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Governments cannot limit participation in the decentralization of Cardano

Published 14.3.2023

The US government is proposing to impose a 30% tax on crypto mining. The government's decision can essentially drive Proof-of-Work miners out of the country in a relatively non-violent manner. If mining is unprofitable, there is no point in continuing. The U.S. and China are the two most economically powerful countries in the world that are pushing mining out of their territory. The problem with mining is that it is easy to detect and cannot be operated unless conditions are favorable. This contrasts with Proof-of-Stake networks like Cardano. If you hold ADA coins, the government can't restrict you from participating in the decentralization of Cardano and getting the rewards. According to the analytics firm Morning Consult, 4% of Americans held ADAs in 2022. Any of them can participate in staking and very likely do. While Bitcoin's decentralization will decrease as mining is curtailed, Cardano's decentralization is gradually increasing every year. Dependence on a physical resource is an annoying and so far seemingly effective attack vector.

TLDR

  • Crypto miners would have reporting requirements on the amount and type of electricity used. It kills anonymous mining.
  • PoW mining will likely shift from the US to Kazakhstan and Russia, where fossil fuels are used to produce electricity.
  • Staking itself is essentially a very hidden and anonymous activity that is almost impossible to curb and hard to prove.
  • Just keeping SEED in your head can make you an active staker.
  • In PoS networks, greed has a positive effect on decentralization.
  • Staking is equally available and profitable everywhere in the world.
  • A virtual resource is much more difficult to fight than a physical one.

Bitcoin mining tax

China dominated Bitcoin mining for many years. In 2020, its share of mining was over 80%. The Chinese government decided to drive the miners out of the country, and for a short time, it succeeded. By 2021, the mining share had dropped to almost zero. Now mining is slowly returning to China. Bitcoin mining today is dominated by the US with 35%, Kazakhstan with 18%, Russia with 11% and Canada with 10%.

It seems that regulation will again significantly change the share of mining, especially in the US. US crypto miners could eventually be subject to a 30% tax on electricity costs under a budget proposal by the President aimed at reducing mining activity. The tax will apply to all types of energy, regardless of whether it is from the grid or produced by miners. The tax is expected to start at the end of 2023, phased in over three years at a rate of 10% a year, reaching the max 30% tax rate by the third year.

Crypto miners would have reporting requirements on the amount and type of electricity used as well as the value of that electricity. This essentially means that everyone involved in Bitcoin mining must provide KYC to the authority. Something like anonymous mining will be outlawed, and it can be assumed that miners will not risk punishment.

Providing KYC is not that big a deal, as mining is a regulated business and in the US it involves large companies that have issued their own shares. Individual companies decentralize Bitcoin despite being known to the authorities. The unpleasant thing is that the tax will make mining unprofitable and force miners to leave the US.

We can say that this is unfair, that it limits freedom, and that the US is missing an opportunity. If we are unable to change the government's position on the proposal, there is nothing we can do about it. The reality will be that the citizens of the country with the largest economy lose the opportunity to participate in the decentralization of Bitcoin.

From our point of view, this is a bad decision and we do not agree with it. People should have the right to consume energy as long as they pay for it and there is enough of it. The tax should only apply to emissions.

From a network consensus perspective, it is important to note that energy dependence is an unpleasant attack vector for PoW. The attacker does not need to consume energy to directly attack the network (the 51% attack). It is enough to limit energy consumption and thus effectively affect the decentralization of the network. Not necessarily security, since if mining is profitable elsewhere, the hash rate will remain high. The decentralization of Bitcoin will decrease, not necessarily in the number of participants, but on a geographic level.

Europe also objects to the high energy consumption of the Proof-of-Work consensus, so it's probably not an ideal destination for moving the mining. It is possible that the position of Kazakhstan and Russia will strengthen. Unfortunately, in Kazakhstan, to generate electricity coal is mainly used. In Russia, the share of renewable energies is only about 10%. The expulsion of miners from the US will have a negative impact on the environment as more fossil fuels will be used.

This is another negative impact. The Bitcoin community is trying to make mining greener and in the US this activity has been successful. A significant portion of the population is unhappy with the fact that Bitcoin consumes a huge amount of energy. The community has been successful in dampening the negative sentiment with the argument that mining is transitioning to renewables. This will now be more difficult to achieve.

Governments cannot restrict ADA holders

Proof-of-Stake has one huge advantage, namely that you don't need any special hardware or external resource to participate in network decentralization. You just need to own ADA coins and either operate your own pool or delegate coins to any existing pool. Any staker who delegates ADA coins to a pool that regularly produces blocks will be rewarded.

