Bitcoin and governments… Wait, what??

Wasn’t bitcoin about evading the control of governments? Weren’t we at the dawn of a truly global currency that knew no politics? What happened to freedom from boundaries? Won’t governments moving in take out all the fun?

No. Bitcoin was and still is about evading the control of governments. But that doesn’t mean that governments can’t also benefit from bitcoin’s advantages. And the official entities aren’t interested in bitcoin as much as in its underlying technology, the blockchain. Governments, both national and local, as well as central banks, are sniffing around, speaking at conferences, writing papers and trying to figure out how this new financial development can extend their reach and reduce their costs. It makes sense.

by Thomas Brault for Unsplash - bitcoin and governments
by Thomas Brault for Unsplash

But how, exactly, can governments use the blockchain? Leaving aside the potential as a currency and the impact on monetary policy, the list of possible uses is long, and includes archive management, welfare distribution, budget allocation, voting mechanisms… A respectable roster of sovereign organizations are officially “investigating the technology”, which sounds very much like a me-too policy. But more and more concrete use-case studies are emerging, with powerful public backing.

The UK government has been particularly active in the sector. Late last year it pledged funding of £10 million to investigate blockchain technology, and has been coming up with interesting applications. From record keeping to tracking financial movements such as student loans and international aid, the Cabinet Office has been running trials on and investigating practical solutions to bureaucracy-heavy processes.

Just a few days ago, the UK government revealed that it is experimenting with distributing welfare payments on the blockchain, through a digital “benefit coin” which could replace welfare payments. This has raised significant privacy concerns, which in turn is generating healthy focus on the technology and debate on the advantages and drawbacks.

Tomorrow the House of Lords is holding a hearing to debate potential governance applications, which you can watch live at this link if you’re interested.

The US government is not quite as proactive in applying blockchain efficiencies, but is stepping up its funding for research projects. In June, it awarded $600,000 in grants to six projects investigating the application of blockchain technology to the issue of identity, privacy and security. And last week it issued a call for papers on blockchain research relating to the healthcare industry.

The US defense and research agency DARPA wants to look at ways to use the blockchain for secure messaging. The Department of Homeland Security is funding research into blockchain authentication of IoT devices. And the initiatives are not just federal: in May the State of Delaware launched an initiative that includes the blockchain trial to store and secure government archives.

Estonia is often held up as an example of blockchain governance. Over a decade ago it launched an e-residency program (not blockchain-based) which allows anyone to establish “fiscal” residence in the nation, to set up companies and administer their finances. Late last year it announced a collaboration with BitNation to offer a blockchain notary service to these e-residents, which would not just cover company documents but also marriage licenses, birth certificates, etc.  Earlier this year it started the process of storing all of its health records on the blockchain.

Ukraine announced a few days ago that it would start to use eAuction, a blockchain-based auction platform, to sell government assets, eliminating the possibility of official interference. A few weeks ago Sweden revealed that it is testing the blockchain for land registration, and the Republic of Georgia has been trialling blockchain-based land titling since April. The city of Zug, in Switzerland, allows its residents to pay for public services with bitcoin. The Finnish city of Kouvola has just received €2.4m of public funding for a blockchain-based smart container shipping system.

In spite of the huge potential scope, it does look like the most advanced initial projects are the relatively “easy” ones of managing documents. Which is, of course, totally understandable, as well as efficient and necessary. The problem in most cases is not that the systems are not digital. The problem is more one of inter-communication between different systems, and the portability of data. A file on one system in this day and age still needs to be replicated on another, even if the end use is similar, and even if the end owner of that information is the same. The blockchain gives governments the opportunity to streamline processes, optimize storage, and extract and share more useful information while keeping it private and secure. The integrity of public registries is fundamental, not only as a matter of trust in authority, but because the information they contain – property and automobile ownership, passports, birth certificates, marriage certificates, business licenses, penal records, and a long etc. – is often the base of a democracy and an economy.

A few intrepid initiatives are looking at the sticky problem of voting, an issue which fundamentally affects most sovereign nations in this day and age. The current process is cumbersome, inefficient and often subject to tampering. But since this revolves around the even sticker problem of online identity, few initiatives have progressed much beyond the initial stage.

