ETH 2.0 Explained: Staking, Sharding, and Scaling Ethereum

Interdax
Interdax
Jun 24, 2020 · 23 min read

In the first post in a series looking at the mechanics and potential for Proof-of-Stake (PoS) cryptoassets, we analyse Ethereum 2.0, explain the transition to PoS and look at the implications of this upgrade for the second largest blockchain network.

Ethereum 2.0: Improving Crypto-economic Incentives

The shift to PoS significantly alters the crypto-economics of Ethereum, changing the incentives for validating the blockchain and participating in the network. Ethereum 2.0’s first phase is technically due to commence at the end of July 2020 — coinciding with Ethereum’s fifth birthday — with the launch of the Beacon chain (currently in testing).

How Ethereum Currently Works

At present, Ethereum uses a Proof of Work (PoW) system that is found in most blockchain networks (such as Bitcoin and Litecoin) where miners run nodes and try to guess a value below a specified target and build valid blocks with transactions by expending energy and resources, competing with other miners to build the next block.

Miners are compensated for their time and resources through block rewards. Each time a miner successfully submits a valid block to be added to the blockchain, they receive a block reward. Ethereum miners get a 2 ETH block reward, plus a variable reward from transaction fees paid to the network.

The main advantage of PoW blockchains is that they have the potential to be extremely secure. For an adversary to rewrite a block, they would be required to rewrite all previous blocks up until that point, so it is computationally expensive to attack PoW chains. Due to the cost of the energy expended to rewrite the blockchain, it would take a massive amount of resources and deters such attacks.

Ethereum’s PoW blockchain. Miners organise transactions into blocks. The hash of the previous block is used to create the next block.

PoW chains trade off scalability and accessibility for security. Only a finite amount of data can be included in an Ethereum block at the moment, since each block is mined sequentially. If the number of pending transactions exceeds the available block space, then the remaining transactions have to wait for the following block. Consequently, Ethereum can only process 7–15 transactions per second — any ‘killer app’ that gains adoption can bring the network to a halt and push transaction fees higher.

Another concern with PoW is the centralisation of mining. The barriers to entry are high, making the industry less competitive, and some coins are more susceptible to certain attacks — such as the 51% attack and selfish mining. Entrants to the mining industry need to buy hardware, have access to low-cost electricity and be able to operate at scale to achieve efficiency.

As a result, the mining of PoW coins is mostly an oligopolistic market which prevents smaller players and individuals from earning block rewards. As the chart below shows, just three mining pools control more than 51% of Ethereum’s hash rate:

Distribution of Ethereum hash rate by mining pool on June 24, 2020. Source: Etherchain.

Note: Hash rate distribution is a convenient proxy, but miners and pools are not synonymous, therefore it is not an 100% accurate representation of the true distribution of hash power. Also, hash power distribution is just one consideration of the degree of decentralisation of the mining industry.

Ethereum’s Vision for Proof of Stake

In Ethereum 2.0 (or Eth2/Serenity), one goal is for PoS to level the playing field for more individual validators to take part, where they can earn a shared return on maintaining the truth of the network.

Unlike miners (which expend physical energy by using electricity to build/validate blocks) validators in Eth2’s PoS system will commit 32 ETH as ‘skin in the game’, i.e., the stake. The fixed block reward shifts to a variable issuance model (which is determined by the amount of ETH staked).

It is important to get the economic incentives right for PoS networks. If the incentive to stake is too low, the network will not get the minimum amount of validators needed to secure the chain. If the incentive is too high, the network overpays for security and inflating at a rate that may be detrimental to the economics of the network as a whole.

To participate in PoW blockchains, miners are faced with capital expenditure/CapEx (the purchase of ASICs and other equipment) and operating expenditure/OpEx (such as electricity and real estate costs). Regardless of whether miners are successful in producing valid blocks, these costs must be borne by participants of any PoW network.

While the potential loss of economic value secures PoS networks, i.e., the validator does not incur realised costs. In the case of a fork, PoW miners will allocate resources to what they believe to be the correct branch of the fork. However, in PoS there is no intrinsic cost to securing the network (such as electricity) so there’s no downside for the validator to stake on both forks.

