Feature Stories | Jun 28 2021
In Part III of FNArena's exploration of crypto currency, we examine the rise of Ethereum, and the implications of Ethereum's far more extensive application capacity.
-Drawbacks to bitcoin
-The proof-of-stake model
-The rise of DeFi on the Ethereum platform
-The risks for Ethereum
By Greg Peel
This is the third part in FNArena’s series on the world of crypto. Part I explains just what bitcoin is and how it works. Part II compares bitcoin and gold as stores of wealth. Links below.
Proof of Work
As explained in the first part of this series, bitcoin is backed by the blockchain ledger system. Critical to bitcoin’s existence is the verification of each block in the chain, which is provided by solving a complex algorithm available in “open source”, and which does not require a superior brain but rather the capacity to run bllions of calculations to arrive at the right answer.
This process is known as “mining”, as the reward for verification of a block is an amount of new bitcoin. Given the work involved in bitcoin mining (by computers), the process of verification is known as “proof of work”.
The onerous proof-of-work process is what provides bitcoin with its capacity to be a store of wealth – what makes bitcoin sufficiently “rare”. It is rarity that underpins the world’s traditional store of wealth – gold. Not only is gold hard to find to begin with, the cost involved in exploration, mining and processing also underpins its value.
Bitcoin mining also comes at a cost – being that of significant energy usage required to successfully mine a bitcoin.
Bitcoin dominates the crypto-currency market due to first mover advantage. The creators of bitcoin first created the blockchain system, which, being “open source”, is universally available to anyone. Hence there are now some 8000 crypto-currencies, and growing. Bitcoin enjoys the unquantifiable “brand awareness” factor, which helps to underpin its value.
And being the first, it has a 12-year track record. In all that time, no one has been able to hack into bitcoin – into the blockchain. This is a primary selling point of crypto. And because it is a decentralised peer-to-peer system, it is not subject to regulation.
The issue of regulation has become more pressing in recent weeks. Bitcoin may not be able to be hacked, but nor is it able to prevent “bad actors” from using it as an untraceable currency perfect for money laundering. Indeed, wholly suitable for criminal activity.
Ransomware attacks on the Colonial oil pipeline, and JBS Meats – the US and world’s largest meat packer/distributor – have brought this problem to the fore, and they represent just two high profile cases among many others. By demanding payment in bitcoin, hackers ensure those funds cannot be traced to their destination.
Or so they thought. Enter the recently formed US Department of Justice Ransomware & Digital Extortion Taskforce. It was able to recover a majority of the millions of dollars equivalent paid in bitcoin to the DarkSide network responsible.
Bitcoin supporters were somewhat shocked to hear this news. In the world of real dollars, beating criminals would be lauded by everyone other than the criminals. In crypto-world, the fact the DoJ was able to find and recover bitcoins rather brings into question all that crypto is meant to be. The dollar price of bitcoin fell on the news.
So we could list bitcoin’s major problems/threats as being energy intensity, regulation (both in investor protection and crime prevention) and, given the number of crypto-currencies now out there, competition.
Proof of Stake
There may still be daylight in between, but emerging as the biggest rival to bitcoin is ether, the crypto-currency behind the Ethereum platform. But while bitcoin and ether might be competing currencies, Bitcoin (the platform) and Ethereum do offer significant differences.
Like Bitcoin, Ethereum runs on a proof-of-work basis. Hence ether can be mined in the same fashion as bitcoin. Unlike bitcoin, ether is open-ended. As the pool of bitcoin grows, the number of bitcoins provided as reward for successful mining halves at intervals, and once that pool reaches 21 million, no further bitcoin will be released. At the current pace, forecasts are for this to occur around 2040.
The reward for successful ether mining is fixed at 5 ether, and there is no ultimate limit. One might suggest this instinctively makes bitcoin a more valuable longer term investment, but for Ethereum, the ether currency is only part of the story.
Ethereum was established in 2015 – six years behind Bitcoin. Rather than being a simple copy-cat, Ethereum was designed to be much more than just a payment system. In the creators’ own words, it is a “decentralised platform that runs smart contracts: applications that run exactly as programmed without any possibility of downtime, censorship, fraud or third party interference”.
