Proof of Stake — A New Dawn for Crypto and Beyond
Cryptocurrency has been one of the hottest topics worldwide ever since Bitcoin became known for its high value and rapidly increasing market capitalization. The crypto market thrived, with more and more cryptos emerging soon after the Bitcoin boom. Still, Bitcoin, although it fluctuates a lot, has always maintained its first place — the global cryptocurrency market capitalization now is around $1.05 Trillion, with 38% Bitcoin dominance (CoinGecko, 2022).
Despite the prevalence of Bitcoin — a type of cryptocurrency that uses blockchain technology to distribute wealth and secure transactions — this topic still seems mysterious. We might hear about “mining” new coins. We might know Bitcoin needs significant computing power and consumes a gargantuan amount of energy. We might know cryptocurrency is decentralized. But there is always a cryptic mist around this topic, blocking us from knowing how exactly blockchain works, why it is so attractive to miners and investors, and what the future is for cryptos. Luckily, a revolutionary transition to Proof of Stake is happening in the crypto world, and it will be our very key to opening this treasure chest. Here, I will unravel the mystery for you. In debates over the future of crypto, the critical transition to Proof of Stake sheds light on building a sustainable crypto world for our global society, despite noteworthy obstacles, including public trust and the volatile crypto trading market.
First and foremost, what is holding up this ever-growing crypto empire together on the back end? The answer lies in the blockchain system. Investopedia defines blockchain as a distributed database or ledger shared among a computer network’s nodes (Adam, 2022). One of the essential blockchain properties is that all the information in the previous blocks, such as the sender and receiver information of precedent transactions, is passed onto the new blocks, holding the chain together and locking all the verified history irreversible. As a result, it is imperative to validate the new entries before locking them in the single chain so that only the correct information will be broadcasted to everyone in the network and the whole transaction history remains valid. Unlike traditional currency systems, this process is carried out without a central agency censoring for wrong entries in the chain and reinforcing the information broadcasting; instead, a set of mathematical formulas accessible to everyone checks for false information and keeps the process going smoothly.
This significant process in crypto is realized and secured by the consensus mechanism to prevent malicious attackers from adding false entries, causing possible forking in the chain, and attacking the system. There are two general types of consensus mechanisms — Proof of Work (PoW) and Proof of Stake (PoS). PoW is currently the dominant consensus mechanism as it was modified for Bitcoin and has been proven to be safe over time and extensive practices. As signaled by its name, PoW is based on work which means solving mathematically complex problems. In other words, PoW is anchored by its extremely high requirement for computing power to solve mathematically complex tasks. Your chance of creating the next block is proportional to your relative computing power in the network. Subsequently, miners have invested tremendously in supercomputers to compete to earn Bitcoins and make transactions. Then, this process further adds value to Bitcoin as it anchors the intangible blockchain in the substantial world. More importantly, the mathematically complex tasks make it nearly impossible for attackers to launch attacks. This is because the complex tasks are so demanding that only a few active mining pools in the world can compete successfully to mine new coins or add new transaction blocks. As these active miners have invested so much in mining Bitcoins and currently hold large stakes of Bitcoins in the network, there is no incentive for them to ruin the reputation of Bitcoin security or their own reputation in the crypto world just for one successful attack. The possible gain from launching an attack is incomparable to the loss — their previous investments in supercomputers and Bitcoins holding in their hands will lose value if Bitcoin’s reputation is ruined. Thus, it is safe to conclude that PoW ensures safety in a hard-core way as a decentralized currency without traditional central agency monitoring transactions. Therefore, people agree Bitcoin has a high value for its security and decentralization.
