Decrypting the concepts of blockchains and cryptocurrencies

I'm fascinated by cryptocurrencies. But I've yet to be convinced that they offer major advantage to regular currencies.

Sue Halpern's essay Bitcoin Mania New York Review of Books 12/21/2017 is informative. But it also serves to reinforce my suspicion that cryptocurrencies at the moment are some combination of a high-risk speculative bubble, a techie fad, a swindle and a libertarian daydream that takes way too much energy and is based of thin-ice economic assumptions.

Halperin flags the problem with the renowned unhackability (to date) of Bitcoin, the best known of the crytocurrencies at the moment. Digital currencies like Bitcoin and Ether - there's not even a consensus yet on whether the names should be capitalized or not - run on a distributed-ledger network arrangement called a blockchain. Large blockchains are not easy to hack. Yet.

But to buy and use the digital currencies, people need other applications like exhanges and wallets. Thus the problem as Halperin describes:

While a blockchain is not a full-on solution to fraud or hacking, its decentralized infrastructure ensures that there are no “honeypots” of data available for criminals to exploit. Still, touting a bitcoin-derived technology as the answer to cybercrime may seem a stretch in light of the high-profile — and lucrative — thefts of cryptocurrency over the past few years. [David] Gerard notes that “as of March 2015, a full third of all Bitcoin exchanges” — where people stored their bitcoin — “up to then had been hacked, and nearly half had closed.” There was, most famously, the 2014 pilferage of Mt. Gox, a Japanese-based digital coin exchange, in which 850,000 bitcoins worth $460,000,000 disappeared. Two years later another exchange, Bitfinex, was hacked and around $60 million in bitcoin was taken; the company’s solution was to spread the loss to all its customers, including those whose accounts had not been drained. Then there was the theft via malware of $40 million by a man in Pennsylvania earlier this year. He confessed, but the other thieves slipped away, leaving victims with no way to retrieve their funds.

Unlike money kept in a bank, cryptocurrencies are uninsured and unregulated. That is one of the consequences of a monetary system that exists — intentionally — beyond government control or oversight. It may be small consolation to those who were affected by these thefts that neither the bitcoin network nor the Ethereum network itself has been breached, which perhaps proves the immunity of the blockchain to hacking. (In 2016, there was a $60 million hack of a company running on the Ethereum system, but the theft occurred because there was a bug in that company’s software.) [my emphasis]

For normal household or business purposes, this is like using a bank with no deposit insurance, or trusting your 401(k) savings build up over 30 years to a penny-stock operator.

She also gives some illustration of the energy issue with cryptocurrencies. With Bitcoin, new instances of the cryptocurrency are created by "miners." The blockchain process makes this a validation process that requires a staggering amount of electricity:

When the bitcoin network began operating in 2009, people could run the validation program on their personal computers and earn bitcoins if their computer solved the puzzle first. As demand for bitcoin increased, and more people were vying to find the random, algorithmic proof of work validation number, speed became essential. Mining began to require sophisticated graphics cards and, when those proved too slow, special, superfast computers built specifically to validate transactions and mine bitcoins. Individual miners have dropped out for the most part, and industrial operators have moved in. These days, mining is so computer-intensive that it takes place in huge processing centers in countries with low energy costs, like China and Iceland. One of these, in the town of Ordos, in Inner Mongolia, has a staff of fifty who oversee 25,000 computers in eight buildings that run day and night. A company called BitFury, which operates mining facilities in Iceland and the Republic of Georgia and also manufactures and sells specialized, industrial processing rigs, is estimated to have mined at least half a million bitcoins so far. At today’s price, that’s worth around $7.5 billion.

Still, it’s not exactly free money. Marco Streng, the cofounder of Genesis Mining, estimates that it costs his company around $400 in electricity alone to mine each bitcoin. That’s because bitcoin mining is not only computationally intensive, it is energy-intensive. By one estimate, the power consumption of bitcoin mining now exceeds that of Ireland and is growing so exponentially that it will surpass that of the entire United States by July 2019. A year ago, the CEO of BitFury, Valery Vavilov, reckoned that energy accounted for between 90 and 95 percent of his company’s bitcoin-mining costs. According to David Gerard—whose new book, Attack of the Fifty Foot Blockchain, is a sober riposte to all the upbeat forecasts about cryptocurrency like the Tapscotts’—“By the end of 2016,” a single mining facility in China was using “over half the estimated power used by all of Google’s data centres worldwide at the time.” [my emphasis in bold]

One of the advantages of cryptocurrencies was supposed to be that they could avoid or minimized transactions fees. But the transaction fees involved in using them can be significant. With Bitcoins, the validation process for mining and using them also makes them significantly slower in terms of the number of transactions that can be processed in a given length of time than what "legacy" financial companies can do. Halperin writes, "transactions can be held up for hours or days or dropped altogether."

So, we've got a type of currency that's slow, expensive to use, very volatile in value, insecure, un-insurable, and not backed by a government. Remind me again just why I would want to use this.

Even for shady businesses like drugs, illegal arms deals, or money-laundering, these strike me as big drawbacks. Oh yeah, those have the added legal risks as well.

One of the nice things about articles like Halperin's at this moment in time is that they include helpful definitions of what techie things like a blockchain are:

A blockchain is, essentially, a way of moving information between parties over the Internet and storing that information and its transaction history on a disparate network of computers. Bitcoin, for example, operates on a blockchain: as transactions are aggregated into blocks, each block is assigned a unique cryptographic signature called a “hash.” Once the validating cryptographic puzzle for the latest block has been solved by a mining computer, three things happen: the result is timestamped, the new block is linked irrevocably to the blocks before and after it by its unique hash, and the block and its hash are posted to all the other computers that were attempting to solve the puzzle. This decentralized network of computers is the repository of the immutable ledger of bitcoin transactions.

Blockchains are apparently far more useful for the secure storage of data. Halperin suggests that the use of blockchains for "smart contracts" is a potential valuable usage.

But the power demands alone would seem to be a major issue for any system that requires the kind of continuous fast transactions that a cryptocurrency does.

She also discusses ICO, i.e., "initial coin offerings."