Could this Achilles’ heel bring Bitcoin tumbling down?

In today’s low carbon world, energy intensive industries are under the spotlight.

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Key points

  • The world is in the midst of an energy crisis
  • Bitcoin’s proof-of-work protocol is hugely energy-intense
  • This Achilles’ heel restricts it to a speculative asset class

Bitcoin (CRYPTO: BTC) has enjoyed a bounce over the past 24 hours. The world’s biggest crypto by market cap is up 2% to US$36,472 (AU$51,152).

Despite that bounce, Bitcoin remains down 23% so far in 2022. And the token is down 47% since its 10 November all-time highs, according to data from CoinMarketCap.

Ethereum (CRYPTO: ETH), the world’s No. 2 crypto, has fared even worse. Since hitting its own record highs on 16 November, Ethereum has lost 51% of its value.

Down another 4% over the past 24 hours, Ethereum has slipped 36% so far this year.

Looking ahead though, Ethereum’s future may be brighter than its bigger rival. That’s because Bitcoin still relies on what’s called “proof of work” while Ethereum has been transitioning to “proof of stake”.

Why is that an issue?

According to Saxo Bank’s cryptocurrency analyst Mads Eberhardt, “The future in energy-intensive proof of work looks dim.”

This deficiency could hobble Bitcoin

Earlier today, online trading and investment specialist Saxo Bank released its Q1 2022 quarterly outlook for global markets.

In the report, Eberhardt notes, “As the world is experiencing an energy crisis, the high energy consumption of the present consensus protocol – called proof of work – of both Bitcoin and Ethereum is not expected to go unnoticed.”

Ethereum has been working on shifting from proof of work to proof of stake. This process is expected to be completed this year.

Proof of stake, Eberhardt explains “is a consensus protocol where holders of the native cryptocurrencies can stake a part of their holdings, and through this validate transactions instead of miners”.

Unlike proof of stake, he said the “proof-of-work protocol is hugely energy-intense as it revolves around countless servers keeping the network alive. In return for a great deal of electricity and server capacity, the Bitcoin network returns the availability to solely execute 6 transactions per second”.

While some Bitcoin veterans have questioned the security of proof of stake, Eberhardt says, “Over the last years, the majority of newly launched cryptocurrencies have been based on proof of stake, so the framework has arguably proved its worth.”

Bitcoin, however, looks to be sticking with the proof-of-work protocol, which Eberhardt says “will likely not come without severe challenges”.

Just how much electricity does Bitcoin use?

The University of Cambridge estimates Bitcoin uses some 0.5% of global electricity. Which, Eberhardt points out, doesn’t even take into account the energy needed to produce the resources required to make the servers. And its electricity use tends to rise in line with its price.

For a better picture of its energy use, look at Kazakhstan.

Yes, Kazakhstan.

Following China’s ban on crypto mining last May, when it accounted for 71% of the Bitcoin hash rate (total Bitcoin mining capacity), miners flocked elsewhere, predominantly the US and Kazakhstan.

According to Eberhardt:

From originally accounting for a minor share of the hash rate, Kazakhstan … is today the second-largest miner, with 18 per cent of the total hash rate. From typically experiencing an annual growth of 1 or 2 per cent in its electricity demand, Kazakhstan witnessed an 8 per cent increase last year, contributing to severe power shortages, occasionally leaving some of the population without electricity.

Proof of work ‘a millstone around the crypto market’s neck’

“Bitcoin needs to adopt the alternative” proof of stake, Eberhardt says.

He notes Ethereum’s transition to proof of stake (ETH 2.0) will cut Ethereum’s energy use by 99.95%.

Eberhardt adds: 

Ethereum’s transition demonstrates that it is not only possible to introduce new cryptocurrencies based on proof of stake but to adopt the framework while having been launched upon proof of work. Besides drastically decreasing Ethereum’s energy use, ETH 2.0 will make Ethereum significantly more scalable in terms of achievable transactional output. 

Eberhardt said that with the world’s focus on decarbonisation only likely to increase, “individual investors, institutions, and developers are likely to reconsider committing time and money towards Bitcoin or other proof-of-work cryptocurrencies”.

So could this Achilles’ heel be Bitcoin’s undoing?

According to Eberhardt:

As we see it, the proof-of-work consensus mechanism is simply too fragile to operate harmlessly through an energy crisis spiced with an ever-changing regulatory environment and the ascending intention to be sustainable. 

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The Motley Fool Australia's parent company Motley Fool Holdings Inc. owns and has recommended Bitcoin and Ethereum. The Motley Fool Australia has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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