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Hi folks,
This week has been sandwiched between very two hot & happening weeks in the blockchain eco-system. It has been a bloodbath on the crypto-currency front with the popular Bitcoin breaking its $30,000 resistance level last Tuesday only to rise spectaculary in the 2nd half of the week 💥 And for the next week, we have the Ethereum Blockchain moving from Proof-of-Work consensus to Proof-of-Stake mechanism and we all have our eyes & hearts glued there! 👀
And that’s the topic for this week - a deep dive into Proof-of-Stake, how does it work and the impact going ahead.
🎏 Moving towards Proof of Stake
In the last issue, we had listed down 3 reasons as to why Ethereum blockchain is moving from Proof-of-Work towards Proof-of-Stake:
Circulation of Ether - Infinite supply makes it inflationary
Gas Fees - Transaction fee one has to incur which is very volatile and expensive
Green impact - Mining consumes high electricity having an adverse environmental impact
In Proof-of-Work, the work of validating the transactions on the blockchain is done by the miners and they are rewarded with the underlying currency of the blockchain. So, for the miners of the Bitcoin blockchain, for every block, they are credited with 6.25 BTC (bitcoin) into their wallets. Similarly, for Ethereum miners, their reward is 2 ETH (ether) currently.
Fun fact:
‘Bitcoin’ with the capital ‘B’ is the blockchain
‘bitcoin’ with the small ‘b’ is the blockchain’s currency
This concept for creating its own currency for a blockchain and paying the miners through that currency was envisioned to provide high-grade security to the blockchain. The currency, which in turn became the asset, is very much responsible for the security of the blockchain.
But, we do have to think of the efficiency of this consensus mechanism, i.e. what is the cost that the miners are incurring to provide this security vis-a-vis the incentives or the return that they are getting for the same. Or in simple words, how much fuel does this consensus mechanism and the miners need to consume, to provide 1 unit of security?
In the case of Proof-of-work, it turns out that is very resource-intensive (read gas fees and environment effects) and hence the need to search for new, different methods of securing the blockchain.
In a report published by Galaxy Digital and confirmed by International Energy Agency (IEA), the annual electricity consumption of the Bitcoin network stood at 113.89 terawatts per hour per year (TWh/year) whereas, the banking systems consume 263.72 TWh/yr, while gold mining consumes around 240.61 TWh/yr of energy. This electricity consumption can power an entire Malaysis or a Sweden for over a year!
Source : https://www.cnbctv18.com/business/explained-whats-bitcoin-mining-and-how-much-energy-does-it-consume-9359151.htm
🚀 Enter Proof of Stake!
According to the Ethereum community, the Proof-of-Stake (PoS) mechanism of securing the network is going to be roughly 10x more fuel-efficient than PoW. To achieve this efficiency, one would need to:
Control the issuance of freshly minted ETH on the blockchain
Eliminate the minted ETH which is already existing on the blockchain
We can also try to reduce new ETH being minted (from point one), but that would disincentivize the miners and make them move away from the Ethereum network. Instead, if we can eliminate or as it is called, burn the existing ETH, and if the rate of this burn > issuance of new ETH, we can reduce the supply of Ether over time (Part of this existing ETH is basically the gas fees incurred while transacting on Ethereum).
Thus, we would have ETH whose supply has been increasing till now, but over time, see a reduction in its supply as seen below:
🔗 How would this “Secure the Ethereum Blockchain”?
The resource used by miners to secure Bitcoin blockchain was electricity (used for solving computational problems with high end hardware/computers). In order to become a miner, one would need to purchase hardware and pay electricity bills. As long as 51% of the miners don’t gang up to attack and defy Bitcoin, this PoW mechanism would work. And this is working till date, because amassing > 51% of hardware and thus > 51% of electricity, both of which are roughly distributed across the world is very difficult. But it’s expensive.
In the case of proof-of-stake, this scarce resource is going to be real money. The way that one would become a consensus participant is by locking up some ETH (specifically 32 Ether) that allows one to become a blockchain validator.
In simple terms, in Proof of Stake, one has to ‘STAKE’ their own Ether to become a miner / validator.
Staking up one’s own ETH would give one the right to make votes. Every 6.4 mins or every epoch (era of time in a blockchain network), one would make a vote. With every good vote, you get rewarded ETH; but for every bad vote, you would be penalized. This basically provides the incentive alignment to do a good vote, i.e validate the transaction correctly and not cause mischief.
Consider this similar to a game of poker - one has to stake / put money in the pot to play the game. If you don’t put anything in the pot, you can’t play. Similarly, one needs to stake Ether in order to become a validator and thus help in securing the blockchain.
🎆What about the gas fee burn, that you earlier talked about?
Part of the reward a miner/ staker would get is in the issuance of newly minted ETH. But with PoS, the miner would also get a tip - which would basically be the transaction fee that is not burnt. In PoS, basically:
Transaction fee = Gas Base Fee (Fixed) + Tipping Fee (Variable)
Gas Base Fee: The minimum fee to include transactions in the blocks at any point of time and this would get burned
Tipping fee: The fee miner would get by being the first to validate the transaction in the block
It's the transaction fee that everyone is going to be paying equally to include their transactions in the block. But, the tipping fee is basically a winner-takes-all situation. For example, if there is a $1000 bill someone has dropped on the floor, and we have people racing to take it, the first person to grab it there, gets to keep it. Similar is the tipping fee - the miner who first validates the block amongst everyone and that too correctly gets to pocket the tipping fee.
You can check out the real-time gas price of Ethereum here - https://www.gasnow.org/
So, just to recap, the validators are now incentivized with 2 ways : issuance of new ETH and the tips that don’t get burned.
What’s the big thing for next week?
The most significant change from PoW to PoS is coming to the Ethereum blockchain next week - 4th August to be precise.
EIP-1559 (Ethereum Improvement Proposals): Called as the London fork, this update would happen at block number - 12,965,000. This proposal will split the gas fee into two parts -- a base fee and a tip as described above.
After the merge to Proof of Stake, Justin Drake’s model estimates as a “best guess” that 1,000 ETH will be issued per day, and 6,000 ETH would be burned. Assuming more validators join, the annual supply change will be -1.6 million ETH, reducing the annual supply rate by 1.4%
This ties to our above analysis, that if the rate of this burn > issuance of new ETH, the supply of Ether would decrease over a period of time, making it deflationary. It also gives the other 2 advantages : decreasing the transaction fee on the blockchain and reducing mining for combating environmental impact.
🎶 Podcast of the week: Justin Drake - Ethereum: Into the Ether
We would very much like to end this issue by sharing this podcast with our readers, where Justin Drake has described Ethereum as a triple point asset - solid, liquid and vapor (extra marks for guessing the fourth state - Ether) (pun intended)!!!
A must listen and a sneak peek below:
I kind of want to give the listeners an opportunity to hear what that sounds like so I'm going to play a little sound clip. Every time someone makes a transaction on Ethereum, some of the ETH will be vaporized and leave the system. It will become this gas money. Then on the flip side, when people are staking, the money is going to get frozen, and this is what it sounds like... At the end of the day, the liquid portion in the middle which sounds like this, by the way, the liquid portion in the middle will just be very, very small because you're going to have a large portion that is burnt, a large portion which is frozen, and a liquid portion in the middle which will be fueling the high-velocity Ethereum economy, so that includes, for example, being available on exchanges to buy and sell processing payments, for example, payments on NFTs, for NFTs or, for example, being the unit of trading and the unit of liquidity on platforms like Uniswap or being simply a store of value or a long-term investment.
That’s for it today folks!
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Great writeup guys!