The government has no reason to restrict staking in the context of energy consumption, as Cardano is 99% more environmentally friendly than Bitcoin. Stakers only need 1 minute to select a pool and send a single delegation transaction to the network. They can then monitor pool activity via the browser. In case they want to delegate to another pool, they again only need to open their wallet for a minute.

Stakers can do this completely anonymously and do not need to provide KYC to the government. Of course, the government can demand it. However, it is much easier to hide staking than mining. Users can delegate ADA to the pool and then delete the wallet. Just keep SEED hidden and you will still be an active staker.

It is very difficult for governments to limit the decentralization of Cardano. ASIC hardware can be seized. Large mining halls can easily be cut off from the internet or power supply. Staking itself is essentially a very hidden and anonymous activity that is almost impossible to curb and hard to prove.

If the US banned staking, then in an extreme case people could travel across state borders. In another country, they can buy ADA and delegate coins to a pool. The only thing they will bring across the border will be SEED, which they can keep hidden in their heads. When they go on vacation next year, they can withdraw staking rewards.

Once you have ADA coins, you basically have a forever stake in the Cardano network that no one can take away or even limit the size of. In the PoW system, you have to fight your competitors for your stake. The competition can be so strong and effective that it's not economically worth it to maintain the stake. In PoS you have a stake forever, including the right to a reward.

This is a very important concept in PoS networks, as greed has a positive effect on decentralization. At any time, anyone can buy ADA coins and thus participate in the decentralization of Cardano. Even if the market value of ADA coins is stable, the staker will secure a certain passive income. In PoW networks, the struggle for stakes leads to centralization because of the need to increase efficiency. Just move the business to a country with cheaper energy and you have an advantage that others will not be able to compete with in the long run.

The elimination of competition, together with the economy of scale effect, is gradually leading to increasing centralization of mining. The largest miners are stock companies, which can have a 5 to 10% share of the hash rate. A ban on mining in the US may put some companies out of business, but it will almost certainly not put mining back in the hands of hobby miners. Other large companies will emerge in other countries.

The expenditure related to energy has a major impact on decentralization from a geographic perspective. If the state drives out the miners because of the poor environmental impact of mining or because of high taxes, most mining activity will take place where the conditions are therefore most favorable. Staking does not have this limitation and is equally available everywhere in the world. There is no country where staking is more profitable than another. The cost of staking is exactly the same everywhere in the world because the market value of ADA is the same at any given time.

The quality of Cardano's decentralization is not dependent on an external resource that can serve as a proxy to combat the network. ADA coins are a virtual asset existing only in the digital world. Stakers own them through SEED. There is no better resource for decentralization than a virtual one.

The security of blockchain networks is directly related to decentralization. As decentralization decreases, security also decreases as strong centers of power emerge that are easy to attack. A huge mining hall with 10,000 ASIC miners is an easier target than 10,000 hobby miners scattered around the country.

With PoS, this is not such a big problem either. A whale holding a large number of coins is the center of power, but it can remain anonymous and is more difficult for the government to find. It is difficult to sell ASIC hardware quickly or somehow protect them from seizure. A whale can sell ADA coins on exchange at any time, making it much easier to protect them from seizure. Or she can keep them and claim he doesn't have any. Proving it can be nearly impossible.

Conclusion

It is sometimes said that Bitcoin is the most decentralized network. People mistakenly think that the number of nodes in a network determines the quality of decentralization. This is not the case. Blockchain is a distributed network and the number of nodes affects availability, integrity, reliability, etc. Decentralization refers to the distribution of the resource that is used for network consensus. For Cardano it's ADA coins, for Bitcoin it's hash rate. ADA holders and miners decentralize the network, not the number of nodes. Without the resource, i.e. hash rate and coins, a new block will never be produced.

The potential expulsion of miners from the US will have an impact on decentralization by prohibiting a specific group of people from consuming a resource used to distribute power. It is difficult to predict whether miners will take their business elsewhere or go out of business. Theoretically, it is possible that one large miner that goes out of business will be replaced by several smaller ones. That would be positive, but over time some will gain some economic advantage and displace the competition. I dare say that no one will drive ADA holders out of the US, because there is no reason to do so, and, more importantly, it is almost impossible to enforce. Staking can be done completely anonymously. It can be difficult for the government to prove it to anyone and impossible to stop without the consent of the owner of the coins. Ironically, regulators are fighting for greater decentralization of PoS networks because they don't like staking on exchanges.

PoW and PoS consensus mechanisms can be compared from different perspectives. The reality is that in terms of the influence of governments on decentralization, PoS is more resilient. A virtual resource is much more difficult to fight than a physical one.

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