Proof of What? Proof-of-Work, Proof of Stake, and the Ethereum Merge

Merge/POW

Consensus is at the heart of crypto. Blockchain technology is a way to help different parties agree with no centralized oversight. Where security and trust are instead guaranteed by a decentralized network of computers. To reach a shared consensus, blockchains have different mechanisms. At the time of writing, both Bitcoin and Ethereum are using a proof-of-work consensus. Ethereum, however, is in the process of completing ‘the Merge’, which will update Ethereum’s consensus to proof-of-stake.

The Merge has the potential to drastically upscale the effectiveness of Ethereum, making it more scalable and vastly reducing the environmental impacts seen with PoW. It has been previously christened ‘Eth 2.0’, but it is not a fork of the original Ethereum and for most users, the way they interact with Ethereum will remain identical, so it is now known as the Merge. This is because it involves merging the Beacon chain, which has already been testing the new consensus, with the current Ethereum mainnet. This will mark the beginning of a new chapter in Ethereum’s history.

Memes about the endless wait for the upgrade to proof-of-stake are already old and tired. This upgrade has taken forever. Many thought it may never happen. Yet Ethereum has now penciled in a soft deadline for release: 19th September 2022. There has been plenty of chatter, excitement – and even price action – as the date approaches. Yet what exactly is it? Why is Ethereum bothering to upgrade at all if Bitcoin still uses proof-of-work? And why are crypto communities, and markets, so excited about the change from one to the other? Let’s find out.

Proof of Work and Nakamato’s Big Idea

Nakamoto’s big idea was to use proof-of-work (PoW) cryptographic hash functions to create an ‘electronic cash’ system. In essence, Bitcoin, Ethereum – or any crypto – is a giant ledger. The history of transactions is the currency. A user – any user – can simply add details to the ledger to make transactions and then broadcast their transactions so everyone else can update their ledger. Yet how can we guarantee both those transactions and the validity of everyone else’s ledger? This is where proof-of-work comes in.

Proof-of-work trusts the version of the ledger that has the most work put into it, and everyone updates their ledger with that copy when making new transactions. The central authority is substituted for the computational effort. In this system, the ledger is divided into blocks, representing groups of transactions, that are then chained together.

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Miners spend computational power to solve arbitrary maths problems for the right to add the next block of transactions. It functions like an energy lottery. They attempt to find a special number, through trial and error, that results in the SHA 256 hash output to equal a defined parameter. In Bitcoin’s case, for example, the resulting hash of a block has a certain number of zeros at the beginning. Although it is very difficult to guess this value, it’s extremely easy for the other miners to check once it’s been found, meaning you can prove a certain miner has done the work. The result of the problem is also dependent on the contents of the previous block, meaning that as the chain grows, it’s more and more likely to be considered final.

How Mining Competitions Creates Security

Doing this proves they have expended significant energy, and that their ledger should be trusted. It shows their commitment to the network – as the energy comes at a cost, both financial and environmental (which we’ll return to later).

Miners compete with one another for the chance to create the next block and commit the next batch of transactions to the blockchain. They are then rewarded with $BTC, $ETH, or the chain’s native currency as an incentive to continue mining and guaranteeing the validity of the blockchain.

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This competition also ensures the security of the chain. The system works because the computational power required to manipulate the chain is unfeasible due to the work of other competitive miners. You would have to do more computational work than every other miner combined to manipulate the transaction data on the chain, to ensure that your chain remains longer than everybody else. This, then, is how Nakamoto conceived of a decentralized currency that everyone can trust.

The issue with proof-of-work is all those arbitrary maths problems add up. The energy drain to sustain Bitcoin has been a keen avenue for media assault on cryptocurrencies, and derision by people who would otherwise be keen on cryptocurrencies. There is something inherently displeasing about a system that’s entirely reliant upon an intrinsically profligate activity.

It’s also very difficult, now, to compete in mining. You need giant rigs, access to cheap energy, specialized hardware, and huge capital investment, to be able to mine Bitcoin or Ethereum properly. The fear that large mining pools could band together to execute a 51% attack remains a problem, and there is the idea that over time a proof-of-work system results in a less decentralized currency, as the barriers to entry for new entrants to secure the network are too high.

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Proof-of-stake is vastly more environmentally efficient. It’s a way of maintaining consensus on the blockchain without requiring extensive computational power. Moreover, it allows more of the user base to benefit from ‘mining rewards’, as the barrier to entry is far lower. Even those with small amounts of capital can participate in the security of the network and improve its decentralization.

A General Overview of Proof-of-Stake

Proof-of-stake randomly selects validators for the next block from a pool of users that have staked their tokens within the network. Staking involves locking away your tokens inside the protocol in return for the chance to be selected and earning rewards for then creating the next block.

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Any user can be a validator, but there are often technical or capital requirements to be so. Thus, users can instead delegate their tokens to a validator pool that’s composed of thousands of users and enjoy passive income from the block rewards. Validators who misbehave see their stake slashed, and decentralization occurs due to the diverse pool of potential validators who all have a vested interest in the network’s success.

The switch to proof-of-stake allows more scalability and increased decentralization through future upgrades such as sharding. It won’t however mean reduced gas fees, which will be achieved via rollups.

Ethereum’s Proof of Stake and the Merge

Ethereum is due to move from proof-of-work to proof-of-stake when The Merge completes. The Merge refers to integrating the Beacon Chain, which is already running on proof-of-stake consensus, with the Ethereum mainnet that everyone uses today and which is still maintained by proof-of-work

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Since 2020, the Beacon chain has been running in parallel to the mainnet, with its transactions secured by proof-of-stake instead. Testing is approaching completion, and the plan is now to install this new consensus layer underneath the existing mainnet. From that moment on, Ethereum will no longer be maintained by miners doing proof-of-work, but by validators using proof-of-stake. The entire transaction history of Ethereum will be ported over, so nothing will be lost. The Beacon chain can’t handle smart contracts or user accounts, so the mainnet will remain the execution layer, while the Beacon chain handles validation, staking, and future sharding upgrades.

Those who have been staking Ethereum on the Beacon chain already will not be able to withdraw their stakes immediately, though, and stakes will probably remain locked on the Beacon chain for at least the first six to twelve months after The Merge completes until the Shanghai update – a later Ethereum change.

Ethereum’s move to proof-of-stake is driven by its desire to scale. Using the old proof-of-work consensus, Ethereum suffered logjams at times of high activity, and the idea of the world’s financial systems – or any systems – running on-chain seemed a pipe dream. Now, Ethereum’s roadmap is based on rollups to power its speed, and sharding for its scalability. Ethereum’s sharding roadmap is dependent on the successful transition to proof-of-stake. The Merge is just the next step in a long-term vision of making Ethereum scale to meet the needs of the world, not just of the crypto-native few.

 

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