Chapter 18 of the book Reckless: The Story Of Cryptocurrency Interest Rates is published below. The full book is available on Amazon. The book was written before the bankruptcy of FTX and therefore does not include coverage of this event. However, the book does provide useful commentary in the run up to the failure of FTX, which provides context for the eventual calamity.
In early 2011, seventeen year old Vitalik Buterin discovered Bitcoin. While sceptical at first, as the price of the coin increased, he began researching it, before covering the topic as a writer for Bitcoin Magazine. By Autumn 2013 he was already contemplating something called “Cryptocurrency 2.0”. While with Bitcoin one could make financial payments, the idea was that the blockchain could be more flexible and support a whole plethora of features and applications. These ideas included distributed exchanges, domain name registries, messaging applications, gaming and more layers of tokens. It was possible to do much of this on Bitcoin, however some in the Bitcoin community were keen to only focus on financial payments. In addition to this, adding these layers of features on Bitcoin was technically very challenging, normal Bitcoin nodes wouldn’t enforce the rules of these applications or each new type of application would require a specific upgrade to the Bitcoin network rules. It was not practical to build these systems on top of Bitcoin. The idea of Cryptocurrency 2.0, which was later named Ethereum, was that it would natively support any kind of application, enabling all kinds of innovative ideas that Vitalik hadn’t even thought of yet.
Ethereum conducted a crowd sale in 2014, raising US$18 million worth of Bitcoin and the new blockchain finally launched in 2015. Right from the start Ethereum was always contrasted to Bitcoin, its ancestor system. However, almost every individual parameter and mechanism in Bitcoin was tweaked or improved for Ethereum. During the crowd sale Ethereum proponents made one thing clear, they eventually intended to use a different consensus system to Bitcoin. While Bitcoin uses Proof of Work to select the valid blockchain to follow, Ethereum was going to move onto something called Proof of Stake. However, at the start, Ethereum was to use Proof of Work, until researchers could work out how to build a strong enough Proof of Stake system.
Proof of Work is a mechanism whereby computers perform a calculation called a hash function using the data inside the block as an input. These hash functions need to be conducted many millions of times, each time randomly changing part of the input, until randomly by chance, the output of this hash function is of low enough value. The more of these hash functions you do, the more blocks you are likely to produce. Conducting these hashes requires computational power, which requires electrical energy, a real world resource. This thereby anchors Bitcoin to the real world, the world of energy and industry. The valid chain with the most energy spent on it, is the one nodes follow.
Proof of Stake, on the other hand, is when nodes choose the blockchain with the most accumulated stake backing it. For this to work, stakers set coins aside in a pool and then bet, vote or attest to a particular block and the blockchain to follow is the one with the most votes. The chain still has hash functions, which prove the order of the blocks, by referencing the previous blocks, however there is no significant difficulty target. The output of the hashes can have any value in a pure Proof of Stake system, it does not need to be especially low. While Proof of Stake technology was not ready in 2014, Vitalik was determined to switch to it after further research into it had been conducted.
There were several major technical flaws in Proof of Stake systems, the most significant of them being something called the “Nothing at stake” problem. This is the idea that it is possible to maliciously use the same stake twice on conflicting competing chains. It was possible to punish stakers for doing this, but sometimes changing your mind and staking on two chains was totally legitimate, after all changing one’s mind to follow the majority is how consensus is supposed to be achieved. Ethereum struggled with this problem for years. Eventually it was discovered that arranging stakers into committees helps mitigate the problem. Rather than all stakers having the opportunity to vote on each block, stakers were arranged into groups and only a tiny subset of the stakers were allowed to vote on each occasion. Thereby, individual stakers no longer need to change their minds, as if they made the wrong decision, a different set of stakers would be able to decide. By the time the staker had a chance to vote again, the “mistake” would already be part of history and decided on by others. There are still other outstanding technical issues and uncertainties with respect to Proof of Stake, however, eight years after Ethereum conducted the crowd sale, in September 2022, Ethereum finally switched to Proof of Stake.
One of the key reasons for switching to Proof of Stake is avoiding the environmental externality from Proof of Work. Proof of Stake systems have no anchor to the real world, it works entirely within itself. In a Proof of Work system, a significant proportion of the rewards are emitted externally, to semiconductor foundries and power producers, while in Proof of Stake, rewards are kept within the system. Therefore, while Proof of Work uses real world resources to secure the chain, Proof of Stake is said to be more efficient.
