On the Equitability and Decentralization of Proof-Of-Work
There is a recurring narrative in the debate of Bitcoin vs Ethereum alleging that PoW is more equitable and decentralized than PoS, and that the latter emulates outdated designs intended to make the “rich get richer” and concentrate power.
These ideas are often promoted along with explanations of how PoW is an open system with a “working class” (miners) while PoS is instead unfair and ruled by aristocrats (stakers). While neither system is perfect, a careful dissection reveals how PoW is actually much more problematic, and how its promoted openness and equitability are just an illusion.
PoW will lead to centralization. It is inevitable and the centralization forces behind it will become self-evident with time. There has never been a more perfect set of market dynamics that will result in an endgame where only the strongest will survive.
PoW Market Dynamics In a Nutshell
There is only one customer in the Bitcoin mining market: the Bitcoin network.
There is only one product: hash power. It can be produced anywhere, by any means, and also delivered from anywhere in the world at no additional cost.
There are no geographical, language or other subjective forms of consumer preference. The Bitcoin network does not care where the suppliers are from, what language they speak, if they are polite or attractive, if they treat their employees well or use slave labor, or if they use clean energy or burns piles of garbage to power their machines.
The only driving force and the only thing that matters is cost cutting.
The only driving force and the only thing that matters is cost cutting.
The only driving force and the only thing that matters is cost cutting.
This will become a major problem when mining margins start to shrink. Sooner or later Bitcoin’s block rewards will stabilize or start to fall, but miners will continue to join the network as long as it is profitable. As a result, mining difficulty will increase, causing operating costs to eventually catch up with revenue, and margins will go down.
As margins are reduced, smaller mining operations will become unprofitable and will be forced to merge, get acquired, or get pushed out of the market entirely. Only a handful of players are likely to survive the endgame of PoW. Centralization is inevitable, and it will threaten the neutrality of the network.
Capital Is Always the Real Driver
Both PoW and PoS are activities driven primarily by access to capital. This may sound unintuitive since “proof-of-work” requires the consumption of various resources and implies the need of labor input. However, access to all types of resources in capitalist economies (including labor) is enabled by capital. Money or things of value that can be exchange for money is what grants economic actors access to resources. Capital is the real driver of consensus algorithms. This stands true for both PoW and PoS, however PoW is also heavily affected by economies of scale, bargaining power, politics and access to cheap energy sources.
For starters, the word “work” from “proof-of-work” is referring to computational work, not labor. The work is done by electrical circuits, which have a relatively low operational cost in terms of human upkeep. Even if this was not true, it must be noted that capitalist economies allow for resources such as mining equipment, electricity and labor to be exchanged for capital. In simpler terms, if a product requires labor to be produced, a person living in a capitalist society does not have to work directly on its production, he/she just needs to have money and use it to purchase labor. In even simpler terms, labor and capital are interchangeable in capitalist societies.
Then, there are the typical centralization forces of capitalist economies. Miners who design and manufacture their own ASICs have a competitive edge. Large customers of manufacturers or bulk buyers also have an edge. So do people who are lucky enough to live in a region with cheap electricity. If they have enough money to build mining facilities near cheap energy sources, they have an edge. Those with political connections to gain access to natural resources ala volcano mining will have an edge. Finally, corporations that have enough capital to become mega operations controlling all aspects of mining, from chip design to energy production, will have a massive edge. Big players will swallow little ones, as it always happens in markets with such conditions.
Not only does industrial mining lead to centralization, it is also nearly impossible to conduct such operations covertly. This is a problem, especially if governments decide to have a change of heart regarding the legitimacy and/or autonomy of such activities. Yes, if governments criminalize mining they can relocate to a different country… as long as that same government allows them to pack all their gear and leave. If they manage to relocate, they will have to comply with two jurisdictions: the country where mining rigs are located, and the country where the operating company is originally from.
To make matters even worse, PoW disproportionately favors large investors, which creates a market dynamic that will eventually push small and micro mining operations entirely out of the market.
Spending Versus Investing
PoW proponents also like to point out that mining is built upon another fundamentally different dynamic than PoS: the requirement to “spend” resources that are external to the network. This is primarily referring to the depreciation of ASIC miners as well as the electricity cost of operating them. This is the basis used to promote the idea that PoW is an open and equitable system since anyone is allowed to become a miner, and in theory profitable mining rigs are also readily available to anyone.
In order to understand why these allegations do not hold up in the real world we must first clarify the difference between the terms “spending” and “investing”. The key difference is that investments imply the expectation of a positive economic return coming from the consumption of resources. The motivation of an investment is purely based on the pursuit of profits. Spending, on the other hand, is motivated by subjective personal preferences that may or may not result in economic profit, but is not driven by it.
This is a key difference because miners don’t spend resources, they invest resources. Dollar per dollar, they will only engage in mining if it yields BTC at a lower operational cost than the current market price. If their operational cost is higher than the current price of BTC, then they would be better off buying BTC instead of mining.
