Blockchain: ”Imagine if your car idled all night produced solved sudokus you could trade for heroin.” 

That is how one Twitter user famously described cryptocurrency during the height of the crypto mania in the late 2010s. 

I recently read two popular accounts of the crypto phenomenon: Number Go Up, by Bloomberg contributor Zeke Faux, and Easy Money, by Ben McKenzie (yes, that Ben McKenzie). Of course I wanted to read both of these books, but more importantly, I felt I needed to. 

Cryptocurrency has now been around for a decade and a half. That’s long enough for many of BudgetBakers’ adult users to have grown up hearing about the craze for “digital gold,” or “decentralized finance (De-Fi),” or “Web. 3.0,” or one of a hundred other hyperbolic descriptions of the technology, community, or shadow economy — however one chooses to view the phenomenon that is crypto. 

It’s also long enough for many of those reading to have been too young to remember some of the major scams, frauds, and other crimes that have been perpetrated in the Web 3.0 universe. 

Defining Cryptocurrency

Because many of our customers ask us about crypto, and about supporting crypto investing in our products, we felt it was high time to give you a solid background on what cryptocurrencies really are, how they really work, and why we’ve, for the most part, avoided making them a part of our ecosystem.

Cryptocurrency, decentralized finance, NFTs (Non-Fungible Tokens), and other concepts have captured the imaginations of tens of millions of people, and represent, for some, a seeming chance for instant wealth and financial freedom. At the same time, the list of frauds and scams perpetrated on these hopeful crypto-punters has only grown longer, with the thefts and lies becoming ever more brazen.

While no blog length article can tell you everything you should know about crypto or Bitcoin (especially before you decide to risk real money on it), or the massive ecosystem that has grown up around the technology, this one aims to be at least a jumping off point for a skeptical but fair view of the whole idea. While it will be critical of many of the claims that crypto enthusiasts have made, it will be as fair as it can reasonably be.

This post will lay out a number of claims that are made by the crypto community, and attempt to give you a rounded view of their accuracy and credibility. This and much more information can be found in the two deeply investigated books I’ve linked above. 

“Crypto is a Revolutionary Technology”

As detailed in the first “white paper” published by the pseudonymous Satoshi Nakamoto in 2008, cryptocurrencies, specifically in this case Bitcoin, is intended to function as a trustless, peer-to-peer digital currency,  that is theoretically free from the interference of any government, company, or other regulatory authority. Unlike regular money, which depends on a government or central bank to place money into circulation, cryptocurrency is based on the rules of code alone. 

We won’t go too deeply into how the technology works, but here’s a brief overview of crypto’s most popular form, Bitcoin: 

Nodes

A network of computers, called Nodes, each stores a copy of a list of transactions, called the Ledger. When one user would like to make a currency transaction with another, they send that transaction to the network of Nodes, which compete with each other to process that transaction, earning a fee for doing so. The fact that the nodes compete to process transactions helps to create a consensus among the nodes that the transaction is real.

Mining

At the same time, the nodes can “mine,” or solve complex mathematical equations (for no real world purpose, other than to “validate” transactions on the ledger). Solving these equations rewards these Miners with Bitcoins. Once a Miner proves to the rest of the network that they have in fact solved the equation, the rest of the network then must agree, and award that miner a block of bitcoins. The miners then continue on to the next block, hoping to be first to solve the next equation.

Ledger

As each transaction is copied to the rest of the nodes, it is appended to the ledger, causing it to grow. The ledger continues to store every single transaction ever entered on it, just as long as there continue to be nodes that host that ledger. In addition, each entry in the ledger is appended in such a way that any alteration of any previous block can be noticed by the rest of the network, so that if I try to modify my version of the ledger, the other validators will be able to see it easily. How this is accomplished isn’t super important, but suffice to say it does indeed provide a degree of protection.

Cryptography

As the number of miners rises, and as the number of coins left to be mined decreases, the equations get harder and harder, requiring more and more computing power to solve. Today, massive industrial computing operations are involved in mining most of the Bitcoins that are entering the ecosystem. The energy wasted solving these equations is hard to estimate, but some have likened it to the entire energy output of a medium sized country, like Argentina (46 million people).

