money – Marcus Vorwaller

Disclaimer: I’m not a crypto expert. Please feel free to correct me in the comments.

Proof of work

Proof of work describes how new cryptocurrency coins are created, how cryptocurrency transactions are validated, and it determines how quickly new cryto coins are created. For this article, we’ll discuss proof of work in terms of bitcoin, however there are many other proof of work cryptocurrencies.

At a high level, to generate, or “discover”, new bitcoins, computers do puzzles that generate hashes. Hashes are long strings of characters, like this “81019284c2f9615e20a6825c…”. Once a computer running the bitcoin software has successfully generated a hash, called “mining”, the hash is checked to see if it happens to be a valid bitcoin. Sometimes it is, but most of the time it isn’t.

The work done to create the new hash also has the important side-effect of validating transactions on the blockchain. In addition to potentially generating a new block, miners are paid transaction fees to validate transactions. At some point all 21 million bitcoins will have been mined and no more will be created. At that point, transaction fees will be the sole incentive for miners to continue validating transactions.

To modulate the speed of coin creation, the difficulty of the work that’s necessary to mine a bitcoin block automatically gets adjusted to be more difficult when miners generate hashes faster. Conversely, the work is adjusted to be easier if the overall rate of coin creation decreases. For example, the difficulty decreased recently when China banned bitcoin mining and lots of mining computers went offline.

So when you generate a new bitcoin, you’re “proving” that you did the work to create it. This is what allows bitcoin to be decentralized–anyone can create one if they do the work, no one can create one without doing the work.

Some people consider the energy used to create new bitcoins to be wasteful. I won’t try to argue for that one way or another, but because of this, many other types of cryptocurrencies use other types of proofs to create new coins. The most popular alternative to proof of work is what Ethereum 2 uses, which is called proof of stake.

Proof of stake

Proof of stake also describes how some new crypto currency is created. The main benefit is that it uses significantly less energy.

For proof of stake to work, an initial quantity of the cryptocurrency has to be somehow distributed to a lot of people first. This process, which we’ll call bootstrapping, can happen in any number of ways. For example, the cryptocurrency can be given away or, in the case of Ethereum, it can be mined using proof of work for several years, then switched to proof of stake later.

In some proof of stake cryptocurrencies, no new coins are created in the future. Proof of stake is only used to validate transactions being added to the blockchain. I’ll explain how that works shortly.

Once the cryptocurrency has become proof of stake, if the currency does create new coin, they’re generated without the requirement to generate hashes by solving puzzles. The newly created coins are instead given to everyone who already holds some of the cryptocurrency as long as they’ve “staked” the currency.

To stake the currency, you have to lock it so it can’t be spent or transferred for a specified period of time. Then, when new coins created, anyone who has staked coins will automatically get more coins in an amount proportional to the amount they have staked.

For example: If Bob stakes 10 blogcoins, a fake proof of stake currency, and Maria stakes 20 blogcoins Bob will get 1 new blogcoin and Maria will get 2. In the end, neither is richer or poorer relative to each other than they were before. They just have a larger number of coins.

If neither Bob or Maria gain anything, why create new coins at all? It’s mostly to increase the total number of coins. If you want to sell 20 people a slice of a really big pizza that’s only sliced in 10 pieces, you’d need to cut each slice in half first to “create” 20 slices. You’re not generating more pizza out of thin air, you’re just making it possible to distribute the existing pizza to more people.¹

The other function of staking is, as mentioned above, to verify transactions. When you stake your blogcoins, you’re saying “I’m going to validate this block of transactions in exchange for a fee. If I falsely validate it, I understand that the blogcoins I’ve staked will be taken from me. If I validate it correctly, in addition to not losing my staked coins, I’ll get a small reward for doing the validation.” Staking is a way to incentivize good behavior.

Just like energy use is the downside of proof of work, proof of stake’s downside is that it’s less proven in the real world and, as such, potentially less secure. It also could be that it staking results in less liquidity since the incentives to keep your coins staked is very high.

