What Is Proof-of-Stake, and Why Is Ethereum Adopting It? | Cryptocurrency

Just looking at the headlines, cryptocurrencies are in a downturn.

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The price of Bitcoin has dropped by around half since its peak. More speculative projects, such as Dogecoin, have fallen even further. While this may be discouraging to day traders and fast money types, for longer-term investors, there are exciting developments in cryptocurrency.

For one thing, the drive continues toward more exchange-listed funds and trusts in the sector. There’s also a key debate in a technical area: Is the future of cryptocurrencies found in proof-of-stake protocols?

The proof-of-work versus proof-of-stake issue comes down to this question: How to ensure the integrity of a cryptocurrency. Most legacy cryptocurrencies, such as Bitcoin, rely on a proof-of-work mechanism. When you see an image of thousands of computers in a mining facility, that’s a proof-of-work operation. The computers solve complicated algorithmic puzzles. In return, the miners receive tokens of the underlying cryptocurrency as reward.

What Is Proof-of-Stake?

Proof-of-stake, by contrast, relies on validators to maintain the cryptocurrency. In a proof-of-stake model, owners put up their tokens as collateral. In return, they get authority over the token in proportion to the amount they stake. Generally, these token stakers get additional ownership in the token over time via network fees, newly minted tokens or other such reward mechanisms.

In the beginning, proof-of-work was appealing because people just needed an ordinary computer to mine coins. Nowadays, however, specialized expensive gear is needed to mine leading proof-of-work tokens. Much of mining is now done by large, well-financed pools, which has cut out the general public from the equation.

In the debate proof-of-stake versus proof-of-work battle, the former could be more democratic. Anyone with tokens is able to participate as a validator or staker and tap into the decentralized finance (DeFi) ecosystem. More broadly, analysts have focused on the environmental burden from proof-of-work protocols. Bitcoin, in particular, has developed a large environmental footprint as it has gained wider adoption. Proof-of-stake, by cutting out the advanced cryptographic puzzles, reduces this environmental cost dramatically.

Proof-of-work advocates protest that proof-of-stake deviates from the original vision of cryptocurrency. Bitcoin differentiated itself from other financial assets because the database or blockchain record was inherently valuable. The mining process, while inefficient in terms of energy, created a distinct and tamper-proof record of all financial transactions. Proof-of-stake, at least in basic forms, has some vulnerabilities.

The nothing at stake problem, for example, is centered around the fact that when there is no cost to creating forks or putting bad information into the consensus, it encourages malicious behavior. Proof-of-work’s energy cost inherently limits manipulation; proof-of-stake, by contrast, must use more sophisticated methods to try to stop these security issues.

The proof-of-stake versus proof-of-work debate has largely stayed within the technical realm. Proof-of-stake has a notable leader in Cardano, but the biggest projects have stayed with proof-of-work. However, Ethereum’s plans to migrate from proof-of-work to proof-of-stake are bringing this subject into the spotlight. Ethereum’s move began in earnest in 2020, when Ethereum launched its proof-of-stake Beacon Chain. Development continues, with Phase 1 aiming to launch later in 2021 and the full merge into proof-of-stake for Ethereum happening over the next year.

It’s Complicated Switching to Proof-of-Stake

So, given the benefits of proof-of-stake, why has Ethereum taken so long to make the switch? “The main impediment for faster adoption of proof-of-stake has certainly been the difficulty of migrating the largest smart contract network Ethereum from proof-of-work to proof-of-stake,” says Justin Giudici, head of product at the Telos Foundation. “The challenge of changing the consensus mechanism on Ethereum has been compared to ‘fixing a plane while flying it.’ This is because with thousands of existing smart contracts on the Ethereum chain along with billions of dollars in assets at stake, the migration challenge is significant.”

