Bitcoin money and trust essay PDF

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History an-d functioning of bitcoin/ ecological impact of bitcoin...

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I.

Background: Where does Bitcoin fit in the Broad History of Money?

States have always wanted to issue and control currency. However, since the economic crisis of 2008, the world has witnessed flaws in centralized currencies. Modern cryptography, which offers secure protocols and carries out operations that were thought to be impossible, and the installation of worldwide networks, are making a huge step forward in our monetary systems. A new form of currency has emerged: purely digital, managed collectively without the intervention of any central authority, allowing secure, instantaneous, and low-cost transfers from one point of the globe to another: cryptocurrency. But while Bitcoin was the first known electronic currency in the world, it was not the first in history. Before the advent of money, barter governed many human relationships and widespread at the same pace as civilizations expanded. But it did not facilitate exchanges: supply does not always meet demand. For an exchange to succeed, both parties must want the exact item that the other person is willing to exchange. The system therefore quickly finds its limits. It is therefore necessary to create a common value in order to exchange goods more easily by detaching oneself from the function of barter. Quickly, shells, then precious metals (gold and silver) became the currency of exchange. One must wait the V-VIIth century BC in Lydia (Ancient Turkey) to see the first coins appear. Currency takes its rise in the Greek and Roman Empires and until the 19th century, keeps its function of convenient counter-value. Easily exchangeable, it has an intrinsic value due to its rarity. According to the economist Felix Martin, money is a system of credit and clearing enabling people to transact with each other. He argues that money must consist of an abstract, universal measure of value, a form of account keeping, and decentralized negotiability. Fiduciary coins appeared in the 19th century. They have value only when they are trusted. This became even more relatable when the gold standard was abandoned in the United States in 1971 (Bretton Woods). Since the dollar is no longer plated with gold, it becomes easier to print banknotes. In the 20th century, exchanges became Eleonore de Cardes 670006846 BEE3109

dematerialized through credit cards and the appearance of the first electronic currencies at the end of the 1990s. These are the ancestors of Bitcoin, driven by the cypherpunks: a group of cryptography passionates seeking to protect the information of the private life on the communication networks through cryptography. The Bitcoin project was later built on the ruins of the Subprimes as trust in the international markets collapsed. Privacy and security became primarily sought by investors. On a chronological timeline, we could place its origin on October 31, 2008, although its creator claims to have started working on the 2007 project. On October 31, the White Paper is released by Satoshi Nakamoto. It describes the peer-to-peer functioning of bitcoin, with the aim of eliminating the trusted third party hitherto imposed by the banks. The first block was mined on January 3, 2009. Bitcoin is a digital form of currency used as a means of exchange within a network. Unlike traditional banking systems, transactions are tracked in an encrypted and public blockchain and can be carried out directly between participants (peer-to-peer network) without the use of an intermediary. Bitcoin is based on blockchain technology. It is a linear chain of multiple blocks, connected and secured by cryptographic evidence. Most blockchains are designed as a distributed, decentralized digital register. This technology is similar to a public digital ledger where transactions are recorded transparently. As new blocks are added to the blockchain, the linked blocks are recorded continuously. The blockchain is almost impossible to modify because the blocks are linked by cryptographic evidence. In order to produce new blocks, the network participants have to get involved in an expensive and intensive computing activity called mining. Mining appears as a distributed consensus system used to confirm transactions by including them in the blockchain. It imposes chronological order, protects network neutrality, and allows different computers to approve the blockchain. In order to be confirmed, transactions must be included in a block that must comply with very strict cryptographic rules that will be verified by the network. These rules prevent the Eleonore de Cardes 670006846 BEE3109

