller than the
target, the loop will be broken with a “Success!” message. The nonce
that satisfies the condition is the golden nonce.
This is an example of trying different nonce values to see if we
get a hash value that is smaller than the target given. Here, we start
with a small nonce and try a bigger nonce every time the loop runs.
Of course, it can be other methods to try out different nonce values,
such as to randomly select a nonce number in a range or to start
with a large number and try a smaller value in every round.
Once the target is met, miners can broadcast the new block
they find to the network. If recognised, more miners will use this
block as the latest block and calculate the hash value of the next
block to mine another new block. Successful miners can collect the
reward generated with the new block and the transaction fees via
the transactions included in and confirmed with the block. This
is the economic incentive for miners to keep the bitcoin network
running.
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98 Blockchain and Smart Contracts

References
Gordon, A. D. and Jeffrey, A. (2004). Types and effects for asymmetric
cryptographic protocols. Journal of Computer Security, 12(3–4), 435–483.
MacKenzie, D. (2019). Pick a nonce and try a hash. London Review of Books,
41(8), 35–38.
Merkle, R. C. (1980). Protocols for public key cryptosystems. In Proc. 1980
Symposium on Security and Privacy, IEEE Computer Society, (pp. 122–133).
Nakamoto, S. (2019). Bitcoin: A peer-to-peer electronic cash system. Manubot.
Nguyen, G. T. and Kim, K. (2018). A survey about consensus algorithms used in
blockchain. Journal of Information Processing Systems, 14(1), 101–128.
O’Dwyer, K. J. and Malone, D. (2014). Bitcoin mining and its energy footprint.
Conference working paper.
Sobti, R. and Geetha, G. (2012). Cryptographic hash functions: A review.
International Journal of Computer Science Issues (IJCSI), 9(2), 461.
December 24, 2020 14:17 Blockchain and Smart Contracts: Design Thinking. . . 9in x 6in b4043-ch03 page 99

Chapter 3

Consensus for Blockchain

and Distributed Ledger Technologies
Ernie Teo∗

3.1 Introduction
When a group arrive together at a decision and agree to support it,
the group would have achieved consensus among its members. The
decision is what is considered an acceptable resolution, a decision
that the group can support even if it is not the preferred option of
individuals in the group. A government election is one example of a
group coming together to make such a decision.
Consensus is an important concept for blockchain networks and
distributed ledgers as there is no central authority to provide the
source of truth. The network members have to arrive at a conclusion
about the state of the network by following some rules. These
rules are the consensus algorithms programmed into the blockchain
protocol. In Bitcoin, the consensus algorithm used is Proof of Work or
Bitcoin mining. Nodes on the Bitcoin blockchain can choose which
transactions to include into a block they are mining or validating.
They can also choose to ignore transactions that are broadcasted to
the network. When a block is mined, a majority of nodes on the

∗
Adjunct Senior Lecturer, National University of Singapore; Co Vice-Chairman,
Blockchain Association Singapore, Singapore.

99
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100 Blockchain and Smart Contracts

network agree on the state if they choose to mine on top of the

previous block. Consensus is thus achieved when a block is accepted
into the blockchain.
A good consensus protocol needs to maintain a consistent ledger.
It should keep the network up to date, fix errors and ignore malicious
nodes. In a blockchain network, it also needs to ensure that the
transactions put on the ledger are valid. For consensus algorithms
to achieve the objective to maintain a valid blockchain ledger, it
needs to be able to do the following:

• If bad actors try to broadcast invalid transactions, they should be

ignored by the good nodes and not included in the ledger.
• When bad nodes try to mine a block with invalid or fraudulent
transactions, the majority of the network should agree not mine
on top of it.

In Figure 3.1, suppose there are four nodes on the network

and the correct action is to “Proceed”. Node B has the wrong
information “Wait” and Node D is maliciously trying to get the nodes
to “Cancel”. A good consensus algorithm needs to update Node B
such that it chooses “Proceed” and successfully ignores Node D.
To achieve this, the blockchain nodes need to do the following:

• be able to keep track of historical transactions;

• authenticate and validate current broadcasted transactions;

Figure 3.1: Example of a good consensus algorithm.

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Consensus for Blockchain and Distributed Ledger Technologies 101

• reach an agreement on what goes in the ledger with the other

nodes;
• receive appropriate incentives to “do the right thing”.
Incentive is a key element for blockchain consensus for a public
network. Since anyone can join the blockchain, the right type of
reward needs to be in place such that the members would do what
is required to get rewarded. The rewards need to be aligned with
actions we want the members to take such that a goal of a consistent
and correct network is achieved. This is also known as the network
economics or mechanism design of the network.
Proof of Work (PoW) is not the only method to achieve consensus
in a blockchain network. Since the inception of Bitcoin more than
10 years ago in 2008, several shortcomings were found in PoW.
Bitcoin PoW incentivises miners to pool resources and compete in
hardware, which causes centralisation on the network where there
are only a few large miners controlling the network. PoW also
consumes large amounts of electricity as a result and is not very
environmentally friendly. These short comings were recognised early
and there were many attempts to replace PoW as the industry
evolved and matured. In this chapter, we will go through a survey of
the types of consensus methods being used. First, we start with the
concept of network fault tolerance in the next section.

3.2 Fault Tolerance

Fault tolerance is the ability of a system to operate in the event
of failure of one or some of its components. There are two types of
failures that can occur on a distributed network: network and node
failures. A network fails when it loses connectivity fully or partially.
In the event of partial loss in connectivity, segregated parts of the
network should be able to continue operating and sync up again when
the network is reconnected. The linear nature of blockchain networks
does not allow this to happen and hard forks will result. Structures
like Directed Acyclic Graph (DAG) address this and will be discussed
in Section 3.3.3.
The other type of failure is node failure. A node can experience
faults such as crashes, power outages, hardware problems or running
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102 Blockchain and Smart Contracts

out of memory. These are generally known as crash faults. In the

event of a crash fault, the node should be able to rejoin the network
and sync up after it recovers. There is another type of fault when
a node acts maliciously to send conflicting messages to other nodes.
This is known as a Byzantine failure. When a Byzantine failure has
occurred, the system may respond in any unpredictable way, unless
it is designed to have Byzantine fault tolerance. Byzantine faults
include the following:

• omission failures (e.g., crash failures, failing to receive a request,

or failing to send a response);
• commission failures (e.g., processing a request incorrectly, corrupt-
ing local state, and/or sending an incorrect or inconsistent response
to a request).

Most blockchain consensus is designed to deal with Byzantine

faults or at least crash faults. The term Byzantine fault comes from
the Byzantine Generals Problem. It describes a situation where a
network of actors needs to agree on a strategy where some of these
actors are malicious. Several armies, each led by a general, are closing
in on an enemy fortress from different directions. They have made
camp and can observe the enemy from their point of view. The
generals must decide whether to attack or retreat. The armies must
all attack at the same time in order to succeed. The only way to
communicate is to send messengers between the army camps. Some
of the army generals are unreliable and could be traitors. Traitors
can prevent a decision from being made by influencing decisions like
attacking when most generals do not wish to attack or confusing some
generals to the point that they are unable to make up their minds.
To reach a consensus among the generals on the plan of action, a set
of rules must be made. This set of rules needs to be Byzantine fault
tolerant (or resistant to traitors) and the following conditions need
to hold:

A. All loyal generals will decide upon the same plan of action.
a. The loyal generals will all do what the set of rules says they
should, but the traitors may do anything they wish.
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Consensus for Blockchain and Distributed Ledger Technologies 103

b. The algorithm must guarantee condition A regardless of what

the traitors do.
B. A small number of traitors cannot cause the loyal generals to
adopt a bad plan.

Similarly, in a blockchain network, the consensus algorithm is the

set of rules that the nodes (or “generals”) have to follow:

A. All good nodes have to agree on the same plan of action (whether
a transaction is valid).
a. All good nodes will follow the rules set by the consensus
algorithm; check the ledger history to ensure that a transaction
is valid before putting on the ledger. Bad nodes can do what
they want such as work together to invalidate legitimate trans-
actions or validate double-spent transactions (by invalidating
the first transaction).
b. The consensus algorithm must guarantee A no matter what
the bad nodes do.
B. As long as the number of bad nodes is small enough, the good
nodes will not adopt an invalid transaction.

Lamport, Shostak and Pease (2019) suggest various solutions to

the Byzantine Generals Problem. In the oral message version with
one general acting as a leader, it is found that a solution will exist
for the Byzantine Generals Problem when

n ≥ 3m + 1,

where n is the number of generals in the system and m is the number

of traitors (faults). In other words, the algorithm can ensure correct
operation only if fewer than one-third of the processes are faulty.
If unforgeability of messages is possible, higher fault tolerance is
possible.
Patel (2020) explains that Byzantine fault tolerance on PoW
networks is 50%, assuming zero network latency (messages can be
sent around the network instantaneously). Under actual observed
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104 Blockchain and Smart Contracts

conditions, it is 46% for Ethereum and 49.5% for Bitcoin, but it

goes down to 33% if network latency is equal to the block time and
reduces to zero as network latency approaches infinity. Thus, under
most conditions, a malicious actor needs to control around 50% of
the network to successfully launch a Byzantine attack on a PoW
network.
In general, there are two fundamental stages to a BFT system:
1. Agreement
2. Execution
The agreement stage is where the nodes agree on what should be
done. Each consensus algorithm has its way for the majority of the
nodes to reach an agreement. Once the outcome is agreed upon, it
moves on to the execution stage and puts the outcome on the ledger.

3.3 Consensus Protocols Used in Blockchain

and DLT
Other than PoW, there have been many consensus algorithms that
were proposed and implemented onto live blockchain networks. Some
of these variations are driven by the need to overcome the short-
comings with PoW by reducing the amount of energy consumed or
improving the amount of decentralisation on the network. Others are
proposed to overcome scalability issues that Bitcoin is experiencing,
aiming to be able to process more transactions per second. Then,
there are those that are specifically created for use in permissioned
blockchain networks where nodes are considered trusted and there
is less need for incentive mechanism to ensure behaviour. Figure 3.2
summarises the consensus algorithms we will cover in this chapter
and their type.

3.3.1 Consensus for Trustless Blockchains

In trustless blockchains, none of the nodes are considered trusted.
We need to rely on the consensus algorithm and the appropriate
incentives like mining rewards to ensure that the network members
behave in the right way. It is important that the incentives are aligned
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Consensus for Blockchain and Distributed Ledger Technologies 105

Figure 3.2: Categories of consensus for blockchain and DLT.

to encourage the appropriate actions. Some general guidelines to

consider are as follows:
1. Doing the right thing gets rewarded.
2. Rewards from continuing to do the right thing should outweigh
the potential net benefits from doing bad things — the costs of
doing bad things should be high.

Proof of Work
Proof of Work is the grandparent of trustless consensus in a
blockchain. PoW has been tried and tested since 2008 and is working
well. Bitcoin, Ethereum, Litecoin and Dodgecoin are some of the
cryptocurrency networks that have adopted PoW. Nodes on the
network can create blocks in the ledger when they participate in
PoW. PoW is competitive in nature as only one node can win the
mining reward for each block. The steps in PoW are as follows and
are described in Figure 3.3:
1. Receive new broadcasted transactions and check them against the
ledger to ensure that they are legitimate (sender has signed the
transaction and sender address has enough balance).
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106 Blockchain and Smart Contracts

Figure 3.3: Steps in PoW consensus.

2. Discard the transaction if it is invalid.

3. Package legitimate transactions into the current block.
4. Attempt to mine the block.
5. If successful, broadcast the mined block to the network. Start
again from Step 1 and mine on top of the block you just created.
6. If not successful (next block is broadcasted before yours), check
that the new block broadcasted is valid, go back to Step 1 and
mine on top of the new block.

The act of mining is to solve a cryptographic puzzle that requires

computation power. The more computation power one has, the more
permutations one can try per second and the higher the chance of
mining the block. Competition in mining over the years has caused
miners to amass large amounts of powerful hardware in order to
increase their chances. This tends to favour the resource rich; one
miner using a hundred dollars of resources to mine will have higher
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Consensus for Blockchain and Distributed Ledger Technologies 107

chances than a hundred miners with a dollar each. This is otherwise

known as economies of scale. Mining is also not environmentally
friendly and uses a lot of energy. As time is needed to solve the
cryptographic puzzle, transactions are not immediate.

Proof of Stake
One of the first proposals as an alternative to address the issues with
PoW is Proof of Stake (PoS). One needs to have a stake (or hold some
coins) in the system to participate in PoS. In its simplest form, if you
own 5% of the total stake, your chance of mining the next block is
also 5%. In this way, not much computation (to solve a cryptography
puzzle) is needed. PoS is more energy efficient than PoW. PoS is also
competitive, only one staker can mine each block.
PoS is also not susceptible to economies of scale; a dollar is a
dollar. The chances of mining the block are the same for someone
with a hundred dollars’ worth of coins and a hundred persons with
a dollar each. Attacking a PoS is also more costly than PoW as you
will lose your stake if the network detects that you are malicious.
In PoW, you do not lose your coins or your mining hardware if you
launch a malicious attack.
However, the main issue in PoS is the “nothing at stake” problem.
In the event of a fork (where two miners create the next block at the
same time), PoW miners have to choose the block they wish to mine
on top of as their computing resources are limited. For a PoS miner,
there is nothing to lose if they stake on both forks. When a fork
occurs, the staker will have coins on both forks, allowing it to stake
on both sides. This leads to no resolution on what is the correct chain
(see Figure 3.4).
Different projects have made attempts at solving the “nothing
at stake” problem. Peercoin1 is one of the first cryptocurrencies
to use PoS. It used checkpoints which prevent a reorganisation of
the blockchain beyond the last known checkpoint. This was later
made optional as the blockchain network reached a suitable level of

1
https://docs.peercoin.net/#/proof-of-stake.
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108 Blockchain and Smart Contracts

Figure 3.4: The “Nothing at Stake” problem in PoS.

distribution. In the Nxt2 protocol, only reorganisation of the last 720

blocks is allowed. However, this only contains the problem but does
not solve it. Ouroboros3 is a PoS used by the Cardano blockchain;
this method has been mathematically proven to be secure and uses
an innovative method to randomly choose the block miner with a
secure multiparty implementation of a coin-flipping protocol.
In Ethereum’s proposal for switching to PoS, nodes can be
“punished” if they stake on top of more than one blockchain branch.
As of June 2020, Ethereum is underway to transition to Casper4
(Ethereum’s version of PoS) in two stages. Once implemented, one
can become a validator (stake) on the Ethereum blockchain by
staking 32 Ethers.

Delegated Proof of Stake

In Delegated Proof of Stake (DPoS), as the name implies, the staking
is delegated. Owners of coins (or stake holders) can elect and choose
leaders who will stake/vote on their behalf. Since there are fewer
stakers to coordinate, this is faster than PoS.
EOS5 utilises DPoS; 21 leaders (or witnesses) are elected at a time
in EOS and there is a pool of standby nodes in case one of the existing

2
https://nxtdocs.jelurida.com/Nxt Whitepaper#Nxt.E2.80.99s Proof of Stake
Model.
3
https://www.cardano.org/en/ouroboros/.
4
https://docs.ethhub.io/ethereum-roadmap/ethereum-2.0/proof-of-stake/.
5
https://eos.io/.
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Consensus for Blockchain and Distributed Ledger Technologies 109

witnesses drops out or turn outs to be malicious. The witnesses are

paid a fee (that is set by the stake holders) for producing blocks. The
21 witnesses produce blocks one at a time in a round-robin fashion.
Thus, a witness cannot produce consecutive blocks, making double-
spending attacks by the witness impossible. A witness is skipped if
it is unable to produce a block within the allocated time slot. Stake
holders can vote out witnesses that continue to miss blocks or publish
invalid transactions.
DPoS is collaborative instead of competitive as everyone has a
turn. This method allows faster blocks and scales better than PoW
or PoS. Other than EOS, Steemit, Bitshares and Lisk also use DPoS.
However, this method is also more centralised than PoW and PoS.
The control over the network falls mostly on the 21 witnesses. If a
stake holder has sufficient coins, it can vote itself in to be a witness
and control the entire network.

Proof of Weight
Proof of Weight refers to a large class of consensus algorithms where
the chance of being chosen to validate or mine the next block is based
on a weighted score. This class of consensus usually aims to make it
more costly to lose the acquired weighted score, thus ensuring that
validators continue to be good. Proof of Weight is generally energy
efficient but incentive mechanism design is important, and it may be
hard to ensure that incentives are aligned to the outcomes. Proof of
Believability, Proof of Space and Proof of Importance are forms of
Proof of Weight.

Proof of Believability
Proof of Believability is used by IOST6 and utilises several factors
to compose a believability score. With Proof of Believability (PoB),
IOST aims to encourage decentralisation in the network. Central
to this is the reputation-based sub-token system called Servi. Servi
tokens serve as a measurement of a user’s contribution to the network

6
https://iost.io/.
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110 Blockchain and Smart Contracts

and a way to encourage members to contribute to the development of

the network. These non-tradable tokens are awarded to good actors
within the ecosystem and factor heavily into the process of choosing
the next validator. Servi tokens are non-tradable; only the awardee
can use the tokens. Once it is used, the balance is cleared; thus, one
cannot accumulate the tokens to gain more advantage. All nodes will
have a fair chance at validating a block. Its creation and issuance are
also embedded into the protocol; a user’s account will be credited
after certain contributions to the network.
PoB divides all validators into a believable group and a normal
group. The believable group validate the transactions in the first
phase and the normal group sample and verify transactions in the
second phase. The chance to be elected into the believable group is
determined by the believability score, which is calculated by multiple
factors such as token balance, contributions to the community and
reviews. Believable validators are formed into smaller groups (one
validator per group) and transactions are randomly distributed to
these groups for validation, thus improving the transaction speed.
This poses a security issue if the validator node is malicious.
Thus, the normal group samples the transactions in order to detect
inconsistencies. A malicious validator is also at risk of losing their
believability (including all the tokens and reputation) if detected.
The costs of being caught should outweigh the benefits of entering the
bad transactions into the ledger. As a believable validator is unlikely
to misbehave, the single validator approach for the transactions
makes PoB very fast.

Proof of Space
Proof of Space (PoSpace) was first proposed by Dziembowski et al.
(2015). Also called Proof of Capacity (PoC), it dedicates a certain
amount of disk space in order to participate in validating a block.
It is similar to PoW as the miner needs to provide a mathematical
proof to demonstrate that the resources (computational power or
disk space) have been committed. This is implemented through the
use of hard-to-pebble graphs. The prover needs to build labelling
of a hard-to-pebble graph and commit to the labelling. To verify
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Consensus for Blockchain and Distributed Ledger Technologies 111

the commitment, the prover has to open several random locations

in the commitment. PoSpace is seen as fairer (disk space is general
purpose compared to specialised mining machines) and greener (uses
less electricity). PoSpace is also good for preventing spam and denial
of service attacks. Burstcoin and Spacemint are projects that utilise
PoSpace.

Proof of Importance
Proof of Importance (PoI) is the consensus algorithm adopted by
NEM.7 It pays out to members participating in PoI based on their
importance which depends on various factors, such as notoriety
(based on purpose-designed framework), balance and the number
of transactions made to and from that position. This “importance”
calculation aims to measure the “helpfulness” of a network member.
Similar to PoS, to be eligible to participate in PoI, a network
member needs to have a minimum stake of coins (10,000 XEM).
Importance is calculated using a specific algorithm and determines
the chance one will win the PoI reward. It aims to be a fairer system
where anyone who contributes to the network gets to be rewarded.
Due to its construct, PoI is also resistant to arbitrary manipulation,
Sybil and loop attacks.

Proof of Burn
In Proof of Burn, you “burn” your coins by sending them to an
address where they are irretrievable. In exchange, you earn a privilege
to mine on the system based on a random selection process. In most
implementations, you “burn” cryptocurrency from an alternative
chain such as Bitcoin. The more you burn, the higher the chance
of being selected to mine the next block. Over time, this probability
declines, so you will need to keep burning more coins to retain the
same chance. Although the network itself does not exhaust much
energy to run Proof of Burn, the cryptocurrencies required to be
burnt also expand resources. This method also does not address the

7
https://docs.nem.io/ja/gen-info/what-is-poi.
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112 Blockchain and Smart Contracts

fairness issue; those with money to “burn” have higher chances of

mining. Slimcoin and TGCoin (Third Generation Coin) uses Proof
of Burn.

3.3.2 Consensus for Trusted Blockchains

In trusted blockchains, all nodes are known, and thus malicious acts
can be identified. Since the nodes have been vetted before being
allowed on the network, they are generally assumed to be trusted
to validate transactions. Thus, consensus for trusted blockchains is
focused on preventing crash faults rather than Byzantine faults in
general.

Proof of Authority
In Proof of Authority (PoA), validation is done by approved accounts
called validators. The validators validate the transactions and blocks
that are recorded on the blockchain. Validators run software that
automates this process and need not constantly monitor their
computers. However, the validators do need to ensure that their
computers are not compromised or attacked. The general conditions
to approve a node as a validator are as follows:

1. It must be a verified identity that links the node to real world

identity. Ideally, this identity can be cross-checked on a publicly
available domain. Identity must be formally verified on-chain, with
a possibility to cross-check the information in a publicly available
domain.
2. It must be difficult to become a validator. This ensures that the
right to validate transactions is valuable to the validator. The
validator should view this value highly, such that it would not
risk losing validator status by acting maliciously. An example is
requiring a node to be an authorised notary in order to be a
validator.
3. There must be complete uniformity in the checks and procedures
for establishing an authority.
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Consensus for Blockchain and Distributed Ledger Technologies 113

By attaching a reputation to identity, validators are incentivised

to uphold the transaction process, as they do not wish to have their
identities attached to a negative reputation, thus losing the hard-
earned validator role. This method is centralised as there needs to
be an authority that vets and admits validator nodes. Thus, it is
usually used in private and permissioned blockchains. PoA is much
faster than PoW as no computation is required. It is used by VeChain,
POA Network and the Ethereum testnets Kovan and Rinkeby.

Proof of Reputation
Proof of Reputation (PoR) is similar to PoA; it depends on the
reputation of the participants to keep the network secure. A validator
risks financial or brand consequences if they attempt to be malicious.
Thus, the validator also needs to have a reputation important enough
such that the consequences are costly. To be admitted into the
network, a potential validator needs to pass verification and prove
their reputation. Existing validators may vote on the eligibility of the
new entrant or a weighted matrix may be used to decide. Other than
the method of choosing the validator, PoR operates like PoA once the
validators are admitted into the network. Due to its similar nature
to PoA, PoR is also more suitable for trusted and permissioned
blockchains. GoChain8 uses Proof of Reputation.

Proof of Elapsed Time

Proof of Elapsed Time (PoET) was invented in early 2016 by Intel.
It is used in permissioned blockchains to decide who gets to mine
the next block. It is based on the principle of a fair lottery system
where every node is as likely to be the winner. It relies in specialised
hardware and this cannot be adopted universally by a public network.
PoET algorithm works as follows:
• Each participating node is randomly assigned a period of time to
wait and goes to sleep for the specified period.

8
https://gochain.io/proof-of-reputation/.
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114 Blockchain and Smart Contracts

• The first node to wake up (with the shortest waiting time) gets to
mine the next block and commit it to the blockchain network.
• The same process repeats for the next block.
The PoET network consensus mechanism needs to ensure two
important factors:
• First, participating nodes must be given a waiting time that is
indeed random and not a shorter duration chosen purposely by
the participants in order to win.
• Second, the winner must complete the waiting time.
To achieve this, Intel utilises their SGX technology to execute
trusted code in a protected environment. This prevents any attempt
to alter the code and also ensures that the results are verifiable by
external parties. PoET is used by the Hyperledger Sawtooth project
which is led by Intel.

Practical Byzantine Fault Tolerance

Practical Byzantine Fault Tolerance (PBFT) was one of the first
solutions proposed for the Byzantine Generals Problem. There is a
leader node in a PBFT system, and all other nodes are backup nodes.
Every node will communicate with each other to come to agreement
on the state of the system using majority voting. For PBFT to work,
the number of malicious nodes cannot exceed one-third of the system.
There are four phases in a round of PBFT consensus:
• A request to add a transaction to the network is sent to the leader
node.
• The leader node broadcasts this to all the other nodes.
• Each node executes the request and sends a reply to the requestor.
• The requestor waits for n+1 does returning the same result, where
n is the maximum allowable number of malicious nodes.
The leader node is alternated and can be changed if certain
amount of time has lapsed or the other nodes determine that the
leader node is faulty. PBFT is usually only used in permissioned
networks as there is no incentive mechanism to prevent untrusted
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Consensus for Blockchain and Distributed Ledger Technologies 115

malicious nodes from joining the network and making up the

majority. The benefit of PBFT is that it is fast and scalable. It is
used in Hyperledger Fabric V0.6 and Zilliqa (Zilliqa, 2017).

Federated Byzantine Agreement

Federated Byzantine Agreement (FBA) is another class of solutions
to the Byzantine Generals Problem used by currencies like Stellar
and Ripple. Nodes are known and verified ahead of time. The nodes
choose who they trust, and eventually quorums of nodes emerge from
decisions made by the individual nodes making up the FBA network.
A quorum is the minimum number of nodes required for a solution to
be correct. After a quorum forms, the block is validated and included
on the blockchain. FBA uses “quorum slices”, which are subsets of
quorums that can convince specific nodes operating on the network
to agree with them. In Ripple’s FBA, transactions are grouped into
sets and are validated in four rounds starting with 50% agreement
and working up to 80% quorum in the fourth round. This ensures
that the transactions are not double spend.

RAFT
RAFT9 is named after Reliable, Replicated, Redundant, and Fault-
Tolerant. RAFT is not Byzantine fault tolerant and is usually used
in permissioned networks. It is a way to ensure each node in the
network agrees upon the same transactions. It arrives at consensus
via an elected leader. Nodes in a RAFT network can be leader or
a follower. A follower can also be a candidate in the case that the
leader becomes unavailable. The leader replicates the ledger to the
followers. The followers know that the leader exists from a heartbeat
message sent by the leader. If no heartbeat is received in a stipulated
amount of time, the follower switches to a candidate and initiates a
leader election. RAFT is used in Quorum and in later versions of
Hyperledger Fabric.

9
http://thesecretlivesofdata.com/raft/.
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116 Blockchain and Smart Contracts

3.3.3 Hybrid Blockchain Networks

Delayed Proof of Work
Delayed Proof of Work (dPoW) is a hybrid consensus method. It
utilises a secondary blockchain’s hashing power to provide additional
security for the primary blockchain. The primary blockchain can be
either a public or a permissioned blockchain.
Komodo10 makes use of dPoW by attaching itself to the Bitcoin
blockchain. A group of notary nodes add data from the primary
blockchain to the secondary blockchain. Komodo allows for either
PoS or PoW to be run on the primary blockchain and only works for
PoW secondary blockchains. To tamper with a transaction on the
primary blockchain, one must also change the data on the secondary
blockchain. Thus, Komodo can rely on the security of the larger
Bitcoin blockchain to keep its data immutable.
There are two types of nodes within the Komodo dPoW system,
notary nodes and normal nodes. Sixty four notary nodes notarise
and add confirmed blocks from the primary dPoW blockchain to the
attached secondary blockchain. Notary nodes are elected by dPoW
blockchain stakeholders. The notarisation process requires a majority
(33 nodes) to sign the transaction. Notary nodes do this in a round-
robin fashion, reducing the competition for rewards. Normal nodes
partake in the usual consensus on the primary blockchain such as
PoS or PoW. If the secondary blockchain network goes down, the
primary network can go on as usual without the additional security
of the attached blockchain.
This concept of piggybacking on a stronger network allows for
increased security without high-energy usage. It also allows for chains
of blockchain to be formed, for example another blockchain network
can attach itself to Komodo which is attached to Bitcoin. This allows
the Bitcoin blockchain to value add to other dPoS blockchains. It also

10
https://komodoplatform.com/security-delayed-proof-of-work-dpow/.
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Consensus for Blockchain and Distributed Ledger Technologies 117

creates incentives for other networks to support larger networks like

Bitcoin without being entirely reliant on its functionality.

Directed Acyclic Graphs

Directed Acyclic Graphs (DAGs) are generalised forms of blockchain
and can be applied to both trusted and trustless networks. The
DAG structure allows transactions to be added in a parallel fashion,
making it highly scalable; see Figure 3.5 for an example. In most
blockchain systems we have looked at with a linear structure, blocks
are added one by one to the blockchain. This makes blockchains
inherently slow. In DAGs, each block or transaction confirms a
number of previous blocks. Although deemed be the next-generation
blockchain structure, one of the main issues of DAGs is that smart
contracts are usually implemented via oracles and not be directly
deployed on chain.
There are a number of variations which depend on the algorithm
for choosing which previous blocks to verify, the ordering of transac-
tions and how transaction finality is reached. We introduce three such
algorithms below. Other consensus using DAG structure includes
Holochain, Block-Lattice, ByteBall and Mokka.

Figure 3.5: Example of directed acyclic graph network.

Note: Arrows are pointing from parent to child.
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118 Blockchain and Smart Contracts

Tangle
Tangle11 is the DAG consensus algorithm used by IOTA.12 Tangle
adopts a pay-it-forward type of consensus. In order to send a
transaction, one needs to validate two previous transactions. As more
transactions are added to the network, the validity of the transactions
is strengthened. Technically, if one has the ability to generate one-
third of the transactions on the network, it would be able to convince
the rest of the network that its invalid transactions are valid. Thus,
transaction volume needs to be large enough for it to be infeasible
to do so. IOTA has implemented a centralised node called “The
Coordinator” to double check all of the network’s transactions and
will remove it once the network is large enough.

Hashgraph
Hashgraph is a gossip protocol consensus developed by Baird (2016).
Known transactions are shared with other nodes at random such
that all transactions are eventually gossiped to every node. Hedera
Hashgraph13 is a public blockchain network that combines the hash-
graph gossip protocol with a Proof-of-Stake consensus and promises
a transaction rate of 10,000 transactions per second. Hashgraph
consensus protocol has also been implemented in permissioned
distributed ledgers.

SPECTRE
Serialisation of Proof-of-work Events: Confirming Transactions via
Recursive Elections or SPECTRE (Zohar, 2016) is a proposal to
scale Bitcoin that combines PoW and DAGs. Each block mined
in SPECTRE points to multiple parents such that the network
can support multiple blocks at the same time. SPECTRE is not
implemented yet in reality, but can be an interesting solution to
scaling cryptocurrency networks.

11
https://blog.iota.org/the-tangle-an-illustrated-introduction-4d5eae6fe8d4.
12
https://www.iota.org/.
13
https://www.hedera.com/.
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Consensus for Blockchain and Distributed Ledger Technologies 119

3.4 Conclusion
Consensus algorithms are an important part of ensuring consistency
and accuracy on a blockchain or distributed ledger. Developing an
understanding of how the types of consensus algorithms work would
give us an appreciation of blockchain-based applications, assets and
investments, and allow us to make informed decisions. Ultimately,
the choice of consensus depends on what the network implementer
wants to achieve. It could be for a decentralised public system which
needs to be self-governing or an enterprise consortium blockchain
which needs to handle sensitive transactions.
The area of consensus algorithms is still evolving as we learn
more about how network participants react to different incentives
(especially for cryptocurrencies). With a variety of use cases emerging
for blockchain, we would expect as much variety in the type of
consensus used. With the multitude of blockchain solutions, any
blockchain network may also be required to communicate with
several others; interoperability will become a key consideration.

