Law School of Harvard University / 2022 - 2023

Blockchain, Cryptocurrency and Fintech

Professor Allen Ferrell
Fall 2022

Available for download starting at 9am EST 12/8.

Must be electronically submitted 3 hours after download, or by 12:30pm EST 12/8,
whichever time is earlier

The exam mode is TAKEHOME.

This exam is 6 pages long. Please check to see that you have all 6 pages.

This is an open-book examination. You may use a laptop computer.

There are twelve questions in this exam. They will count equally in determining your final grade.
Should you find it necessary in answering a question to assume a fact not given in the problem as
stated, you may do so. You should clearly indicate that you are making an assumption, however, and
briefly explain why you consider it a reasonable assumption to make.

You may not discuss the examination with anyone, either while taking it or thereafter until everyone
has taken the exam.

By submitting your exam answer(s), you acknowledge the above instructions, and
certify that the work you are submitting is your own, that you have not received
unauthorized assistance on the exam, and that you have followed applicable rules,
including rules for accessing reference and other materials during the exam.

Exam4 will automatically print your Anonymous ID and word count on the exam.

== Good luck! ==

© 2022-2023 by the President and Fellows of Harvard College.

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QUESTION ONE

Satoshi wrote in the seminal 2008 paper “Bitcoin: A Peer-to-Peer Electronic Cash
System” the following:

The traditional banking model achieves a level of privacy by limiting access to

information to the parties involved and the trusted third party. The necessity to announce
all transactions publicly precludes this method, but privacy can still be maintained by
breaking the flow of information in another place: by keeping public keys anonymous.
The public can see that someone is sending an amount to someone else, but without
information linking the transaction to anyone. This is similar to the level of information
released by stock exchanges, where the time and size of individual trades, the "tape", is
made public, but without telling who the parties were. As an additional firewall, a new
key pair should be used for each transaction to keep them from being linked to a common
owner. Some linking is still unavoidable with multi-input transactions, which necessarily
reveal that their inputs were owned by the same owner.

An academic paper recently stated:

The decentralized nature of the Bitcoin protocol makes it easy for [illicit operators] to
operate — they only need to have their servers in a country where the authorities are
willing to tolerate their existence. If know-your-customer [exchanges] are allowed to
accept flows from [exchanges] that are not following strict know-your-customer norms
(the current state), then the digital footprint has a very limited effect on preventing tainted
flows from entering into wide circulation.

Do you agree or disagree with their views on the privacy of Bitcoin transfers?

QUESTION TWO

Can fiat-backed stablecoins and central bank digital currencies co-exist? Given your
views on this, is that an argument for or against a central bank digital currency for the United
States?

QUESTION THREE

Explain how a proof of stake consensus solves the Byzantine Generals Problem. Does
this explanation indicate in your view any strengths and/or weaknesses relative to the proof of
work consensus solution to the Byzantine Generals Problem?

© 2022-2023 by the President and Fellows of Harvard College.

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QUESTION FOUR

Assess the following:

The economic value finance trades on is generated by humans and their relationships.
Because web3 lacks primitives to represent such social identity, it has become
fundamentally dependent on the very centralized web2 structures it aims to transcend,
replicating their limitations. . . . The lack of a native web3 identity makes today’s DeFi
ecosystem unable to support activities in the real economy, such as undercollateralized
lending or simple contracts, like an apartment lease. . . . [R]epresenting social identity
with soulbound tokens could overcome these limitations and bring the ecosystem far
closer to regenerating markets with their underpinning human relationships in a native
web3 context.

QUESTION FIVE

Why is there blockchain trilemma? In other words what explains why there is a trade-off
between scalability, security and decentralization?

QUESTION SIX

Will the blockchain trilemma in your view ultimately impede further widescale adoption
of blockchain technology in the financial system? Why or why not?

QUESTION SEVEN

One commentator explaining their view on the collapse of FTX said:

Imagine that I own a house and I create a million coins representing the value of the
house. I give half of the coins to my wife. I then sell one of my coins to my wife for $10.
Now the house has a nominal value of $10 million dollars and my wife and I each have
assets worth $5 million. Of course, no one is likely to buy my house for $10 million or
lend me money based on my coin wealth but suppose I now get my friend Tyler to buy a
coin for $15. Tyler says why would I want to buy your s!@# coin! To encourage Tyler to
buy I give him a side-deal that is not very public. Say an extra 5% of our textbook
royalties. Tyler buys the coin for $15. Now the coins have gone up in value by 50%. My
wife and I each have $7.5 million. Other people may want to get in while they can—
Tyler bought in! Are you in? I’m in!

Now if it’s not obvious, I am SBF in the analogy, and my wife is Alameda run by his
sometimes girlfriend Caroline Ellison. Who is Tyler?—the seeming outsider who gets a
kind of under-the-table deal to pump SBF’s coins? One possibility is Sequoia a venture
capitalist firm who invested in FTX, SBF’s house, while at the same time FTX invested
in Sequoia. Weird right? Tyler in this example is also a bunch of firms that Alameda

© 2022-2023 by the President and Fellows of Harvard College.

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invested in but which were then required to keep their funds at FTX. Many other
possibilities exist.