The will is there, though, and it is only a matter of time. Most governments have moved from rejecting the frivolous notion of a universal and immutable digital currency, to realizing that bitcoin is just a certain type of information, and that the blockchain can be used for other types of information as well. We have seen some practical applications, and will see many more emerge over the coming months. And we will all of us, soon, be enjoying greater blockchain-enhanced bureaucratic efficiency, without even noticing the technology that makes it work.

Bitcoin, central banks and irony

The idea of bitcoin and central banks joining forces is not quite as farfetched as it seems. True, bitcoin is a decentralized global currency system, and regional central banks are, well, centralized and regional. So, on the surface they have nothing in common, except for the objective of a fast, efficient, low-cost method of payment and settlement. The main difference between bitcoin and the central banks is in how they think that should be governed and executed.

What do central banks want? They want an efficient way of settling interbank trades. They want a healthy banking system. And they want to influence the economy by controlling both the money supply and the interest rates.

What does bitcoin want? It wants to empower individual users to control the use of their own money, free from intervention, manipulation and censure, and totally open to market forces.

Could central banks use bitcoin’s technology to achieve their goals? In theory, yes. Would this end up being the irony of ironies? No, not really.

by My Life Through A Lens, for Unsplash - central banks
by My Life Through A Lens, for Unsplash

Central banks would not so much be interested in bitcoin as in its underlying technology of the blockchain. More efficient settlement, increased transparency, less economic vulnerability and a greater control over the money supply would have a significant impact on the Bank’s power and usefulness. It could be positive, or it could be negative. We could see a consolidation of central banks’ influence. Or, we could see them blockchained out of existence.

One of central banks’ main functions is to act as a clearing house for interbank trades. A vast amount of money is electronically transferred between banks at the end of each business day, to make sure that the net positions reflect that day’s financial activity. The central banks coordinate and settle this, using a variety of transfer platforms. It’s efficient. But it could be more so, especially if the need for a central clearing house was eliminated. What if the network of commercial banks and other financial institutions could settle directly on the blockchain? The central banks’ obligations could be reduced to that of regulation and monetary policy.

Another main function of central banks is that of issuing the currency. What if, instead of fiat currency, they issued a blockchain-based digital currency? (Which would, technically, also be fiat in that it is backed not by gold or similar, but by faith in the central bank.) That way we could all hold money directly issued by the central bank. Right now the only way to do that is with cash. If we could all effectively “open an account” with the central bank, there wouldn’t be much point in also having commercial bank deposits. Apart from the additional unnecessary costs, commercial banks are not as secure. They do not hold enough liquid assets to offset the client deposits, which leaves clients at the (remote, but still) risk of not being able to take their money out when they want to. With the central bank, that’s not a problem.

But with no retail deposits, commercial banks couldn’t lend as much as they do. Now, they take their retail deposits and lend them out to other individuals and business, thus making money more efficient and giving the economy a boost (not to mention making a profit in the process). This has the added effect of increasing the money supply, by effectively “re-using” money. It’s good for the economy (at least on the surface), but it’s difficult to control. The startling reality is that we don’t actually know what the money supply is at any given time. Central bank deposits at commercial banks can be used to back loans, but the scope is obviously more limited.

So, with commercial deposits replaced by central bank digital currency, lending would dry up (unless we can come up with a way to leverage central bank deposits). But some economists argue that it wouldn’t be a bad thing at all. Either way, the central bank would have a much tighter control on the money supply, and a much greater influence on the economic performance of the country. In theory, anyway – we all know that when it comes to economics, that is rarely the same as reality. The idea is a radical departure from the current economic system that we know. But, coming full circle, that is the point of bitcoin, the reason technologists have been searching for decades for a solution to the persistent problem of decentralized trust. Yet while bitcoin wants to be an alternative to central bank hegemony, the central banks themselves want to get in front of the inevitable change that this new technology will most likely force on the traditional system.

And all of this is not as farfetched as it sounds. Central banks are looking into these ideas, and the past few months have seen a slew of pronouncements from central banks all over the world. Just last week the Bank of England released a report that claims that a central bank-issued digital currency would permanently increase GDP by 3%. In March, Bank of England Deputy Governor Ben Broadbent gave a speech in which he outlined what such a system of central bank digital currency and blockchain settlements could look like. In January of this year the Bank announced that it was looking into the possibility of using the blockchain for the UK interbank settlement system. Last September the Bank of England’s top economist, Andrew Haldane, proposed the idea of issuing a state-backed cryptocurrency while simultaneously applying a negative interest rate on paper currency, or even banning paper currency outright.

