Where does money come from? Dollars are printed by the US Mint. For cryptocurrencies, the answer is more complicated. Until now, the digital tokens with the biggest market value, Bitcoin and Ether, have only been issued to pay for tasks performed by so-called miners in what are known as proof of work systems. It’s an approach that has drawn increasing criticism for the large amounts of energy consumed and pollution produced. Around Sept. 15, Ethereum, the platform for Ether, is switching to a different system, called proof of stake, in a process known as the Merge. Proponents say the approach can cut Ethereum’s electricity use by 99%.
1. What are the ‘proof of’ systems for?
Cryptocurrencies wouldn’t work without blockchain, a new technology that performs the old-fashioned function of maintaining a ledger of time-ordered transactions. What’s different from pen and paper records is that the ledger is shared on computers all around the world. Blockchain has to take on another task not needed in a world of physical money — making sure that no one is able to spend a cryptocurrency token more than once by manipulating the digital ledger. Blockchains operate without a central guardian, such as a bank, in charge of the ledger: Both proof of work and proof of stake systems rely on group action to create, validate and safeguard a blockchain’s sequential record.
2. How does that happen?
Today, in the main Bitcoin and Ethereum networks, transactions are grouped into “blocks” that are published to a public “chain,” but only after proof of work ordering is performed. With Bitcoin’s software, that happens when the system compresses the data in the block into a puzzle that can only be solved through potentially millions of trial-and-error computations. This work is done by miners who compete to be the first to come up with a solution and are rewarded with free cryptocurrency if other miners agree it works.
3. What are proof of work’s drawbacks?
When Bitcoin and Ether were worth pennies, mining was also cheap. But as the value of the currencies rose, an arms race of a sort set in, as miners poured in resources in the quest to win new coins. The software responds to increased competition by revving up the computational difficulty. The resulting sky-high electricity usage led to calls from the environmentally conscious to shun Bitcoin and Ether. The European Union considered banning proof of work practices before deciding that cryptoasset providers should be required to disclose the energy consumption and environmental impact of the assets they choose to list. The proof of work system has also led to a growing dominance by huge, centralized mining farms, a development that’s created a new vulnerability for a system designed to be decentralized. In theory, a blockchain could be rewritten by a party that controlled a majority of mining power.
4. What is proof of stake?
The idea behind the proof of stake system being adopted by Ethereum is that its blockchain can be secured more simply if you give a group of people a set of carrot-and-stick incentives to collaborate. People who put up, or stake, 32 Ether (1 Ether traded at around $1,900 in mid-August) will be able to become “validators,” while those with less Ether can become validators jointly. Validators are chosen to order blocks of transactions on the Ethereum blockchain. If a block is accepted by a committee whose members are called attestors, validators are awarded Ether. But someone who tried to game the system could lose the coins that were staked. Ethereum’s proof of stake system is already being tested on a blockchain, called the Beacon Chain, that’s separate from the proof of work system; so far $25 billion worth of Ether has been staked there. The two blockchains are expected to merge in September.
5. What are the system’s advantages?
It’s thought that switching to proof of stake would cut Ethereum’s energy use — estimated at 45,000 gigawatt-hours per year, or a bit more than New Zealand’s — by 99.9%. In terms of its carbon footprint, it would essentially be like any other internet operation whose energy use involves nothing more than running a network of computers, rather than a venture resembling a collection of gigantic digital factories.
6. What are its vulnerabilities?
Proof of stake is less battle-tested than proof of work, whose security has been scrutinized for more than a decade. So new vulnerabilities could be found. Also, there’s a risk that an additional new player in the Ethereum ecosystem could become dangerously powerful: the so-called builder. Builders will package transactions into blocks and relay them to the validators. There are more than 400,000 validators currently but only a few builders. If a major provider of crypto wallets, software for transferring and storing coins, decides to send all transactions to a particular builder, that builder may be able to censor transactions and command high prices. Proof of stake proponents think the risks are worth what would be gained in terms of environmental benefits, as well as from bringing a broader group of users into the process.
7. What kind of issues could come up during the Merge?
Major software upgrades almost never go smoothly. Despite years of testing prior to the Merge, various bugs and issues could potentially crop up in the hours and even months after the switchover. There could be issues with different validators getting out of sync with each other, and requiring the blockchain to be paused. More importantly, there’s the danger of replay attacks, in which hackers repeat a user’s transaction to steal coins. While Ethereum has been hardened against such attacks, some applications running on the network may not have included the necessary protections in their code.
8. If the Merge succeeds, what will this mean for proof of work blockchains?
If the new Ethereum system starts working well, it could put more pressure on proof of work systems (notably Bitcoin’s) to switch to a more energy-efficient process as well. Environmental concerns surrounding such blockchains have long prevented large companies and funds that are committed to environmentalism from investing in crypto. Ethereum’s hope is that once the platform becomes more environmentally friendly, more institutional investors will give it a second look, and more developers who avoided building finance, gaming and other applications for the network due to its high energy consumption will move over. This could potentially result in something cryptoheads call “flippening” — essentially, Ethereum’s market capitalization exceeding Bitcoin’s for the first time. Today, Bitcoin’s value is double that of Ethereum.
9. How could the Merge change the economics of Ether?
Today, only a small percentage of Ether in circulation is used in staking on Ethereum’s trial proof of stake blockchain. Within a year or two of the Merge, around 80% of the Ether may be staked, meaning that it will be locked up for a period of time. That could have implications for Ether’s long-term pricing and liquidity.
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