I have a fascination with everything new.
And so…I have had an ongoing fascination with crypto! For years, it always seemed to be just more of an interesting little corner of the digital world, but increasingly it is touching more and more of the mainstream world and sometimes transforming it in the process. For example, the rising interest in digital currencies is causing at least a few governments to seriously think about whether they need to issue digital currencies of their own. Although I am primarily a business investor, cryptocurrencies are starting to impact the broader world in a way where it doesn’t make sense to just assume it stays contained in its little corner of the world anymore.
While this post is about crypto, it’s actually more of a general discussion about how I think the world and economy works with regards to the creation of trust. I promise there’s probably something for you even if crypto is not your cup of tea.
One of the most interesting technical problems in crypto is figuring out how to secure transactions without a centralized authority. In other words, people need to figure out how to know what is trustworthy and real without relying on a centralized, all-knowing authority and without knowing or trusting anyone else on the network.
Solving this problem is key because the point of crypto is to be able to recreate a lot of the things people love about the financial system without the parts that cryptomaximalists find problematic.
From their perspective, the problematic parts include central banks that “print” a lot of money as well as centralization and concentration of the financial system in the hands of a few public and private entities. These entities may include stodgy banks or increasingly powerful platforms like a whole host of tech or fintech companies that can decide what you can or can’t do with your money and more.
This is a very interesting technical problem because it requires quite a bit of creativity to figure out how you can create trust without actually knowing anything about anyone on the network. On the Bitcoin blockchain, for example, you can transact without knowing anything about any of the miners that verify the transactions, and you do not need to explicitly trust any of them. The system is designed to work without requiring much trust.
So how does it work?
There are a couple of different approaches so far.
For the Bitcoin blockchain, the whole system revolves around something called “Proof of Work”.
Here’s Coinbase’s explanation of Proof of Work:
Proof of work is the original crypto consensus mechanism, first used by Bitcoin. Proof of work and mining are closely related ideas. The reason it’s called “proof of work” is because the network requires a huge amount of processing power. Proof-of-work blockchains are secured and verified by virtual miners around the world racing to be the first to solve a math puzzle. The winner gets to update the blockchain with the latest verified transactions and is rewarded by the network with a predetermined amount of crypto.
Proof of work has some powerful advantages, especially for a relatively simple but hugely valuable cryptocurrency like Bitcoin (learn more about how Bitcoin works). It’s a proven, robust way of maintaining a secure decentralized blockchain. As the value of a cryptocurrency grows, more miners are incentivized to join the network, increasing its power and security. Because of the amount of processing power involved, it becomes impractical for any individual or group to meddle with a valuable cryptocurrency’s blockchain.Source: Coinbase
For Proof of Work, doing “work” is the means of creating trust. The amount of “work” required grows over time, commensurate with the growth of the blockchain / network.
This isn’t useful work, mind you…it’s just work to prove that you are, essentially, credible. And the amount of work required has to keep rising so that an attacker cannot falsify transactions without paying a very hefty cost, especially as the value of the network rises. The “work” here means a lot of calculations and a lot of electricity.
You may have heard about Bitcoin’s electricity problem…while it seems problematic, it’s actually a feature of the system. The cost has to keep rising as the value of the system rises in order to make it difficult for attackers to falsify transactions.
And the cost here is the cost of computation and electricity…the cost of work.
Feature. Not a bug.
Okay but maybe that’s not such a good idea? We don’t want to transform our trust problem into a climate apocalypse problem after all.
Newer models are based on something called Proof of Stake.
Here’s Coinbase’s explanation of Proof of Stake:
In a proof of stake system, staking serves a similar function to proof of work’s mining, in that it’s the process by which a network participant gets selected to add the latest batch of transactions to the blockchain and earn some crypto in exchange.
The exact details vary by project, but in general proof of stake blockchains employ a network of “validators” who contribute — or “stake” — their own crypto in exchange for a chance of getting to validate new transaction, update the blockchain, and earn a reward.
The network selects a winner based on the amount of crypto each validator has in the pool and the length of time they’ve had it there — literally rewarding the most invested participants.
Once the winner has validated the latest block of transactions, other validators can attest that the block is accurate. When a threshold number of attestations have been made, the network updates the blockchain.
All participating validators receive a reward in the native cryptocurrency, which is generally distributed by the network in proportion to each validator’s stake.
Becoming a validator is a major responsibility and requires a fairly high level of technical knowledge. The minimum amount of crypto that validators are required to stake is often relatively high (for ETH2, for example, it’s 32 ETH) and validators can lose some of their stake via a process called slashing if their node goes offline or if they validate a “bad” block of transactions.Source: Coinbase
So here the idea is that instead of doing a lot of useless work to prove that you are trustworthy for clearing transactions, the system will assume you are trustworthy if you have a LOT to lose.
By “staking” a lot of resources and putting a lot of money on the line, it shows the rest of the system that you are less likely to be an untrustworthy party because you could lose what you stake if you violate that trust.
That makes a lot of sense!
A lot of how the world works is actually based on such a principle. For example, a bank is willing to give you a mortgage and trust that you will pay it back to your best ability because you have a LOT at stake, including your house and your financial credibility. Because at the end of the day, it’s not just about whether you have the ability to pay, but whether you are motivated to pay and keep your promises.
For most of the blockchains built on Proof of Stake, the resource required for staking is usually the currency itself (i.e. money).