Also in March of this year, researchers from the University College of London (not affiliated with the Bank of England) proposed the RSCoin framework for cryptocurrencies issued by central banks. This would allow the central banks to centralize the money supply, allow direct access to payments, and give an exact figure for the money supply at any given time. The cryptocurrencies would run on nodes validated by authorized “mintettes” (I think they’re being serious, I’m not sure).

Just last month it emerged at a conference of 90 central banks from around the world, hosted by the World Bank, the IMF and the Federal Reserve, that several of them have been investigating the blockchain for some time. Earlier this year the Dutch central bank revealed the development of an internal digital currency prototype called DNBCoin, for experimental purposes. And the following month the French central bank announced that it has been actively looking into bitcoin, digital currencies and distributed ledgers. Even Russia’s central bank has expressed an interest in the possibility of a central bank-issued digital currency.

A few weeks ago the Bank of Canada revealed that it has been experimenting with how to apply the blockchain to interbank payments. In May, the Deputy Governor of the Bank of Japan urged central bankers around the world to consider the implications of this technology. India’s central bank is investigating how to use the blockchain to reduce the dependence on cash and improve tax collection. China’s central bank is looking into issuing its own digital currency. The central bank of South Korea is researching distributed ledger applications. Barbados, Kazakhstan, the list goes on. And we can expect many more similar announcements in the coming months.

Cryptocurrencies are a reality, and with technological improvements and increased opportunity, they will become a more widely spread mechanism of financial transaction.  Central banks can watch while their power to control the money supply is whittled away by the increased use of money outside their influence. Or, they could try to compete by incorporating cryptocurrencies into their national spheres. This obviously is not a simple proposition, and the ripple effects will need to be seriously considered. And no-one likes the idea of “experimenting” with something as fundamental as national and global economics. But change is inevitable, cryptocurrencies offer significant advantages, and the demands of the market are evolving. Calling for the disruption of the central banks is at this stage irresponsible, especially since we don’t yet have a viable alternative. However, if the central banks start to disrupt themselves, we could gradually move into a new economic order, with potential and promise that reach far beyond lower costs, faster transactions and enhanced transparency.

Identity and the blockchain: what are we looking for, anyway?

Identity theft and falsification has been a problem ever since, well, since identities were identities. And it’s easy to understand why. Apart from political necessity (the need to escape persecution), there’s criminal intent (I’m harder to catch if you don’t know who I really am), and the frivolous desire for fun (so I’m not really responsible for what I do). Most of us have seen those movies, read those books and played the game of fantasizing about being someone else for a while.

And as the headlines and the police constantly remind us, online it is so easy to become someone else. Pseudo Twitter accounts, fake Facebook profiles and anonymous chat room IDs are the tip of the iceberg when it comes to assuming the personalities of others. You’ve probably seen the famous New Yorker cartoon:

Internet_dog - identity

So far we have not yet found a way to get around the problem. And the more we think about it, the less clear the problem becomes.

Is it one of identity verification? Is it one of identity portability? Or is it more a question of showing the right things to the right people at the right time? What exactly is it that we’re looking for?

We haven’t found an ideal solution yet, but we seem to be getting close. The technology of the blockchain – the public, decentralized database that is hard to hack and modify but easy to distribute – has opened up new possibilities that could solve some of the stubborn barriers that online identity has been coming up against.

The advantage of the blockchain is that just about anything can be digitized, hashed (compressed) and stored. Because the ledger is public, the information can be accessed from anywhere, and sent to anyone. It can only be modified by the holder(s) of the private keys. And because the ledger is decentralized, no one person or entity can stop it from being used.

You’re no doubt asking yourself, “in what way would that stop falsification?”. Obviously just putting information on the blockchain doesn’t make it true.

by Kantemir Kertiev for Unsplash
by Kantemir Kertiev for Unsplash

Several blockchain business have emerged, hoping to make identities easier to create and use. And yet most focus on identity management rather than verification. Netki announced a funding round of $3.5 million a few days ago, to develop a digital certificate of identity, piggybacking on an official US identity program and making it usable on any blockchain. ShoCard wants to use the bitcoin blockchain for identity tokens that can not only be used by banks to identify transactors, but can also change the way we travel by holding our passport details, photo, airline tickets, hotel reservation… It can be pulled from the blockchain for confirmation by any airline or airport official, anywhere in the world.