Since there’s no opportunity cost to stake on a particular chain, the validators have ‘nothing at stake’. So rational validators should simply vote on every competing branch they see, so as to maximise their returns. PoS cryptocurrencies have addressed the ‘nothing at stake’ problem in different ways. Ethereum’s PoS and sharding related research began prior to January 2014, with co-founder Vitalik Buterin proposing the following solution to the ‘nothing at stake’ problem at the time:

“Make the chain aware of other chains. Then, if a miner is caught mining on two chains at the same time, that miner can be penalised.”

What Buterin described above eventually evolved into Casper, an algorithm designed to punish any validators who validate more than one fork or who otherwise harm to the network, getting around the ‘nothing at stake’ problem.

The design of Eth2 supposes individuals are more averse to risking money in the form of staked cryptocurrency when attacking the network compared to the cost of electricity. A failed PoW attack, results in a loss of electricity costs, while slashing a validator’s stake is equivalent to a miner burning down their entire PoW server farm in the failed attack. The cost to launch an attack on Eth2 is equal to the amount of staked ETH (and so is the penalty). Because Eth2 incentivises honest validators and discourages malicious validators, the network’s defense from malicious actors should be stronger.

Eth2/Serenity Overview

Eth2 will be implemented in a series of phases: Phase 0, Phase 1 and Phase 2, as detailed in the diagram below:

The phases of the transition to Eth2. Source: docs.ethhub.io.

These upgrades will increasingly encompass more of Ethereum and more of the community at each step. As a user, you can either get involved early with staking in Phase 0, or you can simply wait until Ethereum’s PoW chain (or Eth1) fully migrates into Eth2.

The network will remain live even in the face of a single client having a consensus issue as long as no client has more than one third of total nodes/validators:

Eth2 clients. Source: docs.ethhub.io

We list several concepts central to Eth2 below:

  1. Casper: A combination of Casper the Friendly Finality Gadget (FFG) and LMD-GHOST (also known as known as ‘Gasper’) will provide a smooth transition from the legacy PoW consensus mechanism to PoS by first overlaying the new protocol on the current protocol. The LMD-GHOST fork choice rule an acronym for Greedy Heaviest Observed Subtree-Last Message Driven. More details on how the network will transition to full PoS can be found here. Two Casper Commandments are enforced. The first is that a validator must not publish two distinct votes for the same target height. Second, a validator must not vote within the span of its other votes. This mechanism avoids most of the issues present in both existing PoS approaches and the family of Byzantine Fault Tolerant consensus algorithms. Any validator who violates either of these commandments is considered malignant, and their entire deposit (not just their stake) is slashed. To increase availability and reduce censorship of transactions, validators nodes that go offline are also punished.
  2. The Beacon chain: As the first step in the transition to PoS and complete Eth2, the Beacon chain launches in Phase 0 and delivers the Casper PoS mechanism. As the foundation of the PoS network, the Beacon chain provides the tempo for reaching consensus, and comprises of slots and epochs. Once the Ethereum community reaches a certain level of social consensus regarding stability of different clients, the Deposit Contract will be published on Eth1. The purpose of the Deposit Contract is to collect stakes from potential ETH 2.0 validators so that they are eligible to validate data on the Beacon chain. Once a predetermined quantity of ETH (524,288 ETH) has been deposited, the Beacon chain will activate and blocks will be produced.
  3. Sharding: At present, every node has to verify and execute every transaction which reduces the scalability and throughput of Ethereum. Sharding is a potential solution to the blockchain scalability problem that will be introduced in Phase 1 and is a term that refers to horizontally partitioning a database. Generally, a shard chain has a subset of validators processing it, only processing and validating transactions in that shard. It is expected that a sharded Ethereum will process over 15,000 transactions per second. Each shard is a separate blockchain with its own state (account balances, smart-contracts) and transaction history. In Phase 2, Sharding will take centre stage and scale Ethereum’s PoS blockchain.

Phase 0: The Beacon Chain

Eth2 is in the beginnings of Phase 0, which involves testing the Beacon chain — the core of the new PoS chain — and will launch sometime in 2020.

