#5 Proof of Work, big investors, censorship and Don Quixote
Proof of work is a technological feature of Bitcoin that helps explain many of the features that make crypto unique (including the infamous energy consumption).
Proof of work
Proof of work is the consensus mechanism that happens during the mining process, and that guarantees that the Bitcoin blockchain is really decentralized, p2p, and secure. If you understood this sentence clearly...congratulations, you are way past Bitcoin 101 and can move on to the next sections.
But with this next piece, we want to help the rest of the people know their way around the Bitcoin protocol. Indeed, you don't need to be a watchmaker to read the time, but if you're trusting some of your money and your future to crypto, you're better off knowing about the nuts and bolts of blockchain.
To understand the initial sentence, we need to climb a ladder of concepts: some blockchain basics and an approach to what miners are and what they do, and then a closer look at the block validation process, which is where Proof of Work happens.
Blockchain first! What Satoshi Nakamoto proposed in 2009 was a solution to several long-standing conundrums that had prevented decentralized digital money from happening. All attempts to exchange value over the internet required a central authority -banks, governments...- supervising the process.
Nakamoto solved the problem of digital scarcity and double-spending. Any asset shared digitally creates two copies. For example, think of a pdf sent through email. The receiver gets a copy of the pdf, while the original still exists in the sender's drive. This creates double-spending.
We call double-spending the possibility of spending twice the same money. This is impossible with physical money (you cannot hand out a coin and also keep it). In the case of digital money, it´s the responsibility of banks and payment processors to make money disappear from the sender's account.
In other words, Bitcoin is the first system where a digital file can be transferred without generating copies.
Avoiding double-spending and creating digital scarcity without intermediaries is the single, most revolutionary contribution of blockchain technology to the world. This is achieved through true decentralization. The Bitcoin blockchain is the result of a complex puzzle of technologies and solutions working together to create trust between people who don't know each other.
At its core, a blockchain is nothing more than a database—an uber-Excel spreadsheet where the information of all transactions is recorded. But instead of there being a central authority, a bank, writing down that sheet and keeping a copy safe, it is a community of miners who is in charge of management. Miners are special actors in the system: they are people running the Bitcoin protocol in their computers and keeping a copy of the validated database. Anyone can become a miner if they have the will and the hardware to do it; some stats say there are around 1M people worldwide mining bitcoin. One million copies of the transaction list. Imagine trying to hack that.
Now it's time to see Proof of Work in action. Every time two people make a transaction in bitcoin, this is the process:
Let´s say Abe and Betty want to exchange BTC. Their transaction enters the mempool (comes from Memory pool), a waiting room of sorts where transactions wait to be validated and approved.
Every miner then accesses the mempool, makes a bundle out of many transactions, and proposes this bundle to the community. That block, aka "candidate block," is each miner’s proposal of what the next block in the chain should look like. At this point in the process, hundreds of thousands of candidate blocks could be validated. But, just like in Highlander, "there can only be one."
And here’s when proof of work kicks in.
Bitcoin needed a process to pick one block out from all the possible candidates -to find “the chosen one.” To make validation automatic but also fair, Satoshi Nakamoto decided two things: one, miners who got their candidate block picked would be rewarded in bitcoin to incentivize them to participate; two, to get their block picked, they should prove their interest by putting effort into the process. Miners’ computers have to solve a complex mathematic puzzle that requires consuming computer power and energy.
In other words: when miners bring forth their candidate blocks, a race starts between them, where the first one to solve a super-sudoku and show it to the rest wins. Their block then becomes the chosen one. Finally, it is appended to the official blockchain. The resulting database is then spread across all computers that participate in mining, thus setting it in stone forever and ever, amen. And… the process starts again.
Satoshi Nakamoto's genius was designing a structure where a huge network of anonymous miners are incentivized to work cooperatively, validating and adding new blocks to the blockchain. And a huge community of miners cooperating is the defensive moat against hacking. Proof of Work is the automatic process where miners agree on what transactions are valid, add them to the database, and update the database copies on their computers.
