One intriguing aspect of bitcoin is the way it makes explicit the cost of running a monetary system.
Bitcoin mining requires a lot of energy: nearly as much as Switzerland, according to the latest statistics. Unsurprisingly, in an age of heightened concern about climate change, many criticise cryptocurrencies for their environmental footprint.
The costs of the traditional financial system are no less real. In addition to the infrastructure costs, there are significant hidden costs: for example, the trillion-dollar 2008 bank bailout, or the rising income inequality caused by central bank quantitative easing. These costs are often glossed over by critics of cryptocurrencies.
But is it possible to look at bitcoin’s energy consumption from a different perspective? Can we measure it in the same way as a physicist or engineer would assess the efficiency of a machine like a turbine?
Yes, says Dhruv Bansal, co-founder of Unchained Capital, who has a PhD in theoretical physics. Thermodynamics, the branch of physics that studies the relationship between heat and other forms of energy, offers us some guidance.
New Money Review: Dhruv, how do cryptocurrency networks convert energy into money?
Dhruv Bansal: “The ‘proof of work’ mechanism that underlies bitcoin and similar cryptocurrencies translates an energy cost into an economic transaction. In effect, you’re paying X in fees to access the security of a network that is using Y in energy to protect your data.”
New Money Review: How efficient is bitcoin?
Dhruv Bansal: “Bitcoin has some built-in inefficiency. It comes in the form of so-called ‘dust’ outputs—very small unspent transaction outputs, or ‘UTXOs’.”
[All the bitcoin in existence is contained in the form of UTXOs. When a bitcoin transaction occurs, it spends the output from previous transactions (i.e., UTXOs). That transaction then generates new UTXOs—outputs that can be spent in future transactions. UTXOs with very small monetary value, which are often generated as change in larger transactions, are referred to as ‘dust’—New Money Review comment]
“A certain amount of bitcoin is unspendable at a given level of transaction fees”
“When bitcoin transaction fees hit a peak of $60 in December 2017, between 25 and 50 percent of UTXOs were dust-like. So bitcoin was only operating at 50-75 percent efficiency in terms of its data structure.”
“In other words, there’s a certain amount of bitcoin that’s unspendable at a given level of transaction fees. It’s not a huge problem, but if left unaddressed, at some point it might be.”
New Money Review: Could you draw an analogy?
Dhruv Bansal: “In a heat engine, it’s very difficult to extract energy from the molecules of gas that have become cold. They contribute to the noise and the inefficiency of the engine. So there’s a direct analogy. Like those cold gas molecules, there’s a tiny amount of bitcoin—in the form of unspent UTXOs—that sits there clogging up the system.”
New Money Review: How efficient can any physical network ever be?
“We can never build a 100 percent efficient system”
Dhruv Bansal: “Given constraints like temperature and system size, there are theoretical limits on how efficient a physical system can ever be. The universe seems to have inbuilt rules that mean we can never build a 100 percent efficient system.”
New Money Review: How does the design of bitcoin impact its efficiency?
Dhruv Bansal: “Because there’s no one in charge, because there’s no leadership hierarchy to enforce behaviour and everything has to be built up through incentives, you end up creating a very local system.”
“It looks more like a box of gas than a corporate hierarchy. Because of that we see a resemblance with a steam engine and therefore some theoretical optimal level of efficiency. It’s unlikely to be 99 percent efficient, more like 50-75 percent. This is also why we need a ‘layer two’ payments system to be built on top of bitcoin, because the system we created at the base level has inherent limits.”
New Money Review: Which physical systems have the highest efficiency?
“Bitcoin looks like a system built by humans”
Dhruv Bansal: “Very few engineering systems get into the level of 80-90 percent thermodynamic efficiency. Perhaps only passive systems reach this figure—for example, containers of wax that store energy by heating up and melting during the day, then cooling at night. Most of the stuff we build is of middling efficiency, say 25-75 percent. So in that sense bitcoin looks like a system built by humans.”
New Money Review: What does bitcoin’s efficiency score say about its potential uses?
Dhruv Bansal: “Unchained Capital’s research on HODL waves shows that a lot of bitcoin just sits around and that many people consider bitcoin as a store of value. Blockchain-based cryptocurrencies are not great as a medium of exchange. It’s not a substitute for the Visa network. Instead, a blockchain is a kind of IOU network, which replicates the history of trade networks.
New Money Review: One key measure in thermodynamics is entropy (a system’s degree of randomness). Does this concept exist for bitcoin?
Dhruv Bansal: “We don’t yet have an equation that lets us calculate directly the entropy, energy or work content of bitcoin as a system. We’re still at the early stages of doing what physicists would call the phenomenology of bitcoin: defining the variables we need to monitor to understand the system. Ultimately, the efficiency of bitcoin as a network is likely to be one of the measures we need to understand. And there may be various ways of measuring it.”
New Money Review: How far should we take analogies between physical systems and information systems like bitcoin?
Dhruv Bansal: “You have to be careful assuming that a measure in one type of system applies to the other.”
“Take thermodynamic entropy and entropy in information systems, for example. There are purely mathematical systems, such as the prime numbers, for which we can impose a concept of energy and derive rather interesting thermodynamics. This approach is actually fruitful for understanding certain properties of the distribution of prime numbers.”
“But there’s no ‘heat’ involved in this system as there’s nothing physical whatsoever. It is extremely tantalizing that physics-inspired approaches are useful in pure mathematics, but at the moment, one probably shouldn’t take the analogy of prime numbers as having entropy too far beyond a theoretical framing.”
“Systems such as networks, databases and blockchains operate in a space of pure digital information. But they are still grounded in the reality of squishy atoms, communications delays, error corrections, and heat. I see no reason why traditional thermodynamics isn’t relevant to these ‘machines’.”
New Money Review: What does the blockchain tell us about income distribution?
Dhruv Bansal: “Measured by the Gini coefficient, the distribution of bitcoin ownership is far less egalitarian than the distribution of the US dollar. Some people rail about the 1 percenters, but that concept is far worse in cryptocurrencies.”
“But this data is approximate. Bitcoin, like most cryptocurrencies, does a very good job of keeping ownership secret. It’s extremely difficult to go backwards from public data like the blockchain to private data like coin ownership.”
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