Ethereum, the most mature and popular blockchain technology with smart contracting capabilities, transitioned from a Proof-of-Work (PoW) consensus mechanism to a Proof-of-Stake (PoS) on 15 September 2022. Before delving into the significance of this switch, some key terms are explained.
First, what are blockchains? As the name implies, they are a chain of blocks, a digital ledger, that records transactions in an open, decentralized, distributed, transparent, and permanent manner. The main features of a blockchain are its data structures, cryptographic security, incentive mechanisms, and consensus rules.
In PoW networks such as the Bitcoin blockchain, miners add blocks to the canonical chain to earn a financial reward. Mining involves solving an arbitrary complex mathematical puzzle designed to enhance the network’s security. This energy- and computationally-intensive process has always been a concern, especially for environmentalists. PoW consensus rules gained more spotlight recently as energy use became a hotly contested topic, especially in light of the energy crisis that precipitated from the Ukraine-Russia war. PoW also results in slow transaction speed and expensive fees, which have partly disincentivized certain market participants from utilizing blockchain solutions.
Smart contracts translate contract laws into computer protocols, albeit they provide security that surpasses classical contract laws. This additional layer of protection is because transactions that emanate from these arrangements are completed by similar rules that underpin pure blockchain transactions.
Ethereum smart contracts historically used PoW as its blockchain consensus mechanism. For more than six years, there had been plans to switch to PoS. However, this transition did not materialise until 15 September 2022. PoS removes the mining process. Instead, validators are randomly selected to write the next block on the chain based on their stake. The more a validator’s stake, the better its chance of being chosen. Ethereum is the most mature and popular blockchain-enabled smart contract. Therefore, this new change in consensus could have significant ramifications for the blockchain industry.
Positive consequences of the transition
The most apparent benefit of the switch is energy-use reduction, which the Ethereum Foundation claimed would decrease by 99.95%. Before the transition, Ethereum was believed to use 113 terawatt-hours per annum, as much power as the Netherlands. In the medium-term, transactions would become much faster and less expensive. These factors will likely increase the adoption of Ethereum smart contracts that already power thousands of decentralized applications (dApps) today. Some of these dApps include decentralized finance (DeFi) instruments and non-fungible token (NFT) projects, both of which have a market capitalization of US$ 67 billion at the time of writing. Web3 companies, especially those solving climate issues, would benefit from this transition as there would now be an increased rationale to develop climate tech solutions on dApps, focussing mainly on the value proposition presented by cryptocurrencies and blockchains.
Not without its risks
PoW supporters oppose the PoS system, claiming it presents new centralization and security risks, allowing malicious actors to directly buy control of the network. They also believe that PoS is a less battle-tested system than PoW, which has demonstrated resilience as the cornerstone of some of the largest blockchain networks.
The transition could impact the price of Ethereum’s native cryptocurrency, ETH. The switch has resulted in a fundamental change in how new tokens are distributed by entities adding blocks to the chain. ETH issuance will fall, and more of it will be burned annually. There would also become an increased incentive to hold ETH to participate in validating. These factors are likely to cause a structural upward pressure on the price. On the flip side, the PoS might prove unsuccessful, negatively affecting ETH. With so many variables and unknowns, it is challenging to predict ETH’s direction.
There are also uncertainties about classifying ETH as a security or utility token. Some experts argue that Ether in a PoS system qualifies as security since the staking framework is an investment contract with an expectation of returns. Security tokens are regulated compared to utility tokens, and such oversight could impact the direction of Ethereum. For instance, the CEO of Ripple Labs was sued by the United States Securities and Exchange Commission (SEC) in December 2020 after the Commission deemed its cryptocurrency (XRP) as an unregistered security.
City College online diploma in Blockchains, Bitcoins, and NFTs
Ethereum’s PoS transition, amongst other trends impacting the blockchain and cryptocurrency industry, will be covered in City College’s online diploma in Blockchains, Bitcoins, and NFTs. The course kick-starts on 6October 2022.
Olakunle Alao – Ph.D., Electrical and Electronics Engineering
Lecturer, City Colleges
To book your place please click here