A warning against proof-of-stake cryptocurrencies and against altcoins

I am making this post since recently several altcoins which are not mined by proof-of-work problems have gained a very high market cap and because I see a major downside to these non-minable coins. Furthermore, the newer cryptocurrencies are non-minable, and people should be very wary of non-minable coins.

To make things short, there are two ways in which transactions are verified in a cryptocurrency without the use of a central authority, namely proof-of-work (POW) and proof-of-stake (POS). With POW, people gain the right to validate cryptocurrency transactions by solving a computationally difficult problem (the process of solving this problem is known as “mining”), and the people are rewarded for solving these POW problems and validating the transactions with newly minted coins and with transaction fees. The difficulty of this problem is automatically adjusted so that the average time it takes to solve the problem remains constant. POS does away with the need to solve such a computationally difficult problem. With POS, the cryptocurrency rewards an entity the right to validate transactions according to how much of the cryptocurrency the entity possesses. POS should be thought of as a cheap alternative to POW, and by cheap I mean that POS is of low quality rather than inexpensive as a result of a community unwilling to put the effort into making a good POW problem and solving these problems.

In this post, I am not going to discuss whether POS is suitable as a mechanism for validating transactions in the long run since I am currently far from the best person to write about such an issue (this post will therefore not be very technical). However, I am going to make the case that one needs POW in order to fairly initially distribute a cryptocurrency and that POS is insufficient for initially distributing the cryptocurrency. Most of the ideas in this post are not original ideas and they have been broadcasted elsewhere by other people.

We observe that recently POS coins have been gaining a high market cap while the POW coins have not received such great gains. Furthermore, the newer cryptocurrencies with a high market cap are all POS coins as opposed to POW coins. I also want to make it clear that my criticism of POS is only limited to the initial distribution of the coin.

So there is about 800 billion dollars in cryptocurrencies floating around as of 1/06/2017. With such a high market cap, we must now ask the question as to whether the people who own these cryptocurrencies have truly earned the coins that they have. A related question one should also ask is whether the coins have been distributed evenly and fairly. If these cryptocurrencies have not been distributed fairly, we must then find and employ the best strategy for fairly distributing these new coins.

One possible solution to the initial distribution problem without resorting to POW is to give every single person in a certain region of the world. For example, in the cryptocurrency Auroracoin, an equal number of coins were given to each citizen of Iceland. This solution however has its problems. Cryptocurrencies distributed like Auroracoin have a major competitive disadvantage since such cryptocurrencies are limited to certain regions of the world, and as a result any coin similar to Auroracoin will probably have a low market cap. By limiting a cryptocurrency to a certain part of the world, such a cryptocurrency is not that much different from fiat currencies since cryptocurrencies should not be limited to certain groups of people. Fairly distributing a cryptocurrency to every citizen of a nation also has some logistic disadvantages since during the initial distribution, not every citizen would accept such a cryptocurrency and there is no guarantee that the citizens of that nation would accept such a cryptocurrency in the future. It is difficult to distribute a currency if the people do not want that new currency.

Auroracoin’s solution to the initial distribution problem is the best possible solution to this problem without resorting to POW. Other solutions to the initial distribution problem in a POS system are very unfair and/or logistical nightmares. For example, if the coin has been initially distributed through an ICO (initial coin offering), then one’s wealth is determined solely by how much one gives to a central non-government organization. While this method of initial distribution works well for distributing stocks, it is not a fair way to distribute new cryptocurrencies because it is necessary for cryptocurrencies to be distributed as evenly as possible. There is no way to evenly and fairly distribute a new cryptocurrency solely through a high risk ICO since ICOs distribute coins based on how much people are willing to risk their money at cryptocurrency projects which have not been launched yet and which have not stood the test of time. ICOs are unnecessary to develop a new cryptocurrency since new cryptocurrencies could be launched simply by cutting and pasting, and the development of the cryptocurrency could be funded by a sort of treasury system similar to that of the cryptocurrency Dash. Let us also observe that many ICOs are complete scams. If a cryptocurrency must use an ICO, then only a small portion of the total number of coins should be distributed through that ICO and the rest of the coins should be distributed by using POW (Ethereum has combined ICO with POW for its initial distribution and that is fine).

Would you like your national currency to be initially distributed based on how much money one gives to someone who may or may not be a scam artist? Or would you instead like your national currency to be distributed to people according to how much they work for it?

Many people say that POS is cheaper than POW. But the damage to an economy caused by POS because all of the wealth has been distributed to the wrong people will be much more expensive than POW could ever be.

Even though I consider POW to be a fair way to initial distribute a new cryptocurrency, one still has to be careful with POW coins since POW still could have major initial distribution problems if it is not done correctly.