Object-Collab is a research and proof-of-concept project working with banks and regulators around the world to design a global ID that is individual, secure and accessible from anywhere. Cambridge Blockchain offers a platform that allows transacting parties to learn certain types of information about one another without compromising their full privacy. BitID wants to convert your bitcoin wallet into a unique and universal ID that would allow you to pay for goods online, check in to hotels, authenticate identity on websites… Trunomi makes KYC easier for financial institutions, and facilitates consent-based sharing of financial data. Cryptid uploads your official ID onto the blockchain, and assigns you a card along with a QR code that makes the ID more portable and more secure. Civic’s goal is not to issue nor to manage your identity, but to protect it by letting you know every time it is used online. Identifi combines identity with reputation.

And thinking big, BitNation offers a global ID that accompanies your passport, allowing you to become a “world citizen”. For those without a passport, it can issue a Blockchain Emergency ID to facilitate refugee access to aid and donations. These are just some of the ideas and businesses tackling the identity issue, and we will no doubt be hearing more about these and others in the months to come.

Big tech companies are also very interested in the field. A few days ago IBM completed a blockchain identity trial with French bank Crédit Mutuel that would allow banks to securely share their customers’ identities with third parties such as utility companies and online businesses. A few weeks ago Microsoft announced a collaboration with Ethereum developer Consensys and Blockstack to build an open-source identity platform that bridges Bitcoin and Ethereum.

With so much brain power and money behind the search for a solution, why is it proving so elusive? Some say that it’s because the solutions are too fragmented. I believe that it’s because we’re asking too much of the solution.

What is identity, anyway? I’m currently reading Richard Morgan’s Altered Carbon. In it, the protagonist is digitally sent back to Earth and assigned a “sleeve” (someone else’s body). But he’s himself, using his own name, and carrying around his own complicated past. His body is just a garment. Given that we can’t disassociate ourselves from our bodies, what are we? Are we our past? Our thoughts? Our abilities? Or are we something more solid? Perhaps an amalgam of our history and our qualifications, represented by a set of physical features. Given that both our past and our physiques are constantly changing, how can these relatively fluid concepts irrefutably identify us?

And, why do we need it? For transactions? Access? Privileges? Each “need” requires proof of different aspects of our self. My passport alone won’t get me a job, or a discount at the college bookstore. My job title is not enough to allow me into a country, or entitle me to a tax rebate. The fact that I’m a CFA won’t let me open a bank account, or get me treated at the local hospital.

We live in a world of fragmented identity, with different organizations issuing different validations for different requirements. As we have seen above, many blockchain services are trying to find a solution of unification and portability. But is this even possible? We can upload our identity (or identities) online, adapt them for many uses, send them around the world. But what identity? Who issues that which we upload? And how does anyone know that it is correct? Identity documents, after all, are only as trustworthy as the issuer. My British passport carries more weight than my coupon card from Val’s Laundromat.

It is also much more useful, and much, much harder to fake. But it can be done. Getting a passport is not easy, but as we know, false ones are available to those with the right connections and resources. Which highlights the difficulty, if not impossibility, of truly verified identities online. If identities can be faked offline, it’s even easier when you can’t look the person in the eye. Photos of smiling faces holding identity documents to prove physical similarities can be doctored. Scans of official documents can be manipulated. Signatures can be forged. Links can be diverted. Identity creation, validation (which is not the same as verification), dissemination and protection are all fundamental for secure online transactions. But they don’t address the issue of what identity is, and how we can be sure that it’s real.

Maybe there is no “one identity” that will do. And maybe that is just fine. Maybe we need to rethink at the concept of identity for this new, hyper-connected and multi-layered world. Online it’s easy to be many different people. Offline, it’s harder. So, maybe we need to forget about the search for how to represent one true identity, and focus on what that identity is needed for. What characteristics does it need to have?

In “Identity is the New Money”, David Birch proposes fragmenting our identities and offering the part that is needed according to the situation. Notice the plural – online, most of us have more than one identity, often without realising it. We sign in to services using different avatars. We use different platforms for different reasons. And while the superficial identities are easy to set-up and destroy, that doesn’t make them any less real.