Ethereum is also in the process of migrating from a proof-of-work model to a “proof-of-stakee” model.
In a proof-of-stake model, there is no mining, and thus no excessive draw on energy. Rather than miners, there are “validators”. There is no complex algorithm to solve. Instead, to be rewarded, validators must first own ether (in Ethereum’s case) and then put that ether balance on the line to certify that a block is valid.
This way, any malicious activity will result in that ether balance being lost.
And whereas miners of bitcoin receive bitcoins as a reward for their verification of blocks, validators of ether will simply receive a fee for every transaction and smart contract they validate. On the other side of the ledger, the parties that want a transaction or smart contract to be executed will pay a fee to have it completed and added to the blockchain.
Proof-of-stake in theory removes two of the proof-of-work model’s major drawbacks, being energy intensity and the potential for malicious activity such as the recent ransomware demands made on the Colonial Pipeline, JBS meats and others.
As Creighton University (US) academics suggest, “Bitcoin is striving to provide fast and secure transactions while Ethereum is focusing on much more. As more and more smart contracts and decentralised applications are built, Ethereum’s popularity and profitability will increase”.
Both currencies remain volatile at this point, but ether is still relatively new. And Ethereum’s migration to the proof-of-stake model is still pending, with guidance remaining vague at this point. It could yet take a while.
“Decentralised finance”, notes investment bank DBS, is a catch-all term, relating to a series of financial services that can be carried out on public blockchains. Two parties, anywhere in the world, can engage in peer-to-peer lending/borrowing, buying/selling insurance, trading assets and so forth.
DeFi promises to be a virtual, egalitarian, decentralised “Wall Street” that is open, flexible and fast, while being at once private but publically transparent. DeFi apps running on blockchain can help users lend out their crypto assets, earn interest of rewards on lending, or on the other hand obtain loans along a wide spectrum of duration.
Running on a set of self-executing rules established by the user community, DeFi takes out the role of or risk associated with a central standard-setting authority.
To date the primary blockchain platform preferred for DeFi is Ethereum.
It hasn’t been smooth sailing so far for this new concept. Teething pains have included a high cost of trading, volatility and regulatory uncertainty. However, it’s early days for what promises to be a source of a variety of financial intermediations, DBS suggests.
“If DeFi can pass the test of speed, cost, and transparency, financial institutions would find it in their interest to join in, issuing tokens and acting as the bridge between centralised and decentralised finance. Regulators will have to evolve as well, needing to approve protocols and smart contract before they are widely used.”
Note that a digital “token” is issued with regard a DeFi transaction, as opposed to digital “coins” which are simply a currency.
The total amount of funds locked in DeFi is a good proxy, Citi suggests, for ascertaining its accelerating adoption. The total value locked in DeFi in currency terms in November 2020 was US$12bn, and in March 2021, US$45bn. The overall market capitalisation in March 2021 including tokens rose to over US$90bn. Citi believes:
“Increase in volume locked in DeFi over time represents growing confidence among consumers to place money in smart contracts to interact with new financial tools. Rapidly rising aggregate market capitalization of tokens issued by DeFi projects, indicate current investor enthusiasm for long-term potential of DeFi applications.”
In February this year, a guy by the name of Mike Winkelmann sold a piece of video art for US$6.6m. The world did not really sit up and pay attention until March, when a collage of video art by the same artist, who goes by the name of “Beeple”, sold for US$69m.
Paintings by the Grand Masters have in recent times sold in the US$100-200m range, but this is a collage of a vast number of images — a digital cut & paste. It exists only in cyberspace, and anyone can view it. The buyer did not receive anything physical, just a crypto asset called a “non-fungible token” – a sort of virtual certificate of ownership and authenticity.
NFTs are unique. Unlike a currency, in which one amount of $10, say, is the same of any other amount of $10, NFTs are not interchangeable (fungible). Presently, NFTs are being transacted in a digital marketplace with crypto-currencies as payment and Ethereum the platform of choice.