So, that’s a high level summary of why proof of work and proof of stake are different. There’s much more to be said on the subject, but for now, I’ll leave it at that.

¹ Because of the way staked coins are distributed, it isn’t inflationary in the same way as a fiat currency like the US Dollar. When new dollars are created they’re not distributed proportionally to everyone who already has dollars. The recipients of the new dollars are the winners, and everyone else loses because the dollars they’ve saved decrease in value.

Money is much more complex than just being the currency that whatever country you live in issues. It comes in many forms and, with cryptocurrencies and other digital currencies, there are more choices today than ever. This is great, but it also means that there is more risk and a higher learning curve to figuring out your options.

It’s not something you should ignore. Money is the most pure representation of your time and work that exists. Think about that. If you value them, it’s worth thinking about what you use to store their value. Whatever it is, the most important consideration is if it will retain its value over time.

1. Story

The fitness of all money, above all, is based on a shared story. The strength of the story is the most fundamental factor in determining the health of any type of money. The reason everyone accepts US Dollars is that we all believe everyone else will do the same thing and we think there are good enough reasons for that to keep happening. If for any reason we stop believing that, US Dollars become nothing but paper or numbers on a computer screen.

Gold, silver and a few other forms of money have the advantage of having an intrinsic value outside of the story we tell about them. This makes them much less susceptible, but not completely immune, to the story behind their value being undermined. Precious metals have their own problems, but story is certainly their strong point.

2. Stewardship

In addition to story, the stewardship of money, meaning the person or organization that controls its supply, is important. In the case of US Dollars, the US Government and the Federal Reserve are the stewards. They decide when more money is created and to whom and under what terms that new money is distributed.

When a steward decides to create more money, no matter what the reason or how valid it is, it lowers the value of all existing money.

Mmm, cookies

A simple, but illustrative way to understand this is to imagine that there are 10 cookies for sale and 10 friends who’d like a cookie. Unfortunately, there are only 5 cookie coins available and each one is worth 2 cookies. In a stroke of inspiration, you decide to simply make 5 more cookie coins.

At that moment, two things have happened. The first is that each of the original cookie coins are now only worth 1 cookie. They lost value because while there are new coins, there are still the same number of cookies. The second is that there is now more flexibility in the system since there are enough coins for each person to have one. What’s important here though, is how the 5 new cookie coins are distributed.

If 5 friends started with the original 5 coins, and each gets one new cookie coin there’s very little change. They’re all just as rich (and not richer) with 2 cookie coins each than they were with just one. If, however the 5 new coins are given to the 5 friends who had none, they’re now richer while the 5 original cookie coin owners are poorer–before they could afford 2 cookies each, now they can only afford one. You might think “well that sounds equitable” and in a sense, it would be, but it is of course more complicated than that. Say the 5 original cookie coin owners earned their coins by working all morning in the hot sun while the 5 who had no coins sat around the pool telling jokes.

The point of the cookie coin story isn’t about what’s fair. The point is that when the steward of money meddles with the supply there are consequences for everyone in the system. Some will be winners, some will be losers.

The big risk is that if too many people are losers for too long, the all important story behind the money breaks down, and we’ve already discussed what can happen then.

3. Suitability

In addition to the story and stewards of money, we need to consider suitability. Suitability is the technical side of money. It’s:

how easily and cheaply it’s transferred from person to person and place to place within and across borders
how private it is
its ability to be used in interactions with the government, primarily meaning to pay taxes
its liquidity, or how easily and quickly it can be used to purchase the things people want to buy
it’s durability; how easily can it be physically or digitally lost or destroyed

All these are important considerations but be warned not to mistake suitability for being more important than story and stewardship. It doesn’t matter how amazingly perfect and awesome a potential money is if it can’t get popular support or it’s mismanaged.

Conclusion to part 1 and what’s up next

We’ve now seen what kind of considerations come into play when choosing where to store your time and energy. Next we’ll consider what our options for money are and how they compare to each other in light of the above criteria.