However, for all the security, cryptos anchored by PoW, like Bitcoin, are not innocuous. In fact, cryptos supported by PoW are now consuming a surprisingly extensive amount of energy due to their reliance on computing power. The amount of electricity Bitcoin mining consumes annually is estimated to be around 150 terawatt-hours, more than the entire country of Argentina, with a population of 45 million. Producing that energy emits some 65 megatons of carbon dioxide into the atmosphere annually, comparable to the emissions of Greece, making crypto a significant contributor to global air pollution and climate change (Jeremy, 2022). It is undoubtedly a sizable impact that can be avoided, especially given that we are currently experiencing severe environmental issues due to rising greenhouse emissions. What’s more, as more miners participate in the competition of computing power for new coins, the requirement for computing power has skyrocketed and is now gathering miners together to pool their computing power to create new coins and transaction blocks. Thus, 20 big pools, such as F2pool and Antpool, almost exclusively own the new blocks with the computing power they invested to pool together, deviating from the concept of decentralization that got crypto started (Jordan, 2022).
To address the concerns about energy consumption and the loss of decentralization due to PoW, brilliant people have devised an alternative consensus mechanism — Proof of Stake. Ever since it first appeared in public attention, people have been worried about its security as it is not anchored on computing power. This notion of PoS originated from Bitcoin Forum on Jul 11th, 2011 (QuantumMechanic). PoS was envisioned to be based on your stake in the network that will lower the entry barrier of computing power so more people can participate. The logic behind it is simple: the more crypto you have in hand, the less incentive you have to ruin the system at the expense of losing the value of your cryptos. Instead of competing to solve mathematically complex problems to earn the chance to create the next block, PoS has an algorithm to randomly select validators to form a committee to verify all the proposed transactions from different nodes at every checkpoint. People, who are attracted by the rewards for honest validators, need to deposit a certain amount of cryptos in the system to enter the selection process, and the chance of being selected is proportional to the stakes deposited. With this deposit, PoS is further secured by a reward and punishment mechanism to guard against attacks. The selected validators are incentivized by rewards to validate the new block based on the checkpoints of previous blocks honestly. If they validate the wrong entries, their stakes and rewards will be reduced or slashed, losing a considerable amount of money. For Ethereum 2.0, a user needs to deposit a minimum of 32 ETH to enter the validator selection process. Consequently, they will lose at least 32 ETH, about $56,352, if they are slashed (CoinGecko, 2022). Furthermore, two-thirds of the validators on the committee need to say yes to validate a new checkpoint. To prevent attackers from taking up two-thirds of the seats and validating wrong nodes, PoS includes an activation queue, which is like a demand function, that will output the minimal committee size based on the new transactions proposed in the network and how many people staked to be a validator. Moreover, there are validated and finalized checkpoints in PoS that will perform the voting procedure twice. The two actions together lower the chance of attack to even lower than one in a trillion (Chih-Cheng, 2019). The chance further decreases with the activation queue outputting a larger minimal committee size when more people participate. As more people are expected to join due to the simplified process with PoS, the increasing nodes can improve decentralization, whereas Bitcoin’s PoW decreases the nodes, causing the loss of decentralization. As a result, although PoS is not theoretically as secure as PoW, PoS is sustainable with practical security in transactions and improved decentralization.
As PoS became complete and tackled its safety concerns, it has been practiced in some less popular cryptos, such as Peercoin, but not as fully tested as PoW. Then, the turning point came when Ethereum, the crypto with the second highest market capitalization, merged to PoS on Sep 15th. Ethereum has performed well since the merge, proving the practical security of PoS. As an extensive amount of data is generated for this application of PoS, we will surely see more analysis between PoW and PoS with the comparison between Bitcoin and Ethereum, helping PoS further advance the security and become a full substitute for the PoW transaction function.
As expected, the merge to PoS dramatically reduces Ethereum’s energy requirements, cutting the network’s energy demands by 99.95%, proving that PoS is capable of alleviating the environmental concerns around cryptos (ConsenSys, 2022). However, instead of the technological shift, our attention was carried over to the market since the merge. Although Ethereum’s transition from PoW to PoS began with the launch of Beacon Chain in December 2020, long before the actual merge date, the market still experienced a sharp drop — ETH price dropped 15% since the major Ethereum network upgrade (Jha, 2022). The ETH price dropped from around $1750 to $1250 from Sep 10th to Sep 21st, staying around $1270 until Oct 22nd (CoinGecko, 2022). This drop was mainly because some trades shifted investments from Ethereum into alternatives like bitcoin as they expected Bitcoin to outperform (Kharpal, 2022). Then, as the continuous operation of Ethereum validated the practical security, the ETH price gradually recovered to $1600 around Nov 6th. This U-shape in ETH prices between Sep 10th to Nov 6th indeed shows an overreaction to the merge as a result of the public distrust in PoS. It is surely a tough task to educate the public and build public trust of PoS. Hopefully, Ethereum can manage to build trust over time.
