Questions and questionable answers on the blockchain and cryptocurrencies

Quick note: This post is way too long… but it felt weird to split it up considering it all came from the same burst of research, and I didn’t want to cut some of the finer details because I’m using this for reference. So apologies! ¯\_(ツ)_/¯

I’ve been aware of cryptocurrencies and the blockchain for a long time but have never taken a moment to dig in. Recently there’s been a lot of buzz around the blockchain amongst people I know and like. Some of these people have historically been pretty skeptical about it, as have I, so this has made me curious about what might have changed.

This is an attempt to get to the bottom of a few concepts and questions that have been lingering in my mind. It starts with a very basic attempt to describe the blockchain and crypto and then moves on to topics I’m particularly concerned about, especially energy usage, risk / legality, and the impact on the digital divide. I’m calling these answers “questionable” because I’m definitely still learning, but I’ve done enough research and thinking around it all that I’m comfortable with what I’ve written here. If you read any of this and think I’ve gotten something wrong, let me know.

I’m most interested in why non-fungible tokens (NFTs) are getting so much hype right this moment but decided to focus on the blockchain and crypto first since it forms the foundation of NFTs. A dive in to NFTs is to come separately.

What is the blockchain?

The blockchain is a way of storing data cryptographically. You can think of the term quite literally: blocks of data are chained together to form an ever-growing and nearly immutable ledger. The blockchain as we know it was invented in 2008 and was implemented for the first time with the Bitcoin protocol in 2009, creating the cryptocurrency bitcoin.

The blockchain is decentralized, meaning it isn’t stored in any one place. It is instead distributed across every different computer, or node, that has interacted with it on a particular network. The blockchain is one of many decentralized technologies, but it is more of a concept than a unique protocol such as Dat or the InterPlanetary File System (IPFS) (neither use the blockchain, to be clear). There are many different blockchain protocols with different advantages.

On the blockchain, each block of data and the way it is connected to the previous block is permanent and verifiable without the need for any third-party involvement or intervention. Because of this, one of the most common applications for the blockchain that we’ve seen so far is cryptocurrency transactions and investment.

But it’s worth noting that the blockchain can be useful for much more than cryptocurrencies and decentralized finance (DeFi). I’m particularly interested in the Handshake Network, a decentralized domain name system (DNS) alternative. And the blockchain could also be used to track the supply chain to prove with 99.9% certainty that a particular product’s manufacturing didn’t involve things like child labor.

Why are people excited about the blockchain?

Since the blockchain is inherently decentralized, you don’t have to rely on a third party like a bank for transactions in the case of bitcoin, or on ICANN for domain names in the case of the Handshake Network. This is exciting in an era when the public feels like it may no longer be able to trust major organizations due to events like the 2008 financial crisis which was fueled by many large financial institutions’ poor decisions. Decentralization can also makes the blockchain more robust against attacks, it removes the Achilles Heel of similar centralized systems.

People are also using the blockchain to reinvent the way they monetize their digital creative work through smart contracts and NFTs.

And many are excited about the anonymity the blockchain affords. For example with bitcoin, the only identifying information associated with a transaction is your wallet address. As long as you keep your wallet address private, completely distinct from other identifying information such as your IP address, your email, your name, or anything else, the transaction remains essentially anonymous. This could be useful for activists living under violent authoritarian regimes. Unfortunately it could also be useful for people trying to organize extremist movements.

What is cryptocurrency?

Cryptocurrency, or crypto, is digital currency that relies on the blockchain. Cryptocurrencies are very different from fiat currencies such as USD or GBP in that they aren’t physical, they aren’t issued or managed by central authorities, and they haven’t been declared legal tender by a government (yet).

Of course a major problem with any currency, real-life or digital, is counterfeiting. Counterfeiting is very difficult with most major physical currencies due to anti-counterfeit measures like watermarks, holograms, serial numbers, and security threads. Cryptocurrencies on the other hand use peer-to-peer (P2P) protocols prevent duplicates and double-spending on the network.

