Ethereum 2.0: Switching to Proof-of-Stake (PoS)
Proof-of-Work vs. Proof-of-Stake
Ethereum is the second-largest cryptocurrency by market capitalization – behind Bitcoin – and currently runs on a proof-of-work consensus protocol like Bitcoin. This energy-intensive means of validation allows the decentralized Ethereum network to come together and authenticate complex mathematical transactions that are then added as blocks to the Ethereum blockchain. Miners compete against each other to solve these mathematical problems to create a new block. Miners who are successful in creating a new block are given rewards via the creation of new Ethereum (ETH) coins. Due to the competitive process of trying to be the first miner to solve a transaction and get the new ETH coins, huge amounts of computational power are used to be first across the line. The Ethereum Foundation believes that to maintain security and decentralization of the Ethereum network, proof-of-work uses the energy equivalent of a medium-sized country like Austria on an annual basis.
Proof-of-stake works towards the same goal as proof-of-work – a secure, decentralized network – but by a different process. Instead of miners competing to create new blocks, validators are instead chosen to solve these puzzles. Validators stake their own Ethereum (ETH) coins to enable them to compete to solve new puzzles and are chosen at random by an algorithm. Ethereum validators need 32 ETH, or to be part of a pool that has 32 ETH, to become part of the validation process and collect their newly minted ETH. Validators can lose some, or all of their stake, if they fail to validate transactions or if they collude in acts of bad behavior which may damage the blockchain. Due to the random nature of choosing who validates a block, the computational power needed to run the PoS consensus is a fraction of a comparable, competitive PoW consensus.
So When Will the Upgrade to Ethereum 2.0 Go Live?
According to the Ethereum Foundation, the move to PoS was always a ‘key part in the community’s strategy to scale Ethereum via upgrades. However, getting PoS right is a big technical challenge and not as straightforward as using PoW to reach consensus across the network’. So far the Beacon Chain upgrade (allowed staking) has gone live, the Merge (PoW to PoS) is estimated to go through later this year, while Shard Chains (expand Ethereum’s transactions and data capacity) will be rolled out in 2023.
Why Does this Consensus Change Matter to Traders?
One of the main complaints about Bitcoin, and Ethereum, is that the PoW model uses huge amounts of electricity to validate transactions. Various models have predicted that Ethereum consumes more electricity than Italy, Saudi Arabia, or Mexico use in a year, while another estimates that a single Ethereum transaction could power a US household for 6 days. This energy consumption has been one of the main targets for regulators over the last few years who are trying to tackle both climate and energy crises. A leaner, greener Ethereum would be better positioned for the future, and any upcoming regulation, with PoS said to use 99% less energy than the current PoW model. In addition, the current Ethereum model is expensive to use with its gas fees – a fee to perform a function on the Ethereum blockchain - a major concern to users. This relays down to traders who will look at other chains that can perform the same functions at a cheaper cost. One of the major advantages of the new PoS Ethereum model is transaction speed. Currently, Ethereum transactions are slow – thought to be around 30 per second – while the new PoS model is expected to be eventually able to handle up to 100,000 transactions per second, mainly due to Shard chains. Cheaper fees and increased transaction speed make the PoS Ethereum model much more attractive for a trader.
Ethereum vs. Bitcoin Performance
Ethereum has outperformed Bitcoin over the last two years but still lags its peer in market capitalization terms. This outperformance is in part due to Ethereum’s roadmap towards changing to Proof-of-Stake and the fact that it allows a wide range of other companies to develop on its blockchain. With the full Ethereum upgrade expected in 2023, this outperformance may continue in the months ahead as longer-term traders positioned themselves.
The weekly Ethereum/Bitcoin spread chart shows Ethereum’s multi-month outperformance and a bullish technical set-up, a cup and handle pattern, which can be clearly seen. This technical set-up suggests that Ethereum will outperform Bitcoin, pushing the ETH/BTC spread back to multi-year high levels.
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