There is yet more complexity to the system, involving the equations becoming more complex as more miners join in, and the transactions becoming more expensive as more are being processed. At the same time, the “block reward” becomes smaller over time, leading to Bitcoins becoming rarer, and theoretically, more valuable. 

Limitations

There are other limitations as well: there can only be a finite number of Bitcoins on the ledger (21 million in total, of which about 19m have already been mined). Bitcoin in its original form cannot process more than a tiny number of transactions every second, creating a bottleneck that prevents it from being used frequently, or indeed reliably, by everyday users.

In theory, Bitcoin and other cryptographically secure currencies are invulnerable from certain types of fraud, such as “double spending,” which is when someone sends the same tokens to two different people at the same time, hoping to fool both into believing that they have received the only copies of those tokens. The distributed nature of the blockchain uses consensus to ensure that the blockchain has not been interfered with. But there are problems with this approach, which we’ll address later. 

Another limitation is that because the entire system is essentially a “digital contract,” that does not rely on any form of external regulation or reporting, once a transaction is approved by the majority of nodes, it is not reversible. This means that if a person’s “personal key,” is stolen and used illicitly, the damage cannot be undone. In order to fix such a situation, the entirety of the blockchain must be “forked,” or copied and rolled back to an earlier version. Getting a group of people to do this is no easy task.

Finally, the built in scarcity of coins has led critics to describe Bitcoin as a “deflationary” currency, because as the supply of Bitcoins becomes more restricted, their price will have to continue to rise precipitously as more people compete to buy fewer coins. Refer to our article on inflation for a good explanation of why that isn’t a great thing.

Revolution?

In truth, the claims that blockchain technology are revolutionary are a mixed bag. The idea of organizing a currency this way is certainly novel and unusual. However, there are some very good reasons why currencies have never worked as perfectly trustless and regulation free distributed cryptographic systems. 

At the same time, as a technology, there is not much that is really new about Blockchains. They are essentially databases that have been copied and distributed around the world. The idea of creating irrevocable data trees that each point to their own predecessors, in order to establish an unalterable “heritage” from one addition to the next, predates blockchain technology. Technologies like Git have been using this approach for decades already.

It would be most fair to say that Bitcoin innovated the use of cryptography as a way of securing peer-to-peer currency transactions. That had never really been done before. And there are reasons why that we will discuss later. The use of cryptography as a key element of the currency also creates certain critical problems with this currency model.

“Bitcoin is Digital Gold”

While Bitcoin continues to be the most well known and most valuable cryptocurrency in the world, the fundamental limitations of its original coding, including the transaction handling and the supply limit, have drawn criticism. 

The fact that Bitcoins are created by using increasingly large amounts of computing power has led some governments to heavily restrict or ban the mining of coins. China, most notably, banned crypto mining in 2017 because it feared that the huge industrial mining operations being undertaken in the country would destabilize the country’s power grid.

Energy Waste

The issue of the massive waste of energy resources has never really been addressed when it comes to Bitcoin. The system continues to consume enormous amounts of electricity, and presumably, to have a negative impact on the world’s climate. Exact figures are very hard to quantify, because the production of bitcoins often occurs where energy is the cheapest; therefore often in places where energy production is more ecologically sound (such as via geothermal, hydro-electric, nuclear, and other green sources). 

Nevertheless, owing to the existence of “mining pools” in which thousands of computers around the world network together in order to harness more computing power and win bitcoins and other crypto, it’s very likely that a large amount of energy is being wasted. Much of that energy is also being stolen, either directly from the grid (as was once common in China), or from places like Airbnbs, industrial plants, or data centers that are being used against the owner’s knowledge to mine coins. 

Attempts to address these issues have resulted in a myriad of competing standards, of which some of the most famous have been “BitcoinCash,” Ethereum, LiteCoin, and the joke currency DogeCoin. 

The persistence of the popularity of Bitcoin has led it to be regarded by many as a kind of “digital gold,” a reserve currency of sorts, that need not be used for day-to-day transactions, but which can “back up” the supply of more day-to-day uses of cryptocurrencies, leaving only large institutions to transact in real bitcoins, paying the high associated costs of doing so. 

