As cryptocurrencies continue to gain demand, asset owners are slowly weighing their best approaches to build exposure to them. For many, this requires a mixture of assessing their inherent volatility, plus their sizeable environmental impact.
However, some institutional investors are focusing more on the innovation and investment potential of cryptocurrencies, even if the assets are not environmentally friendly.
THE ENERGY COST OF CRYPTO MINING
The heavy energy consumption associated with the cryptocurrency Bitcoin comes from mining, a process used to create new Bitcoin and maintain the security of the cryptocurrency’s network. Altogether, 75% of Bitcoin mining has been traced to China, which primarily uses coal to generate its electricity.
Bitcoin transactions are essentially created through a network of participants around the world, who add transactions in the form of “blocks” on a blockchain by solving complex cryptographic problems. These participants, known as miners, compete to solve these problems to complete the transactions, for which they are rewarded with transaction fees and Bitcoin of their own.
The complex cryptographic problems requires a great deal of computational power to solve. Bitcoin’s protocol, known as “proof-of-work”, is designed in such a way that miners must prove they have invested a certain amount of computational power to solve these problems, Johannes Sedlmeir, who researches applications of blockchain technology at the University of Bayreuth in Germany, told AsianInvestor.
“Computational power basically corresponds to energy. So, if I compute a lot, I need a lot of energy. And so, this proof of work mechanism is basically energy intensive by design,” he said.
In addition, the Bitcoin algorithm was designed so a new “block” on the block chain can only be created every 10 minutes on average.
This means that as miners put in more effort to compete to create blocks, the more complex the cryptographic problems become, which require higher amounts of energy to solve.
That means that as Bitcoin rises in popularity, driving up its price and transactions fees, miners will try harder to compete to create blocks.
That will lead to a higher amount of energy being used to both maintain and grow the cryptocurrency.
PROOF OF WORK VS PROOF OF STAKE
Bitcoin, and all other cryptocurrencies, are underpinned by blockchain.
This is a distributed ledger technology that updates all parties involved in a transaction at the same time. Not all blockchains use Bitcoin’s energy-intensive “proof-of-work” protocol.
Ethereum, the second-largest cryptocurrency by market capitalisation after Bitcoin, has said it is looking to change its network from a “proof-of-work” to “proof-of-stake” protocol. It would make sense for Bitcoin to also do so, at least from a sustainability perspective, but that is unlikely to happen.
First, the cryptocurrency does not have a leader to make decisions over its functions. Instead, its supporting network consists of thousands of miners (or millions, as it is unknown how many miners there are). Most of them would have to agree to change the Bitcoin protocol.
“It’s like a democracy. Everybody has a say on what’s going on,” said Ipek Ozkardeskaya, senior analyst at online trading platform Swissquote. “And there’s also one more problem with the proof-of-stake is for a purist, the proof-of-stake means that those who have the biggest stake have got more power and more say.”
While proof-of-work requires miners to prove their work, i.e., computing power, proof-of-stake gives more weight to miners with a larger stake i.e., higher percentage of coin ownership.
“Bitcoin purists don’t want it to happen this way, even though we know that mining leaches so much energy,” she said.
“There’s also some religious aspects behind this. [Some people] think that Satoshi Nakamoto’s protocol should not be changed that significantly,” Sedlmeir agreed, referring to the mythical founder of Bitcoin whose identity has never been verified for sure.
“There are also a lot of people who argue that proof-of-work is more secure,” he added. “But I don’t personally see that.
“There are a lot of researchers that have demonstrated that proof-of-stake can be secure. And so far, experience shows that proof-of-stake cryptocurrencies that are already there seem to work quite fine. Algorand, Cardano, Polkadot, Tezos, there are a lot of them.”
This article was first published in the summer 2021 edition of the AsianInvestor print magazine. Click here to read part 1 of this story.