Another relevant point to our analogy is that there are one million coins but only a
handful of them are traded, the handful that are traded are called the float. Similarly,
many crypto coins were created with emissions schedules where only a few coins were
released, the float, with a majority of the coins “locked” and only released over time.
Keeping the price high, and thus the imputed value of the stock high, meant you only had
to control the float.

Ok, so far this is crazy but despite nominal values in the millions a relatively small
amount of real money has actually changed hands. But suppose that I now open a bank or
an exchange. People want to bank with me since I have clearly shown that I know how to
get wealthy! Now the money coming into the exchange is real money and it’s a bull
market so when people check their accounts everything looks great, everyone is making
money.

Suppose I take some of these assets and lend them to my wife for her to take speculative
bets on. Is this illegal? Well, it’s actually hard to say. A bank is supposed to make loans.
It’s more complicated with an exchange. Maybe it’s illegal, maybe not. After all, when I
lend assets to my wife I can say that there was lots of collateral. What collateral? Well
remember my wife has $7.5 million in coins so I am lending say $3 or $4 million which
is backed by twice as much collateral—that looks safe, right? Actually, it’s even better
since she is going to invest the assets in other assets, unfortunately other coins not the
S&P500, but now there is even more collateral. Everything looks safe.

Importantly, if the assets my wife is investing in are going up in price—she is getting

very, very rich. She borrowed billions and keeps all the profits on the upside. Give me a
house of assets to stand on and with leverage I will rule the earth! Moreover, the more
prices go up, the safer this trade looks since the collateral is increasing in value. Also, my
wife and I can coordinate on which coins to buy. She buys and then I list the coins on my
exchange and offer them to all my customers. More demand, more price appreciation,
more demand. My wife decides to borrow even more, since the trade is working so well.

Ok, now we get to the end of 2021 and what happens? After a massive run up in prices,
crypto price start dropping. . . . Now, the bets aren’t starting to look so good. So what do
I do. Either I come clean and reorganize or double down. It looks like SBF doubled
down. More borrowing and more big bets. Amazingly, SBF offered to buy [bankrupt
crypto firms] and bail them out. At the time, this looked like a visionary move to save
crypto. Finance experts compared SBF to JP Morgan, the private banker who took big
bets in 1907 to reestablish confidence like a proto-central bank. What we learned later,
however, was that SBF owed these firms money and if they started to demand payment
that would put pressure on his collateral, the coins on the house that we talked about
earlier. So SBFs efforts to buy these firms were an effort to keep his own weakness
hidden. Indeed, as people start to sell their coins, Alameda had to step in to buy, to keep
the price up.

© 2022-2023 by the President and Fellows of Harvard College.

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Eventually, as people began to look more closely at the assets of Alameda and FTX they
realized that many of the numbers were huge stock-valuations made on tiny floats–not
just the original house coins but also many of the coins, like Serum, bought by Alameda
as investments. And once people realized that, they ran to get out before the house burned
down. Now everything works in reverse—a $10 trade goes to $1 and your valuation is cut
by billions overnight. We also get fire sales—as firms try to sell assets to meet their
customer demands the prices of those assets fall which makes people sell other assets and
so the contagion spreads.

Ok, final analogy. Suppose to help me run my house I invite over a bunch of friends and
we do a lot of drugs and hook up together and suppose that none of us really knows
anything about accounting or financial controls.

Well that about covers it.

Do you agree or disagree? Why or why not?

QUESTION EIGHT

One of our guest speakers made the following argument: In Howey the original scheme
was an “investment contract” but that does not mean that selling those oranges later at the grocery
store is likewise an “investment contract.” On a similar note, while the initial distribution of a
cryptocurrency might constitute an “investment contract” once that cryptocurrency is sold later in
the secondary market it is not an “investment contract.”

Do you agree or disagree with this argument? Under what conditions in your view would
it hold true and under what conditions would it not?

QUESTION NINE

Does the proposed Digital Commodity Consumer Protection Act represent an

improvement over the current state of regulation? What changes would you make to the
proposed legislation?

QUESTION TEN

How should “utility tokens” be defined and, given that definition, regulated?

QUESTION ELEVEN

In a famous speech, a top SEC official in 2018 stated the following:

[W]hen I look at Bitcoin today, I do not see a central third party whose efforts are a key
determining factor in the enterprise. The network on which Bitcoin functions is
operational and appears to have been decentralized for some time, perhaps from

© 2022-2023 by the President and Fellows of Harvard College.

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inception. Applying the disclosure regime of the federal securities laws to the offer and
resale of Bitcoin would seem to add little value. And putting aside the fundraising that
accompanied the creation of Ether, based on my understanding of the present state of
Ether, the Ethereum network and its decentralized structure, current offers and sales of
Ether are not securities transactions. And, as with Bitcoin, applying the disclosure regime
of the federal securities laws to current transactions in Ether would seem to add little
value. Over time, there may be other sufficiently decentralized networks and systems
where regulating the tokens or coins that function on them as securities may not be
required.

Do you agree or disagree with his view on how “decentralization” affects the application of the
Howey test as a legal matter? Should it as a matter of policy?

QUESTION TWELVE

In your view, has blockchain as currently implemented actually increased or reduced

reliance on “trusted” intermediaries? How will this change in your view in the years to come?

== End of Exam ==

© 2022-2023 by the President and Fellows of Harvard College.

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