Crypto is the future. This argument is brought up by the people who support the concept. Middlemen, such as banks, will be replaced by smart contracts that run on blockchains giving rise to efficient and creative financial services. This could be collectively called “decentralized finance”.
The foundations of this building are weak. At the same time, today’s blockchains are technical marvels, energy-intensive, and, perhaps counterintuitively, centralized. The truth is that crypto developers are still attempting to resolve the technology’s fundamental trade-offs correctly.
Consider banks to be the custodians of vast, opaque databases containing information on their customers’ accounts and the money in them. The account holders must have confidence in the institutions’ ability to act in their best interests. But there are certain occasions where the banks fail. They may make poor investments and fail, or they may freeze depositors’ funds at the government’s request.
Blockchains lay the groundwork for a new sort of finance that avoids such issues. Account databases would be managed by users’ computers instead of a central authority. A wallet may be frozen only with the agreement of a particular majority of people responsible for maintaining the blockchain.
To ensure the system’s operation, publicly accessible blockchains must possess two unique characteristics. The first is a “consensus mechanism,” which allows users to agree on how new transactions should be written to the database. The second one is a set of incentives and it ensures the system’s continued existence. Rewards must attract a sufficient number of users to assist in the blockchain’s maintenance. And the consequences must deter them from attacking it, such as by creating a large number of bogus users to overwhelm the system.
Approximately every ten minutes, thousands of specialized computers known as “miners” enter a lottery to solve a mathematical riddle. The computer that discovers the solution first notifies the other miners and confirms it. It updates the blockchain and receives payment (each puzzle solved earns 6.25 coins valued at $308,270 at the time of writing). The greater the probability of winning the lottery, the more money miners must invest in computing equipment and electricity. To modify the blockchain in their favour, for example, they would need to control more than 50% of the mining power by fabricating a transaction. However, engineering such an attack would be costly and would almost certainly bring down the system they aim to profit from.
This approach, dubbed “proof of work,” is straightforward and has yet to be successfully hacked. However, it has numerous significant disadvantages. For one thing, it is not scalable. Bitcoin can only process seven transactions per second, and transaction fees are expensive. Additionally, the system has evolved some degree of centralisation. A few large “pools perform the majority of puzzle-solving.” These enable miners to pool their resources and boost their chances of earning the reward and provide them with the ability to affect the system’s evolution. Additionally, evidence of effort consumes energy. According to some estimations, Bitcoin’s electricity use may be reaching that of Italy.
The growing returns to scale of proof of work result in power hunger and centralisation. These factors encourage miners to continue expanding. The more processing power they possess, the more likely they will receive a prize. The larger they are, the more money they earn and the more room for expansion.
Thus the drive for improved blockchains. For example, Chia is a “proof of space and time” system. Like Bitcoin, participants earn coins. But the stick wastes digital storage instead of computing power. If widely adopted, Chia may prove more sustainable and less centralised than Bitcoin.
Proof of stake is an intelligent digital money’s strategy. The blockchain update is decided by a vote among bitcoin holders, not by a technological arms race. Voting power and reward share rely on how much holders are willing to risk. If a player misbehaves, this stake is lost.
Proof of stake saves a lot of power. And it’s now faster than Bitcoin: The Avalanche blockchain processes hundreds of transactions each second. But it has significant flaws. Ethereum, the chosen blockchain for DeFi apps, has been converted from proof of work to proof of stake. Even Ethereum co-founder Vitalik Buterin concedes that proof of stake is “surprisingly complex”. And when over $100 billion in DeFi money is at stake, anything can go wrong. The coders plan to move in 2022 after multiple delays.
But this system would still be centralized. Holders with larger shares can receive more significant returns. This gives early buyers of a cryptocurrency more power, and hence they may dominate the blockchain. Newer Proof of Stake projects is trying to avoid this. A consortium operates hedera Hashgraph. Avalanche and Tezos aim to ensure decentralisation by making it simple for “validators” to join.
Complication and inefficiency are inevitable, but not centralisation. According to early adopter David Rosenthal, any popular blockchain would face increasing returns to scale. He claims that the result is a system administered by people who are even less trustworthy than those who run traditional financial institutions.
Others may see a degree of centralisation as a cost of the various benefits of blockchains. Avalanche creator Emin Gün Sirer of Cornell University thinks the critical advantage is that governments will find it tougher to control blockchains than banks. According to Wharton School professor Kevin Werbach, the openness of blockchains facilitates the development of new financial services. Still, the drive for improved blockchains reveals that nothing is for free even in crypto-land.