Proof of work is the consensus mechanism that happens during the mining process, and that guarantees that the Bitcoin blockchain is really decentralized, p2p and secure.
Does the sentence make more sense now?
Proof of Work is the heart that pumps transactions into the Bitcoin protocol. And, as hearts do, it consumes great amounts of energy. Proof of Work requires participants to invest energy (and the money and time tied to it) if they want to participate in Bitcoin as miners. And, as we have seen, energy consumption is one of the most relevant reputational issues in the space. It has caused Elon Musk to back up from his initial pledge of allegiance, it might be behind China’s current hard position on Bitcoin, and it is frequently mentioned in press conferences by relevant political figures as a problem that, as long as it remains unresolved, will be an obstacle for governments to have a more welcoming position towards crypto.
Remember, you can always send questions and comments to us at team@carbono.com, @carbono_com, @raulmarcosl, or @mrubio on Twitter.
⬡ Six Angles
We select six topics to illustrate the very different angles crypto can be approached from. We could choose dozens, but six is the atomic number of carbon… and otherwise we'd be writing for ages.
1. Corporate Treasury | Microstrategy
MicroStrategy is a company that provides “powerful software solutions and expert services that empower every individual with actionable intelligence. “ It offers data analytics superpowers to corporate clients who want to improve their business results or their productivity. And somehow, they have become a household name in crypto.
It all started in August 2020, when Microstrategy adopted bitcoin as their primary treasury reserve asset and purchased $250M worth of BTC to prove their point. By December 2020, the CEO Michael Saylor had converted the initial bet into a more than $1B move. Those were beautiful times for bitcoin. Many hedge fund billionaires were starting to welcome the innovation (Paul Tudor Jones, Stanley Druckenmiller, Rick Rieder…). Saylor even played inception on Elon Musk.
As institutional investors lack options to invest in bitcoin, they started to buy Microstrategy to have exposure to it. And Saylor took the opportunity: Microstrategy has raised $2.2 billion in three different offerings ($650M in December 2020, $1.05B in February 2021, and $500M in June 2021). A few weeks ago, Microstrategy invested its last half-billion dollars, ramping up its bitcoin holdings to over $3.6B (105,085 bitcoins).
Without the long waited bitcoin ETF approval, Microstrategy stock has become a de facto ETF for people who want exposition to crypto. As a result, buying Microstrategy stock has become a synonym for buying bitcoin stock.
2. VC | Andreessen Horowitz, Blockchain Capital
Andreessen Horowitz, AKA a16z, is a Menlo Park-based venture capital firm operating since 2009. They are a synonym of Silicon Valley success. Just scroll through their portfolio and try to find a place where there is a name you do not recognize.
Fun fact: it is called a16z because there are 16 letters between the initial A and the final Z.
a16z recently announced its third crypto fund, a $2.2B investment fund for crypto ventures. Following their philosophy, they will be stage agnostic, and they will focus on what they identify as the five main business opportunities crypto offers:
Next-generation payments.
Modern store of value.
Decentralized finance.
New ways for creators to monetize.
Web 3.
Andreessen Horowitz’s crypto fund has become even bigger than their prior Bio Fund ($1.4B). It is an expression of their business optimism towards the space. And although their endorsement does not necessarily mean new money being poured directly into crypto and has therefore had no immediate impact on prices, it is certainly a long-term bet on the future of crypto, which will help companies and the sector reach the next level.
3. Blockchain | Apple Daily
Blockchain as a technology has generated almost as much hype as its killer app, Bitcoin. Ever since Satoshi Nakamoto put it to use for financial purposes, there hasn’t been a day someone has not come up with an unusual application for blockchain’s value proposition.
Blockchains bring decentralization, trustless governance, tamper-proof records… But, so far, only financial applications have managed to make a dent in society. Art, collectibles or gaming are trying to follow suit (most of them on the wings of NFTs) but always closely related to payments.
