You are currently viewing Fiat & Crypto Trilemmas and the Debate Between Proof-of-work & Proof-of-stake |  by Arnold Hui, CFA, FRM, SCR |  Coinmonks |  Sep 2022

Fiat & Crypto Trilemmas and the Debate Between Proof-of-work & Proof-of-stake | by Arnold Hui, CFA, FRM, SCR | Coinmonks | Sep 2022

This blog shares the journey of my transition as a central banker, with 16-year experience in i) overseeing the operations of the Linked Exchange Rate System of Hong Kong and ii) researching on the asset allocation and ESG Policy for the Exchange Fund, to my recent new role at the Sustainability Bitcoin Protocol. While my fresh pair of eyes may see something interesting, there must be plenty of room to deepen and expand my knowledge. Hence, your comments and feedback are very much valued and appreciated!

As a student of economics who was born and raised in Hong Kong and worked for its central bank, I was particularly interested in the Mundell–Fleming model which is an open economy version of the IS — LM model. In less nerdy terms, the model, often named as the “impossible trilemma” or “policy trilemma”, argues that an economy cannot maintain i) a fixed exchange rate, ii) free capital movement, and iii) an independent monetary policy all at once. Policymakers can only achieve two out of the three policy goals as illustrated in the chart below.

Why so? If an open economy maintains an independent monetary policy and, for instance, cuts its local interest rate to stimulate the economy, its currency will in general depreciate and therefore exchange rate stability will be lost. If the exchange rate is fixed for an open economy and pegged to another currency, monetary policy independence cannot be achieved as the peg and the currency value are usually maintained by aligning its interest rate with that of its backing currency. Alternatively, capital control can be imposed to maintain a fixed exchange while retaining monetary policy independence to an extent commensurate with the level of control.

Trilemma in the blockchain world

Interestingly, a similar trilemma also exists for blockchain and crypto-currencies. Understanding this concept helps address one common response I got when I shared about my new role to drive a sustainable future for the Bitcoin network — “why not just change Bitcoin’s consensus mechanism from proof-of-work to efficiency other schemes with greater energy such as proof-of-stake?”

I shared the same thought previously as I had only learned about the buzzwords in relation to crypto from some eye-catching tweets without digging into their inherent structures and properties. While, before taking up my role, I spent some effort going a little deeper to see whether I could be convinced by my future work. The crypto trilemma is a fundamental concept to explain why each crypto scheme has its own pros and cons and, more specifically, why proof-of-work makes Bitcoin what it is.

So what is blockchain trilemma? Similar to the policy trilemma in the fiat FX world, blockchain trilemma, a concept coined by the co-founder of the Ethereum blockchain Vitalik Buterin, states that a cryptocurrency can only perform well for two out of the three main blockchain network attributes — decentralization, security , and scalability. Let’s briefly explain what they are.

Note: In this blog post, I avoid using jargon such as permissionless and trustless which, to me, was a bit dense when I started to learn about the subject.

Decentralization refers to the transfer of control and decision-making from a centralized entity to a distributed network. Within the distributed network, each transaction is verified and approved through different consensus mechanisms (eg proof-of-work and proof-of-stake). By avoiding a centralized entity, it can free the network from i) a single point of vulnerability (eg a bank run or hack) and ii) reliance on a trusted third party (ie no single entity has absolute power). As such, the more decentralized a network is, the more resilient it is to outside attacks and hence the better blockchain security. This, in turn, helps safeguard user confidence and promote wider adoption and long-term growth of a cryptocurrency. Intermediate, a decentralized, secured network comes at the cost of scalability or speed as a transaction requires confirmation multiples and consumes more resources.

As decentralization is the cornerstone of most cryptocurrencies, blockchain trilemma usually boils down to striking the right balance between security and scalability, depending on the crypto currency’s key functions and visions. Bitcoin’s whitepaper outlines its key function as “a purely peer-to-peer version of electronic cash would allow online payments to be sent directly from one party to another without going through a financial institution.” To this end, it is natural for Bitcoin to adopt proof-of-work, a consensus mechanism that prioritizes security over scalability. But how can this be done?