When you look at it that way, you will realize that mining functions as a mechanism that guarantees a minimum level of liquidity to BTC investors. In addition, BTC acquired through mining is obtained at a discount. This is to be expected because mining has a higher implied risk due to variations of mining difficulty, electricity cost and the rate of depreciation of equipment.
The problem with PoW is that the amount of the discount obtained through mining is heavily affected by factors which disproportionately favor large investments. This has significant implications in terms of equitability and accessibility, and it is one of the reasons why smaller mining operations will eventually be priced out of the market.
Security and Attack Resolution
One question that is frequently raised about PoS is related to the nature of staking as a built-in mechanism to achieve network consensus. “How can a system rely on its own structure to sustain security integrity?”
It’s not the first time this type of design has been achieved through clever engineering. It’s basically how arched bridges work. External infrastructure support is needed during construction, but it is no longer necessary upon completion of the bridge.
PoW had a critical role to bootstrap cryptocurrencies. It provided permissionless and trustless liquidity before the existence of exchanges and decentralized markets that have since emerged around ether.
PoW served as the equivalent of infrastructure support for arched bridges, but it is no longer needed. Ethereum has reached critical mass through a combination of high liquidity available on global exchanges, and liquidity provided within its own digital economy (ICOs, DAOs, DeFi, DEXes, NFTs, etc.).
There is another concern about PoS’s security and the potential for bad actors to seize ether and use it to attack the network. In this regard, it’s easier to protect cryptographic information than it is to protect physical property like industrial mining facilities. Bitcoin is deemed to be seizure-proof because its ownership is established by cryptographic keys. PoS just extends that into the consensus mechanism of the network, making it more secure and allowing for greater flexibility pertaining to contingency plans.
If bad actors such as governments or custodial services are stupid enough to confiscate and use ether to attack PoS, the addresses will be immediately identifiable, the network will fork and slash the attacker’s balance, and everyone who was smart enough not to trust custodial services will be rewarded with an instant reduction of supply.
Bad actors can also try to accumulate a controlling stake through rightful acquisition, but it is very unlikely that Ethereum will ever get attacked in this manner because anyone with a pinch of common sense will figure out that the identification of bad actors (addresses from signed transactions) and resolution to the attack (slashed balances) is simple and will cause a permanent loss of ether.
The Endgame
Sooner or later, the price of BTC will stop doubling every four years. This means that BTC’s mining revenue will eventually stabilize or decrease over time unless transaction fees are able to make up for the loss of revenue incurred by halvening events.
The best case scenario for PoW, but still rather unlikely, is that revenue will stabilize while hash power catches up. This stability and predictability of revenue will lower the implied risk of mining, and markets will eventually squeeze margins as hash power continues to increase. It is only a matter of time until margins are so low that smaller operations become unprofitable. At that point small miners will still be free to participate in BTC’s consensus mechanism, but there will be no economic incentive for them to do so.
This type of scenario will never happen with Ethereum’s PoS. Ethereum imposes a minimum requirement of 32 ETH to become a validator, but this does not prevent investors from using decentralized staking apps like Lido and Rocket Pool to participate indirectly in the consensus mechanism.
Interestingly, investors with at least 16 ETH, but less than 32, actually need smaller stakers in order to start their own validator with staking dApps. This mutualistic relationship, along with the fact that these systems are operated within Ethereum’s trustless computing platform, results in a low friction environment that minimizes value extraction and eliminates custodial risk.
It will be more profitable and less risky to stake using such decentralized apps when compared to custodial services such as Coinbase. The incentives are there to result in a more decentralized, frictionless, inclusive and equitable consensus mechanism.
Conclusion
All the talk about how PoW is better because it requires “work” is just backwards thinking. The value of an activity should not be measured by the amount of work it requires, but rather by what it accomplishes. The whole point of technology is to accomplish more with less work.
The idea that PoW requires labor and “spending” resources is also used to misconstrue (perhaps unwillingly) the economic forces behind it. The bottom line is this: labor, resources and capital are exchangeable, and miners are just investors allocating capital with the expectation of profit; it is all about capital allocation.
It should clear how PoW and PoS are not all that different from each other as it is often proposed by Bitcoin maximalists. However, in PoW, larger investments will yield disproportionately larger returns due to lower fixed overhead costs, economies of scale, greater bargaining and negotiating power to acquire resources such as ASICs and electricity. Mining profits can be reinvested for compounding returns and thus completing a cycle where the “rich gets richer”.
Not only that, smaller miners will eventually not be able to compete due to shrinking margins, and ultimately the only way the little guy will be able to partake will be by acquiring equity of mining companies on traditional financial markets (the very same markets that almost inevitably lead up to mergers, acquisitions, and the concentration of power).
In the end, PoW introduces friction, value extraction, and centralization elements from the “real world” into a system that was supposed to move away from such problems: cryptocurrencies.
Ironically, it is the absence of interactions with “external resources” that allows Ethereum to operate in a more inclusive fashion. One that is more equitable and resistant to centralization forces over the long run.
Join Coinmonks Telegram Channel and Youtube Channel learn about crypto trading and investing
