Why is Ethereum is switching to PoS?
The Emperor
In this article I explain why the real purpose of Ethereum’s switch to proof-of-stake is to create long-term holders of ether. First, I describe ether’s design and purpose as an appcoin, explaining the problem appcoins face. Then, I show that the main purpose of the switch to proof-of-stake is to solve this problem.
Ether is an appcoin
What is ether’s purpose? It isn’t supposed to be money. It is meant to be used as a way to pay for computation; fuel for operating applications on the Ethereum platform. Let’s look at the definition of ether, who are the intended holders, and it’s supposed relationship to bitcoin: (As stated in https://ethereum.org/)
What is Ether?
Ether is a necessary element — a fuel — for operating the distributed application platform Ethereum. It is a form of payment made by the clients of the platform to the machines executing the requested operations.
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Who needs ether?
Developers who intend to build apps that will use the ethereum blockchain. Users who want to access and interact with smart contracts on the ethereum blockchain.
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What’s the relationship between bitcoin and ether?
Ethereum would never be possible without bitcoin — both the technology and the currency — and we see ourselves not as a competing currency but as complementary within the digital ecosystem. Ether is to be treated as “crypto-fuel”, a token whose purpose is to pay for computation, and is not intended to be used as or considered a currency, asset, share or anything else.
The holders of ether are supposed to be people who will use or provide services on Ethereum platform — no one else is supposed to be holding ether. Notice that ether isn’t supposed to compete with bitcoin. It isn’t “intended to be used as or considered a currency, asset, share or anything else”, just as “crypto-fuel, a token whose purpose is to pay for computation”.
Ether is an appcoin (i.e. a medium-of-exchange token). This isn’t ambiguous. Vitalik Buterin defines a medium-of-exchange token, or appcoin, in his blogpost “On Medium-of-Exchange Token Valuations”:
“The general pitch for this kind of token goes as follows. We, the developers, build a network, and this network allows you to do new cool stuff. This network is a sharing-economy-style system: it consists purely of a set of sellers, that provide resources within some protocol, and buyers that purchase the services, where both buyers and sellers come from the community. But the purchase and sale of things within this network must be done with the new token that we’re selling, and this is why the token will have value.”
According to this definition, ether pretty clearly fits the bill. It is a form of payment made by the clients (buyers) of the platform to the (sellers’) machines executing the requested operation. The sellers are providing the resources within some protocol. In Ethereum, it is machines that execute requested operations. The buyers are the “clients” who pay for that service, and the people who should hold ether are the ones who want to make use of those services. This is all taken from the people who designed it. I am not making any contested claim.
One further point must be stated. Vitalik’s definition also states “where both buyers and sellers come from the community.” This is also true for Ethereum, as anyone can become a “seller” by providing computing power, and anyone can purchase those services. So, I conclude that ether is, uncontroversially, an appcoin.
An appcoin’s value is always unstable
In March 2014, Daniel Krawicz published “Appcoins Are Snake Oil”, where he explained why the value of an appcoin would always be unstable. Vitalik doesn’t seem to have realized this until later. Eight months later, he claimed to have reached the conclusion that “alternative tokens which are meant to serve primarily as “cryptofuels” [appcoins] do not suffer from currency-specific network effect deficiencies at all. Let a thousand cryptofuels bloom.”¹ without ever addressing the problem Krawicz explains. But then in October 17, 2017 Vitalik published “On Medium-of-Exchange Token Valuations” where the conclusion is the same as the one reached three years before by Krawicz: An appcoin’s value is unstable. I won’t go through the details (for the reader can access the original articles), but I will go through the main idea.