Some have pushed back on this idea, arguing that this logic, claiming Proof of Stake is more efficient, is economically flawed. The argument is that by using coins to stake, this capital is not being used for other productive purposes. For instance, perhaps one is delaying consumption or forgoing investment into productive assets. This may therefore be the inefficiency of Proof of Stake systems. Comparing the level of efficiency between Proof of Work systems and Proof of Stake systems may therefore be extremely difficult. The difference being that Proof of Stake obscures the waste, while Proof of Work does not. Perhaps, the first person to criticise Proof of Stake in this way is Paul Sztorc, in 2015.
There may be a reasonable analogy here with an argument made by the French economist Frederic Bastiat’s in his 1850 essay on the “Parable of the broken window”. In Bastiat’s essay a small boy breaks a pane of glass and the economic consequences of this are discussed. The same Bastiat who had argued in favour of the legitimacy of interest, in a debate with Proudhon a year earlier.
Suppose it cost six francs to repair the damage, and you say that the accident brings six francs to the glazier’s trade – that it encourages that trade to the amount of six francs – I grant it; I have not a word to say against it; you reason justly. The glazier comes, performs his task, receives his six francs, rubs his hands, and, in his heart, blesses the careless child. All this is that which is seen.
But if, on the other hand, you come to the conclusion, as is too often the case, that it is a good thing to break windows, that it causes money to circulate, and that the encouragement of industry in general will be the result of it, you will oblige me to call out, “Stop there! Your theory is confined to that which is seen; it takes no account of that which is not seen.”
It is not seen that as our shopkeeper has spent six francs upon one thing, he cannot spend them upon another. It is not seen that if he had not had a window to replace, he would, perhaps, have replaced his old shoes, or added another book to his library. In short, he would have employed his six francs in some way, which this accident has prevented.
Perhaps the environmental cost of Proof of Work mining is easier to see, while the delayed consumption or forgone capital investment, associated with large investment inflows into Ethereum, attracted by the staking yields, will go unseen. The logic here is somewhat controversial. It seems perhaps almost impossible that we will get universal agreement on these apparent costs of Proof of Stake, just like we can’t agree on whether central banks keeping rates too low for too long caused the economic boom bust cycles. Can we really get all these economic benefits for free? Be it an unstoppable distributed consensus system or strong sustainable economic growth and continued asset price appreciation, or is there always some unseen hidden cost that eventually emerges in the form of a crisis?
Some supporters of Proof of Stake systems have argued that Paul Sztorc’s logic is flawed, because capital may only be locked up for a short amount of time. In Ethereum, at the time of writing, the funds are actually locked up in staking and cannot be withdrawn at all, until the network upgrades. However, once this upgrade occurs, one should be able to withdraw the funds within perhaps a few months, depending on several factors such as the length of the exit queue. Other alternative Proof of Stake systems allow even faster withdrawals, within a few weeks. Therefore, supporters of these Proof of Stake systems argue, nothing is locked up and there are no externalities. Paul Sztorc has a retort to even this, in any competitive system, he asserts, marginal costs will tend to marginal revenue. In other words, if there are rewards for staking, people will keep spending more and more costs to earn those rewards, until profit margins are low, no matter what those costs are. Anyway, even if the funds are not locked up, as long as they are deployed in a staking protocol, they are not used to invest in productive projects.
Ethereum switching to Proof of Stake or “The Merge” as it is called, is a significant development for the cryptocurrency space. One potential consequence is that it could attract many new yield hungry investors. The high yield could make Ethereum a more attractive asset to hold, boosting the price. It could also be said to make Ethereum even more speculative. Even though the Merge has often been cited as positive for the price of Ethereum, as the coin’s supply growth may be more constrained than under Proof of Work, the positive impact the yield could have on the price may be underestimated. Switching to Proof of Stake is also assumed to boost the appeal of Ethereum to environmental, social and governance (ESG) minded investors, who may be worried about investing in Bitcoin due to the perceived high carbon footprint of Proof of Work. Although this environmental argument may attract investor flow into Ethereum, it also may not have as significant an impact as the yield.
Ethereum’s native yield could cause a huge flow of funds into Ethereum, from outside the cryptocurrency world. Of course, there are other Proof of Stake coins, however outside investors are perhaps correctly sceptical of these other high yields, wondering where the yield comes from. Ethereum has far greater legitimacy than these other coins and a much more powerful marketing infrastructure and more real users. The Ethereum developers are also smarter than the developers of the other Proof of Stake coins and they have therefore designed a stronger system, one which is more resilient. The combination of these factors could send the price of Ethereum to stratospheric levels in some of the future cycles.