Bitcoin was the first cryptocurrency, but thousands of other cryptocurrencies have proliferated since 2008. Ether, built on the Ethereum blockchain, is the second most popular cryptocurrency after bitcoin based on market capitalization, and it may well overtake bitcoin in the next few years due to Ethereum’s popularity in uses other than as a cryptocurrency, its large developer community, and the recent launch of Ethereum 2.0.

Cryptocurrency is attractive to many people since transactions can be much faster than traditional transactions (especially in the US), the percentage commission taken for each transaction is generally substantially less than with platforms like PayPal (though it can be more than with traditional brokerage firms like Fidelity), and investments are often seen as insulated from the vagaries of Wall Street (though this is becoming less of the case, and crypto investments have their own volatility issues).

How do you store and use cryptocurrency?

To use cryptocurrency, you have to buy some and store it in a “wallet” which is simply a digital storage space for the keys involved in a cryptocurrency transaction.

Some people choose to store their cryptocurrency on a physical device such as a hard drive or USB stick. This is less common now but was very common in the early days of crypto since there weren’t many platforms that could handle it for you. People that still store crypto on a physical device may do so out of habit or may prefer it if they feel they can’t completely trust a platform or can’t trust themselves to keep an online account 100% secure. If you’re interested in the root of this mistrust, look up the Mt. Gox or Quadriga CX fiascos, or the Binance hack. The downside of storing your crypto on a physical device is that it is easier to misplace, and you may lose access if the device is corrupted. Horror stories abound of early crypto investors who lost their physical storage and so lost out on millions as the value skyrocketed.

That said, most people use platforms as a wallet since they are easy to use, accessible nearly anywhere, and many also perform as exchanges allowing you to buy and sell crypto. If you are thinking of going with a platform, it’s worth figuring out which exchange you want to use to purchase cryptocurrency before you set up your wallet.

You can use a centralized exchange such as Coinbase or Gemini if your priorities are ease of use or abiding by geographically-based regulations. Alternatively, you can use a decentralized exchange like LocalCryptos if your priorities are anonymity, avoiding the control or hacking risk of a centralized exchange, or circumventing geographical restrictions. And some more “traditional” finance platforms are even beginning to offer cryptocurrency exchange, though most only offer them as securities so it’s not really spendable cash. Robinhood is an example, but I doubt they’ll be on the field for long due to how they handled the GameStop short squeeze.

To find the right exchange for you, it’s best to have a search online for exchanges that deal with the cryptocurrency you’re interested in and that operate in your locality. For example, if you’re a New York resident, you’ve got to work with an exchange that has a BitLicense, a NY state regulation that went in to effect in 2015. When comparing exchanges, keep in mind your locality’s restrictions on exchanges, ease of use, privacy, speed of transactions, fees, transaction amount limits, insurance and protection policies, and the general reputation of the exchange.

Once you’ve got your wallet set up and you’ve set up an account with the exchange you want to use, you can purchase some cryptocurrency. On centralized exchanges, you usually purchase cryptocurrencies by linking your bank account or credit/debit card so that it is easier to make purchases using fiat currency.

It can be intimidating to look at the current value of a cryptocurrency and see that one coin is worth several thousand US dollars, but it’s important to remember that these are not stocks, you can buy fractions of cryptocurrencies. For example, the smallest amount that Ether can be divided into is 0.000000000000000001 ETH. So you can go ahead and purchase whatever amount you feel comfortable with.

Once you have some cryptocurrency, you could sit on it as an investment in and of itself, following its value as it rises and falls. You could also use it to invest in other companies in an initial coin offering (ICO), or as a patron of creative work via the Zora protocol and ZNFTs. You can also purchase assets with cryptocurrency such as digital art on NFT platforms like SuperRare. There are online marketplaces popping up that allow you to buy more traditional IRL products and things like flights, web hosting, and games. And a handful of brick-and-mortar stores and food chains are starting to accept it as well.

Of course you can earn crypto as well. You could sell your creative work on NFT platforms, you could charge your clients in crypto. It’s not something my clients would be on board with, but yours might be different!

Keep in mind that though the blockchain is decentralized, the whole system becomes more centralized as you work with platforms like Coinbase to manage your cryptocurrency or SuperRare to purchase art. These are companies so you should expect fees, usually as a percentage rather than a flat rate, and this happens with any transaction whether you are buying crypto, buying an asset with crypto, selling with crypto, or cashing out to fiat currency.

