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Two Roads Diverged in the Crypto Currency Market

Imagine two jewelers who are experts at identifying diamonds – Jeweler A and Jeweler B.

Jeweler A gets his hands dirty. He tears up the Earth using any method he can to find a real diamond: heavy artillery, dynamite, his own bare hands even. For him, it’s a race. He works for his diamond, leaving a path of destruction in his wake. But when he finds it, that diamond is real. He’s got the dirt under his fingernails to prove it.

Jeweler B doesn’t have to get his hands dirty. He’s already got a mountain of real diamonds, so he knows what they look like. Because he already has so many diamonds, people are coming to him, inquiring whether their diamonds are real. For his trouble, he is paid with more diamonds. No scorched earth, no metaphorical blood being shed.

No, that’s not how the diamond business works; jewelers don’t also find the diamonds. Just pretend these are full service, farm-to-table jewelers. Which jeweler’s method of validating diamonds is better?

That is a quandary the crypto currency market finds itself wrestling with.

Proof of Work (PoW) and Proof of Stake (PoS) have been hot topic issues of late, as the crypto market has seen major volatility these last few months. They are consensus mechanisms, a network of computers that protect the blockchain from potential attackers and regulate the issuance of new coins[1].  PoW is Jeweler A, PoS is Jeweler B.

Proof of Work was the first consensus mechanism, developed for the first crypto currency, Bitcoin.   Mining crypto is the PoW process in action. Miners race to perform a complex set of computations, verifying transactions, and adding them to the blockchain. For every block of the chain a miner verifies, they are rewarded with a coin.

However, the computational power required to do this is massive. Many articles have been written comparing Bitcoin’s energy consumption to that of literal countries. For reference, on August 10, Bitcoin’s energy output was comparable to Belgium – 81.7 terawatts/year vs Belgium’s 82.1[2]. The PoW model has been criticized for being unsustainable, not worth the massive environmental cost as it scales up to accommodate more miners.

Proof of Stake uses far less energy. It was introduced as a reaction to PoW, to mitigate the extreme perceived dependence on energy consumption. Rather than generating massive amounts of energy, PoS participation is randomly determined by the amount of coins the participant currently has. In PoS, these people are called validators as opposed to miners. Validators with larger amounts of coins are more likely to be chosen to confirm transactions. The theory being that a verifier with more stake in the asset has more motivation to ensure the validity of the asset, keeping the value up[3].  More diamonds, more credibility.

Why not run everything on PoS?

While PoS is not as environmentally impactful as PoW, there are some potential roadblocks. Unlike PoW, a PoS blockchain can be altered. One of the central tenets of PoW is that the past transactions are written in ink, not pencil. Nobody can erase the past, then write something different over top. A 2015 paper by Andrew Poelstra titled “On Stake and Consensus” argued that nothing in a PoS blockchain can be trusted because past blocks in the chain are not based on anything tangible. It’s impossible to verify who was holding coins versus who is. PoW is based on verifiable mathematical computations. The only way to swindle it would be to recreate the entire history of the chain[4].

Swindling also brings up the “nothing-at-stake” problem where a validator might be validating blocks on multiple blockchains, or they simply borrow their coins without actually owning them[5]. Their diamonds are made of glass. Just as above, PoW prevents this issue because it is an open ledger. Everyone can see the work put into verifying the chain.

Proof of Work is widely acknowledged to be more harmful to the environment, with a higher barrier to entry because of the technical/computational power necessary. But it is, arguably, more secure. Proof of Stake is more energy efficient, cheaper, and faster. However, it is more susceptible to manipulation with a “rich get richer” mentality. The two largest crypto currencies are split between the methods. Bitcoin, the largest, uses PoW. Ethereum, aka Ether, its original coin and second largest, uses PoS. Some believe, as Bitcoin continues to be the crypto market driver, it may be impossible for it to move to PoS even if it wanted to.

It’s a philosophical argument without a true winner. It comes down to investor mentality. What does each individual investor truly believe in? What is the environmental cost to each person? Does that even matter? Every investor’s answer is different. The market will dictate the rest.

Joe

 


 

I believe working as a collective will always yield stronger results than working alone. Everyone possesses their own unique perspectives, creativity, and problem-solving abilities, making it possible for the entire team to drive towards a goal. It is this collaborative, teamwork driven mentality that attracted me to Coyle. The desire to work with great people, initiate, innovate, and ultimately help people with their own personal goals is what drives me every day.

I earned a degree in Finance from the University of Illinois at Chicago in 2017. Afterwards, I worked for Morgan Stanley and Bank of America/Merrill Lynch, obtaining both Series 7 and 66 licenses. At Merrill, I was on the self-directed side of the business, exposing me to every aspect of the financial services industry.

Outside of the office, I enjoy checking out the latest movies and TV shows, and am always looking for an offbeat suggestion. During football season you’ll find me watching the Bears and simultaneously wishing I could stop watching the Bears because of the stress it creates on my heart – but I’m a fan through and through and just can’t quit!

www.coylefinancial.com
847-441-5644 | coyle@coylefinancial.com 

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All information is from sources deemed reliable, but no warranty is made to its accuracy or completeness.   This material is being provided for informational or educational purposes only, and does not take into account the investment objectives or financial situation of any client or prospective client.  The information is not intended as investment advice, and is not a recommendation to buy, sell, or invest in any particular investment or market segment.  Those seeking information regarding their particular investment needs should contact a financial professional.  Coyle, our employees, or our clients, may or may not be invested in any individual securities or market segments discussed in this material.  The opinions expressed were current as of the date of posting but are subject to change without notice due to market, political, or economic conditions. All investments involve risk, including loss of principal.  Past performance is not a guarantee of future results.

Copyright © 2021 Coyle Financial Counsel.  All rights reserved.

[1] https://www.investopedia.com/terms/c/consensus-mechanism-cryptocurrency.asp

[2] https://cbeci.org/cbeci/comparisons

[3] https://ethereum.org/en/developers/docs/consensus-mechanisms/pos/

[4] https://download.wpsoftware.net/bitcoin/pos.pdf

[5] https://medium.com/coinmonks/understanding-proof-of-stake-the-nothing-at-stake-theory-1f0d71bc027

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