References
Baird, L. (2016). The swirlds hashgraph consensus algorithm: Fair, fast, byzantine
fault tolerance. Swirlds, Inc. Technical Report SWIRLDS-TR-2016, 1.
Dziembowski, S., Faust, S., Kolmogorov, V., and Pietrzak, K. (2015). Proofs
of space. In Annual Cryptology Conference (pp. 585–605). Springer, Berlin,
Heidelberg.
Lamport, L., Shostak, R., and Pease, M. (2019). The Byzantine generals problem.
In Concurrency: The Works of Leslie Lamport (pp. 203–226).
Patel, R. (2020). Byzantine Fault Tolerance (BFT) and its significance
in Blockchain world. HCLTech. Retrieved from https://www.hcltech.
com/blogs/byzantine-fault-tolerance-bft-and-its-significance-blockchain-wor
ld#:∼:text=Byzantine%20fault%20tolerance%20is%2050,as%20network%20
latency%20approaches%20infinity.
Zilliqa (2017). The Zilliqa Design Story Piece by Piece: Part 2 (Consensus
Protocol). Retrieved from https://blog.zilliqa.com/the-zilliqa-design-story-
piece-by-piece-part-2-consensus-protocol-e38f6bf566e3.
Zohar, A. (2016). SPECTRE: Serialization of Proof-of-Work Events, Confirming
Transactions via Recursive Elections. Retrieved from https://medium.com/
@avivzohar/the-spectre-protocol-7dbbebb707b5.
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Chapter 4

Token Economics and Valuation

4.1 Introduction
DeFi, or Decentralised Finance, has been viewed as the future of
finance. Bitcoin and the underlying blockchain technology have made
a decentralised, distributed and open system feasible. Bitcoin proto-
col, the very first form of crypto-token network with mass adoption,
has provided a potential solution to the lack of trust problem in
the traditional and centralised business world. The token economy
is an alternative to the centralised third-party trust economy. The
underlying financial instruments that drive the decentralised token
economy are crypto-tokens. What exactly is a crypto-token, and what
drives the value of these crypto-tokens?
Digital assets, currencies or tokens that use cryptography tech-
nology are called crypto-tokens. Cryptocurrency is a form of crypto-
token that possesses the monetary circulation property and value
measurement function. They can be used as a payment tool, just
like a currency. Other crypto-tokens without such features are called
non-currencies or non-payment tokens. A crypto-token is not only a
digitised representation of an object but it is also a cryptography-
generated trust carrier formed with consensus by a group of par-
ticipants in the peer-to-peer network. Goods and services, time and
anything of value can be tokenised. The tokenised objects or tokens
can be easily traded, and the value increases with the ability to
exchange for other objects with value.

121
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122 Blockchain and Smart Contracts

Figure 4.1: Key elements of a successful token economy.

Token economy refers to an innovative decentralised network and

system incentivised by the use of crypto-tokens. It was made possible
with the emergence of technology such as blockchain, big data, AI,
cloud and IoT. Tokens earned are used to exchange for goods or
services or certain rights and entitlements. Token economics has to do
with the study of human and system behaviour that reinforces good
behaviour and reduces bad behaviour so that people will pursue more
good behaviour and avoid undesirable behaviour autonomously — in
a peer-to-peer decentralised system.
For a token economy to be effective, three elements are nec-
essary: tokens to be used as reinforcers to exchange for other
reinforcers, back-up reinforcers that act as rewards and specified
target behaviours1 (see Figure 4.1). In particular, a token is digital
or virtual. It may have no intrinsic value on its own and when
it is independent of the network or ecosystem. But, once it can
be exchanged for other material reinforcers, services or privileges
(various forms of back-up reinforcers that act as rewards), the value
is released and can be realised. So, the tokens earned when people
exhibit good behaviours can have a positive effect in encouraging
good behaviours within the network. And as an ecosystem, the

1
https://en.wikipedia.org/wiki/Token economy.
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Token Economics and Valuation 123

Figure 4.2: Token economics introduction.

alignment of interest further enhances the value of those tokens

through the network effect of crowdsourcing resources, wisdom,
contribution and momentum. The social scalability impact of a trust-
distributed interest-aligned network of incentivised agents driven by
tokens, and their value, increases as rewards to form a consensus that
fuels further growth.
The success of a token economy rests heavily on the design
thinking behind the token economy. The signalling of targeted
behaviour needs to be specific and the reward needs to be transparent
and clearly defined. Clear and transparent rules of (i) what to do to
earn a token; (ii) how many tokens are earned; or (iii) how to redeem
rewards (or back-up reinforcers) also should be specified beyond
doubt2 for a token economy to function as intended.
Figure 4.2 gives one definition of token economics. Token economy
is the result of further advancement of a token based on blockchain
technology (Xu, 2019). Token can be a symbol of value or right.
As the symbol of value, the token is the core of the entire eco-
nomic model, while the token economy considers the creation and
distribution of the value, the consumption and the circulation. As
a symbol of right, a token represents a kind of incentive, while the
token economy considers what type of organisation is suitable, how to
create a compelling economics model to embrace partners, suppliers
or even competitors and contribute to the whole ecosystem, and what
the changes to the governance model are.

2
https://www.wisegeek.com/what-is-a-token-economy.htm.
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124 Blockchain and Smart Contracts

The logic underlying token economy is entirely different from that

of current tech giants. For Amazon, Google and Facebook, the main
operational logic is driven by user traffic and precision of matching
with big data. We will discuss the details of several relevant types of
economics in the following section.

4.2 Comparison of Token Economy and Others

The prevalence of emerging technologies and digitalisation has
witnessed many other new terms such as the (i) digital economy;
(ii) Internet economy; (iii) web economy; and (iv) sharing economy.
How are they different from the token economy? Let us focus on the
digital and sharing economies.
As summarised in the Figure 4.3, the digital economy is playing
an increasingly important role in the business world, and people
are getting familiar with it. This probably resulted from substantial
development that has been made over the past few decades in
all three main components of the digital economy as identified
by Mesenbourg (2001): (i) e-business infrastructure including the

Figure 4.3: Digital economy.

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Token Economics and Valuation 125

network, human capital, hardware and software; (ii) e-business that

refers to how businesses are conducted online; and (iii) e-commerce.
In fact, in this era of digitalisation, the differences between the
traditional economy and the digital economy are getting unclear as
many businesses will inevitably involve the usage of the network.
In addition to the digital economy, the term “sharing economy”
is becoming popular, especially with the thriving of companies such
as Uber and Airbnb that offer transportation and accommodation
solutions by utilising the unused part by sharing. It refers to the
economic model where businesses and transactions are conducted
in a peer-to-peer way (see Figure 4.4). Such operations include
the activity of acquiring, providing or sharing access to goods and
services.
However, over recent years, many argue that sharing economy
businesses are not so open and inclusive as the name may suggest
due to the centralised nature. For example, companies like Uber
and Airbnb, although not service providers themselves, control all
the transaction and feedback data of all uses, including both the

Figure 4.4: Sharing economy.

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126 Blockchain and Smart Contracts

buyers (passengers and guests) and service providers (drivers and

hosts). Furthermore, these companies remain in charge of what
data to display and make available on the site. The users do
not have any decision power over that data, as long as they
continue to use the platforms, which will make users dependent
on the intermediary and limit both options and profits for users
(Trinh, 2018).
Fortunately, the invention of Bitcoin and blockchain technology
brings the inspiration of exchange of value in a decentralised
manner, solving many of the pain points. Many of the issues in
the sharing economy do not exist for the token economy. The idea
of decentralisation is achievable, and users can control what to
share and what not to share without the need for a third party
acting as the intermediary or central authority to validate the peer-
to-peer transactions. The similarities and differences between digital
economy, sharing economy and token economy are shown in the
Figure 4.5 (Liu, 2019).

Digital economy Sharing economy Token economy

Processed
Digitalised Digitalised Digitalised
information

Platform Centralised Centralised Decentralised

Business model B2P2C C2P2C P2P

Trusted authority Yes Yes No

Information
No Some Yes
transparency

Verification cost Some Some Very low

Manual operation Some Some Streamlined

Figure 4.5: Comparison between different economies.

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Token Economics and Valuation 127

4.3 Tokens and Design Thinking

A crucial component of token economics, just as the name suggested,
is token. Token economics aims to address various problems related
to tokens, such as its issuance, supply, demand, validation, usage,
behaviour and how these matters affect other things in the ecosystem.
It studies both broader topics such as the entire ecosystem and the
functions and more specific issues such as the technical parameters
and individuals. In general, digital tokens would have the functions
as shown in Figure 4.6.
When designing a token economy, functions of the tokens need to
be thought about thoroughly so that the ecosystem can function
seamlessly and can sustain. In a successful token economy, well-
developed tokens have the features as shown in Figure 4.7.
Besides the roles of the tokens, the future trend of the token and
token values is essential for sustainability. If the tokens have limited
use cases, such as (i) unable to be traded freely or in a short period,
(ii) susceptible to inflation (issuing too much or too fast), (iii) do not
have long-term worth or (iv) unable to meet the legal and technical
expectations, users will not be motivated to earn and use tokens,
thus making the whole ecosystem unreliable.
The price volatility and stabilisation mechanism of a token are
also important matters for any economies, so designers need to

Type Detail

Transactional Transactional tokens provide a form of payment

Utility Utility tokens facilitate transactions, and sometimes mean the ability
to use the platform itself
Operation Token is a determinant of important decisions related to operations
in the ecosystem
Profit Token holders get a portion of revenues or profits, like shares of a
company in some sense
Asset-backed Asset-backed tokens are linked to real-world or virtual assets such
as gold, fiat currency or property

Figure 4.6: Functions of digital tokens.

Source: Lee and Teo (2020), Smith + Crown, and authors.
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128 Blockchain and Smart Contracts

Figure 4.7: Features of tokens.

Source: Hlebiv (2018) and authors.

adopt appropriate monetary policies and have a clear identification

of the token’s role. In a decentralised economy, we need a consensus
algorithm to determine how new tokens are created. An increase in
the token supply will cause inflation or the price to decrease. Different
measures are used to prevent such occurrences. For example, many
cryptocurrencies, bitcoin included, set a limit supply of tokens
(21 million for bitcoin). The maximum number of tokens that
can ever be created in the ecosystem is fixed a priori to prevent
“overprinting” or “inflation”.
Token economics is more than just creating the tokens. But, to
create an entire ecosystem, the designers need to plan for the future
and ensure users are motivated to utilise the platform, with the aid
of tokens.
First of all, network effects should be considered. The term refers
to the phenomenon that is common in economics and business that
growth in the number of users will increase the value of the goods
or services. So, in a well-designed token economy, due to its open,
peer-to-peer and decentralised nature, users should benefit from
the network effects so that the value of the products, services or
the platforms can contribute to further growth with more people
participating in the ecosystem. Figure 4.8 describes the two types of
network effects and two strategies to increase the network effects.
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Token Economics and Valuation 129

Figure 4.8: Types of network effects.

Source: Tönnissen, Beinke and Teuteberg (2020) and authors.

Figure 4.9: Key elements of token economics.

Careful planning of the tokens used in the system is crucial.

Things that may affect the token’s value, such as the purpose, the
supply and demand, and distribution, have significant impacts on
the economy (see Figure 4.9). Developers should design the tokens
in such a way that the tokens are worth holding in the foreseeable
future and people value it not only for speculative reasons but also
for the utilities or benefits in the network or system.
Given the various types and functions of a token, we summarise
them into two types of token economy architecture: dual and simple.
The former uses two tokens of the same type or the different types,
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130 Blockchain and Smart Contracts

and the latter uses only one token. Although a simple architecture
can be successful and have various use cases, there are concerns.
In the case of a single token, if people use it to exchange goods
or services in the platform or pay the transaction fees so that they
can access the platform, the value of the tokens will increase. On
one hand, it is desirable for the ecosystem because people would
have the incentive to join the network, own the tokens and pursue
good behaviours. On the other hand, some token holders, such as
investors and speculators who buy or earn the token, not for its utility
or function but the potential price increase, may sell the tokens in
exchange for profits. This speculative behaviour will cause the price
of tokens to drop, thus increasing the price volatility and destabilising
the financial utility of the token economy.
Therefore, the dual architecture offers a solution to the problem
where two tokens with different roles are introduced in the network.
This is to segregate the tokens into different functions and mitigate
the effect on the value of tokens. Under this scheme, two tokens
are performing different tasks. One example is the payment/utility
token that acts as a transaction fee to facilitate transactions and
gain platform access or resembles “currencies” that can be exchanged
for goods or services. Another token may function like security for
the store of value or collateral that can be exchanged with other
tokens (Brouwer, 2018). There is no reason to stop at two, and design
thinking is the key to solving whatever problems at hand. In the end,
the final design must address the pain points to have value acting for
payment, utility, security or other functions.
Figure 4.10 shows the main factors to consider when making
architecture decisions.
Successful token economics should incentivise not only desirable
behaviour but also be able to stabilise the network operation. In
contrast, inappropriate token economics may lead to a death spiral if
there is a perceived loss of value in the token economy. The following
shows both good and bad examples of token economics.

4.3.1 Good and Bad Examples

Let us start with the very first decentralised cryptocurrency that
still dominates the market today — Bitcoin. It is proven to be
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Token Economics and Valuation 131

Figure 4.10: Key factors affecting the architecture of token economy.

Source: Hlebiv (2018).

a secure and thriving ecosystem that solves the double-spending

problem while incentivising nodes to participate in the network
without the need for a third party to validate the transactions.
Instead, transaction verification is done by nodes. Miners validate
transactions following the consensus protocol, and get rewards for
the work — the reward of a new block generated plus the transaction
fees (all paid in the token, bitcoin). Consequently, more miners will
join the network for the return, which makes the network more secure
and transactions faster.
Some nodes have more duties, such as miners who validate
the transactions and mine new blocks; some participate in the
network with lighter duties, such as users that just use bitcoins
for transaction purposes. As a result of increasing miners and the
associated lower costs, faster transactions and higher security in the
network, the ecosystem will attract more and more users with light
duties, and more people will value the Bitcoin network and its token,
bitcoin. Therefore, the design makes it a win–win–win strategy for
all parties: miners get a reward, investors obtain investment returns
and developers achieve fame. The network becomes safer and more
efficient, while the value of tokens increases. So, there is no conflict of
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132 Blockchain and Smart Contracts

interest among these stakeholders and users, which is a crucial factor

that ensures steady growth of the token’s value.
The consensus protocol and algorithm in practice involve com-
plicated designs, and there are many additional measures taken to
ensure the efficiency of the Bitcoin network. We will not go into
too much detail, but we hope to give a good sense of the issues in
designing a good token economy. These issues determine success and
sustainability. A holistic approach is crucial before any new launch
because faulty design leads to undesirable results when implemented.
FCoin is one of the most well-known examples of bad token design.
FCoin, a cryptocurrency exchange, was launched in May 2018 and
reached a peak daily trading volume of over 10 billion in the following
month. Its value was much higher than any of the cryptocurrency
exchanges at that time. However, soon after the surge, the trading
volume dropped sharply. The exchange eventually went into default
in early 2020 with all the unissued FT tokens and those held by the
team destroyed and burnt, leaving millions’ worth of bitcoins unpaid
to its users (Wan, 2020).
The main reason for the failure appears to be the fundamental
flaws in its token economics design. “Trans-Fee Mining” is a new
model that paid out 80% of the platform’s revenue. Trading fees paid
by traders and collected by FCoin were distributed to FT holders
as dividends (He, 2018). The reward served as a great incentive and
seemed appealing at first. But, the value of the coin depended mainly
on the trading volume and paying dividends naturally led to a price
drop, which in return triggered selling activities of the tokens. The
speed of cashing out signified that the token would be losing value
and unleashed a vicious cycle. New FT tokens were being mined when
these transactions took place, causing the price of the tokens to drop
further (consider the supply-and-demand relationship). The value
of the token was not inflation proof and lacked price appreciation
potential.
A positive correlation between the good business volume of
the exchange and the supply of new coins is a bad design in
this case with no cap. The unlimited supply of new coins as a
reward rapidly increases when business is good. This new supply,
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Token Economics and Valuation 133

in turn, increases the selling volume with no corresponding increase

in demand from expectations of price appreciation. Once the selling
pressure accumulates, the lower price expectations trigger an even
higher selling volume. This volume creates even more supply of new
coins and, therefore, more selling pressure. The end story is written
even before the launch of the coins. Design fault is a significant reason
why many ICOs failed. What makes good token economics? It has
to be good design thinking that increases the value of the coin over
time. The right question is as follows — what designs lead to good
valuation? The answer cannot be explained entirely by traditional
valuation methods.

4.4 Token Valuation

4.4.1 Conventional Valuation Methods
The following are some of the most commonly used conventional
valuation methods for stocks and companies.
a. Discounted cash flow model (DCF)
The discounted cash flow valuation is to assume that the present
value of the company can be calculated as the sum of all the future
cash flows. In formula, it will be as follows:
t=n
 CF t
Value of firm =
t=1
(1 + W ACC)t
where n is the life of the asset, CF t is the cash flow in period t and
WACC represents the discount rate used in the model, which is the
firm’s weighted average cost of capital. This idea can be used for
token valuation if the income flow is in another liquid token (e.g.,
bitcoin or ether) rather than in fiat currencies. However, we can see
that if the design leads to a higher token income stream, it does
not necessarily mean that the valuation will be higher. The value of
FCoin measured in bitcoin or fiat may drop.
b. Dividend discount model (DDM)
While DCF uses future cash flow to estimate the value of a company,
the future dividend is used in DDM. So, the value of a company’s
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134 Blockchain and Smart Contracts

stocks is assumed to be the present value of the sum of all future

dividends paid to its shareholders. Again, FCoin points out the
shortcoming of applying this to token valuation.

c. Relative valuation methods

Individual financial ratios are commonly used methods but mostly
used for comparison. In relative valuation methods, the value of a
company is determined by comparing it to similar or peer companies.
The most commonly used ratios include P/E (Price-to-Earnings) and
P/B (Price-to-Book). The value of a firm can then be calculated
using earnings (book value) multiplied by its peer companies’ or
industry average P/E (P/B) ratio, which is deemed as a more
accurate representation of the firm’s profits and value. This market
comparison method may be used as one that can compare a token
with another. However, as in stocks and shares, these comparative or
ranking measures are a function of the entire crypto market. If one
is in the crypto world and one is willing to ignore the fiat market,
then the method makes sense. That also means that crypto is an
alternative class of currencies. If cryptocurrencies or tokens are used
frequently for exchange of value, then this method will make some
sense. If we think far enough and hold the belief that we are heading
towards a barter trade token economics, then it all makes sense. If
the token economy has some impact and accounts for a 10–20% of
the global economy, these individual financial ratios and comparative
valuation methods may make some sense.
However, almost all these popular conventional valuation meth-
ods are not applicable to value cryptocurrencies or blockchain
startups at this moment. Many of them do not generate predictable
future cash flows (most of them do not generate any cash flows or
positive earnings at all as they are still at a very early stage of
development), nor do they have any accounting data (or at least
accounting data are not publicly available for these fintech startups).
The lack of underlying assets of cryptocurrencies makes the valuation
even more difficult. We need to remind ourselves that we are closer
to valuing intellectual property and patents than a legal entity such
as security, bond or real estate. Even though it is a piece of software
with a business model without a legal entity, it is more than an IP or
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Token Economics and Valuation 135

patent. There is this network effect and the underlying philosophy of

tokenised collaborative cooperatives in an autonomous sense. A token
is a trusted carrier formed by consensus with little barrier for others
to join the network to add more value. The emphasis on strategic
importance may be an essential dimension to ponder, and therefore
it is worthwhile to focus on strategic valuation.

4.4.2 Valuation for Cryptocurrencies

The characteristics of crypto-tokens and the token ecosystem should
be considered to analyse the value of a token or a fintech startup.
The value of a token and its function in the entire ecosystem play
important roles in the value of cryptocurrencies (Cong et al., 2020).
Three main components to value fintech companies are shown in
Figure 4.11 (Jain, 2019). The value of a fintech business depends
on (i) the nature of the problem that it solves, which will affect
the demand of the company’s products or services; (ii) the potential
increase of scale (for example, people from all around the world can
buy and hold the cryptocurrencies or tokens); and (iii) the lower cost
(e.g., decentralised network). These unique factors of fintech startups
call for new valuation methods.
Figure 4.12 summarises the following potentially feasible meth-
ods for fintech startups. Relative methods do not work, but the
more flexible scorecard method may be applied using customised
parameters to compare the company with its peer or a benchmark
company. Other approaches to assess companies at a relatively early
stage include the Berkus method, a quick and easy way to evaluate

Figure 4.11: Components of fintech valuation.

Source: Jain (2019), https://www.toptal.com/finance/valuation/how-to-value-a
-fintech-startup.
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136 Blockchain and Smart Contracts

Figure 4.12: Possible methods to value fintech startups.

Source: Jain (2019) and the authors.

a startup, the risk factor summation method, the cost to duplicate

method and the venture capital method. While some of the examples
are using bitcoin for easy expositions, we can easily substitute the
word bitcoin with token.
a. PESTLE
The PESTLE model proposed by Aguilar (1967) is a possible method
for blockchain startups. It stands for political, economic, social,
technology, legal and environmental factors and details are shown
in Figure 4.13. These are the points which business owners must first
consider before establishing their company.
Yuneline (2019)3 highlighted the importance of economics, social
and legal factors for cryptocurrency. Each of them affects the
cryptocurrency’s role as a medium of exchange, society’s acceptance
and legal restrictions in respective countries. What stood out in
Yuneline (2019) was his attempt to discuss Sharia Law’s acceptance
of cryptocurrency as a form of money. His example carries widespread
social implications for cryptocurrency as it affects whether members

3
https://www.emerald.com/insight/content/doi/10.1108/JABES-12-2018-0107
/full/html.
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Token Economics and Valuation 137

Figure 4.13: PESTEL model.

of the Islamic faith will accept cryptocurrencies as forms of payment.

Earlier in April, the US Congressional Research Service (2020)4 had
surfaced economics and legal issues raised by the 116th Congress.
These include the economic role of cryptocurrency as a medium
of exchange and store of value. Besides, legal aspects concerning
money laundering, risks and cross-border transactions are raised with
relevant bills passed by Congress to regulate cryptocurrencies. In
essence, it is essential to note that different PESTLE forces affect
cryptocurrencies differently for different countries. There is no fixed
and fast rule, but PESTLE is extremely important in determining the
ability to grow and sustain for crypto markets, or even to exist and
operate. We can only view it from a strategic viewpoint for valuation.
b. Store of Value
Under the Store of Value (SOV) approach, the value of a digital asset
can be determined by its ability to act as SOV, which represents
the potential or ability to be valuable while maintaining purchasing
power over a prolonged period (Yuneline, 2019). An everyday use
case of this theory is gold. It is widely accepted as a form of payment

4
https://fas.org/sgp/crs/misc/R45427.pdf.
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138 Blockchain and Smart Contracts

with a relatively stable level of value over the years. The value of
gold may be due to gold’s naturally limited supply, which provides
gold with the ability to have intrinsic value that does not diminish
over time.
Cryptocurrencies often have finite supplies by design, such as in
the case of Bitcoin, where computer codes predetermined the upper
boundary of 21 million bitcoins. Hence, in terms of capping of supply,
Bitcoin may be akin to gold and it probably fulfils SOV in theory.
It was not surprising that bitcoin was a follow-through from bitgold
proposed by Nick Szabo (2005).5
The fair value of cryptocurrencies could be derived by calculating
the fair value of the price of the currency with SOV, by assuming that
the cryptocurrency would ultimately replace gold as the go-to store
of value for investors (Leilacher, 2019). For example, the value of
bitcoin could be derived by factoring the value of global gold bullion
and the ultimate number of bitcoins in circulation.
Total Global Gold Value
Value of bitcoin =
Total number of Bitcoin
$8 trillion
$380, 000 per bitcoin =
21 million BTC
There is no reason why cryptocurrencies cannot replace a portion of
the commodity market. In that case, one can add to the denominator
by the number of potential cryptocurrencies that will be liquid as
well as just taking a percentage of the commodity market that will
be replaced.
Total Global Commodity Value
Value of a token =
Total number of liquid tokens
$20 trillion ∗ 0.2
$x per token =
y billion tokens

c. TAM SAM SOM

The TAM, SAM and SOM analysis (shown in Figure 4.14) is a
method used to better understand a business’s relationship with the

5
https://nakamotoinstitute.org/bit-gold/.
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Token Economics and Valuation 139

• Total Addressable Market (TAM) represents

the total possible demand for a product
TAM
• Serviceable Addressable Market (SAM) represents
the portion of the TAM that a product or service
SAM could attain. This typically represents a market
filtered by geography or demographics

• Serviceable Obtainable Market (SOM) represents

SOM the portion of the SAM that a product or service
could directly acquire over the a shorter-period of
time due to the practical limitations of the business

Figure 4.14: TAM, SAM, SOM model.

market (Denault, 2018). The usual way of deriving the values of

this model is through a top-down market approach, where one starts
at the top of a macro-set and logically filters the data to arrive at
an intended market subset (Graham, 2017). Ultimately, deriving the
values for a business’s TAM, SAM and SOM would demonstrate both
a solid understanding of the market as well as one’s comprehension
of the business limitations. This method may apply to digital assets
and blockchain startups that have a revenue model. Again, business
judgement is key to this strategic valuation method.

d. Token velocity
Wang (2014) proposes the token velocity theory to derive a value of
Bitcoins according to the fundamental macroeconomic equation of
exchange: M V = P Q. Specifically, P (price) was set to 1, resulting
in M being the total market capitalisation of the crypto asset, while
Q was defined as the amount of value that is transferred across the
network. V remains as the velocity. Substituting M by the market
capitalisation gives us the following equation:

Q
pb =
nb V

where M = nb pb , where nb = number of coins circulating, pb = price

of a coin.
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140 Blockchain and Smart Contracts

Subsequently, Wang (2014) further assumes that V can be

expressed as a linear function of Q,6 which gives us the following
equation:
1
pb =
nb ∗ lt ∗ vt
where lt represents the likelihood of bitcoin being transacted and vt
is the velocity of bitcoins being spent.
The velocity of transaction and the total number of bitcoins
circulating remain constant. This leaves only the likelihood of
transaction, lt , being inversely proportional to the price of bitcoin, pb .
Following this model, we are now able to model the price of bitcoin
by accessing the likelihood of bitcoin transaction — the higher the
likelihood of bitcoin being transacted, the lower its price.
e. INET model
The INET model was developed by Burniske (2017) to illustrate the
price of a fictional cryptocurrency asset, INET, using the J-curve.
The J-curve is commonly used in economics to illustrate different
cash flows over time. However, in the cryptocurrency context, a
J-curve represents the change in two forms of single cryptocurrency
asset value: The Current Utility Value (CUV) and the Discounted
Expected Utility value (DEUV). The CUV represents the value of the
cryptocurrency asset that is driven by utility and usage today, while
the DEUV represents the present value of an expected utility value
that happens in the future (Lannquist, 2018). We derive the DEUV
by dividing expected utility value in future, with an appropriate
discount rate, akin to our PV formula.

6
Wang (2014) assumed that velocity is proportional to the amount of bitcoins
that are saved and transacted, the likelihood of bitcoin saved being ls and the
likelihood of bitcoin transacted being lt . As such, the velocity for bitcoins saved
and spent is expressed as vs and vt , respectively. Another assumption made by
Wang (2014) was that the velocity of bitcoin transacted is significantly larger than
the velocity of bitcoin saved, vt vs , resulting in the value of vs being equal to 0.
The final assumption then states that velocity can be expressed as a linear
function of Q : V = lt ∗vt ∗ Q.
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Token Economics and Valuation 141

As time advances, CUV and DEUV will take turns to drive the
price of cryptocurrency. This process works in this manner. Initially,
during the launch of the cryptocurrency asset, anticipation drives up
DEUV, causing it to be higher in relative percentage terms to CUV.
As time progresses, the initial anticipation dies down, while the cryp-
tocurrency asset delivers its true value. During this time, CUV will
be in a higher relative percentage to DEUV. Eventually, the market
cycle would be reached where both the CUV and the DEUV are
expanding. This process allows us to model and estimate the value of
a cryptocurrency asset to that of its maturity in a product life cycle.
It is worth highlighting that various factors, such as the velocity,
size of asset base, discount rate, adoption rate and supply of tokens,
are key considerations when factoring in the model for the utility
token INET (Burniske, 2017). As such, previous critics against
velocity still stand for the INET model.
f. Network value to transaction (NVT) ratio
The NVT is a valuation metric that attempts to study the rela-
tionship between the price of a cryptocurrency and its fundamentals
(Leilacher, 2019). NVT is very similar to the Price Earning (P/E)
ratio, which is typically used in traditional finance. The P/E ratio
provides a measuring stick for comparing if a stock is over or
undervalued at any point in time (Elmerraji, 2020), by comparing
the valuation of a company to their actual earnings.
While cryptocurrency does not have any earnings (some do have
yields from mining or staking) for measurement, one could argue
that a suitable fundamental proxy could be derived by assessing
the transaction volume of the particular cryptocurrency (Kalichkin,
2018). The principle behind NVT operates similarly as outlined in
the following formula:
network value
NVT =
daily transaction volume
Therefore, a high NVT for a cryptocurrency would suggest that
the cryptocurrency might be overvalued, hinting that the network
could be entering a bubble, or simply that the network is experiencing
a high growth phase.
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142 Blockchain and Smart Contracts

g. Metcalfe’s Law

Metcalfe’s Law highlights that each user in a network can com-

municate with (n − 1) users, which would theoretically form a
network of connectivity. This network of connectivity is subsequently
found by various researchers to have the potential to evaluate
cryptocurrencies. Zhang et al. (2015) find empirical evidence that
supports Metcalfe’s Law using data from Tencent and Facebook.
Alabi (2017) also concludes that Metcalfe’s Law modelled Bitcoin,
Ethereum and Dash reasonably well.
Under the network effect theory, the value of a network is the
square of the users’ base with respect to Metcalfe’s Law. In other
words, as shown in Figure 4.15, the value of a digital currency
network can be calculated as the market capitalisation divided
by the square number of active daily users. Hence, under such
circumstances, cryptocurrencies sharing similar comparables could
still stand to thrive together within the cryptocurrency market.
Metcalfe’s Law in describing connectivity among users can be
better explained with a simple example: If there are three students
in a room, there could be a total of 2 + 1 = 3 connections, and if one
imagines a room with 100 students, there could be a total of 4,950
different connections. The example demonstrates the phenomenon of
a network’s value growing in a nonlinear fashion as more people join

Figure 4.15: MET ratio.

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Token Economics and Valuation 143

the network. As such, the value of a network of size n would be equal

to
n(n − 1)
2
Metcalfe’s Law was initially intended to identify the break-even
n, where the total network costs are considered with proportionality
factor (A), which might decline over time. Therefore, the equation
could be best represented as
n(n − 1)
c·n=M =A
2

h. Economics and finance of cryptocurrencies

Lee and Teo (2020) propose the mining model that affects the value
of cryptocurrencies and discuss a few other factors that affect the
economics and finance of cryptocurrencies. In distributed networks,
a consensus protocol acts as the incentive mechanisms to ensure
a well-functioning token economy. It also controls the creation of
new tokens, or the supply of new coins, and thus has a significant
impact on the price of the cryptocurrencies. As the consensus
protocol is predetermined as part of the programming codes, it is
difficult to change and usually has set a cap for the maximum
supply, so it creates scarcity of cryptocurrencies. Therefore, the
new tokens created are just one factor of the market supply. The
scarcity issue will encourage users to hold more coins and drive the
price up. Also, the price volatility driven by speculative investors
in the cryptocurrency market and the fragmented cryptocurrency
exchange industry make the arbitrage and speculation phenomenon
even worse.
On the demand side, when people have low trust in the financial
system, such as the 2018 Venezuela hyperinflation, the demand of
cryptocurrencies increases. Other crypto-specific factors, such as the
utility of the token and cost of production, affect cryptocurrency’s
demand as well. Hayes (2016) and Hayes (2019) document that the
marginal cost of production plays an essential role in explaining
prices of Bitcoin. Thus, we may expect that during periods of excess
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144 Blockchain and Smart Contracts

demand (or when price bubbles appear), either the market price
will fall and/or the mining difficulty will increase to resolve the
discrepancy (Lee and Teo, 2020).
From a broader scale, the popularity of cryptocurrencies (or
investor attention), cryptocurrency market sentiment and factors
related to the associated blockchain networks such as incentives,
social scalability, consensus, utility and governance influence the
price of the tokens. There is no doubt that token valuation methods
will evolve with new designs beyond the income from mining, staking,
hedging against loss of trust, option for future payments, etc. Many
of the modified quantitative ideas from traditional finance will be
applicable with some ingenious twist and understanding of the
philosophy underlying the blockchain community. Below are some
qualitative methods that are compatible with scoring and ranking
valuation methods.

