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What the bitcoin price drop reveals about ‘crypto’

One of the definitive downsides of cryptocurrencies raised its head this week when the nosediving price of bitcoin – brought on by the Luna/Terra crash and subsequent cascading effects – rendered bitcoin mining less profitable. One bitcoin today costs $19,410, so it’s hard to imagine this state of affairs has come to pass – but this is why understanding the ‘permissionless’ nature of cryptocurrency blockchains is important.

Verifying bitcoin transactions requires computing power. Computing power (think of processing units on your CPU) costs money. So those bitcoin users who provide this power need to be compensated for this expense or the bitcoins ecosystem will make no financial sense. This is why the bitcoin blockchain generates a token when users provide computing power to verify transactions. This process is called mining: the computing power verifies each transaction by solving a complex math problem whose end result adds the transaction to the blockchain, in return for which the blockchain spits out a token (or a fraction of it, averaged over time).

The idea is that these users should be able to use this token to pay for the computing power they’re providing. Obviously this means these tokens should have real value, like dollar value. And this is why bitcoin’s price dropping below a certain figure is bad news for those providing the computing power – i.e. the miners.

Bitcoin mining today is currently the preserve of a few mining conglomerates, instead of being distributed across thousands of individual miners, because these conglomerates sought to cash in on bitcoin’s dollar value. So if they quit the game or reduce their commitment to mining, the rate of production of new bitcoins will slow, but that’s a highly secondary outcome; the primary outcome will be less power being available to verify transactions, which will considerably slow the ability to use bitcoins to do cryptocurrency things.

Bitcoin’s dropping value also illustrates why so many cryptocurrency investment schemes – including those based on bitcoin – are practically Ponzi schemes. In the real world (beyond blockchains), the cost of computing power will but increase over time. This is because of inflation, because of the rising cost of the carbon footprint and because the blockchain produces tokens less often over time. So to keep the profits from mining from declining, the price of bitcoin has to increase, which implies the need for speculative valuation, which then paves the way for pump-and-dump and Ponzi schemes.

permissioned blockchain, as I have written before, does not provide rewards for contributing computing power because it doesn’t need to constantly incentivise its users to continue using the blockchain and verify transactions. Specifically, a permissioned blockchain uses a central authority that verifies all transactions, whereas a permissionless blockchain seeks to delegate this responsibility to the users themselves. Think of millions of people exchanging money with each other through a bank – the bank is the authority and the system is a permissioned blockchain; in the case of cryptocurrencies, which are defined by permissionless blockchains, the people exchanging the money also verify each other’s transactions.

This is what leads to the complexity of cryptocurrencies and, inevitably, together with real-world cynicism, an abundance of opportunities to fail. Or, as Robert Reich put it, “all Ponzi schemes topple eventually”.

Note: The single-quotation marks around ‘crypto’ in the headline is because I think the term ‘crypto’ belongs to ‘cryptography’, not ‘cryptocurrency’.