IN THE NEWS

🔻Snap Shares Take a Nose Dive (FT)

Explained:

• Shares of Snap (SNAP) fell more than 30% on Friday after the social media company reported results that came in weaker than what Wall Street expected.
• Snap said sales increased 6% in the third quarter compared to the previous year, which was its slowest rate of growth since going public and below the 8% the company said it was seeing in August.

What to know:

• The company has been hit hard by a declining online advertising market, increased competition, and Apple’s (AAPL) privacy changes that make it more difficult to target ads and track their performance.
• Facebook parent Meta (META) and Google (GOOG) fell 5% and 3%, respectively, while rival Pinterest fell 7% on the Snap news.
• As of Thursday, Snap shares were down 77% this year, and the company said it expected revenue growth to decelerate through the end of the year.

😬 Biden Administration Has Concerns About Elon Musk (Bloomberg)

Explained:

• Twitter (TWTR) shares fell as much as 5% in Friday morning trading as the proposed takeover by Elon Musk is facing new questions from the Biden administration and weak Snap (SNAP) results weighed on social media shares.
• Biden officials are discussing whether Elon Musk’s ventures should be subject to national security reviews, including the Twitter deal and SpaceX’s Starling satellite network.

What to know:

• Washington is concerned that Musk’s investment consortium to acquire Twitter includes foreign investors from Saudi Arabia and Qatar.
• Biden officials also have grown troubled about Musk’s favorable public posture towards Russian President Vladimir Putin.
• The Washington Post reported that the Tesla (TSLA) founder plans to make large staff cuts at Twitter if his purchase goes through. In discussions with investors, he said he planned to eliminate 75% of the company’s workers.

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WHAT ELSE WE’RE INTO

📺 Watch: Calculating the intrinsic value of Apple’s stock, by your newsletter co-writer Shawn.

👂Listen: Warren Buffett-inspired real estate investing with Keith Wasserman, hosted by Robert Leonard on the Real Estate Investing 101 podcast.

📖 Read: Why dollar swap lines won’t fix the current global currency crisis, a Twitter thread.

DIVE DEEPER: PROOF-OF-STAKE VS PROOF-OF-WORK

Disclaimer

Folks, we’ve got a slightly long and rather nerdy deep dive for you today.

But if you’re interested in learning more about a subject you’ll continue to hear about for years into the future, then we’d encourage you to take the time read through the rest of this newsletter.

If not, we’ll see you back here again on Monday — No hard feelings.

Carry on ⬇️

Overview

We wrote about Bitcoin mining a few weeks back in response to criticisms about the digital asset’s energy usage, and with respect to Ethereum’s recent transition to a proof-of-stake mining method, as opposed to the proof-of-work model employed by Bitcoin.

Today, we’d like to do a more comprehensive comparison of the two vastly different approaches to operating a cryptocurrency network.

Both models aim to add valid transactions to blockchains, but the differences in how they reach agreement (or “consensus”) about this carry significant security and efficiency ramifications.

This debate is profoundly important to the developing asset class’s future, so let’s start with the basics.

For this, we turned to the great Lyn Alden’s writings. She has become a thought leader in both traditional investing spaces and in the digital asset space, and we love her analysis.

Proof-of-work 101

Bitcoin, founded by the mysterious and pseudonymous Satoshi Nakamoto in 2008, who published its whitepaper, pioneered the cryptocurrency space.

The Bitcoin network uses a so-called “proof-of-work” method to reach consensus on valid transactions.

As Alden explains, the network is programmed to create a new “block” of transactions every ten minutes which are then added to the blockchain (this consists of the hundreds of thousands of transaction blocks rendered since Bitcoin’s inception).

Bitcoin miners serve to produce these new blocks by contributing computer processing power, and correspondingly, real-world energy in the form of electricity to solve cryptographic puzzles (hence the name cryptocurrency).

If a miner solves the puzzle, it can package thousands of pending Bitcoin transactions, as validated by “full nodes” (computers that voluntarily assist in fully validating transactions and blocks) into the block and add that block to the blockchain. In doing so, they enable transactions to be settled without any intermediaries like banks.

And for solving it, they also get a reward (newly created Bitcoin), which is what incentivizes them to use their own electricity to help process the transactions that people all around the world make using Bitcoin.

Diving deeper

As an additional wrinkle, the network also makes difficulty adjustments every two weeks to ensure that new blocks are added to the blockchain approximately every ten minutes.

If miners drop off the network, and it takes longer than ten minutes for the puzzles to be solved, then puzzles are made easier.

If too many miners compete to solve the puzzles, then they’re made more difficult.

Millions of machines, then, apply processing power toward the network in competing to solve the cryptographic puzzles, and this, along with full nodes, ensures that the network remains decentralized.

While critics see this scattered and intensive problem-solving as a waste of energy, it serves to impose a physically restrictive cost that prevents any single authority from garnering control of the blockchain.