modification of a previous block because it would invalidate all subsequent blocks. Mining also induces the equivalent of a competitive lottery that prevents any individual from easily adding blocks consecutively in the blockchain. To validate each Bitcoin exchange, a miner must solve a very complex problem which solution must be approved by other minors. This protocol is called 'proof of work'. The protocol is designed not to exceed the threshold of 21 million units in circulation. The miners are also responsible for the creation of money: a complex mathematical equation is submitted to them every ten minutes and the fastest machine receives a reward in Bitcoins. This reward is currently 12.5 Bitcoins, halved every four years, and the last unit will be produced around 2140. The miners are paid with transaction fees. Also, since mining is the only way to create new tokens, it avoids the risks of inflation that threaten traditional fiat currencies, for which a government is able to control the money supply. Bitcoin, therefore appeared as a revolutionary tool that enabled a new currency prevailing security and privacy, which central banks failed to provide. Indeed, hash functions are a series of mathematical and cryptographic operations that produce a result, also known as a hash function or signature. They are usually used to secure a transfer of information. They rely on determinism (income must be the same as the outcome), non-reversibility (hard to reconstruct the original password), collision resistance, non-predictability, and diffusion (a change in one bit of the original password should result in a change to half the bits of its hash). There are other cryptocurrencies than Bitcoin, each with its own characteristics and mechanisms. Today, we count around 5760 different cryptocurrencies listed on CoinMarketCap. Some are created on an existing blockchain and some are totally independent. They use a different protocol. The proof of work, well known for, can be replaced by proof of stake (most common after the proof of work). After the publication of Satoshi's White Paper, many cryptocurrencies have emerged, including Litecoin and Ripple, which are two alternatives to Bitcoin. Litcoin brings a new transaction validation algorithm, Scrypt. Ripple is Eleonore de Cardes 670006846 BEE3109

still considered an important active cryptocurrency today although it is much more centralized than Bitcoin. Then, more original currencies appeared such as Monero, which aims to overcome the non-fungibility problem of bitcoin, and Ethereum which enable the creation of smart contracts (programs that exist on a blockchain and allow the completion of certain tasks independently). As result, we can agree that new forms of money have appeared in order to circumvent the flaws of central banks to our fiat currencies. They allow decentralized transfers (peer to peer) and security.

Eleonore de Cardes 670006846 BEE3109

II.

Bitcoin, a burden for the environment?

Today, at a time when cryptocurrency is enjoying unprecedented popularity, voices are being raised to denounce its ecological cost. But how can this energy cost be explained? Invented in 2008, Bitcoin implements a decentralized peer-to-peer system in which network operators develop complex mathematical calculations to decrypt and ensure the security of the transactions. The resolution of these problems requires high consumption of energy. This can be explained by the proof of work from which the people in charge of verifying the transactions are paid. Consequently, network operators need to use processors with a high computing capacity in order to be able to solve mathematical problems in the shortest possible time, which results in high energy consumption. How has Bitcoin impacted the environment and how do the actors of cryptocurrencies aim to reduce this impact? In the early days of Bitcoin, a simple computer was enough to mine. Recently competition among miners has increased. Miners are looking for tools, such as the ASIC machines, that are increasingly efficient. But the faster ASICs mine, the harder it will get to solve the problem of maintaining the 10-minute gap between each block. Now, most of the profits are being channeled into 'mining farms', an extremely energy-intensive business. China accounts for 58% of these data centers, according to a study by the University of Cambridge. It describes “an arms race amongst miners to use the cheapest energy sources and the most efficient equipment to keep operators profitable”. Yet China remains the world's largest consumer of coal, which accounts for about 60% of its energy mix. These phenomena of geographic concentration are mainly explained by the differences in the cost of electricity from one country to another. China thus offers the cheapest electricity, often in areas where hydroelectric dams have been built in anticipation of massive influxes of new inhabitants or the establishment of new cities, allowing these industrial activities to benefit from lower-cost Eleonore de Cardes 670006846 BEE3109

