In the beginning was the Bitcoin. The blockchain technology behind the pioneering cryptocurrency follows a “Proof-of-Work (PoW) model.” Ethereum, like Bitcoin, currently uses this same Proof-of-Work framework. However, this summer, Ethereum is switching to a Proof-of-Stake (PoS) model, a significant move for Crypto to a more sustainable and scalable system.
Proof of work (PoW) is a decentralized consensus mechanism that requires members of a network to expend effort solving an arbitrary mathematical puzzle to prevent anybody from gaming the system.Investopedia.com
Bitcoin is a digital currency that has a distributed ledger – blockchain – underpinning it. This ledger records all Bitcoin transactions in blocks, which are publicly available or “distributed.” Any improper changes to the ledger would be identified and rejected. PoW is used to validate transactions and mine new tokens in cryptocurrency. This system allows Bitcoin and other cryptocurrencies to be processed without a third party. However, the PoW system requires a huge amount of energy generated from computing power used to randomly engage hashing functions until it arrives at an output with the correct minimum amount of leading zeros.
Each block contains 745 transactions involving over 1,666 bitcoins and the header of the previous block in the chain. If someone attempted to change a transaction by even a small fraction of a bitcoin, the resultant hash would not match and would be rejected as a fraud attempt.
Proof of Stake is a built-in consensus mechanism that is used by a cryptocurrency’s network or validators. It cannot be earned, but you can help secure a network and earn rewards by using a cryptocurrency client that participates in PoS validating or becoming a validator.Investopedia.com
PoS was created to be a more efficient alternative to PoW, and attacks on PoS networks are viewed as less likely, because the compensation structure makes these attacks less advantageous.
The system reduces the amount of computation needed to verify blocks and transactions in the blockchain that keep it secure. PoS changes the verification of blocks from miners solving hashes to owners offering coins as collateral for the chance to validate blocks. Owners who stake coins become “validators.” These validators are randomly selected to “mine” – validate the block. This system uses a randomized selection of miner rather than the competition-based system like PoW. Blocks are validated by more than one validator. Once a certain number of validators verify that the block is accurate, it is finalized.
To become a Ethereum validator, owners must stake at least 32 ETH. Ethereum’s PoS system uses “shards” for transaction submissions. Validators verify transactions, which are added to a shard block. This shard block requires 128 validators to attest to its accuracy. After verification, the shards create a block. Two-thirds (or 86) of the validators must agree the transaction is valid to finalize the block.
This sharding effectively splits the Ethereum network into several smaller portions to spread the burden. This should ease network congestion and boost transaction speeds. Sharding should facilitate scaling on the Ethereum network. Further, having the first-move advantage will make Ethereum more desirable than its rivals as Ethereum becomes the dominate Web 3 blockchain.
Proof-of-Stake vs Proof-of-Work
PoW is a competitive approach to verify transactions. People look for ways to get an advantage over others to earn more crypto. For example, Bitcoin miners earn Bitcoin by verifying transactions. The computing power required for this process is not without environmental costs. Bitcoin mining uses as much energy as a small country.
PoS seeks to solve these problems by replacing computing power with staking. Miners’ ability to mine is random rather than competitive. This drastically reduces energy consumption because miners no longer need massive farms to get an advantage. According to Ruben Merre, CEO of crypto wallet NGRAVE, once Ethereum completes the change to PoS, energy consumption will be reduced by 99.95%, which will eliminate a carbon footprint around the size of Finland.
Benefit to Ethereum Owners
For owners, staking Ethereum in the PoS system is akin to passive investing. Right now, the yield from staking Ethereum is expected to be somewhere between 10% and 15%. This is much higher than the current rates offered by BlockFi and Celsius of around 5%.
Further, the shift to PoS will make Ethereum a deflationary asset – a store-of-value asset – which is something Bitcoin claims now. In August, the Ethereum Improvement Proposal (EIP) 1559 introduced a mechanism to burn some fees paid to miners. So far, net supply of Ethereum has been reduced by nearly two-thirds. After the shift to PoS, Ethereum is projected to drop by 90%, which would lead similar level of fees to reduce Ethereum’s supply by up to 5% per year.