Ethereum’s weaknesses — criticizing the backbone of “the internet 3.0”

Thijs Maas

Thijs Maas is a Dutch LLM student who developed a keen interest in the interplay between distributed ledger technologies and law. He started LawAndBlockchain.eu to help narrow the increasing gap between legal doctrine and regulatory challenges posed by blockchain-based asset classes.

In my last article, I explained what Ethereum is; I explained the Ethereum’s potential to become the backbone of the internet 3.0. However, hype often comes with a positive bias and I believe staying critical is of great importance. So balance out all this positivity, I will now present Ethereum’s weaknesses.

Scalability & centralisation

Ethereum’s most valid criticism, as articulated by Vitalik Buterin, is its (lack of) scalability. The network is currently capable of handling about 5 transactions per second, which is nowhere near the capacity needed if Ethereum is ever going to function as the backbone of the internet of value. For contrast, an application like Über handles 12 rides a second. Ethereum’s developers are currently working on a number of technical solutions to increase the transaction capacity. These include plasmashardingthe raiden network and changing the consensus mechanism from proof of work to proof of stake.

Illustration 1: Transactions per second in Ethereum. Credits to Etherchain.org

Centralisation is also arguably going to become a bigger problem for Ethereum than Bitcoin. The ledger that keeps track of your balance is secured on thousands of nodes instead of one centralized server. In other words, a malicious party would have to hack thousands of computers on the same time, instead of one single server. The ledger is secure, because it is decentralized. In my critical analysis of Bitcoin, I stated that, if the size of the blockchain gets too big, it becomes difficult for normal users to run nodes. This was a huge problem for Bitcoin, but Ethereum’s blockchain size is growing even faster than Bitcoin’s.

The change to Proof of Stake might help both scalability and decentralization, but changing the consensus mechanism this late in the game is also a potential issue. In proof of work consensus is reached through the process of mining, in which miners use large amounts of computational power to solve a cryptographic puzzle in order to add a block to the chain and get the block reward. In proof of stake on the other hand, the probability of adding a block is not based on computational power, but on the amount of wealth held by the staker (also forgers or minters). This eliminates the waste of energy needed to run the GPU’s but is criticized itself as well. Some believe that it is irresponsible to even try such a transition, criticize the lack of peer review of the code and see it as adding an untested and insecure component to the network. There is a large debate about PoW vs PoS in general.

Another of Ethereum’s weaknesses is the cult-like following that has formed behind its creator. Undoubtedly, Vitalik Buterin is a smart man, and he is acting as a benevolent dictator for Ethereum. However, Buterin is a dictator nonetheless in the sense that he, due to his large following in the Ethereum community, single-handedly has a gigantic impact on the future development decisions of Ethereum. This makes him the single point of failure in a world that aims to eliminate such points.

Smart contracts

While smart contracts are praised widely, it should be noted that they, too, have their disadvantages.

  • First of all, smart contracts are only as good as the people that write them. A hacker almost stole $50 million from the original DAO due to bad coding last year.
  • Secondly, immutability can be a big problem if the contract has a mistake in it.
  • Smart contracts are, for now, only really useful for really simple contracts. Contracts function to divide risks between parties and to understand the complexity hereof we have a huge body of case law and legal nomenclature. Most contracts cannot be boiled down to an easily verifiable set of requirements.
  • Third, smart contracts ignore the social context in which contracts operate.
  • Fourth, smart contracts need reliable data as input in order to come to the right execution. Thus, either a third party or an oracle is needed. While a third party brings back concerns of centralisation, oracles are not well-developed enough for the foreseeable future. Prediction markets, other blockchains and the internet of things might start to play a role in this respect.
  • Finally, smart contracts raise interesting legal questions as well (is code law?).

 

Bubble Trouble

Another factor contributing to Ethereum’s weaknesses is that the hype around it has reached bubble-like proportions. Projects without any proof of concept, consisting only of a whitepaper and a website are raising many millions through ICO’s. Take, for example, the Gnosis project. Gnosis is a prediction market that sold out its ICO in 15 minutes, raising about $15 million. However, only 5% of all tokens were distributed, meaning it was valued at $300 million! The ICO was based on a whitepaper and an alpha version without any actual proof of concept. Such blatant over-valuations are sadly not uncommon as speculation in the space is at an all-time high. Meanwhile, celebrities like Jamie Fox, Paris Hilton and Floyd Mayweather are happily promoting ICO’s on social media. This all very much resembles the irrationality of the markets during the dot-com bubble, when celebrities were publically hyping up stocks and a website like pets.com, was valued at $300 million.