energy. Today, according to the Bitcoin Energy Consumption Index, the Bitcoin protocol needs 77,78 TWh of electricity, which is comparable to the power consumption of Chile. Its carbon footprint is 36,95 Mt CO2 and corresponds to the carbon footprint of New Zealand. Also, in terms of electronic waste, Bitcoin annually encounters 10,32 kt, comparable to the e-waste generation of Luxembourg. Because the amount of energy in a country is limited at any given time, mining could affect household consumption and even medical and industrial supplies. If a mining farm is located next to a hospital or infrastructure for which a disruption in electricity supply could represent a danger to citizens, the issue becomes vital. From a geopolitical point of view, an increase in electricity consumption would also lead some countries to be more dependent on others. Indeed, all the countries of the European Union are net energy importers; increased energy dependence would place the sovereignty of these states at risk, leaving them at the mercy of countries controlling energy resources. Cryptocurrencies are also likely to have an impact on local temperatures. Although studies have not yet been conducted on possible warming of the areas around mining operations, the heat released by farms into the atmosphere, with sometimes more than 600 computers, is significant. Iceland is conducive to intensive mining because electricity is cheap and low temperatures allow computers to cool down naturally. Conversely, in countries with warmer climates, companies are forced to keep machines at low temperatures, which leads to higher electricity consumption. There is a vicious circle: the more energy consumption increases to produce virtual currencies, the more energy is needed to cool the machines, leading to disproportionate energy consumption for the production of a currency that has no value guaranteed by a state or a material such as gold. Finally, the production of cryptocurrency requires powerful computers, running at full speed all day long and therefore having a limited lifespan. If the production of these computers and the materials they are made of is often not taken into account in the ecological balance of Eleonore de Cardes 670006846 BEE3109

digital currencies, it is nevertheless a major issue, especially in terms of environmental protection. This consumption seems bound to increase in the future due to the growing complexity of calculations to verify transactions. Unlike fiat currencies guaranteed by central banks, the price of cryptocurrencies corresponds to the energy consumed to produce them. Surely this energy cannot be returned, and the price of these digital currencies is solely based on the confidence of investors and users, who attribute a value to a currency without any guarantee.

Recently perspectives seem to have changed regarding the energy waste caused by Bitcoin. Cryptocurrency actors are aiming to find solutions to the ecological impact of Bitcoin. Indeed, while China controls 66% of the global ‘hashrate’ (a measure of the power of computers connected to the bitcoin blockchain that controls the production of coins) (Reuters, 2019), China decided in 2018 to reduce its mining activities. Other initiatives are flourishing, such as in Austria, where a company is promising hydroelectric mining farms. However, the major problem with the power consumption of cryptocurrencies remains the proof of work and therefore induces the development of alternative uses of the blockchain. However, their security is often less certain, and they present a risk of centralization. The main alternative is the proof of stake. The block validation mechanism is based on the fact that network nodes wishing to participate in the issuance of new blocks on the blockchain must be able to prove that they have a certain number of tokens issued on the blockchain. Thus, the number of validators is limited. To become a validator (miner in the bitcoin blockchain), it is necessary to deposit a certain number of tokens. This deposit will then be used as a guarantee for the validation defined in the protocol. This one exposes itself to the total loss of the tokens deposited beforehand. It is thus encouraged to validate the blocks without trying to defraud the protocol in place. According to S. Seibold and G. Samman (KPMG: 5), the proof of stake aims Eleonore de Cardes 670006846 BEE3109

