DeFi To Revolutionize Finance At The Environment’s Expense?

In 2008, in response to the financial crisis, Satoshi Nakamoto released the whitepaper “Bitcoin: A Peer-to-Peer Electronic Cash System”. What followed was the emergence of a movement that has ever since kept disputing the role of the banking sector and well-paid intermediaries. Of course, we are talking about Bitcoin, blockchain and, most importantly, the entire decentralized finance (DeFi) industry. While visionaries and tech-nerds hail it as the dawn of a more democratized future, critics decry the technology for its intangibility, pointless waste of energy and vast carbon footprint. So what is this environmental debate all about? Is DeFi revolutionizing finance at the environment’s expense?

What exactly is DeFi?

Before engaging in the aforementioned discussion, let us rewind and quickly look at the DeFi space itself. While Bitcoin is the most well-known cryptocurrency, there have emerged a plentitude of other ambitious projects. In a nutshell, DeFi describes a movement striving to develop a new financial system that does not rely on any “too big to fail” institutions, intermediaries and central authorities, and that is open to anyone.

At its core is the blockchain technology, a decentralized way of storing data into blocks by distributing numerous copies of it among a peer-to-peer network, secured through cryptography and “chained” together through hash values. In order to allow for this technology to offer more functionalities than mere payment transactions, projects like Ethereum – one of the backbones and first instances of DeFi-capable platforms – or Cardano, incorporate extensive Smart Contract functionalities, which make it possible to map more complex transactions on a blockchain as well.

Decentralized Finance: Blockchain- and Smart Contract-based Financial Markets (Source: Fabian Schär)

Need for a consensus mechanism

The key issue any digital currency has to face, and all decentralized approaches previous to Bitcoin have not been able to resolve – is the so-called double spending problem. From a theoretical point of view, it’s the “Byzantine General’s Problem” that needs to be solved in distributed systems. It got introduced (and actually coined with this name) by Laslie Lamport, Robert Stoshak and Marshall Pease in their famous article titled “The Byzantine generals problem”, published in the journal ACM Transactions on Programming Languages and Systems in 1982.

As the money only exists digitally, who is to prevent a malicious party from simultaneously spending the very same unit of currency more than once? Or, as the network is distributed: Who is to prevent actors to modify or change messages that are to be distributed to other peers?

Blockchains rely on a consensus mechanism specifically designed to stave-off attacks like this. The two most important types are proof of stake (PoS) and proof of work (PoW).

Proof of stake is built upon validators that are selected randomly by the network and who verify transactions and thereby adding new blocks to the chain. To become a validator, one has to stake a certain number of the project’s native coins, i.e. locking it up for a certain period of time. Hence, it is assumed that consciously weakening the network by including fraudulent transactions is not likely to occur, since it would result in the validators losing their staked funds through a penalty (called a “slashing” event). This mechanism consumes very little energy, and is thus considered fairly environmentally friendly, even amongst critics. Though, it is not as secure as the proof of work (cf. the following paragraph), but “secure enough” for practical applications.

On the other hand, there is the proof of work consensus mechanism, which requires so-called “miners” who are responsible for adding blocks and keeping the network secured, to solve complex mathematical problems (basically through brute-force techniques) by investing substantial amounts of computational power, and therefore ultimately, energy. That way, they are calculating quintillions of hash values – a mathematical function that converts any input into a fixed-sized output. This massive need of energy is supposed to deter network participants from acting maliciously by tampering with the transactions history as this would require to change all previous blocks (and not just the actual block for a specific transaction) which are chained together one by one.

And it is exactly this huge amount of energy that is often deemed a fatal flaw in the likes of Ethereum and Bitcoin, preventing them from becoming even more adopted. Ethereum is currently using a proof of work consensus algorithm, but intends to switch in 2022 to a proof of stake mechanism (Ethereum 2.0). Before coming to hasty conclusions, let us take a look at some crucial metrics:

Figure 1: Annual GHG Emissions of Ethereum, Bitcoin, and more (2021)

An argument made on occasion is that the banking system serves way more people, so it is acceptable if they emit more CO2. To scrutinize this, let us make a simple calculation:

As of today, at least 300 million people use cryptocurrencies in one way or another: 109  / 300 = 0.36. That means each DeFi user is responsible on average for roughly a third of a ton of carbon released into the atmosphere. If we compare this (assuming about 4 billion people make use of banking services) with 1,368 / 4,000 = 0.34 we see that the numbers only slightly differ.

Equally interesting is the fact that in terms of “environmental scalability”, an ever growing user base of cryptocurrency will barely enlarge its carbon footprint, since – at latest with Ethereum 2.0 which is set to slash Ethereum’s energy consumption by 99% – the majority of projects in the industry will operate using PoS and other, more sustainable consensus mechanisms (e.g. Proof of Authority, Delegated Proof of Stake).

What does the energy mix look like?

The University of Cambridge, while conducting their 3rd Global Cryptoasset Benchmarking Study in September 2020, found that about 39% of all energy consumption by PoW blockchains originate from renewable sources, with 76% of all miners utilizing renewables as part of their power mix.

Figure 2: Composition of the PoW energy mix

However, there are for example also other studies claiming that even as much as 74% of all Bitcoin mining is powered by renewable energy sources.

Furthermore, previous mining epicenters such as Sichuan and Yunnan (their future role remains to be seen after the Chinese government banned Bitcoin mining) excessively use otherwise wasted hydroelectric power, making up for almost 10% of global mining capacities in the dry season, and up to 50% during the rainy wet season respectively.

Assuming that Bitcoin’s energy consumption, and more importantly its carbon footprint will grow exponentially lacks taking into account several important developments. A 2018 study even claimed that Bitcoin emissions alone might push global warming 2 degree Celsius above pre-industrial levels.

Let’s look at some more facts. Continuously dropping prices and hence affordability of renewable energies poses a clear incentive for miners to shift increasingly to sustainable power sources – the reliance on fossil fuels will keep diminishing. There are even initiatives like the Crypto Climate Accord rooting for a cryptocurrency industry that accomplishes net-zero emissions by 2030.

And with Layer2-solutions finding more and more adoption, Bitcoin’s scalability does not have to come at the environment’s expense.

PoW is supposed to consume energy

But: Another point often disregarded is that, in its essence, the proof of work is about energy usage on purpose. It is about the process of transforming energy by solving cryptographic puzzles into a digital commodity. The sum of expended energy to build this “ecosystem” is part of what attaches inherent value to it, what makes bitcoin a contender for “digital gold”. It is a feature, not a bug, securing the entire network as costly computations and equipment prove transparently that work has been put in.

And maybe it is also one of the reasons that helped cryptocurrencies gain more traction in the first place. The real focus should not lie on the energy usage as such, but rather shift towards where that energy comes from and what needs to change for a greener future.

Final Thoughts

The DeFi industry is pursuing bold objectives, and as always, this comes at a certain cost.

Projects whose seamless running requires more energy consumption than that of countries like Sweden, Argentina, or the Netherlands, along with the consequential carbon emissions, have sparked numerous heated debates in the past months and years. While both supporters and critics have valid arguments, there are some indisputable facts and developments we considered worth highlighting in this article.

As less energy-intensive consensus mechanisms enjoy rising adoption and clean energy use becomes growingly accessible, we are convinced there is reason to believe that a greener future and the further democratization of finance can go hand in hand. In this way, the revolution of finance can also be made more sustainable and does not just act at the expense of the environment.