Because ICO valuations are out of control, the quality of projects on the Ethereum network is going down rapidly. If my startup was to be valued at $300 million after half a year of work and I would personally pocket a good 10%, how much incentive do I have to keep working? I could just sell my tokens and retire. To participate in the ICO madness, many developers do not seem to care whether they have a functioning product or not. They don’t have to, as they know people will throw money at their project anyway. If this gets you excited, here is a complete guide to profiting from the ICO hype:

  • Step 1: Launch website with a nice catchphrase like: “The First Ever Distributed (…..) That Democratizes And Disrupts Traditional (…..), Empowers Citizens and Benefits Holders Through Trustless Blockchain Technology”.
  • Step 2: Write a mediocre white paper and be vague about how the project actually makes any economic sense.
  • Step 3: Say you will actually build the DApp.
  • Step 4: Retire and profit.

Without regulation, developers believe they can just make the most blatant claims about the future of their project. For your financial health, do this quick exercise when investing in an ICO. Do a quick google search for ‘project name’ + scam. If this gives thousands of results, maybe it’s time to reconsider your plans. If it doesn’t, ask yourself: Is the project solving a real problem? Why should this solution be decentralized? Does the project actually benefit from peer-to-peer networking? Why does this project even need a token, what is the token for, and could the same goal be achieved differently? Do they have a working prototype?

That the quality of projects on the Ethereum network is going down, can also be seen by the amount of hacks during ICO’s. An estimated $225 million worth of Ethereum has been stolen from ICO-related activity in the last 12 months. There are also widespread ‘scam coins’, whose developers are probably at Step 3 of my (not so) unique step-by-step plan to financial freedom. Some examples of scams include Onecoin, Paycoin and the recently by the SEC investigated REcoin and DRC. There are many more projects which I suspect are less than legitimate, but at the risk of losing my mind, I will not go into those. For a good frame of reference, at one point there was an ICO for a coin that on its website “www.ponzi.io” (I am not kidding) literally stated it was “the first ever distributed pyramid scheme”. The project received millions in funding (I really wish I was kidding).

Researchers at the University of Cagliari state that:

“in the first 1.5 years of life of Ethereum, there have been a multitude of experiments to implement Ponzi schemes as smart contracts: indeed, ∼ 10% of the 1384 contracts with verified source code on etherscan.io are Ponzi schemes.”

Aside from the large amount of scams, Ponzi schemes and hacks, the (perceived) regulatory grey area also resulted in widespread spoofing of price orders and pump and dump schemes. This all inevitably attracts the attention of regulators which brings us to the last, and perhaps biggest, issue: legal uncertainty.

Illustration 2: Regulatory uncertainty is prevalent

As of yet, there is little regulatory certainty around the legal status of tokens and their distributions. While China has banned the ICO altogether until the enactment of suiting legislation, many countries have no idea if and how to address the topic yet. Whether a token is a security will inevitably depend on its characteristics, way of distribution, and the rights it gives to its holder. It is clear however that a token can definitely be a security, depending on how it is structured (see the SEC’s decision on the DAO). Many tokens, with characteristics resembling that of a security, do not comply with any of the applicable regulations. This means investors are not getting the information they need as a lack of compliance results in a lack of transparency.

While I would love to go into the subject here, I could write a whole thesis about this (and as a matter of fact, this is exactly what I am doing). Celebrities promoting ICO’s should be careful though: a tweet that takes 10 seconds to write might just have immense consequences.

As a final point, I would like to raise the question of what it is that fuels the demand for Ethereum. At the moment, a reasonably valid argument can be made that it is mostly the ICO hype. To buy tokens, you need Ethereum/Bitcoin. Now if we follow this line of reasoning, and if a large part of Ethereum’s value is indeed determined by the irrationality of the current ICO market, then what will happen when this market inevitably collapses under its own hype?

Conclusion

Blockchains give the potential to provide efficient, fast, secure, reliable and auditable transacting of value. Like the internet before it, the blockchain promises to upend business models and disrupt industries. Blockchain technologies are pushing us to challenge how we have structured society, defined value and rewarded participation. This is why some refer to blockchains as the enabling technology for the internet 3.0, or the internet of value.

As almost anything can be coded and deployed on Ethereum’s blockchain, Ethereum might just form the base of this new internet. However, high potential comes hand in hand with hype, and talk of the internet 3.0 brings problems resembling the ones surrounding the dot-com crisis.

Looking back, the dot-com bubble upset the market for quite a while. However, it did make the world aware of the possibilities made possible by the internet. At the high-point of the bubble, the combined market cap of the top 280 internet stocks was almost 3 trillion dollars. At the time of writing, the total market cap of the crypto market is $0.145 trillion.

“We always overestimate the change that will occur in the next two years and underestimate the change that will occur in the next ten.” — Bill Gates

Illustration 3: Visual representation of the relation between human perception of potential and development thereof
Thijs Maas is a Dutch LLM student who developed a keen interest in the interplay between distributed ledger technologies and law. He started LawAndBlockchain.eu to help narrow the increasing gap between legal doctrine and regulatory challenges posed by blockchain-based asset classes.
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