Proof of stake may close the circle

Anyone who has sent or received an international cheque, been a victum of fraudulent payments from customers or tried to find a safe place to hold funds protected against the vagaries of foreign exchange rates would agree that our global financial system is far from perfect.

It is no wonder that cryptocurrencies such as Bitcoin, Ether and even Dogecoin have garnered such interest. It isn’t just the wild fortunes that are being made, but also the promise of simplifying the financial system that is highly attractive.

Of course, these two statements conflict with each other. One person’s profit or fortune or is another’s overhead. That’s why when banks and traders make super profits it means there is friction in the economy.

But, for some, it is more than removing friction that is attractive, they want to upend a world order that has seen central banks, regulators and financial institutions setting the rules and running the infrastructure that we all rely on.

When Elon Musk co-founded PayPal, it was embraced (and still is) for the same attractive goal of reducing friction and simplifying payments. However, when it sold making Musk his first fortune, the premium he received was not because PayPal removed friction but because it found its own premium that the market was willing to accept.

Now with new electric car and space fortunes, Elon Musk is looking again to the future of the financial system. Tesla is one of the highest profile investors in Bitcoin, but recently Musk paused his plans while expressing concern at the environmental impact of cryptocurrencies.

Since 2015, I have written and talked extensively in the media on the inefficiencies of blockchain in general and cryptocurrencies in particular. Now that these issues are in the mainstream and challenging the future of cryptocurrencies, the search for a solution is on in earnest.

The energy demand of blockchain is a result of its clever approach to protect the integrity of the distributed ledger by harnessing enormous processing power in exchange for rewards. This technique is called a “proof of work” which is performed, for cryptocurrencies, by “miners”. The energy (and cost) intensive nature of this approach is a requirement to ensure that bad actors don’t fraudulently overwhelm the network.

The obvious approach being advocated by many blockchain enthusiasts is to move this mining activity to renewable energy sources. Such a simplistic solution is both impossible to police and inherently problematic given that any use of such resources will push other demand into more polluting generation.

A less computationally intense approach to validating transactions that is emerging is “proof of stake”. Instead of depending on the cost of computation dissuading would-be attackers, this alternative assumes that those with the most ownership of the currency have the most at-stake to ensure its integrity. It is likely that Ethereum (the platform supporting Ether) will be the first to make this move.

Those cryptocurrencies that migrate from trusting no-one to trusting only those with the largest stake are likely to see, over time, that a smaller and smaller number of big holders of their currencies dominate the oversight of the integrity of the whole system. There is an ironic parallel with the early Internet pioneers who looked to offer a democratised platform for large numbers of small businesses but have seen the rapid consolidation of much of the online commercial activity into a few big companies.

While cryptocurrency communities debate their future, central banks around the world are beginning to experiment with their own digital currencies. These digital currencies depend as much on database platforms as cryptography and are backed by the fiat currencies controlled by the same entities.

Over time, it is likely that there may be very little difference between the digital currencies created and controlled by central banks and cryptocurrencies overseen by a few big stakeholders who may even be central banks themselves.

Whether you regard this as a good thing or not depends on your worldview.