How to fix this? How can Ethereum survive?

Vitalik and the Ethereum Foundation surely know of this problem, as they clearly defined ether as an appcoin (cryptofuel) and Vitalik explained the problem those kind of tokens face. All the information required to reach this conclusion was produced by them (although, as we have seen, Vitalik’s idea in the blog post was originally proposed by Krawicz). In short, they are aware of this problem. How are they trying to solve it?

One option is to pivot and change the purpose of ether and try to make it a currency that works as money and becomes the preferred coin. This would eliminate the cost of holding ether. It would be a mistake to assume that this change is of little importance, as it represents a radical change in ether’s and therefore Ethereum’s purpose. We will look at the challenges it would face if it tries to be a currency.

The main issue Ethereum faces is that it would be competing with bitcoin and all other coins designed to be money in a zero-sum game where only one can ultimately win, as there could be no stable equilibrium of two coexisting cryptocurrencies. This point was developed by Krawicz in “The Coming Demise of the Altcoins,” which I highly recommend. To make clear why this is the case, imagine this scenario in the Fiat world we used to live in: all the world governments end the monopoly of currencies in their country and the legal tender laws, an immutable monetary policy is defined, and you are able to exchange currencies quickly and at a minimum cost. In this world, after some time, would there be anyone left holding the Argentinian Peso with its 25% inflation rate? Or would everyone move to the Swiss Franc, the USD or another currency that holds its value better? That is how the competition in a crypto world works, no legal tender laws, predefined monetary policy and fast and cheap exchanges.

Image from cointelegraph

Currencies without a government-imposed monopoly compete with each other in a zero-sum game. How does ether compare to its fiercest competitor as a currency? Bitcoin is the best cryptocurrency, it was designed to be money and nothing other than money. All of its developers have been working for 9 years on making bitcoin work better as money, as it has no other intended use. It has the most secure and immutable blockchain with all the energy expenditure we keep hearing is going to destroy the world used to secure the network. It has a first mover advantage which is essential to build the network effect needed for a monetary good. All others coins are copies of it, it’s the most liquid, and once the lightning network is fully operationally anonymous, instant and virtually free transactions will be possible at scale. It uses a simple programming language to avoid problems like the DAO hack and the Parity multisig issue from happening. It is the most decentralized network, as it has no single point of failure, which makes its monetary policy immutable because no one has the power to change it. It has withheld attacks and is looking stronger than ever. The NYA debacle showed us that not even 90% of the miners can control it. Bitcoin truly appears to be antifragile.² Ethereum has already abandoned its original monetary policy and right now it isn’t defined, and we need to trust that it “will not give preferential treatment to any particular group of people.”³

What advantages does Ethereum have over Bitcoin? The advantage that Ethereum has is the versatility in what can be done in its platform, which allows a wide range of applications to be developed. But that isn’t needed in a currency: money must work as a store of value, medium of exchange, and unit of account. The one that is able to fill these functions better will be the ultimate winner. If Ethereum tries to compete with Bitcoin in its game, it has a low chance of success.

If pivoting ether to make it a currency has a brittle future, what other options are there? One must address the original cause of the problem. Try to eliminate the holding cost, and create long-term holders of the coin. How can one do this? With proof-of-stake.

Switching from proof-of-work to proof-of-stake is a sacrifice in security and immutability, which are the main properties of a blockchain. It also doesn’t really reach distributed consensus, as demonstrated here by Andrew Poelstra. It implies moving from a system that has been proven to work (as it right now secures about $170 billion dollars in the Bitcoin network) to a system that might work, but that is supposed to create the immutability that right now requires enormous amount of energy out of nothing and without any cost. It sounds sketchy to say the least. This two Twitter threads (1, 2) by Hugo Nguyen explain the main issues. There are many sacrifices on switching to proof-of-stake. This should create a question in everyone’s mind as stated by Nguyen on the first thread:

So, what is really the point in doing this? Vitalik and the people in Ethereum Foundation are not stupid⁴, so what are they thinking? Are they really doing it because they don’t want to “waste” so much energy, which as they know⁵ it is not wasted, for it is what secures the network? Or rather could such risk aim to solve an existential problem Ethereum faces? That would definitely be worth it.