The initial distribution mining period needs to be long enough for the cryptocurrency to be fairly distributed among the users. If most of the coins are given to the early adopters and the cryptocurrency gains a high market cap only after most of the coins have been distributed, then a few people will have an excessive amount of wealth that they have not worked for and which they have not earned. In my opinion, the initial distribution period should last at least a decade for a fair distribution, and Bitcoin’s halving period of four years is too short for newer cryptocurrencies (of course even a one year initial distribution period using POW is much better than any ICO since at least with a POW people are investing in a cryptocurrency that has been launched).

With what I had said, you may be tempted to cry foul at the initial distribution of Bitcoin, but I would not consider the initial distribution of Bitcoin to be unfair in any way. The early investors into Bitcoin became rich, but they also provided a great deal of value to the cryptocurrency community. The early investors into Bitcoin were the people who made the notion of a cryptocurrency what it is today, and the early investors of Bitcoin were necessary in order for the market caps of cryptocurrencies to grow to where they are today. However, one cannot make the argument that if someone becomes rich from being an early adopter of an altcoin, then that person has truly earned his money. An early adopter of an altcoin has not helped make cryptocurrencies become mainstream so it is unfair for such an entity to have an enormous amount of wealth. The early adopters of Bitcoin also deserve their wealth because they decided to get Bitcoin early because they truly understood either how Bitcoin works or how Bitcoin is important; the same cannot be said of the early adopters of altcoins. Since Bitcoin early adopters truly deserve their wealth because they believed in the system and because they helped bring cryptocurrencies into the mainstream, one could argue that Bitcoin is the most fairly distributed cryptocurrency.

The cryptocurrency must also choose a useful POW problem that has real-world applications outside of the cryptocurrency community. For example, the POW problem for Bitcoin is to find a SHA256 hash $k$ so that $k < C$ where $C$ is a number that changes every 2016 blocks; the hashes $k$ with $k < C$ have no purpose outside of the cryptocurrency itself, nor is the process of mining bitcoins of much value. Bitcoin mining therefore becomes a nearly useless job whose only purpose outside the cryptocurrency is to keep people employed doing a nearly useless job.
A useful POW problem cannot be seen as wasteful in any way since the work needed to solve that problem will be used to advance science, technology, or mathematics.

If a person gets rich from solving useless POW problems from cryptocurrencies, then that person has not done work to improve anyone’s lives. It is not fair for someone to get rich off a cryptocurrency by performing a nearly useless job. It is definitely not fair for all coins in a cryptocurrency to arise from performing a nearly useless job.

We need a useful POW problem also because people should get paid for performing useful jobs rather than useless jobs. Unfortunately, the cryptocurrencies launched so far have not successfully employed useful POW problems, so mathematicians still have a lot of work to do.

Now, it is not solely up to the cryptocurrency authorities to solve the initial distribution problem, but the people can also help solve the initial distribution problem by investing in a diversified set of cryptocurrencies. One will incur a much lower risk by investing in a diverse set of cryptocurrencies at least until stable cryptocurrencies emerge. While useful POWs whose mining period elapses over several years will help fairly distribute cryptocurrencies, the people need to also do their part by investing in a diverse set of cryptocurrencies and creating systems that will allow others to more easily invest in a diverse set of cryptocurrencies.

I should mention that POW and POS are not the only ways of initially distributing new cryptocurrencies since one could use proof-of-burn in order to transfer coins from an existing cryptocurrency to a new cryptocurrency. However, proof-of-burn is a rarely used consensus and initial distribution mechanism, so proof-of-burn currently should not be considered to be a substitute for proof-of-work or proof-of-stake.

Let me know your thoughts about the cryptocurrency initial distribution problem.

Extraneous remarks:

If you want to know if a cryptocurrency is a proof-of-work coin or a proof-of-stake coin, go to https://coinmarketcap.com/ and look for the cryptocurrency; if you see an asterisk next to the cryptocurrency, that means that the coin is not minable and hence it is not a proof-of-work coin.

One may claim that Auroracoin’s solution to the initial distribution problem is an act of socialism, but Auroracoin is not quite as socialistic as one might think at first glance. First of all, the people of Iceland have the choice of accepting Auroracoin as a legitimate currency or not, and since the people may choose to accept Auroracoin, Auroracoin should be considered as a part of a capitalistic society even though the initial distribution of Auroracoin is socialistic. Second of all, Auroracoin is only a socialistic in its initial distribution, so the socialistic distribution of Auroracoin will only dominate the cryptocurrency in the short-term. Finally, the socialistic initial distribution of Auroracoin is not intended to spread socialism but instead to solve the initial distribution problem.

While I have criticized POS coins in this post, we must give the POS coins some credit for testing POS in practice so that people better understand its advantages and disadvantages.

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