“All of the identities we exchange are virtual, and while these virtual identities are of course linked to our mundane identities, they should not be confused. None of them is ‘real’.”

So the search for the “real identity solution” is looking for something that doesn’t exist, because there is no one particular universal format or need. Maybe the answer lies not in finding the solution that fulfils all needs, but in finding a multi-format but coherent solution that adapts to whatever the need is. A solution that is secure but updatable, easy to share but difficult to steal, decentralized but universal, adaptable but compact… This sounds complex, as are the issues around who would create such a system and how it would be maintained. But well designed and implemented, on a public blockchain, with official involvement and creative leeway for businesses and services, its use could end up being simple. And if it works, and if users, businesses, regulators and governments learn to trust it, the opportunities it opens up for efficiency, safety, wealth creation and freedom are immense.

(This article was first published on LinkedIn. I’m not sure which is more efficient, to post there or here first. Advice welcome.)

The hype of the halving is hardly helping

(Terrible title, I know, but how often do I get the opportunity to start with a string of “h” words?)

First of all, what is the halving? It’s when the amount of bitcoins that the block validators (the “miners”) get as a reward for processing transaction blocks is reduced by half. The bitcoin protocol has the reward falling by 50% every 210,000 blocks, to control the supply of bitcoins and permit a gradual tapering off of new coins as the limit of 21 million is approached (we have a way to go yet, that’s not expected until 2140). The last halving was in November 2012, when the reward fell from 50 bitcoins to 25. The next one is expected tomorrow.

It’s one of the reasons cited for the sharp increase in bitcoin’s price over the past few of weeks. And now that it’s so close, it’s one of the reasons for its sharp fall today. Which totally makes sense (not really).

The potential vulnerabilities the halving leaves us with:

  • A concentration of mining power. Many miners will have to drop out of the businesses as their operations become unprofitable. We’ve already seen the beginning of this, as KnCMiner announced their bankruptcy a few weeks ago, citing the upcoming event as one of the reasons. What would this mean for the sector? Increasing concentration in the hands of the powerful. This goes against the very idea behind bitcoin: a network run by everyone. That undermines the credibility of its story and its goal. But a more insidious worry is the vulnerability to manipulation. In a decentralized network, we can trust the honesty of the crowd. In a centralized one, not so much.
  • Slower transaction times. The removal of part of the hashing power (computers running the network) would make block confirmations even slower. As you know, blocks are confirmed by finding the right random value that gives a hash (= a condensed string of characters that results from passing the block through a certain algorithm) within a certain range. The range is set to be narrow or broad enough to ensure that blocks can be validated in about 10 minutes. If they get validated faster, the difficulty increases. Slower, it decreases. With fewer machines churning the random numbers and algorithms, it’s very likely that the block validation time will slow. Fewer machines searching for the right random variable will lead to a longer time to find the correct one, just as fewer people searching for a needle in a haystack leads to it taking longer to find the pesky needle. Slower transactions will lead to the system re-setting the difficulty, but that only happens every 2016 blocks. Until then, big frustration for people trying to pay with bitcoin.
  • An offloading of bitcoins. To help cover profitability shortfalls until faster and cheaper equipment appears, miners may well have to start selling some of their considerable bitcoin holdings on the market. That could push prices down. Or, given the fickleness and jitteriness of markets, the possibility that that could happen could be enough to trigger a fall.
by Danielle MacInnes for Unsplash - halving hype
A half is not as good as a whole – by Danielle MacInnes for Unsplash

Basic economics says that when the supply of something decreases, the price increases. So, many bitcoin experts are convinced that the bitcoin price will increase right after the halving. And so far, they’ve been proved right, the bitcoin price has gone up over 50% in the past three months.

But here’s the thing: the supply is not decreasing. In fact, it’s increasing. At a slower rate, true, but it’s steadily increasing. And here’s something else that I don’t understand: this slowdown in the rate of increase is totally expected. It has been expected since the beginning of bitcoin. So in a rational market, the price would have already discounted this halving, and would have no reason to increase in the run-up to it. The expected effect would already be in the value. It should be, in a rational market, price neutral.

So, either there’s something else going on (hello, China? You feeling ok?). Or, bitcoin’s market is not rational. Neither makes me feel particularly good as an investor.