What to know

In other words, proof-of-work has enabled software protocols to leverage tangible barriers (electricity costs from computer processing) to block abuses of power and censorship.

Basically, no bank, government, corporation, or otherwise unilaterally powerful entity, can decide at their discretion who is able to transact and who isn’t.

It’s the ultimate egalitarian construct that allows everyone to save and spend their Bitcoin without having to trust one another.

And the more energy that Bitcoin’s network uses via proof-of-work mining, the more secure it becomes, since it would require greater processing power to try and “hijack” the network in an attacker’s favor.

Below is a chart of Bitcoin’s average daily hash rate, which represents the amount of energy miners used to verify and secure the network.

Why it’s special

You can’t copy Bitcoin, says Alden, because although you can re-create its programming, you can’t easily reproduce the millions of miners who choose to allocate their computing power to the network.

She says, “Trying to copy Bitcoin would be like if I copied the content from Wikipedia and hosted it on my website. Technically it could be done, but it wouldn’t do much. It can’t gain the real Wikipedia traffic, because it wouldn’t have hundreds of millions of links pointing to it from other websites.”

Proof-of-stake 101

In the proof-of-stake model, the tie to the physical world via expenditures of electricity to solve puzzles is removed.

Instead, large holders of a cryptocurrency, such as Ethereum, lock up or “stake” their coins, and they then vote on the valid blockchain. In return, they’re rewarded with more coins for helping generate new blocks.

By staking their coins, they demonstrate that they have skin in the game in protecting the network, at least in theory. The system, though, becomes much more complicated and abstract. It also relies heavily on trust.

In this model, power is distributed by your wealth essentially.

The more coins you have, the greater voting power you have in the network.

Comparison

Alden compares it to a “political system where you get a vote for every hundred dollars you have, and then also get paid a dollar by the government for casting each vote. 

Mary, the high school science teacher with $20,000 in net worth, gets 200 votes and earns $200 from the government for voting. Jeff Bezos, with $200 billion in net worth, gets 2 billion votes and earns $2 billion from the government for voting. 

He’s a more valuable citizen than Mary, by a factor of a million, and also gets paid more by the government for already being wealthy.”

She continues by suggesting that it’s an oligopoly-like model that tends to increasingly concentrate wealth in the hands of those who have power (individuals or groups with enough ether to meaningfully stake).

So, while proof-of-stake can still discourage attacks, as an attacker would need to acquire a large amount of the cryptocurrency to take control of the network (aka a majority or outsized voting power on block creation), it relies on the trust that sizable stakeholders will not collude together.

Downside

By removing the tether to real-world costs like in proof-of-work, the proof-of-stake model succeeds in reducing its energy expenditure, but it does this at the sake of decentralization and security.

Would you want to store your wealth long-term in a system based on trust towards the largest stakeholders with the benefit that it’s highly efficient?

Or would you rather utilize a system that maximizes integrity through necessarily imposing real-world costs (lots and lots of computer processing power) on those who hope to exploit a cryptocurrency in their favor (spending the same token twice, for example)?

We’d argue that, over time, despite the convenient advantages and idealistic benefits of a trust-based proof-of-stake system, eventually, it collapses from bad actors exploiting the system.

You could say this dynamic is quite similar to the model we have today, where bankers and governments, aka the largest stakeholders in our financial system, wield the most power.

Takeaways

Look no further than the 2008 financial crisis for evidence of how a proof-of-stake system can be abused.

Main Street bailed out Wall Street at considerable expense, yet Wall Street controlled the financial system, and we had implicitly trusted them to manage it well.

The dynamic is similar with Ethereum and the many other proof-of-stake cryptocurrencies that use their “99% less energy usage than Bitcoin” claims to argue that they offer the superior system.

The energy costs and perceived inefficiencies of Bitcoin’s proof-of-work model are, as they say, “a feature, not a bug.”

Such a system is far more conducive to long-term survival, and when discussing the emergence of global monetary systems, the relevant time horizon is undoubtedly long-term.

If we are to hope that any cryptocurrency will innovate and improve our financial system, we must optimize for what’s least likely to break to serve as the bedrock of our digital and real economy.

In this spirit, Alden compares Bitcoin to the U.S. Constitution, which establishes three branches of government that all limit each other’s power.

Such a system of checks and balances is highly resistant to change and intentionally slow-moving.

Wrap up

To understand why this is true, and the many more nuanced arguments that she makes, we’d encourage you to read Alden’s full essay here.

And for more on proof-of-work versus proof-of-stake, our podcast host Preston Pysh had an excellent discussion comparing the two models with Jason Lowery, a U.S. National Defense Fellow researching Bitcoin.

It’s deeply insightful — Give the episode a listen.

Let us know, readers, what do you think of our breakdown here?

What did we miss?

There’s a lot more to be said, and we’d love to feature any particularly good feedback in follow-up newsletters.

Just hit reply to this email 😉

SEE YOU NEXT TIME!

That’s it for today on We Study Markets!

See you later!

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