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 largest 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 received increasing criticism for the large amounts of energy consumed and the pollution produced. Around September 15, Ethereum, the platform for Ether, switches to another system, called proof of stake, in a process known as Merge. Supporters say the approach could cut Ethereum’s power usage by 99%.
All About Proof of Stake, Ethereum’s Plan for Greener Crypto
1. What are the “proof of” systems for?
Cryptocurrencies would not work without blockchain, a new technology that performs the old-fashioned function of maintaining a ledger of time-ordered transactions. What differs from pen and paper records is that the ledger is shared on computers all over the world. Blockchain must take on another task that is not necessary in the world of physical money – making sure that no one is able to use a cryptocurrency token more than once by manipulating the digital ledger. Blockchains operate without a central guardian, such as a bank, in charge of the ledger: Both proof-of-work and proof-of-stake systems rely on group actions to create, validate and secure a blockchain’s sequential record.
Today, in the main Bitcoin and Ethereum networks, transactions are grouped into “blocks” that are published to a public “chain”, but only after the proof of work order is executed. With Bitcoin’s software, that happens when the system compresses the data in the block into a puzzle that can only be solved through potentially 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 is evidence of the work’s disadvantages?
When Bitcoin and Ether were worth pennies, mining was also cheap. But as the value of the currencies rose, an arms race of sorts began, as miners added resources in the quest to win new coins. The software responds to increased competition by increasing the calculation difficulty. The resulting skyrocketing power consumption led to calls from environmentalists to avoid Bitcoin and Ether. The European Union considered banning proof of labor practices before deciding that cryptoasset 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 the increasing dominance of 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 rewritten by a party that controlled a majority of the mining power.
4. What is proof of stake?
The idea behind the proof of stake system adopted by Ethereum is that the blockchain can be secured more easily if you give a group of people a set of carrot-and-stick incentives to cooperate. People who put up, or stake, 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 community validators. Validators are elected to order blocks of transactions on the Ethereum blockchain. If a block is accepted by a committee whose members are called attestors, validators are awarded Ether. But someone who tried to game the system could lose the coins that were bet. Ethereum’s proof of stake system is already being tested on a blockchain, called the Beacon Chain, which is separate from the proof of work system; so far, $25 billion in Ether has been staked there. The two blockchains are expected to merge in September.
5. What are the system’s advantages?
It is believed that switching to proof of stake would cut Ethereum’s energy use – estimated at 45,000 gigawatt-hours per year, or slightly more than New Zealand’s – by 99.9%. In terms of its carbon footprint, it will essentially be like any other Internet operation whose energy use involves nothing more than running a network of computers, rather than a venture that resembles a collection of giant digital factories.
6. What are the vulnerabilities?
Proof of Stake is less battle-tested than Proof of Work, whose security has been scrutinized for more than a decade. So new vulnerabilities can be found. There is also a risk that an additional new player in the Ethereum ecosystem could become dangerously powerful: the so-called builder. Developers will package transactions into blocks and forward them to the validators. There are currently more than 400,000 validators, but only a few builders. If a major provider of crypto wallets, software for transferring and storing coins, decides to send all transactions to a particular builder, that builder may be able to censor transactions and command high prices. Evidence for effort advocates believe the risk is worth what can be achieved in terms of environmental benefits, as well as by bringing a wider group of users into the process.
7. What kind of problems can arise during the merger?
Major software upgrades almost never go smoothly. Despite years of testing before the merge, various bugs and issues can potentially appear in the hours and even months after the transition. There can be problems with different validators not being in sync with each other and the blockchain having to be paused. More importantly, there is the danger of replay attacks, where hackers repeat a user’s transaction to steal coins. While 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 is successful, what will this mean for proof of blockchains?
If the new Ethereum system starts working well, it could put more pressure on proof of work systems (especially Bitcoins) to switch to a more energy efficient process as well. Environmental concerns surrounding such blockchains have long prevented large companies and funds committed to environmental protection from investing in crypto. Ethereum’s hope is that as the platform becomes more environmentally friendly, more institutional investors will give it a second look, and more developers who avoided building finance, games and other applications for the network because of the high energy consumption will move over. This could potentially result in something crypto-heads call “flipping” – essentially, Ethereum’s market cap is above Bitcoin’s for the first time. Today, Bitcoin’s value is double that of Ethereum.
9. How could the merger change the economics of Ether?
Today, only a small percentage of Ether in circulation is used to stake Ethereum’s proof of stake blockchain. Within a year or two after the merger, around 80% of the Ether may be staked, meaning it will be locked up for a period of time. That could have implications for Ether’s long-term pricing and liquidity.
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