4.4.3 More Considerations for Token Valuation

On top of the aforementioned valuation methods, below are some
key conceptual frameworks that are also important when valuing the
tokens and token economies. Quantitative methods can be developed
along those ideas mentioned here.
a. 4Es
The 4Es refer to Economies of Scale, Economies of Scope, Economies
of Integration and Economies of Convergence, which are four impor-
tant aspects when considering the value of fintech companies (see
Figure 4.16). It may be very different from valuing services and
products provided by fintech companies and traditional companies
as the tokens and products are digital, which have entirely differ-
ent cost and production relationships. In particular, the marginal
costs of an additional unit of products are minute. The fourth E
(Economies of Convergence) becomes vital as the convergence of
technology brings a convergence of profit and social objectives, which
is also why the leapfrog economies may have mass adoption before
others.
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Token Economics and Valuation 145

Figure 4.16: 4Es.

b. 3Cs
The 3Cs describe characteristics of an environment (geological or
institutional) that are ideal nurturing grounds for successful fintech
companies, and by extension, cryptocurrencies.
Community
The concept of clustering in economics describes how companies who
that in the same industry tend to gather together in geographical con-
centrations. This increases the general productivity of the industry
as a whole as it fosters productive competition among the industry
peers. Similarly, a strong community has a high tolerance for failure
and encourages innovative thinking which is extremely important for
a technology company or product like cryptocurrency to succeed.
Compassion
Another factor that spurs innovations in technologies is their com-
passion to failure. The mindset of people within these communities
is that failure is not the end of the world but rather a valuable lesson
for the next attempt. Such a mindset is important in the world of
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146 Blockchain and Smart Contracts

fintech startups and especially for the cryptocurrency market where

the competition is steep and failure rate high. Empathy is another
compassion factor that helps with social scalability in the sense that
a sticky customer base grows exponentially in a short time.
Creativity
With the first two traits, it then comes as no surprise that creativity
can be fostered in such a community as innovation is not just
encouraged verbally but also backed by economic action.
c. LASIC principles
Outlined in the LASIC principles are five characteristics that the
cryptocurrencies should have to maximise the chances of success and
minimise the risk of government or social media resistance. So, they
are important factors to consider for token valuation.
Low Margins
Low margins are meant to prevent competition and to attract users
to achieve critical mass in terms of a sticky user base. With low
margins, economies of scale can take place and monetisation becomes
easier. For fintech companies and cryptocurrencies, low margin is a
key feature, compared to conventional businesses.
Asset Light
Asset light companies are able to keep fixed costs low and stay nimble
and flexible. Scaling a company that is asset light is also much easier
in this case.
Scalable
As mentioned above, a product’s ability to scale directly impacts
the product’s future profitability. The number of sticky users is a
key factor in monetising the product and estimating the value of the
product. For example, cryptocurrencies that can scale well will be
able to handle more business transactions and will thus enhance the
value of token economy.
Innovative
Similar to creativity in the 3Cs rules, businesses should remain
innovative, so should their products. It is important to tap into the
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Token Economics and Valuation 147

future trend to remain competitive. Another way is to lead the trend,

as in the case of Apple and Bitcoin and its blockchain technology.

Compliance Easy
Finally, providing services or products that are compliance easy
will minimise the risk of regulating bodies restricting their use and
jeopardising the prospects for a fintech startup. Changes in the
regulatory environment and compliance process may have major
influences on the costs of fintech companies and thus affect their
profitability and value.

d. 6Ds

The First Industrial Revolution involved steam and coal power to

operate machinery. The Second used electricity. The Third involved
electronics and information technology to automate production.
Currently, we might be in the midst of the Fourth Industrial
Revolution, which aims to use AI and IOT technology to transform
the physical and digital world further. This transformation will take
the form of 6Ds: Digitalisation, Disintermediation, Democratisation,
Decentralisation, Diminishing Oneself and Data Privacy Protection
(see Figure 4.17).

Figure 4.17: 6Ds.

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148 Blockchain and Smart Contracts

First, the discussion of the digital economy is inextricable from

the concept of “Digitisation”. Digitisation and digitalisation are
sometimes used interchangeably, but the meanings are completely
different. Digitisation is the process of converting information from
a physical format to a digital format and the vector and form of
information changes. The change of physical conversion into numbers
can be understood as information digitisation, that is “digitisation”.
When information exists in digital form, there will be “quali-
tative” changes in our way of work and workflow. Therefore, the
use of digital information to improve business processes and even
change business and business models is called digitalisation. That is
the digitalisation of business processes and business models, namely
digitalisation. There is a big difference between digitisation and
digitalisation. Digitalisation will have a significant impact on the
economy and can solve many current economic imbalances.
At the same time, in the virtual world, once such a trust
has been attacked by invasions or illegal control, the loss will be
incalculable. Therefore, in the long run, we advocate sequential,
gradual “decentralisation” to promote the establishment of dis-
tributed trust mechanisms. The gradually appropriate distribution
of trust is the most important foundation to achieve sustainability
and stability. Decentralisation and data privacy are vital to the
digital economy. In addition to the technology, one must abandon
self-centred thinking — that is diminishing oneself.
In general, to make things available for the general public, many
of the e-commerce or fintech companies have done the first 3Ds, but
not the fourth — decentralisation. The diminishing is also important
as this may not create an extra barrier when bringing the services
and products abroad. But, the most valuable companies are the ones
that can accomplish the last 3Ds (to protect the users).
e. 7Ws
The 7 Dimensions or 7Ws ( ) refer to seven key characteristics that
a fintech company has that can make it highly valued: Open, Altru-
istic, Global, Crowdsourcing Wisdom, Crowdsourcing Contribution,
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Token Economics and Valuation 149

Encompassing Interest of All and Beneficial to All. The idea was first
mentioned by Shen (2015).
Open
Openness refers to how open a project or company is. For example,
if the source code is open and publicly available, like Python and
Bitcoin, it becomes easier for developers to implement the codes,
build additional layers on it, revise it and develop it. Stakeholders
such as users and investors can also be more assured about the design
and function of the network.
Altruistic
The founding team and managing team of fintech companies should
also be altruistic. If they think only about themselves, it is difficult
to see if the stakeholders’ interests will be valued in the long run,
thus limiting the value of the firms.
Global
As mentioned earlier, the user base plays an important role in any
business’s success, more so for fintech companies. Digital services or
products that typical fintech companies provide do not have many
geographical restrictions as traditional ones, making going global an
easier target to achieve. The security and reliability of the system
depend on the number of people that use it, and the more, the
better. Hence, fintech companies should consider catering to a global
audience instead of merely focusing on their local jurisdiction.
Crowdsourcing Wisdom
Crowdsourcing wisdom will utilise the wisdom of the crowd or the
network. A little breakthrough from multiple sources will result in a
huge breakthrough when brought together.
Crowdsourcing Contribution
Similar to the above, a decentralised cryptocurrency can crowdsource
contributions to attain supercomputers like processing speeds and
power. Mesh technology, for example can lower average costs if more
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150 Blockchain and Smart Contracts

Figure 4.18: Summary of conceptual valuation frameworks.

people contribute to the network. The crowdsourcing concept is

crucial in a token economy to enjoy the economies of scale.
Encompassing Interest of All
It is important to consider every stakeholder group. In particular, for
a peer-to-peer network, every stakeholder is important as they play
key roles in the development of the project and determine whether
a token economy can function well.
Beneficial to All
In addition to ensure the interest of all stakeholders are aligned, it
is important to make sure all players can benefit from the services,
products, or behaviors.
Figure 4.18 summaries the discussed conceptual frameworks to
consider when valuing fintech companies.

4.5 Conclusion
To better understand the value of a token, the overall ecosystem and
underlying blockchain design thinking cannot be neglected. From
a business perspective, we can look at the governance, economic
incentives and scalability dimensions to continuously distribute trust
and increase the cost of hacking. Looking at one project or company
is not enough, as out of 100, 95 may just be loss ladders to build the
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Token Economics and Valuation 151

capabilities for the entire ecosystem. Without the ladder projects,

the ecosystem can never be built and so we may need to consider
the value of the entire ecosystem — something that traditional
bankers and fund managers find difficult to reconcile and explain to
shareholders and investors when an individual or too many projects
fail before the last few succeed. One would have been fired long before
the supernormal returns are obtained.
The collapse of projects like FCoin could have been avoided with
a better design of the token economics — that is why factors such
as the role and functions of the tokens, the architecture and the
monetary policy discussed here are so important. If there is no token,
the winner likely takes all. That is why we need tokens and token
economics. The company, platform provider or developer will have
control of all the data and earn most of the profits, which is not
what we aim to do. Traditional economics has already covered many
of the topics. Token economics is just an expansion to include the
knowledge of the cryptocurrencies and tokens as well as the new
business models. We are anticipating a variety of token economics
applications, a more inclusive ecosystem and the emergence of widely
accepted and effective valuation methods for tokens.
In future, the majority of companies will likely use tokens to raise
funds, similar to what ICOs did before but with different schemes
and/or names. Many blockchain startups failed with ICO because
they treated tokens as securities or financing instruments without
thorough considerations about the token utilities and economics.
Tokenisation is a process and an alternative that can be much more
powerful — it accords “affordable” legal status to those things that
do not have a clear ownership structure and legal status previously,
such as livestock. For instance, previously, only the ownership of a
cow had legal status and transactions of the cow possible. Investors
can purchase a fraction of a cow or exchange for other things. It
bypasses the expensive step of forming a company to own the cow.
The token itself defines the property right and can fractionalise the
livestock without having to deal with the shares of the company.
Tokenisation provides solutions to tackle many pain points in the
businesses today and helps achieve an inclusive and ultimate goal of
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152 Blockchain and Smart Contracts

maximising the value for all. Also, the value of the tokens and stocks
shall not compete with each other, but supplement each other to
increase the values of both. In fact, shares that define voting rights
can be now tokenised as a governance token. How this can be achieved
is what we should focus on in the future and experiment in DeFi, also
known as decentralised finance, distributed finance or simply as open
finance.7

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Kalichkin, D. (2018). Rethinking Network Value to Transactions (NVT) Ratio.

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Chapter 5

Cryptocurrency as an Alternative
Investment Class
Jointly written with Guo Li∗

5.1 Introduction
The surge of Bitcoin’s price and emerging applications of blockchain
technology had prompted heated discussions over cryptocurrencies.
Over 1,000 cryptocurrencies had been launched until early 2018,
and that number has gone up to over 7,000 during the past two
years, according to CoinGecko.com (see Figure 5.1). Hundreds of
billions worth of total market capitalisation (see Figure 5.2) indeed
poses great investment opportunities for investors, with one third, or
around US$90 billion, consisting of altcoins (cryptocurrencies other
than bitcoin; see Figure 5.3).
In a nutshell, the cryptocurrency market has the following
features: (i) attracting a large amount of funds, (ii) increasing number
of altcoins and (iii) altcoins playing an increasingly important role.
However, constructing an investment portfolio using cryptocurrencies
and how it performs compared to the mainstream asset classes
such as stocks, bonds and other alternatives (e.g., commodities and
REITs) are under-examined. Investing in cryptocurrencies means

∗
Assistant Professor, Fudan University; Academic Researcher, Shanghai Institute
of International Finance and Economics, Shanghai, People’s Republic of China.

155
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156 Blockchain and Smart Contracts

Figure 5.1: Cryptocurrency market overview.

Source: https://www.coingecko.com/en.

Figure 5.2: Total market capitalisation.

more than simply investing in Bitcoin alone as there are many

other choices (i.e., altcoins). As a result, the cryptocurrency market
generates many investment opportunities and is worth studying.
In our paper, titled “Is cryptocurrency a new investment opportu-
nity? ”, we analyse the diversification effect of cryptocurrencies (Lee
et al., 2017). Then, we perform sentiment analysis and based on the
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Cryptocurrency as an Alternative Investment Class 157

Figure 5.3: Market capitalisation dominance.

results, we construct a portfolio which has generated a significant

alpha.

5.2 Data
We collect cryptocurrency data from CoinGecko.com and data for
other traditional asset classes from Bloomberg. The whole sample
period spans from August 2014 to March 2017. Here, we use CRIX
(CRypto IndeX1 ) as a proxy for cryptocurrency market performance,
like S&P 500 for the stock market. It was established as early as
2014 and incorporated various numbers of constituents that can best
reflect the whole cryptocurrency markets based on both liquidity and
market value rules (Trimborn and Härdle, 2018). For the analysis, we
included the top ten cryptocurrencies that had been included most
frequently in the CRIX index, shown in Figure 5.4.
For the traditional assets, we include S&P 500, Gold, S&P GSCI
Commodity Index, Oil futures, private equity and REITs. If we plot
the cumulative returns of CRIX and traditional asset class, we can

1
https://thecrix.de/.
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158 Blockchain and Smart Contracts

Figure 5.4: Top 10 cryptocurrencies included in the CRIX.

Figure 5.5: Cumulative returns of assets.

see that the return of the CRIX index had increased a lot from
2015 to 2017, much higher when compared to the rest of the asset
classes (Figure 5.5). But, it seemed much more volatile than the
others in the meantime.
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Cryptocurrency as an Alternative Investment Class 159

Mean SD Skew Kurt Min Max Rho

CRIX 0.0012 0.0326 −1.0375 12.8923 −0.2264 0.1932 0.0135

BTC 0.0008 0.0388 −0.5274 10.3023 −0.2518 0.2014 −0.0059
XRP 0.0009 0.0515 1.1100 10.1929 −0.1958 0.3286 0.1357
LTC 0.0041 0.0794 −0.0954 36.5501 −0.8635 0.7619 −0.1126
DASH 0.0027 0.0766 0.6470 9.7346 −0.3740 0.5476 −0.0489
DOGE 0.0005 0.0589 1.7617 17.5638 −0.2752 0.4802 0.0183
XMR 0.0033 0.0839 1.6386 16.0059 −0.3363 0.7203 0.0315
BTS −0.0008 0.0730 1.4375 12.7584 −0.2933 0.5252 0.0572
MAID 0.0040 0.1210 3.7434 55.4465 −0.4900 1.6675 −0.1411
NXT −0.0019 0.0724 2.0406 20.3759 −0.3636 0.6999 −0.0794
BCN −0.0008 0.0577 −0.5688 23.7415 −0.5472 0.3744 −0.0451

Mean SD Skew Kurt Min Max Rho

T-Note 4.95E-06 6.54E-06 0.9694 2.7994 0 2.00E-05 0.989

S&P 500 0.0003 0.0084 −0.3068 5.6039 −0.0402 0.0383 0.0095
Gold 0.0001 0.009 0.3896 5.998 −0.0338 0.0459 −0.0446
Oil −0.0006 0.0258 0.1879 4.5863 −0.1079 0.1015 −0.1287
GSCI −0.0004 0.0138 0.0958 4.5697 −0.0659 0.0526 −0.0872
REITs 0.0002 0.0097 −0.5848 4.7931 −0.0486 0.0284 0.0332
PE 7.26E-05 0.0087 −0.7855 7.6016 −0.05 0.0327 0.1888

Figure 5.6: Summary statistics of assets.

From the summary statistics, we can see that cryptocurrencies

outperformed the traditional asset class in terms of average daily
return (see Figure 5.6). For example, the daily return of CRIX
is 0.12%, four times higher than that of S&P 500. However, this
outperformance comes with a high degree of volatility, in other words,
a higher risk.

5.3 Diversification Analysis

We then look at how cryptocurrencies improve the performance of
a portfolio that consists of traditional assets. We first evaluate the
comovement between cryptocurrencies, including the CRIX index
as the market representative and ten major cryptocurrencies, and
traditional assets by studying the correlation coefficients (Chen et al.,
2016). We apply a static correlation model and a dynamic conditional
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160 Blockchain and Smart Contracts

Static Correlation
CRIX BTC XRP LTC DASH DOGE XMR BTS MAID NXT BCN
S&P 500 0.036 0.038 0.22 0.013 0.102 −0.001 0.084 0.044 0.058 0.057 0.044
T-Note −0.02 0.017 −0.01 0.006 −0.013 −0.037 −0.011 −0.04 0.058 −0.072 −0.035
Gold 0.036 0.069 −0.064 0.045 0.045 0.01 −0.053 0.02 0.018 0.041 0.047
Oil −0.065 −0.075 −0.006 −0.076 −0.03 −0.094 0.032 0.005 0.009 −0.021 −0.025
GSCI 0.015 0.03 0.004 0.031 0.043 0.029 −0.01 −0.033 0.028 0.003 −0.015
REITs −0.014 0.004 0.003 0.043 −0.025 −0.016 −0.045 −0.058 0.011 −0.036 −0.052
PE −0.037 −0.007 −0.02 −0.029 −0.039 −0.017 −0.02 −0.094 0.024 −0.079 −0.012

Dynamic Conditional Correlation (DCC)

Mean SD Min Q25 Median Q75 Max
S&P 500 −0.0182 0.0250 −0.0810 −0.0357 −0.0193 −0.0007 0.0697
Gold 0.0233 0.0494 −0.1326 −0.0081 0.0231 0.0531 0.2442
Oil −0.0951 1.64E-07 −0.0951 −0.0951 −0.0951 −0.0951 −0.0951
GSCI 0.0330 4.60E-08 0.0330 0.0330 0.0330 0.0330 0.0330
REITs −0.0263 2.29E-07 −0.0263 −0.0263 −0.0263 −0.0263 −0.0263
PE −0.0279 7.42E-09 −0.0279 −0.0279 −0.0279 −0.0279 −0.0279

Figure 5.7: Correlation between CRIX and the rest.

correlation (DCC) model (Engle, 2002). Almost all correlations,

between that of the CRIX and traditional asset classes, are less than
0.1 (see Figure 5.7). For example, the correlation between CRIX and
the S&P 500 is 0.036. In fact, according to the first row, a majority of
cryptocurrencies we studied have correlations with the stock market
that are less than 0.05. These very low correlations reinforce our
statement that cryptocurrencies may be a promising investment class
in terms of hedging the risk of mainstream assets.
If we look at the dynamic correlation, instead of average corre-
lation, cryptocurrencies still show good diversification potential over
the whole sample period as even the largest, 0.2442, is still considered
quite low. The persistence of low comovement with mainstream assets
further suggests good investment opportunities in cryptocurrency as
an alternative asset class.
We then examined the performance after adding the CRIX index
into a portfolio that originally consists of traditional assets such as
S&P 500, private equity, REITs and Gold. From the efficient frontier
in Figure 5.8, we can see the return and standard deviation of CRIX
and six common investments. CRIX has the highest return and it is
the only one that lies on the efficient frontier, while the return of Oil
is the lowest with a relatively high level of risk. In other words, CRIX
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Cryptocurrency as an Alternative Investment Class 161

Figure 5.8: Efficient frontier and transition map.

seems to provide the best performance for a risk-averse investor who

can take a high risk.
According to transition map of our portfolio performance, S&P
500 and CRIX dominate the portfolio, while the other investments
only contribute to the portfolio when the portfolio risk is low.
Moreover, for any risk-averse investor who is willing to tolerate daily
volatility above 2%, the transition map suggests investing more than
half of his or her initial wealth into CRIX.
The efficient frontier figure, Figure 5.9, plots the market efficient
frontiers of the mainstream portfolio with and without CRIX. The
inclusion of CRIX shifts the efficient frontier upwards. This means
that under the same level of risk, a portfolio with CRIX has a higher
return than the portfolio consisting of only mainstream assets.

5.4 Sentiment Analysis and Portfolio

5.4.1 Sentiment Analysis
We further investigated the sentiment effect in the cryptocurrency
market, using the average return in the past ten trading days as
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162 Blockchain and Smart Contracts

Figure 5.9: Efficient frontier and optimal portfolio.

the proxy of investor sentiment for each cryptocurrency. Extant

literature suggests that sentiment-induced overnight returns are
reversed during the trading day because rational investors will come
into the market to correct the mispricing, investors will buy (sell) the
assets with high (low) past returns and then a strong return reversal
will be observed later (Berkman et al., 2012).
To examine whether this effect exists in the cryptocurrency
market, we select the top 100 cryptocurrencies that have been
included in CRIX over the whole sample period. The average return
in the past 10 trading days is used as the proxy of investor sentiment
for each cryptocurrency in our analysis. After sorting them into three
groups according to the sentiment level (high, median and low) for
each trading day, we defined the day that a certain crypto falls into
the high (low) sentiment group as its high (low) sentiment event day.
Each cryptocurrency may have multiple event days (see Figure 5.10).
As shown in Figure 5.11, the results suggest that return
cryptocurrencies with high (low) past return/sentiment will drop
(increase) in the following day. So, investor sentiment strongly affects
the cryptocurrency market as there is an obvious return reversal
for both high and low sentiment groups. The reason may be that
cryptocurrencies, unlike other traditional asset classes, do not have
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Cryptocurrency as an Alternative Investment Class 163

Figure 5.10: Sentiment in cryptocurrency market.

Figure 5.11: Sentiment effect of cryptocurrency market.

real underlying assets and their fundamentals are hard to understand.

So, without fundamental support, investor sentiment will affect the
market.

5.4.2 Sentiment Portfolio

Since we have observed a confirmed reversal effect in the returns
of cryptocurrencies, next we will try to explore this investment
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164 Blockchain and Smart Contracts

Figure 5.12: Sentiment-based portfolio strategy.

opportunity by constructing a long–short portfolio based on our

sentiment measure. In other words, we would act like rational
investors, who enter the market to correct the mispricing, and form
a portfolio strategy based on sentiment information to gain positive
risk-adjusted profits (see Figure 5.12).
We construct the sentiment portfolio based on the strategy of
buying low-sentiment and selling high-sentiment cryptocurrencies2
for the whole sample period using the top 100 cryptocurrencies
included in CRIX. We also include an equally weighted portfolio
that invests equally in all 100 cryptocurrencies. The trading costs
have been ignored for research purposes.
Figure 5.13 shows that the cumulative returns of the sentiment
portfolio are over 20 times the initial investment after 2016, much
higher than that of CRIX and the equal-weighted portfolio.
According to the portfolio cumulative return for each sentiment
group, low-sentiment groups have highest cumulative returns and the
high-sentiment groups have the lowest return (see Figure 5.14). This
result serves as strong evidence supporting the fact that investor
sentiment plays a very important role in the cryptocurrency market.
The distribution of average monthly abnormal return of the
sentiment portfolio may provide additional information about the
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Cryptocurrency as an Alternative Investment Class 165

Figure 5.13: Sentiment portfolio performance.

Figure 5.14: Sentiment portfolio performance of different levels.

portfolio’s performance. We can clearly see the frequency at which

average monthly abnormal return occurs (in bins) during the whole
sample periods. Each frequency bin stands for a range of abnormal
returns. The daily abnormal return is calculated as stock returns
minus CRIX index returns to adjust for cryptocurrency market risk.
We can see that the portfolio’s average abnormal return falls between
50% and 100% for the most months, followed by 100% and 200%.
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166 Blockchain and Smart Contracts

Figure 5.15: Portfolio monthly return distribution.

Notably, none of average monthly returns are negative. Thus, the

sentiment-based strategy has outstanding performance, indicating a
good arbitrage opportunity (see Figure 5.15).
In addition, we compared the performance of sentiment portfolio
with other investment assets, including traditional investment tools
and other cryptocurrencies, using several risk-adjusted return mea-
sures. For the information ratio, S&P 500 is used as the benchmark.
We find that of all investment classes, the sentiment-based
cryptocurrency portfolio has the highest average return, 2.34% daily
(see Figure 5.16). In terms of risk-adjusted returns such as the Sharpe
ratio and information ratio, it also significantly outperforms the
others. Therefore, it is safe to conclude that our sentiment portfolio
provides very good risk arbitrage return to investors.

5.4.3 Robustness Check

Considering that previous results do not account for transaction
costs, we further analyse the portfolio performance in a more
practical way. Namely, we conduct the following robustness checks:
one with an assumption of non-zero transaction costs and the other
with different sentiment formation periods.
Results show that performance of our sentiment portfolio does not
vary much with different trading costs (see Figure 5.17). For example,
in the cases of an extreme trading cost of 10 bps, the sentiment-based
trading strategy still generates a high annual return (11.22 times)
with a t-value of 15.50. So, the sentiment portfolio is insensitive
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Cryptocurrency as an Alternative Investment Class 167

Figure 5.16: Sentiment portfolio performance and other asset classes.

Figure 5.17: Sentiment portfolio performance with different transaction costs.

to transaction costs, which implies a relatively low turnover of our

strategy.
In addition, we test whether the selection of the formation period
will have any great impact on the portfolio’s performance. Previously,
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168 Blockchain and Smart Contracts

Figure 5.18: Sentiment portfolio performance with different sentiment forma-

tion periods.

a formation period of 10 trading days was used to average the

daily returns. So, in the robustness check, we adopt various periods
(from 11 days to 20 days) as the formation periods. From the table
below, we can see that the portfolio performance is insensitive to the
selection of formation periods. In particular, when we use 20 days as
the formation period, the annualised portfolio return is 11.22 with
a t-value of 14.99, suggesting a consistent sentiment effect on the
cryptocurrency market (see Figure 5.18).
This strategy may encounter some obstacles in practice. For
example, we cover 100 cryptocurrencies that have been most fre-
quently included in the CRIX; sort them based on the investor
sentiment to find the portfolio group to short and long; hold for 1 day
and rebalance the next day; and repeat the strategy every day. Also,
the short positions of cryptocurrencies are not feasible. However,
evidence that investor sentiment affects the cryptocurrencies still
provides valuable information about the prices of cryptocurrencies.

5.5 Conclusion
The cryptocurrency market has large investment potentials as it
brings many new investment opportunities. We have thousands
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Cryptocurrency as an Alternative Investment Class 169

of cryptocurrencies to choose from with a total market value of

hundreds of billions. It outperforms many mainstream asset classes
in terms of risk-adjusted return, has generally very low correlations
with existing investment tools and plays an important role in the
diversification of portfolios. In further investigation of sentiment, we
find that it largely affects the cryptocurrency market. A portfolio
strategy based on cryptocurrency investor sentiment generates sig-
nificant excess returns.

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econometric analysis of the CRIX family. Working Paper.
Engle, R. (2002). Dynamic conditional correlation: A simple class of multivariate
generalized autoregressive conditional heteroskedasticity models. Journal of
Business & Economic Statistics, 20(3), 339–350.
Lee, D. K. C., Guo, L., and Wang, Y. (2017). Cryptocurrency: A new investment
opportunity? Journal of Alternative Investments, 20(3), 16–40.
Trimborn, S. and Härdle, W. K. (2018). CRIX an Index for cryptocurrencies.
Journal of Empirical Finance, 49, 107–122.
 b2530   International Strategic Relations and China’s National Security: World at the Crossroads

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December 24, 2020 14:17 Blockchain and Smart Contracts: Design Thinking. . . 9in x 6in b4043-ch06 page 171

Chapter 6

A Look at Security and Privacy:

Bitcoin, Cryptocurrencies
and Blockchain Networks

Ernie Teo∗

6.1 Security of Blockchain Networks

The design of Bitcoin and its blockchain ensured that the data stored
in the ledger are very hard to change and tamper with; the use
of cryptography in blockchain ensures this. Incentive mechanisms
embedded in the consensus protocol help to align all validators to be
good. The distributed network checks the validity of the transactions
to ensure that no fraudulent transaction goes through.
The security of the blockchain network comes with its decentral-
isation and distribution. As these features diminish, someone could
gain control of the network and be able to compromise the security
of the network. Some common network attacks are hard to execute
on a blockchain network.
Take, for example, a Sybil attack, where someone attempts to
take over a network by creating multiple accounts on the system. This
would mean running multiple nodes on a blockchain network. If the

∗
Adjunct Senior Lecturer, National University of Singapore; Co Vice-Chairman,
Blockchain Association Singapore, Singapore.

171
December 24, 2020 14:17 Blockchain and Smart Contracts: Design Thinking. . . 9in x 6in b4043-ch06 page 172

172 Blockchain and Smart Contracts

attacker can get access to enough nodes, he can block transactions

(from other users) and disconnect you from the public network.
By separating you from the main network, he can double spend or
block your transactions.
Consensus algorithms make it hard to carry out a Sybil attack;
one usually has to expand resources (such as computer power or
tokens) in order to become a node on the blockchain network. This
makes it expensive and difficult. Miners have a strong incentive to
keep mining honestly as a large number of resources are needed to
mine coins. However, this sort of attack is known to happen in real
life to weaker/smaller blockchain networks. In really large-scale Sybil
attacks, where the attackers manage to control the majority of the
network computing power or hashrate, they can carry out a 51%
attack.

6.1.1 The 51% Attack

In blockchain networks running Proof-of-Work (PoW) consensus,
nodes are usually programmed to look for the blockchain with the
most blocks as the correct version of history. Miners with more
than 50% of the network hashing power can take advantage of this.
This miner (let us call it Miner X) can send funds to one address
(Wallet A) on the main chain, and double spend the same funds to
another address on a forked copy of the blockchain that it is secretly
mining with more hashing power than the main chain.
Other miners will continue to mine on the “Main Chain” while the
secret fork is not revealed (see Figure 6.1). Thus, they will recognise

Figure 6.1: Mining process, forks and creation of chains.

December 24, 2020 14:17 Blockchain and Smart Contracts: Design Thinking. . . 9in x 6in b4043-ch06 page 173

A Look at Security and Privacy 173

the 100 btc transferred to Wallet A as valid. Cryptocurrency

exchanges may pay out in fiat currency as a result.
Miner X with more hashing power can mine faster on the secret
fork. Once it has more blocks than the main chain, Miner X can
reveal it. The rest of the miners will mine on the longer fork when it
is revealed. The secret fork will be recognised as the main chain and
the 100 btc in Wallet A will become invalid. However, if someone (like
an exchange) has paid out fiat money or goods and services based on
the receipt of the 100 btc in Wallet A, this may not be recoverable.
This is also known as a “double spend” attack.
Ethereum Classic (ETC) fell victim to a 51%-attack on
January 5, 2019.1 This went on for three days, finally halting on
January 8, 2019, with estimated losses of US$ 1.1 million. On
January 7, digital asset exchange Coinbase reported that its systems
had detected unusual activity on the Ethereum Classic blockchain.
As a result of the suspicious activity, the trading platform suspended
all ETC trades in order to protect user funds.
According to Mark Nesbitt (the security engineer at Coinbase),2
the platform’s systems had detected this activity as early as Jan-
uary 5, a couple of days before the reports began in the media.
At that time, ETC developers contended that the unusual activity
detected by Coinbase could be attributed to the testing of new mining
machines and denied any double spends or any losses stemming from
the activity.
However, more reports and evidence began to trickle in from
blockchain analysis firms as well as other digital asset trading
platforms. Gate.io was the first exchange to corroborate Coinbase’s
findings.3 Gate.io research confirmed that the ETC 51% attack
happened successfully. In the analysis, they detected seven roll-
back transactions (invalid transfers due a block becoming invalid).

