Ethereum is on the cusp of a major transformation that will prove to be a turning point for the entire industry. The leading smart contract blockchain is replacing energy-intensive “mining” known as proof-of-work (PoW) as a form of validation with a more energy-efficient process known as “staking,” or more formally, proof-of-stake (PoS). This will introduce a more secure, scalable and eco-friendly platform.
With this monumental event just around the corner, it’s a good time to remind ourselves just why we are so excited about this transition.
If you've yet to master Ethereum, never mind Ethereum 2.0, check out our Ether 101 whitepaper —it’s the perfect place to start.
For those already up to speed, let’s dive in.
A new dawn of Ethereum: No more mining
The most significant development of this upcoming merge will be the move from PoW to PoS.
Why does this matter? Before we give you our take, let’s remind ourselves about the differences between the two forms of validation.
What is proof-of-work?
Ethereum currently uses a form of validation called proof-of-work, just like Bitcoin. For the right to approve transactions that get added to the blockchain, “miners” use specialized computers that expend large amounts of power to compete against each other to solve cryptographic puzzles. The first miner to solve the puzzle receives a reward in the form of the blockchain’s newly minted native token and transaction fees paid by users of the network. The miner then adds the new block to the blockchain that the rest of the network can verify. The rewards they receive are incentives to approve transactions and help offset the cost of equipment and energy that’s used to mine.
What is proof-of-stake?
In comparison, PoS asks people to stake (put up their coins as collateral) for the chance to validate new transactions and gain rewards in the form of more ether. The right to validate and gain rewards is usually assigned based on the proportionate value of what you are staking. For example, if you provide five per cent of all the ether staked on the network, you will likely be able to validate five per cent of the blocks. To stake on Ethereum’s upgraded network, you need 32 ETH per validator. You can also join a staking pool where smaller players can pool their ETH to help validate transactions on the Ethereum network.
Under PoS, token holders replace miners as validators, but don’t need specialized computer equipment to participate. They are also incentivized to approve transactions to receive newly created cryptocurrency. If there’s inactivity, dishonest validations, or any other malicious behaviour on the validator’s part, they risk what is called a “Slashing Penalty” and could lose some of their stake.
3 benefits to proof-of-stake protocols
This move to PoS offers some compelling narratives for investors.
1. PoS is way more environmentally friendly
As PoS blockchains rely on collateral to achieve consensus, rather than computing power like PoW does, their energy consumption is massively reduced. The Ethereum Foundation estimates that a PoS Ethereum blockchain could use 2400x less energy than the PoW system it’s currently built on. (1)
“Ethereum's energy usage will soon decrease by ~99.95%” – Ethereum Foundation
This is good news for large institutions with strong ESG mandates that have reservations about being associated with an asset class that has become synonymous with excessive energy usage. If Ethereum’s transition to PoS proves to be as light on energy consumption as it promises, large inflows of capital from these investors could not be far off. (2)
2. Yield generation
The beauty of staking is that it amounts to passive income investing. By putting ether up for collateral, long-term holders not only get to take part in the upkeep and health of the Ethereum network, they also can get rewarded for their efforts in the form of staking rewards.
Staking rewards could be anywhere between four per cent and 15 per cent, according to some sources. (3) Ether Capital, which acts as a special advisor to Purpose, recently became the first company in the world to stake a significant portion of its ether balance (20,603 ETH). It also surpassed $1 million in staking rewards (calculated at a rate of five per cent) less than four months after its initial staking commitment. This is exciting news for investors. Ethereum could offer an attractive yield in an economic environment where many traditional investments do not out-perform inflation. (4) That’s nothing to scoff at.
Coupled with the markedly improved energy efficiency of the Ethereum network, these potential returns will likely only amplify institutional interest in the protocol.
The move to PoS also sets the stage for “sharding” (don’t worry, we will get into what that is in a second) to vastly improve throughput. Though this innovation has a rather amusing name and is not expected to be introduced until at least 2023, it promises to resolve serious issues surrounding the ability of the Ethereum network to scale.
One of the main roadblocks to mainstream adoption of blockchains is their low rate of transactions per second (TPS). Bitcoin can currently only manage five, while Ethereum can do about 10. Visa, on the other hand, can process 2,000. (5)
The difference is significant. The ability to handle a large number of different transactions will undoubtedly be a positive development for Ethereum.
This is where “sharding” comes in. At a high level, it allows the Ethereum blockchain to be broken up into smaller pieces called “shards.” These shards act as semi-autonomous fragments of the main blockchain and can process transactions on their own. Some estimates outline the potential of sharding to increase Ethereum blockchain’s TPS to 100,000. (6)
Looking forward at Ethereum’s future
The full impact of Ethereum’s transition to 2.0 is yet to be realized. And yet, there are still many unknowns about how this move to PoS will play out. However, a move to a greener, more scalable future is exciting and promises to facilitate the transition of the Ethereum network into the mainstream.
— Josh Bubar, VP of Product at Purpose Investments, and Brian Mosoff, CEO of Ether Capital
(1) Ethereum average energy consumption per transaction compared to that of VISA as of January 10, 2022, Statista: https://www.statista.com/statistics/1265891/ethereum-energy-consumption-transaction-comparison-visa/#:(2) Ethereum proof of stake, Ethereum: https://ethereum.org/en/energy-consumption/#:
(2) Bitcoin ESG Concerns Might Slow Institutional Adoption, for Now, Coin Desk: https://www.coindesk.com/markets/2021/05/26/bitcoin-esg-concerns-might-slow-institutional-adoption-for-now/
(3) Traders Bet on Ether Staking After Ethereum 2.0 Upgrade, Coin Desk: https://www.coindesk.com/markets/2022/03/21/traders-bet-on-ether-staking-after-eth-20-upgrade/
(4) Decoding the “real” disconnect between interest rates and inflation, Black Rock: Decoding the “real” disconnect between interest rates and inflation: https://www.advisorperspectives.com/commentaries/2021/09/14/decoding-the-real-disconnect-between-interest-rates-and-inflation
(5) Transactions per Second (TPS), Binance: https://academy.binance.com/en/glossary/transactions-per-second-tps
(6) Ethereum 2.0, Phase 1: Boosting Throughput with Sharding, Gemini: https://www.gemini.com/cryptopedia/ethereum-2-0-proof-of-stake-pos-blockchain-serenity
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