One of the criticisms that has been levelled at the crypto space is that it is not energy efficient. While it is true that blockchains that use the proof-of-work consensus mechanism consume considerable energy, this energy pales in comparison to that consumed by other sectors, such as the banking sector. Moreover, cleaner energy and renewable energy could always be used to secure these blockchains. Switching to a more energy-efficient consensus mechanism could be explored. Ethereum recently transitioned to a proof-of-stake consensus mechanism that will not only make it more energy efficient but ultimately reduce its transaction costs and speeds. The collapse of FTX and Alameda has led to some soul searching in the centralized crypto space, which has experienced several failures this year. As customers have exited centralized exchanges in favor of self-custody and decentralized exchanges, to reassure potential users, centralized exchanges have decided to publish proofs-of-reserve, which though infallible, are a good first step. DeFi exchanges, lenders, and protocols, although imperfect, have continued to work as programmed.
Episode Highlights
Helpful links
Ethereum Merge and Proof of Stake
The FTX Collapse
Proof of Reserves and Centralized Exchange Transparency
Hi, Welcome to Decentralized, a podcast on the crypto space where I'll be talking about the crypto landscape, the crypto infrastructure, crypto assets, and the crypto market, as well as factors that affect it. My name is Loraine Mutyaba, and I am the host of decentralized.
The last couple of months have been exciting and shocking. The last month in particular has been shocking. Ethereum, the most valuable blockchain has moved to transition to a more energy efficient mechanism for verifying transactions. Which is exciting. And then in a sequel to what happened earlier in the year, a sequel that no one wanted, no one expected, and that has shocked everyone, FTX and Alameda Research, both founded by Sam Bankman-Freid, also known as SBF are no more. While there've been other noteworthy events over the last couple of months, these two are quite significant, and so that's going to be the focus of the episode today. The merge of Ethereum and the total collapse of SBF’s Empire.
So the Merge sounds like a horror film, like The Blob or The Shining, but it's anything but. The Cambridge University Center for alternate finance revealed that Bitcoin mining in particular consumes enough energy to power a small country like Switzerland or Malaysia. However, Ark investments revealed that Bitcoin mining consumes the same amount of energy that 10% of the banking sector consumes. And it emits less than 5% and 45% of the emissions that the banking and gold mining sectors emit. So there have been questions about what an industry deserves to consume in terms of energy? And if that energy is clean energy, is that a problem? And if that energy is renewable energy or energy that would otherwise have gone to waste, is the energy consumed a problem? As these questions have been raised, developers in this space have tried to find ways of making certain blockchains more energy efficient. So the question is, why does Bitcoin mining consume so much energy? Well, that's because Bitcoin uses a proof of work consensus mechanism.
A consensus mechanism is a system that is used to validate and secure blockchain. So to verify transaction on the Bitcoin blockchain, a miner has to compete with other miners to guess the answer to a complicated mathematical problem. And the reward for finding this answer is Bitcoin, as well as a portion of the transaction fees. There will only ever be 21 million Bitcoins in circulation. Right now, there are only under 19 million Bitcoins, and most of those have entered circulation via mining. In 2019, 12 trillion times more computing power was required to mine Bitcoin than in 2009. Clearly, these miners are not using your PCs or your MacBooks to mine Bitcoin. They are using some sophisticated hardware that consumes a lot of energy, but proof of work isn't the only mechanism that is used to verify transactions.
There is also proof of stake. So how does proof of stake work? Let's say, um, blockchain C has a coin that's native to it called coin C. So if you want to verify transactions on this blockchain, you need to lock up a certain amount of coin C, put it up as collateral so that you have a chance of being selected to verify transactions on that blockchain. Both proof of work and proof of stake have pros and cons. None is a panacea for all the problems that we have when it comes to the verification of transactions. What does this all have to do with the merge? So, for the longest time, since 2015, Ethereum has used the proof of work mechanism to verify transactions. In September, Ethereum transitioned to a proof of stake mechanism, which is a big deal because this will mean that over time the transactions on Ethereum will be faster, the fees will be lower, the security will not be compromised. Lastly, the energy consumed by the Ethereum network will reduce by at least 99.5%. Less than two months after the Merge, there were two seismic events in the space whose reverberations are still being felt. The collapse of FTX and it is the company, Alameda Research
Earlier in the year, there was an implosion of exchanges and centralized entities, and the causes of these implosions, at least for the centralized entities, were bad loans, bad bets, irrational optimism, bad trades, and bad luck. SBF swooped in like a white knight, brandishing that sword of effective altruism to save crypto. And he did save a few entities from at collapse. On November 2nd, an article on CoinDesk sent tremors throughout the crypto space. It showed that Alameda Research and FTX were linked in a way that made it impossible to know where one started and the other ended. It also revealed that Alameda. was illiquid.
People started withdraw their crypto from the FTX Exchange. This trickle of withdrawals turning into a flood, and by November 11th, FTX was filing for bankruptcy and Alameda research was no more. So what happened in the aftermath of this? Well, there was an outflow of crypto from most of the centralized exchanges. Binance experienced a net outflow of 1.4 billion between the 9 and the 16th of November. And according to Nansen, a data analytics platform, Defi protocols experienced a growth in users, and a growth in transactions.
It has since come to light that SBF was funneling funds to Alameda Research, which should have failed in May, along with Celsius and Voyager, a portion of those funds were user deposits. What is clear right now is that trust in centralized crypto funds is at an all-time low It's been eroded by the collapse of FTX. Exchanges have tried to reassure their customers that they are trustworthy and that they are solvent and that they are liquid. They have done this by publishing a proof of reserves, an independent audit prepared by a third party that shows that an exchange is holding what it claims to hold on behalf of its customer and users. It remains to be seen what other methods exchanges are going to use to reassure their customers. But a proof of reserves is a good first step. What I would like to emphasize is that decentralized protocols, whether lenders or exchanges, have continued to work as programmed. All transactions, all movements of funds in the decentralized space happen on chain and anyone can see them. Because of this transparency in the DeFi space, there is no need to trust an entity or a person.
As someone who loves the crypto space, what has happened with FTX is shocking and disheartening. I do not know how many times I have used the word “shocking” in this episode, but it has all been shocking. The onus right now is on centralized crypto firms to reassure their customers. Their very survival depends on it. That's all I have for you this week. Thank you so much for listening. Until next time. Take care of yourselves.