Where does the money come from? As for dollars, they are printed by the US Mint. For cryptocurrencies, the answer is more complicated. From the time of their birth, the digital tokens with the largest market value, Bitcoin and Ether, were issued only to pay for tasks performed by so-called miners in what are called “proof-of-work” systems. It is an approach that has received increasing criticism for the large amounts of energy consumed and the pollution produced. That changed on September 15, when Ethereum, the platform that powers the Ether coin, switched to a system called “proof of stake” in a major upgrade known as “Merge.” Proponents say the approach will cut Ethereum’s power usage by 99%.
Why Ethereum’s Merger Means Crypto That’s Much Greener
1. What are the “proof of” systems for?
Cryptocurrencies would not work without blockchain, a relatively new technology that performs the old-fashioned function of maintaining a ledger of time-ordered transactions. What differs from pen-and-paper records is that the ledger is shared on computers around the world. Blockchain must take on another task that is not necessary in the world of physical money – making sure that no one is able to use 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 order and secure a blockchain’s sequential record.
Until the merger, in both the Bitcoin and Ethereum networks, transactions were grouped into “blocks” that were published to a public “chain”, but only after proof-of-work ordering was done. With Bitcoin’s software, this happens when the system compresses the data in the block into a puzzle that can only be solved through trial-and-error calculations that could potentially need to be run millions of time. 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 that it works.
3. What is evidence of the work’s disadvantages?
When Bitcoin and Ether were worth pennies, mining was also cheap. But as the value of the currencies rose, an arms race of sorts began, as miners added resources in the quest to win new coins. The Bitcoin system’s software responded to increased competition by increasing the computational difficulty of the blockchain tasks. The resulting skyrocketing power consumption led to calls from environmentalists to avoid 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 the increasing dominance of huge, centralized mining farms, a development that has 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 the mining power.
4. What is proof of stake?
The idea behind the proof-of-stake system adopted by Ethereum in the Merge is that the blockchain can be secured in another way: by giving a group of people a set of carrot-and-stick incentives to cooperate on the task. People who put up, or stake, 32 Ether (1 Ether traded at around $1,600 on September 14th) can become “validators”, while those with less Ether can become community validators. Validators are elected 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 bet. Ethereum’s proof of stake system was first tested on a blockchain called the Beacon Chain that was separate from the proof-of-work system. The two blockchains were merged in the merger.
5. What are the system’s advantages?
Switching to proof-of-stake should cut Ethereum’s energy use—estimated at 45,000 gigawatt-hours per year, or slightly more than New Zealand’s—by 99.9%. In terms of its carbon footprint, it will essentially be like any other Internet operation whose energy use involves nothing more than running a network of computers, rather than a venture that resembles a collection of giant digital factories.
6. What are the 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 can be found. There is also a risk that an additional new player in the Ethereum ecosystem could become dangerously powerful: the so-called builder. Builders do the work of wrapping transactions into blocks and forwarding them to the validators. There are currently more than 420,000 validators, but only a few builders. If a major provider of crypto wallets, software for transferring and storing coins, decides to send all its transactions to a particular builder, that builder may be able to censor transactions and command high prices. Proof-of-stake supporters believe the risk is worth what can be achieved in terms of environmental benefits, as well as by bringing a wider group of users into the process than was possible when becoming a miner could involve a large outlay for specialized computers.
7. What kind of problems can arise in the merger?
Major software upgrades almost never go smoothly. Despite years of pre-merger testing, various bugs and issues can potentially crop up in the weeks and even months following the transition. Some of these problems are related to so-called forks — copies of Ethereum expected to emerge that will still use miners. Because of these forks, there is a risk of replay attacks, where hackers replay a user’s transaction done on one chain on the Ethereum network with proof of stake 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. Will the Merger Change the Ethereum User Experience?
No, the merger will not change network transaction costs or speed. But it lays the groundwork for future software upgrades that proponents of the platform hope will improve both.
9. If the merger is successful, what will this mean for proof-of-work blockchains?
If the new Ethereum system starts working well, it could put more pressure on other proof-of-work systems (especially Bitcoins) to switch to a more energy-efficient process as well. Environmental concerns surrounding such blockchains have long prevented large companies and funds committed to combating climate change from investing in crypto. Ethereum’s hope is that as the platform becomes more environmentally friendly, more institutional investors will give their coin, Ether, a new look, and more developers who avoided building finance, games and other applications for the network because of the high energy consumption will move over. This could potentially result in something crypto-heads call “flipping” – essentially, Ether’s market cap is above Bitcoin’s for the first time. Before the merger, Bitcoin’s value was roughly double that of Ether.
10. How could the merger change the economics of Ether?
By changing the characteristics of Ether, the merger will make it more akin to yield-bearing securities. Staking Ether will generate a return, expected to be around 5.2% immediately after the merger, according to tracker Staking Rewards. Coupled with an expected net decrease in Ether token supply, possibly a few months after the update, that should make the coin more attractive to investors. Today, only around 11% of Ether in circulation is used for betting on Ethereum. Eventually, around 80% of the Ether can be staked, meaning it will be locked for a period of time. That could have implications for Ether’s long-term pricing and liquidity. The token’s new status as a yield-yielding asset could also lead to financial regulators starting to treat it as a security, a possibility raised soon after the merger by US Security and Exchange Commission Chairman Gary Gensler. Such a designation will bring closer scrutiny.
11. What does it mean that stake Ether is locked?
Ethereum must undergo another software upgrade – expected to happen at least six months after the merger – before the Ether stake can be withdrawn. Even then, withdrawals will be limited. So investors are taking on a lot of risk when locking up Ether.
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