Is cryptocurrency risky or illegal, and is it protected in any way?

One of the goals of this whole exercise is understanding how all of this affects me, so unfortunately a lot of the following is very US-centric since I’m now living in the US. I’m really interested in exploring the regulations and rules around cryptocurrencies outside of the US, but it is such a broad, convoluted, and fast-changing subject that I can’t go in to more on it here without making this four times as long as it already is. If you have any thoughts to share about non-US regulations or laws, please do!

Investing in cryptocurrencies is inherently risky in the same way that investing in stocks is inherently risky, there is always a chance that your investment isn’t going to pan out. Of course there’s also a chance that you’ll win big.

Managing risk in cryptocurrency investments is subjective and not something I’m that familiar with so I won’t go in to it at length here, but suffice it to say it’s never a great idea to put all your eggs in one basket. And the assumption that cryptocurrencies’ value is unrelated to the stock market is likely false. As certain cryptocurrencies become more mainstream, their value is beginning to trace similar rises and falls as the wider world of finance. So putting your money in cryptocurrency is not necessarily going to shield you from a burst bubble in the stock market.

There’s also the risk inherent in trusting so heavily in the cryptography and configuration of a piece of technology with something that could affect your livelihood, such as your finances. The cryptographic fingerprint or hash of each block should be sound, but if the cryptographic tools underpinning a blockchain protocol are put together in insecure ways, then you’ve got a problem. Blockchain protocols that have been around for a while and are well used are probably safe enough due to the sheer amount of testing they’ve gone through, but all protocols may have vulnerabilities that haven’t been found yet.

And then there’s the cryptography itself. Part of the reason that hashed data is so secure is that the hash algorithm usually takes an inordinate amount of computing power to break, though some algorithms are stronger than others. Quantum computing could make cracking a hash much simpler or even trivial. There have been efforts to create quantum-resistant cryptography but it seems like an arms race, is quantum computing going to be here faster than post-quantum cryptography or vice versa? To be honest, quantum computing is going to threaten much more than just the blockchain and cryptocurrencies—what happens to traditional financial transactions? HTTPS? VPNs? wireless networks? 😬—but it’s worth mentioning since it may be just over the horizon.

Besides the potential investment- and tech-related risks, it’s also worth considering the risks involved in trusting a centralized platform as your wallet and exchange. Again, one of the main benefits of a centralized platform is its ease of use. One of the main downsides is that it effectively acts as an Achilles Heel; if an exchange is brought down by hacking, mismanagement, bankruptcy, or anything else, you could be in for a world of hurt. Since so much of the world’s cryptocurrency is tied up in a very small handful of centralized exchanges, there’s a very good chance that one of these exchanges going down would have a serious impact on the value of a cryptocurrency. Besides this, if the exchange you use for your own wallet and trading goes down permanently for some reason, you could lose your investment entirely.

In the US, traditional brokerage accounts for trading on the stock market such as those offered by Fidelity are generally protected by the Securities Investor Protection Corporation (SIPC) up to a limit. Some brokerage firms also offer insurance in excess of this limit so that all of your assets are protected. Cash funds in these accounts, as in cash that is not tied up in securities, are insured by the Federal Deposit Insurance Corporation (FDIC). All of this means that if the brokerage firm is closed to due bankruptcy or any other problem and a customer’s assets go missing, those assets will be recovered either in full or up to a reasonably high limit. Besides this, many brokerage firms have policies in place to help you recover funds in the event that your account is compromised or hacked as long as you have taken a few basic precautions.

The cryptocurrency held in exchanges on the other hand is not SIPC or FDIC-insured, though the fiat currency balances held by these exchanges is usually FDIC-insured up to a certain amount. Centralized exchanges do sometimes have separate insurance arranged, but this varies.

As an example, Coinbase does have insurance, but only on the roughly 2% of digital currency in hot storage. Their insurance doesn’t cover losses from cold storage, nor losses from hot storage resulting from a breach in Coinbase’s physical security, cyber security, or employee theft. They also don’t insure losses in the event that a customer account is hacked or compromised. See Coinbase’s policy for more. As another example, Gemini has insurance but only on hot storage assets as well (no information on what percentage of total assets this is estimated to be). They do insure losses resulting from a security breach or hack, a fraudulent transfer, or employee theft, but they don’t insure losses resulting from unauthorized access to a user account. See Gemini’s policy for more.

