CWC Newsletter #16 (Mar. 2, 2020)

By KJ Kingsley, Analyst


What is cryptocurrency distribution? Why do cryptocurrency pundits love to discuss their thoughts about a particular public, decentralized coin by citing its distribution model? Because the level of distribution of a cryptocurrency helps determine the security, health, and longevity of the network.


In short, the wider the token is held by many people around the world, the better the security and longevity of a decentralized blockchain. If a small population holds and owns a particular cryptocurrency, one could make the argument that it is a more centralized and fragile token that could be manipulated to the desires of the few.


There is cause for concern that the top blockchains in the world are controlled and dominated by a select few. 40% of all circulating Bitcoin (BTC) is reported to be controlled and held by 2,000. Ripple (XRP) has experienced a difficult time distributing fairly its token. The Tron (TRX) blockchain unfroze a third of TRX in January 2020 and may create an oversupply that would quell strong demand. The creator of TRX, Justin Sun, and his colleagues at Binance are widely believed to own and control 55% of the Tron network.


Other cryptocurrencies may provide a better model in token distribution. Ethereum (ETH) has shown recently that their token distribution is more robust now due to increasing developer activity on the network. The token distribution on the EOS mainnet was praised in the initial coin offering because it allowed for a year-long sale so that retail investors would have an opportunity to obtain tokens rather than big whales scooping up the majority of tokens.


Distribution of a Cryptocurrency


To begin with, I would first like to introduce you to the concept of distribution of cryptocurrencies. The initial distribution of cryptocurrencies can be placed within two camps: mined coins and pre-mined coins.


The best known mined coin is bitcoin. The distribution of mined coins is that everyone, in theory, is capable of mining these coins with the needed computer hardware. In the early years of Bitcoin, one was able to mine Bitcoin from their laptops. However, due to the consensus algorithm of mining Bitcoin, over time it became harder for individuals to mine Bitcoin with their laptops or personal computers. Now only large server farms can successfully compete to mine Bitcoins and make a profit.


The biggest pro of mined coins is that creates an intimate relationship between security and profit. For example, on the Bitcoin blockchain the miners who secure the network are incentivized to mine BTC because it provides an avenue to generate revenue to pay for their operational costs. The biggest con of mined coins is the potential for a 51% attack.


For pre-mined coins, the majority of cryptocurrencies have been distributed through Initial Coin Offerings (ICO). The best known pre-mined coins are cryptocurrencies on the Ethereum (ETH) network. Primarily known as ERC-20 coins, these pre-mined coins allowed the creators to raise funds for their blockchains by conducting crowdsales (ICOs) where investors would send in ETH and in return would receive the pre-mined cryptocurrency.


Investors were drawn to pre-mined coins because it offered a new way to raise funds outside the control of Wall Street. However, the Securities Exchange Commission (SEC) has recently cracked down on unregulated ICOs and have forced many pre-mined tokens to stop operations.


Mined and pre-mined tokens have their strengths and their flaws. In response to these two methods, a new wrinkle in token distribution can be observed in the EIDOS mining/token distribution. In late 2019 on the EOS mainnet, users were able to expend their CPU allocation to mine EIDOS tokens. Users would send a small amount of EOS to the EIDOS smart contract and in return would receive the exact amount of EOS back in addition to EIDOS tokens. Although this congested the EOS mainnet, it allowed a more fair and equitable distribution of the EIDOS token.


Security Through Distribution


The security of a cryptocurrency network, protocol, or platform depends on the consensus mechanism. The distribution of the cryptocurrency is directly related to the security of the network through a particular consensus mechanism.


The two most popular consensus mechanisms are Proof of Work (PoW) and Proof of Stake (PoS). Besides PoW and PoS, there are many different other forms of consensus mechanisms in the cryptocurrency space. Bitcoin and Ethereum are currently using the PoW consensus mechanism. EOS and Tezos are the most popular PoS protocols.


Within a Proof of Work network, the distribution of hash power is more important in dictating the direction of the chain rather than accumulating more coins. However, PoW networks are costly to secure due to the need for upgrades in hardware specs and increase use of electricity. In addition, PoW networks are purported to be an ecological disaster in terms of the burning of fossil fuels to power the large server farms.


In a Proof of Stake network, the more coins you hold determines your "stake" in the network. Rather than having bitcoin miners who compete for transaction fees and bitcoin mining, a Proof of Stake model offers more participants a chance to help secure the network. The largest token holders become the defacto miners in a bitcoin sense because the more tokens you stake to the network, the more the network becomes secure.


