One of the most versatile used cryptocurrencies, Ethereum will have a major upgrade in 2020 shifting to the proof of stake protocol. Transactions on the Ethereum blockchain will be validated by those who stake or hold a certain number of coins in contrast to the current process where miners process the transactions.
How Ethereum 2.0 will changes the industry of cryptocurrencies and mining from 2020? Let’s first understand what is this major upgrade and how it will work in the future.
Mining and consensus protocol
Blockchain technology’s innovative value-add on is the distributed ledger, which records every prior transaction like a chain. The technology behind is using a distributed ledger – distributed in a sense that there is no central database to hold the information, but it is rather stored on a computer network, consisting of multiple devices around the world.
The most crucial point of operating a distributed ledger is that the network must ensure the participants collectively agree that the data stored on and being added to the ledger is valid. This collective agreement is called the consensus protocol and also often referred to as mining. The consensus is the way to avoid double-spending, forking or entering invalid data on the network.
There are many ways you can reach an agreement or consensus on the network. All of them have been designed to help the participants to reach an agreement, but they are utilizing different methodologies to get to a consensus eventually. The most popular consensus protocols are Proof of Work (PoW) and Proof of Stake (PoS) systems, but there are others available as well, like the Delegated Proof of Stake (DPoS) and Federated Byzantine Agreement (FBA).
For example, bitcoin mining is the process where the bitcoin network is validating each transaction entered to the blockchain through there own Proof of Work system. Bitcoin mining is a way miners reach consensus on the bitcoin network and approve transactions.
Proof of Work vs Proof of Stake
In order to understand how the different consensus mechanisms work, let’s look at the two major agreement methods, proof of work and proof of stake how they work in reality.
How Proof of Work works
Bitcoin is the most popular cryptocurrency for the proof of work system, but most of the altcoins employ this consensus mechanism as well, independent of the underlying algorithm they use for mining blocks.
During bitcoin mining, the network bundles a group of transaction into a mempool (memory pool). Miners take this mempool and verify the transactions in the pool by solving a complex mathematical problem to make sure the transactions are valid. The miner who manages to solve the mathematical problem the first is rewarded with a new bitcoin (this is called the block reward) and they also receive the transaction fee. Once the mempool is verified, it means the transactions added to the mempool are also valid. The verified mempool now becomes the next block on the blockchain.
How Proof of Stake work
The Proof of Stake system is very different from the above-described proof of work process but serves the same purpose to validate the transactions entered into the blockchain and to reach consensus.
In the Proof of Stake consensus, there is no complex mathematical problem to solve, so there is no need for mining hardware, like ASICs which are specifically designed to solve these problems with efficient energy consumptions. In the world of the proof of stake consensus, a deterministic way is used to choose the creator of a new block – based on their stake.
Stake means the number of coins the validator (or miner) possess at a given time.
For example, if A coin holder owns 10 coins, and another B coin holder owns 100 coins, then there is 10x more chance for the B coin holder to be chosen as the next block validator who will also receive the transaction fees as a reward for maintaining the blockchain.
Although as mentioned above, Ethereum is about to introduce proof of stake system in 2020, there are a lot of cryptocurrencies which are using already the proof of stake system, like
Dash, Neo, XLM, ALSO and BTT.
It is clear from the above, that while the proof of work system requires a high investment in ASIC miner devices, that is an indirect investment, during the proof of stake protocol, individuals are incentivized to invest directly in the cryptocurrency and stake an ever-growing number of coins in their wealth. The more coins they own, the bigger the chance they will be selected as a validator next time.
Pros and Cons of Staking
Advantages of Staking Coins
There are a lot of advantages of utilizing PoS system and start staking coins.
- There is no need to buy an expensive mining hardware, staking can be run from a wallet where the validator is chosen based on their stake.
- Since there is no expensive mining hardware, there is no depreciation expense the miners need to suffer, as with the technology development, ASIC miners often get inefficient quickly. The value of the stake is only depending on the price of the coin.
- Investors are encouraged to hold coins and invest directly in cryptocurrency driving up the prices of coins due to the scarcity effect.
- PoS consensus mechanism is environmentally friendly as it is saving a lot of energy as opposed to proof of work mining which is using electricity to run the mining equipment.
- The risk of 51% attacks is lower in the PoS system.
Disadvantages of Staking Coins
Besides talking about the benefits of staking coins, it is also important to mention the drawback of the PoS system. As with any mechanism, both sides need to be explored.
- Staking coins means you cannot use or sell these coins, as they are locked up for a certain period of time.
- In the case of falling cryptocurrency prices, staked coins can result in significant losses as there is no way to sell these coins.
- While the potential amount that can be earned through staking coins is possible to be calculated upfront, predicting the future price of cryptocurrencies is challenging. It is possible that the earnings from staking are not covering the losses from price depreciation.
Ethereum’s PoS system
Staking helps with one of the biggest issues of cryptocurrencies: scalability. With the PoW system, there is a constant need to develop, manufacture and run expensive hardware to be on the front line of the mining game. While with the PoS system validators only need to concentrate on owning or staking coins. This is the reason why Ethereum is planning to upgrade to the PoS system with the Ethereum Casper upgrade next year, so it can ensure the scalability of the cryptocurrency.
According to a recent study in the current state of the Ethereum network, validators will need 32 ETH to become a miner on the future PoS system. 32 ETH is currently worth around $6000. In exchange for staking 32 ETH on the Ethereum network as a validator, stakers could earn potentially between 4.6-10.3% annualized return from the transaction fees they will get once they are chosen as a validator for the next block, based on their wealth.
In the current economic situation where fixed income returns are close to zero or even negative, equities are also underperforming these returns represent a significant diversification opportunity in a well-vetted portfolio.
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