We illustrate the architecture of the Beacon chain below:

The Beacon Chain. Adapted from: https://ethos.dev/beacon-chain/.

In Phase 0, the Beacon chain cannot process transactions, execute smart contracts or other functionalities found on the PoW Ethereum chain/Eth1. The Beacon chain will have Casper finality, a random number generator to shuffle validators, and simulate crosslinking in the non-existent shard chains. Eth1 will continue to receive upgrades and operate alongside the Beacon Chain.

Eth2 is designed to have a minimum of 16,384 validators (it is expected that this figure will increase to hundreds of thousands within a couple of years). Validators will be able to vote on blocks and then earn staking rewards on the Beacon chain in the latter half of 2020.

The random shuffling of validators ensures no malicious entities can plan an attack on the network, as the validators are spread out across different blocks. Each block has a randomly chosen committee of validators, so it is unlikely that an attacker controlling less than one third of all validators can mount an attack on a single block.

The first implementation of Casper will use Ethereum’s current PoW proposal mechanism to introduce new blocks onto the blockchain. If two blocks are proposed simultaneously, validators are only rewarded for betting on one chain, so it only makes sense to bet on the original chain, as this is the one that is most likely to succeed.

More importantly, Casper introduces a mechanism that will instantly confiscate the entire stake of any validator who tries to support an invalid chain by validating more than one block at a time. Should a validator maliciously attempt to compromise the network (i.e. validate incorrect data history), all or some of their 32 staked ETH will be slashed. Users can submit evidence of voting on the wrong chain by miners to penalise incorrect votes. Casper therefore handles the nothing at stake problem by introducing a wrong-voting penalty to the protocol.

Also, if a validator fails to stay online in Eth2 and does not execute their share of computational responsibilities, their block reward will moderately decrease to incentivise validators to stay online as consistently as possible.

How do Validators Vote on Blocks Built in Eth2?

We can think of the Beacon chain as the metronome for Ethereum 2.0, providing the tempo for the system to reach consensus.

Each slot is 12 seconds, and an epoch is 32 slots, which equates to 6.4 minutes (illustrated below).

Every 12 seconds, one beacon (chain) block is added when the system is running optimally. Adapted from: https://ethos.dev/beacon-chain/.

At every epoch, a pseudo-random process RANDAO selects proposers for each slot, and shuffles validators to committees. Validators can only be in one slot, and in one committee per epoch. Block proposers are validators that have been pseudo-randomly selected to build blocks with RANDAO — using a weighting on validator’s balances. A minimum of 128 validators participate in each committee for each slot.

The validator is participating in the consensus of that assigned shard so that it can vote for that shard’s head (although ‘real’ shards aren’t introduced until Phase 1). The validator links the shard head to the beacon block for a slot. Validators also police each other and are rewarded for reporting other validators that make conflicting votes, or propose multiple blocks.

A committee is pseudo-randomly assigned a shard to crosslink into a beacon block. Committees are never persistent. The committee responsible for crosslinking a shard block changes block-by-block. Shard committees that solely build shard chain blocks is a topic for future research.

Validators are shuffled into committees for each epoch to create attestations (or votes) for each of the 32 slots. Adapted from https://ethos.dev/beacon-chain/.

The primary source of load on the Beacon chain are the votes (or attestations). An attestation is a validator’s vote (weighted by their balance) and these attestations are broadcasted by validators in addition to blocks.

The block in the first slot of an epoch is known as a checkpoint or epoch boundary block. There is always one checkpoint block per epoch, where all validators cast Casper FFG votes. A block can also be a checkpoint for multiple epochs.

Most of the time, validators are attesters that vote on beacon blocks and shard blocks. These votes are recorded in the Beacon chain. The votes determine the head of the Beacon chain, and the heads of shards.

When committee members vote for a block, they must reference and vote for a particular historic checkpoint block, as well as vote on a particular block proposal. Or more precisely reference to the transition from one checkpoint block to another (a source checkpoint and a target checkpoint) — a mechanism that gives assurance that the voting process has been settled.

A block becomes “justified” if a checkpoint block is built on top of it and over two-thirds of the committee members reference that checkpoint in their votes, across the index of all committees in an epoch. The earliest that this can be achieved two-thirds of the way through an epoch. When the epoch ends, the checkpoint is justified.

