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On the myth of proof of stake systems

Dr. Craig Wright recently published an article titled “Decentralization,” where he discussed the common misconceptions surrounding the topic, which BTC supporters claim is the primary reason for Bitcoin. Dr. Wright laid out an argument on why proof of stake (PoS) system tokens are just securities, and PoS is just a backdoor method by which control can be exercised by way of anonymized bearer shares.

The article focuses on the misconceptions of proof of stake being a method to scale blockchains. This primarily revolves around the fact that proof of stake doesn’t require all of the hash power and thus capital/energy expenditure for an entity to participate in the operation of the network. This is actually false, as proof of stake algorithms have little to do with the scaling of the platform, as the energy expenditure has little to do with the ability of the platform to process txns—the only way in which scaling a system actually matters (transactions capable of being processed per unit of time). It is clear that the only way to scale which matters is by increasing the systems’ aggregate capacity to process transactions, and not in any other contrived dimension.

If proof of stake consensus systems doesn’t actually help the practical scaling of blockchains, then what do they achieve? According to the paper, the true motive for PoS is to re-introduce the notion of bearer shares and obscure ownership of public enterprises. When introduced with pseudo-anonymity, this allows large holders of the token to be able to exert control of the platform and earn dividends from the platform secretly, without anyone knowing that they exist. 

This is due to the fact that a large holder can simply spread their ownership over a large set of private keys, which makes them look like many small shareholders.

When coupled with the fact that in a PoS system, it is the validators that earn token rewards from performing the validation tasks on the system, and the fact that these rewards are proportional to the aggregate holding size of the stakeholders, this allows the large holders hidden from public scrutiny an unprecedented level of control and advantage over smaller stakeholders. This leads to a whole raft of old problems, which specific laws introduced since the famous exploitation with hidden shell companies by Enron and WorldCom were aimed to address. PoS is just a new way of ‘getting around the laws’ so that the big fish can exploit the small fish and get bigger without anyone knowing.

The irony is that this behavior actually harms the decentralization of the system, the exact opposite of what it claims to do. Consider this, in a PoS system where large stakeholders can hide by appearing like a pool of seemingly individual small stakeholders; they can enjoy hidden control of the platform without any public scrutiny. This makes a PoS blockchain less decentralized than traditional companies like Google, or Apple, whose shareholder ledgers are public, and all shareholders and their actual holding sizes are exposed and transparent to all. And thus, their actions and behaviors have consequences.

The only thing left is to show then that control over a blockchain through token holdings by its validators can be equivalent to holding shares in a corporation.

Is a blockchain platform equivalent to a corporation? Let’s apply Howey!

The answer seems to be YES, even though legal professionals have yet to put this to the test via a court case. Let’s address each of the four criteria of the Howey test for securities:

1) Is there an investment of money…

Yes, every validator who holds a blockchain token to stake originally purchased it by exchanging some form of money or monetary value. (Although subsequent re-invested earnings through validation rewards or dividends would be separate)

2) in a common enterprise…

Yes, the public common ruleset and consensus system requisite to any blockchain makes it equivalent to a common enterprise. Every node knows what they are expected to do as a validator and for what purpose, and they enter into it willingly together.

3) with the expectation of profit…

Indeed, all operators of nodes in a blockchain system do it to earn profit in the blockchain token. While in PoW blockchains, the size of payout for validation services of the common platform is regardless of holdings size, PoS systems pay dividends to their validators in proportion to their holdings (which may be hidden), just like an equity security.

4) to be derived from the efforts of others…

Prima facia, all stakeholders of blockchain projects benefit from the efforts of others, whether that be developers improving the protocol or other businesses building on the platform, thereby increasing the value and liquidity of the token in which dividends are paid. In fact, the simple notion that as the platform gains more stakeholders (besides the large shareholder), the value of the token and the shared enterprise as a whole increases, is enough to prove this point sufficiently.

Proof of Stake tokens are functionally equivalent to equities.

In contrast, Proof of Work tokens are more of commodities.

The key point here is that we must apply the Howey test to the validators or node operators of the platform, not just the common speculators who buy the token on the secondary market. As it is the generation/distribution of new tokens issued that matters. In this regard, only PoS validators/node operators, who earn their profits in newly issued tokens paid in the form of validation rewards (dividends), are guilty of holding securities.

In contrast, proof of work validators on blockchains such as Bitcoin with a fixed supply (called miners) does not issue any new tokens. The tokens have already been issued by the issuer initially, and the PoW algorithm determines how they are distributed.

Hopefully, soon there will be court cases to test out these concepts, but in the absence of these, it is simply apparent why PoS blockchains appeal to many. Just the same as why bearer shares are so appealing. It helps facilitate money laundering, and it allows large stakeholders to gain more than their fair share without being restricted the same way large stakeholders of companies are.

/Jerry Chan

Watch: Dr. Craig Wright’s keynote speech “Set in Stone: What is a Commodity?” at the CoinGeek New York Conference

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