Beyond Bitcoin: Ethereum and DeFi

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. An error in the original publication has now been addressed

Apologies. In the previous publication the label "proof of stake" was erroneously labelled as "proof-of-scale". That error has been seen to in this republication. This story was originally published on June 6, 2021.

-Drawbacks to bitcoin
-The proof-of-sake 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.

Yet.

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.


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