“Proof of Stake Fixes Crypto”

The issue of how crypto-currency is created and managed has led to much controversy. Some have argued that coins like Bitcoin and Ethereum should switch from a “proof of work” to a “proof of stake” structure. Proof of work is the above mentioned system in which miners compete to solve complex equations. 

The other possible structure, “Proof of Stake,” involves the nodes providing the coins they hold as a “Stake,” for use in validating new transactions. This model awards new coins to nodes by chance, with the nodes that stake more coins having a higher chance of winning the right to validate a new transaction. The Ethereum blockchain now uses Proof of Stake to validate and award new coins. Ethereum made this switch in 2021.

New Tech, Old Problem

While the use of Proof of Stake does largely eliminate the energy waste involved in mining or minting new coins, it presents a new problem: if the validators who have the most coins available for staking are most likely to be awarded new coins, then the system will, over time, accumulate more and more rewards to a few individual validators who have the largest stakes.

If that problem sounds familiar, then it should. That sort of system in which a person or organization’s wealth allows it to grow more wealth over time is exactly the kind of system that “Bitcoin maximalists” (people who believe Bitcoin is the future of money), see as unfair about our current financial system. In solving the serious environmental problems of blockchain technology, Proof of Stake just recreates the same problem of inequality that our current system has. 

McKenzie argues that all attempts to “decentralize” the production of new currency inevitably become what they claim to despise: centralized systems of control and reward which accrue power and wealth to those who have the most resources, either in terms of energy or existing wealth.

This leads to our next dubious assertion: 

“Crypto is Decentralized” 

While the argument for proof of stake does have a kind of logic, it also undermines the original stated mission of Bitcoin, and all decentralized finance: the idea of decentralization itself. 

As Bitcoin becomes harder to use, it will increasingly only be used by large institutions, such as crypto exchanges, which function sort of like banks, and “stable coins” which attempt to function sort of like central banking authorities. As the size of the Bitcoin ledger grows (it now exceeds 570 gigabytes in size, making it unwieldy for use from a typical home computer or smartphone), more users will rely solely on intermediaries to both bank and transact with their coins. 

“Not Your Keys Not Your Coins”

McKenzie’s investigation reveals that only a tiny fraction of those who engage with the crypto economy do so directly with any cryptocurrency. He also found that the majority of all block rewards are now being won by a tiny handful of mining operations. Most users do not mine or stake any form of cryptocurrency. The vast majority use stable coins or exchanges, which maximalists deride as “not your keys, not your coins.”

Yet if most of the money in cryptocurrency is to be found in these centralized service providers, then the system is not very decentralized at all.

At the same time, Proof of Stake coins like Ether will have a similar problem, as described above, with larger validators gaining more and more rewards for processing transactions. Eventually, these validators will become de-facto banks, controlling much of the available supply of the currency.

In fact, according to both Faux and McKenzie, the vast majority of crypto users transact through a tiny selection of exchanges and stable coins, with the dollar-backed Tether (more on them later) being the most common stable coin used to transact with Bitcoin. This makes cryptocurrency already arguably more centralized than the global banking system, in which people continue to transact daily with nearly 200 different currencies. 

Over time, these intermediaries, including exchanges and stable coin providers, will function increasingly as de facto financial institutions, which mimic the functions and the behaviors of the banks and central banks that Bitcoin was intended to replace.

Yet these growing institutions have none of the protections that have been developed over the last 500 years in order to stabilize and regulate the financial system, leading to our next claim:

“Stable Coins are Backed by Fiat Money”

The need for a simple and usable currency in the crypto sphere has led to the rise of “stable coins.” Stable coins like Tether are private companies which take deposits in real money, and offer their own “Stable Token” or Stablecoin in exchange. Tether claims to back its USD-T coin on the basis of one US Dollar to one Tether, with a reserve of US Dollars in cash. This “pegged” currency is meant always to represent an exact correspondence with a real currency.

This means that when someone buys a Tether coin from Tether (or more likely through an intermediary exchange, since Tether does not allow transactions below a fairly large amount), theoretically, the US dollar being spent on that coin goes into a bank-like reserve which Tether safeguards, offering to exchange that tether for a dollar at any time upon request.

