Is a greener, faster and more decentralized alternative to Bitcoin possible?
VSRYPTO IS THE key to paradise, especially financial. At least that’s what the fans claim. Greedy intermediaries, like banks, will be replaced by smart contracts (self-executing rules) that run on blockchains (distributed databases). This will give birth to efficient and innovative financial services, collectively referred to as “decentralized finance” (DeFi).
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The foundations of this building are however fragile. Today’s blockchains may be coding masterpieces, but they’re also wickedly complex, power-hungry, and, perhaps counter-intuitively, centralized. Despite years of work, crypto developers are still trying to fully overcome the compromises inherent in technology.
You can think of banks as maintaining large, opaque databases that contain information about customers’ accounts and the money they contain. Depositors must have confidence that these institutions are acting in their best interests. Sometimes, however, banks may not: they may make bad investments and collapse; or they could freeze depositors’ accounts at the request of a government.
For their supporters, blockchains form the basis of a type of funding that avoids such problems. The account databases would be managed not by a central authority, but by the computers of those who use them. An account can only be frozen if a certain majority of those who maintain the blockchain commit to it.
For the system to work, publicly available blockchains have two special characteristics. One is a “consensus mechanism,” a way for users to agree on how to write new transactions to the database. The other is a set of incentives that keeps the system alive. The rewards must attract enough users to help maintain the blockchain. And the sanctions must deter them from attacking it, for example by impersonating many bogus users in order to overwhelm the system.
In the case of the Bitcoin blockchain, the carrot is a newly minted coin. Every ten minutes or so, hundreds of thousands of specialized computers called “minors” participate in a lottery to solve a mathematical puzzle. The computer that first finds a solution alerts the other miners and if they confirm the result, it updates the blockchain and gets paid (each puzzle solved is rewarded with 6.25 coins, which were worth at the time of writing. this item $ 308,270). Calculating the numbers also acts like a stick: the more chances minors want to win the lottery, the more money they have to invest in hardware and electricity. To rewrite the blockchain in their favor, for example by simulating a transaction, they would have to control more than half of the mining power. Yet designing such an attack would be expensive and likely bring down the system they seek to take advantage of.
This approach, called ‘proof of work’, is straightforward (when it comes to blockchains) and hasn’t really been hacked yet. But it has several big drawbacks. On the one hand, it does not evolve. Bitcoin can only handle seven transactions per second and the fees can be steep. The system has also developed certain forms of centralization. Most puzzle solving is done by a few large “pools”. These allow miners to combine their resources and increase the odds of winning the reward, but also give them the power to influence how the system evolves (as changes are often put to a vote). Plus, proof of work is energy intensive. By some estimates, Bitcoin’s power consumption is approaching that of Italy.
The thirst for power and centralization stem from the increasing returns to the proof-of-work scale. These push the miners to continue to develop. The more computing power they have, the more likely they are to win a reward. The bigger they are, the more they earn and the more they can develop.
Hence the quest for better blockchains. Chia, for example, is a system based on the “proof of space and time”. As with Bitcoin, the carrot is that participating users earn coins. Yet the stick is different: instead of wasting computing power, Chia wastes digital storage. However, it is not yet clear whether Chia will prove to be more sustainable and less centralized than Bitcoin if it becomes widely used.
Smart digital currency is therefore on another approach: proof of stake. Here, decisions about updating the blockchain are not made by a computer arms race, but by a vote among cryptocurrency holders. Voting power as well as the share of rewards depend on how much holders are willing to bet on the outcome. This stake can be destroyed if a participant misbehaves. In this system, the carrot and the stick are the cryptocurrency itself.
Proof of stake consumes much less energy. And its latest incarnations are much faster than Bitcoin: Avalanche, a blockchain that uses the approach, processes thousands of transactions per second. But he still has big problems. Coders have attempted to move Ethereum, the preferred blockchain for DeFi applications, from proof of work to proof of stake. Even Vitalik Buterin, one of the inventors of Ethereum, admits that the proof of stake is “surprisingly complex.” This means that a lot can go wrong, especially when nearly $ 100 billion of capital in DeFi applications has to tip over. After several delays, the coders hope to pass the milestone in 2022.
However, this system would still tend towards centralization. Bigger holders can reap more rewards, further increasing their holdings. This concentrates power among the early buyers of a cryptocurrency and could allow them to take control of the blockchain. Newer projects that use proof of stake try to find ways to avoid this. Hedera Hashgraph is governed by a consortium, much like the one that runs Visa, a credit card network. Avalanche and Tezos seek to ensure decentralization by facilitating the membership of “validators”, the participants who maintain the blockchain.
For critics, centralization is inevitable, even if energy inefficiency and complexity are not. The problem of increasing returns to scale will raise its head for any popular blockchain, predicts David Rosenthal, an early practitioner. “You’re wasting all of those resources to end up with a system controlled by people you have even less reason to trust than those who run mainstream financial institutions,” he says.
For others, a degree of centralization may simply be a price to pay for the other benefits of blockchains. Emin Gün Sirer of Cornell University, who co-founded Ava Labs, which created Avalanche, says the main benefit is that governments will have a harder time influencing blockchains than conventional banks. Kevin Werbach of the Wharton School at the University of Pennsylvania says the openness of blockchains facilitates the development of innovative financial services. Yet if the quest for better blockchains shows one thing, it’s that even in crypto-paradise, there is no free lunch. ■
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This article appeared in the Finance & economics section of the print edition under the title “Build block better”