Checkpoints and finality. Adapted from https://ethos.dev/beacon-chain/.

A block is then finalised when the blockchain contains two justified blocks after it. Typically, a user will need to wait around one epoch (~6.4 minutes) for justification) and two epochs (~12.8 minutes) for finalisation.

A vote that is made by two-thirds of the total balance of all active validators, is deemed a supermajority. Once a supermajority is achieved and the checkpoint is finalised, the transactions in that block have been permanently recorded to the blockchain and cannot be reversed — i.e., Casper finality.

The LMD-GHOST fork choice rule ensures that when calculating the head of the chain, only the latest vote made by each validator is considered, and not any of the votes made in the past (which dramatically decreases the computation required).

For Casper the FFG, all votes consist of two sub-votes. One vote for the epoch that is attempting to be justified and another for an earlier epoch that is to become finalised. The two sub-votes effectively reduces the need for extra communication between nodes, enabling the network to scale to a large number of validators.

Consensus within Eth2 relies on both:

  • LMD-GHOST (which adds new blocks and decides on the chain head). Enables blocks to be added quickly and efficiently to the chain, and
  • Casper FFG (which makes the final decision on which blocks are and are not a part of the chain), provides safety following behind LMD-GHOST and finalising epochs.

Collectively, all validators in an epoch attempt to finalise the same checkpoint via the Casper FFG vote and all validators assigned to a slot attempt to vote on the same Beacon chain head via the LMD-GHOST vote.

Linking Eth1 to Eth2

To participate in Phase 0, a new Ether token is created for the Beacon Chain (BETH) which is pegged to ETH. BETH is created through a one-way transaction (from Eth1 to Eth2) and cannot be returned to the old chain in Phase 0. Using BETH on shard chains (for smart contracts) will be available in Phase 2.

Once ETH is deposited into the Bridge contract, the user is credited with an equal amount on the Beacon chain. Users will be able to deposit a minimum of 1 ETH, but at least 32 ETH are needed to become part of the validator set. A one-way bridge favours security and simplicity but introduces lock-up risk (as well as potential futures markets emerging for the separate Eth1 and Eth2 tokens).

The Beacon chain mainnet will process deposits for those users (after a delay to ensure no “double spends” occur) and make them validators. The validators can then validate blocks on the Beacon chain and earn rewards through new issuance (at least until transactions are allowed).

To launch of Phase 0, a minimum of 524,288 ETH is to be staked across 16,384 validators to ensure sufficient decentralisation and security. No rewards will be paid out until this threshold is reached. Users will also be able to pool their funds as the Ethereum ecosystem will host a number of products and solutions.

With the minimum 16,384 validators, the annual return is approximately 20% (assuming 95% uptime amongst validators). But returns will decrease as more ETH is staked and more validators join the network. The chart below shows steady growth in the number of potential validators in the past year.

The number of potential validators for Eth 2. Only Externally Owned Accounts are included. Source: Glassnode

As many as 115,411 Ethereum addresses owned at least 32 ETH as of May 17, 2020 (more recent data is behind a paywall), higher than the required number of validators (16,384) to launch Phase 0 by a factor of approximately seven.

Potential Returns (and Risks) for Validators

There are various costs and benefits for investors to consider if they are interested in running a validator for Eth2. For example, the Beacon chain deactivates all validators whose balance reaches 16 ETH, known as a ‘forced exit’. Stakers will be able to withdraw any remaining validator balance (except in Phase 0 of Eth2).

An honest validator’s balance is withdrawable in around 27 hours. Validators can also ‘voluntary exit’ after serving for 2,048 epochs (equal to nine days). In any voluntary or forced exit, there is a delay of four epochs before stakers can withdraw their stake. Within the four epochs, a validator can still be caught and slashed. But a slashed validator incurs a delay of 8,192 epochs (approximately 36 days).