1
https://cointelegraph.com/news/ethereum-classic-51-attack-the-reality-of-pro
of-of-work.
2
https://bravenewcoin.com/insights/etc-51-attack-what-happened-and-how-it-
was-stopped.
3
https://www.gate.io/article/16735.
December 24, 2020 14:17 Blockchain and Smart Contracts: Design Thinking. . . 9in x 6in b4043-ch06 page 174

174 Blockchain and Smart Contracts

Four of them were created by the attacker and in total 54,200 ETC
was transferred. Gate.io further corroborated Coinbase’s findings
that the attack was not just an innocent deep-chain reorganisation.4
Revealing the attacker’s wallet addresses as well as other informa-
tion pertinent to the malicious transactions, Gate.io also explained
the attack had resulted in losses amounting to US$40,000 for the
exchange. However, the exchange said it would not pass on the
losses to its users. It also raised the confirmation number for
ETC transactions and called on the ETC developers to change the
consensus mechanism for the blockchain in order to avoid another
attack. Following the Gate.io revelation, more exchanges began to
either limit ETC trading activity on their platforms or increase the
confirmation limit. Some of these include CoinCheck and Bitflyer as
well as the mining pool Etherchain. Concurrently, ETC developers
finally confirmed the presence of a 51% attack, referencing a report
that a single party had been able to acquire over 50% of the network’s
hashrate.
On January 9, SlowMist published a report with in-depth analysis
of the attack.5 The firm found that the first attempted malicious
transaction was carried out on the trading platform, Bitrue. The
attacker executed a double spend worth US$14,000. Appearing to
confirm Coinbase’s estimate of US$1.1 million lost as a result of the
attack, Slow Mist said that the attacker halted its activities due to
the actions of exchange. “Based on continuous tracking, we found
that, in view of the increase in block confirmations and the ban on
malicious wallet addresses by exchanges, the attacker’s 51% attack
on ETC has stopped after that.”
Coinbase was able to protect its users by halting trading of
ETC. Given that ETC was one of the top 20 digital assets by
market capitalisation, the 51% attack reverberated throughout the
cryptocurrency community. It was easy for machines mining ETH to

4
This can happen in certain circumstances as the blockchain network is asyn-
chronous and some machines mine faster than others.
5
https://medium.com/@slowmist/the-analysis-of-etc-51-attack-from-slowmist-
team-728596d76ead.
December 24, 2020 14:17 Blockchain and Smart Contracts: Design Thinking. . . 9in x 6in b4043-ch06 page 175

A Look at Security and Privacy 175

Figure 6.2: PoW 51% attack cost (same as footnote 5).

switch to mining ETC as ETC uses the same mining algorithm as

Ethereum. Since the ETC network was much smaller than ETH’s,
it was easy to gain the majority hashrate. The rise of cloud-
based mining has made “hashrate for hire” a norm in the industry.
And, for blockchain networks that are relatively small, it became
attractive for bad actors to launch such attacks. Crypto 516 lists
the estimated costs of renting the necessary hash power for some
popular cryptocurrencies. It is surprising how low the costs of
launching such attacks were. Figure 6.2 is a snapshot taken from
Crypto 51.
An hour-long attack on Ethereum Classic, for example, could
be done for around US$6,000. A Litecoin hijack would cost around
US$16,000 an hour; even Ethereum could be attacked at a cost of
around US$120,000 an hour.

6
https://www.crypto51.app/.
December 24, 2020 14:17 Blockchain and Smart Contracts: Design Thinking. . . 9in x 6in b4043-ch06 page 176

176 Blockchain and Smart Contracts

In May 2018, Bitcoin Gold (a Bitcoin fork) was also attacked.7

Bitcoin Gold’s hashrate was significantly lower than that of Bitcoin,
making it vulnerable to attacks. The cost of the attack on Crypto 51
was only US$400. In Figure 6.3, we compared the number of nodes
on both networks in February 2019. Bitcoin Gold’s nodes make up
less than 2% of Bitcoins. Thus, we can see that a blockchain network
is more vulnerable to 51% attacks if the network size is small. Larger
networks like Bitcoin and Ethereum enjoy more resilience to such
attacks as the costs make it harder to achieve both monetarily as
well logistically (see Figure 6.4 for number of nodes in the Bitcoin
network). This factor needs to be considered for anyone looking
to invest in cryptocurrencies or to run their applications on their
blockchain networks.

6.1.2 Denial-of-Service Attacks

A Denial-of-Service (DoS) attack aims to make a system or network
inaccessible to its users. This is done by constantly sending traffic or
information to the target, causing it to crash. A DoS attack blocks
legitimate users from accessing the service. High-profile organisations
are usually susceptible to these attacks, like financial institutions,
media or government organisations. DoS attacks usually do not result
in loss of information or assets, but the down time it causes can be
costly as well. For example, if a bank gets attacked, it may not be
able to process financial transactions.
The decentralised nature of blockchain makes for strong protec-
tion against DoS attacks. If certain nodes on the network had gone
offline, the blockchain network can continue to validate transactions
and create blocks. When the nodes come back online, they can
sync up with the network and resume from the current block.
However, in blockchain networks with distributed computing such
as Ethereum, DoS attacks are possible if there are vulnerabilities in
the code.

7
https://qz.com/1287701/bitcoin-golds-51-attack-is-every-cryptocurrencys-nig
htmare-scenario/.
December 24, 2020 14:17 Blockchain and Smart Contracts: Design Thinking. . . 9in x 6in b4043-ch06 page 177
A Look at Security and Privacy 177
Number of nodes in Bitcoin Gold.
Source: https://status.bitcoingold.org.
Figure 6.3:
December 24, 2020 14:17 Blockchain and Smart Contracts: Design Thinking. . . 9in x 6in b4043-ch06 page 178
178 Blockchain and Smart Contracts
The number of nodes in Bitcoin.
Source: https://bitnodes.earn.com.
Figure 6.4:
December 24, 2020 14:17 Blockchain and Smart Contracts: Design Thinking. . . 9in x 6in b4043-ch06 page 179

A Look at Security and Privacy 179

In 2016, the Ethereum network experienced such an attack.8 On

22nd September, the first day of Devcon (Ethereum foundation’s
annual conference), nodes running the Geth client started to crash
due to lack of memory. The crash only affected clients that were
based on the Go language, and Ethereum created a hotfix the next
day to address it.
Vitalik Buterin (Ethereum’s founder) released a statement9 in
the post-mortem. The underlying problem involved Ethereum’s
EXTCODESIZE attribute, which is included in each transaction by
design. An attacker could use this attribute to ask for additional
checks against the Ethereum network database, up to 50,000 at a
time. This caused the clients to crash as they ran out of memory; it
caused a two to three times reduction in the rate of block creation.
As stated by Vitalik, there was no consensus failure, and neither the
network nor any client at any point fully halted.

6.1.3 Software Flaws

Although the flaw (which allowed the DoS attack) in the Ethereum
was patched, this event also revealed the vulnerability of more
complex blockchain networks. In particular, networks that have
applications or smart contracts running on them are susceptible
to flaws in the code or bugs. Smart contracts are only as good
as the humans who write them, and code bugs or oversights can
lead to unintended adverse actions being taken. Smart contracts on
blockchain are meant to be immutable; this means that when the
code gets exploited, there is no easy way to prevent this. Various
software bugs have been found in decentralised apps (dApps) or
smart contracts, which has led to tens of millions in damages over
the years.
One of the first large incidents with smart contracts was the DAO
(Decentralised Autonomous Organisation) hack.10 “The DAO” was

8
https://cointelegraph.com/news/ethereum-is-under-ddos-attack-miners-are-al
erted.
9
https://blog.ethereum.org/2016/09/22/transaction-spam-attack-next-steps/.
10
https://blockgeeks.com/guides/ethereum/.
December 24, 2020 14:17 Blockchain and Smart Contracts: Design Thinking. . . 9in x 6in b4043-ch06 page 180

180 Blockchain and Smart Contracts

a project run by a team behind a startup called Slock.it. The aim

was to create a decentralised venture capital firm where investors
can make decisions to invest through smart contracts. It was funded
through a token sale that raised US$150 million dollars. Shortly after
the fund raise was completed in 2016, the DAO was hacked by an
unknown attacker who stole US$50 million worth of ether. This was
possible because of a backdoor in the code.
As a large amount of money was involved, the Ethereum
foundation got involved and the community voted to roll back
the blockchain and execute a hard fork. ETC (Ethereum Classic)
was a result of this, being the original blockchain where the hack
happened. ETH (Ethereum) was where the majority agreed to
rewrite a small part of the blockchain and return the stolen money
to the owners. Both blockchains are identical up to the point where
the fork was implemented. This move was intensely debated and
controversial. A blockchain network in principle is meant to be
immutable. By executing the rollback, a dangerous precedent has
been set which goes against the spirit of blockchain.
As such, any smart contracts that are to be deployed into a
blockchain network should go under intense review and testing.
Smart contracts and code should be reviewed and audited by external
parties. The application should undergo penetration testing. It is
advisable to have good security practices in place as flaws may remain
hidden for a while. No matter how experienced the programmer,
mistakes can be made.

6.1.4 Cryptocurrency Exchange Hacks

The final blockchain security issue is not an issue with the actual
blockchain network and its technology; it is to do with cryptocur-
rency exchanges. Exchanges are very attractive to hackers as they
hold massive amounts of cryptocurrencies and sometimes do not have
very good security practices. Most exchanges operate in a centralised
manner and thus they do not have the benefits of the decentralised
blockchain. Private keys and wallets containing the cryptocurrencies
of investors were not well protected, allowing hackers to steal these
keys and transfer the assets out of the wallets.
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A Look at Security and Privacy 181

The most famous exchange hack was that of Mt. Gox in 201411
where around 850,000 bitcoins, worth US$470 million (at that time),
were stolen by a hacker. Mt. Gox was the industry leader at that
time; they process about 70% of all bitcoin transactions. All the
affected users were unable to get their money back. Exchange hacks
were still prevalent, and hundreds of millions were stolen by hackers.
It is always good practice to transfer your crypto holdings to self-
managed secure wallets (such as a hardware device). If you have large
amounts of cryptocurrencies, consider using a custodian service with
high levels of security.
Although blockchain networks are secure by design, they can
still be vulnerable to bad actors such as in situations described
above. The risk of such attacks needs to be considered when trading
in cryptocurrencies and deploying a blockchain network. However,
security considerations go beyond hackers. In the next section, we
look at protecting user data privacy.

6.2 Ensuring Privacy of Users on Blockchain Networks

Owners of bitcoins enjoy some amount of anonymity when they
transact on the Bitcoin blockchain as they are only identified by
their public addresses. However, all transactions are transparent
on the blockchain. Forensic analysis can bundle addresses and find
patterns. When you transact with exchanges, regulation requires
that the exchange collects your identity and information. Even if
you transact on a peer-to-peer basis only, your IP address can be
logged in nodes and be linked to your bitcoin address. When you
purchase something online with bitcoin, your physical address and
other information can also be linked to your bitcoin address. This
means that a bitcoin user’s privacy is not entirely protected when
they transact on blockchain. Privacy is an important element when it
comes to digital payments. With paper money, you have the freedom
to use it without being tracked.

11
https://www.wired.com/2014/03/bitcoin-exchange/.
December 24, 2020 14:17 Blockchain and Smart Contracts: Design Thinking. . . 9in x 6in b4043-ch06 page 182

182 Blockchain and Smart Contracts

6.2.1 Ensuring Privacy of Cryptocurrencies

The crypto community has been working to improve the privacy
aspects of cryptocurrencies. Figure 6.5 provides an overview of the
technologies.
One commonly used method is coin mixing. Coin mixing services
prevent users’ addresses from being tracked by mixing coins from
multiple senders before they are sent to the recipients. The ownership
of coins is obfuscated with coin mixing. Some examples are Mixcoin,
CoinJoin, SharedCoin and CoinShuffle. The solutions differ in the
amount of security they provide.
Another method is to anonymise signatures. The two most com-
monly used signature schemes to achieve this are “group signatures”
and “ring signatures”. Group signature is a cryptography scheme
proposed in the 1990s. With this scheme, any member of a group can
sign a message for the group using her own secret key. The digital
signature can be validated by the group public key. The verifier
can only know that the signature came from the group but not the
identity of the actual signer. The group signature scheme requires an
administrator or authority to add and remove group members. By the
nature of its design, this is suitable for consortium blockchains.
The ring signature scheme also achieves anonymity with a group
of users. However, a group administrator is not required. With
ring signatures, one cannot determine who the actual signer within
the group is. The group can be arbitrarily formed by any users

Privacy Technologies used in Blockchain

Secure
Anonymous Homomorphic State
Coin Mixing Multiparty
Signatures Encryption Channels
Computing

Zero Trusted
Group
Knowledge Execution
Signatures Proofs Environments

Ring
Signatures

Figure 6.5: Privacy technologies used in blockchain.

December 24, 2020 14:17 Blockchain and Smart Contracts: Design Thinking. . . 9in x 6in b4043-ch06 page 183

A Look at Security and Privacy 183

without any additional setup. Thus, such schemes are good for public
blockchains. Examples of public blockchains with ring signature
schemes are Monero and Ethereum.
Another important method to protect data privacy is homomor-
phic encryption. It is a cryptography method that allows certain
operations to be performed on encrypted data. This means one can
perform a calculation without having to decrypt the data. For exam-
ple, one can determine if a wallet has sufficient amount for a transfer
without knowing the actual amount of funds in the wallet. This
technique can be used to store data on blockchain without having to
change the properties of the blockchain. It allows public blockchains
to operate without having to store transactional data publicly.
Ethereum smart contracts can provide homomorphic encryption on
data stored on the Ethereum blockchain. Zero Knowledge Proofs are
one form of homomorphic encryption and are used by blockchains
such as ZCash.
Another widely discussed type of privacy protection technique
is Secure Multi-Party Computation (SMPC). This technique allows
multiple parties to each compute part of the input data in a way
which does not compromise on the privacy of the input. Many real-
world problems (where inputs need to remain anonymous) such as
voting and bidding can be solved with SMPC. SMPC eliminates the
need for a trusted authority to count votes or check bids. In 2015, a
decentralised (blockchain-based) SMPC platform called Enigma was
proposed. Enigma provides autonomous control and protection of
personal data while eliminating the necessity and dependency of a
trusted third party.
Enigma utilises a Trusted Execution Environment (TEE). TEE
is an isolated computing environment, where other applications
within the machine will not be able to access or tamper with the
computation. One notable type of TEE technology is the Intel
Software Guard eXtensions (SGX). It forms the basis for secure and
privacy-preserving smart contracts on Enigma. One use case is for a
decentralised credit-scoring algorithm. Multiple inputs for a person’s
credit score such as account information, transactions, payments
and credit history can be stored in an encrypted manner on the
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184 Blockchain and Smart Contracts

blockchain. When required, the credit score is calculated within the

TEE and only the credit score is returned to the requestor (without
exposing the raw data). Blockchain provides additional trust for the
encrypted raw data as it cannot be tampered with once stored.
Another method of ensuring privacy on a permissioned blockchain
is the use of state channels.
These are private channels between two or more users. These
users exchange the signed transactions between each other without
broadcasting to the blockchain. We can imagine state channels
as mini blockchains within the main blockchain network. State
channels can be configured to have a limited lifespan and the channel
can be closed by updating the latest state of transactions to the
blockchain.

6.2.2 Privacy Considerations and Design

for Blockchain Applications
Privacy on blockchains extends beyond cryptocurrency transactions.
In many business applications, sensitive business data are involved.
These data need to be shared appropriately with the members on
the blockchain network. Global regulations around user privacy are
also evolving rapidly and becoming stricter. The implementation
of the EU’s General Data Protection Regulation (GDPR) in May
2018 changed the landscape of technology. When personal data
are collected, companies have to indicate what it will be used for
and cannot use it for anything else. They need to minimise the
amount of data they collect and keep, limiting it to only what is
necessary for the purpose intended. When requested, companies have
to be able to tell users what data they hold and alter or delete
the data.
The largest causes of data leaks are human related (see
Figure 6.6).
Thus, privacy is not just about the technology but also its design
and policies that restrict what humans are able to do. Data privacy
is concerned with the proper handling of data. There are three key
considerations: consent, notice and regulation. Specifically, practical
data privacy concerns often revolve around the following:
December 24, 2020 14:17 Blockchain and Smart Contracts: Design Thinking. . . 9in x 6in b4043-ch06 page 185

A Look at Security and Privacy 185

• whether or how data are shared with third parties;

• how data is legally collected or stored;
• regulatory restrictions such as GDPR and PDPA.

Most government regulations include obligations in terms of

where data processing can take place, also known as “transfers of
personal data” to third countries. The Indonesian data protection
bill guarantees that the data pertaining to the personal data of
Indonesians will exist only within Indonesia and will be protected
by the government. The GDPR specifies that personal data can
generally only be transferred to third countries if they are deemed
“adequate”. This presents an interesting problem for decentralised
blockchain networks. It may be necessary to border off the blockchain
network to ensure that the data do not leave the geographical
constraints of the country.
Another consideration is how the data are being stored; some
amount of processing could increase the privacy of the data. Various
techniques can be used to fulfil this purpose. Pseudonymisation
can be used to hide personal data by replacing information that
links the data to particular individuals with artificial identifiers.

Figure 6.6: Causes of data leaks.

Source: https://www.dataprivacymonitor.com/cybersecurity/deeper-dive-huma
n-error-is-to-blame-for-most-breaches/.
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186 Blockchain and Smart Contracts

One can mask the data by hiding parts of the data by replacing
it with random characters or other data. Data blurring is one form
of pseudonymisation. Pictures and videos containing faces can be
blurred out to protect the identity of individuals captured by the
camera. In pictures of identity documents such as passports, the
sensitive information can also be blurred out.
Encryption converts data to another form which is only readable
to someone who has access to a key or password. There are two
categories of encryption, symmetric and asymmetric. In symmetric
encryption, there is only one password and anyone with the password
can decrypt the data. In asymmetric encryption, there are sets of key
pairs (public and private key). The key pairs are required to encrypt
and decrypt the data. Asymmetric encryption is widely used in the
design of blockchain systems. Data should be encrypted while being
moved and also while in storage.
As data in a blockchain can be read by its network, we need
to consider two types of risks when storing sensitive data on a
blockchain. “Reversal risks” are the likelihood that the data can
be decrypted, such as when someone is able to gain access to the
keys. Reversal risks exist as long as the keys exist. Many encryption
techniques may one day be cracked. Thus, it is not sufficient to just
store encrypted data. “Linkability risks” occur when one can link the
data to an individual by analysing patterns.
Hashing techniques that are used in blockchain applications are
non-reversible. Whether personal data are hashed is widely debated.
It also comes down to whether there are potential reversibility and
linkability risks. It may be possible to reverse a hash using brute force if
the data come from a known set of possibilities (e.g., numbers from one
to a million). This can be mitigated by salting or peppering the data,
where extra data (that is only known to the generator of the hash) is
added before creating the hash. Transactional data on blockchain may
be linkable if you use an application to perform actions on your behalf
which is linked to your address. This can be mitigated by using the
anonymous signature schemes described above.
When designing a blockchain network which will store user data,
one needs to consider the following points (see Figure 6.7).
December 24, 2020 14:17 Blockchain and Smart Contracts: Design Thinking. . . 9in x 6in b4043-ch06 page 187

A Look at Security and Privacy 187

Privacy Considerations for Blockchain Data

WHAT kind of Should

Is the data
data is being sensitive?
encryption
stored? be used?

WHY is the
What is the
data being purpose?
stored?

WHEN is the How long

data being should it be
stored for? stored for?

Figure 6.7: Privacy considerations for blockchain data.

Privacy by Design

Respect •Keep it
•Positive-sum, for user user-
not zero-sum privacy centric

Full Visibility and

functionality transparency

•Keep it open End-to-end

security
Privacy

•As the default setting

•Full lifecycle
•Embedded into Proactive protection
design
not reactive
•Preventative
not remedial

Figure 6.8: Privacy by design principles.

One should pick the appropriate techniques and apply them to

the design of the network. “Privacy by Design” is an approach to
systems engineering which requires privacy to be taken into account
throughout the whole engineering process. It is based on seven
“foundational principles” (see Figure 6.8).
December 24, 2020 14:17 Blockchain and Smart Contracts: Design Thinking. . . 9in x 6in b4043-ch06 page 188

188 Blockchain and Smart Contracts

In the current data economy, many services like social media

or messaging platforms are offered free to users in return for the
use of their data. This landscape is now changing due to increase
in user protection from various governments. However, this does
not mean that users cannot choose to share aspects of their data
in return for free services. Blockchain networks can potentially be
used to help manage users’ consent with regard to their data.
New developments in applied mathematics around cryptography,
blockchains and machine learning can allow for data-driven business
models. By solving the privacy concerns, we may be able to create
a decentralised data economy where the market can all share and
trade data. With tools like secure multiparty computing and zero
knowledge proofs, data can be used to train machines learning
algorithms without revealing the raw data. Users can contribute
to their data and get paid for it. Data from humans, devices,
applications and algorithms can be agglomerated and analysed.
December 24, 2020 14:17 Blockchain and Smart Contracts: Design Thinking. . . 9in x 6in b4043-ch07 page 189

Chapter 7

Introduction to Blockchain Smart

Contracts and Programming with
Solidity for Ethereum
Ernie Teo∗

7.1 Introduction
The concept of smart contracts was first discussed in Nick Szabo’s
(1997) paper, “The Idea of Smart Contracts”. He proposed smart
contracts as a means to embed contractual clauses into digital assets.
For smart contracts to be useful for digital assets, there needs
to be transparency and trust between the contractual parties. The
emergence of Bitcoin reignited the discussion of smart contracts
as an application for blockchains. It serves as a system that aids
trustworthy execution of smart contract. They run exactly as
programmed without any possibility of downtime, censorship, fraud
or third-party interference. Instead of recording transfers of bitcoin
on the blockchain, smart contracts are stored (see Figure 7.1).

∗
Adjunct Senior Lecturer, National University of Singapore; Co Vice-Chairman,
Blockchain Association Singapore, Singapore.

189
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190 Blockchain and Smart Contracts

Figure 7.1: Characteristics of smart contracts.

Figure 7.2: Smart contract for music.

Take, for example, the sale of original music online (see

Figures 7.2 and 7.3).
December 24, 2020 14:17 Blockchain and Smart Contracts: Design Thinking. . . 9in x 6in b4043-ch07 page 191
Introduction to Blockchain Smart Contracts and Programming 191
Assignment of smart contract to blockchain address.
Figure 7.3:
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192 Blockchain and Smart Contracts

Figure 7.4: Buying a song via a smart contract on blockchain.

Suppose Billy wants to buy a song. Using the smart contract,

Billy will go through the following steps (see Figure 7.4):

1. He sends US$1 from his blockchain wallet to the smart contract.

2. The song will be available for Alice to download.
3. The smart contract assigns the rights to download the song to
Billy’s wallet.
4. US$1 is distributed to the song creators (the smart contract can
even keep part of it as a fee).

There is no middleman (like a record label or a music platform)

in the above process. The smart contract will always action as it is
programmed.
Other ways that smart contracts are used on blockchain include
the following:

1. Issuing of tokens. Tokens can represent virtual currency or

physical assets. These tokens can be used for fund raising; Initial
Coin Offerings (ICOs) are a good example. Other types of assets
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Introduction to Blockchain Smart Contracts and Programming 193

that can be tokenised include property, gold or even fiat currencies

like the USD.
2. Ecommerce. This reduces the need for middlemen for the sale
of virtual goods such as the music in the example in Figure 7.2.
Another great use case for ecommerce is escrow contracts. Escrows
hold custody of payment between a buyer and seller until the
transaction is completed. Instead of having a trusted middleman
(such as Paypal) to hold the payment, a smart contract holds the
funds (in token form) instead.
3. Lotteries. A smart contract can act as a lottery. Users can buy
the lottery by sending funds into the contract. After the results
are determined, the smart contract will be paid out to the winners.
The process is transparent and cannot be changed.

7.2 Ethereum
Ethereum’s global computer (or the Ethereum virtual machine)
processes code in a decentralised way, relying on the resources of the
nodes on the blockchain network (see Figure 7.5). Invented in 2013,
the first version of Ethereum was released in 2016 (see Figure 7.6).
Before Ethereum was conceptualised, blockchains had limited
ability to process code. Ethereum is different; rather than giving
a set of limited operations, it allows developers to create whatever
operations they want. This means developers can build thousands
of different applications that go way beyond anything we have

Figure 7.5: Characteristics of Ethereum.

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194 Blockchain and Smart Contracts

Figure 7.6: Ethereum’s timeline.

Figure 7.7: Ethereum Virtual Machine.

seen before. Ethereum aims to be “Turing complete”; anything that

can be mathematically represented can be programmed and put
into a smart contract. Ethereum is a decentralised global computer
that processes smart contracts.
The Ethereum Virtual Machine (EVM) is software that runs on
every computer on the Ethereum network (see Figure 7.7). This
allows one to run any program, regardless of the programming
language given enough time and memory. The EVM makes the
process of creating blockchain applications much easier and more
efficient than ever before. Rather than building and deploying a new
blockchain for each application, Ethereum allows for the development
of potentially thousands of different applications all on one platform.
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Introduction to Blockchain Smart Contracts and Programming 195

In Ethereum, smart contracts are stateful decentralised applica-

tions that are stored in the Ethereum blockchain for later execution
by the EVM. One pays the network for executing the instructions
embedded in Ethereum contracts with ether (or more technically
“gas”). Ether or ETH is the native currency on the Ethereum
Blockchain (similar to how bitcoins or BTCs are native on the Bitcoin
blockchain); it is used to pay for transactions including deployment
and invocation of smart contracts. Smart contracts on Ethereum can
be implemented in a variety of Turing complete scripting languages.

7.3 Tools for Ethereum Smart Contract Development

Figure 7.8 describes high-level architecture for Ethereum Smart
Contract (ESC); it includes the front end, the development platform
and the blockchain network. Figures 7.9–7.14 provide descriptions of
the various applications described in Figure 7.8 and their applications
in creating ESC.
Some useful links for setting up the development tools:
1. Metamask Wallet
(a) https://metamask.zendesk.com/hc/en-us/articles/3600154895
31-Getting-Started-With-MetaMask-Part-1-.
2. Truffle Framework
(a) https://truffleframework.com/.

Figure 7.8: Overview of Ethereum smart contract architecture.

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196 Blockchain and Smart Contracts

Figure 7.9: Solidity for Ethereum smart contract development.

Figure 7.10: MetaMask for Ethereum smart contract development.

Figure 7.11: Remix IDE for Ethereum smart contract development.

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Introduction to Blockchain Smart Contracts and Programming 197

Figure 7.12: Truffle for Ethereum smart contract development.

Figure 7.13: web3.js for Ethereum smart contract development.

Figure 7.14: TestRPC for Ethereum smart contract development.

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198 Blockchain and Smart Contracts

3. Solidity
a. https://solidity.readthedocs.io/.
4. Web3
a. https://web3js.readthedocs.io/.
b. http://www.dappuniversity.com/articles/web3-js-intro.

7.4 Writing Your Own Ethereum Smart Contracts

with Remix
To get started, you should have a Metamask wallet set up (https://
metamask.io/). You will also need some testnet tokens; we will use
the Rinkeby network. Visit https://faucet.rinkeby.io/ for RETH. We
will use the Remix IDE (https://remix.ethereum.org) to develop and
deploy our smart contracts.

7.4.1 Getting Started

After opening the Remix IDE in your browser, choose “New File”.
Name your contract “myfirstcontract.sol”. You will see a blank
document. To start, we use “version pragma” to declare the version
of Solidity compiler we are using; all Solidity codes start with it. It
helps to prevent issues with future compiler versions. You can declare
a specific version or a range, for example,

pragma solidity ∧ 0.5.16;

pragma solidity >= 0.4.0 < 0.6.0;

Next, create your contract by typing

contract MyFirstContract {

Do the following to compile the contract (see Figure 7.15). If there

are errors in the code, the contract will fail to compile. If you cannot
find the Solidity compiler, add it with the Plugin Manager.
A contract contains the code (functions) and data (state) that
reside at a specific Ethereum address. Let us start with a simple
“Hello world” code to get acquainted with Solidity contracts.
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Introduction to Blockchain Smart Contracts and Programming 199

Figure 7.15: Contract compilation.

We start by defining a state variable called “message” which will

be the string type. The Get function will return the value of the
variable “message”. The Set function will assign a new value to the
variable “message”.
To define the function, we start with the reserved word function,
followed by the name of a particular function, then the parameters
and finally the visibility specifiers. The contract will look like this:

pragma solidity ˆ0.5.0;

contract MyFirstContract {
string message;
function get() public view returns(string memory) {
return message;
}
function set(string memory message) public {
message = message;
}
}
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200 Blockchain and Smart Contracts

Functions can be public or private. Public functions can be called

outside of the contract. Private functions can only be called from its
current contract (by some other function).
Function Visibility Specifiers:

• public: visible externally and internally

• private: only visible in the current contract
• external: only visible externally (only for functions)
• internal: only visible internally

Functions can also be pure, view or payable. If a function does not

write any data on blockchain, it is recommended to be view, because
view functions do not cost any gas.
Function Modifiers:

• pure: Disallows modification or access of state

• view: Disallows modification of state
• payable: Allows them to receive Ether together with a call

If the function returns some value, you will need to specify that
with the reserved word returns and then in regular brackets to
specify which type does function returns. In this case, it will be
string (because we return our variable message which is string).
If the function does not return any value, there is no need for
returns statement. It is common practice to write function arguments
with underscore syntax ( message). This convention came from
JavaScript, where private methods and variables start with .
Next, we test the contract. We compile (as described previously)
and deploy. To deploy, choose the Deploy and Run module (add the
module if it is not there). Choose JavaScript VM as the environment;
we are deploying the smart contract in your computer memory (see
Figure 7.16).
After deployment, you will see the deployed contract below where
you can test the functions. We can now see methods from our contract
(see Figure 7.17).
There are two buttons (get & set) for our two public functions
(private cannot be seen here).
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Introduction to Blockchain Smart Contracts and Programming 201

Figure 7.16: Deploy and Run.

Figure 7.17: Execution of function.

