‘Proof of work’

BY: Bernard Otabil

IN January 2019, a high level research paper authored by Raphael Auer was released by the Bank for International Settlements (BIS) as part of the regular BIS Working Papers. 

The title of this particular document was “Beyond the doomsday economics of ‘proof-of-work’ in cryptocurrencies”, and focused on “how Bitcoin and related cryptocurrencies verify that payments are final, i.e. irreversible once written into the blockchain.”

The author further explained that the paper points to the high costs of achieving such finality via “proof-of-work”. “It then weighs the outlook for cryptocurrencies based on this kind of algorithm, and looks at possible future avenues for progress”.

In broad terms, a working paper is normally a preliminary scientific or technical paper, which is released to share ideas about a topic and to solicit for feedback to enrich the final output. In the referenced paper above, it was made up of 31 pages and sought to show the two economic limitations affecting cryptocurrencies modelled on “proof-of work”.

The paper shows that two economic limitations affect the outlook of cryptocurrencies modelled on proof-of-work. “The first lies in the extreme costs of ensuring payment finality in a reasonable space of time.

The second is that these systems will not be able to generate transaction fees that are adequate to guarantee payment security in future.

The paper shows that the future of Bitcoin and related cryptocurrencies is crucially affected by the interplay of these two limitations”, the author wrote.
And, interestingly, a key finding of the paper was that “after surveying the market for transactions and the way fees are determined, the paper finds that the liquidity of cryptocurrencies is set to shrink”.

Well, from the get-go, let me point out that I have adapted “Proof- of- work” to describe another dimension of the dynamics within the cryptoassets ecosystem and not the concept so adapted to securing digital money by Hal Finney in 2004 through the idea of “reusable proof of work, which formed the basis of the research paper.

The “proof-of-work” that is currently exhibited in the crypto ecosystem with the collapse of Celsius, one of the world’s largest cryptocurrency lenders, as reported on July 14 by the financial press, is worrying indeed.

The high-profile nature of Celsius’ collapse undoubtedly caused a sharp fall in the price of other crypto-assets. Bitcoin, for example, dropped below its benchmark level of US$20000. In fact, even though Bitcoin recovered some of the lost ground, it was still a far cry from the trading price experienced just some few months back. But was the Celsius collapse a major surprise?

To my mind, it shouldn’t be a big surprise to market watchers. In fact, in the June 18 edition of this column, l stressed on how a volatile day for crypto market on June 13 saw a drop in bitcoin to a 17-month low, to US$23,629, after the announcement by Celsius Network that it had halted withdrawals because of “extreme market conditions”.

At the time, the Binance exchange temporarily suspended bitcoin withdrawals and the total value of the digital asset market dipped below $1tn (£820bn). The decision by Celsius meant that all withdrawals and transfers between accounts for its 1.7 million customers were stopped!

Celsius explained as follows: “Due to extreme market conditions, today we are announcing that Celsius is pausing all withdrawals, swap, and transfers between accounts,…. “We are taking this action today to put Celsius in a better position to honour, over time, its withdrawal obligations.”

That expected better position should be forgotten, at least in the short term because the company has taken a bad turn again. “The embattled company built one of the leading crypto lending platforms by assuring prospective customers it was less risky than a bank. But that reputation was smashed to pieces yesterday with the crisis dubbed in the crypto community as a ‘Lehman Brothers moment’ for the sector as the company’s financial troubles set off a domino effect that saw other major crypto firms felled”, thisismoney.co.uk reported on July 14.

According to Celsius, the bankruptcy process was “the best opportunity to stabilise the business” and allow it to undertake restructuring.

I have followed this story with keen interest because of the cloud of uncertainty over cryptoasset pricing and high volatility. We all want to rely on the “proof-of-work”, and this time the “trusted” Celsius could not do enough to cool market temperature.

As l have always maintained in this column, current developments in the crypto market point to a bumpy road ahead for investors. So why are crypto assets allowed to enjoy strong patronage despite the high market volatility? As a store of value, crypto assets seem to be short-changing many due to its high volatility.

Take the case of Terra. Just a few weeks ago, Terra’s algorithmic stablecoin UST was de-pegged from the US dollar. And according to analysts, at the time, Terra’s native token LUNA and UST were the ninth and 10th largest cryptocurrencies by market capitalisation — together valued at $42 billion. But both tokens have since evaporated- worthless. With it has come low market confidence in issuers of crypto assets.

Now we have the proof about crypto assets, and as the Bank of England’s deputy governor for financial stability, Jon Cunliffe, said in October 2021, cryptocurrencies could spark a global financial crisis unless tough regulations were introduced.

At the time, Cunliffe’s concerns were about the rate of growth of the crypto-asset market, which had moved from a $16 billion valuation five years earlier to $2.3 trillion in October 2021. “When something in the financial system is growing very fast, and growing in largely unregulated space, financial stability authorities have to sit up and take notice,” he said.

In effect, there is no further argument anywhere that proves that crypto-assets are stable to a large degree. No. Liquidity is the biggest problem with the crypto market, so if you refuse to heed the market signals, you will get into trouble with your investment.

In fact, disclosures made by Celsius in a filing submitted to a federal court in New York revealed listed assets of between £847 million and £8.5 billion but it only had £141million cash on hand. That is a challenge. The lesson is clear: Know the risk before you jump in with both feet!
This email address is being protected from spambots. You need JavaScript enabled to view it.