Cryptocurrencies & passive income

The Interest: Issue #5

The Interest: Issue #5

About 10 years ago someone had an idea for a new kind of digital money. The pesky thing about money is that you can’t be allowed to spend the same dollar twice. And the pesky thing about something digital is that it’s easy to copy over and over again. This new kind of digital money, called Bitcoin, solved that problem by making each unit of digital money impossible to copy. It uses cryptography to do it, thus the term “cryptocurrency.”

You might think “wait, I can buy things online — my money is already digital.” And, yup, you’re right. The trade off that’s being made (which isn’t even a trade off in some circumstances) is that to make yourmoney digital there has to be some trusted third party in the middle that keeps track of what you have and what you’ve spent (a bank, PayPal, Venmo, etc.). That’s the other innovation of Bitcoin, instead of a central third party maintaining the ledger (i.e. the database of transactions and resulting account balances), the ledger is maintained in a new type of database called a blockchain.

That’s where it gets interesting. Let’s say you’re of the mind: “meh — I’m OK with trusting a bank with my money, and, I’m actually perfectly fine with good old USD as my method of storing my savings.” That’s basically my opinion (and I think most people’s), with the caveat that I believe this new technology can replace the way we transact our money — doing away with the archaic credit card processing system. Anyway, let’s say you’re in that “meh” camp and thus eye roll at the Bitcoin craze. That eye roll may very well be justified, but to extend it to all of the other uses that this new technology enables, would, in my opinion, be a mistake.

What’s this got to do with personal finance!? There’s a point, I promise, and it’s not even investing in these currencies as speculation (I don’t think I’m allowed to give such advice publicly without a license).

The interesting thing about all of this to me, from a personal finance standpoint, is the potential for passive income to be earned via some of the new products and services that are being created using blockchains. It’s not just digital money — so many other digital services will be decentralized and made better for it, and regular old people will be able to participate in the verification processes necessary to run such services, and therefore get paid for doing so. I’ll whet the whistle by wrapping up this “blockchain intro” with one concrete example of a passive income opportunity, but I’m going to dive more into these in a part 2 to this piece, next week.

It’s necessary to understand a tiny bit more about how blockchains work. A blockchain is a public database. A transaction gets recorded in this database as long as there is consensus that it’s legit. The method of reaching that consensus is different from blockchain to blockchain. Some require the approval of only a small number of pre determined verifiers (booo). However most, including the most widely used blockchain, called Ethereum, reaches consensus in a more decentralized way. Ethereum, like Bitcoin, uses a complex method called proof of work.

Ok, an analogy. Let’s say there’s a contest to guess the number of jelly beans in a jar. A centralized approach to reaching consensus on who wins is to trust the person running the game. They’ve presumably counted the jelly beans ahead of time and everyone believes their answer and a winner is declared. No big deal at your neighborhood fall festival, but, what if the winner got $1 million. Then all of a sudden trust becomes an issue.

A decentralized approach would be to empty the jelly beans onto a table so that anyone can participate in the verification process, with the winner being declared as long as 51% of the verifiers agree (i.e. they reach consensus). In proof of work, in order to submit a verification individual verifiers have to prove that they spent the time/money necessary to count the jelly beans. In exchange for this they get 2 things: 1) an individual verifier knows whether or not the ultimate answer was correct, without having to trust anyone else; and 2) they get transaction fees for their efforts. Anyone playing in the jelly bean guessing game, but choosing not to spend the time/money to participate in the verification process, only has to trust that no one verifier was able to get more than 51% of the verifying power necessary to commit fraud. If someone with less than that amount of power tried to give an answer they knew to be wrong (so that they would win the jelly bean guessing game), all they’ve done is waste the time and money it took to submit a verification.

Ethereum is scheduled to switch their consensus method from proof of work to proof of stake, sometime in 2019. The rules for PoS are easier to understand than PoW. In PoS, all you need to do to become a transaction verifier is to stake (i.e. put on deposit) a certain amount of money. As long as you verify transactions according to the rules (that is, you let the software running on your computer verify the transactions without tampering with it), you earn transaction fees. If you try to submit a verification that the other verifiers in the network don’t agree with, then your deposit is “slashed,” which keeps everyone honest.

That’s passive income. Stake some money, let your computer run some software, and collect transaction fees. That’s interesting. With Ethereum specifically, it’s looking like you’ll need to stake “only” 32 Ether (the native cryptocurrency of the Ethereum blockchain) to become a transaction verifier once they make the switch next year. I say “only” because it was first thought to be north of 1,000 Ether, but the community decided that wouldn’t be decentralized enough. As of the time of this writing, buying 32 Ether would cost $7,328. I’m not advocating for doing so (again, not allowed to do that), but, now you know how much it’d cost to get in on this passive income opportunity in the future, and if you’re interested, you should go learn a bunch more about it first.

There are other opportunities as well — I’ll give a rundown of some interesting ones in part 2 next week.

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