Below, we highlight the benefits and costs associated with validator nodes:

Benefits:

  • Attester rewards: Validators get rewards for making attestations (LMD-GHOST and Casper FFG votes) that the majority of other validators agree with. In Phase 1 of Eth2, validators will also receive rewards for crosslinks. Attestations in finalised blocks are worth more.
  • Proposer rewards: Proposers of blocks that get finalised obtain rewards. Validators that are consistently online doing a good job accrue approximately one-eighth of a boost to their total rewards for proposing blocks with new attestations. When a slashing happens, proposers also get a small reward for including the slashing evidence in a block.
  • Whistleblower rewards: Whistleblowers can earn rewards for highlighting validators that are committing a slashable offence. In Phase 0 of Eth2, all whistleblower’s rewards actually go to the block proposers.

Costs:

  • Rough estimates on computing costs are $120/year for a beacon node and validator client.
  • Attester penalties: Validators get penalties for not attesting or if they attest to blocks that are not finalised.
  • Inactivity leak penalty: if enough nodes become inactive, they lose their balance over time so that the ratio of online validators to total validators (weighted by stake) can once again exceed two-thirds so Eth2 can continue to make decisions as a protocol. Inactivity leaks are one of the ways Eth2 has been designed to survive an apocalyptic event. If more than one third of all validators were knocked out, then the offline validators would find that their balances decreased to the point that their participation was no longer necessary.
  • Slashable offences: penalties ranging from over 0.5 ETH up to a validator’s entire stake. As long as a validator does not sign a conflicting attestation or proposal, the validator cannot be slashed. A validator loses at least 1/32 of their balance and is deactivated, i.e., ‘forced exit’. The protocol also imposes an additional penalty based on how many others have been slashed near the same time, such that if one-third of all validators commit a slashable offence in a similar period of time, they lose their entire balance.

The slashable offences are:

  • Double proposal: a proposer proposes more than one block for their assigned slot,
  • FFG surround vote: validator casts an FFG vote that surrounds (or is surrounded by) a previous FFG vote they made, and
  • FFG double vote: When a validator casts two FFG votes for any two targets at the same epoch. This can happen during a fork.

Each validator’s reward follows an inverse square root function with respect to issuance. The higher the number of ETH that is staked in Eth2, the greater the issuance of Eth2 to compensate validators.

As more ETH is staked, the validator return deteriorates as the benefits of staking are outweighed by the higher issuance, dampening the returns of individual validators. The chart below shows the varying levels of yield and issuance based on the amount of ETH staked.

When the amount staked increases, the base validator yield falls and issuance rate increases. If 10 million ETH are staked in Serenity, this results in an annual yield of 5.72% and a maximum annual issuance of 572,433 ETH.

When considering yield, it is also important to look at the inflation of the token to assess the real yield (equal to yield minus token inflation). Since rewards will be paid to both Eth2 validators as well as the normal PoW block rewards, the combined inflation of the two chains may spike initially (but then trend towards the 0% to 1% range as the PoW chain is gradually de-emphasised in Phase 2).

If you wish to join as a validator, you can refer to this calculator to help you calculate returns.

Network fees will also be a primary driver of higher validator yields. If block rewards are too low, then without significant growth in transaction fees, the network becomes less secure as the incentive to stake is weak. If transaction fees are burned because of the successful implementation of EIP 1559, then it increases the need for a developed fee market to support validators.

Phase 1: Shard Chains

Phase 1 is due to go live around one year after the launch of the Beacon chain (Phase 0).

In this phase, the Ethereum blockchain is sharded into 64 shard chains that run in parallel and are interoperable with each other. Sharding enables greater scalability by allowing Ethereum to process multiple transactions simultaneously (theoretically, 64 blocks at a time). At first, only blockchain data will be sharded while execution and state changes will not become sharded until Phase 2.

The sharding structure also provides flexibility to those wishing to run nodes. Users could choose to run a node from a variety of different types such as:

  • Super-full nodes downloads the full data of the Beacon chain and every shard block referenced in the Beacon chain,
  • Single-shard nodes act as top-level nodes, but also fully downloads and verifies every collation on some specific shard that it cares more about.

Shard data chains could offer utility for apps that need a high availability data store, as the total data available to the system is estimated to be in the 1–4 MB/s range.

