Proof of how cryptocurrencies based on proof-of-work have intrinsic value, part 1 of 3

One of the frequent objections from skeptics of cryptocurrencies is that they think their only value comes from the "greater fool" theory; that is, you may buy them today only because there is a high expectation that you will be able to sell them tomorrow at a higher price to an even greater fool.

Bill Gates, Warren Buffet make the specific argument they are worthless because they don't produce something of value, unlike equity stock in companies, or gold, that has its applications [reported by Newsweek here]. I have friends who have argued that proof of work is too wasteful.

I would like to examine all three claims. In this article I will refer to the issue of whether proof of work is wasteful, soon I will address the other two.

Is proof of work wasteful?

Decentralization has benefits and costs. For example, a system of government in which political power is not based on a pre-agreed upon figure of authority (king, emperor, dictator, chairman, supreme leader) has a non-trivial cost in terms of lack of coordination and the costs required to select and change the people in positions of power. In democracies these expenditures are significant, as in the many billions of dollars spent on electoral campaigns in the USA. This is an argument I took from the economist Paul Sztorc at this article in his blog.

I have frequently compared the decentralization at the core of cryptocurrencies as a similar phenomenon to the independence of the United States: Instead of continuing an absolute monarchy system of government, there was a shift to a republican system based on a dynamic equilibrium between political agents; cryptocurrencies also use dynamic equilibriums based on game theoretical systems of incentives, only that cryptocurrencies are more radical in that they don't rely on promoting agents to positions of authority such as the president, justices or congresspeople nor the requirement of trust on those authorities.

Just as there are evident advantages on the republican system of government, there are evident advantages on not promoting participants in a network to positions of privilege, power or authority, including that those in positions of power automatically become a potential point of failure, either vulnerable to external attacks or internal corruption.

There is the need to build consensus, and there are many mechanisms, but proof of work [frequently abbreviated PoW], as invented by Hal Finney, has not only the advantage of the experience accumulated by Bitcoin and many other early cryptocurrencies, but other easy to prove guarantees that allow real life, valuable, applications we will explain them in the part 2.

If there are benefits to trustless decentralization, then the question of whether a particular mechanism that achieves it is wasteful is not meaningful except in comparison to other choices. Unfortunately, I have yet to see a thorough comparison, it seems the critics make implicit assumptions such as "there must be trust between the parties" which, if made explicitly, could be proven false.

For example, in this presentation by David Schwartz, "Developing Blockchain Software", he only mentions PoW to say it is wasteful, the consensus building mechanism he explains is just majority consensus, but this requires the network participants to already trust each other. When I saw that presentation, I did not know better, that there was a mechanism that did not require participants to trust themselves beforehand. Because this was the most detailed exposition on cryptocurrencies I had seen, it helped me think I knew the basics of what cryptocurrencies were, which seemed not very interesting, while in fact I only knew the basics of rather controversial cryptocurrencies such as Ripple. Eventually, after 14 months that I now regret, I finally got the key missing piece on my understanding of cryptocurrencies, the proof of work consensus building mechanism and at least to me, it became evident the revolutionary nature of cryptocurrencies; having made the mistake of not realizing I was making these incorrect assumptions, I don't particularly blame Gates, Buffet for their "failure of imagination", quite the opposite, knowing these misunderstandings are easy to make motivates me to write what I am writing.

To my knowledge, there are no cryptocurrency miners [the cryptocurrency network participants that do PoW with the intention of getting the rewards] that have been coerced into doing mining, that is, there are some economic agents in the world that choose to do mining presumably because they have cheap energy available to them. In particular, I subscribe to the theory that mining is concentrated in China because of many factors including that their electrical energy supply was developed with significant misalignment with regards to the development of the heavy industry that would consume that energy, leaving plenty of otherwise not-useful electrical energy available cheaply for other purposes. Also, PoW for cryptocurrencies have an inherent strong incentive towards decentralization, which in turn is an incentive for the decentralized generation of electricity such as solar photovoltaics, which has its own "externalities" or benefits to the world. There are other externalities, for example, the ascent of Bitmain as a chip designer that rivals in size traditional companies such as nVidia, AMD and Intel, is probably a positive development, as well as the renewed enthusiasm to develop the mathematics of cryptographically secure hash functions.

Bottom line, the current consumption of energy doing cryptocurrency mining, estimated to be 2% of worldwide production probably means there was a 2% of relatively inefficient allocation of electricity production that found an application. It will be interesting to see how this situation evolves; potentially, the cryptocurrencies will continue to appreciate in general and the better understanding of the benefits of trustless decentralization will lead to the ways to accomplish it, including PoW, to be more important and consume more resources.

In a later article I will illustrate the benefits of trustless decentralization by examples, applications with obvious real-world value, then I will prove how cryptocurrencies are the natural way to incentivize PoW, and hence prove cryptocurrencies have intrinsic value because they are one way to get the benefits of those applications.