And yet I am still a bitcoin fan. I want the volume to be strong and the price to increase. But this focus on the price, and the inherent volatility of the market, is not what bitcoin needs. It’s great for speculators. But for bitcoin to occupy the place in the world economy that it deserves, as a decentralized alternative to global transfers, we should be focussing on its inherent value, on its utility and on its future.

The halving will have a market impact. But it’s very unlikely that it will be long-lasting. Miners may drop out. Others will step in to take their place, with newer and faster and shinier machines. The price could go haywire. But it will calm down. There could be structural problems. But they will be fixed. And we will probably see some impacts that no-one expected. We’re new at this. But we’ll figure it out. I believe that focussing on this event is short-termist, and missing the big picture. The price increase is exciting, and I couldn’t be more pleased, but relating the price movements to halving event is latching on to easy explanations and buying into the media hype. And that the fundamentals of bitcoin deserve better.

Proof of Work, Proof of Stake and The Bitcoin Halving

You probably know that bitcoin’s security system is called Proof of Work (if not, see here). It’s based on the idea that the amount of work required to attack the system is a deterrent. The costs you would incur from changing transactions that were processed several blocks ago, to either double-spend or to modify details of the embedded data, would be greater than the potential gain. The same applies to what you could gain from denial of service or consensus attacks. By requiring a lot of computer power, Proof of Work assures the integrity and security of the system.

But Proof of Work is not the only game in town. It may not even be the best one.

by Aditya Siva for Unsplash
by Aditya Siva for Unsplash

What are the potential flaws in this system? For one, it consumes a LOT of electricity. A report came out recently suggesting that bitcoin mining (the generation of new bitcoins through successful block validation) will end up consuming as much electricity as Denmark by 2020. While this could well be exaggerated, it does help to envisage the scale of the energy needs. Some innovative ideas suggest that bitcoin mining rigs (the powerful computers used to generate new bitcoins and validate blocks) could simultaneously be used to heat buildings. There’s an ecological thought.

Two, imagine that electricity prices come down and computing power becomes more energy-efficient. And, imagine that there are billion dollar transactions on the network. It’s therefore not hard to imagine that there would be a strong economic incentive to try and change a previous transaction. The costs to engineering an attack on the system would not be so high. The cost of Proof of Work could cease to be a deterrent.

Three, given the current concentration of mining power in China, it’s not hard to see how a consortium could “break” the system by pooling their resources together. All an attacker looking to influence or change the course of the blockchain needs is 51% of the system’s computing power (different types of attacks could be pulled off with less). The top 3 mining pools in China hold 61%. And while there is no indication that they would ever do this (in fact, they have taken steps to dilute their power to avoid such doubt), it is technically possible. The incentives could be personal, or as a response to state pressure, or as a result of bribery, extortion or blackmail.

proof of stake
graph via

So what are the alternatives? One alternative used by some blockchains is Proof of Stake. While Proof of Work depends on computing power, Proof of Stake depends on the amount of the currency owned. In most Proof of Stake systems, a block validator “pledges” or “deposits” a certain amount of coins. That amount influences the likelihood of that validator processing the next “winning” block. While the reality is somewhat more complex than that, the premise is simple enough: to have a say in the development of the chain, you need to have a stake in the currency.

Proof of Stake has similar vulnerabilities to Proof of Work. But the likelihoods are lower, and the consequences very different. It is theoretically possible for an attacker to accumulate 51% of a cryptocurrency’s supply, especially in the younger, lower value currencies. In the case of Bitcoin, however, that would cost almost $5 billion at today’s price. And that’s assuming that the price holds still, which it obviously wouldn’t if someone started buying that many bitcoins. The real cost would be much, much higher. The bounty would have to be pretty spectacular to warrant that type of investment. Comparing this security with Proof of Work, it’s unlikely that accumulating 51% of Bitcoin’s computing power would cost anything like that. In this aspect, Proof of Stake would ensure greater security than Proof of Work.

Another shared vulnerability is that of centralization. As I mentioned before, Proof of Work tends to centralize through access to the “work” resources, specifically electricity (cheaper in some parts of the world than others) and computing hardware (more accessible in some parts of the world than others). Proof of Stake would centralize by making it easier for those with a higher stake to generate new coins through block validation. The higher your stake, or deposit, the easier the problem that needs to be solved. So the new coins tend to go to those who already have a high stake. But, those who hold a large amount of the currency are more likely to act in the currency’s interest, than those whose stake is high-powered computing equipment. Again, in this aspect, through the power of incentives (or disincentives), Proof of Stake would ensure greater security than Proof of Work.