The problem Ethereum and all other appcoins face is the instability of the value of the coin caused by the “implicit cost” of holding the appcoin. No one would want to hold the coin as it incurs a cost. What incentives could there be to be a long-term holder of the coin? Enter proof-of-stake. Proof-of-stake basically intends to replace proof-of-work by switching the miners and their energy expenditure for “stakers” who instead of requiring energy to mine a block need to prove ownership of coins and lock those funds for some time. If what they did was valid they receive the block reward, the fees paid and their funds are unlocked; otherwise, their locked funds are lost. So an attack is supposed to be counterproductive.

What does this achieve? It creates a system of rewards for holders of ethers as they “stake” their coins and receive the block rewards for it. Creating the possibility of an appcoin with a value that isn’t unstable. There should always be people willing to hold the coin in order to gain the block rewards by “staking” their holdings (if the amount of stakers is reduced the profit gained by staking increases). An equilibrium could be reached were the income of holding the coins by “staking” them would be equal to the cost of holding that coin instead of the coin one would prefer to hold. It appears it could eliminate the “risk of collapsing at any time,” and its value could able to reach an equilibrium with the preferred coin.⁶

If holding an asset (in this case an appcoin or crypto-fuel) is going to incur a cost, when compared to holding another asset (like bitcoin), then it has to pay an interest to compensate the holders. Otherwise there would be no long-term holders, only users of the appcoin, causing its value to have a risk of collapsing at any time.

The switch to proof-of-stake is a huge security risk, whose supposed intended purpose is not worth it. On the other hand, Ethereum as originally designed faces an existential problem and Vitalik knows this. The switch to proof-of-stake directly addresses and could solve this problem.

Vitalik has showed interest in proof-of-stake since August, 2013 when he wrote “What Proof of Stake Is And Why It Matters.” But this interest seems to be because he didn’t understand proof-of-work. He thought that the problem with proof-of-work was that it wasted energy and an algorithm that could use that energy for something useful would be preferred, not realizing that the whole point of proof-of-work is that the energy can’t be serving any other purpose. Otherwise someone who derives enough value from what is produced by that energy could afford to attack the network, as he isn’t “wasting” his energy expenditure while doing so.

However, when he understood the problem Ethereum faces and, we assume, saw how proof-of-stake might solve it, his motives for switching probably changed. He now seems to be more interested in doing the switch soon than doing it right, as in 2017 Vlad Zamfir (a top Ethereum researcher and developer on proof-of-stake) said “Vitalik is more driven to implement something soon, whereas I’m more driven to search for theoretically optimal solutions even if it means some delays.”⁷ Maybe it is because he doesn’t want people to realize the purpose of the switch before it is done.

If my hypothesis is correct, and the real reason behind the switch to proof-of-stake is to solve the holding cost problem, then they could not say so publicly. Were they to do this, they would have to acknowledge the fact that Ethereum as originally designed faces an existential problem and thus that a pivot must be made to try and save the platform. If Vitalik or the Ethereum Foundation were to acknowledge this publicly before the change is made, the price of ether (along with many altcoins) would plummet. The stated reason should not matter. As long as we can see everything that is achieved by the change, we can determine what its main purpose is.

So what is the real purpose of switching to proof-of-stake? You be the judge.

Even if they manage to pull this off and switch to proof-of-stake before people realize the existential problem Ethereum faces in its current protocol, I remain highly skeptical of its long-term viability, as there are still many issues with Ethereum. It has not showed any real world utility. Proof-of-stake might destroy the security of the network. Its centralization around Vitalik and the Ethereum Foundation creates a single point of failure — the precedent created for non-technically motivated hard forks undermines the essential immutability of the blockchain, among other issues.

As I see it, the switch to proof-of-stake isn’t the solution to all their problems, but the only option they have to try and save their project that was supposed to “change the world.” The protocol they originally designed is doomed to fail, and they know it.