The Beacon chain will need at least 262,144 validators (equivalent to over 8 million ETH staked) to produce blocks that include 64 crosslinks. Each of the Shards 0–64 below can be thought of as representing separate blockchains that communicate with each other.

Shard chains are linked to the Beacon chain through shard crosslinks. Adapted from https://ethos.dev/beacon-chain/.

The multiple validator committees per slot from Phase 0 are now mapped to the shards. Each shard has its own staker voting committee, which changes during each proposer committee period.

Similar to the Beacon chain, one member of the committee is given the task of producing a block in an allocated time slot, while the remaining committee members vote on each proposal. When the Beacon chain references the shard blocks via crosslinks, all this voting information is included in the Beacon chain.

A crosslink is a reference in a beacon block to a shard block and is how the Beacon chain follows the head of a shard chain.

Crosslinks serve three main purposes:

  • To enable votes in the shard chain block committees to be counted as votes on the main Beacon chain, and
  • To justify and finalise shard chain blocks,
  • For all other forms of cross-shard communication (such as transferring ETH or other assets across shards),

As there are 64 shards, each beacon block can contain up to 64 crosslinks. A beacon block might only have one crosslink, if at that slot, there were no proposed blocks for 63 of the shards. All validators assigned to a committee attempt to crosslink a particular shard.

In Phase 1, validators are allocated randomly to either: the Beacon chain or a particular shard. When there is fewer than 8.4 million ETH being staked, there are not enough validators to fully service all shards, and therefore the shards could slow down to some extent.

The Beacon chain provides assurance over transaction finality inside of the shards. Once the relevant blocks in the Beacon chain become finalised, users in the shard chain can gain assurance over the transactions in shards.

EVM 2.0: eWASM

The Ethereum shards will not use the existing Ethereum Virtual Machine (EVM) but will jump straight to using eWASM. Each shard will include an eWASM-based virtual machine, the equivalent of today’s Ethereum Virtual Machine.

An eWASM, or Ethereum-flavored WebAssembly, is an engine that executes smart contracts and will make a significant difference to how many transactions can be processed and subsequently added to a block — further increasing transaction throughput.

Other benefits of eWASM include greater security and support for more programming languages.

Phase 2: Shard Chain Execution

As with Phase 1, there’s no definite date, but this phase is planned to begin in 2022. In Phase 2, both PoS and Sharding are successfully implemented, which will enable ether accounts, transactions, transfers and withdrawals, and smart contract execution on Eth2.

ETH holders will not have to undergo any token transfer or swap and can to use tokens on Eth2 seamlessly. The history of the original PoW chain/Eth1 will still exist, it will no longer need the PoW consensus mechanism to be maintained.

The Eth1 blockchain will be brought into Eth2 and exist as one of the 64 shard chains alongside the Beacon Chain, so that there is no break in continuity or data history.

There are two possible routes for bringing ETH 1.x into ETH 2.0:

  1. Converting Eth1 EVM and history as one of the Eth2 Phase 2 Execution Environments (EEs), which minimises the migration requirements for Dapps.
  2. An alternative is based on Eth1 stateless client software, where the state of shard 0 can contain the state root of the Eth1 system. The registered Eth1-friendly validators, may be randomly selected as a shard 0 block proposer and would have to maintain Eth1 nodes.

You can read more about the merging of Eth1 and Eth 2 here.

One area of research in Eth2 that has a lot of relevance in Phase 2 is known as stateless clients. Stateless clients enable shard nodes to forgo maintaining the state. The concept of state exists at the application layer and but not at the consensus layer; meaning that nodes only “plug in” to a particular Execution Environment that they need to be aware of. Instead of storing the entire state in each shard block, the Merkle root hash generated from the data is stored instead.

Nodes are not required to maintain a big database of the current active storage. Instead, they can use the witness data in every transaction as a database and provide Merkle branches for the state values that a particular transaction is required to access.

In the new stateless model, it makes the current implementations of Phase 0 and Phase 1 much more efficient. Also, there is no requirement for the separate shuffling of committees. It improves security as the reduced shuffling period on the shard chain means that validators have less time to collude and syncing a full node becomes easier. The longer shuffling period on the Beacon chain committees means the network is more stable and reduces the load on syncing a light client every six minutes.