And, it’s cheaper. Proof of Work implies a lot of computing power churning calculations and consuming electricity. Proof of Stake also uses resources, but fewer.

And, it’s more “democratic”. To mine bitcoins with Proof of Work, you need to invest in the equipment that can do the work. And you need to know how to operate and maintain it (or hire someone who does). It requires a significant initial outlay. With Proof of Stake, you need to buy the currency. That’s accessible to everyone. True, you need to have the funds and the tech knowledge to open a wallet, but it’s definitely easier.

Although it may sound like it, I’m not saying that Proof of Stake is better than Proof of Work. Conceptually, it has advantages. But practically, it hasn’t been tested at large scale. Technically, it is vulnerable to certain attacks (convoluted and rare, but a vulnerability is a vulnerability). And theoretically, on its own it isn’t ideal for consensus. Consensus is about everyone rapidly reaching a conclusion as to what is the “correct” chain. What’s to stop stakeholders from “betting” on multiple chains and thus reaching a stalemate? In its purest form, Proof of Stake is unlikely to work. The currencies that use it (Peercoin, BitShares, NXT, and Novacoin are a few) have each come up with ways to solve that problem, many of them using a combination of Proof of Work and Proof of Stake. Ethereum, the crypto-currency with the second-largest market capitalization, is planning to switch from Proof of Work to a Proof of Stake hybrid next year.

What does all this have to do with the halving?

First of all, what is the halving (sometimes called “the halvening”)? It’s when the amount of bitcoins that the block validators (the “miners”) get as a reward for processing transaction blocks is reduced by half. The bitcoin protocol has the reward falling by 50% every 210,000 blocks, to control the supply of bitcoins and permit a gradual tapering off of new coins as the limit of 21 million is approached (we have a way to go yet, that’s not expected until 2140). The last halving was in November 2012, when the reward fell from 50 bitcoins to 25. The next one is expected in mid-July of this year.

And here’s the thing: in theory, the halving increases Proof of Work’s vulnerability. But not Proof of Stake’s. Or at least, by not nearly as much.

Why would Proof of Work be more vulnerable after the halving? Because if everything else remains the same, it will lead to increased centralization. With increased centralization, miners would find it easier to collude to distort the system and to control block creation. Why would that lead to increased centralization? Because with the act of validating the blocks suddenly so much less profitable, it is possible or even probable that many participants would drop out. If the marginal ones drop out, that concentrates power in the larger miners and in the mining pools.

However, that theory does not take into account price movements. A doubling of the price would offset the reduction in the number of bitcoins received as a reward. And the price of bitcoin has gone up considerably since the beginning of the year – up 60% at time of writing. Is that enough to keep validation profitable for the marginal miners?

That’s hard to say, and harder to maintain. Bitcoin’s price is relatively volatile. It went up sharply and quickly (90% of the increase has been over the past month!). It could fall sharply and quickly. It’s an unreliable metric to base predictions of mining profitability on.

With Proof of Stake as a consensus method, this would not be as much of a problem. Proof of Stake requires less computation power, and as such, lower hardware costs and lower electricity costs. With lower costs, a lower reward is not as punitive. Centralization is always a risk with Proof of Stake, as we saw above. But in this case it would not be because of a contraction in production.

Obviously, bitcoin is not going to switch to Proof of Stake or any of its derivatives any time soon. Proof of Work is so deeply ingrained in its protocol and its culture that a switch would be turbulent, to say the least (and the Core developers do not seem eager to embrace radical change of any sort). But the comparison of the two systems and the increasingly obvious flaws in the decentralization assumptions of the bitcoin design highlight that we are all of us still learning as we go along. Bitcoin and other alternative currencies are still an experiment. In the case of bitcoin, one that’s shown impressive reach, resistance, activity, support and real-world potential. But nevertheless, an experiment. And in the grander scheme of things, when it comes to attempts to profoundly change the way society works, seven years is not a very long time. It’ll be interesting to see what happens next.

(This post was originally published on LinkedIn. Sometimes I publish there first, sometimes here. Experimenting.)