Although PoS is a feasible plan, it is not perfect in every sense. As you might have discerned, PoS does entail a favor towards the firstcomers with abundant stakes in the system since they can easily deposit larger stakes for a higher chance of being selected as a validator. To resolve this inequality, some cryptos, such as Peercoin, use the concept of coinage which takes account of the time you have been holding the coin instead of just coins. After being selected as the validator and behaving honestly, you can still have your coins back, but your coinage is reset to zero, lowering your chance of being selected for the next round. This coinage concept still has a long way to go to be qualified as a trustworthy application. As we can see from the low market value of Peercoin, persistently around 0.4$, the crypto world has yet to accept the application of coinage in Peercoin (CoinGecko, 2022). Hopefully, an improved solution can come with the opportunity to further examine PoS from the Ethereum merge and the form of public trust towards PoS.
Another unsolved problem in PoS is its limited functionality. So far, PoS is only able to substitute the transaction function and cannot operate as the single consensus mechanism for crypto, especially when it comes to creating a whole new crypto. This is because PoS still has not resolved the initial coin creation problem. For example, in cryptos based exclusively on PoS, such as Nxt, the entire available supply of 1 billion pre-mined coins was released initially. Other cryptos, such as Novacoin, Blackcoin, and Ethereum 2.0, utilize a mix of PoW and PoS, with PoW for coin creation and PoS for transactions (BitFury Group, 2015). As a result, back to the environmental concerns surrounding Bitcoin mining, although the shift to PoS is sustainable because the energy consumption of PoS blockchains is several orders of magnitude lower than that of PoW (Johannes et al., 2020), PoS cannot eliminate the crypto energy consumption problem; rather, it is only capable of reducing the energy consumed for transactions.
Zooming out for a bigger picture, critics have long questioned whether crypto is just a speculative bubble with no intrinsic value and high volatility. Indeed, persistent and broad skepticism about the stability of all cryptos might further delay innovations in this field. The recent FTX crisis is one noteworthy cause of skepticism. FTX is a crypto futures exchange where people trade Bitcoin and Ethereum futures contracts and the third-largest crypto exchange by volume before its collapse in November 2022. The FTX liquidity crisis began when the CEO of Binance tweeted on Nov 6th that he liquidated all of Binance’s FTX’s native token holdings due to “recent revelations” that FTX was lobbying “against other industry players behind their backs.” This tweet caused a bank run as FTX customers piled in to pull funds off the exchange. A whopping $6 billion exited FTX over 72 hours, compared to the “tens of millions” in withdrawals ordinarily handled on an average day (Hakki, 2022). Shortly after, FTX filed for bankruptcy on Nov 11th (Yaffe-Bellany, 2022). FTX collapse wiped out $183 Billion of value from digital assets on Nov 17th (Ledesma, 2022). So far, the impact of this catastrophe has not yet been recovered. Bitcoin and Ethereum stayed around a historically low price.
As the crypto industry remains gigantic after the crisis, surely some people are seeking solutions. The CEO of Binance unveiled his work on a new fund to help the struggling crypto sector, which has been negatively affected by the fall of FTX, by assisting leading crypto companies that have liquidity issues in his Nov 14th tweet (Editorial Staff, 2022). Binance’s role here is like a centralized agency intervening in the market. Another recent development in consensus mechanisms might also offer a solution for the future. Proof of Liquidity is a consensus mechanism built on PoS with an aim to enhance liquidity and create decentralized exchanges as borderless and uncensorable versions of the centralized exchanges (2022, Polkadotters). Although this idea is relatively recent and less trialed, it has the potential to develop and further realize the decentralization characteristics, especially after the FTX collapse.
