Where does the money come from? Dollars are printed by the US Mint. For cryptocurrencies, the answer is more complicated. Until now, the digital tokens with the highest market value, Bitcoin and Ether, have only been issued to pay for tasks performed by so-called miners in so-called proof-of-work systems. It is an approach that has drawn increasing criticism due to the large amounts of energy consumed and the pollution produced. Around September 15, Ethereum, the Ether platform, is switching to a different system, called proof-of-stake, in a process known as a merger. Proponents claim that the approach can reduce Ethereum’s electricity consumption by 99%.
Analysis | All About Proof of Stake, Ethereum’s Plan for Greener Crypto
- Susan G. Hall
- on Aug 26, 2022
1. What are “proof of” systems used for?
Cryptocurrencies wouldn’t work without blockchain, a new technology that performs the outmoded function of keeping a record of time-ordered transactions. What is different from pen and paper records is that the ledger is shared on computers all over the world. The blockchain must take on another task that is unnecessary in a world of physical money: ensuring that no one can spend a cryptocurrency token more than once while manipulating the digital ledger. Blockchains operate without a central custodian, such as a bank, in charge of the ledger: proof-of-work and proof-of-stake systems rely on group action to create, validate, and save the sequential record of a blockchain.
Today, in the major Bitcoin and Ethereum networks, transactions are grouped into “blocks” which are published on a public “chain”, but only after the proof-of-work command has been executed. With Bitcoin’s software, this happens when the system compresses the block’s data into a puzzle that can only be solved through millions of trial-and-error calculations. This work is done by miners who compete to be the first to come up with a solution and are rewarded with free cryptocurrency if other miners agree that it works.
3. What are the disadvantages of proof of work?
When Bitcoin and Ether were worth pennies, mining was also cheap. But as the value of currencies rose, something of an arms race took hold, as miners dumped resources in the quest for new coins. The software responds to increased competition by accelerating the difficulty of calculation. The resulting exorbitant electricity consumption has led to calls from environmentally conscious people to avoid Bitcoin and Ether. The European Union considered banning proof-of-work practices before deciding that crypto-asset providers should be required to disclose the energy consumption and environmental impact of the assets they choose to list. The proof-of-work system has also led to increasing domination by huge centralized mining farms, a development that has created a new vulnerability for a system designed to be decentralized. In theory, a blockchain could be overwritten by a party that controls the majority of the mining power.
4. What is proof of stake?
The idea behind the proof-of-stake system adopted by Ethereum is that its blockchain can be more easily secured if you give a group of people a carrot-and-stick set of incentives to collaborate. People who have staked or staked 32 Ether (1 Ether traded at around $1,900 in mid-August) will be able to become “validators,” while those with less Ether can become joint validators. Validators are chosen to order blocks of transactions on the Ethereum blockchain. If a block is accepted by a committee whose members are called attesters, the validators receive Ether. But someone who tried to thwart the system could lose the coins staked. Ethereum’s proof-of-stake system is already tested on a blockchain, called Beacon Chain, which is separate from the proof-of-work system; so far, $25 billion worth of Ether has been staked there. The two blockchains are expected to merge in September.
5. What are the advantages of the system?
It is believed that switching to proof-of-stake would reduce Ethereum’s energy consumption – estimated at 45,000 gigawatt hours per year, slightly more than that of New Zealand – by 99.9%. In terms of carbon footprint, it would be essentially like any other Internet operation whose power consumption involves nothing more than operating a network of computers, rather than a business resembling a collection of gigantic digital factories.
6. What are its vulnerabilities?
Proof of stake is less proven than proof of work, which has been under scrutiny for security for more than a decade. Thus, new vulnerabilities could be found. Moreover, there is a risk that an additional new player in the Ethereum ecosystem will become dangerously powerful: the so-called builder. Constructors will group transactions into blocks and pass them to validators. There are currently over 400,000 validators but only a few builders. If a major provider of crypto wallets, coin transfer and storage software decides to send all transactions to a particular vendor, that vendor may be able to censor transactions and demand high prices. Proponents of proof of stake believe that the risks are worth what would be gained in terms of environmental benefits, as well as involving a wider group of users in the process.
7. What kinds of problems could arise during the merger?
Major software upgrades almost never go smoothly. Despite years of testing before the merge, various bugs and issues could potentially arise within hours or even months of the switchover. There could be issues with different validators getting out of sync with each other and requiring the blockchain to be paused. More importantly, there is the danger of replay attacks, in which hackers repeat a user’s transaction to steal coins. Although Ethereum has been hardened against such attacks, some applications running on the network may not have included the necessary protections in their code.
8. If the merger succeeds, what will it mean for proof-of-work blockchains?
If the new Ethereum system starts performing well, it could put more pressure on proof-of-work systems (notably those in Bitcoin) to transition to a more energy-efficient process as well. Environmental concerns surrounding these blockchains have long prevented major corporations and funds committed to environmentalism from investing in crypto. Ethereum’s hope is that once the platform becomes more environmentally friendly, more institutional investors will give it a second look, and more developers who have avoided building funding, games and other applications for the network due to its high power consumption will pass. This could potentially lead to something cryptoheads call “flipping” – essentially, Ethereum’s market capitalization surpassing that of Bitcoin for the first time. Today, the value of Bitcoin is twice that of Ethereum.
9. How could the merger change the economy of Ether?
Today, only a small percentage of Ether in circulation is used in staking on Ethereum’s proof-of-stake trial blockchain. In a year or two after the merger, around 80% of Ether can be staked, which means it will be locked up for a while. This could have implications for Ether’s long-term prices and liquidity.
More stories like this are available at bloomberg.com