Strength in Large Numbers

by Matthias Wüllenweber
12/11/2021 – ChessBase has minted a series of NFTs on world chess champions. The success of NFTs is closely linked to the current rise of cryptocurrencies like Bitcoin and Ethereum. Here, we take a look at this fast-growing world of virtual assets. At their current stage, cryptocurrencies are still viewed with a great deal of controversy. For many, they are breakthrough technology, growth market and a sharp sword to protect civil rights. Others see them as a speculative bubble that diminishes the capability for monetary policy of central banks because they can no longer be controlled by central authorities.

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Taxpayer bailout of banks motivates a new money technology

In 2008, international investment banks plunged the world into a financial crisis whose consequences we are still struggling with today. The hidden bundling of bad U.S. real estate loans into securities with exaggerated yields led to a bubble whose bursting was followed by one crash after another. States were forced to bail out banks with public money, marking the beginning of the European debt crisis. In Hamburg alone, the rescue of HSH Nordbank cost a total of 14 billion euros (18 times the cost of Hamburgs new concert hall "Elbphilharmonie"). In the countries of the global south, existential poverty grew. In the course of 2008 alone, the number of people suffering from hunger rose by 75 million.

For a small group of highly talented developers, this downside of a poorly regulated banking sector became the motivation for a bold and ingenious project. They came up with the concept of an independent digital currency that would become a counterweight to the power of institutional big finance. Not central banks, states or individual corporations were to carry this currency, but a globally distributed network of computers constantly synchronizing and monitoring their states. "Decentralized" was the key term for an accounting system that could not be falsified, in which no one had decision-making power, but fixed algorithms provided security and predictability. They called the currency "Bitcoin" and the decentralized accounting "Blockchain".

 

How do Bitcoin and Blockchain work?

The mastermind behind Bitcoin was Satoshi Nakamoto. He published the legendary "Bitcoin Whitepaper" on October 31, 2008, in which all the technical basics were already outlined. To this day, it is unclear who is behind the pseudonym Satoshi Nakamoto. It is considered likely that he is no longer alive and that his immense fortune in Bitcoin is lost forever.

Memorial for Satoshi Yakamoto in Budapest.

By Elekes Andor - Own work, CC BY-SA 4.0, https://commons.wikimedia.org/w/index.php?curid=112023036

The basic idea of cryptocurrency is: A payment with classic cash represents a trustless transaction. The creditworthiness of the buyer is irrelevant. The transaction is completed when the money changes hands. Our entire economic system is based on transactions. But every non-cash payment needs an intermediary, e.g. a bank or a notary. This generates costs, eats up time, and poses trust problems if the intermediary turns out to be unreliable. Cryptocurrency enables trustless transactions of any amount without an intermediary bank, completed in minutes.

Technically, this transaction is realized through the so-called blockchain. The blockchain is a database consisting of chained blocks. In simple terms, each block contains a number that is calculated from the content of all previous blocks. If one were to forge an entry in any previous block, this current number would no longer be valid and thus the chain would be inconsistent. The blockchain's data is distributed among several thousand computers ("nodes"), which monitor each other and thus ensure the chain's integrity in a virtually indestructible manner. This decentralized organization makes the stored information robust for all time.

 

The Bitcoin blockchain has 713251 blocks right now (Dec. 8, 7:15 p.m.) and weighs about 380 GB, meaning it can still be stored on a regular hard drive.

 

The individual blocks contain the transactions, i.e. the transfers between two addresses. A new block is added to the chain about every ten minutes. The generation of new blocks is a calculation contest with huge numbers between the so-called "miners". Whoever is the first to calculate a certain, previously unknown value ("hash") from the existing transaction data according to a given formula, appends the block to the chain and is rewarded by double the earnings: an amount of currently 6.25 newly created Bitcoin for winning the computing competition and the fees for each individual transaction stored in the block.

One of the technical subtleties of Bitcoin is that the difficulty of the computational race is automatically adjusted so that the solution always takes an average of ten minutes. As more "miners" compute new blocks with faster and faster hardware, the difficulty increases. In the early days of Bitcoin, you could find new blocks on your own computer and gain cryptocurrency with them. However Bitcoin was worth less than a cent then. Later, that required at least a good graphics card. Today, it's ASICs, hardware built specifically for this purpose. A miner can run hundreds of such ASICs, multiplying the probability of successfully generating a block. The block reward is roughly €300,000 at the current exchange rate. Bitcoin's curse and blessing lie in this enormous computing effort. On the one hand, the energy consumption is enormously high. On the other hand, this makes system so secure that it can no longer be attacked, even by governments.

 

The pros and cons of cryptocurrencies

Bitcoin in the underworld

Cryptocurrencies like Bitcoin have rightfully struggled with a rotten image from their pioneering days. When law enforcement agencies still lacked tools to track transactions on the blockchain, Bitcoin was the currency of the darknet and thus a means of payment for drugs, weapons, money laundering and extortion. However the percentage of illegal transactions has been falling for years. There are two reasons for this:

1. There are special "on-chain analysis" companies that specialize in monitoring blockchains and serve as service providers to law enforcement agencies. The blockchain may be anonymous on the surface, but every transaction remains openly stored there for all time. If the right mappings are found, money flows become traceable even years later.

2. Regulators in most states require crypto trading exchanges to have a water tight "know-your-customer" policy, or they risk losing their licenses. In practice, this means that one is only allowed to trade larger amounts after identity verification.

 

Energy consumption and climate crisis

The computational process of storing new transactions and mining Bitcoin consumes so much energy that the first-generation cryptocurrencies account for about 0.2% of global CO2 emissions. This is a serious objection, and frequently heard counter-arguments seem weak:

1. the banking system or gold mines by themselves generate more CO2 than Bitcoin.