An iteration of Proof of Stake is called Delegated Proof of Stake (DPoS). Similar to a representative democracy, DPoS allows for token holders to vote specific miner pools or block producers to validate transactions.


However, it is interesting to note that Ethereum is transitioning from a Proof of Work to Proof of Stake in order to better secure their network. Since 2015, the Ethereum developer community has been hard at work trying to implement PoS upgrade through protocols called Casper. It appears that the future of token security will be some form of PoS or DPoS.


Health of a network


The health of a public cryptocurrency is based on a delicate relationship between decentralization and security for a widely-distributed coin. But within the history of cryptocurrencies, there has been many things that have undermined a healthy ecosystem.


Proof of Work has seen the rise of mining pools. In the nascent period of bitcoin mining, anyone with a laptop or desktop were able to mine bitcoins. However after a couple years from bitcoin's release in 2008, people were unable to mine bitcoin with just their personal computers. In order to mine effectively, people began to "pool" their computation power together to form different types of mining pools.


These mining pools became powerful enough to determine (1) whether to accept or deny particular upgrades to the bitcoin protocol and (2) attack the network.


Bitcoin's code upgrades have met past resistance where the Bitcoin chain has forked to other Bitcoin clones, such as Bitcoin Cash (BCH) and Bitcoin SV (BSV). In addition, popular cryptocurrency Ethereum also experienced a hard fork early in their existence, which produced Ethereum Classic (ETC).


Besides hard forks that can disrupt a PoW blockchain, 51% attacks have plagued the health of PoW blockchains. A 51% attack means that a mining pool that controls more than 50% of the network is able to dictate transactions, reverse transactions, or other malicious attacks that would erode the confidence and trust in that blockchain. The HBO show Silicon Valley hilariously captured the essence of a 51% attack within PoW cryptocurrencies-here and here.


Ethereum Classic experienced a 51% attack in early 2019. Although initial confidence was lost, the price of Ethereum Classic has rebounded and in February 2020 saw a market cap of $1.3 billion and $11.81 per ETC.


Proof of Stake networks have not been immune from attacks to the health of their blockchains. One of the first Proof of Stake blockchains, Lisk, saw the miners form cartels that dominated the direction of the network. With coin holders voting in their designated miners, large Lisk mining pools have conspired to vote in their miner friends. This collaboration has created a smaller number of mining pools that are able to claim mining rewards, which goes against decentralization.


EOS has also seen the rise of cartels but due to its governance consensus.


In short, mining of cryptocurrencies on both PoW and PoS networks have witnessed the rise of cartels and large mining pools that have dominated the security and integrity of particular blockchains. On Bitcoin, 5 large mining pools controls more than 50% of the network. On Ethereum, 3 large mining pools controls more than 50% of the network. On the EOS mainnet, there are 21 mining pools that equally control the network.


Finally, another aspect to determine the health of a blockchain network is the annual inflation of the token. Annual inflation occurs through the creation of new tokens to pay those companies and miners who help secure and operate the network. A robust network would have a low inflation and a governance model that makes it difficult to increase or decrease the inflation without consensus. The three major platforms--Bitcoin, Ethereum, and EOS-- have the following inflation rates: Bitcoin at 3.6%, Ethereum at 5%, and EOS at 1%.


Will it Last?: The Longevity of a Network


In conclusion, the distribution model is very important when considering the value proposition of any cryptocurrency. One should look keenly into how the network is secured, upgraded, and governed.


Last week saw the EOS mainnet's mining pools agree to decrease the annual inflation from 5% to 1% and to burn a fund worth over $100 million. This was the latest sign that the EOS mainnet was not centralized and that the mining pool operators prioritized the health and longevity of the network over short-term profits. This is due to the fact that the EOS protocol distinctly aligns the destinies of token holders with the mining pool operators, something that is lacking on the Bitcoin and Ethereum networks.


I am excited to see what the EOS mainnet has in store for 2020 because the distribution, security, and governance of EOS is looking quite solid for token holders, developers, and miners.


Disclaimer: KJ Kingsley is not a financial advisor and holds the digital tokens or cryptocurrencies represented in the content above. This content is for informational purposes only, you should not construe any such information or other material as legal, tax, investment, financial, or other advice. Nothing contained in this post constitutes a solicitation, recommendation, endorsement, or offer by myself to buy or sell any securities or other financial instruments in this or in any other jurisdiction in which such solicitation or offer would be unlawful under the securities laws of such jurisdiction. The opinions expressed in this publication are those of the author. They do not purport to reflect the opinions or views of any of the author’s employers.

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