Click the Get button for the EVM to execute the function. You
will see an empty string returned. Now, type a message in the “set”
field and click the Set button. Click the Get button again, and your
message will be returned.
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202 Blockchain and Smart Contracts

However, it does not say Hello world; we can initialise the message
with a constructor. You can write constructor in Solidity with

constructor() public {
// do something. . .
}

We update the code to the following:

pragma solidity ˆ0.5.0;

contract MyFirstContract {
string public message;
constructor() public {
message = “Hello world!”;
}
function set(string memory message) public {
message = message;
}
}

We have made the message public and removed the Get function.
If we make the state variables public, one can claim their values
from outside the contract. Solidity will make for each public state
variable a method with the same name which can be called as a
regular function. We do not need the get function once we do this.
This will reduce the size of the code and make it cheaper to deploy.
You can compile, deploy and test the updated code. A message
button now replaces the Get function; it will return the value of
message.
Next, we will create an ERC-20 contract. The token contract
consists of the following:
• ERC-20 Interface — The token rules or standard
• SafeMath Library — Add-on arithmetic operations
• Your customised token contract
ERC-20 tokens follow a list of rules so that they can be shared,
exchanged for other tokens or transferred to a crypto-wallet; these
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Introduction to Blockchain Smart Contracts and Programming 203

are defined in the ERC-20 Interface. The ERC-20 standard consists

of three optional rules and six mandatory rules. If you include certain
functions in the token’s smart contract, you are ERC-20 compliant.
Mandatory rules:
• totalSupply
• balanceOf
• transfer
• transferFrom
• approve
• allowance
Optional rules:
• Token Name
• Symbol
• Decimal (up to 18)
Below is an ERC-20 Interface contract:
pragma solidity ˆ0.5.0;
contract ERC20Interface {
function totalSupply() public view returns (uint);
function balanceOf(address tokenOwner) public view returns
(uint balance);
function allowance(address tokenOwner, address spender) pub-
lic view returns (uint remaining);
function transfer(address to, uint tokens) public returns (bool
success);
function approve(address spender, uint tokens) public returns
(bool success);
function transferFrom (address from, address to, uint tokens)
public returns (bool success);
event Transfer(address indexed from, address indexed to, uint
tokens);
event Approval(address indexed tokenOwner, address indexed
spender, uint tokens);
}

The Safe Math Library is needed to correctly implement some

functions. Arithmetic operations in Solidity wrap on overflow; this
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204 Blockchain and Smart Contracts

can easily result in bugs. Safe Math restores this intuition by

reverting the transaction when an operation overflows. Using this
library instead of the unchecked operations eliminates an entire class
of bugs, so it is recommended to use it always.
The code for the Safe Math Library is the following:

contract SafeMath {
function safeAdd(uint a, uint b) public pure returns (uint c) {
c = a + b;
require(c >= a);
}
function safeSub(uint a, uint b) public pure returns (uint c) {
require(b <= a); c = a - b; }function safeMul(uint a, uint b) public
pure returns (uint c) {c = a * b; require(a == 0 ||c / a == b); }function
safeDiv(uint a, uint b) public pure returns (uint c) {require(b >0);
c = a / b;
}
}

In Solidity, inheritance is pretty similar to classic oriented object

programming languages. For example,

contract baseContract {
// base contract code...
}
contract inheritedContract is baseContract {
// inherited contract code...
}

When a contract inherits from multiple contracts, only a single

contract is created on the blockchain, and the code from all the base
contracts is copied into the created contract. Our main token contract
will inherit the ERC-20 Interface and the Safe Math Library:

contract CoinContract is ERC20Interface, SafeMath

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Introduction to Blockchain Smart Contracts and Programming 205

In our token contract, we define the three optional rules:

• Name — gives your token an identity

• Symbol — usually three letters
• Decimals — defines the lowest possible value of the token. The
maximum number of decimal places allowed is 18. Eighteen
decimals is the strongly suggested default; avoid changing it.

string public name;

string public symbol;
uint8 public decimals;
uint256 public totalSupply;

totalSupply has a uint256 data type and decimals uint8. Solidity

is a statically typed language, which means that the type of
each variable (state and local) needs to be specified at compile
time. Solidity provides several elementary types which can be
combined to form complex types. Integers can be int or uint:
signed and unsigned integers of various sizes. An unsigned integer
is an integer that can never be negative; signed, on the contrary,
can be both negative and positive. We will use only uint in our
contract.
Our token also needs an initial supply, and a record of all balances.
In constructor, we will initialise our contract, including the initial
supply tokens to the creator of the contract (that is msg.sender).
You can set your own name and symbol.

constructor() public {
name = “TokenName”;
symbol = “XYZ”;
decimals = 18;
totalSupply = 100000000000000000000000000;
balances[msg.sender] = totalSupply;
}
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206 Blockchain and Smart Contracts

To store balances, we use mappings. Mapping types are declared

as mapping( KeyType => ValueType). We can mark mappings
public and have Solidity create a getter. The KeyType will become
a required parameter for the getter and it will return ValueType.
The ValueType can be a mapping too. The getter will have one
parameter for each KeyType, recursively. We map address (that is
a data type also) to uint:

mapping(address => uint) balances;

mapping(address => mapping(address => uint)) allowed;

The blockchain contains transactions within blocks, and each

transaction contains log entries. These log entries represent results
of events coming from a smart contract. In the Solidity source code,
to define an event, you mark it thus by preceding it with the event
keyword (similar in usage to the function keyword). For example,
you can find the following in the ERC-20 Interface contract:

event Transfer(address indexed from, address indexed to, uint

tokens);

You then call the event in the body of whatever function you
wish to cause to generate the event. You can do so using the emit
keyword:

emit Transfer(address(0), msg.sender, totalSupply);

The token contract now looks like this:

contract CoinContract is ERC20Interface, SafeMath {

string public name;
string public symbol;
uint8 public decimals;
uint256 public totalSupply;
mapping(address => uint) balances;
mapping(address => mapping(address => uint)) allowed;
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Introduction to Blockchain Smart Contracts and Programming 207

constructor() public {
name = “TokenName”;
symbol = “XYZ”;
decimals = 18;
totalSupply = 100000000000000000000000000;
balances[msg.sender] = totalSupply;
emit Transfer(address(0), msg.sender, totalSupply);
}
}

We also need to add code for the six mandatory functions in our
main token contract:

1. totalSupply
Identifies the total number of ERC 20 tokens created. The purpose
of this method is to determine the total number of tokens floating
around the ecosystem.

function totalSupply() public view returns (uint)

{
return totalSupply - balances[address(0)];
}

2. balanceOf
Returns the number of tokens that a particular address has in
their account.

function balanceOf(address tokenOwner) public view returns

(uint balance)
{ return balances[tokenOwner];
}

3. allowance
In order to carry out a transaction, one of the most important
data that the contract should know is the balance of the user. If
the user does not have the minimum required number of tokens,
the function cancels the transaction.
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208 Blockchain and Smart Contracts

function allowance(address tokenOwner, address spender)

public view returns (uint remaining)
{
return allowed[tokenOwner][spender];
}

4. approve
To give approval to the user to collect the required number of
tokens from the contract’s address. The approve function also
checks the transaction against the total supply of tokens to make
sure that there are none missing or extra. It makes sure that
counterfeiting or double spending is impossible.

function approve(address spender, uint tokens) public returns

(bool success)
{
allowed[msg.sender][spender] = tokens;
emit Approval(msg.sender, spender, tokens);
return true;
}

5. transfer
This function lets the owner of the contract send a given
amount of the tokens to another address just like a conventional
cryptocurrency transaction.

function transfer(address to, uint tokens) public returns (bool

success)
{
balances[msg.sender] = safeSub(balances[msg.sender],
tokens);
balances[to] = safeAdd(balances[to], tokens);
emit Transfer(msg.sender, to, tokens);
return true;
}
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Introduction to Blockchain Smart Contracts and Programming 209

6. transferFrom
transferFrom() allows you to automate payment transfers to a
specific account.

function transferFrom (address from, address to, uint tokens)

public returns (bool success)
{
balances[from] = safeSub(balances[from], tokens);
allowed[from][msg.sender] = safeSub(allowed[from][msg.
sender], tokens);
balances[to] = safeAdd(balances[to], tokens);
emit Transfer(from, to, tokens);
return true;
}

The final code looks like the following:

pragma solidity ˆ0.5.0;

// —————————————————————————-
// ERC Token Standard #20 Interface
//
// —————————————————————————-
contract ERC20Interface {
function totalSupply() public view returns (uint);
function balanceOf(address tokenOwner) public view returns
(uint balance);
function allowance(address tokenOwner, address spender)
public view returns (uint remaining);
function transfer(address to, uint tokens) public returns (bool
success);
function approve(address spender, uint tokens) public returns
(bool success);
function transferFrom(address from, address to, uint tokens)
public returns (bool success);
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210 Blockchain and Smart Contracts

event Transfer(address indexed from, address indexed to, uint

tokens);
event Approval(address indexed tokenOwner, address indexed
spender, uint tokens);
}
// —————————————————————————-
// Safe Math Library
// —————————————————————————-
contract SafeMath {
function safeAdd(uint a, uint b) public pure returns (uint c) {
c = a + b;
require(c >= a);
}
function safeSub(uint a, uint b) public pure returns (uint c) {
require(b <= a); c = a - b; }function safeMul(uint a, uint
b) public pure returns (uint c) {c = a * b; require(a == 0 ||c /
a == b); }function safeDiv(uint a, uint b) public pure returns
(uint c) {require(b >0);
c = a / b;
}
}
contract CoinContact is ERC20Interface, SafeMath {
string public name;
string public symbol;
uint8 public decimals; // 18 decimals is the strongly suggested
default, avoid changing it

uint256 public totalSupply;

mapping(address => uint) balances;
mapping(address => mapping(address => uint)) allowed;
/**
* Constructor function
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Introduction to Blockchain Smart Contracts and Programming 211

*
* Initializes contract with initial supply tokens to the creator
of the contract
*/
constructor() public {
name = “TokenName”;
symbol = “XYZ”;
decimals = 18;
totalSupply = 100000000000000000000000000;
balances[msg.sender] = totalSupply;
emit Transfer(address(0), msg.sender, totalSupply);
}
function totalSupply() public view returns (uint) {
return totalSupply - balances[address(0)];
}
function balanceOf(address tokenOwner) public view returns
(uint balance) {
return balances[tokenOwner];
}
function allowance(address tokenOwner, address spender)
public view returns (uint remaining) {
return allowed[tokenOwner][spender];
}
function approve(address spender, uint tokens) public returns
(bool success) {
allowed[msg.sender][spender] = tokens;
emit Approval(msg.sender, spender, tokens);
return true;
}
function transfer(address to, uint tokens) public returns (bool
success) {
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212 Blockchain and Smart Contracts

balances[msg.sender] = safeSub(balances[msg.sender],
tokens);
balances[to] = safeAdd(balances[to], tokens);
emit Transfer(msg.sender, to, tokens);
return true;
}
function transferFrom(address from, address to, uint tokens)
public returns (bool success) {
balances[from] = safeSub(balances[from], tokens);
allowed[from][msg.sender] = safeSub(allowed[from][msg.
sender], tokens);
balances[to] = safeAdd(balances[to], tokens);
emit Transfer(from, to, tokens);
return true;
}
}

You can now compile, deploy and test your contracts. The next
step is to deploy to the testnet. To do so, change the environment to
“Injected Web3” (see Figure 7.18).
Before you click Deploy, make sure that your Metamask wallet is
set to a testnet wallet with enough token balance (If your Metamask
wallet is connected to the Main Ethereum Network instead, your
wallet will be charged real ETH and the contract will be deployed
into the live network). Once you click Deploy, Metamask will prompt
you to approve the payment for the transaction fee (see Figure 7.19).
Once the transaction is complete, you can see a green tick in the
console box. You can also click on the link to check the transaction
on Etherscan (an Ethereum blockchain explorer). You can find your
wallet address (creator), the smart contract address and the token
details on Etherscan (see Figure 7.20).
Clicking on the token link will bring you to the Token page (see
Figure 7.21).
You can add the token to your Metamask wallet by following the
steps below (see Figure 7.22).
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Introduction to Blockchain Smart Contracts and Programming 213

Figure 7.18: Deploying Testnet.

Figure 7.19: Approval of payment by Metamask wallet.

Congratulations! You have created an ERC-20 token on the

Ethereum testnet.
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214 Blockchain and Smart Contracts

Figure 7.20: Checking transaction on Etherscan.

Figure 7.21: Token page.

7.5 ERC-20
The key use of the ERC-20 contracts has been for raising funds
through a mechanism called ICOs. Thus, Ethereum is also known
as the ICO crowdfunding machine. One of the easiest applications
of Ethereum’s smart contract system is to create a simple token which
can be transacted on the Ethereum blockchain instead of ether. This
kind of contract was standardised with ERC-20. Ethereum became
the host of a wide scope of ICOs.
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Introduction to Blockchain Smart Contracts and Programming 215

Figure 7.22: Adding token to Metamask.

The concept of funding projects with a token on Ethereum

became the blueprint for a new and highly successful generation of
crowdfunding projects. To invest in tokens on top of Ethereum, you
simply transfer ETH to the ICO smart contract from your wallet.
The tokens appear in your account and you are free to transfer them
as you want. There are a set of smart contracts written specifically
for this purpose termed “Token Sale” contracts.
In “ERC-20”, ERC stands for Ethereum request for comments
and 20 stands for a unique ID number to distinguish this stan-
dard from others. A token on Ethereum is basically just a smart
contract that follows some common rules — it implements a
standard set of functions that all other token contracts share,
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216 Blockchain and Smart Contracts

such as transferFrom(address from, address to, uint256 tokenId) and

balanceOf(address owner). So, basically, a token is just a contract
that keeps track of who owns how much of that token and some
functions, so those users can transfer their tokens to other addresses.
Since all ERC-20 tokens share the same set of functions with the
same names, they can all be interacted with in the same ways.
An application that is capable of interacting with one ERC-20
token is also capable of interacting with any other ERC-20 token.
More tokens can be added to the App (one example is the Metamask
wallet) in the future.
Another example of this would be an exchange. When an
exchange adds a new ERC-20 token, really it just needs to add
another smart contract it talks to. The exchange only needs to
implement this transfer logic once; then, when it wants to add a
new ERC-20 token, it is simply a matter of adding the new contract
address to its database. The ERC-20 standard can also be used to
represent physical assets, for example, a piece of property. This allows
the physical asset to be fractionalised and traded.

7.6 What’s Next

Now that you have a basic understanding of Solidity smart contracts,
you can start writing contracts for your own use cases. To make
your application complete, you will also need to connect your smart
contract to a front-end application. Given below are some resources
to follow to find out more:
• https://www.dappuniversity.com/articles/the-ultimate-ethereum
-dapp-tutorial.
• https://www.moesif.com/blog/blockchain/ethereum/Tutorial-fo
r-building-Ethereum-Dapp-with-Integrated-Error-Monitoring/.
• https://medium.com/coinmonks/ethereum-land-marketplace-da
pp-tutorial-part-1-create-and-deploy-a-smart-contract-351bc0d6
2be2.
• https://www.trufflesuite.com/tutorials/pet-shop.
December 24, 2020 14:17 Blockchain and Smart Contracts: Design Thinking. . . 9in x 6in b4043-ch08 page 217

Chapter 8

Hands-On Lab with MultiChain

Roy Lai∗ and Yu Yinghui†

8.1 From Bitcoin Blockchains to MultiChain

8.1.1 Double-Spending Problem and Byzantine
Generals Problem
The term “blockchain” originally refers to the underlying technology
used in implementing the Bitcoin protocol and network in Satoshi
Nakamoto’s paper “Bitcoin: A Peer-to-Peer Electronic Cash System”
in 2008. As the paper title indicated, blockchain technology has been
used to solve the Double-Spending Problem.
In the digital world, data such as photos and emails can be easily
copied and replicated (see Figure 8.1). Preventing double-spending
problems (see Figure 8.2) is the key to create an effective digital proof
of IOU (“I owe you”).
In the real world, people use fiat money and double spending is
not an issue, as the physical cash transactions are managed by a
centralised trusted third party (the bank).
In a decentralised digital world, to solve the double-spending
problem without the need for a trusted third party, another problem
needs to be solved first. It is called the Byzantine Generals Problem
(Lamport et al., 1982; see Figure 8.3).

∗
Founder, Sentinel Chain.
†
School of Business, Singapore University of Social Sciences, Singapore.

217
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218 Blockchain and Smart Contracts

Figure 8.1: Duplication in the physical vs digital world.

Figure 8.2: Double-spending problem illustration.

As a continuation of the ancient Roman Empire in its eastern

provinces, the Byzantine Empire ruled most of Eastern and Southern
Europe throughout the Middle Ages.
The Byzantine Generals Problem describes a scenario where
several divisions of the Byzantine army were camped outside an
enemy fort and trying to take the fort down (see Figure 8.4). Each
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Hands-On Lab with MultiChain 219

Figure 8.3: Byzantine Generals Problem.

Figure 8.4: Consensus process and effects of Byzantine Generals Problem.

Note: Lamport et al. (1982). The Byzantine Generals Problem.

division was commanded by its own general, and all the generals
could communicate with one another only by messenger. The generals
needed to have a coordinated plan of action in order to take down the
enemy fort. However, some of the generals could be traitors and they
would try to present an agreement to be reached. The generals must
have an algorithm to guarantee that (A) all loyal generals decide
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220 Blockchain and Smart Contracts

upon the same plan of action, and (B) a small number of traitors
cannot cause the loyal generals to adopt a bad plan.
The Byzantine Generals Problem assumes that there will be an
unknown number of participants that are expected to misbehave and
attempt to subvert the network; hence, it is often used as an analogy
in computer science to describe the challenges faced by distributed
systems in achieving consensus over unreliable communication
links.
Solving the Byzantine Generals Problem requires complicated
algorithms, and such algorithms did not exist until the 1970s. They
only worked in lab-like environments, however, and they can only be
deployed in large-scale and expensive developments, such as Boeing
airplanes or submarines, where every component within the entire
system has to work with a very tight margin of error (see Figure 8.5).
Bitcoin and Boeing 777 share the similarity that both solve
the Byzantine Generals Problem, but Bitcoin solves it with cheap
hardware. The trade-off is that the confirmation in the Bitcoin (or
some other cryptocurrencies) network takes place in a different way:
the network needs time to collect votes and reach consensus. In
essence, time is the price (or rather, a unique feature) that the Bitcoin
network pays to reach consensus in a decentralised setup.

Figure 8.5: Byzantine Generals Problem in reality.

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Hands-On Lab with MultiChain 221

8.2 Bitcoin Concepts

8.2.1 Bitcoin and Blockchain
Bitcoin (“B” as upper case) refers to the protocol used to secure
bitcoin currency and govern how nodes in the network communicate
with each other, whereas bitcoin (“b” as lower case) refers to the
cryptocurrency traded, which is essentially just numbers built in the
blocks within the network (Figure 8.6).
The technology that is used to implement this protocol is called
blockchain.

8.2.2 Peer-to-Peer Network Protocol

There are a few ways to design a network (Figure 8.7). In a centralised
network, there is a decision-making authority. A decentralised net-
work means that there is no single authority and that multiple
nodes on the network are involved in decision-making. A distributed
network means operating loads are shared across all nodes. It is
usually a decentralised network taken to the extreme (note that
a centralised but distributed network may be possible). Bitcoin
network is a decentralized network of distributed Bitcoin nodes.

Figure 8.6: Bitcoin and blockchain.

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222 Blockchain and Smart Contracts

Figure 8.7: Bitcoin network and distribution protocol.

Figure 8.8: Peer-to-Peer network protocol.

In this public decentralised network, the distributed nodes need to

discover other nodes with the same software installed (see Figure 8.8).
Similar to applications like BitTorrent, this peer-to-peer discovering
process is described as a “handshake”, which refers to the process
that two nodes establish a connection with each other and start to
exchange version and verack messages, in order to ensure compliance
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Hands-On Lab with MultiChain 223

Figure 8.9: Cryptography.

between peers. Other metadata will also be passed on, such as block
size and configuration of time needed to arrive at consensus.

8.2.3 Cryptography
A hash function is a function that maps data of arbitrary size to fixed-
size values, and it is in one direction only. Symmetric cryptography
means the same key is used for verifying the authenticity of data.
Asymmetric cryptography is used extensively in blockchain, and it
involves using pairs of related keys — a public key to process the
data and a private key to validate it. On the contrary, in the Digital
Signature Algorithm (DSA), data are signed with a private key but
can be verified with the public key. Public keys may be disseminated
widely, but private keys are known only to the owners.
One type of the asymmetric cryptography is elliptic-curve cryp-
tography (ECC), an approach based on the algebraic structure of
elliptic curves over finite fields (see Figure 8.9).

8.2.4 Elliptic Curve Digital Signature Algorithm

(ECDSA)
The equation of an elliptic curve follows the formula y 2 = x3 +ax+b,
and Bitcoin uses a particular set of parameters called secp256k1, the
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224 Blockchain and Smart Contracts

Figure 8.10: Elliptic Curve Digital Signature Algorithm.

Note: “A (relatively easy to understand) primer on elliptic curve cryptography”,
Nick Sullivan.

formula being y 2 = x3 + 7, in its Elliptic Curve Digital Signature

Algorithm (ECDSA) (see Figure 8.10). Secp256k1 has the desired
feature of efficient computation and is able to generate keys of smaller
size and at a speed 30% faster than other curves.

8.2.5 Bitcoin Private Key

Every bitcoin wallet has a private key. The Bitcoin private key is
essentially a 256-bit number, and it is generated in a random way,
and hence it is only known to the user who generates it.
In the Bitcoin network, a sender signs data using his private
key and the receiver can verify the legitimacy of the data using the
sender’s public key (the public key can be seen by everyone in the
network).
In the multichain context, a private key serves three purposes:
• For you to send native currency or native assets to other addresses.
• For you to prove ownerships to items published on streams.
• For you to assign permissions and get authorisations.
The Bitcoin private key can be stored either as
• A hexadecimal number (see Figure 8.11), or
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Hands-On Lab with MultiChain 225

• A Base58 encoded string also known as Wallet Interchange Format

(WiF), as shown in Figure 8.12.

Losing a private key will grant others access to your currency,

assets, streams and permissions; hence, private keys should be man-
aged independently and externally, for instance, by HSM (Hardware
Security Modules), and used only when required to sign transactions
(see Figure 8.14).

8.2.6 Bitcoin Public Key

• The Bitcoin public key is derived from the Bitcoin private key, but
not vice versa.
• A public key can be used by others to verify your signature without
knowing your private key.
• A public key is represented by the following:

Figure 8.11: Hexadecimal number.

Figure 8.12: Wallet interchange format.

Note: Two encoding systems are used here — hexadecimal and Base58. Base58
is a group of binary-to-text encoding systems used to represent large integers
as alphanumeric text, introduced by Satoshi Nakamoto for use with Bitcoin. It
consists of the twenty-six letters of both upper cases and lower cases and numbers
0–9, while excluding 0 (zero), O (capital o), I (capital i) and l (lower case L) to
avoid confusion to human eyes. Figure 8.13 exemplifies how decimal numbers are
represented by the two encoding systems.
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226 Blockchain and Smart Contracts

Figure 8.13: Representation of numbers in the two encoding systems.

Figure 8.14: Bitcoin private key.

• A 65-byte hexadecimal number that starts with a 4 (old

uncompressed format), or
• A 33-byte hexadecimal number that starts with a 2 or 3 (new
compressed format).
The Bitcoin wallet address is derived from a public key, but not
vice versa (see Figure 8.15). A wallet address is used
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Hands-On Lab with MultiChain 227

Figure 8.15: Bitcoin wallet.

Base58Check

16UwLL9Risc3QfPqBUvKofHmBQ7wMtjvM

Figure 8.16: Wallet address.

• By others to send you native currency or native assets on

blockchain.
• By others to verify your ownership of items published on
blockchain.
• By the blockchain to verify your permissions.

A wallet address looks as shown in Figure 8.16.

But, it is stored internally as shown in Figure 8.17.

• 25 bytes for Bitcoin

• 28 bytes for MultiChain (see Figure 8.18).

As the address indicates, multichain is extended based on the

Bitocoin blockchain and it is essentially a fork of Bitcoin Core (the
Bitcoin software). There are well-selected features and enhancements
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228 Blockchain and Smart Contracts

Figure 8.17: Bitcoin wallet storage.

Figure 8.18: MultiChain address.

in multichain that enable users to launch a customised private

blockchain that is easy to configure and can be used by organisations
for financial transactions. This chapter discusses these features and
enhancements of multichain, by comparing Bitcoin blockchain and
multichain in details.
There are two types of Bitcoin addresses (Figure 8.19). An
address that begins with “1” is based on the hash of a public
key. Hence, such an address belongs to and represents the public
key owner, i.e., a human being. This is the most common type of
address on the Bitcoin network. Addresses that begin with “3”, on
the contrary, are based on the hash values of Bitcoin scripts. They
represent special programs on the network. Users send transactions
to such addresses when certain conditions need to be fulfilled in order
for bitcoins to be received, e.g., for escrow purposes.
One example is a multi-signature address, which is essentially
a script to make sure that enough signatures are received before a
transaction can go through (see Figure 8.20).
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Hands-On Lab with MultiChain 229

Figure 8.19: Types of Bitcoin addresses.

Figure 8.20: Multi-signature address.

8.2.7 Bitcoin Block Structure

A blockchain data structure is a linked list (hence the term “chain”)
of data blocks (see Figure 8.21). Each block contains the hash value
of the preceding block, and this serves as a link to the preceding
block and establishes the order throughout the chain of blocks.
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230 Blockchain and Smart Contracts

Figure 8.21: Blockchain data structure.

Figure 8.22: Block structure.

A block primarily contains two parts: the list of transactions

collected from all other nodes and the block header (see Figure 8.22).
The block header contains a few fields:

• Version: Users have to use the same version of the protocol. A

block generated using a different version will not be accepted
• Hash of the Preceding Block : It is also the transaction ID of the
preceding block. If there is any slight change in the transaction
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Hands-On Lab with MultiChain 231

details in the preceding block, then the hash value will be

completely different from what is stored in the next block, and
the chain will be broken.
If someone would like to change transaction details in an existing
block, then he needs to regenerate all the blocks that have been
linked after that block. It is extremely difficult due to the proof-
of-work process involved in generating blocks.
• Merkle Root: It is the hash of all the hashes of all the transactions
in the block. It is the top hash (or root hash) of a tree structure
(called Merkle Tree), where transactions are hashed in pairs, then
the obtained hash values are concatenated in pairs and hashed
again. The Merkle Root is a short yet unique fingerprint of all the
transactions and helps to verify if a transaction belongs to this
block. To verify if a single transaction is included in the block,
not all the transactions in the data are needed. Instead, one only
needs to know the hash values along the path (from the bottom
transaction up till the Merkle Root). This process is called Merkle
Proof.
• Difficulty Level: It measures how many hashes (statistically)
should be generated to find a valid solution to solve (hence
generate) the Bitcoin block and earn the mining reward. It is set to
be “inefficient” in a sense, in order to stipulate enough time for all
the nodes to synchronise. Difficulty is adjusted from time to time
to make sure that on average it takes 10 minutes to generate a
block.
• Nonce: A 32-bit (4-byte) field whose value is randomly regenerated
by miners, until the hash of the block is less than or equal to the
current target of the network.

8.2.8 Proof-of-Work Consensus Algorithm

The block-generating process is like a lottery held every 10 minutes
on average (see Figure 8.23). The node who finds an eligible nonce
value first has the privilege to attach this block to the blockchain
and receive the mining reward.
When a miner successfully generated a hash value that is smaller
or equal to the target, this hash value is called Proof of Work
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232 Blockchain and Smart Contracts

Figure 8.23: Proof-of-Work “lottery”.

Figure 8.24: Proof-of-Work algorithm.

(PoW). PoW also refers to this consensus algorithm where miners

keep generating nonce and calculating hash values in order to hit the
jackpot, i.e., generating the next block (see Figure 8.24). Hashing
is regarded as “work”, and statistically, it all comes down to the
computing power a node owns.
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Hands-On Lab with MultiChain 233

Figure 8.25: Proof-of-Work winner takes all.

As part of the consensus mechanism, once a miner submits his

Proof of Work, the rest of the network must accept his block (see
Figure 8.25).
A Sybil attack is a kind of security threat to a system where one
person tries to take over the network by creating a large number of
pseudonymous identities and uses them to gain a disproportionately
large influence. The Proof-of-Work consensus algorithm means the
ability of a node (or a group of nodes) to create blocks must be
proportional to the total processing power. This renders Sybil attacks
economically impractical, since a party that tries to launch a Sybil
attack needs to actually own the computing power (imagine 51% of
all the mining machines in the world) to keep creating new blocks
(Figure 8.26).
Changing previous blocks on the Bitcoin network is also very dif-
ficult based on the same logic. Under the PoW consensus algorithm,
all nodes accept the longest chain and work on the next block based
on the longest chain. If a node changes a previous block, he will have
to create new blocks to attach to the changed block, and at a faster
speed than the rest of the world so that his chain will outgrow the
original one. One will need to own 51% of the computing power of
the whole network in order to do that (see Figure 8.27).
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234 Blockchain and Smart Contracts

Figure 8.26: Proof-of-Work protection against Sybil attack.

Figure 8.27: Proof-of-Work protection immutability.

8.2.9 Blockchain Fork

A fork can happen on the blockchain due to two correct blocks being
generated at the same time, and the network accepts the longer chain
(see Figure 8.28). To be secure against such a fork (double spending),
a transaction should not be considered as confirmed until it is a
certain number of blocks deep. On Bitcoin blockchain, usually six
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Hands-On Lab with MultiChain 235

Figure 8.28: Blockchain fork.

Figure 8.29: Forks across different geography.

Source: Mastering Bitcoin by Andreas M. Antonopoulos.

new blocks need to be generated after a transaction, in order to

consider that transaction as confirmed.
Such forks sometimes happen in different geological areas —
where physical proximity makes a slight difference in the speed of
synchronisation (see Figure 8.29).
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236 Blockchain and Smart Contracts

Figure 8.30: Types of intentional forks.

There are three types of (intentional) forks. A soft fork refers to

a change of the blockchain protocol which is backward-compatible.
Non-updated nodes are still able to process transactions and generate
blocks, so long as they do not break the new protocol rules (see
Figure 8.30).
A hard fork is a change of protocol which is incompatible with
the previous versions. When a hard fork is planned, nodes voluntarily
upgrade their software to follow the new rules, leaving the old
versions behind. The ones who do not update are left mining on
the old chain, which very few people will be doing.
If a fork is controversial, it means there is disagreement within the
community about the upgrade, and the protocol is usually forked into
two incompatible blockchains, hence two different cryptocurrencies.
A source code fork is not a fork in the blockchain, but rather a
change in the source code which might result in new software.

8.2.10 Bitcoin Transactions

Before going into the details of bitcoin transactions, one thing to
note is that unlike the transactions in the real world where money or
cash is passed around, bitcoin transactions are analogous to handling
the recipient a key, which can be used to unlock the bitcoins from
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Hands-On Lab with MultiChain 237

Figure 8.31: Explaining bitcoin transactions.

a previous transaction, and hence represent the ownership of these

bitcoins.
A transaction contains two parts: inputs and outputs
(Figure 8.31). Total value of the outputs will be equal to or smaller
than the total value of inputs; the difference is the mining fee.
A transaction input is made of the following (see Figure 8.32):
• Previous transaction’s ID : The ID is a hash of a previous
transaction.
• Previous transaction’s output.
• ScriptSig: ScriptSig is the short form for signature script. It is the
first half of a script (the other half is scriptPubKey) and it is the
unlocking script that satisfies the conditions placed on the previous
output by the scriptPubKey, and it is what allows it to be spent.
A transaction output is made of the following (Figure 8.33):
• A single value of cryptocurrency (note that it is smaller than the
total value of inputs).
• ScriptPubKey: ScriptPubKey is the second half of a script (the first
half is scriptSig) and it is a locking script placed on the output of
a Bitcoin transaction that requires certain conditions to be met in
order for a recipient to spend the bitcoins.
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238 Blockchain and Smart Contracts

Figure 8.32: Bitcoin transaction input.

Figure 8.33: Bitcoin transaction output.

• Metadata: Metadata are not relevant to the transaction itself, and

are usually used to extend Bitcoin protocol. They can be used to
contain special instructions to certify and transfer the ownership
of a variety of assets beyond cryptocurrency, or just save arbitrary
pieces of data which do not affect transfers of bitcoins.
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Hands-On Lab with MultiChain 239

Figure 8.34: Unspent Transaction Output (UTXO).

A transaction output can only be referenced by confirmed

transaction input ONCE. Before the reference, it is called Unspent
Transaction Output (UTXO), and after the reference it is output
spent (see Figure 8.34).
A transaction is valid if all inputs reference UTXOs and if the
scriptSig in each input can unlock the scriptPubKey of the respective
previous output, i.e., it satisfies the conditions placed on the output
by scriptPubKey (Figure 8.35).
Wallet balance is the sum of all UTXO that has been sent to this
wallet address (but not spent yet; see Figure 8.36).

8.2.11 Bitcoin Script Language

Bitcoin Script language is a rudimentary, stack-based program-
ming language that enables processing of the transactions on the
Bitcoin blockchain, and it is not a Turing complete language (see
Figure 8.37). Turing Completeness is a mathematical concept and is
a measure of the computability of a programming language. A non-
Turing Complete language basically means that the language is
designed without complex constructs such as loops and conditions
which limit its ability to create general purpose programs. In
Bitcoin’s case, this is by design as it avoids the risks of bad
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240 Blockchain and Smart Contracts

Figure 8.35: Valid transaction.

Figure 8.36: Wallet balance.

programming such as infinite loop from bringing down the entire

network.
Script expressions use Reverse Polish Notation (RPN) and are
processed using stacks and a postfix algorithm (see Figure 8.37).
RPN, also known as postfix notation, is a method of placing the
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Hands-On Lab with MultiChain 241

Figure 8.37: Bitcoin script language.

operation function at the end of a sentence. For example, adding 5

and 6 in Script must be written as “5 6 +” rather than “5 + 6”.
A stack is a data structure that is linear and can be thought of
as a real physical stack or pile. Items at the top of the stack can
be added (pushed) or removed (popped) in a “Last In, First Out
(LIFO)” order. Using RPN, Bitcoin script pushes operands onto the
stack first, followed by the operator which triggers the evaluation.
Specifically, the operator will be popped out of the stack, followed
by the operands, and the expression gets calculated, and the result
will be pushed back onto the stack.
In a bitcoin-spending transaction, output can only be spent in dis-
crete value (Figure 8.38). For example, Alice wants to send 25 units
to Bob. Assume Alice only received two transactions previously,
where she received 10 bitcoins in one transaction, and 20 bitcoins
in the other. The outputs of these two previous transactions (the
two UTXOs) will be referenced as inputs for the new transaction
to Bob. The new transaction to Bob will have two outputs: one is
to send Bob 25 bitcoins, and the other is to send the balance of
5 bitcoins (or slightly less than 5 if we consider transaction fee) back
to Alice herself.
From an earlier discussion, we also know that for Alice to
successfully spend the UTXOs, she will need to provide ScriptSig (the
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242 Blockchain and Smart Contracts

Figure 8.38: Spending bitcoins.

