This piece is a counter of sorts to this week’s Long Read 3 about how tech is taking over geopolitics, at the core of whose argument lies smart contracts (self-executing rules, not enforced by an intermediary or an authority) that run on blockchains (decentralised or distributed databases). The most popular application of this concept so far has been cryptocurrencies. This article argues that even cryptocurrencies including the popular Bitcoin has flaws which threaten not only its own sustainability but the larger extension to other spheres of life, let alone replacement of nation states.
The three main issues the article points to are that the technology is energy intensive and hence not particularly eco-friendly, that they are not fast enough to claim supremacy over the status quo and finally that it is not decentralised enough as mining is still done by a few large pools (as access to resources is an edge).
“Hence the quest to come up with better blockchains. Chia, for instance, is a system based on “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. It is not yet clear, though, whether Chia will prove more sustainable and less centralised than Bitcoin if it becomes widely used.
The smart digital money is therefore on another approach: proof of stake. Here decisions about updating the blockchain are made not through a computing arms race, but by a vote among the holders of a cryptocurrency. Voting power as well as the share of the 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 both carrot and stick are the cryptocurrency itself.
Proof of stake does use much less energy. And its latest incarnations are much faster than Bitcoin: Avalanche, a blockchain that uses the approach, processes thousands of transactions a second. But it still has big problems. Coders have been attempting to shift Ethereum, the preferred blockchain for DeFi apps, from proof of work to proof of stake. Even Vitalik Buterin, one of the inventors of Ethereum, admits that proof of stake is “surprisingly complex”. That means that lots can go wrong, especially when nearly $100bn in capital in DeFi apps must switch over. After several delays, the coders hope to make the move in 2022.
Yet this system would still tend towards centralisation. Bigger holders can reap more rewards, increasing their holdings further. This concentrates power among early buyers of a cryptocurrency and could allow them to take control of the blockchain. Newer projects that use proof of stake are trying 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 decentralisation by making it easy for “validators”, participants who maintain the blockchain, to join.
To critics, centralisation 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 waste all these resources only to end up with a system that is controlled by people you have even less reason to trust than those who run conventional financial institutions,” he says.
To others, a degree of centralisation may simply be a price to pay for the other advantages of blockchains. Emin Gün Sirer of Cornell University, who co-founded Ava Labs, which created Avalanche, says that the main benefit is that governments will find it harder to influence blockchains than they do conventional banks. Kevin Werbach of the Wharton School of the University of Pennsylvania says that the openness of blockchains makes it easier to develop innovative financial services. Still, if the quest to come up with better blockchains shows one thing, it is that even in crypto-paradise there is no free lunch.”

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Note: the above material is neither investment research, nor financial advice. Marcellus does not seek payment for or business from this publication in any shape or form. Marcellus Investment Managers is regulated by the Securities and Exchange Board of India as a provider of Portfolio Management Services. Marcellus Investment Managers is also regulated in the United States as an Investment Advisor.

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