What is the underlying cost of saying goodbye to cash?

Daniela Zamora Uribe, Carl van Roon, Liselotte van Unen

November 2018

Cryptocurrency and Blockchains in a nutshell

Cryptocurrency is based on cryptography: a widely used practice in computer science whose purpose is to protect data that is transmitted across insecure networks (such as Internet), allowing only authorized people to read it and share it with each other. Following this idea, Cryptocurrency was designed as a digital asset that can be transferred in a safe fashion, involving two main sets of actors: public ledgers and a network of computers. The combination of these two is called a Blockchain. This name explains the fact that all new transactions are bundled into “blocks” (uniquely identified), which are added at the end of a “chain” of existing blocks that have stored all prior transactions. Since both the ledger and the network of computers are decentralized, the Blockchain does not rely on a central point of authority and storage, hence, all nodes belonging to the Blockchain own a full copy of transactions. In other words, whenever a transaction is made, the verification and recording of the transaction is

immediate and permanently stored on each node of the Blockchain, creating a system that is neither incorruptible nor manipulable. This structure enables the network to perform transactions without the involvement of a third party, such as a bank. Furthermore, a change in the ledger must be independently approved by all computers in the network, and in case a computer is acting out of the ordinary (e.g. is hacked), the other computers will cancel the transaction immediately.

Although there are several implementations of Blockchain technology, this column focuses on cryptocurrency, namely, bitcoins.

Bitcoin: the first Blockchain protocol.

The most renowned and successful implementation of cryptocurrency around the world is called “Bitcoin”, which was introduced in 2008 and became the first Blockchain protocol. At this point in time, the main actors of Financial Technology (FinTech) sector, including major financial institutions, insurance companies and start-ups, identified enormous opportunities for improving the security and reliability of their transactions by implementing such protocols, reducing transactions latency and process friction between the parties.

A transaction, which is a transference of value between Bitcoin wallets, is performed approximately every ten minutes, in which a new block is added to the blockchain. As previously mentioned, every block must be approved by all computers in the network, which are also called miners. This process can be established by multiple consensus rules. Precisely, Bitcoin works with a consensus algorithm that is called “proof-of-work”. In this algorithm, the next block that will be added to the blockchain is the block made by the first miner that produces a valid one, which is only generated after solving a complex mathematical challenge that is proposed to the network. All the miners competes against each other by trying to find this solution in order to create a valid block for all the transactions for which no block has been added yet. Once such a ‘solution block’ is found, the miner that solved it informs the other miners that belong to the network, and now all of them accept this block and discard the block they have been working on. Afterwards, the accepted block is added to the corresponding Blockchain, and the miner which found the ‘solution block’ receives a reward in bitcoins.

Can we replace cash with Bitcoins?

The most remarkable feature of cash that can be easily beaten by bitcoins is what is called ‘materiality’. Physical cash is vulnerable to theft, loss, fire or rain, and in more severe cases, counterfeiting and money laundering. By using digital assets, all these problems are solved instantaneously, as there are no tangible resources to exchange when performing online transactions. In fact, nowadays over 100,000 merchants worldwide, such as Microsoft, Expedia and Newegg, already accept bitcoins as a means of payment, and novel systems like crypto-credit cards are capturing the attention of many bitcoin users. Indeed, BitPay is one of the most popular suppliers of these new products, which have been used by international companies like Virgin and Neteller.

These cards let people make withdrawals with VISA compatible ATMs or spend money in any authorized VISA merchant. Additionally, customers can also send and receive bitcoin payments from 240 countries around the world in just a few minutes, defeating traditional transaction banking in terms of speed. For instance, whenever money is transferred in the weekend through banks, recipients usually need to wait until the following Monday to receive their money, and if a person makes a transaction and wants to modify it, the process can be exclusively done by requesting a change in the ledger of the bank. Likewise, other transactions such as cross-border payments, usually take several working days to be processed, whereas with these cards, bitcoins can be exchanged from any mobile device or computer in a fraction of that time.

Another interesting advantage of exchanging bitcoins instead of cash, is the Bitcoin’s privacy model supported by its Blockchain technology. The participation of a third-party in a transaction always supposes a certain risk of information disclosure, even though this information is stored in secured databases. One of the most recent cases regarding data leakage involved the firm Equifax, which in September of 2017 announced a cyber-security breach which affected approximately 143 million people in the United States. By employing the Bitcoin’s decentralized network, such situations could be mitigated as the anonymity of all the parties is ensured by the encryption of their identities. Moreover, since there is no central core to attack directly, it is way harder for a hacker to manipulate information.

