Ethereum’s Proof-of-Stake May Be A Profitable Venture For Current Holders
In a recent post, I outlined how the use of real-world resources tie cryptocurrencies like Bitcoin and Ether back to real world monetary value. Today, I’m going to flip the script and talk about Ethereum’s plan to eliminate the need for heavy duty computing power, and why that may not be such a bad thing from a financial perspective.
Recap of Proof-of-Work
If you’re familiar with the idea of cryptocurrency mining, you know that in order to keep a blockchain running smoothly, it takes a lot of computing power to verify new transactions. This process, known as mining, is currently used by both Bitcoin and Ethereum to maintain their blockchains.
One of the main issues with mining is the vast amount of electricity that it uses. Vitalik Buterin, the creator of Ethereum, has estimated that the amount of electricity needed to mine Bitcoin and Ethereum runs up a $1M daily bill (https://www.youtube.com/watch?v=SiKnWBPkQ4I&feature=youtu.be). Another study recently showed that the amount of electricity consumed by the Bitcoin mining network is comparable to the energy used by all of Ireland (https://karlodwyer.github.io/publications/pdf/bitcoin_KJOD_2014.pdf).
If things continue as-is, cryptos are going to be a big problem for the environment.
Ethereum has a plan to fix that.
Mining fills a big need — providing consensus among network participants regarding the state of the world of historical and current transactions. Because miners solve complicated problems using transaction information and cryptography, what they do is referred to as proof-of-work.
There are, however, other methods for getting a group of disparate participants to agree on transactions. The most popular of which is referred to as proof-of-stake.
The basic idea is as follows.
Instead of miners competing to solve really tough math problems, the network will instead use a pool of validators. Validators are people that are willing to stake their cryptocurrency on the blocks of transactions that they claim should be added to the public blockchain.
When someone is selected to validate a block (or, in some cases, propose a set of transactions that should be added together as a new block), they stake some of their crypto on their proposal. Users would be chosen as the lead to validate a new block on a pseudo-random basis, weighted by the amount of crypto they’re willing to stake.
As blocks get added to the chain, new validators then stake additional crypto on new blocks that are added on top of prior blocks. As chains grow, validators are incentivized to validate the chains that have the most crypto staked in their contained transactions, as well as to validate chains that contain crypto staked on previous blocks that they’ve put crypto up against.
As more and more blocks get validated, these validators get a portion of the transaction fees that are included in each transaction — so in a sense, they’re earning interest on the crypto that they’ve staked. Assuming that they’ve staked crypto on valid transactions, they’ll be able to reclaim their original crypto and their claimed interest after some point in time has passed (or when they remove themselves from the validator pool).
Because proof-of-stake doesn’t involve competing to solve heavy duty complications, it eliminates a large part of the energy requirements needed to mine.
It also introduces a few interesting concepts, such as the idea of staking Ether on new transactions, losing one’s stake if they try to validate a fraudulent or otherwise incorrect transaction, eliminating potential threads such as a 51% attack, while introducing new threats specific to the new protocol.
If and when Proof-of-Stake is implemented, it would be a major shift in the world of cryptos. There’s no telling how the market will react, and it’s likely it would need to be done as a hard-fork, causing a good amount of volatility.
Fortunately, Ethereum isn’t slated to switch over to proof-of-stake for a while (at least until 2018, I believe).
When it does, though, there could be some very interesting implications for investors in Ether.
Many are suggesting that since there’s no longer a large need to compensate miners with new tokens, the creation of new Ether may be significantly or completely eliminated. Going one step further, it could even mean that existing Ether is eliminated when bad transactions aren’t included into the main blockchain.
This could mean that the supply of Ether will significantly decrease, causing a dramatic increase in its value. On top of that, any user can now stake some of their Ether in order to validate blocks (as long as they are able to stake the minimum amount, to be finalized by Ethereum’s core developers), earning interest on their existing stake.
And since new Ether will likely no longer be created by mining, it could mean that existing holders of Ethereum will benefit disproportionately from the process of proof-of-stake due to their ability to put their existing Ether to work at a larger and faster stake than newcomers (this mostly applies to retail investors and not institutions with large amounts of capital).
All-in-all, it’s hard to say whether Ethereum will switch to proof-of-stake, and if they do, when that may be. However, Vitalik has always included proof-of-stake in his core roadmap, and he’s produced multiple white papers on how he plans to implement it, so my guess would be that it gets done.
And if it does, current ETH holders may benefit greatly.
Note, if you’re interested in learning more about proof-of-stake, I found the following resources to be helpful