Given the volatile market, broad skepticism, and public distrust of cryptos, it’s imperative to analyze the impacts of this shift to PoS in a broader setting and whether it will help transform cryptocurrency to be a sustainable system in our society. Although cryptos backed with blockchain surely sound like a great plan with decentralization and security, it can be a concept that came a little bit early. It is known that blockchain’s decentralization characteristic enables crypto to be a whole different currency system outside of the traditional banking system. However, we are still living in a very tangible world that has not yet been set up for large-scale decentralized currency. Cryptos are not commonly used as a currency but remain as speculative investments. Most people trade cryptos through centralized exchanges instead of actually having their key or owning the cryptos themselves. Decentralization hardly exists with the dominance of centralized exchanges. Moreover, the whole crypto world is highly susceptible to even a tweet about one exchange. So, there is a need to dissipate the enormous influence of centralized platforms if the end goal is to land the decentralized currency. Suppose cryptos and crypto knowledge can become more accessible to a broader audience. In that case, more participants will sustain the system, decreasing the impact of one exchange and reducing the market volatility. In this direction, the Ethereum merge from PoW to PoS might just be an early stage on the way to lowering the barrier of entry, marking the transition from “tech people only” to everyone with a regular laptop. Although the audience now is still limited to tech people and those interested in blockchain, the audience in the future might be everyone who spends. Although PoS hasn’t resolved the favor towards incumbent players in its formula and still has a high initial investment required (32 ETH), it significantly lowers the barrier compared to Bitcoin with Pow. PoS also builds a great foundation for further innovations in the consensus mechanism, just as shown in the invention of coinage and PoL.
Furthermore, there is expected supervising and countering force from the governments to cryptos’ long-term development. A recent crypto-related lawsuit is around Do Kwon, the founder of Terraform Labs. Terraform Labs is the company behind the algorithmic stablecoin terraUSD or UST, and its sister token, Luna. These coins were worth around $60 billion before they collapsed spectacularly in May. After its collapse, South Korean authorities have been seeking Kwon’s arrest and planned to freeze $62 million of bitcoin linked to Do Kwon (Kharpal & Lee, 2022). It is the first time a crypto case with the government’s direct intervention came to public attention, and it might be the beginning of government supervision in the crypto world. Besides, in late September 2021, the People’s Bank of China (PBOC) banned all cryptocurrency transactions in China, given the interesting fact that the Chinese Bitcoin mining pools dominantly control 65% of the network hash rate (Jordan, 2022). The PBOC cited the role of cryptocurrencies in facilitating financial crime as well as posing a growing risk to China’s financial system owing to their highly speculative nature (Francis, 2022). After banning cryptocurrency, China launched its pilot digital yuan later in January 2022 (Vidya). So far, this ban has not yet had an influence on major Chinese mining pools operation or active Chinese participation in cryptos. However, with increasing government awareness and intervention worldwide, the public distrust of cryptos aggravated and the sustainability of cryptocurrency in our society remains to be determined.
The evolution of blockchain is similar to the formation of civilization. The evolution from PoW to PoS is like how we evolved from the agrarian age to the creation of voting procedures. Back in the agrarian age, we individually or collaboratively worked to produce and maintain crops and farmland, just like mining in PoW. Then, we gradually developed into a society with a jurisdiction system enabling us to vote against the discerned dishonest behavior like validators in PoS. Crises are throughout the history of us and cryptos, and that is how we recover and improve.
All in all, although PoS lowers the crypto entry barrier to a limited extent, it is a milestone for opening the door of crypto to everyone and preparing the foundation for innovations. Only by embracing more participants can we achieve decentralization and reduce the volatility in the crypto market. But crypto’s developing track is susceptible to public distrust and government intervention, and the shift to PoS will only alleviate the energy consumption concern to a certain extent since PoS can only replace PoW for transactions. In the fast-evolving crypto world, we are ready to improve further and adapt the consensus mechanism on its flaws with the hope of keeping up with the future.
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