Finally, the reduction of commissions fees is also becoming a promising benefit of bitcoin’s transactions. For instance, Bitcoin debit cards offered by companies such as Revolut and BitPay have no transference fees, and for crypto-credit cards, only a fiat 1% settlement charge is needed. On contrast, sending money overseas through banks is way more expensive since there are many more costs involved. Namely: the cost per transfer, extra costs for an urgent transfer, supplementary fees if the transfer needs to be changed, and additional costs if the transfer should be cancelled.

Having this said, cryptocurrencies, such as bitcoins, seem to outperform many traditional banking processes. However, nothing is foolproof. The increment in the number of miners around the world has generated one major global obstacle that affects everyone: the environmental costs.

How expensive is to generate Bitcoins?

By design, the cryptocurrency mining process needs to be complex, as it must ensure that blocks and bitcoins are only created at a certain rate and time. This means that every time a miner joins the network, the system must guarantee that the complexity of the problem to be solved is higher than before, so that the network keeps generating bitcoins every ten minutes or more. Having said this, finding a ‘solution block’ becomes a process of trial and error, in which numerous attempts are made every second. Therefore, a lot of computers with large computational power are employed, along with massive cooling systems to prevent them from crashing and an always-on internet connection. This fact makes the process of mining very energy-consuming. For instance, in Venezuela, where “the bolivar” has lost 99.9% of its value since 2016 due to the hyperinflation, bitcoins have become an appealing alternative for many people. Nevertheless, early in 2017, Venezuelan authorities decided to interrupt a mining operation in which approximately 11.000 computers were involved, given that the whole process was consuming the same amount of energy an entire city uses in times of short supply.

To put this in a more general perspective, in 2017 the average consumption of one transaction in the Bitcoin network, was similar to the energy consumption of around 400,000 VISA transactions, and looking at the whole network, in November of 2017, the power consumption of the network of Bitcoin was estimated to be equivalent to Ireland’s energy consumption.[1] In fact, by 2020, the estimated rate of energy consumption for Bitcoin’s proof-of-work algorithm will become equal to Denmark’s.

With the current environmental problems already present in the world, this energy consumption weighs heavily on the negative side of bitcoins. Unless the energy consumption is either drastically lowered or changed to renewable energy, the Venezuelan example might follow in other countries as well, which could result in less participants using cryptocurrencies, and consequently, the eventual disappearance of some of them.

Envisioning the future

The cryptocurrency community has been aware of these environmental issues for the past few years, and although envisioning a theoretical solution is doable, implement it from scratch is a different story. Nonetheless, the tech giant company Intel has been leading this process by trying to design new consensus protocols. One of them, invented in 2016, is called “Proof of elapsed time”, in which each miner waits for a randomly chosen time period by going to “sleep”, and then, the lucky miner with the shortest waiting time “wakes up” and is enabled to create the new block, receiving the rewards. This protocol ensures that miner’s processors do not work constantly, reducing the power consumption.

Another renowned protocol is named “Proof of stake”, in which the chance of adding new blocks or validating transactions depends on the number of bitcoins each miner has. Therefore, the more bitcoins he has, the higher his mining power. This protocol seems to reduce energy consumption by limiting the percentage of transactions based on the miner’s wealth. Thus, a miner who owns 10% of all available bitcoins can mine only 10% of the blocks.

Other approaches consider the usage of renewable energies, in which the company HydroMiner is the pioneer. Currently, they only use hydropower to operate its hardware, spending 85% less energy than the average energy consumption in Europe. Likewise, other entrepreneurs in California, US, are developing solar facilities to power bitcoin mining, which promise to be successful.

On the one hand, Bitcoin miners support their operations, stating that changing the structure of this technology is extremely difficult since its algorithm and design is what allows it to have all the advantages already mentioned. In addition, other bitcoin users consider that the environmental impact generated by the mining process is comparable to the extraction of natural resources. Nevertheless, several climate scientists over the world have found that a massive mining process has enough power to increase the global temperature by two degrees celsius, debunking this statement. Therefore, although there already exist solutions that attempt to alleviate computational burden, a completely migration from cash to digital currencies seem to be a challenge we are not prepared to overcome yet.

Even if the idea of paying your cup of coffee using bitcoins is appealing, there is an underlying question that remains: What is the real price that you, and all of us, are paying for it?


Footnotes

[1] The amount of energy consumed by the Bitcoin network is an estimation, since there is no central register with all active machines and their performances.

References


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