2. the civilizational value of a hard, highly functional money that cannot be controlled by authoritarian regimes is so high that this can be accepted because the security of the system lies precisely in the expensive computing effort.

The following argument seems more valid: Bitcoin miners work for profit. Energy costs are their biggest expense. Energy from water, wind or sun is the cheapest and thus most profitable source of energy for crypto mining. It is in the nature of renewable energy production that the generated power always poorly matches the current consumption. Energy is lost. Every owner of a solar roof knows this: on a sunny noon, 5000 watts of power are generated, but your apartment or house draws just 200-300 watts when you're typing quietly at your computer. So you can feed in over four kW. Unfortunately, no one needs them now, because all people cook and wash in the evening, and e-cars are charged in the dark of the night.

This is where Bitcoin mining can become a catalyst for investment in renewable power plants: Combine mining with power generation in such a way that it consumes the surplus generated, and a significant additional revenue stream would be available to store energy as value and transport it over long distances better than by any physical means.

However, the blockchain of the second largest cryptocurrency, Ethereum, which handles much of the total NFT trading volume as well as our Chess World Champions, is taking a very different approach going forward: it wants to move away from decentralized calculation races ("proof of work") and rebuild the network so that transactions are validated by the amount of capital tied up in network nodes ("proof of stake"). This consumes little energy, but is theoretically more vulnerable to manipulation by very rich players who get their hands on many nodes.

When China still allowed Bitcoin mining, flooding around China's Three Gorges Dam hydropower plant affected the network's computing power.

Christoph Filnkößl, CC BY-SA 3.0 <https://creativecommons.org/licenses/by-sa/3.0>, via Wikimedia Commons

 

Restricting the room for maneuver of central banks and governments

The most interesting objection to cryptocurrencies is aimed at an expected long-term success. At the moment, all cryptocurrencies together have a market capitalization of just under three trillion dollars. That's peanuts, of course, since gold alone has a market capitalization of ten trillion.

But the higher their share of stored value and financial transactions, the greater the significance of Bitcoin and co. compared to conventional currencies. This brings with it two problems: First, if a currency like the dollar functions worldwide as a reserve currency and standard means of payment, it has geostrategic significance that will not be given up lightly. So it's not surprising that both Donald Trump and Hillary Clinton have just come out sharply against cryptocurrencies in this sense.

Bitcoin cannot be controlled. There is no boss, no administration, no central office. The amount of Bitcoin is limited to 21 million for all time. This makes it hard money especially when there is a risk of inflation, but its potential success secondly limits the scope of action of central banks. The world financial crisis of 2008 and the Corona crisis showed that concerted action by governments can cushion economic distortions. The world has learned from the mistakes of deflationary policies in the Great Depression of 1929. If countries thus lose some of their monetary sovereignty, expansion of the money supply, for example, can no longer act as a tool to combat economic crises.

Proponents see precisely this as the power of an independent decentralized currency: expanding the money supply leads to inflation. Inflation brings redistribution from the bottom to the top. Small savings are eaten up, while a rich upper class invests in tangible assets such as stocks, real estate, art, etc., which escape inflation because their price simply rises with it.

 

Small dictionary of the "Crypto Space"

If the above objections don't scare you off, then you might be interested in learning more about the "Crypto Space". This term means the totality of all markets, investors, products and media dealing with cryptocurrencies. There is a jargon here, the mastery of which makes it easier to get started and aptly describes typical phenomena.

 

FOMO

"Fear Of Missing Out". Dangerous emotion. A stock price shoots up exponentially and the feeling arises: everyone is getting rich except me. The accompanying greed often leads to bad decisions.

Original meaning as a side effect of social media: everyone is experiencing great things but me.

HODL Legendary typo of "holding" and a popular investment strategy: trade as little as possible. Behind this is the expectation that so far every technology has still gained increasing acceptance over time. Thus, the value of market-leading cryptocurrencies would continue to increase.
DYOR "Do Your Own Research". The opposite of price-fixated gambling. You should inform yourself as detailed as possible about the technical and economic aspects of a cryptocurrency. You should invest only if you believe to understand them und find them convincing. Do not buy stuff because everybody does it.
FUD „Fear Uncertainty Doubt“. All news and theories that disturb the fantasy of getting rich quickly in the Crypto Space. Common and quite relevant examples: "Bitcoin has no intrinsic value and will fall to zero". "States will ban cryptocurrencies". "The stable coin Tether is fraudulent, and its exposure will bring down the entire market".
KYC “Know Your Customer”. Rule for all crypto exchanges requiring identification by ID document. Also creates fiscal transparency.
FIAT Money “It shall be money” (latin). Fiat money is a government-issued currency that is not backed by a commodity such as gold. Fiat money gives central banks greater control over the economy because they can control how much money is printed.
GAS The cost of a transaction on the Ethereum Blockchain. Needs to be paid when bidding for NFTs at an auction and is currently unfortunately expensive.
WALLET Software (or hardware) in which NFTs and crypto assets are stored. If you lose the password, everything is gone.
EL SALVADOR The only country in the world where Bitcoin is an official currency and where the energy of an active volcano is used for mining (no nonsense).
GERMANY One of the few countries in the world where crypto profits are still tax-free after a holding period of one year. Currently no active volcanoes.

Disclaimer: This text attempts to outline the character, strengths and weaknesses of digital currencies and does not constitute investment or tax advice.

 

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Matthias Wüllenweber, CEO of ChessBase
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