And then there’s the risk involved in maintaining your wallet. Cryptocurrency wallets are pretty heavily targeted since they can be an easy way to steal big bucks. A lot of the normal security precautions apply: use multi-factor authentication using an app such as Authy wherever you can; don’t use duplicate passwords; don’t store your private keys in your email or plain text anywhere; don’t enter your private keys on a site that isn’t extremely familiar to you; be on the lookout for phishing attempts and malicious ads, if an offer looks too good to be true it almost certainly is. Also, if you really get in to investing in crypto, consider a cold wallet, an offline device that can store your cryptocurrency.

In terms of legality, it really depends on where you are resident.

The US has a handful of laws relating to virtual currency which in effect require exchanges to be registered as Money Services Businesses, to get the necessary licenses for trading cryptocurrency, and to tell law enforcement about suspicious transactions. Certain states also have their own regulations such as the BitLicense which is required for exchanges to operate in New York state. These regulations can effectively limit the exchanges that you can legally work with.

And then there are taxes. Inevitable and confusing.

In the US, the Internal Revenue Service (IRS) classifies cryptocurrency as property along the lines of stocks or securities, meaning that gains and losses have to be reported. There are solid arguments against this classification. It is strange that a virtual currency would be treated like a stock as opposed to a fiat currency. You don’t get taxed extra on your USD savings if the value of USD goes up, for example. But it is what it is for the time being.

Reporting gains and losses to the IRS is pretty easy with traditional stocks, you can just refer to the 1099-B form issued by your brokerage firm. It’s more complicated with crypto. If you’re using a big-name centralized exchange you can sometimes get a form from them, but these are usually 1099-Ks which are more merchant-focused and don’t show anywhere near the detail of consumer-focused 1099-Bs. The exchange Uphold is a notable exception, they’ve made the proactive decision to issue 1099-Bs. If you’re using an exchange that doesn’t supply any forms or you can’t get any forms from your exchange, you’ve either got to use an third-party service like TaxBit or it’s up to you to track gains and losses for every crypto transaction you make. I have absolutely no idea how you would go about that due to how much the value fluctuates and how your initial purchase can be split up down the line. The IRS is cracking down on crypto underreporting, and crypto investors are getting frustrated with exchanges refusing to issue 1099-B forms. So we might see a change there at some point, but who knows when.

Perhaps it’s worth mentioning that the pseudonymity of cryptocurrency transactions of course means that it’s dangerously easy to hide funds from any tax body. Personally I wouldn’t mess with hiding earnings—IMO it’s illegal and dumb on a social level to not pay your taxes unless you’re living under an objectively despotic government—but it highlights the difficulties that governments face when figuring this out.

The TL;DR when it comes to crypto and taxes: it’s complicated, most big centralized exchanges have decided they don’t need to compile the necessary forms that consumers are used to (especially in countries other than the US), and the enforcement and regulation is still evolving. Probably best to talk to an accountant.

Why is the blockchain said to be bad for climate change?

The single biggest downside most people cite when talking about the blockchain is energy consumption. It is certainly one of the main reasons I wrote it off for years.

One problem is that blockchain ledgers can become very large. For example the Bitcoin blockchain is estimated to be over 300GB as of today, and growing larger by the second. The number of computers storing this information can also grow exponentially due to the blockchain’s decentralized nature. And all of those computers probably have some sort of backups in place, redundancy to ensure that the data is kept safe in the event that the original is corrupted or lost. All this storage means more data centers using ever more energy.

More concerning though is that energy consumption is baked in to the core of most blockchain protocols. All blockchain protocols rely on a consensus mechanism in order to verify each chunk of data as it is added. Consensus is a common problem in computing, it is difficult to ensure that two different systems or computers agree on one bit of data without human intervention. This mechanism is a core component of the blockchain, without it the blockchain as a concept wouldn’t exist.