Here are some numbers to put the challenge in perspective. “Development on Ethereum has far outpaced its ability to change and thus scale. It’s easy to understand why when you consider the DeFi phenomenon, which saw an industry go from zero to $76 billion in the last year. Then, during the first two quarters of 2021, non-fungible tokens exploded, bringing in $2.5 billion. Building on the Ethereum Network has been happening at an explosive rate, while the switch from proof-of-work to proof-of-stake is a long, arduous process,” says David Waslen, CEO of Rublix Development, a blockchain and smart contract software company.

It’s easy to migrate from one technology to another in a vacuum. However, as Ethereum’s decentralized finance system has already gained wide adoption, it’s vital to maintain continuous network stability. “There could be unexpected critical bugs or circumstances that are difficult to predict before the merge occurs. This is a good reason for not rushing the transition,” says Mattias Nystrom, community manager for the Golem Network.

“Ethereum’s timeline can be seen as a product of its strength: decentralization. It’s a complex project with lots of stakeholders and beyond that, it’s censorship resistant and permissionless socially. This means anyone can join the project and give their input on changes to the network. So you need consensus among developers creating the code and among the wider community for things to progress,” Nystrom says.

Proof-of-Stake and Transaction Costs

Another factor is the recent decline in cryptocurrency prices, and the ensuing amount of mining power devoted to proof-of-work protocols. Transaction fees on Bitcoin, Ethereum and other leading proof-of-work projects support the mining network. As crypto has dropped, transaction fees fell. But even if the average transaction fee drops from, say, $25 to $5, that can still be a huge cut of smaller decentralized finance transactions.

Also, as emerging markets such as El Salvador adopt cryptocurrency, fees will need to come down dramatically. El Salvador’s gross domestic product per capita works out to around just $11 per day. So if cryptocurrency will be the default money in that economy, it’s vital that user fees aren’t a large portion of a worker’s average daily wage.

Additionally, high transaction fees often found in proof-of-work protocols stifle progress for cryptocurrency adoption.

“There’s a huge impact to innovation in languishing on slower, more expensive consensus technology. Historically, the transition from proof-of-work to proof-of-stake and other high speed consensus models is comparable to the transition from dial-up internet to broadband,” Giudici says. “Quite simply, the number and types of use cases, level of adoption and impact of the technology go up orders of magnitude as entrepreneurs release products that couldn’t even be imagined using slower more limited technology.”

Ethereum is supposed to adopt proof-of-stake over the next year. But like the switch from dial-up to broadband, don’t be surprised if proof-of-stake still takes a while. “Even though the changeover from proof-of-work to proof-of-stake is beginning in 2021, the final result is a long way off. [Ethereum founder] Vitalik Buterin has even pointed to an extended process of ‘cleanup’ after the scheduled hard forks and the eventual chain merge before the Ethereum platform problems such as lack of scalability, costs and congestion can be aggressively addressed,” Waslen says.

Proof-of-Stake’s Broader User Impact

Proof-of-stake has one other widely discussed effect: the graphics card market. As Ethereum and other leading crypto projects adopt proof-of-stake systems, it should reduce the demand for graphics cards in for cryptographic mining. This could finally break the shortage in the area. That’s great news for gamers.

Jahon Jamali, co-founder of Sarson Funds, agrees that graphics card demand could free up with proof-of-stake adoption. However, the best proof-of-stake user benefit comes elsewhere. “The big positive effect is that consumers get to participate in the consensus mechanism. It’s more scalable and they can participate in the staking rewards. They will benefit greatly by being able to participate in a broader ecosystem,” Jamali says.

And it’s no guarantee that graphics card applications will decline in a proof-of-stake world. Giudici suggests much of this crypto-mining infrastructure could go from supporting proof-of-work systems to other crypto-backed applications such as distributed research in fields such as cancer, Alzheimer’s disease and climate change. Using a staking model, users could be rewarded with tokens for sharing their computing resources while also advancing a greater good beyond simply maintaining the Bitcoin or Ethereum networks.