But some blockchains can get pretty creative.
Like Chia. Chia has their own take on this with something called “Proof of Space”. It basically requires staking / putting up a lot of hard drive space to prove trustworthiness:
Proof of space can be thought of as a way to prove that you are keeping some storage unused on your hard-disk drive. Users of the Chia blockchain will “seed” unused space on their hard-disk drive by installing software which stores a collection of cryptographic numbers on the disk into “plots.” These users are called “farmers.” When the blockchain broadcasts a challenge for the next block, farmers can scan their plots to see if they have the hash that is closest to the challenge. A farmer’s probability of winning a block is the percentage of the total space that a farmer has compared to the entire network.Source: Chia
In a way, a “farmer” on the Chia network is also putting up a lot of “money” but in the form of hard drive space.
There are likely many more permutations and creative methods that people have come up with, but sometimes it leads to unusual outcomes…
For example, the growth of the Chia blockchain has led to a MASSIVE amount of wasted hard drive space devoted to “farming” for the Chia network that will never be used for anything else / useful.
In a way…it sounds like Proof of Work! Except without the massive electricity cost.
I promised at the start of this post that this is about more than crypto.
Having spent years thinking about Proof of Work and Proof of Stake and now Proof of Space (and even Proof of Time), I periodically wonder how much cryptomaximalists have thought about how trust is created in the real traditional old school world.
This is a genuine question.
Proof of Work is fascinating but it’s not scalable. And it costs a lot of energy by design. The downsides are not escapable.
Proof of Stake gets around the energy and scalability problem, but it is a system that rewards those that can stake the most.
What’s another name for people that can stake the most?
I suppose the right, industry-specific term would be cryptolords.
But no matter what we call it, is it not true that this system is built to reward the ones that already have the most?
Is this not a system that cements the existing ladder and ensures that those that already have the most will continue to be the ones that have the most?
A month ago, I wrote the post “It’s All The Same”. I lamented that the crypto space seems to be casting aside its original promise as a way to change how the world works. Increasingly, it looks more and more like the old way of doing things, just with new faces and a new rhyme.
Why do I say this?
Because Proof of Stake sounds a lot like how the current financial system works!
If I have a lot of money and I put it in the bank, the financial system rewards me disproportionately more than someone that has a lot less at “stake”. If I have a lot of money, my interest rate on borrowings is near zero. If I have a lot of money, my credit card gives me stuff. If I have a lot of money, I can make more money and pay less taxes.
The more I have, the more I get.
That’s what’s kind of broken about the existing system.
So it disappoints me to see that we are creating this in crypto space.
Yes, the faces are different. But it’s never been a problem with specific faces. The problem is how it works.
So here’s the kicker I want to leave you with.
Everyone probably understands that the real issue with the existing financial system is how it rewards those that already have more than they need, while making it very difficult for someone that has nothing to have something.
What if that wasn’t always the case?
I’ve thought long and hard about the philosophy and nature of the world and trust. And I’ve come to the conclusion that it wasn’t always this way.
Trust wasn’t always about having the most money.
What made America (I’m using America as a general stand-in for “turn-of-the-Century modern capitalist society”) different from the Old World was actually exactly the opposite…Old Money carried less weight than it did in the Old World.
How did that happen?
You probably sort of know – The US strived to be a meritocratic country.
Yes, but what does it mean?
How is trust established in a meritocracy?
The answer is one word: Reputation.
Trust is earned and lost, and Reputation was the primary currency.
I can even modernize this concept by calling it “Proof of Reputation”.
The way it works is not that different from Proof of Stake. Instead of staking money or hard drive space or what-have-you, young America staked reputations. The bigger and more positive your reputation, the more you were rewarded. And the bigger your reputation, the more likely you would not cut corners or risk the reputation at stake.
It wasn’t always perfect. But everyone has a reputation. And it rises and falls. And it is the primary currency that created trust. In a Proof of Reputation world, anyone and everyone was born with a way to make their way in the world that had less dependency on what you inherited. Some people still got a head start, but at least no one is born in the whole with a negative reputation. And losing your reputation was enough to prevent predatory behavior.
I don’t know when, but somehow reputational trust eventually gave way to different methods of establishing trust, of which the dominant form is wealth and income level.
This has not been a good change for society. No one is technically born in debt, but many people may start to accumulate debt long before they have any capability to generate income (such as through educational costs). In a way, a world centered on wealth and income, many people are entering the world with “negative” starting positions in a way that is less likely to happen in a Proof of Reputation world.
The challenge, of course, is that such a system requires you to know something about the people you interact with. Much of the crypto world assumes that the best outcome is a world where we never need to know anything about the parties that are involved with making transactions happen. That’s okay. That may work for some things, but I question whether that base assumption is workable for everything we do. Go to Silicon Valley or New York or any network where massive value is being created. It certainly feels like none of this would work by removing trust and removing the humanness of everything that goes on including the egos and visions. If you listen deeply in these places, it almost screams that reputation and trust are more valuable and central than ever. Serial founders get trusted more. Reputation is more important a currency than anyone lets on.
Crypto could be the dawn of something new.
There’s a lot of promise.
I would hate for it to end up looking the same as the ossifying financial system we currently have…a system that is essentially “Proof of Stake” but based in Fiat money that has us all stuck in a hamster wheel.
THAT would be a lot of effort for very little gain.
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