The transparency of ownership and transaction can solve problems, notes DBS, that can sometimes arise with various non-virtual investments such as art, jewellery and property. Tokenisation can also provide more value for the content creator. For years, artists have been arguing they should be due a royalty every time their artwork changes hands, just as musicians do each time their song is played on the radio. NFTs can make this possible.
One of the greatest threats to crypto mining is energy intensity. Bitcoin pundits shrug this off by noting mining can always be undertaken with the use of renewable power. According to the Cambridge Center for Alternative Finance, 76% of miners use some level of renewable energy and 40% of all mining is based on renewable energy.
This does not overcome the issue of the world (or most of it) rapidly investing in new renewable energy generation, not just to reduce emissions but to meet future demand in an ever electrifying world. More and more of the developing world is heading down the same industrialisation and urbanisation path as China has done, and the developed world (in which we can now include China) is madly embracing EVs (not all the developed world of course).
So mining crypto from renewable sources is all well and good, but does not detract from the fact it is still sucking up power that could be more functionally put to use elsewhere.
China has banned crypto mining in parts of the country.
Aside from the far greater DeFi world Ethereum offers, beyond the simple currency of bitcoin, its migration to a proof-of-scale model (whenever that happens) will alleviate the energy consumption issue.
There remains, nevertheless, the same regulatory threat to Ethereum as there is to Bitcoin. Indeed, Citi suggests the greatest challenge to the DeFi ecosystem is regulatory. Pseudonymous usage (you need not use your real name) means that important laws such as the US Bank Secrecy Act cannot be enforced. And if there are any misdeeds undertaken on the platform, who do you go after?
Citi also cites as a risk the simple fact DeFi is new and its protocols are hard to comprehend (see, it’s not just you). DeFi solutions multiply the complexity, requiring understanding of complex technical and financial models.
There is also the chicken & egg problem of a lack of liquidity in the early stages, compared to long established traditional financial markets. And finally, at the end of the day the code for these platforms is written by humans, so there remains the potential for human error, and the potential for hacking.
Nothing, it would seem, is impenetrable.
Crypto fans are as smug on the issue of regulation as they are on the issue of energy consumption. Bring it on, they say. The more crypto is regulated, the more it is legitimised as an alternative medium of exchange, and medium of finance.
Unless, of course it’s banned altogether, but that is not the most likely outcome.
Already a group of tech and finance corporates, including IBM, Intel, Cisco, the London Stock Exchange, JPMorgan, Wells Fargo and others, have teamed up to create Hyperledger – — an open source project inspired by Bitcoin that the companies will hope will one day provide a more secure way of trading stocks and other assets.
As early as 2015, Microsoft began offering Ethereum as a service in its Azure cloud business.
IBM believes blockchain technology is key to the success of the Internet of Things. As more and more devices are connected to the internet, the ability for them to interact by using Ethereum’s smart contracts becomes ever more valuable, suggests Creighton University.
If it gets to the point of over a billion devices being connected, IBM believes “the blockchain is the framework facilitating transaction processing and coordination among interacting devices. Each manages its own roles and behaviour, resulting in an ‘Internet of Decentralised, Autonomous Things’, and thus the democratisation of the digital world”.
If we’re talking Bitcoin versus Ethereum, it looks as if we might already be looking at a Model T to Mustang comparison, or AOL to Google. But again (and while no one is denouncing bitcoin just yet), this is to cite only two blockchain platforms. When I began writing this series of articles, the latest quote was some 8000 different crypto-currencies. In the process of writing this instalment, I have since heard 9800.
So another threat to Bitcoin, and even Ethereum, is competition. But maybe the greatest competition could come from the very representatives of old world currencies and financial markets bitcoin originally was designed to cut out of the system – central banks.
Stay tuned for Part IV.
Part I – Bitcoin: What's That All About? (https://www.fnarena.com/index.php/2021/04/30/bitcoin-whats-that-all-about/)
Part II – Bitcoin Versus Gold (https://www.fnarena.com/index.php/2021/05/31/bitcoin-versus-gold/)
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