The main idea developed by Krawicz and rewritten (without the proper credit to Krawicz) by Vitalik is the following:
There exists an “implicit cost” in using an appcoin. This is because if there were another coin (bitcoin, or the USD for example) that the user would prefer to hold, then there would be an implicit cost in holding the appcoin instead of the coin the user would prefer. The “implicit cost” would be the expected change in the exchange rate between the appcoin and the coin the user would prefer to hold. It also depends on the the time the user must hold the appcoin in order to use or provide services on the platform. Thus, users would want to get rid of the coin as fast as possible to minimize this cost. Vitalik then explains that “the market cap of an appcoin depends crucially on the holding time H. If someone creates a very efficient exchange, which allows users to purchase an appcoin in real time and then immediately use it in the application, then allowing sellers to immediately cash out, then the market cap would drop precipitously” before he goes on to explain how those exchanges are going to be developed.
As such, the conclusion reached in both articles is (in Vitalik’s words) that “What this all serves to show is that relying purely on the medium-of-exchange argument to support a token value, while attractive because of its seeming ability to print money out of thin air, is ultimately quite brittle. Protocol tokens using this model may well be sustained for some time due to irrationality and temporary equilibria where the implicit cost of holding the token is zero, but it is a kind of model which always has an unavoidable risk of collapsing at any time.”
We have that this kind of model “always has an unavoidable risk of collapsing at any time.” Then, as Ethereum originally had this kind of model it necessary needs to change the model to avoid an “unavoidable risk of collapsing at any time.”
Before we go on, it is worth stating that the current apparent stability in the valuation of ether does not contradict anything said here. As “protocol tokens using this model may well be sustained for some time due to irrationality and temporary equilibria where the implicit cost of holding the token is zero.” But in the end, as long as Ethereum has this kind of model it would always have a risk of collapsing. The model must be changed.
How to fix this? How can Ethereum survive?
Vitalik and the Ethereum Foundation surely know of this problem, as they clearly defined ether as an appcoin (cryptofuel) and Vitalik explained the problem those kind of tokens face. All the information required to reach this conclusion was produced by them (although, as we have seen, Vitalik’s idea in the blog post was originally proposed by Krawicz). In short, they are aware of this problem. How are they trying to solve it?
One option is to pivot and change the purpose of ether and try to make it a currency that works as money and becomes the preferred coin. This would eliminate the cost of holding ether. It would be a mistake to assume that this change is of little importance, as it represents a radical change in ether’s and therefore Ethereum’s purpose. We will look at the challenges it would face if it tries to be a currency.
The main issue Ethereum faces is that it would be competing with bitcoin and all other coins designed to be money in a zero-sum game where only one can ultimately win, as there could be no stable equilibrium of two coexisting cryptocurrencies. This point was developed by Krawicz in “The Coming Demise of the Altcoins,” which I highly recommend. To make clear why this is the case, imagine this scenario in the Fiat world we used to live in: all the world governments end the monopoly of currencies in their country and the legal tender laws, an immutable monetary policy is defined, and you are able to exchange currencies quickly and at a minimum cost. In this world, after some time, would there be anyone left holding the Argentinian Peso with its 25% inflation rate? Or would everyone move to the Swiss Franc, the USD or another currency that holds its value better? That is how the competition in a crypto world works, no legal tender laws, predefined monetary policy and fast and cheap exchanges.
Currencies without a government-imposed monopoly compete with each other in a zero-sum game. How does ether compare to its fiercest competitor as a currency? Bitcoin is the best cryptocurrency, it was designed to be money and nothing other than money. All of its developers have been working for 9 years on making bitcoin work better as money, as it has no other intended use. It has the most secure and immutable blockchain with all the energy expenditure we keep hearing is going to destroy the world used to secure the network. It has a first mover advantage which is essential to build the network effect needed for a monetary good. All others coins are copies of it, it’s the most liquid, and once the lightning network is fully operationally anonymous, instant and virtually free transactions will be possible at scale. It uses a simple programming language to avoid problems like the DAO hack and the Parity multisig issue from happening. It is the most decentralized network, as it has no single point of failure, which makes its monetary policy immutable because no one has the power to change it. It has withheld attacks and is looking stronger than ever. The NYA debacle showed us that not even 90% of the miners can control it. Bitcoin truly appears to be antifragile.² Ethereum has already abandoned its original monetary policy and right now it isn’t defined, and we need to trust that it “will not give preferential treatment to any particular group of people.”³
What advantages does Ethereum have over Bitcoin? The advantage that Ethereum has is the versatility in what can be done in its platform, which allows a wide range of applications to be developed. But that isn’t needed in a currency: money must work as a store of value, medium of exchange, and unit of account. The one that is able to fill these functions better will be the ultimate winner. If Ethereum tries to compete with Bitcoin in its game, it has a low chance of success.
