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What Is Proof of Stake?

Ethereum 2.0 will bring the move from Proof of Work to Proof of Stake. Proof of Stake offers unique revenue-generating capabilities to ETH holders.

A version of this article was first published here.

In 2020, the first phase of Ethereum 2.0 will go live, marking an overhaul of the existing Ethereum 1.0 blockchain and notable improvements in scalability and accessibility. The core of the Ethereum 2.0 architecture is the Proof of Stake (PoS) consensus mechanism, which will replace the existing Proof of Work (PoW) consensus mechanism.

PoS comes with a number of improvements, including energy efficiency, lower barriers to entry, stronger crypto-economic incentives, and greater revenue-generating capabilities for a broader set of users. This article aims to clarify what Proof of Stake is, how it will be implemented in Ethereum 2.0, and how ETH holders can anticipate interacting with the new architecture.

Understanding Consensus Mechanisms

In distributed systems, a consensus mechanism is the method by which the network agrees on a single source of truth. Unlike in centralized systems, where a source of truth is decided upon by a single controlling entity, distributed systems rely on large numbers of autonomous authorities to cooperate in the maintenance of a single network. These distinct nodes must have a computational mechanism by which to arrive at an agreement of what the most recent and accurate record of data is. To drive the point home, these distributed networks must all adopt an identical cryptographic mechanism to arrive at consensus.

Proof of Work Consensus Mechanism

The Proof of Work (PoW) consensus mechanism is currently the most widely-used consensus mechanism and arguably the best understood. Pioneered by Satoshi Nakamoto with the release of Bitcoin in 2008, PoW has so far powered the majority of highest-profile blockchains, including Ethereum.

For an emerging technology like blockchain, PoW has proven an extremely secure and trustworthy consensus mechanism. The basic components of PoW are miners and energy. Miners are the individuals or entities that maintain the network by running and managing nodes (computers). Miners direct nodes to expend electricity in the form of computational energy to solve increasingly complex mathematical problems. The miner that solves the problem first earns the right to add a block of transactions to the ever-growing chain of consecutive blocks, creating a single and verifiable history of data on a PoW blockchain.

The expenditure of computational power costs money in the form of electricity––on top of the initial hardware costs of setting up a functional node. The cost of being a miner, however, is made worthwhile by block rewards. When a miner successfully mines a block into existence, they receive a block reward in the form of the blockchain’s native coin (i.e. BTC, ETH, etc.).

As more miners begin to run nodes on a blockchain, the hash rate (i.e. computing power of the network) increases, meaning the next block may be mined into existence a little faster than the previous.

The network attempts to maintain a consistent block time (the time between each block); Ethereum is mined every ~14 seconds and Bitcoin is mined every ~10 minutes.

If the hashrate increases and a block is mined a bit faster than before, therefore, the difficulty is increased automatically for the next block, ensuring it becomes a bit harder to mine a block and the block time is re-stabilized. The difficulty regularly adjusts after every block so the block times stay relatively stable.

As miners leave the network (which can happen for a variety of reasons, including a decrease in the USD value of the native coin), the difficulty will decrease, meaning it becomes easier for miners to mine blocks and receive rewards. This decreased difficulty serves as an incentive for more miners to return to the network, ensuring the network remains strong and sufficiently decentralized.

PoW blockchains have proven extremely resilient and secure. The incentive against a malicious actor attempting to compromise a PoW blockchain is the cost of electricity required to generate the sufficient amount of computational energy to take over a majority hash rate. The combined computational power required for an individual to compromise a well-established PoW blockchain like Bitcoin or Ethereum would cost an extraordinary amount of money, and may not even exist.

Though simple and secure, PoW chains face three main challenges: accessibility, centralization, and scalability.

Accessibility: The barriers to entry to becoming a PoW miner are high. Proof of Work chains require a substantial amount of energy to maintain. A miner must purchase, set up, and maintain all the necessary hardware to run a PoW mining rig. Additionally, PoW mining is extremely energy-intensive. Not only is the underlying mechanism inefficient from an energy standpoint, but it further increases the barrier to entry. To earn significant block rewards, it is better for a miner to live in a region with lower electricity costs. Additionally, jurisdictions often offer lower electricity costs to corporations, meaning a miner who wishes to maximize their profits would need to form a company and purchase enough mining hardware to offset the effort and associated costs. Altogether, energy inefficiency, variable electricity costs, hardware costs, and corporate electricity breaks all present significant barriers to entry for most would-be miners.

Centralization: Barriers to entry for mining can have the adverse secondary effect of greater centralization of miners. As it gets more costly and less profitable to become a miner, the network naturally sees a concentration of mining into two categories. First, large mining conglomerates that operate in areas with low electricity costs and cold weather (to reduce the cost of manually cooling mining hardware) such as Mongolia and Siberia. Second, mining power is centralized in the hands of mining pools. As it becomes less profitable for most people to mine individually, they buy hash power from a mining pool, which operates as a single mining entity. By the end of 2019, over 50% of blocks on Ethereum were mined by just two mining pools.

Scalability: In the current Ethereum Proof of Work chain, each block is mined consecutively. Each block can only contain a certain amount of data, known as the block size. This means that if there are more pending transactions than can fit into a block, the transactions that do not make it into the next block to be mined must “wait” for the following block for another chance to be included. On Ethereum, a block is mined once every ~14 seconds, but during particularly high transaction events, some users could wait hours for their transactions to be processed.

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