Keeping the lights on
Most of us have by now accepted that our savings live as digital numbers that we see in a web interface or on a piece of paper produced by a trusted entity - a bank, a broker etc. This comfort comes from implied trust in the network’s stability - i.e. there’s a central bank that will bail someone out, there’s insurance etc. Effectively, it’s the trust in relationships between the stakeholders / regulations.
Moving further along the services spectrum, where does the comfort of using digital tools come from? All that data, stored somewhere in the cloud, e-money, online payment providers etc. This comfort is based on the knowledge that there’s a cluster of data centres somewhere, managed by Google, Amazon or some other private companies / investors and those renting the computer power will pay the monthly invoices and lights will stay on.
This means that we are rely on professional third party service (infrastructure) providers in the patterns of a) or b) as per below.
Bitcoin’s launch in 2009 was the first effort to shift the infrastructure landscape towards ‘c)’. It was called Proof of Work.
Proof of Work
In order for any blockchain network to function, there are complex cryptographic algorithms that needs to be solved every single second by a widely dispersed network of machines. Simply put, if want to be a part of that network, you can buy a piece of hardware, manage it in a certain way (with the main cost being electricity to power the device) and for every cryptographic equation your machine solves, you get rewarded with a coin. It’s called ‘mining’ and it’s a highly lucrative business (current operating margins exceed 70%).
In the early days of Bitcoin, you average laptop could process these equations, but as the market evolved, this is how a ‘mining farm’ looks now:
These are highly sophisticated large scale operations, where a small concentrated group of miners dominates the market in a way which is not too different from the traditional data centre model. They also collect all the rewards (i.e. infrastructure rent) with consumers paying the bill.
Most other coins operate in the same way, but there’s a new business model on the horizon.
Proof of Stake
New-generation crypto networks, lead by Ethereum, have been exploring a different way of solving cryptographic algorithms - called Proof of Stake. A brief visualisation can be seen below.
Basically instead of burning electricity to power up ‘mining’ equipment, crypto users can ‘lock’ their coins into a digital contract which will run cryptographic equations in the background. This means that any crypto user / holder can participate in ‘infrastructure provision’, ensuring a more distributed network (scenario ‘c’ in the image above) and can extract the infrastructure rent too. This will create networks where every users is also a ‘node’ - e.g. imagine that in order for your digital service to go under, every single user will have to ‘switch it off’ on their device. Quite an unlikely scenario leading to a more resilient network.
There’s complex economic modelling behind it…
… while the process of joining the network is quite simple and can be done via a laptop.
For those with no desire to run this software on their devices, aggregation services have emerged where you can pull your coins together with others. With just a few clicks you can help maintain the network’s infrastructure and get paid for it.
With the right economic incentives in place and the process substantially simplified, we can expect the next-generation crypto networks to be much more resilient and scalable than both the initial crypto networks and their traditional Web counterparts.