Consensus Mechanism and Price
Mon May 30 2022
Almost all cryptocurrencies begin as proof of work. Proof of work provides security for the network and a permission-less means of onboarding new participations before exchange/market adoption. Ethereum is upgrading to proof of stake from proof of work. According to Ethereum, this upgrade will make the network more secure and more energy efficient.
In proof of work, miners expend energy to create new blocks and nodes validate the blocks meet consensus rules. Mining is now out of the hands of the average person, but running a node can be done by anyone. The power to validate consensus is cheap. In the early days of Bitcoin (2013), there were worries about 51% attack. This is where a collusion of miners with 51% of the hash power can rewrite the blockchain and create a fork with a longer chain. If that chain breaks consensus then it will not be accepted by the nodes and will not be propagated to wallets. The forked chain will die and become irrelevant as it will not be accepted as Bitcoin. Since the Blocksize wars of 2018, after which UASF was used as a successful deterrent to both mining and big business collusion, it is generally assumed that users who run nodes determine the future of the network.
Proof of stake was created to reduce the energy utilization of blockchains. Rather than relying on cpu intensive work to generate unique hashes in POW, POS relies on nodes who have coins staked (locked into a smart contract). Validators with staked coins sign off on valid new blocks. If the new block did not adhere to consensus rules, the validators coins will be burned. At the time of this writing, POS is not yet live on Ethereum. Eth’s beacon chain which runs POS is expected to be merged in soon.
Proof of work is a novel system for setting a minimum value on a commodity which has no existing use, but which has a potential future use as store of value. By wasting (burning) electricity to produce new cryptocurrency, this undertaking means that someone thinks this cryptocurrency is worth at least the electricity (real world resource) spent either presently or in the near future. This bootstraps the cryptocurrency and provides a bottom for the price in the form of cost of electricity per coin. Electricity cost per coin is dependent on the cost of electricity, and the mining difficulty. The higher the difficulty, the more electricity is needed to produce bitcoin. When price falls below this value, we enter a miner capitulation phase where the less efficient and less determined miners will shut off. Shut off reduces difficulty in the next cycle and allows miners to reduce electricity cost per coin. During the initial cycle of miner shutoff, less supply of bitcoin is produced due to fewer miner participation.
In the early days of bitcoin, block rewards were 50 BTC, after every halving (roughly 4 years), block rewards are cut in half. We are currently in the 3rd halving with block rewards at 6.25. In the early days, block rewards accounted for a significant percentage of the the trading volume (~10%). Currently, block rewards are less than 1% of total trading volume. The impact of miners and their new supply is not as important as they were before. As of 3 months ago, US accounts for the highest percentage of miners (after China made bitcoin mining illegal). Access to deeper capital markets helps miners smooth out operational growth in the face of wild fluctuations in bitcoin price with mining equipment as collateral. This further reduces the short term impact of miners on the short term price action.
Long term, bitcoin supply matters a lot. Bitcoin is the only mathematically scarce asset in the world so far. It has recently experienced failed power grabs and failed attempts at altering the consensus protocols, proving that it is still immutable and impervious to both financial and political manipulation. After the next halving, bitcoin inflation rate will be less than that of gold, which historically (over thousands of years) has been the best store of value. As rate of inflation reduces further in future halvings, the rarity will increase and so will the price. The investors who believe in bitcoin have priced in the halvings and believe the future value to be significantly higher — between $600k - $10M, but most investors are not aware of the nuances of bitcoin mechanism and therefore don’t price the future rarity in the present. As the rarity increases, the markets will absorb the change in the form of higher prices, which will improve its attractiveness to investors on the sidelines.
Bitcoin is possibly the most volatile asset. Even at market cap of $1T, price drops and increases of 20% are possible in 1 day. When price rises, news articles pique the interest of new investors. As new investors flood in, price rises ever more quickly until it cannot be sustained and investors start to take profit, crashing the price in the process. Every cycle brings in new investors and plenty are also flushed out in the crashing process. The ones that remain become ardent HODLers and are rewarded with the feeling of winning the lottery in slow motion. This mechanism is unlike any other asset. Since Bitcoin has no usefulness other than store of value and store of value is a social concept, not a technology one, Bitcoin’s high volatility and market cycles are a natural form of conversion from normal investors to Bitcoin Maxis.
Ethereum was never designed to be store of value. Ether is the currency for executing smart contracts. As a result, Ether neither needs or wants either proof of work or a mathematically determined issuance rate. Upgrading to proof of stake is a risky change. Problems at scale sometimes are not replicable on testnet. Since Eth is not store of value, potential short term problems created by merging in POS are outweighed by long term benefits of reduce energy use. This is not a tenable upgrade for Bitcoin — which needs to be risk adverse in order to prove itself as a store of value. Bitcoin needs Ethereum to absorb the desire to push blockchain capabilities to new limits while allowing Bitcoin to stay the same. Bitcoin price and Ethereum price are currently highly correlated, but ultimately only Bitcoin can be a store of value.