The most common consensus mechanism used by cryptocurrencies is Proof of Work (PoW), and the first cryptocurrency to use it was Bitcoin. The problem is that the PoW mechanism requires proof that a certain amount of computational work has occurred to a specific end, and computation requires energy. So PoW is energy intensive by design.

Bitcoin is probably the cryptocurrency most vilified for its energy consumption. Bitcoin mining is the process of creating new bitcoin by solving mathematically complex problems (the computation part of PoW). As new bitcoins are introduced to the market through mining, these problems become progressively more difficult, requiring more computing power. This is not only bad for the environment, it has led to malicious activity such as the creation of bitcoin-mining botnets which infect devices and harness their computing power. But again, Bitcoin isn’t the only cryptocurrency using PoW, it’s just the oldest and the one with the biggest market capitalization. Ethereum also uses PoW, and all cryptocurrencies using PoW have similar energy consumption problems. They just might not be as big as bitcoin yet.

Thankfully, PoW is not the only consensus mechanism. Proof of Stake (PoS) is probably the second most frequently used, followed by a whole host of other mechanisms. With Proof of Stake, instead of giving weight to computing power, weight is given to a combination of randomization and the stake. The stake is usually wealth (so how many of a coin is held) or age (the combined age of the coin held), meaning that computing power isn’t integral for consensus. Because of this, it’s probably better to use the term “minting” or “staking” instead of “mining” to describe the process of creating new PoS-based crypto coins.

Are there probably downsides to PoS vs. PoW, possibly some unintended consequences? Likely (there’s a con for every pro), but I haven’t had the chance to look in to it a ton. At least it takes the energy consumption out of the equation.

Unfortunately PoS is not very widely used just yet, certainly not amongst the biggest cryptocurrencies. Ethereum 2.0 (“Serenity”) uses PoS, however this was only recently launched this past December and the full launch is likely to happen in 2022 at the earliest. This may really shift the energy and climate change conversation around the blockchain since Ethereum is rapidly climbing in popularity, but until Ethereum 2.0 is fully available, we’re stuck with the inefficient PoW-driven cryptocurrencies for the most part.

How do cryptocurrencies and the blockchain affect the digital divide?

The element I’m most concerned about and need to do the most further research on is how the use of cryptocurrencies and the blockchain can either help or hinder efforts to close the growing digital divide, the gap between those who benefit from our increasingly digital world and those who fall by the wayside.

It feels like cryptocurrencies in particular are only broadening the cavernous gap right now, but hopefully that can change.

The big question: who benefits the most from the success of the blockchain and cryptocurrencies?

As with anything new, it is always the early adopters that stand to lose or win the most due to their risk. But with cryptocurrency, there are huge swaths of the population that can’t get involved, couldn’t take that risk even if they were interested. Early crypto adopters are almost exclusively the most technically- and financially-savvy among the population, usually with at least a little money to burn. In other words, some of the most privileged. This isn’t these individuals’ fault, but if we ignore this reality, we’re basically just pouring gasoline on to a systemic bias fire that already exists due to lack of infrastructure, lack of digital literacy education, and so much more.

Besides individual early adopters, there are also the large corporations to consider. This includes behemoth financial institutions like TD Ameritrade, ING, and JP Morgan as well as companies like Amazon, Overstock, Google, Microsoft, Comcast, Intel, and more. They’re all building enterprise use cases on the blockchain, largely the Ethereum ecosystem. This is all well and good in some ways, having these large organizations involved in the blockchain is surely a driving force. But are smaller organizations and local governments ever likely to benefit from this? Or is this all proprietary, closed source?

I think that this is why the excitement around the blockchain and cryptocurrencies can feel particularly insular and myopic. Often the hype focuses on the incredible economic opportunities it affords or a small handful of big problems it solves while failing to engage with (or deliberately minimizing) the potential negative long term implications which can be smaller in scale but great in number. This may be changing, the conversations about the blockchain do feel a little more intersectional than they did years ago, but there is still a long way to go.

To be clear: I’m not saying that people who are excited about the blockchain shouldn’t be excited about it, should stop working on it, or should pull out of cryptocurrencies. The blockchain definitely has the potential to address some big problems, and it’s absolutely worth attention.

