Our CEO explains Cryptocurrencies – Part Two

In this segment on Cryptocurrencies, I will explain the different mechanisms used to generate/create Cryptocurrencies known as mining. I will also include an explanation for why I don’t consider Ripple’s XRP coin to be Crypto. Your views on the matter are welcomed…

 

The central tenant underlying the Crypto principle is that it applies the real-world concept of scarcity to this virtual asset i.e., limited supply and the difficulty of mining. In the real world, minerals such as gold and diamonds are scarce and hard to mine. Mining is consequently expensive and ever more expensive the more scarce a resource is and the more difficult it is to get to. In the real world, the combination of these elements combined indirectly sets a base price for a mineral or commodity. As an example: between the costs of prospecting for oil (the upfront investment) coupled with the cost of extraction determines whether or not an oil reserve is viable to extract over time e.g., if the cost of extraction is $100/ barrel, and the price is $70 you wouldn’t extract the oil. As supply and demand shift relative to the cost of extraction, the market finds a balance. This applies to all commodities and minerals. Gold is the only tangible commodity that is mined, for the most part, but not exclusively, as a store of value, whereas the majority of others are governed by “use” based demand (for gemstones this is for jewelry, which as a use case is debatable).

 

So why is this relevant to Cryptos? I will explain using Bitcoin as an example:

 

Mining is the process of using computing power to solve an algorithm within a 10minute period or block. Because the process is difficult it relies on a large number of miners mining at the same time trying to solve this algorithm which entitles that miner to confirm the next transaction on the network. Bitcoin requires 3 miners to solve this so there is “consensus” that, from an effectively random 3 people, the transaction is valid. The prize for solving this algorithm is the block reward at that point in time. Initially, this was 50 bitcoins per block. This has been reduced to 6.25 bitcoins per block. In addition to this halving process, the difficulty factor (an exponentially increasing factor) in the algorithm increases over time.

 

All these talks to the increasing challenge and cost to mine. Mining uses an ever-increasing amount of computing power and consequently electricity to mine. Power and equipment are the real costs of mining. Bitcoin requires specialized equipment to mine called ASIC miners or “Application Specific Miners”. These machines are power-hungry – the top-of-the-line machines consume 1400w/h. Machines that were profitable to mine a year ago now consume more in power than they produce in Bitcoin rewards. Essentially you must continue to upgrade equipment over time to mine profitably (unless your power is free). So Bitcoin conforms to the same principles as real-world commodities and minerals:

 

  • Scarcity: The Bitcoin white paper and associated technical structure limit the total number of coins to be mined to 21 million.

 

  • Difficulty: The mining algorithm increases in difficulty over time coupled with the reduction (halving every 4 years) of the coins mined per block, results in increasing difficulty to mine at an ever increased power cost.

 

This type of mining is called “Proof of Work”. Ethereum, amongst other Cryptos, conforms to this principle, although in slightly different ways. Essentially the mining challenge is the “Proof” that you had to work really hard to earn the block reward if you are one of the first three miners to solve the algorithm. In practice, the chances of individually solving this are really low – in the order of “lottery ticket winning low”. Consequently, miners join together in a pool to mine collectively and share the reward. Pool mining uses the power of large number of statistics to ensure a predictable share of the reward for each pool member.

 

There are further elements to the consensus nature of Cryptos. Consensus is used to confirm transactions above. In addition, the consensus is used to determine the next iterations of the code to be released to the network. A majority of miners need to agree on code forks for these to be released over time. This is necessary to ensure that the Crypto remains relevant and performant. The issue with this is that if the majority of mining resources are concentrated into a small number of hands, the network can be manipulated through code changes that suit the majority. When you join a mining pool you give up your right to “vote” on these code changes to the pool owner. As an example, with Bitcoin, the Ant Pool, owned

by Bitmain, also the largest supplier of mining equipment, is the largest Pool owner. Bitmain is based in China. In order to improve its optics, Bitmain has set up side pools in other countries, which they still control. It is not exactly clear what percentage Bitmain controls of the mining pool, but the estimates are that they control as much as 70% and therefore control the code fork consensus. All this being said and done, it is debatable whether the original principle of Satoshi still holds for Bitcoin due to the mining control of a single entity – it is not very democratic.

 

I won’t go into the same detail for the other mining forms as I did above, or this segment may just put you to sleep J but here they are:

Proof of stake: essentially mining is still power-hungry for the most part, however, your ability to earn coins is a function of how much you own. On the face of it, this seems counter to the democratic principles of Crypto as it entrenches the “man with the gold makes the rules” principle. There are however mechanisms to counter this to some extent.

 

Proof of Authority: miners/confirmers are a selected group of trusted parties. In these networks, you have to essentially reveal your identity and stake your reputation on the fact that you can confirm transactions. For me, it is debatable whether this fits the bill for the original Crypto principle, as the network is controlled by a selected group. In principle, Ripple falls into this category but distances itself from the Crypto principle further in that all the coins were issued at the start of the network and are controlled by the Ripple Foundation. There is no mining. Ripple, in my mind, is a good solution for transaction processing but is not a Crypto, it is an alternative to networks such as SWIFT using a distributed ledger. In my opinion, the XRP coins are simply Ripples “shares” and the price is its “share price”. By launching it through an ICO they avoided the scrutiny of traditional stock markets.

 

That’s it for the second segment in the series.