Figure 8.39: Verifying expenditure of UTXOs.

unlocking script, based on her private key) in the new transaction (see
Figure 8.39). This ScriptSig is combined with the ScriptPubKey (the
locking script, based on her public key) in the previous transactions
and executed. If the returned result is TRUE, it proves that Alice
does indeed own the private key paired with the public key, and the
spending is successfully executed.
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Hands-On Lab with MultiChain 243

Figure 8.40: Spending bitcoin at the script level.

Now, we look at how spending is executed at the script level.

ScriptPubKey consists of five components as shown in
Figure 8.40.

(1) OP DUP
(2) OP HASH160
(3) pubkeyHash
(4) OP EQUALVERIFY
(5) OP CHECKSIG

ScriptSig contains two components: Signature and Public Key.

(1) sig
(2) pubkey

When ScriptPubKey and ScriptSig are combined, the two com-

ponents from ScriptSig are appended at the front of ScriptPubKey’s
components (i.e., in front of OP-DUP), and they are pushed onto the
stack in turn for calculations (see Figures 8.41 and 8.42).

Step 1: Signature is pushed onto the stack (see Figure 8.41).

Step 2: Public Key is pushed onto the stack.
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244 Blockchain and Smart Contracts

Figure 8.41: Stacking of components of ScriptSig and ScriptPubKey.

Figure 8.42: Stacking and execution of spending.

Step 3: Operator of Duplicate [OP DUP] is pushed on the stack:

duplication operation is triggered and results in two [Public
Key]s on the stack.
Step 4: Operator of Hash160 is pushed onto the stack: This operation
returns the 20-byte hash value of the public key [PubKey-
Hash] (see Figure 8.42).
Step 5: [PubKeyHash] from the scriptPubKey is pushed onto the
stack.
Step 6: The operator [OP EQUALVERIFY] is pushed on the stack,
and it verifies if the two [PubKeyHash] currently on the stack
are the same. Note that the first one [PubKeyHash] is from
scriptSig, and the second is from scriptPubKey.
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Hands-On Lab with MultiChain 245

Figure 8.43: List of commonly used script Opcodes.

Step 7: Once Step 5 returns true, the last operator [OP CheckSig]
will be pushed onto the stack. It verifies if the public key
is generated by the private key which is used to sign the
signature.
If the returned result from Step 6 is true, the spending is
successfully executed.
A list of commonly used script opcodes are shown in Figure 8.43.
With these opcodes, functions other than spending can be achieved.
For example, instead of sending a transaction to a wallet address,
one can publish a transaction on the network and send bitcoins to
anyone who can return a certain hash value. Any user who can return
such a hash value will be able to unlock the transaction and receive
the bitcoins.

8.3 Purposes and Differences of Public

and Private Blockchains
Bitcoin blockchain is a public permissionless blockchain
(Figure 8.44). Anyone from the public Internet can join or leave
the blockchain network without any need for providing any forms
of identification or asking for permission.
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246 Blockchain and Smart Contracts

Figure 8.44: Public permissionless blockchain.

For a public blockchain, most classical distributed systems algo-

rithms that require nodes to be known ahead of time will not work,
since authentication is not used. As the environment is assumed to be
public Internet and anonymous, a public blockchain is susceptible to
Sybil attacks, and consensus protocols that cannot handle Byzantine
failures are not applicable.
A private blockchain on the contrary provides a more sanitised
environment (Figure 8.45). Figure 8.46 further lists the differences
between public and private blockchains, as well as the pros and cons
for turning to a private blockchain.
A private blockchain assumes that all actors on the network
are known and trusted, belonging to a controlled membership.
These actors can be individuals such as employees and customers
or organisations such companies or departments within companies.
A central authority (or group) may be required to perform the
identity verification and approval of membership.
Since all members are known and access is permissionable, use of
token mining to create an intrinsic incentive model is not required;
therefore, solution can achieve better performance.
The public blockchain and private blockchain are examples of the
blockchain trilemma, which suggests it is not possible to achieve all
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Hands-On Lab with MultiChain 247

Figure 8.45: Private permissioned blockchain.

Figure 8.46: Comparing public and private blockchains.

three preferable features: decentralisation, security and performance.

Bitcoin blockchain is regarded as having high decentralisation,
high security, but not so much on the performance. A private
blockchain can achieve security and performance, while sacrificing
decentralisation.
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248 Blockchain and Smart Contracts

8.4 Introduction to MultiChain

MultiChain is a private blockchain platform based on a fork of
Bitcoin Core. It is a new and special form of high-resilience database
that allow shared control across organisational boundaries.
MultiChain has the well-structured features of being lightweight
and easy to configure. It is used by prominent companies and software
(see Figure 8.47).
Setting up a private blockchain on multichain follows four steps
(see Figure 8.48):

Step 1: Install the multichain software.

Step 2: Configure the first node, i.e., the admin node.
Step 3: Use the first node to configure the permission of other nodes.
Step 4: Connect with other nodes.

On the bitcoin blockchain, the assets (bitcoins) are issued by the

protocol itself, while on the multichain, the owner can issue his/her
owner assets, similar to a central bank printing its own money if it
is permissioned to do so (Figure 8.49).
On multichain, streams can be used for data storage (Figure 8.50).

Figure 8.47: Features of multichain.

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Hands-On Lab with MultiChain 249

Figure 8.48: Steps to set up private blockchain on multichain.

Figure 8.49: Issuance of assets on multichain.

Given in Figure 8.51 are the three executable files needed during
the setup and use of multichain. The two main configuration files
should be set before the chain is created and running. Some hidden
folders will be created while setting up the blockchain.
Multichain-util is used to create a blockchain and kick off the
process (see Figure 8.52).
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250 Blockchain and Smart Contracts

Figure 8.50: Data storage on multichain.

Figure 8.51: Executive files needed for multichain.

Multichaind is the service running on the nodes (see Figure 8.53).

Multichain-cli is the command line tool to issue command lines
to the nodes (see Figure 8.54).
The multichain.conf file contains parameters for the specific node.
“rpcuser”, “rpcpassword” and “rpcallowip” are the three fields that
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Figure 8.52: Multichain-util.

Figure 8.53: Multichaind.

need to be changed in the configuration file, which enables the user

to talk to the blockchain nodes remotely (see Figure 8.55).
The params.dat file contains parameters for the multichain, which
are the same for every node (see Figure 8.56). The parameters cannot
be changed once the blockchain is initialised.
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252 Blockchain and Smart Contracts

Figure 8.54: Multichain-cli.

Figure 8.55: Multichain.conf.

8.4.1 MultiChain Permissions

MultiChain allows permissions to be assigned according to wallet
addresses (see Figure 8.57). Low-level permissions include whether a
node can connect to the other nodes, and whether a node can send
or receive assets. Medium-level permissions include the capability to
issue assets and create streams. Operators can mine or change the
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Figure 8.56: params.dat configuration file.

Figure 8.57: MultiChain permission types, scope and relevant information.

permissions for other nodes, and the administrator has the highest
power to change all permissions for any address.

8.4.2 Peer-to-Peer Handshaking Protocol

on MultiChain
As the configuration of nodes on multichain is a bit more complicated
than that of the Bitcoin blockchain (for example, various multichain
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254 Blockchain and Smart Contracts

Figure 8.58: Bitcoin handshake vs multichain handshake.

nodes might have different permissions), the handshake between

nodes on multichain is also more complicated; the entire configura-
tion file needs to be sent to each other (see Figure 8.58). Specifically,
three messages will be sent, version, verack and verackack, and they
perform the following additional functions:

• Check that both peers are on a blockchain with the same name.
• If necessary, download the blockchain parameters from the other
side; otherwise, check that both are using identical parameters.
• Each node identifies a public address which has connection per-
missions and for which it has the private key.
• Each node sends a challenge message to the other node which it
must sign using the private key corresponding to the address it
presented.

As there are different levels of permissions on multichain (espe-

cially since an admin role has the most powerful permissions), a
consensus governance model is applied. More than one admin node
exists on the network, and it takes certain number of votes from
admin nodes in order to reach consensus.
For example, a decision needs to be made regarding whether
to grant admin role to a new node. If the admin-consensus-admin
parameter is set at 0.6, then confirmations from more than 60% of
the existing admin nodes are needed in order to reach consensus and
grant the new node the admin role (see Figure 8.59).
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Hands-On Lab with MultiChain 255

Figure 8.59: Granting of permission on multichain.

Figure 8.60: Incentive for mining.

8.4.3 MultiChain Consensus

As discussed earlier, the mining reward is not necessary in the private
blockchain context such as multichain (see Figure 8.60).
One dilemma posed by private blockchains is that one participant
could monopolise the mining process. MultiChain solves this dilemma
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256 Blockchain and Smart Contracts

Figure 8.61: MultiChain consensus protocol.

Figure 8.62: Effect of mining diversity = 0.75.

by applying a constraint on the number of blocks which may be

created by the same miner within a given window (see Figure 8.61).
To implement a round-robin schedule (where the permitted
miners must create blocks in rotation), a parameter called “Mining
Diversity” is set up with the constraint 0 ≤ Mining Diversity ≤ 1.
The number of permitted miners on the blockchain is multiplied
by the Mining Diversity, and the result is rounded up to get an integer
called spacing. If the miner of a block has mined one of the previous
spacing-1 blocks, the block is invalid.
Figure 8.62 illustrates the effect of setting Mining Diversity
to 0.75.
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Hands-On Lab with MultiChain 257

Figure 8.63: Effect of mining diversity = 0.50.

There are five permitted miners in this example. Hence, spacing

(i.e., the window size) is calculated as 5 × 0.75 = 4, which means
that a miner cannot mine two or more blocks in any four consecutive
blocks. A miner who had mined a block needs to wait for three
blocks to be mined by other miners before he can generate a block
again. Otherwise, his block will be rejected when he submits it to
the network.
The higher the Mining Diversity is, the more the miners will be
involved in the block generation. The possible downside is that the
whole blockchain freezes up if some miners become inactive.
Figure 8.63 illustrates what might happen if the Mining Diversity
is set at 0.5.
Spacing (i.e., the window size) is calculated as 3 (i.e., 5 multiplied
by 0.5 and then rounded up). A miner who has mined a block needs
to wait for only two blocks to be mined by other miners before he
can generate block again. As the spacing is shorter now compared
to when the diversity was set at 0.75, there is a higher chance that
multiple miners are generating blocks simultaneously.
Figure 8.64 illustrates what might happen if the Mining Diversity
is set at 0.25.
Spacing (i.e., the window size) is calculated as 2 (i.e., 5 multiplied
by 0.25 and then rounded up).
Figure 8.65 illustrates what might happen if the Mining Diversity
is set at 0.
For Mining Diversity set at 0, there is no restriction at
all, and every permitted miner can mine blocks at any time.
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258 Blockchain and Smart Contracts

Figure 8.64: Effect of mining diversity = 0.25.

Figure 8.65: Effect of mining diversity = 0.

The concentration risk is higher in that one miner is generating more

blocks than others, and in that it takes fewer miners to collude in
order to undermine the network.
In summary, the Mining Diversity parameter defines the strict-
ness of the round-robin scheme, i.e., the proportion of permitted
miners who would need to collude in order to undermine the network.
A value of 1 ensures that every permitted miner is included in the
rotation, whereas 0 represents no restriction at all. In general, higher
values are safer, but a value too close to 1 can cause the blockchain to
freeze up if some miners become inactive. Usually, a value of 0.75 is
regarded as a reasonable compromise. To conserve resources, nodes
will not attempt to mine on a chain in which they had already mined
one of the previous spacing-1 blocks.

8.4.4 MultiChain Asset

Native currency on a blockchain is generically generated by the
protocol, such as Bitcoin and Ethereum (see Figure 8.66). Native
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Hands-On Lab with MultiChain 259

Figure 8.66: Difference between native assets and native currency.

assets are issued by addresses, and the word “native” means that
the logic for validating such assets is embedded within the protocol.
There can be many different assets in multichain, but only one native
currency.
Bitcoin 2.0 is a concept that refers to leveraging the Bitcoin
protocol above and beyond its native currency bitcoin, such as
securing and validating external transactions that do not originate
on the main chain (see Figure 8.67). A related term is “colored
coins”, which describes a class of methods for representing and
managing real-world assets on top of the Bitcoin blockchain. Earlier,
we discussed that the Bitcoin Script language allows it to store
small amounts of metadata on the blockchain, which can be used
to represent such asset manipulation instructions. However, the
presence of such non-native assets encoded in the metadata is not
subjected to network-level verification, because Bitcoin nodes cannot
read the metadata and also because neither Bitcoin nodes nor Bitcoin
tracks such non-native assets. The only way to validate the balance
of such non-native assets is to download the full history of bitcoin
transactions.
MultiChain assets, on the contrary, are built into the protocol and
validated at the network level (Figure 8.68). It encodes the identifiers
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260 Blockchain and Smart Contracts

Figure 8.67: Difference between multichain assets and bitcoin 2.0 protocols.

Figure 8.68: Features of multichain assets.

and quantities of all assets into each transaction output, using an

extension provided by bitcoin’s scripting language.
The rule for validating transactions is extended to verify that the
total quantities of all assets in a transaction’s output are exactly
matched by the total in its inputs (this equality requirement is
stricter than the constraint for the native currency, in which the
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Figure 8.69: Definition of a stream.

output may be less than the input, with the difference collected as a
fee by miners).

8.4.5 MultiChain Streams

A stream is a set of data storage functionality introduced to multi-
chain in 2016. It is mainly for general data retrieval, timestamping
and archiving, rather than the transfer of assets between participants
(Figure 8.69).
Steams can be used to implement three different types of
databases on a chain (see Figure 8.70):

1. A key–value database or document store, in the style of NoSQL.

2. A time series database, which focuses on the ordering of entries.
3. An identity-driven database where entries are classified according
to their author.

8.5 Hands-On Lab with MultiChain

This section introduces how a hands-on lab session with multichain
is done, where participants set up a private blockchain, set up
permissions, create and issue native assets and make transactions.
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262 Blockchain and Smart Contracts

Figure 8.70: What, When and Who of multichain streams.

8.5.1 MultiChain Installation

A Microsoft Azure account1 and Putty are needed for this session.
Initially, create virtual machine on Ubuntu server in Azure (see
Figure 8.71).
Then, connect to the virtual machine using Putty (see
Figure 8.72).
Next, download the latest version of multichain community from
https://multichain.com/download-community/ (see Figure 8.73).
Note that there need to be at least three participants in this
session, so they can set up Server 1, 2 and 3 following the abovemen-
tioned steps. In later sessions, they will act as three different nodes
on multichain.

8.5.2 Setup a MultiChain Private Blockchain Network

The participants form into groups of 3 members, and in each group
they identify each member as Node 1, Node 2 and Node 3.

1
https://azure.microsoft.com/.
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Hands-On Lab with MultiChain 263

Figure 8.71: Creation of virtual machine on Ubuntu.

Figure 8.72: Connect to virtual machine using Putty.

Overview
Below are the steps for setting up Node 1 and Node 2 and establishing
a connection (see Figure 8.74):

Step 1: Node 1 runs multichain-util create chain1 to create the first

node, which is also the admin node.
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264 Blockchain and Smart Contracts

Figure 8.73: Download multichain community.

Figure 8.74: Steps 1–4, establishing connections between Node 1 and Node 2.

Step 2: Node 1 then runs multichaind chain1 -daemon to start

running multichain as a service from this node.
Step 3: Node 2 sends a request to connect to Node 1, by running mul-
tichaind chain1@<IP address of Node 1> :<port number>.
As this is the first time Node 2 tries to connect, it will be
automatically rejected, but Node 1 will receive notification.
Step 4: Node 1 grants permission to connect to Node 2 by running
multichain-cli chain1 grant <wallet address of Node 2>
connect.
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Hands-On Lab with MultiChain 265

Figure 8.75: Steps 1–3, establishing connections with Node 3.

Node 1 needs to let Node 2 know that the permission has

been granted, then Node 2 repeats the 2nd step to connect.
Step 5: Node 2 runs multichaind chain1 -daemon to start running
multichain.

Setting up a third Node and connecting it to Node 1 and Node 2

works in a similar way (see Figure 8.75):

Step 1: Node 3 sends a connect request to Node 1 or Node 2, by

running multichaind chain1@< IP address of Node 1 or Node
2>:<port number>.
Step 2: Node 2 or Node 1 can grant permission by running
multichain-cli chain1 grant < wallet address of Node 3>
connect.
Other permissions such as admin, send and receive can
also be granted.
Step 3: Node 3 repeats Step 1 to connect.

Detailed Steps and Execution

Node 1 runs multichain-util create chain1 and creates a blockchain
called “chain1”. Node 1 then should be able to see the folder called
“.multichain” (see Figure 8.76).
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266 Blockchain and Smart Contracts

Figure 8.76: Set up chain 1.

Figure 8.77: Edit parameter file.

Enter the folder “.multichain”, and further enter the sub-

folder “chain1”; Node 1 will see two files: “multichain.conf” and
“params.dat”.
Node 1 should then immediately change the parameters, as these
parameters cannot be changed once he starts to run the multichain
(see Figure 8.77).
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Hands-On Lab with MultiChain 267

Figure 8.78: Other useful parameters.

The default-network-port is for node-to-node connection and will

be used later by other nodes to connect to the blockchain. Rpc-port is
for programming purposes. In this example, we changed the network
port to 2020 and rpc-port to 2021.
The parameters discussed previously such as Mining Diversity
and admin-consensus-admin should be decided and updated now. In
this example, we changed admin-consensus-admin to 0.6.
Some other useful parameters (see Figure 8.78) that should also
be considered and updated are target-block-time (the average time to
generate a block), maximum-block-size (the maximum size of a block)
and anyone-can-connect (if anyone can connect to this blockchain. If
it is set to “Yes”, then it becomes a public blockchain).
When Node 1 runs the daemon command, the blockchain called
chain1 will officially start running. Note that daemon can be run
in the background, so that Node 1 can still operate in the console
(Figure 8.79).
Node 2 runs multichaind chain1@<IP address of Node 1>:<port
number>to connect to Node 1, and he will be able to see the wallet
address of Node 1 from the output (see Figure 8.80).
Node 1 grants Node 2 permissions to admin, connect, send and
receive. It is important to have another admin node in the network
(see Figure 8.81).
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268 Blockchain and Smart Contracts

Figure 8.79: Run multichain daemon.

Figure 8.80: Connecting Node 2 to Node 1.

Node 2 connects to Node 1 again and this time it should be

successful (see Figure 8.82).
Node 3 will request to connect to Node 2 in a similar way
(Figure 8.83).
Node 1 and Node 2 can view the permissions and it is important
that both should be admin nodes (see Figure 8.84).
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Hands-On Lab with MultiChain 269

Figure 8.81: Granting permission on Node 1.

Figure 8.82: Connecting Node 2 to Node 1 again.

Admin nodes verify the value of admin-consensus-admin. In this

example, we set the parameter to 0.6, which means 60% of the admin
nodes are needed to reach consensus. This means both Node 1 and
Node 2 need to grant permission to Node 3 in order for the permission
to be effective (see Figure 8.85).
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270 Blockchain and Smart Contracts

Figure 8.83: Connecting Node 3 to Node 2.

Figure 8.84: Assessing permissions on Node 1 and Node 2.

Node 1 grants permission. It is equivalent to a 50% admin vote

(there are two admins in total), hence the permission status is still
pending (see Figure 8.86).
Node 2 also grants permission. It is equivalent to a 100% admin
vote (there are two admins in total), hence the permission is approved
(see Figure 8.87).
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Figure 8.85: Verify consensus settings for admin on Node 1 and Node 2.

Figure 8.86: Granting permission on Node 1.

Node 3 now can connect to Node 2 (see Figure 8.88).

8.5.3 Use MultiChain API with Multichain-cli

API (Application Programming Interface) is a computing interface
to a software component or a system, which defines how other
components or systems can use it. It can be regarded as a software
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272 Blockchain and Smart Contracts

Figure 8.87: Granting permission on Node 2.

Figure 8.88: Connect to Node 2 again.

intermediary and is designed for external applications to talk to the

service and issue commands. In this session, we illustrate how to use
multichain API to issue commands and control how the multichain
operates (note that MultiChain is compatible with any API library
developed for Bitcoin Core).
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Hands-On Lab with MultiChain 273

We will focus on accessing API via multichain-cli command-line

tool (alternatively, it can be done via the other JSON-RPC client;
see Figure 8.89).
The latest updates of the API commands are available at https:
//www.multichain.com/developers/json-rpc-api/(see Figure 8.90).

Figure 8.89: Accessing multichain API.

Figure 8.90: Run multichain-cli.

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274 Blockchain and Smart Contracts

Figure 8.91: Basic JSON syntax.

JavaScript Object Notation (JSON) is an open standard,

language-independent file format and data interchange format that
uses human-readable text to store and transmit data objects consist-
ing of attribute–value pairs and array data types. It is a very concise
data format and easy to transfer through the network. Figure 8.91
provides some examples of the paired JSON objects and arrays
objects (nested arrays means that some arrays are nested within
other arrays).
Figure 8.92 provides some of the most used API commands.
getinfo returns general information about this node and
blockchain. There are five attributes (highlighted in blue), namely
“protocolversion”, “protocol”, “port”, “blocks” and “connections”,
that the node can compare against other nodes and understand if
the node is connected to the other nodes properly. For example, all
nodes should have the same protocol, same protocol version, same
port number and the same number of blocks (if they are well in sync).
getpeerinfo returns information about the other nodes to which
this node is connected. For MultiChain blockchain, handshake and
handshakelocal fields are also available, showing the remote and
local addresses used during the handshaking for that connection (see
Figure 8.93).
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Hands-On Lab with MultiChain 275

Figure 8.92: Utilising getinfo.

Figure 8.93: Utilising getpeerinfo.

getblockchaininfo returns information about the blockchain. The

blocks (number of current blocks on the chain) and bestblockhash
(hash value of the most recent block) can be compared across nodes
to check if they are perfectly synchronised (see Figure 8.94).
getblock returns information about the block with the given hash
or at the given height in the active chain (see Figure 8.95).
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276 Blockchain and Smart Contracts

Figure 8.94: Utilising getblockchaininfo.

Figure 8.95: Utilising getblock.

In the returned attributes, the term “confirmations” means the

number of confirmations (new blocks) since that block was mined;
hence, it is a measure of how deep the given block is in the blockchain.
getblockchainparams returns a list of values of this blockchain’s
parameters. These values are stored in the file params.dat (see
Figure 8.96).
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Hands-On Lab with MultiChain 277

Figure 8.96: Utilising getblockchainparams.

Figure 8.97: Utilising getaddresses.

getaddresses returns a list of addresses in this node’s wallet. Set

verbose to true to get more details about each address. If an address
has the attribute “ismine” set as true, then this address resides with
the current node (see Figure 8.97).
listpermissions returns a list of all permissions which have been
explicitly granted to addresses. It can also list all addresses with a
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278 Blockchain and Smart Contracts

certain permission. For example, listpermissions admin will return

addresses of all the admin nodes (see Figure 8.98).
grant is used to grant permissions to an address or a comma-
separated list of addresses. For global permissions, set permissions
to one of connect, send, receive, create, issue, mine, activate, admin
or a comma-separated list thereof (see Figure 8.99).

Figure 8.98: Utilising listpermissions.

Figure 8.99: Utilising grant.

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Hands-On Lab with MultiChain 279

Figure 8.100: Utilising getnewaddress.

For per-asset or per-stream permissions, use the form asset.issue,

send, receive, activate, admin or stream.write, read, activate, admin
where asset or stream is an asset or stream name, ref or creation txid
(transaction ID).
Only admin nodes can run the grant command. This command
returns the txid of the grant transaction sent.
getnewaddress returns a new address whose private key is added
to the wallet. If multiple users are using a single multichain node’s
wallet, call getnewaddress to get a different address for each user
(Figure 8.100).
importaddress is used to add an address (or an array of addresses)
to the wallet, without the associated private keys. This creates
one or more watch-only addresses, whose activity and balance can
be retrieved via various APIs (e.g., with the includeWatchOnly
parameter), but whose funds cannot be spent by this node (see
Figure 8.101).
The more addresses a node chooses to watch, the slower the node
becomes, as it monitors more transactions coming in.

8.5.4 Manage Native Assets Using Multichain-cli

This section illustrates how to create and manage native assets on
MultiChain.
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280 Blockchain and Smart Contracts

Figure 8.101: Utilising importaddress.

Figure 8.102: Steps 1–4 in issuing Asset 1.

Overview: Issue Native Assets using Multichain-cli

Figure 8.102 summarises the steps to issue a native asset called
“asset1” using multichain-cli:

Step 1: Node 1 grants itself the permission to issue, send and receive.
Step 2: Node 2 grants itself the permission to receive.
Step 3: Node 1 issues an asset called “asset1” to its own wallet; the
total quantity is 10,000, and the smallest denomination is
0.01.
Step 4: Node 1 sends a quantity of 100 asset1 to Node 2.
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Hands-On Lab with MultiChain 281

Step 5: Node 2 runs listassets and getaddressbalances to check if

asset1 is received. Node 1 can run the same commands and
check the balance (which should be 9,900 now).
Commands Used for Issuing Assets
It is recommended to check a developer’s webpage for the latest
updates of the commands (see Figure 8.103).
issue is used to create a new asset on the blockchain, sending the
initial quantity units to the address specified (Figure 8.104).

Figure 8.103: Developer’s page.

Figure 8.104: Issue new assets.

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282 Blockchain and Smart Contracts

sendasset is used to send the specified quantity of the asset to

the address, returning the txid (see Figure 8.105).
getaddressbalances returns a list of all the asset balances for an
address in this node’s wallet (see Figure 8.106). Argument minconf
can be used to specify a minimum number of confirmations that have

Figure 8.105: Send asset to given address.

Figure 8.106: Return asset balances for specified address.

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Hands-On Lab with MultiChain 283

to be satisfied. includeLocked can be set to true to include unspent

outputs which have been locked, e.g., by a call to preparelockunspent.
listassets returns information about assets issued on the
blockchain (see Figure 8.107).
Detailed Steps and Execution
Admin nodes grant permissions to other nodes, so that they can issue
their own assets (see Figure 8.108).

Figure 8.107: Return list of defined assets.

Figure 8.108: Admin nodes granting permissions.

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284 Blockchain and Smart Contracts

Figure 8.109: CheckList of assets issued.

Figure 8.110: Send asset to each other.

Check if the assets are issued successfully (see Figure 8.109).

All nodes send assets to each other (see Figure 8.110) and check
asset balances to verify if the transactions have gone through (see
Figure 8.111).

8.5.5 Manage Stream Using Multichain-cli

This section illustrates how to create and manage streams on
MultiChain.
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Hands-On Lab with MultiChain 285

Figure 8.111: Checking for mining.

Figure 8.112: Steps 1–8 in creating stream 1 using multichain-cli.

Overview: Create stream using Multichain-cli

Figure 8.112 summarises the steps to create a stream called
“stream1” using multichain-cli:

Step 1: Node 1 creates a stream named “stream1”. He sets the

parameter open to false; hence, anyone who wants to write
in this stream needs to get permission first.
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286 Blockchain and Smart Contracts

Figure 8.113: Create a new stream.

Step 2: Node 1 publishes an item (including a key and hexadecimal

data) in the stream.
Step 3: Node 2 subscribes to stream1.
Step 4: Node 2 calls a querying command to view the items on
stream1.
Step 5: Node 1 grants permission to Node 2 to send, receive and
write into stream1.
Step 6: Node 2 publishes an item onto the stream.
Step 7: Node 1 subscribes to stream1.
Step 8: Node 1 can view the items on stream1.

Commands Used for Creating Stream

create is used to create a new stream on the blockchain (see
Figure 8.113). The parameter type should be set to “stream”,
followed by the name of the stream to be created. The node who
calls this command can set the parameter open to true if he allows
anyone to write in the stream, or false if he prefers other nodes to
get permission first in order to write in the stream.
The command returns the transaction ID for the creation.
publish is used to publish an item in a given stream (see
Figure 8.114). The parameters required are stream-identifier, key
and data-hex. The stream-identifier can accept stream name, stream
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Figure 8.114: Publish a stream item.

Figure 8.115: Subscribe to the stream.

reference or creation txid. The key parameter can accept a single

textual key or an array, and the data-hex parameter can accept raw
hexadecimal data.
A node calls subscribe to subscribe (start tracking) to a
stream using stream name, stream reference or creation txid (see
Figure 8.115). The command can also be used to subscribe assets.
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288 Blockchain and Smart Contracts

Figure 8.116: Return stream items.

liststreamitems is a command used to query subscribed streams

(see Figure 8.116). It returns the list of items in the stream.
Set verbose to true for additional information about each item’s
transaction. Parameters count and start can be used to retrieve part
of the list only, with negative start values indicating the most recent
items.
liststreamkeyitems is another command for querying subscribed
streams (see Figure 8.117). It returns the list of items with the given
key only.
liststreampublisheritems is another command for querying sub-
scribed streams (see Figure 8.118). It returns the list of items with
the given address only.

Detailed Steps and Execution

Node 1 creates a new stream called stream 1, and sets parameter
open to false. He then can verify the permissions on stream 1, by
calling listpermissions (see Figure 8.119).
It was discussed previously that when calling this function,
specific permissions can be listed (such as in the form of
stream.write,read,activate,admin), or * can be passed to list all
permissions.
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Hands-On Lab with MultiChain 289

Figure 8.117: Return stream items using given key items.

Figure 8.118: Return stream items by publisher’s address.

Note that node1 should only have “write” permission at the

moment.
Node 1 calls publish to publish an item on stream1. The
item includes a key and certain data in hexadecimal format (see
Figure 8.120).
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290 Blockchain and Smart Contracts

Figure 8.119: Create stream 1 on Node 1.

Figure 8.120: Publish data on stream 1.

Node 2 verifies if the stream has been created properly (see

Figure 8.121). He calls liststreams and checks if the stream named
“stream1” can be seen. Note that Node 2 currently does not have
permission to view the content.
liststreams returns information about streams created on the
blockchain. Specify a stream name, stream reference or creation txid
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Figure 8.121: Verify the new stream.

Figure 8.122: Subscribe and view stream 1.

to retrieve information about one stream only, an array thereof for

multiple streams or * for all streams.
Node 2 subscribes to “stream1”, and then calls liststreamitems to
view the items such as publishers, key and data on the stream (see
Figure 8.122).
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292 Blockchain and Smart Contracts

Note that anyone can do this on the blockchain; hence, stream

item content is available to everyone by design. A publisher can
choose to encrypt the data before publishing.
Data are encrypted and decrypted off-chain, usually with sym-
metric cryptography (see Figure 8.123).
Node 1 grants permission to Node 2 to publish to stream1
(Figure 8.124).

Figure 8.123: Subscribe and view stream 1.

Figure 8.124: Grant Node 2 permission to publish to stream.

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Hands-On Lab with MultiChain 293

Figure 8.125: Publish new items on stream for Node 2.

Node 1 needs to call grant twice to grant such permission. It

is called for the first time to grant permissions, such as to receive
and to send, and it is called the second time to grant per-stream
permissions, such as to write onto the stream.
Now, Node 2 can publish items onto the stream. He can publish
a new item with the same key or a different key (Figure 8.125).

8.5.6 Manage Atomic Exchange Transactions

Using Multichain-cli
This section discusses how to make atomic exchange transactions on
MultiChain.
Earlier examples demonstrated sending of transactions in one
direction, but a trade happens in both directions. One-direction
transaction will not work in a trade due to counterparty risks.
In financial markets, many products are traded in the OTC (over-
the-counter) market. The counterparties sign contracts with each
other without an intermediary and each assumes the risk that the
counterparty might default (see Figure 8.126).
In such bilateral trades, when one party defaults (for example,
the Lehman Brothers during the Global Financial Crisis), the other
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294 Blockchain and Smart Contracts

Figure 8.126: CounterParty risks with over-the-counter market.

Figure 8.127: Lehman Brothers crisis explained.

party will suffer a loss and it could also cause a chain of effects (see
Figure 8.127).
For exchange-traded products, there is a trusted third party
(clearing house) to lower the counterparty risks among participants,
but concentration risk is significantly increased (see Figure 8.128).
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Figure 8.128: Dodd-Frank Act CCP establishment.

What if there is a technology that can do away with the third

party? Is it possible for Party 1 and Party 2 to enter a trade without
a middleman, and the exchange can be completed if, and only if,
both parties receive what they want? Such a trade structure is called
atomic exchange, a computer science term for “all or nothing” (see
Figure 8.129).
This section explains how atomic exchange can be executed in
MultiChain.