I do think that there is much more we can do to ensure that it benefits more people and so that more people can participate. If possible, we should be drawing attention towards blockchain projects that aren’t so cryptocurrency-focused. We should be introducing regulations to ensure that people’s cryptocurrency holdings are protected against unscrupulous exchanges or the compromise of an exchange. We should be absolutely screaming any time a government shuts down the internet in response to a protest. We should be working to fix the infrastructural issues causing poor connectivity in so many of our rural communities, Internet access should be a utility.

But besides these major problems, there is a broader problem that almost anyone interested in crypto can help solve: digital literacy. The way we usually talk about the blockchain on social media, in blog posts, and in the mainstream media is often nearly as cryptic as the cryptography that underpins it. The conversation can be pretty exclusionary and jargon-filled when it doesn’t always have to be. (I feel confident asserting this since it’s a big part of the reason I never properly looked in to it, and I’m exactly the sort of person that should be excited about it!) We could use more plain language introducing the subject, more metaphors, to be more welcoming of those who may not understand, and to work together towards a shared understanding that doesn’t read like programming language documentation. And my goodness, we have to admit that the blockchain isn’t a panacea.

Changing the way we talk about the blockchain and cryptocurrency, making it more inclusive, will help normalize it. This will help people who have wanted to get involved but may have been too afraid or left out, and it will help people who are already involved by making it more mainstream. It’s a tiny drop in the bucket, but it’s something.

I’m sure there are more concrete ways that the blockchain could help narrow the digital divide but it’s not something I’ve wrapped my head around yet. Some of the more interesting things I’ve come across so far that seem to truly be doing good is Decentralised Citizens ENgagement Technologies or D-CENT (via Jaya Klara Brekke) and Circles UBI (via Sarah Friend). It’s just a shame that the buzz around these efforts seem to get so overwhelmed by the massive amount of attention paid to cryptocurrencies instead. At any rate, I’m very open to suggestions about how the blockchain is being used to improve life beyond financial gain.

And seriously, to reiterate a related-but-separate point from earlier: internet access should be a utility. It’s wrong that some kids are doing worse in school because they can’t get a good internet connection or an ISP is charging through the nose for service in their area. Tell your representatives.

So have my opinions changed?

Yes and no. I was pleased to find out about the push towards PoS blockchain protocols with Ethereum 2.0 leading the way, but disappointed that PoS dominance still seems a long way off. I’m also pretty wary of the balancing act between centralized platforms and decentralized protocols, it feels like the platforms may be necessary for widespread adoption but they undermine so many of the major upsides inherent in decentralization. Besides all this, I’ve been happy to find that the conversation around the blockchain seems a bit more inclusive, though most of the more casual conversation on blogs and social media still feels pretty cryptocurrency-centric, hype-driven, insular, and rarified.

I’m still very concerned about whether the blockchain will exacerbate existing inequities or improve things, I came across very few use cases that address this (D-CENT and Circles being notable exceptions). I’m sure more people are talking about it though, so I’d like to dig around. And will try joining Circles!

As for whether or not I’ll give cryptocurrencies a go, I probably will buy a bit but will be selective. I’ll likely avoid bitcoin, partly due to the energy consumption issues and partly since it seems like a one-trick pony. There’s no use for the Bitcoin protocol besides as a cryptocurrency AFAIK, and because of that, I don’t see how they’ll continue to dominate the market forever. I’ll probably give ether a try since the Ethereum team is actively working towards PoS, since it is such a widely used platform amongst people experimenting with the blockchain, and since it underpins the most prominent NFT framework which I’d like to explore next.

Generally speaking, I’m not going to get too excited about the blockchain until PoW is no longer the predominant consensus mechanism, until there are more regulations protecting the use of cryptocurrencies, until we see more conversation addressing the blockchain and the digital divide, and until we see more truly viable use cases for the blockchain that aren’t so currency-focused.

Related to this, some NFT exploration is hopefully to come soon…

Thanks to: Gemma Copeland for reading through this ramble in advance and for pointing out both Jaya Klara Brekke’s work which led me to D-CENT and Sarah Friend’s interview on interdependence.fm (see below for links); and Hannah Parnes for walking me through a few ways that quantum computing could affect the blockchain.