Consensus 101 - What will you do with Consensus?

What value does blockchain provide? panic's two cents

It’s been more than a decade since Satoshi introduced the concept of a p2p eletronic cash system - Bitcoin. Since the, a lot of groundbreaking research has happened in the space of distributed systems and cryptography to enable the creation of new technologies. Ethereum, Solana, DeFi, zk, EigenLayer, etc.

In the past couple of months, we have seen a growing interest from institutions who want to park there money in these digitial assets and use our digitial and veirfiable infrasturcuture. But why are they finally adopting the payments infrastructure?

This blog contains my thoughts, where I believe blockchains really hold value in today’s world, and what I hope there future can look like.

The Math of Consensus

Verifiability is inherently expensive. Imagine that there exists a computer that can execute any task you want it to do, and it requires X number of operations to do it. If you now want to make the execution of that task verifiable, you must have an entire network of nodes do the same calculation. Let’s assume there are n nodes in the network, so now the total operations carried out were n.X

But acheieving consensus itslef requires communication between the nodes, so let’s add a factor f to account for these extra operations: n.X + f

It’s clear to see that n.X + f > X, or in simple words, ensuring that a piece of computation is verifiable will always be more expensive than doing that on a central server.

Right now, this difference may seem huge but overtime, the plan is to reduce this difference by a factor of 10,000 on the mainnet through proposals like danksharding and snarkification. That’s great news right? Well there is another aspect to costs in consensus.

The Economics of Consensus

Proof of Stake mechanisms like Ethereum require people to stake some capital into the network. This capital directly provides the economic security for the network and it is not free. The network must have a rewards system to pay out to each validator for there work.

However, what’s often overlooked is the fact that the rewards are dependent not on the work done but the security provided. It doesnt matter what the system requirements are, you will be paid a percentage of your staked amount as an APY for providing security to the network.

That is why this service is also divided between stakers and validator networks, where stakers are the entities that provide the capital, and validator networks run the actual execution. Stakers don’t provide capital because they want to secure the future of digital finance, there are no altruistic motives. Staking is just another financial instrument to park your capital in.

And there is a simple economics about investment vehicles that we can extrapolate from the real world. There is a concept of risk free return which means the return you get on an investment that carries zero risk. Traditionally this investment is considered to be a 10-year US treasury bond (because you assume the US government as the most stable institution and it will never default on it’s payment). Any investment that is built on top of the US law, hence carries more risk (it’s always likely for a bank in the US juridiction to fail before the government itself no matter how bad the crisis) and hence must pay out greater returns.

Higher the risk, higher the reward. The same can be applied in blockchain econmies, considering Ethereum staking as the risk free return (because if something fails at the protocol level, everything else goes to zero). Any DeFi protocol built on top of Ethereum carries more risk that Ethereum itself and hence must provide a higher APY.

Now imagine you have a PoS network that requires an economic security of $1 Billion. Ethereum staking returns average 2-3% p.a. so let’s assume you’ll have to provide a 3.5% APY to attract that capital. This comes out to a cost of around $35 Million per year. Can you as service (with economic security of a billion dollars), afford to pay 35M a year just for security?

This is the true cost of consensus. Ethereum and L2s allow you to deploy smart contracts and only worry about the execution costs, but not everything can be built on smart contracts. Blockchains fundamentally require infrastructure like oracles, automation networks, etc that require separate consensus networks, and they are expensive.

So what can we do with consensus?

So now after understanding the true costs of a simple blockchain transaction, why are blockchains useful?

Well, blockchains are basically the world computer, a transparaent, secure, immutable and verifiable ledger of any taks you ask it to do. But all these tasks come with a price tag, a price tag higher that what you can achieve on a simple EC2 instance. So it makes sense to use the blockchain for tasks where the value of the task far exceeds these costs, and the benfits are highly desirable.

And the only use cases for now are payments and DeFi. I have seen a lot of people yapping on twitter about institutional investments and hwo the stablecoin market has grown over the last couple of years. But to be honest, I do not believe we’re seeing thsi growth because institutions are taking an interests in the value of blockchains.

I do not believe all these institutions care about their finances being verifiable or decentralised. What I believe is that blockchain and DeFi have survived long enough to be seen as a moderately risky investment vehicle.

Think about it, if you have a $1000 and you want to invest it, you can probably buy stocks or a mutual funds. But doing so with $100 Billion is not that easy, each action in a fund will literally change the price of the instrument itself and affect liquidity.

That is why there is a huge demand for complex financial instruments in wall street, that can allow movement of money at large scales because a 100 billion dollars must be broken up and diversified. I believe DeFi protocols are seen as just another financial instrument, where a fund of $10 billion can deploy say $500 million of capital and diverisfy there portfolio.

But I do believe there’s hope. Payments is a huge use case that can help people in countires with struggling economies, where the people can finally get access to a stable currency through blockchain. And with the eventual optimisations in computation costs, maybe more complex use cases for privacy like verifiable AI can also be possible. But in my opinion, the optimistic goal will always be to use this technology we have to build products that help people in ways not possible without crypto.