Overview of Atomic Exchange Transaction

Figure 8.130 summarises the steps to execute atomic exchange:

Step 1: Node 1 owns asset5 and he prepares to offer 1 unit of asset5.

Step 2: Node 1 creates a raw exchange where he offers 1 unit of
asset5 to Node 2, and asks for 1 unit of asset2.
In this step, Node 1 sends over a script that is essentially
a locking script. In order to complete the exchange, Node 2
not only needs to provide an unlocking script based on his
private key but also needs to own 1 unit of asset2 that Node
1 had asked for.
Step 3: Node 2 prepares to offer 1 unit of asset2.
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296 Blockchain and Smart Contracts

Figure 8.129: Decentralised atomic exchange.

Figure 8.130: Step 1–5 summary of atomic exchange execution.

Step 4: Node 2 combines his unlocking script with the locking script
from Node 2, and asks for 1 unit of asset5.
Step 5: Node 2 sends the combined script onto the blockchain.

Detailed Steps and Execution

Node 1 calls preparelockunspent, the command for preparing an
unspent transaction output (see Figure 8.131). It imposes a lock
on this unspent output amount (similar to a UTXO), and this
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Hands-On Lab with MultiChain 297

Figure 8.131: Protecting against spending with preparelockunspent.

transaction output will be protected against spending unless explic-

itly spent or unlocked.
The command returns two outputs: txid and vout. Previously, we
discussed that one blockchain transaction can have multiple outputs.
The “vout” here indicates that the amount of first output is zero.
Note that if some unspent transaction is locked by mistake, it can
also be unlocked. The node can follow the below steps:

1. Call listlockunspent, which returns a list of locked unspent trans-

action outputs in the wallet. Find the txid and vout that need to
be unlocked.
2. Call lockunspent, which provides the txid and vout that need
to be unlocked, and sets the field “unlock ” to “true”. It will
unlock the specified transaction. The command can also unlock
all transactions if no second parameter is provided.

Node 1 then calls createrawexchange to create an atomic exchange

transaction (see Figure 8.132). He uses the txid and vout output from
Step 1, which contains the information on what he is offering, and
adds in information about what he is asking: 1 unit of asset2. This
forms half of the transaction (as it is only information from Node 1)
and returns a string output in hexadecimal format.
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298 Blockchain and Smart Contracts

Figure 8.132: Creating atomic exchange transaction.

Figure 8.133: Creating atomic exchange transaction.

The output from createrawexchange in Figure 8.133 is the hex-

adecimal presentation of half of the transaction to be sent over to the
other party. It can be decoded with the command decoderawexchange.
decoderawexchange returns details on the offer represented by the
exchange and its present state (see Figure 8.134).
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Hands-On Lab with MultiChain 299

Figure 8.134: Decode the partial raw exchange string.

Figure 8.135: Process of transaction and result of decoderawexchange.

The result from the decoderawexchange command shows that the

party who had created the raw exchange is offering 1 unit of asset5
in exchange for 1 unit of asset 2 (see Figure 8.135).
Node 1 sends the output to Node 2 via email or other channels
(see Figure 8.136).
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300 Blockchain and Smart Contracts

Node 2 calls preparelockunspent to prepare 1 unit of asset2 for

transaction (see Figure 8.137).
Node 2 calls appendrawexchange, where he puts in the half
transaction he received from Node 1, then adds on txid and vout from
his preparelockunspent command (which is what he is offering — 1

Figure 8.136: Sending output from Node 1 to Node 2.

Figure 8.137: Node 2 offering 1 unit of asset 2.

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Hands-On Lab with MultiChain 301

unit of asset2), and adds on what he asks for: 1 unit of asset5 (see
Figure 8.138).
If the transaction is constructed successfully, i.e., the asset names
and quantities between the two nodes match each other, the output
from appendrawexchange will show a complete field set to true (see
Figure 8.139).

Figure 8.138: Node 1 asking for 1 unit of asset5 in return.

Figure 8.139: Checking for completion of trade.

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302 Blockchain and Smart Contracts

Figure 8.140: Certification of completed trade.

Figure 8.141: Illustration of combined transaction.

The output from appendrawexchange is the hexadecimal pre-

sentation of the complete transaction. It can be decoded with the
command decoderawexchange (Figure 8.140).
Figure 8.141 illustrates the combined transaction. In this trans-
action, the input from Node 1 (highlighted in blue) references
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Hands-On Lab with MultiChain 303

Figure 8.142: Illustration of combined transaction.

Figure 8.143: Broadcasting and execution of transaction.

unspent output of 1 unit of asset5, and the input from Node 2

(highlighted in green) references unspent output of 1 unit of asset2.
The transaction is combined and completed when Node 2’s unlocking
script can unlock Node 1’s locking script, and Node 2’s input becomes
output sent to Node 1, and Node 1’s input becomes output sent to
Node 2.
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304 Blockchain and Smart Contracts

Figure 8.144: Successful transaction shown.

If both nodes check their asset balance now, they will not
see the balance change due to the transaction. This is because
the transaction is not confirmed yet on the blockchain (see
Figure 8.142).
Node 2 then calls sendrawtransaction to broadcast this trans-
action to the network. It returns the txid for the transaction. The
transaction goes through once it is confirmed by the blockchain (see
Figure 8.143).
Both nodes will see the balance change due to the transaction
(see Figure 8.144).
Blockchain native assets, data stream management and atomic
exchange transactions are just a few instances of the extended
functionality of MultiChain. The ease of deployment and customi-
sation also make it one of the popular choices when it comes to
private permissioned blockchain for industrial use.

Reference
Lamport, L., Shostak, R., and Pease, M. (1982). The Byzantine generals problem.
ACM Transactions on Programming Languages and Systems 4(3), 382–401.
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Chapter 9

Hands-On Guide to Bitcoin Layer-2

Lightning Network Node Setup
Edwan Chiam∗

9.1 Introduction
The intent of this guide is to allow individuals to have a physical
interaction running a bitcoin node in a more sustainable manner
through affordable devices like a Raspberry Pi (Linux) according
to an easy-to-follow coding instruction. The hands-on tutorial will
cover running a bitcoin core, which is key to understanding Bitcoin
and experiencing what it is like to be running a node, completely
decentralised and not relying on any centralised cloud-hosted nodes.
This tutorial will take a step further by extending beyond the
underlying protocol in overcoming the scalability issue, as seen in
layer-1 bitcoin, by implementing a layer-2 application known as the
lightning solution, which is an almost instant confirmation in bitcoin
peer-to-peer transactions with a minimal fee and increased privacy
simultaneously. In preservation of Cyberpunk’s work, individuals
running their own node can verify and trust their own node, which
is a fairly inexpensive investment that lends an extensive benefit
overall.

∗
Founder of HelloDime.

305
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306 Blockchain and Smart Contracts

Why do we want to run a bitcoin node? As the genesis concept

of blockchain, we ought to understand how the concept of a truly
decentralised blockchain network comes about. By observing and
experimenting with bitcoin core nodes, you will contribute to various
other factors besides understanding and visualising what it takes to
run a node. As of today, May 2020, there are approximately 6700
nodes online of which a majority are running the main bitcoin core
nodes. By running a bitcoin core node, you are contributing to a
faster, more stable and more decentralised network. How else is it
beneficial to ensure that you are following the original consensus
rules of the network?
Cannot contribute to the Bitcoin hash power? Fret not. Node
owners are more important than hashpower as they are the true
validators of the network. Being curious and tinkering to be a part
of this revolution deserves applause.
This guide will take you through the whole process in a testnet
environment so no real money/bitcoin asset is involved. But, with
just a quick flick of a line or 2, we are able to enter into the
main net and explore further down the rabbit hole. If you just
want to experience this up and until the testnet and not interact
with the mainnet, then you do not need to download the bitcoin
core application to your computer/laptop devices in the section
titled “Download Bitcoin Core Application”. At the end of this
exercise, readers can experience all things Bitcoin core node allows
(familiarise and interact with the node through CLI command lines,
verify the bitcoin blockchain, perform P2P transactions by sending
and receiving.), also extending to layer 2 experiencing how lightning
network works (listing peers, opening new payment channels, sending
and receiving) in both testnet and mainnet if they wish to extend this
application. Users must understand what it entails for transacting
on the mainnet as a loss of any of the keys and or sending to
an unintended recipient will result in a partial or complete loss of
assets. Participants need to note that layer 2 is still in constant
experimentation and new versions are being developed along the way.
What is stated here are good versions as of 25th May 2020, tried and
tested on the bitcoin mainnet.
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Hands-On Guide to Bitcoin Layer-2 Lightning Network Node Setup 307

9.2 Setup and Tool Gathering

To begin this exercise, users do not require to have any extensive
coding knowledge, but it is good to understand how command
lines function, how to navigate around your own network, using
tools like PUTTY, SSH, Nano text editor and to have an interest
in understanding why blockchain and/or bitcoin is essential to
appreciate what we are presenting here.
Tools required for this exercise include, but are not limited to,
the following:

1. Having full control of your internet gateway to ensure that you

can communicate with the various testnet and mainnet bitcoin
ports.
2. A Raspberry Pi version 3 model B or newer.
3. USB power adapter to power up the pi (5V, 2.5A for Singapore
standard).
4. A Micro SD Card for the Raspberry Pi, preferably 16 GB or
higher.
5. LAN cable from your internet to the Raspberry Pi (Wi-Fi
connection is fine, but may be slow).
6. External 2.5 hard disk of at least 300 GB (Preferably SSD and
>500 GB will be better for faster synchronisation of the bitcoin
blockchain).
7. Existing computer/laptop running on Mac, Windows or Linux
that has at least 300 GB to download the 1st instance of the
Bitcoin core (taking this file from elsewhere is fine, but you cannot
verify the authenticity of it).
8. Optional (External screen and HDMI cable + USB Keyboard)
device for shortcut troubleshooting using a headed raspberry pi,
otherwise most operations will be carried out headless.

9.2.1 Bitcoin Core Mainnet on External Device

This step is necessary for those who want to extend this application
to the bitcoin mainnet. For those who want to just experiment the
whole process in the bitcoin testnet, this step is not necessary as
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308 Blockchain and Smart Contracts

syncing on the testnet with the raspberry pi 3b is quite light and

quick to do.
To begin, let us download the Bitcoin core on our computer/
laptop by heading to the bitcoin core official website with the respec-
tive installer file for your device. You may install the application on
your local machine. You need to be the administrator of the machine
as well as to be able to find the local storage for the files later on.
Once you download the executable file, verify the source to ensure
its integrity and then you may run it.
We will transfer the block files to the raspberry pi external
hard disk once it is fully synced. It will take around 1–2 days
depending on your machine’s hardware and your internet connection
speed. While it is synchronising, it will show the progress as seen in
Figure 9.1.

Figure 9.1: Screenshot of Bitcoin core syncing.

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Hands-On Guide to Bitcoin Layer-2 Lightning Network Node Setup 309

9.2.2 Raspberry Pi Setup (Hardware)

While waiting for the sync to be done, we will now set up the
raspberry pi device as shown in Figure 9.2.
Ensure that the external hard disk that is to be connected to
the raspberry pi is formatted or new. Ensure no important data
are within the hard disk if you are using an existing hard disk for
this purpose. All information will be erased and formatted for this
operation. Proceed with care. Insert your Micro SD card into the
raspberry pi slot. I will be using a 128 GB for this tutorial.
Connect your LAN cable from your router or your LAN socket to
the LAN port of the Raspberry Pi. Ensure that you have the power
adapter connected to the power socket and the back of the device.
Having an enclosure with a good heatsink for the raspberry pi
as shown in Figure 9.3 will be a great alternative too, but for the
coverage of this tutorial, we will not analyse at length the aesthetics
of the setup.

Figure 9.2: Image of raspberry pi LAN and USB ports.

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310 Blockchain and Smart Contracts

Figure 9.3: Back image of the raspberry pi.

9.2.3 Preparing the Raspberry Pi (Software)

Once the device is connected and ready to be powered up, we will
start to prepare the program for the raspberry pi device.
1. Download the raspberry pi operating system. We will be running
headless operations throughout, so you may proceed to install
Raspbian Buster Lite via the raspberry pi official site.
2. Once you download this ISO image file, you can write this into
the micro SD memory card.
3. Enable SSH to your micro SD card via your computer when
connecting to the memory card. Open the root file and add
a new empty folder named SSH. Eject the card and you may
disconnect it.
4. Start your raspberry pi by ensuring the memory card is installed,
and the power socket is connected to the raspberry pi via the
micro USB cable from the power outlet.
5. The raspberry pi has no physical power on switch besides the
main adapter, but as the power is turned on, you will be able
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Hands-On Guide to Bitcoin Layer-2 Lightning Network Node Setup 311

to see the yellow blinking light and the red LED light indicating
that it is turning on.
6. Here, the raspberry pi will have an IP assigned to it. We need to
make this IP static.
7. Enter your router settings or your default internet gateway via
an external device; key in both the admin and the password to
access this. Check with the administrator if you do not have it.
8. Find the device name “Raspberry Pi” and under DHCP server,
enable the Raspberry Pi to have its IP address static.
9. Configure port forwarding to allow our device to reach the
Bitcoin networks. Set up in the following manner with the
internal IP as above in point 8.
a. Bitcoin Mainnet, External Port 8333, Internal Port 8333,
Protocol both TCP & UDP.
b. Bitcoin Testnet, External Port 18333, Internal Port 18333,
Protocol both TCP & UDP.
10. For Windows users, please use PUTTY for the SSH connection.
For Mac users, you can use the built-in native terminal for SSH.
I will be using Mac and so it will be in the terminal and the
codes will be the same for Windows users accessing via PUTTY.
Next, we can enter into the pi IP address that we retrieve from
the gateway above in point 8. By default, your raspberry pi will
have a username as pi and password as raspberry. In the example
here, I logged in with “pi” as my username and this results in
the command starting with the username as shown in Figure 9.4.

Figure 9.4: Screenshot of login pi as default credentials.

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312 Blockchain and Smart Contracts

Figure 9.5: Entering into the raspberry pi main configuration.

Figure 9.6: Menu of the raspberry pi system configuration.

SSH is enabled and the default password for the “pi” user has
not been changed.
This is a security risk — please log in as the “pi” user and type
“passwd” to set a new password.
Let us now set up some internal raspberry pi configurations using
the code “sudo raspi-config” shown in Figure 9.5.
While in “sudo raspi-config”, these are the commands to perform.
The numbers are shown in Figure 9.6 in the menu order.
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Hands-On Guide to Bitcoin Layer-2 Lightning Network Node Setup 313

1. Change password to a password of your choice [PASSWORD PI].

2. Boot options, choose Desktop/CLI → Console and wait for
network at boot.
3. Localisation and choose your country for the date and time
settings.
4. Advance option, expand file system and set memory split to 16.
5. Exit raspi config and you may choose not to reboot it. Either way
is fine.

Let us now get the latest updates and upgrades for the device
using “sudo apt-get update” and “sudo apt-get upgrade” for this
purpose.
We will now add an admin user using the code “sudo adduser
admin”, change password to your desired password for the admin
using the command “sudo passwd root” and reboot it using command
“sudo shutdown-r now”. Once it is back up, you may log in to the
admin user.
Then we will add another user name “bitcoin” as follows:

pi@Pi:∼ $ sudo adduser bitcoin

New password:
Retype new password:
passwd: password updated successfully
Changing the user information for bitcoin

We will now mount the HDD you have attached to the pi and
format it into the right format. All data will be deleted during this
phase.
Getting the name and details of the hard disk attached, Figure 9.7
shows us that the raspberry pi has identified the HDD.

Figure 9.7: The HDD and the raspberry pi.

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314 Blockchain and Smart Contracts

Figure 9.8: Editor screen of the fstab.

Format the hard disk by locating the name in the previous line;
in my case it is “sda” as the name shows.
pi@Pi:∼ $ sudo mkfs.ext4 /dev/[NAME OF HDD]
pi@Pi:∼ $ sudo nano /etc/fstab [This will lead you into an editor
screen shown in Figure 9.8]
Edit the “fstab” file and add the following as a new line (replace
UUID=your own HDD UUID) at the end as shown in Figure 9.8 and
below.

UUID=XXXXX /mnt/hdd ext4

rw,nosuid,dev,noexec,noatime,nodiratime,auto,nouser,async,
nofail 0 2
As shown in Figure 9.9, make a new directory folder and add the
HDD.
We then mount the HDD and check if it is mounted correctly in
the following line.
Let us attach an owner to the HDD using the command
“Chown-R”.
If you are able to see your HDD mounted, you are doing well.
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Hands-On Guide to Bitcoin Layer-2 Lightning Network Node Setup 315

Figure 9.9: Screenshot to show that the HDD has been mounted.

Figure 9.10: Making a new directory called bitcoin within the HDD.

Figure 9.11: Creation of a new swap file.

We can change the user to bitcoin now, change directory to the HDD
and make a bitcoin folder and exit it (see Figure 9.10).
We will create the swap file to shift it to the HDD instead of the
Internal memory card as shown in Figure 9.11. Log in as ADMIN
to do this. We will delete the old files using “swapoff” and uninstall
it. We will then edit the config file and replace it with the following
configuration:
“CONF SWAPFILE=/mnt/hdd/swapfile”
You will need to remove the default CONF SWAPSIZE line.
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316 Blockchain and Smart Contracts

Figure 9.12: Logging in to admin and making a download directory.

Figure 9.13: Downloading the executable file from bitcoincore.org.

We will then create a new swap file and turn it on with swapon.

9.2.4 Bitcoin Core Raspberry Pi Configurations

Log in to admin “sudo su admin” (see Figure 9.12).
We create a download folder here to sit in the bitcoin core client.
We go into the download folder and download the client from the
bitcoin official site command wget as shown in Figure 9.13.
Here, we will download the latest bitcoin core version and
compare and verify the authentication of the downloaded bitcoin
core application against the checksum of the application in the link
below for this version of 0.19.1. This step is important as it ensures
that the version we have downloaded is indeed an official source.
This is the link you can reach out to for the latest application
version. We will be downloading and installing ARM Linux 32 bit
for the raspberry pi using the “wget” function followed by its URL
link of the installer. You may check against the output in Figure 9.14.
Do look out for the application version with the word OK and
cross-check it with the correct signature as shown below by Wladimir
J. van der Laan.
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Hands-On Guide to Bitcoin Layer-2 Lightning Network Node Setup 317

Figure 9.14: Download and verification process of the application.

Source: bitcoin-0.19.1-x86 64-linux-gnu.tar.gz: OK

Good signature from “Wladimir J. van der Laan (Bitcoin

Core binary release signing key)[email protected]” and
fingerprint of 01EA 5486 DE18 A882 D4C2 6845 90C8
019E 36C2 E964

With these keys, we can do a cross-reference back to verify the

application checksums that you are running from your other device —
laptop/computer.
Once keys matched and are a good version, we can then extract
them and install it onto our device. If the keys are incorrect, check
the source of the download with the above reference once more.
Extracting and installing the file in Figure 9.15.
Once installed, please check the version again. Here, I have
Bitcoin Core version V0.19.1.
Do note that you should check for the latest version. As
of the end of this writing, the community just released version
V0.20.0.
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318 Blockchain and Smart Contracts

Figure 9.15: Installation of the verified bitcoin core application.

Next up, we want bitcoin to run automatically in the background

every time our device starts. This can be achieved through what we
call a bitcoin daemon also known as bitcoind. Bitcoind will run in
the background without any user interface and stores all the data in
a directory we specify.
To perform this, we require the program to point to the directory
(see Figure 9.16) we have created on the HDD. Once it has been
pointed to the right directory, we will be using “ln -s/mnt/hdd”
directory name; we will enter “ls -la” to see if bitcoin is successfully
pointed to the directory. We will then exit the program and see if it
will auto restart the moment we turn it back on.
We will log in as bitcoin users, which we created previously to
run bitcoin functions. Now, we will try to start up bitcoind manually
by running bitcoind as the command.
You should see the script running, which indicates that bitcoin
daemon is running in the background. You may stop it by exiting it
with CTRL + C.
We need to configure the file for the daemon bitcoind. We
will open the configuration editor with this command, “nano
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Hands-On Guide to Bitcoin Layer-2 Lightning Network Node Setup 319

Figure 9.16: Linkage pointing to the correct directory which is the bitcoin
folder in the HDD.

Figure 9.17: Configuration file for the bitcoin daemon.

/home/bitcoin/.bitcoin/bitcoin.conf” (see Figure 9.17), and paste

the following configuration below and save it. For the rpcuser, the
username is “pi” and please choose your own password 2 now. Failure
to remember password 2 will result in a loss of funds.
We will save, exit and now run bitcoind. Curious to see
how it is running in the background, we will now have a
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320 Blockchain and Smart Contracts

Figure 9.18: Background of the bitcoin daemon running.

sneak peek at what it is running with the following command

“tail -f/home/bitcoin/.bitcoin/testnet3/debug.log” as shown in
Figure 9.18.
Now that it is running, let us try to get our hands on some real
bitcoin core command lines called the bitcoin-cli (Figure 9.19).
What we are looking for here is the chain data. Verification
progress should be near 1 to indicate full bitcoin chain synchroni-
sation. And, the chain here is indeed testnet. We can now stop it
and exit (see Figure 9.20).
Now that you have successfully got the bitcoin core to run, we
will set it up to get it to autorun once your raspberry pi starts up.
To do so, we will create a configuration file for it.
Entering into the editor using “sudo nano/etc/systemd/system/
bitcoind.service”
Copy the whole command and paste this into the editor.
# Your Raspberry Pi Name
[Unit]
Description=Bitcoin daemon
After =network.target
[Service]
ExecStartPre=/bin/sh -c ’sleep 30’
ExecStart=/usr/local/bin/bitcoind -daemon -conf =/home/bitcoin/.
bitcoin/bitcoin.conf -pid=/home/bitcoin/.bitcoin/bitcoind.pid
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Hands-On Guide to Bitcoin Layer-2 Lightning Network Node Setup 321

Figure 9.19: Status of the blockchain our node is having.

Figure 9.20: Stopping the bitcoin daemon.

PIDFile=/home/bitcoin/.bitcoin/bitcoind.pid
User =bitcoin
Group=bitcoin
Type=forking
KillMode=process
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322 Blockchain and Smart Contracts

Figure 9.21: Activation of the new configuration file.

Figure 9.22: Results showing that daemon is running.

Restart=always
TimeoutSec=120
RestartSec=30

[Install]
WantedBy=multi-user.target

Save and exit. We will now activate (see Figure 9.21) and enable
the configuration file above.
We will copy a copy of the following configuration to the admin
user.
We will now restart the device to see if the daemon will autostart
as per our configuration.
Once the red and green LED stop blinking, you may enter into
the admin account and check the status of the services. Ensure that
it is active and running as shown in Figure 9.22.
Now, we are done with the configuration and the setup. We will
now wait for the testnet to be fully synced.
In the meantime, do check out some bitcoin command lines to
call while we wait for the testnet to finish its validation progress. It
is good to have a few of the common commands in hands. Once the
node is synchronised, all you need to do is call certain functions to
check the status of your node.
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Hands-On Guide to Bitcoin Layer-2 Lightning Network Node Setup 323

9.3 Layer-2 Application: Lightning Network

The whole idea of having this tutorial is to understand how layer-
2 application solves the scalability problem that has been widely
talked about for many years since the entrance of bitcoin layer
1 in comparison with that of other centralised payment solutions.
This is where several companies come together to try various
implementations and this topic is still under experimental research
as I am writing this tutorial. We do not need to transact at the
main network to experience this. We can still experience the amazing
benefits and properties through alternative networks like the testnet
to have a sense of what lightning network is all about.
In a nutshell, lightning network implementation is said to solve
the scalability problem by aiding the trusted payment channels
also termed as the side chains. Having a side chain will improve
transaction speeds as a message does not require to reach the wider
network and be validated across all nodes. Since it is a trusted
channel, the message will be routed directly through or via other
trusted channel loops, taking the shortest path to reach the intended
destination. All of these are done with on-chain governance over the
payment channels to dissuade cheating from either party. I will not
go further into the length and breadth of the theory of lightning
network for this tutorial.
As mentioned, there are a few different implementations of the
network. We will be using Lightning Labs Daemon also known as
LND for this guide.

9.3.1 Download and Install Lightning Network

Similar to what we have done for the bitcoin applications, we will
go through the same process for Lightneing Networks. You should
realise by now that the codes are similar in nature. We will get
the application link from the source, download them, verify the
application and once verified, we will extract it and install it onto
the device. You can find the lightning application on the Github
lightning network repository. For this tutorial, my latest release is
version 0.10.1 beta.
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324 Blockchain and Smart Contracts

Figure 9.23: Change directory in download folder.

Figure 9.24: Downloading of the source, verification and keys.

Let us start with admin user change directory in the download

folder shown in Figure 9.23.
Here, we point to the download folder, and get the files of the
application, text file, signature and keys.
We will then verify the download as what we did to the BTC core
application. Screenshots of the processes are shown in Figure 9.24.
Our source application has been verified and can be trusted as
shown in Figure 9.25. Again, we identify it from the fingerprint and
the OK status against the right version “lnd-linux-armv7-v0.10.1-
beta.rc2.tar.gz: OK ← Hooray!”.
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Hands-On Guide to Bitcoin Layer-2 Lightning Network Node Setup 325

Figure 9.25: Checking and verifying the downloaded application.

Figure 9.26: Logging into admin user.

9.3.2 Lightning Network Configuration

Now that the Lightning Network (LND) is installed, we need to
configure it to work over our Bitcoin Core and run automatically
on startup. Still as user “admin”, create a symbolic link to the IP
binary located in /bin/ip.
Open a “bitcoin” user session instead of an admin user (see
Figure 9.26).
Create the LND working directory and the corresponding sym-
bolic link (see Figure 9.27).
Create the LND configuration file and paste the following content
(adjust to your alias). We will then save and exit the editor (see
Figure 9.28).
Some explanations about this configuration
When you set nat=true, it means that your router is able to support
UpnP allowing the lightning network to make your node accessible
from outside by configuration port forwarding. If it is not true, then
it will just be a private node without the ability to route payment for
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326 Blockchain and Smart Contracts

Figure 9.27: Symbolic link creation.

Figure 9.28: The editor for the configuration.

others as it will not be visible from the outside. You are required to
remove nat=true, your node will constantly try to connect but will
be unable to and will not start till it finds a network.
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Hands-On Guide to Bitcoin Layer-2 Lightning Network Node Setup 327

Figure 9.29: Running the lnd command.

In the above configuration, I have enabled autopilot and it is set

to open with a maximum of 10 channels with 50% of your funds.
Do note that according to the lightning network Github repository,
they recommend to have 5 channels at 0.6 of the fund.
The autopilot agent will attempt to automatically open up
channels to put your node in an advantageous position within the
network. This is based on preference and for a test, you can just
put some numbers that make sense. If you do not wish to allow
autopilot to enable channels, simply just edit the configuration to
make autopilot.active=0 to disable it.

9.3.3 Running Lightning Network

Again, we switch to the user “bitcoin” and first start the program
manually to check if everything works.
“sudo su - bitcoin”
Run lightning network using the “lnd” command (see
Figure 9.29).
Just like how attaching a screen to the console works, while we
let the lightning daemon run in the background, we need to load up
a second console and let this console run. Open up another terminal/
PUTTY session and log back into the raspberry pi as admin without
stopping this session. To better demonstrate between the first and
second console, I will name it CP2 for console #2.

9.3.4 Lightning Network Wallet Setup

You may be aware by now that both bitcoin core and lightning
have wallet functions to store your assets. Lightning wallets are
different and do not share the same wallet as bitcoin core wallet.
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328 Blockchain and Smart Contracts

Figure 9.30: Creating a new wallet.

Figure 9.31: The 24-word seed phrases

By using “sudo su - bitcoin”, we now enter bitcoin users from the

admin privilege of sudo pn CP2. We then create the wallet using the
following command: “-network=testnet create” (see Figure 9.30).
Enter a new set of passwords for the LND wallet and you
may enter N to start a new wallet by displaying the seeds of the
wallet. These seeds need to be kept and held with care (a good
practice to follow, even though it is on the testnet). The seed phrase
(Figure 9.31) allows you to restore all your assets in the bitcoin wallet
and all the LND channels.
As for the final part, it is the fun part; now that we have a wallet,
we will try to get some coins into the wallet, try receiving, sending it
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Hands-On Guide to Bitcoin Layer-2 Lightning Network Node Setup 329

Figure 9.32: TLS certificate and the read-only macaroon.

and opening payment channels to see the difference between layer 1.

Most importantly, the whole point of this exercise is to experience
the LIGHTNING effects of speed.
We want to allow admin users to have authority of the LND and
call commands from the admin user instead of just solely calling
commands from the bitcoin user.
We will copy the TLS certificate and the macaroon files to the
admin main directory. We will check if the TLS certificates have been
created, check that we have both the admin and read-only macaroon
files created (see Figure 9.32).
We can see that they are indeed created; we will now copy them
over. Do not move it, instead, just copy it to admin.
Let us try to see if the copy is successful and we can call LND
commands from the admin user now. I will do so simply by calling
commands to throw back the blockchaininfo. Do ensure that your
wallet is first unlocked (network=testnet unlock) before calling the
blockchaininfo (–network=testnet getinfo).
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330 Blockchain and Smart Contracts

Figure 9.33: Showing CP1.

Figure 9.34: Information of the server line.

Here is a little cheap thrill, but notice what is happening on

console 1 CP1. You are able to see the status from unlocking of the
wallet to calling certain information.
Turn your attention to CP1 (see Figure 9.33) in particular these
lines [INF] SRVR (see Figure 9.34): Scanning local network for a
UPnP enabled device and [INF] SRVR: Automatically set up port
forwarding using UPnP to advertise external IP
If there are some errors, fret not; it is due to the router not
allowing external connection, but besides allowing for a greater
audience, it still works fine privately. We will stop the LND service in
CP2 (–network=testnet stop) and CP1 will reflect too with a proper
end to the LND session.
We will test out to run the lnd daemon, get its information
(Figure 9.35) and see that autopilot is working well, and we can
then stop it (Figure 9.36).
If you are still following at this point of time, congratulations,
you have gone a long way, and if you are following well and the codes
work as planned, then you have now landed yourself an lnd node and
you have successfully initialised it.
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Hands-On Guide to Bitcoin Layer-2 Lightning Network Node Setup 331

Figure 9.35: Lightning node information.

Figure 9.36: Stopping the daemon.

Figure 9.37: Admin login.

The other parts will be spring cleaning to ensure some smooth

automation when booting and to test out the node by receiving,
paying and listing channels and peers.

9.3.5 Starting Lightning from Boot

We log in as admin user (Figure 9.37) and enter into the LND
configuration page (Figure 9.38).
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332 Blockchain and Smart Contracts

Figure 9.38: Configuration page of the LND.

Figure 9.39: Unlocking the wallet.

CP1
Now, we enable the lightning network, start it and unlock it. We
shall wait for testnet to finish synchronisation with the network (see
Figure 9.39).
Once you see the screen moving quickly with lots of logs (see
Figure 9.40), you have successfully got it to boot automatically.
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Hands-On Guide to Bitcoin Layer-2 Lightning Network Node Setup 333

Figure 9.40: Success of auto boot once I unlock the LND wallet.

Figure 9.41: Calling the node to return me a np2wh address.

Figure 9.42: Balance in satoshis.

9.4 Reaping the Fruits: Testing Time

Due to the inconsistency of the testnet faucet, you may use any
faucet found on the internet at the time you are trying to receive
testnet coins. You can also use a bitcoin testnet explorer to verify
the transactions of receiving it into your lnd node.
Generate an address and send the testnet coins to your own node
(see Figure 9.41).
Check your wallet balance using the command shown in
Figure 9.42.
Now, I check my peers as we have set to autopilot previously to
open up channels (see Figure 9.43).
I can also check the payments that I have made (see Figure 9.44)
with my network. Here, it is 0 as I have yet to make any new
payments.
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334 Blockchain and Smart Contracts

Figure 9.43: Peers connected with.

Figure 9.44: List of payments which is none at this moment.

Figure 9.45: Unconfirmed transaction.