If pivoting ether to make it a currency has a brittle future, what other options are there? One must address the original cause of the problem. Try to eliminate the holding cost, and create long-term holders of the coin. How can one do this? With proof-of-stake.
Switching from proof-of-work to proof-of-stake is a sacrifice in security and immutability, which are the main properties of a blockchain. It also doesn’t really reach distributed consensus, as demonstrated here by Andrew Poelstra. It implies moving from a system that has been proven to work (as it right now secures about $170 billion dollars in the Bitcoin network) to a system that might work, but that is supposed to create the immutability that right now requires enormous amount of energy out of nothing and without any cost. It sounds sketchy to say the least. This two Twitter threads (1, 2) by Hugo Nguyen explain the main issues. There are many sacrifices on switching to proof-of-stake. This should create a question in everyone’s mind as stated by Nguyen on the first thread:
So, what is really the point in doing this? Vitalik and the people in Ethereum Foundation are not stupid⁴, so what are they thinking? Are they really doing it because they don’t want to “waste” so much energy, which as they know⁵ it is not wasted, for it is what secures the network? Or rather could such risk aim to solve an existential problem Ethereum faces? That would definitely be worth it.
The problem Ethereum and all other appcoins face is the instability of the value of the coin caused by the “implicit cost” of holding the appcoin. No one would want to hold the coin as it incurs a cost. What incentives could there be to be a long-term holder of the coin? Enter proof-of-stake. Proof-of-stake basically intends to replace proof-of-work by switching the miners and their energy expenditure for “stakers” who instead of requiring energy to mine a block need to prove ownership of coins and lock those funds for some time. If what they did was valid they receive the block reward, the fees paid and their funds are unlocked; otherwise, their locked funds are lost. So an attack is supposed to be counterproductive.
What does this achieve? It creates a system of rewards for holders of ethers as they “stake” their coins and receive the block rewards for it. Creating the possibility of an appcoin with a value that isn’t unstable. There should always be people willing to hold the coin in order to gain the block rewards by “staking” their holdings (if the amount of stakers is reduced the profit gained by staking increases). An equilibrium could be reached were the income of holding the coins by “staking” them would be equal to the cost of holding that coin instead of the coin one would prefer to hold. It appears it could eliminate the “risk of collapsing at any time,” and its value could able to reach an equilibrium with the preferred coin.⁶
If holding an asset (in this case an appcoin or crypto-fuel) is going to incur a cost, when compared to holding another asset (like bitcoin), then it has to pay an interest to compensate the holders. Otherwise there would be no long-term holders, only users of the appcoin, causing its value to have a risk of collapsing at any time.
The switch to proof-of-stake is a huge security risk, whose supposed intended purpose is not worth it. On the other hand, Ethereum as originally designed faces an existential problem and Vitalik knows this. The switch to proof-of-stake directly addresses and could solve this problem.
Vitalik has showed interest in proof-of-stake since August, 2013 when he wrote “What Proof of Stake Is And Why It Matters.” But this interest seems to be because he didn’t understand proof-of-work. He thought that the problem with proof-of-work was that it wasted energy and an algorithm that could use that energy for something useful would be preferred, not realizing that the whole point of proof-of-work is that the energy can’t be serving any other purpose. Otherwise someone who derives enough value from what is produced by that energy could afford to attack the network, as he isn’t “wasting” his energy expenditure while doing so.