But resistance to censorship is also a key feature. And we have recently seen an example of that. Following Chinese orders, Hong Kong’s tabloid Apple Daily was shut down after 26 years in business because of its critical position towards Mainland China’s policies. In yet another show of rebellion, some Hong Kongese activists have made sure the contents of the tabloid remain uncensorable by uploading them to Arweave, a blockchain-based technology that breaks contents into pieces and sends them across a distributed network of computers. Arweave calls itself a "collectively owned hard drive that never forgets." The right tool to escape censors. Mainland China can block those files in Hong Kong and create laws against distributing or reading them, but they can’t delete them: they are present in thousands of computers.
4 Technology | “I accidentally killed it”
“Power to the people” is a great slogan. But there’s also “with great power comes great responsibility,” the Peter Parker Principle.
In 2017, an anonymous developer, little old devops199, was playing around with code, trying to learn about how Ethereum works when he accidentally made $300M vanish (513,774 ETH, valued at $1.1 billion now).
Someone asked devops199 after the incident: Why did you do it? His response? “I am just a beginner poking around the system!”
Devops199 and his childish curiosity accidentally encountered a loophole in the code of a smart contract developed by Parity, a blockchain infrastructure company that builds solutions for users and corporations. The loophole, bug, or however you want to call it, allowed devops199 to claim ownership and kill a piece of software that was the one and only access gate to wallets with $300M worth of crypto.
Can’t we just rewind and recover the money? We’ll just have to quote two blockchain principles: “code is law” and “there is no turning back.” The inability to undo your mistakes is a feature of the system. It is the safety measure that guarantees evildoers cannot mess with it. And if the code is faulty…too bad. It will have to be solved for future generations, but the damage is already done.
One more power quote: if, like Plato said, “the measure of a man is what he does with power,” devops199 is the size of a cat. A cat walking calmly on a shelf throwing Fabergé eggs to the floor with his tail.
5 Regulation | UK blocks Binance
Binance, the world’s largest cryptocurrency exchange, gets banned by UK regulator, read the headline from CNBC’s website. Binance is indeed the world’s leading cryptocurrency exchange in traded volume as per April 2021 data. And the British financial regulator, the Financial Conduct Activity, had indeed issued a “consumer warning" note (there Brits, always so polite) about Binance. The FCA requested Binance to publish this warning visibly on their website.
BINANCE MARKETS LIMITED IS NOT PERMITTED TO UNDERTAKE ANY REGULATED ACTIVITY IN THE U.K. Due to the imposition of requirements by the FCA, Binance Markets Limited is not currently permitted to undertake any regulated activities without the prior written consent of the FCA. (No other entity in the Binance Group holds any form of U.K. authorisation, registration or license to conduct regulated activity in the U.K.).
Once you start reading the fine print, you realize the ban has minimal effect. It affects Binance Markets Limited, a Binance subsidiary based in the UK, but without actual business activity. Plus, the ban refers to “regulated activity,” “ which does not apply to regular exchange activities (for example, derivatives).
Like Binance tweeted…
Nevertheless, even though the ban has no direct impact on Binance’s activity, the PR damage is done by headlines overlooking the nuances. This is, and rightfully so, another brick in the wall of regulation against crypto assets. Moreover, it rides the wave of China’s efforts to push back crypto and some other advances that prove a more confrontational stance from regulators.
Some in the bitcoin space consider this proof of good shape. Don Quixote said, “they bark, then we ride.”
6 The chart | Bitcoin User Growth
It’s impossible to know exactly how many users Bitcoin has, but analytic platforms like Glassnode offer great estimations, clustering addresses that interact together.
What does this chart say? It shows how after 2019 BTC’s all-time high, Bitcoin blockchain virtually stopped adding new users and didn’t recover until late 2020.
It also shows how, during the recent drop from $64k to $35k, the behavior was different: after a few days of fear, with a drop in the number of new users, the chart went back to showing a positive trend.
We don’t like to offer predictions publicly, but let’s say in Carbono, we are not selling. 😉
If there is any topic you want us to adress, write us at team@carbono.com, or reach out to @carbono_com, @raulmarcosl or @mrubio on Twitter.