In a simplified and less-technical fashion, the chance of winning a Bitcoin block reward is proportionate to how much computation power you can afford to participate in a guessing competition. It is deliberately designed to be expensive in terms of electricity and hardware as a defense against malicious attacks. In theory, subverting the Bitcoin network requires gaining 51% of total computation power which is extremely costly, if not impossible, given the scale of the network. Proof-of-work ensures that the participants have skin in the game, incentivizing them to spend the expensive resources to honestly join the competition, earn Bitcoin rewards and safeguard the robustness of the network.

Why not simply switch to proof-of-stake?

Then, some of you may ask why it is reasonable for the second largest cryptocurrency Ether, the native cryptocurrency of Ethereum, to switch to proof-of-stake from proof-of-work (ie the Merge). The answer comes back to the crypto currency’s functions and visions. Unlike Bitcoin, Ethereum aims to be a blockchain platform for smart contracts and decentralized applications as stated in its white paper. The growing popularity of the Ethereum blockchain which hosts a majority of NFTs, DeFi, and other Web3.0 apps, has started to choke the system. Therefore, it makes sense for the community to take years of research and development to plan for the transition to proof-of-stake which is “more complex than proof-of-work” but “better for implementing new scaling solutions” including sharding as noted on its website.

Again, this blog post focuses on conceptual rather than technical aspects of crypto developments. Interested readers may wish to refer to Ethereum’s website to delve into the details of the transition. However, I want to emphasize that both proof-of-work and proof-of-stake have their pros and cons as discussed here, here, and here.

A paradigm shift must be backed by the relevant mandate or mission

Ethereum’s transition, despite the complexity and challenges as evidenced by the several delays of the transition since 2020, is well justified in order to fulfill Ethereum’s purpose as a web3.0 platform.In contrast, Bitcoin’s key function as a peer-to-peer electronic cash system is well served by proof-of-work. Bitcoin’s robustness and simplicity are the fundamental layers that uphold its role as the most liquid and largest crypto-currency cap. While scalability is critical in burning mass adoption, the Bitcoin community prefers other scalability solutions that retain the proof-of-work protocol intact. In addition, the crypto community is developing different kinds of cryptocurrencies to solve the blockchain trilemma in a collective manner.

Going back to the fiat world, each currency regime tries to achieve its own policy goal. Currency regime shifts, if not considered and handled properly, can wreak havoc on asset markets and the livelihoods of millions of people. Therefore, unless triggered by a financial crisis, a currency paradigm shift must be well justified after careful deliberations on the economic, financial, and development needs.

Some people believe that excessive credit growth driven by quantitative easing (QE) would lead to overproduction and waste which can only be avoided by bringing in monetary discipline such as by re-introducting the gold standard. However, nobody can tell how the financial markets and geopolitics would play out in such a paradigm shift. Likewise, calling for a change of code for Bitcoin with its existing mechanism serving its key function well is not sensible.

Can we not change the fundamentals of the existing fiat and cryptosystems while addressing their respective sustainability challenges? Definitely yes. For instance, the European Central Bank started to include sustainability-linked bonds in its asset purchase programs to promote a green recovery after COVID. Likewise, we at the Sustainability Bitcoin Protocol are promoting sustainable mining that is fully compatible with the established Bitcoin ecosystem as briefly discussed in my first article.

Finally, the debate between proof-of-work and proof-of-stake is just like another religious war similar to that between fiat and crypto I mentioned in my first article. Being bound by discriminative and dualistic thinking or any ideology will only put us all into an endless loop. I hope the crypto communities will join forces and complement each other to build a more efficient, robust, and secure ecosystem together.

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Learn more about the Sustainable Bitcoin Protocol at www.sustainablebtc.org.

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The information herein has not been based on a consideration of any individual investor circumstances and is not investment advice, nor should it be construed in any way as tax, accounting, legal or regulatory advice.

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