Another feature due to be implemented in Phase 2 will be cross-shard transactions, which you can read more about here. Also, Execution Environments will allow Eth1 (and potentially other blockchains as well, like Bitcoin) to be ported over to Eth2.

However, there are still some open questions to be addressed with respect to cross-shard transactions as well as many other parts of Phase 2, including the upgradability of Execution Environments without forks, Execution Environment governance and other specifics for Execution Environments.

Summary

Putting it all together, Phase 0 launches the Beacon chain — which provides the foundation for the future PoS system by setting up validators, issuing rewards and penalties and introducing a one-way peg between ETH and BETH.

Phase 1 launches the shard chains, crosslinking and eWASM as the virtual machine for each shard.

Finally, in Phase 2, Sharding is implemented in full force. Accounts, smart contracts, Dapps and most activity will move to the new chain while the Eth1 chain is gradually brought into Eth2, completing the move to PoS.

An overview of the complete Eth2 architecture is shown below:

Source: Hsiao-Wei Wang

The move to PoS is ambitious, but comes with benefits and risks. The main benefits of Eth2 include:

  • Reduced barriers to entry: PoS removes the need for specialised ASIC machines to participate in validation and earn ETH rewards. More participation in the network, perhaps wider adoption of Ethereu.
  • Potentially improves decentralisation of the network: reduced barriers to entry means anyone with an internet connection, validator client, Beacon node and some ETH can participate in validating the network. Deprecation of PoW eliminates problem associated with ASICs and miner concentration. Improvements in scalability and throughput means it is easier for users to run nodes, making the network more robust.
  • Potential upward pressure on price of ETH: Locked up ETH reduces its velocity, and the circulating supply. Progress in Eth2 may also affect trader sentiment positively.
  • Potential to turn ETH into a yield-producing asset: investors can earn staking returns from holding at least 32 ETH. Might lead to an increase in the demand for ETH and improve investor sentiment towards crypto-assets.

The main risks of Eth2 are:

  • Unproven, limited track record: PoS has an unproven and limited track record as compared to PoW. It is important to get the incentives right to ensure that PoS is not vulnerable to any attacks and so that the network can accrue enough value to provide security. Many PoS/Delegated PoS systems have not demonstrated significant decentralisation in practise, and sacrificing this property for scalability may be a potential risk.
  • Network security driven by the value of ETH: A falling price could precipitate a negative feedback loop. As the price falls, the security of the network falls as well. As stakeholders recognise this, the interest in becoming a validator may dwindle, which depresses the price even further and negatively affect the security of the network even more.
  • Increases concentration of ETH wealth: One concern with PoS systems is that the rich get richer. For instance, Ethereum whales can stake their holdings and run more validators than other participants, potentially increasing the concentration of ETH held by large players.
  • Unanticipated setbacks during the transition from PoW to PoS: with a complicated architecture and the merging of Eth1 and Eth2, there are many protocol-level risks. Also, there’s lots of Research and Development pending, which then has to be implemented into something practical for Phase 2 (and beyond). Given the long timeframe and complex challenges, this introduces the risk of delays which may translate into selling pressure and a weaker sentiment amongst traders.
  • Insufficient Demand for Eth2 Staking: investors will consider the opportunity cost of staking ETH and seek the maximal return for their holdings. Becoming a validator on ETH 2.0 has to be economically attractive enough to draw investors away from other yield-producing investments, such as DeFi and traditional markets. There’s also uncertain hardware requirements and lock-up risks (investors will have to lock up ETH for at least 1 to 1.5 years).

The Eth2 upgrade promises to deliver a scalable platform for decentralised systems and applications, but it will be a complex process that will take several years. Ethereum has plenty of competition from PoS networks such as Cardano, Tezos and Aethereum. A successful transition to Eth2 would most likely solidify its first-mover advantage in the niche of smart contract blockchains.

Disclaimer: This blog post if for informational purposes only and is not meant to be taken as investment advice.

Eth2 has many mechanisms and stages. We’ve provided a high-level overview of the transition to the best of our knowledge based on the current specifications and materials available.

Please contact us if you notice any inaccuracies or have any other feedback.

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