Now that my transaction has been sent from a sender to me, this
is what I got (see Figure 9.45). It still remains unconfirmed.
After 10 minutes, I check again and this is what we have. Now
that it is a confirmed transaction (see Figure 9.46), UTXO, I can
spend it by sending it out if I want to.
Acinq, another company experimenting with Lightning imple-
mentation, has done a cool site for testing lightning transactions
over payment of coffee. Please try getting yourself a nice cold Frappe
for all the effort and determination through the entire process. Wait,
remember, you are on testnet. If you want to get yourself a real treat
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Hands-On Guide to Bitcoin Layer-2 Lightning Network Node Setup 335

Figure 9.46: Confirmed transaction.

of coffee, you need to switch the bitcoin configuration to testnet=1

to 0. Sync all the mainnet block data into the bitcoin directory of
your HDD and check the getblockinfo to ensure that you are on the
mainnet as True and your verification is up-to-date. Do all these only
if you are prepared to lose whatever you can afford to lose. Again,
these are still in the experimental phase.

9.5 Beyond This Tutorial

Throughout this tutorial, we have experienced what it is like to be a
validator of the bitcoin network by playing a part to strengthen the
decentralised network and being a part of the voting rights in the
chain validation. We have experienced how to download, validate
and extract the bitcoin core into a palm-sized hardware connected
to a hard disk, validating blocks all the way from the genesis block
back in 2007. You have a copy of over a decade of chain data in your
possession. Next, we experience how it is to synchronise the chain
data and let it auto run from the raspberry pi. We then move on
to layer-2 applications such as the lightning network to demonstrate
how we can make lightning fast transactions that are useful for micro
payments in a trusted environment that is low or close to negligible
fees. All of these have a governance mechanism that governs the rules
to prevent any party from having an incentive to cheat. All of these
are done via the software together with a simple hardware like the
raspberry pi.
Bitcoin or blockchain programming goes beyond just this. There
are many other concepts and applications that go around the
lightning network. In the case of other digital currencies such as
Ethereum, the concept of layer-2 applications such as lightning works
the same by having a watchtower guarding over side chains. Other
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336 Blockchain and Smart Contracts

useful applications include smart contracts in Ethereum which are

covered in other chapters of this book.
For the tutorial in this chapter, having a node running in your
office/at your home, there are readily available gadgets that aim
to achieve the same objectives. At the time of writing, there are
products such as Casa Node, myNode One, RaspiBlitz by Lightning
in a box and Swift Cryptocurrency Bitbox Base.
The above offer a more robust setup with some having a docker
file with all the dependencies and hardened with security functions to
prevent various forms of network attacks. They are more hardy, aes-
thetically pleasing, with better user experience for troubleshooting
and upgrading of versions, and offer a more sustainable operation,
but all with the same fundamental concepts you have covered in the
tutorial above.
This tutorial does not just end here. There are tons of other
explorations available on how you can integrate your solution above
to a better hardware. For example, the Raspberry Pi 4 or other
services such as using it as a payment gateway for your commerce like
integrating with BTC Pay server to start accepting bitcoin payments,
running with TOR or running it with Electrum paired with your
hardware wallets so you can send and receive bitcoins using your
handy node to validate or broadcast your transactions and you can
finish it off with a nice linkage to a mobile- or computer-compatible
wallet application such as Zap, Zeus or Shango. All of these will not
be possible without the great community out there with an open
source spirit of decentralising their codes.
December 24, 2020 14:18 Blockchain and Smart Contracts: Design Thinking. . . 9in x 6in b4043-ch10 page 337

Chapter 10

Architecting and Designing Your

Own Blockchain Solution
Ernie Teo∗

10.1 Introduction
The world is gradually starting to understand blockchain and
understand its benefits; more people and enterprises are discovering
and experimenting on use cases. The most well-known Bitcoin use
case for peer-to-peer payments has grown into an expanded world of
decentralised finance: stable coins, decentralised exchanges, lending
platforms, prediction markets and more. In the world of traditional
finance, banks have gone beyond cryptocurrencies and have deployed
solutions that are using blockchain for trade finance (letters of credit
in particular); central banks such as the Monetary Authority of
Singapore have experimented with interbank clearing and settlement.
The use cases for blockchain are not restricted to the finance space;
there are government and enterprise efforts in the areas of identity,
personal records, retail, trade and manufacturing (see Figure 10.1).
An emerging technology as blockchain is, it is exciting to think
about implementing blockchain in your business or use case. How-
ever, it is important to remember that not all problems can be solved

∗
Adjunct Senior Lecturer, National University of Singapore; Co Vice-Chairman,
Blockchain Association Singapore, Singapore.

337
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338 Blockchain and Smart Contracts

Blockchain Use Cases:

Select ed Indust ries
• Trade Finance
Finance • Cross border settlement and payments
• Know Your Customer

• Asset Registration
Govt Tech • Citizen Identity
• Medical Records

• Supply chain and logistic

Retail & • Global Trade
Manufacturing • Food Safety
• Loyalty programs

• Underwriting
• Claims processing
Insurance • Asset usage history
• Fraud Detection

Figure 10.1: Blockchain use cases.

or improved with blockchain. A good blockchain use case should have

the following attributes as shown in Figure 10.2.
The business problem (or any other problem statement) should
make sense for blockchain. Sometimes, inefficiencies that exist in the
industry due to a lack of digitisation or coordination can be solved
with more mature technologies. There should also be a clear and
identifiable network of participants, assets (that need to be held and
moved within the network) and transactions (or rules which define
how these assets can be moved). A good blockchain use case usually
arises from a lack of trust between stakeholders. The need for the
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Architecting and Designing Your Own Blockchain Solution 339

A Good Blockchain Use Case

That is difficult to solve with non-
A business problem to be solved blockchain technology

Identifiable network/ecosystem Participants, Assets and Transactions

Requires trust that is Decentralized, Transparent and Secure

Figure 10.2: Attributes of a good blockchain use case.

Decentralized Transparent Secure

• Consensus • Auditability • Immutability

Figure 10.3: Key features of blockchain.

key features (as described in Figure 10.3) of a blockchain to solve a

business problem justifies its application.
Blockchain technology can create trust within a network of
participants that are not necessarily aligned in their objectives.
Decentralisation ensures that there is no one point of failure and
the consensus protocol ensures alignment within the network. The
network agrees on the validity of the transactions that are written
onto the ledger. The blockchain is also transparent to its participants
(to some degree) and this makes it auditable. These features also
makes the ledger secure as the data are immutable and cannot
be easily changed or hacked. This creates a layer of trust for the
participants on the network.
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340 Blockchain and Smart Contracts

10.2 Planning Your Blockchain

Suppose you have established that you have a good blockchain use
case and want to start developing the application. There are many
considerations on how to put your blockchain application together.
This starts with understanding the fundamental use case to deciding
on the network and technology to use. The key steps are outlined in
Figure 10.4.
First, outline the main purpose of using blockchain in the use case.
Are there multiple parties in the process where there is a lack of trust,
resulting in manual checks and bottlenecks? Is there a need to store
evidence or audit trails in a decentralised way such that no centralised
party can manipulate the data? Or is the use case for a decentralised
economy with digital tokens or assets? Next, we take a deeper dive
into understanding your use case and define the requirements, by
considering its users, assets, participants and network.

10.2.1 Define Users

Anyone who would interact with the blockchain network is a user.
This includes administrators, auditors, node operators and end users.
Types of questions to ask include the following:

1. What types of actions do they need to take? Is it view only or do

they need to interact with the blockchain?
2. Are they part of an organisation? What are their roles in the
organisation? Is there an organisational hierarchy to consider?

Define Design the smart Define the

Define users Define assets
transactions contract(s) network
• Identity • Tangibility • Add • Underlying • Participants
• Fungibility • Transfer Rules
• Transferability • Update
• Delete
• Query

Figure 10.4: Planning your blockchain.

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Architecting and Designing Your Own Blockchain Solution 341

3. User actions include the ability to transact and hold assets. Does
this ability depend on their role?
4. How would they usually interact with the system (e.g., mobile
phones or laptops)?
Another important consideration is the identity (or account) of
the user. There are two types of identity to consider. First, consider
if a blockchain-based identity or account is needed. When users
are assigned a blockchain account (or address), they can transact
and hold assets. If this is needed, the other consideration is the
management of user keys. Are your users technically savvy enough
to manage their own private keys (i.e., manage their own blockchain
wallet)? Do you need a mechanism for key recovery? Is it better to
run a key management service? In this case, what are the security
considerations?
The second type of identity to consider is a user’s profile. This
is the connection to a user’s real-world identity. Should your users
transact only with their blockchain accounts? Pseudo-anonymous
blockchains like Bitcoin do not require user identities to be verified.
In most business use cases, some form of identity is required;
there may be legal or business considerations. If there is a need for
this, you also need to consider how you will verify their identity
and what types of identity information is required. Does it include
name, email, identity documents or more? In private or permissioned
blockchains, a gateway or controller ensures that identity is verified
before credentials are issued to the user. Once this information is
collected, you will need to store and manage the user data in a secure
manner. If you are using a public blockchain, you can also collect the
users’ identity on your servers and link them to blockchain accounts.
Exchanges that are legally required to store KYC information are an
example. Other alternatives in public blockchains are identity oracles
that are linked to a trusted database. These sources can come from
governments, financial institutions or utility providers. An example of
this is Uport, which worked with the city of Zug to issue government-
verified identities on the Ethereum blockchain.
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342 Blockchain and Smart Contracts

10.2.2 Define Assets

Digital assets can be broadly defined as any type of information
where ownership can be assigned. The most common type of asset
on blockchain networks is the cryptocurrency. Cryptocurrency is an
on-chain asset; they are generated through algorithms that run on
the blockchain such as bitcoin mining. This type of asset only exists
on the blockchain.
Other types of assets that can be digitised on the blockchain are
rights over physical property such as real estate, vehicles or precious
metals. In this case, a trusted party is required to act as an issuer of
the digital title. There needs to be a legal process behind the issuance
that ensures redeemability of the asset. The benefit of such types of
digitisation is the ability to fractionalise the asset. This makes the
asset more accessible to the mass market and allows the asset owners
to issue tokens to the asset for financing purposes.
Intangible digital assets can also be issued on the blockchain.
These can be generated digitally by entities that are part of the
network. In general, these parties need to be trusted for the network
to acknowledge the legitimacy of the asset. Some examples are letters
of credit, bank guarantees, loyalty points, equity and intellectual
property rights.
An attribute to consider is the fungibility of the digital
asset/token. This also affects the technology you can use to issue
the asset. Cryptocurrencies like bitcoin are non-fungible; one bitcoin
is not distinguishable from another. Tokens representing properties
need to be fungible as each property may have different attributes
and values. However, fractionalised tokens of a particular property
can be fungible as each represents a share of the property (which is
no different from another share).
Digital assets/tokens generally should be transferrable to allow
for changes in ownership and trading of the asset. However, there
is a class of digital assets that should be non-transferrable. These
are assets that are particular to an individual or entity. This
includes medical records, identity registry, education credentials and
employment records.
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Architecting and Designing Your Own Blockchain Solution 343

10.2.3 Define Transactions

Once we decide on the types of assets on the network, we should
consider the rules that govern these assets. These are the transactions
that will occur on the network. These rules depend on both the type
of user and assets. Types of transactions include the following:
1. Add: Creating or issuing of asset
2. Transfer: Change of asset ownership
3. Update: Alteration of asset (such as updating an expiration date
or status)
4. Delete: Destruction of asset
5. Query: Look up information about the asset

10.2.4 Design the Smart Contracts

The next step is to bundle your assets and transactions into smart
contracts; the smart contracts are the rules for your assets in code.
Consider what are the underlying rules or conditions for transfer of
assets. This is where an understanding of the business process comes
in. How are the assets created and by whom? Who is allowed to
own and transfer these assets? Ensure that you have the necessary
functions as smart contracts are hard to change once deployed.
Consider “bad” scenarios to ensure that you have an “exit” if things
go wrong, especially if your smart contracts are dealing with valuable
digital assets.

10.2.5 Determine the Network

Once we have a clear idea of the participants, assets and transactions,
we should consider the network. Who will operate and/or regulate
the blockchain? Are gateways (such as exchanges or data providers)
needed to connect to systems outside of the blockchain network? Do
you need to integrate to external data sources?
There may be participants in your blockchain network that go
beyond users. Additional questions to ask about the participants
include the following: How will they access and interact with
the blockchain? Are they required to be nodes on the blockchain
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344 Blockchain and Smart Contracts

Figure 10.5: Participants in a blockchain network.

network? Figures 10.5 and 10.6 describe the types of participants

that can be part of the blockchain network. Not all types are required
participants of the network and it depends on the use case. Decide
what are the components you need.

10.3 Choose Your Technology

The first step in deciding the technology that you will use is to
determine if you need your own blockchain network. If you have
a token-related use case where the token is used as a utility for
running the network, you will need your own blockchain. Or if you are
using a unique consensus protocol that is designed to incentivise your
network participants, you will need your own blockchain. That would
allow you to customise the blockchain network from the protocol
level. If you intend to run a permissioned blockchain network where
only your partners can join, you will also need your own permissioned
blockchain network. Technologies like the Hyperledger family, Corda,
Multichain and even Ethereum (Enterprise) allow you to customise
and run your own blockchain network.
If you have an experienced blockchain development team that
can code your blockchain from the protocol level, you can write your
own consensus and rules. This might have been your only choice a few
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Architecting and Designing Your Own Blockchain Solution 345

Participants of a blockchain network

Entities, Systems and Hardware
Blockchain Architect Designs the network and the software based on the
system requirements.
Blockchain Developer Develops and code the blockchain protocol and smart
contracts.
Blockchain Operator Runs and manages the blockchain daily operations.
Blockchain Regulator Decides and enforces the rules. Manages the nodes. More
likely in permissioned blockchains.
Certificate Authority Issues authenticated certificates to users and provides
proofs of identity.
Blockchain Node A server on the blockchain network that may or may not
take part in consensus and storing of the blockchain
ledger.
Blockchain Users Individuals or entities that are using the blockchain
network.
Traditional Data Sources and Third party sources of data and systems which may need
Processing Platforms to be connected to the blockchain.
Software
Wallets For management of digital assets assigned to blockchain
users.
Applications Software that provides an interface for the user to
connect to the network and interact with its functions.
Smart Contracts Code that us deployed on the blockchain to manage
assets and transactions.
Ledger The blockchain database that records the transactions.
Events External sources of information (or oracles) that may be
used to trigger a smart contract process.
System Management Program for managing the blockchain network such as
upgrading the protocol and giving permission to nodes.
System Integration Software written to connect the blockchain network to
third party sources of information.

Figure 10.6: Participants in a blockchain network.

years ago. However, many tools for developing blockchain networks

have become mature and can be utilised. It is not always practical
to set up and run a network on your own. Blockchain-as-a-Service
(BaaS) providers like Azure, AWS and Kaleido are offering services
that can deploy a blockchain network with a few clicks. You can
choose between various technology options when using BaaS.
An important consideration when deploying your own blockchain
is whether to keep it permissioned or make it public. Do you
want others to join your network as nodes without requiring
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346 Blockchain and Smart Contracts

your permission? Another factor to consider is the visibility of

the blockchain data. For example, a blockchain network could be
write permissioned and read public. Meaning, only the permissioned
blockchain nodes can write to the blockchain, but the blockchain
ledger is open for the public to access.
Both permissioned (private) and permissionless (public)
blockchain networks have their pros and cons. There are varying
industry opinions. One may argue that running a highly permissioned
system where one control the nodes is merely opening with the same
single point of failure weaknesses which blockchain was originally
designed to overcome. But, others may claim that it is difficult for
institutions to trust a network which anyone can join. It is difficult to
answer which is better; it is subjective to the use case, company poli-
cies and mindset of stake holders. There is no rule of thumb or indus-
try standard to decide which one is better. Some institutions will
choose to trust permissioned systems, whereas a pro-decentralisation
public use case may prefer the permissionless approach.
When creating your own blockchain network, you should also
consider your ability to form the network. If you are intending to
create an industry-wide blockchain, would you be able to get most
of the industry to agree to participate as nodes? Can you get the
relevant authorities like trade associations or regulators to be part
of your network? If participants are potentially competitors, there
may not be enough trust within the participants. If you are starting
a public blockchain, will you be able to get nodes (or miners) to
join your blockchain? How would you make them aware of this
network? Are your incentives attractive enough to make them join?
For this, you will need to consider the network economics (see the
next section).
However, there are cases where you may not need to deploy
your own blockchain network. If your use case is focused on just
developing a decentralised application (DApp), you can deploy your
smart contracts onto an existing blockchain network and can connect
your DApp to the network as well. For example, many applications
run on the Ethereum network. If all you need is an application, having
your own blockchain network may not be necessary.
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Architecting and Designing Your Own Blockchain Solution 347

In making the decision to use an existing public blockchain, you

also have to consider non-functional requirements of the solution you
are developing. What is the number of users, transaction volume
and speed? Is there a minimum level of service you need to provide
for your users? Note that there may be a trade-off between security
and speed. Larger blockchain networks (like Ethereum) may be more
secure but are prone to congestion and high network transaction
fees (gas). However, such networks provide a high level of data
immutability and security which smaller or private networks cannot
provide.
If you do decide to use an existing public blockchain network, the
key considerations would be if the network is healthy (secure) and
if the technical features support your use case. Ethereum is still the
network of choice for deploying DApps, but many next-generation
blockchain networks like QTUM, NEO, Cardano, Zilliqa, EOS, Tron
and Tezos are also catching up. Ethereum 2.0 is also coming up and
aims to address the scaling issues Ethereum currently faces. If there
are privacy requirements, you may consider blockchain technology
with built-in privacy features such as Zero Knowledge Proofs, Secure
Signature Schemes or Private State Channels.
Solely permissioned or solely public blockchains are not the
only options. Private permissioned blockchains may rely on public
blockchains to maintain immutability and trust in a hybrid setting.
This involves posting the blockchain of your permissioned network
to the public blockchain of choice. This provides additional security
(immutability) to the transactions on your blockchain. Such methods
were first discussed in Komodo’s Delayed Proof of Work using the
Bitcoin network, but can also now be found in Kaleido’s Ethereum
tethering service.
The process of choosing the blockchain technology/network is
summarised in Figure 10.7.

10.4 Designing Token Economics

The term token economics stems from mechanism design. Mechanism
design is an economics approach to design incentives (or eco-
nomic mechanisms) to get a strategic outcome (where players
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348 Blockchain and Smart Contracts

Figure 10.7: Choosing blockchain technology.

act rationally). Bitcoin’s mechanism design aims to get miners to

participate in validating transactions, ensures the blockchain ledger is
consistent and prevents double spending of coins. The incentive used
was mining rewards of bitcoins, fuelled by its limited supply. This in
turn gives bitcoins economic value and drives miner incentives.
If you intend to design your own token and consensus, the key
consideration is the outcome you wish to achieve. The incentives
of your network participants must be aligned to drive towards
that outcome, regardless of whether you are using mining or other
methods as an incentive. You should also be on the lookout for
undesired outcomes. When Bitcoin was designed, it was not expected
that there would be consolidation of miners. When bitcoin prices
in reality became extremely attractive, it led to a centralisation of
mining power and the exclusion of nodes with low computational
power. It was also not expected that the intense competition in
mining would lead to such a large consumption of electricity for the
network.
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Architecting and Designing Your Own Blockchain Solution 349

Certificate
Certificate
Issue Issuing
School
Application
Certificate
Student
Issue

Result Verify
Verify
Verify
Employer
Web Cert
Application Hashes
Result
Result
Smart Contract

Blockchain

Figure 10.8: Issuing certificates on blockchain.

Points to take note when designing your tokens are attributes

like how the tokens are created or generated, how the tokens are
distributed to the network (is it competitive) and the utility of the
token within the network. For some cases, your objectives may not
be just the actions that happen within your blockchain network but
also the token price. Token price is determined by factors external
to your network as demand and supply is driven both internally and
externally. Non-participants may trade the tokens and contribute to
price volatility. The token design may affect the price and investors
may attribute scarcity or high utility to potential increases in prices.
If you intend for the token to power the utility within the blockchain
network, you need to consider its price volatility in the external
market. Bitcoin’s volatile and speculative nature has prevented it
from fulfilling its original intension as a payment token.

10.5 Putting it Together

Now that we have gone through the various considerations, we can
put it together by describing the processes within your solution.
A process flow diagram maps the user’s end-to-end journey. The
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350 Blockchain and Smart Contracts

diagram should include the various users or participants, user inter-

faces or applications, the blockchain network, smart contracts and
assets, and the interactions (transactions) between them. Figure 10.8
illustrates an example for the use case of education certificates on a
blockchain. The school uses an Issuing Application to interact with
the blockchain to store hashes of the certificates for verification. The
Issuing Application returns the Certificate to the school, which then
sends it to the student. The student can share this certificate with
a potential employer. Both student and employer can use the Web
Application to verify the authenticity of the Certificate. The Web
Application queries and verifies the Certificate with the hash stored
on the blockchain. If the Certificate is tampered with or fake, the
Web Application will return a negative result.
To get a better idea of how to implement your use case, you
can also sketch or draw the user interface. Create mock-ups of your
website or mobile App; include all functions needed to interact with
the smart contracts and the blockchain. Decide what the user sees
from the blockchain on the UI and what happens in the background.
This will help in the development of the applications and smart
contracts.
Designing and architecting a blockchain solution is an art rather
than a science. It takes a deep understanding of the problem
statements, use cases and user requirements. It also requires an
appreciation of the features of a blockchain and how to utilise and
implement them in the solution that achieves your objectives. This
chapter serves as a guide to get the reader started; the rest comes
with experience.
December 24, 2020 14:18 Blockchain and Smart Contracts: Design Thinking. . . 9in x 6in b4043-index page 351

Index

0x, 91 Blockchain-as-a-Service (BaaS), 345

51% attack, 172 blockchain use case, 338
branch, 83
A brute force, 186
accountability, 6 Byzantine attack, 104
active attack, 6 Byzantine failure, 102, 246
active daily users, 142 Byzantine fault tolerance, 102–103
Advanced Encryption Standard Byzantine Generals Problem,
(AES), 54 102–103, 114–115, 217–218
altcoins, 155–156
anonymise signatures, 182 C
asset light, 146 certificate, 46
asymmetric encryption, 58 certification authority (CA), 47
attack, 176 certificate revocation list (CRL), 48
availability, 4–5 coin mixing, 182
CoinJoin, 65
B CoinShuffle, 66
backdoor, 180 colored coins, 259
Base58, 225 commission failures, 102
believable validator, 110 comovement, 160
Beneficial to All, 149 computationally secure, 8
binary strings, 87 confidentiality, 3
binary tree, 83 consensus, 73, 89, 99–105, 109,
Bitcoin Script language, 239 111–112, 114–119, 123, 128,
bitcoind, 318 131–132, 143–144, 171, 220, 306
bits, 90, 92–93 consensus protocol, 344
Bitcoin blockchain, 10–11 consortium blockchain, 119, 182
Bitcoin transaction, 42 crypto-economy, 11
blockchain, 10–12 Corda, 344
block header, 87–90, 94, 96–97 cost of production, 143

351
December 24, 2020 14:18 Blockchain and Smart Contracts: Design Thinking. . . 9in x 6in b4043-index page 352

352 Index

crash fault, 102, 112 dividend discount, 133

crowdsourcing contributions, 148–149 Distributed Ledger Technology
crowdsourcing wisdom, 148–149 (DLT), 10–11
cryptocurrency exchange, 132, 143, DoS, 176
180 double hash, 87
CRyptocurrency IndeX (CRIX), 157, double-spending, 48, 131, 172, 217,
159–162, 164–165, 168 348
Cyberpunk, 305 dPoS, 108–109, 116
dusting attack, 64
D dynamic conditional correlation, 159
dynamic correlation, 160
data blurring, 186
data authentication, 5 E
Data Encryption Standard (DES), 54
ecdsa module, 35
Data Privacy Protection, 147
Economies of Convergence, 144
DCC, 160
Economies of Integration, 144
decentralisation, 147–148, 339
Economies of Scale, 107, 144, 146
Decentralised Application (DApp), Economies of Scope, 144
179, 346 efficient frontier, 160–161
Decentralised Autonomous Elliptic Curve Digital Signature
Organisation, 179 Algorithm (ECDSA), 34, 224
decentralised economy, 340 elliptic-curve cryptography (ECC),
decentralised exchanges, 337 223
Decentralised Finance, 121, 337 Encompassing Interest of All, 149
Delayed Proof of Work (dPoW), 116, ERC-20, 202
347 ERC-20 Interface, 203
Delegated Proof of Stake, 108 encryption, 49
Democratisation, 147 encrypted Notes, 71
Denial-of-Service, 176 Etherchain, 174
design thinking, 130, 133, 150 Ethereum, 195, 212
Devcon, 179 Ethereum virtual machine (EVM),
difficulty, 91–92 193–194
difficulty level, 92, 231 Etherscan, 212
difficulty target, 20, 88, 90, 93 Exclusive-OR, 49
digital assets, 342
digital economy, 124–126, 148 F
digital signature, 81, 182 fault tolerance, 101
Digital Signature Algorithm (DSA), Fault-Tolerant, 115
223 Federated Byzantine Agreement
digitalisation, 147–148 (FBA), 115
digitisation, 148 Feistel network, 55
diminishing oneself, 147–148 fiat, 133
Directed Acyclic Graph (DAG), 101, fork, 107, 172
117–118 fractionalised, 216
discounted cash flow, 133 fractionalised tokens, 342
Disintermediation, 147 fungible, 342
December 24, 2020 14:18 Blockchain and Smart Contracts: Design Thinking. . . 9in x 6in b4043-index page 353

Index 353

G interoperability, 119
gas, 195 intrinsic value, 122
gateways, 343 investor sentiment, 162–163, 168–169
General Data Protection Regulation
(GDPR), 184 K
Go language, 179 key management service, 341
gossip protocol, 118
greatest common divisor, 24 L
group, 25 LASIC principles, 146
group signatures, 182 Last In, First Out (LIFO), 241
leaf, 83
H leapfrog, 144
handshake, 222 Lightning Labs Daemon, 323
hard fork, 180, 236 lightning network, 323
Hardware Security Modules (HSM), Linkability risks, 186
225 LND, 323
hash, 12–13, 82, 86–88, 90, 92, 94–97, locktime, 81
186 low margins, 146
hash codes, 82
hash function, 82, 84, 223 M
hash value, 82–85, 88–90, 94, 97 main chain, 172
hashgraph, 118 mainnet, 306
hash rate, 97, 172 malicious validator, 110
hashrate for hire, 175 marginal cost of production, 143
hex, 85, 90, 96 mechanism design, 347
hex target, 91 mechanism design of the network,
hexadecimal, 85, 87, 90–91, 93, 224 101
homomorphic encryption, 183 medium of exchange, 137
hybrid encryption, 60 Merkle Path, 18
Hyperledger, 114–115, 344 Merkle Proof, 231
Hyperledger Fabric, 115 Merkle Hash Tree, 16–18, 78, 83, 86,
231
I Merkle root, 83, 86–88, 93–94, 231
identity, 48 mesh technology, 149
immutable, 339 Metadata, 238
immutable ledger, 13 Metcalfe’s Law, 142–143
incentive mechanism design, 109 miner, 172, 257
information ratio, 166 Mining Diversity, 256
Initial Coin Offerings (ICOs), 133, mining pool, 174
151, 192 mispricing, 162, 164
input counter, 79–81 modular arithmetic, 24
inputs, 237 Monero, 66
intangible digital assets, 342 multichain, 224, 344
integrity, 4 multiple contracts, 204
Internet economy, 124 multiplicative group, 26
December 24, 2020 14:18 Blockchain and Smart Contracts: Design Thinking. . . 9in x 6in b4043-index page 354

354 Index

N Proof of Space, 109–111

network economics, 101 Proof of Stake, 107–109, 111, 116,
network effect, 123, 128, 135, 142 118
node failure, 101 Proof of Weight, 109
non-fungible, 79, 342 Proof of Work (PoW), 19–20, 73,
non-transferrable, 342 89–90, 92, 95, 99, 101, 103–105,
nonce, 88, 89, 94–97, 231 107, 109–110, 113, 116, 118, 172,
normal nodes, 116 231–232
notary nodes, 116 properties of hash function, 14
nothing at stake, 107 Pseudo-anonymous, 341
no-message attack, 29 pseudonymisation, 185
nullifier, 71 pseudonymous, 48
pseudorandomness, 9
O public key, 81
public key infrastructure, 46–47
omission failures, 102
on-chain, 342
Q
on-chain governance, 323
one-time pad, 49 quorum, 115
output counter, 79, 81 quorum slices, 115
outputs, 237
R
P RAFT, 115
passive attack, 7 reinforcers, 122
Pay to Public Key Hash (P2PKH), relative valuation, 134
41–45 resistant to traitors, 102
peer-to-peer network, 121 return reversal, 162
penetration testing, 180 reversal risks, 186
perfect secrecy, 49 Reverse Polish Notation (RPN), 240
permissioned blockchain, 113, 116, Ring Confidential Transaction
184, 341 (RingCT), 69
PKCS1 OAEP libraries, 62 ring signatures, 68, 182
Practical Byzantine Fault Tolerance robustness check, 166, 168
(PBFT), 114–115 rollback transactions, 173
prime number, 24 root hash, 231
Privacy by Design, 187 round-robin, 109
private key, 81 RSA Digital Signature (Textbook),
Private State Channels, 347 28–30
Proof of Authority (PoA), 112–113 RSA library, 31
Proof of Believability, 109–110 RSA Optimal Asymmetric
Proof of Burn, 111–112 Encryption Padding (OAEP), 60
Proof of Capacity (PoC), 110 RSA Probabilistic Signature Scheme
Proof of Elapsed Time (PoET), (PSS), 30–31
113–114
Proof of Importance (PoI), 109, 111 S
proof of ownership, 81 Satoshi Nakamoto, 225
Proof of Reputation (PoR), 113 scalability, 305
December 24, 2020 14:18 Blockchain and Smart Contracts: Design Thinking. . . 9in x 6in b4043-index page 355

Index 355

scriptPubKey, 81, 237 token economics, 122–123, 127–128,

scriptSig, 81, 237 130, 133–134, 151, 347
secret key, 53 token economics design, 132
Secure Multi-Party Computation token economy, 121–124, 126–128,
(SMPC), 183 130, 132, 134, 143, 146, 150
Secure Signature Schemes, 347 token economy architecture, 129
sentiment, 144, 156, 162, 164, 166, token velocity, 139
169 tokenised, 121
sentiment effect, 161, 168 top hash, 231
SHA-256, 82, 84, 90 Tragedy of the Commons, The,
sharing economy, 124–126 11–12
Sharpe ratio, 166 transaction paths, 63
signer, 182 transferrable, 342
single contract, 204 transfers of personal data, 185
six-block confirmation, 22 transition map, 161
smart contracts, 179, 189, 336, 343 Trusted Execution Environment
social scalability, 123, 144, 146 (TEE), 183
soft fork, 236 Turing Complete, 194
source code fork, 236 Turing Complete language, 239
spacing, 257 turing completeness, 239
SPECTRE, 118
stable coins, 337 U
stack, 241 Unix epoch, 89
stake, 107–108 unspent transaction output (UTXO),
stake holder, 108–109 80–81, 239
stake of coins, 111 user authentication, 5
staker, 107 user privacy, 3–4
state channels, 184 users’ base, 142
static correlation, 159
statically typed language, 205 V
stealth address, 66 validator, 108–110, 112–113, 171
store of value, 137 verifier, 182
substitution–permutation network, Vernam cipher, 49
57 Vitalik Buterin, 179
subaddress, 68
Sybil attack, 171, 233 W
symmetric encryption, 53–55 wallet address, 45
Wallet Interchange Format (WiF),
T 225
Tangle, 118 web economy, 124
target, 90–97
targeted behaviour, 122–123 Z
testnet, 212, 306, 320 Zcash, 69
textbook RSA encryption, 59 Zero Knowledge Proofs, 183, 347
The Coordinator, 118 zero network latency, 103
timestamp, 88 zk-SNARKs, 69
 Singapore University of Social Sciences - World Scientific
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