Ethereum's 'Merge'

Last week, many of us likely saw in the news or TV headlines about the cryptocurrency, Ethereum’s, successful merge to Proof-of-Stake (PoS). But what exactly is the merge all about, and what is Proof-of-Stake? In this blog, we aim to uncover these topics and provide readers with an overview of ‘the merge’. 

What is Proof-of-Stake?

Ethereum, the second largest cryptocurrency by market cap, recently completed a software upgrade to ‘Proof-of-Stake’ (PoS), which the event has been coined ‘the Merge’. 

So, what is Proof-of-Stake? To first understand what Proof-of-Stake means, we must first understand what a consensus algorithm is. No, one does not need to have a Ph.D. in Computer Science to understand what this means as this is simply a voting process used by blockchains (cryptocurrencies) to reach an agreement that transactions on the blockchain have been fair and accurate. Many have heard of the importance of ‘blockchains’ in future technology but are left scratching their heads at the importance of ‘cryptocurrencies’. Blockchain technology is what underpins all cryptocurrencies, but the cryptocurrency token associated with each of these blockchains is what makes it secure and ‘trustless’. A blockchain without a crypto token attached to it is essentially no different from the databases that are used in everyday technology today, but by requiring individuals (miners) to validate the blockchain transactions and giving them crypto tokens as a reward for their efforts, the blockchain becomes secure and trustless (no trust is required as miners are incentivized to be truthful).

Ethereum previously used the same consensus mechanism that Bitcoin uses today, Proof-of-Work (PoW), which requires individuals (miners) to purchase specific computer mining equipment and run the software 24/7. Many of us have heard of ‘bitcoin mining’ before and have seen images of thousands of computer mining rigs operating in large warehouses - this is a Proof-of-Work mechanism. The mining equipment itself is expensive, energy-intensive, and requires a lot of space and infrastructure. Proof-of-Stake, on the other hand, requires a consumer-grade laptop at most, and a financial commitment of ETH (Ethereum crypto tokens). These miners on a Proof-of-Stake consensus algorithm are therefore using significantly less energy and physical space than on a Proof-of-Work mechanism. 

The Benefits of Proof-of-Stake

We will uncover some of the key benefits that Proof-of-Stake has over Proof-of-Work below:

1. Less Energy Consumption: The software upgrade performed by Ethereum to a Proof-of-Stake model is estimated to reduce its energy usage by 99.98%. To put this into context, the network was previously using about 23 million megawatt-hours per year, and with its software upgrade is now estimated to use ~2,600 megawatt-hours per year. For a ~$163.5 billion network, this new usage is estimated to represent just about 100 houses worth of energy per year, not bad. 
2. Good Yield for 'Stakers': The Proof-of-Stake equivalent of a miner is called a ‘staker’, and this is defined as an individual that holds and uses their ETH (Ethereum crypto tokens) to validate the blockchain. The current yield for being a validator is roughly ~5.0% annually.Source: stakingrewards.com
3. Lower 'Inflation'/Supply Increase for ETH: Similar to how companies issue more shares to fund projects and thus dilute the existing shareholder base, cryptocurrencies issue new tokens each year as a way of rewarding miners for validating the blockchain. The upside to this is that the blockchain remains secure, as miners are incentivized to be truthful, but the downside is that it dilutes the existing crypto holders. As part of the software upgrade to PoS, a certain amount of ETH will be removed from circulation each year, causing the annual inflation of new tokens to be extremely low. In the image below we can see that prior to the software upgrade, Ethereum was inflating at ~3.8% per year, Bitcoin inflates its supply by 1.7% per year, and now with Ethereum on Proof-of-Stake it will inflate by only 0.2% per year. Source: ultrasound.money
4. Ability for Faster Transaction Speeds: As a benefit of the upgrade to Proof-of-Stake, Ethereum has plans in its roadmap for enabling faster transaction speeds, which will make it much more scalable.

The Downsides of Proof-of-Stake

Since the barriers to entry are much lower for Proof-of-Stake than Proof-of-Work, some might argue that it is easier for single parties to gain a high concentration of market share on a PoS model than PoW. This is because only a consumer-grade laptop is required on a PoS model, and a financial commitment of ETH tokens, whereas with PoW, a significant investment in infrastructure, computer mining equipment, and physical space is required. This poses some security risks as it can be argued that the network becomes less ‘decentralized’. There are also risks because it is a new software upgrade, and certain bugs and loopholes may be discovered over time. 

Conclusion

Ethereum’s merge to Proof-of-Stake marks a milestone in the cryptocurrency industry and represents a step forward in reducing energy consumption, providing holders with yield, and scaling up the technology’s speed to match with the likes of modern-day payment systems. Some are calling this the first ‘internet bond’ or ‘internet money with yield’ as the crypto token ETH can be used to make purchases, appreciate/depreciate in price, and now offers holders an attractive level of yield. We will have to wait and see what is in store for Ethereum in the future and how its software upgrade develops! 

Research for Today, Invest for Tomorrow.

Twitter: @5iChris