Cypherium | Decentralized Consensus as an Economic Event
Tags: Economics, Blockchain, Opinion, Decentralization, Security

There is currently a debate roiling throughout the offices of the U.S. Commodity Futures Trading Commission (CFTC): how will our current mechanisms of economic regulation impact, respond to, and grow with the changing landscape of financial technologies?

This fall, the CFTC arrived at a landmark decision in the history of fintech and decentralized technology, when they declared that Ethereum, as it stood, would be considered a commodity. This meant that the technology would be able to support a futures market and that the economy built around Ethereum would not be subject to regulation as a security, which most in the crypto space would hinder severely the growth of the underlying technology. The blockchain community barely had time to rejoice, however. With a clear verdict delivered for Bitcoin and Ethereum, the CFTC shortly thereafter revised their announcement. The Commission clarified that while they had decided definitely that Ethereum 1.0 would be considered a commodity, they had not yet reached a conclusion as to the status of the network upgrade, Ethereum 2.0, scheduled to take place over the course of 2020.

At the core of this confusion is the fundamental shift in technology that Ethereum’s migration will bring into effect, the transition from aa Proof-of-Work consensus mechanism to a Proof-of-Stake model. So, before we try to grapple with the decision now facing the CFTC with regard to the economic models of different blockchains, we might clarify exactly what Ethereum’s transition entails from a technical perspective.

PoW v PoS

Proof-of-Work (PoW) and Proof-Stake (PoS) were the first and second consensus mechanisms, respectively, devised to achieve the distributed consensus required to operate public blockchain technologies. Proof-of-Work was first put forth in Satoshi Nakamoto’s original Bitcoin whitepaper, in 2008, and is for that reason also sometimes referred to as “Nakamoto consensus.” Proof-of-Stake was subsequently proposed in 2014 by Ethereum’s Vitalik Buterin as an answer to some of the scaling difficulties Bitcoin had been facing. Many, however, argue that PoS’s shortcomings outweigh its problem-solving innovations.

Proof-of-Work uses computing power expended in solving a complex mathematical prompt as proof that a given node is a good actor can be trusted to write in the blockchain. The first drawback to Proof-of-Work is its high cost. It is incredibly expensive, both financially and environmentally, as the process uses massive amounts of energy to support a fully scaled blockchain network like Bitcoin. While this ultimately cuts down on the carbon footprint of current financial technologies, this method nevertheless takes a serious toll on the environment.

Moreover, only certain people can afford to obtain the extremely expensive and specialized mining equipment. This leads to the second drawback, which is also the most flagrant for those in the crypto space: centralization. Only the wealthy can afford to mine. Today, something like 8 out of every 10 new BTC is being mined by only a handful of specialized mining companies. If in this situation, the mining superpowers decided to collude, or conglomerate into a cartel, there would be virtually nothing everyday network participants could do to prevent the network from oligarchic hijacking.

The other most popular proof mechanism is Proof-of-Stake, which uses experience and equity in the network as a proof that a given node is a good actor and can be trusted to commit a block into the blockchain. Here the entity responsible and rewarded for producing a block is picked by way of a lottery, in which equity and experience in the network more or less equate to a percentage chance in being selected to mine the next block and receive the block reward. In other words, this mechanism rewards network investment with network leadership, the logic being that an entrenched investor will use the network power to protect their investment by ensuring that the blockchain continues to be valid.

Among a number of possible security issues, there is the so-called “nothing-at-stake” problem, in which a bad actor may spend lots of time and energy, gaining influence at little material cost, only to attack the network. But perhaps the most fundamental problem is an ideological one: Proof-of-Stake can be seen as abandoning the goals of decentralization. Trustworthiness and your ability to write true history into the blockchain, in other words, comes from the amount of wealth you have accrued. In other words, the opportunity and objectivity of the network may ultimately fall into the hands of the powerful, undermining blockchains’ prime advancement toward an open financial system: unimpeachable and permanent transparency.

Cybersecurity vs Cyber Securities

What is a commodity and how is it different from a security? Put simply, a commodity is a thing that has value in-and-of-itself, whereas a security derives its value, second-hand, from an original source. Natural resources — gold, oil, corn, etc — prototypical commodities because they acquire value solely from people wanting them. This innate value creates a market, which then acquires its own value by way of financial instruments — contracts, pricing models, payment plans, etc. Derivates such as securities derive their value from the financial aspects of commodities and form their own secondary markets.

Bitcoin often gets likened to gold for its commodity-like financial structure. People want Bitcoin much in the way they want gold — both as a bearer of value and as a bearer of an abstract quality — in gold, beauty, and in Bitcoin, one might argue, truth or history. The Proof-of-Work mechanism confers this value as it is the cornerstone of the network. This innovative distributed consensus endows the network with something that the population finds inherently valuable: a mathematically derived sense of authentic history that can be shared by all but controlled by none. It is, perhaps, the first “natural technological resource.”

Proof-of-Stake departs from this in several meaningful ways. First and foremost, value is created on a PoS network from its objectivity or open, permissionless structure, but from the very placement of its equity. Like stock in a hedge fund, anyone with equity in a PoS network implicitly expects the value of their stake to rise in accordance with the business acumen of the network’s leadership. The value of a Proof-of-Stake network, especially a network which originated as a Proof-of-Work project, comes from the project’s preexisting investments. It does seem that PoS would be by definition a securitized form.

For these reasons, among many others, Cypherium has chosen not to throw the baby out with the bathwater, and focus on delivering Proof-of-Work to the world of financial technologies. Cypherium solves Bitcoin’s scaling problems not by eradicating its innovations but by revising and innovating them. Our consensus method maintains the open and permissionless consensus of the PoW algorithm, but we combine that mechanism for creating new blocks with a separate process of verifying transactions. We must not fear any particular ruling from the CFTC, rather we must hope that the law veraciously reflects and uphold the possibilities of our technologies. With Proof-of-Work, we know that this will continue to be the case.