This system theoretically solves several problems: it creates a stable value for crypto, which is known to fluctuate wildly in price. It also creates an easy correspondence between the “real” economy and the shadow economy of crypto, allowing people to value real world goods and services using an easy corresponding crypto asset. In theory, I can buy 10 tethers for $10, send you 10 tethers, and then you can exchange your 10 tethers for $10. Job done. 

Is Tether Exchangeable?

However, crucially, Tether’s own terms of service give it the option to simply refuse any such request for a redemption for almost any reason. This means that if a run on Tether’s deposits were to occur, there is absolutely no guarantee that depositors could ever get their money back. Tether, being neither a real bank nor a real currency, has none of the protections that governments provide to the users of real currencies and banks. 

According to McKenzie, almost the entirety of the crypto economy is founded on the belief that this unregulated, tiny, secretive company with a long list of connections to organized crime, will give people their money back. 

Tether has made crypto increasingly accessible to regular people who wish to perform simple peer-to-peer transactions using regular currencies as a basis for the money they are sending.

Human Rights

But Tether has also, according to Faux, enabled heinous human rights abuses, as it has provided a safe and largely anonymous way for bad actors to conduct online scams, move money around the world with impunity, and fund terrorism, official corruption, black market transactions, and many other illegal operations.

The idea that Tether is backed on a one to one basis is also quite suspect. 

Incredibly, even though Tether now claims to control some $99 billion in assets, most of which it claims is in “cash or cash equivalents,” Tether has never provided any real proof of its holdings, as any bank of its size would be required by law to provide its customers. For years, Tether claimed to keep its assets entirely in cash or US Treasury securities – the most safe and secure forms of hard money available. That is, until independent investigations proved this was not true. Overnight, Tether amended its claims, instead arguing that it kept a range of investments, both in cryptocurrency and real money, which constituted a safe and diverse portfolio.

Is Tether Really Backed?

Readers with a passing familiarity with the collapse of the Lehman Brothers bank and the 2008 mortgage crisis may recognize the problem with “a safe and diverse portfolio,” when it comes to a bank’s money reserves. Tether’s owners claim to have attempted to find an auditor (a finance company which provides a legal opinion on the statements that a company makes about its finances), but there is also no proof of this. 

Tether also does not have any form of insurance or deposit protection, such as FDIC or EDIS (the government provided US and EU deposit insurance programs that protect ordinary depositors from bank runs and collapses) as any large bank would have. 

Tether Keeps the Profits

Indeed, early on in Tether’s existence, a large hack wiped out a huge portion of the stablecoin’s crypto assets. At least 30%. Normally, a real bank would be forced into dissolution, with the loss being covered by the state for ordinary depositors, as occurred recently with Silicon Valley Bank. Tether merely passed this loss on to its customers, promising to pay it back over time.

When much of this money was later seized by the US government and returned, the value of the remaining crypto assets had risen high enough that they were now worth more than the money that had been lost. Tether, according to Faux, kept the proceeds as profit.

Faux’s investigation of Tether and its shadowy owner, ex-plastic surgeon and convicted fraudster Giancarlo Devasini, revealed investments in questionable short term debt to construction companies connected with the Chinese government, and other strange investments. The Chinese real estate and construction market is currently in crisis. Devasini, according to Faux, also blogged extensively about his fascination with Ponzi schemes – particularly the Bernie Maddhov fraud, which robbed investors of tens of billions of dollars. 

In addition to all this, it’s important to note that although Tether functions like a central bank, taking in people’s money and giving them what is essentially an IOU in the form of their stablecoin currency, it does not pay any interest to its coin holders, meaning that any money the company makes from interest or appreciation of crypto assets in its very large holdings is profit. Since Tether now holds the majority of its assets in interest bearing investments, both short and long term, it stands to make huge profits from its nearly $100 billion of assets. It does not pay a penny of these profits to its depositors.

Never in history has a larger pool of ordinary retail investor money been under the control of so few people, with so little oversight from outside authorities.

For all these reasons, Devasini and other Tether executives are extremely secretive and largely avoid press and official scrutiny, although they have been targeted by officials from many countries on charges of anything from money laundering to wire fraud.

Whether one believes the claims that Tether makes about its reserves, one thing is clear about our next claim: 

“Crypto is the next phase of digital currency” 

Check back next week for a continuation of this two part series on cryptocurrencies.