to create a "mechanism that punishes nodes that do not follow the consensus protocol. Participants have to bet a predefined amount of digital assets on a consensus outcome. If the outcome does not take place, the malicious nodes (those who bet against the majority consensus) lose their bet”. From an energy consumption point of view, this mechanism replaces the labor-intensive proof of work and resolution of cryptographic evidence in Bitcoin cases. In addition to the proof of the stake, other blockchains have developed. Bram Cohen developed a decentralized peer-to-peer file transfer protocol, BitTorrent. His company called Chia Network offers cryptocurrency based on proof of space rather than proof of work. Essentially, Chia exploits the abundant and cheap unused storage space on hard disks to check its blockchain. Instead of wasting electricity for security purposes, the company is taking advantage of unused storage space that is already widely distributed. This results in a much more decentralized and greener system. According to the company, each block begins with a proof of space and is finalized with a layer of security by eliminating a wide range of attacks to which proof of space is vulnerable. With the emergence of these environment-friendly blockchains, one would think that the first generation blockchains of Bitcoin and Ethereum are in decline, but they are actually trying to improve. The developers of Bitcoin have created a system called the Lightning Network. It aims at increasing the speed and number of simultaneous transactions that the Bitcoin network can support, which in turn, reduces the carbon footprint of the blockchain. The reduction in energy consumption is enabled with the development of the 'sidechains'. Parallel chains can be opened between Bitcoin users. Once opened, all transactions performed will be stored in the sidechain, the transaction will become anchored to the main chain after synchronization. This way the number of transactions carried out on the main blockchain is reduced and the sidechains provide more processing capacity. Surely, this does not eliminate the energy footprint of the mining activity, but the energy cost of a transaction decreases significantly. Eleonore de Cardes 670006846 BEE3109

The environmental impact of the bitcoin is not related to its technology itself but more precisely to the validation protocol of the blocks emitted on the blockchain. If this impact seems important, awareness and solutions dealing with developing new blockchains protocols or changing the existing blockchain of the bitcoin are arousing. One can therefore wonder if we can hope for a technology as secure and popular as the actual bitcoin, but causing less environmental damage to be successful in the future?

Eleonore de Cardes 670006846 BEE3109

III.

Appendix: Group Work Learning Log

As part of the assessment, my peers and I have completed a presentation about the development of Ethereum in Zimbabwe. We focused on the advantages and drawbacks of Ethereum and its application in the country. Firstly, we thought about focusing on the implementation of cryptocurrencies in developing countries, but the topic was obviously too large regarding the amount of time we had to speak. Therefore, we rapidly considered narrowing the subject and focusing on an extreme case of the implementation of Ethereum (the most popular cryptocurrency after Bitcoin), which is Zimbabwe. Tom Grace and I contributed to the first part of the presentation in which we focused on the favorable environment for the development of cryptocurrency. It implied studying the economic situation of Zimbabwe and pointing out the factors that have enabled the implementation of cryptocurrencies. Zimbabwe faces hyperinflation since 2000 which has plunged the country into a massive recession. The government’s interventions to support the currency by increasing interest rates have caused much uncertainty in the country and therefore enhanced people’s willingness to circumvent the inflation and thus use other forms of currencies. Moreover, as the government recently banned mobile transactions, Zimbabweans had to find alternatives to easily send money. As a result, the need for cryptocurrencies aroused. Finally, we can observe that as the use of smartphones and peer-to-peer trade in the continent has increased in the past years, cryptocurrencies have rapidly extended as it appeared as a safe haven for Zimbabweans. It enabled them to transfer money without relying on their untrusted central authority. As regards the making of the presentation, we obviously encountered some difficulties related to the fact that we could not meet in person. However, we managed to organize meetings regularly in order to keep track of everyone’s work. Since we were meeting on Zoom, we did not waste time organizing presential meetings that could needlessly last for long. Our meetings were therefore short and straight-to-the-point. Also, the small amount of time we had to present Eleonore de Cardes 670006846 BEE3109

has impinged on our ability to conceive a rich and detailed work. We were constrained to significantly reduce our arguments and still yield an explanative and coherent work. This time restriction enabled me however to be very critique of the information I found and forced me to be concise and rigorous in order to focus only on the most important material. Overall, I think we managed well to deliver concise work since our topic was precise. Indeed, it was a good idea to focus on the implementation of one cryptocurrency in one specific country, so we were able to yield a short but still quite precise observation of the tendency of Ethereum in the country.

Eleonore de Cardes 670006846 BEE3109

IV.

Bibliography:

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All Cryptocurrencies | CoinMarketCap. (2020), from https://coinmarketcap.com/all/views/all/

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Bitcoin Energy Consumption Index - Digiconomist. (2020), from https://digiconomist.net/bitcoin-energy-consumption/

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