However, when he understood the problem Ethereum faces and, we assume, saw how proof-of-stake might solve it, his motives for switching probably changed. He now seems to be more interested in doing the switch soon than doing it right, as in 2017 Vlad Zamfir (a top Ethereum researcher and developer on proof-of-stake) said “Vitalik is more driven to implement something soon, whereas I’m more driven to search for theoretically optimal solutions even if it means some delays.”⁷ Maybe it is because he doesn’t want people to realize the purpose of the switch before it is done.
If my hypothesis is correct, and the real reason behind the switch to proof-of-stake is to solve the holding cost problem, then they could not say so publicly. Were they to do this, they would have to acknowledge the fact that Ethereum as originally designed faces an existential problem and thus that a pivot must be made to try and save the platform. If Vitalik or the Ethereum Foundation were to acknowledge this publicly before the change is made, the price of ether (along with many altcoins) would plummet. The stated reason should not matter. As long as we can see everything that is achieved by the change, we can determine what its main purpose is.
So what is the real purpose of switching to proof-of-stake? You be the judge.
Even if they manage to pull this off and switch to proof-of-stake before people realize the existential problem Ethereum faces in its current protocol, I remain highly skeptical of its long-term viability, as there are still many issues with Ethereum. It has not showed any real world utility. Proof-of-stake might destroy the security of the network. Its centralization around Vitalik and the Ethereum Foundation creates a single point of failure — the precedent created for non-technically motivated hard forks undermines the essential immutability of the blockchain, among other issues.
As I see it, the switch to proof-of-stake isn’t the solution to all their problems, but the only option they have to try and save their project that was supposed to “change the world.” The protocol they originally designed is doomed to fail, and they know it.
Footnotes
¹ https://blog.ethereum.org/2014/11/20/bitcoin-maximalism-currency-platform-network-effects/
² From Antifragile: Things That Gain from Disorder:
Some things benefit from shocks; they thrive and grow when exposed to volatility, randomness, disorder, and stressors and love adventure, risk, and uncertainty. Yet, in spite of the ubiquity of the phenomenon, there is no word for the exact opposite of fragile. Let us call it antifragile. Antifragility is beyond resilience or robustness. The resilient resists shocks and stays the same; the antifragile gets better. This property is behind everything that has changed with time: evolution, culture, ideas, revolutions, political systems, technological innovation, cultural and economic success, corporate survival, good recipes (say, chicken soup or steak tartare with a drop of cognac), the rise of cities, cultures, legal systems, equatorial forests, bacterial resistance … even our own existence as a species on this planet. And antifragility determines the boundary between what is living and organic (or complex), say, the human body, and what is inert, say, a physical object like the stapler on your desk.
The antifragile loves randomness and uncertainty, which also means — crucially — a love of errors, a certain class of errors. Antifragility has a singular property of allowing us to deal with the unknown, to do things without understanding them — and do them well. Let me be more aggressive: we are largely better at doing than we are at thinking, thanks to antifragility. I’d rather be dumb and antifragile than extremely smart and fragile, any time.
It is easy to see things around us that like a measure of stressors and volatility: economic systems, your body, your nutrition (diabetes and many similar modern ailments seem to be associated with a lack of randomness in feeding and the absence of the stressor of occasional starvation), your psyche. There are even financial contracts that are antifragile: they are explicitly designed to benefit from market volatility.
Antifragility makes us understand fragility better. Just as we cannot improve health without reducing disease, or increase wealth without first decreasing losses, antifragility and fragility are degrees on a spectrum.
⁴ Altough it seems that Vitalik does not understand economics or bitcoin as he demostrated here: https://bitcoinmagazine.com/articles/how-bitcoin-can-actually-help-iranians-and-argentinians-1374585681/
⁵ Vitalik might still not understand this. He didn’t understand in 2013 as I explain later.
⁶ Even if this does in fact solve that problem it would probably cause ownership of ether to be highly centralized in the “stakers”.
⁷ https://www.influencive.com/ethereums-casper-almost-heres-need-know/
