In July 2022, Ethereum’s price surged by more than 40 percent following an announcement that the network would shift from proof of work (PoW) to proof of stake (PoS).
Significant price fluctuations are not unheard of in the world of cryptocurrencies. July’s price surge, however, illustrates how important the difference between PoW and PoS is.
The Merge, as Ethereum’s shift from PoW to PoS is called, has since been completed. According to the Ethereum Foundation, any transaction now consumes ~99.95 percent less energy than previously.
For people who are worried about the value of their coins, The Merge might not mean very much apart from July’s price surge. The price of Ethereum, in fact, drifted downwards in the days after it was completed. Although the difference between PoW and PoS might not be noticeable to the casual investor who has their eyes on price fluctuations, it has important consequences for the technology that gives rise to the coins.
Proof of Stake Versus Proof of Work
- Proof of stake is a consensus protocol for verifying cryptocurrency that doesn’t require energy-intensive cryptographic problems. Instead, those who stake the most coins to the network get rewarded with more cryptocurrency. PoS also makes it easier for individuals to earn money.
- Proof of work is a consensus protocol for verifying cryptocurrency that relies on mining to validate transactions. Mining means that computers that are connected to the network race to solve complicated cryptographic puzzles, which is an energy-itensive process.
Why Do Cryptocurrencies Need Proof?
The U.S. dollar, the Chinese yuan and the European euro all have one thing in common: They’re centralized currencies. They’re issued by a central bank and distributed to the wider public through branch banks.
Technically speaking, no dollar is worth anything. The value of a dollar is determined not by whether you can eat it, drink it, or wear it, but by what you can get in exchange for it. For example, you might be able to buy a small snack for one dollar. One dollar is therefore worth one snack, two dollars are worth two snacks, and so on.
Cryptocurrencies are similar in practice. Back in 2010, a Floridian programmer named Laszlo Hanyecz bought a couple of pizzas for 10,000 Bitcoin. At the time, that’s what Bitcoin was worth. Today, you could buy many more pizzas with this money. 10,000 Bitcoin would roughly equal 200 million dollars at the time of writing this article! The point is, the value of Bitcoin is not determined by the technology itself; it is determined by what you get in exchange for it.
The fundamental difference between Bitcoin or Ethereum and the U.S. dollar is that there is no central bank that issues the former two. Cryptocurrencies are decentralized; that is, no state or other institution is in charge of printing and regulating the money.
There’s just one big problem with this approach: How do we prevent fraudsters from abusing decentralized systems?
As an example, let’s assume that you have 100 Bitcoin. You have seen a nice house in Florida that you’d like to purchase with this money. The house is worth around $2 million dollars, equivalent to 100 Bitcoin. You’re happy and buy the house.
A few months later, you see that the neighboring house is on sale for $2 million. This house is even more attractive than your new one. You don’t want to give up your own house, so you just take the same 100 Bitcoin and buy the neighboring house as well. After all, no bank is watching you!
This so-called double spend problem would destroy all confidence in a currency. If you can buy things worth 200 Bitcoin by spending the same 100 Bitcoin twice, then you might as well buy those things by spending one Bitcoin 200 times. In other words, you would be able to buy anything with tiny amounts of money! Everyone else would do the same, of course, and before long you’d have endless quarrels about what belongs to whom. In the end, people would conclude that the currency isn’t worth anything because it results in fights. The trust has eroded.
With state-issued currencies, the double spend problem doesn’t arise much. States don’t just hand out money; they also have police who can arrest you if you commit fraud.
In decentralized cryptocurrency systems like Bitcoin or Ethereum, however, there are no police. There is no central authority to ensure justice. To avoid the double spend problem, then, one needs something else. A sort of proof that a transaction is valid and that no coin is being spent twice.
In crypto-speak, this kind of proof is generally called a consensus protocol.
What Is Proof of Work?
The oldest of all consensus protocols, proof of work, relies on mining to validate transactions. A term that has somewhat entered the colloquial vocabulary, mining means that computers that are connected to the network race to solve complicated cryptographic puzzles. These are generally hard to solve, so they require a lot of work, or electricity, to complete.
When a computer has successfully completed a puzzle, it sends the result, called a hash, to all other computers. These other computers can verify that the hash is correct.
Generally speaking, cryptographic puzzles that are used for PoW are difficult to solve but easy to verify. On the Bitcoin network, which uses PoW, these puzzles are solved every 10 minutes or so; this means that every 10 minutes all new transactions are added to a block on the blockchain, encrypted, and hashed. Everyone can check and verify these transactions; therefore, if you wanted to spend the same Bitcoin twice, validators would notice and the community would kick you out.
Through PoW, banks aren’t necessary. Miners keep mining and verifying the transactions because, when they do so, they get some coins as a reward. Every transaction is public, so if the community spots a bad actor, they can just ban them.
The downside of this procedure is that it takes a lot of work, or energy. A single transaction on the Bitcoin network emits more carbon than a transatlantic flight from London to New York!
What Is Proof of Stake?
The key difference between proof of stake and proof of work is that no energy-intensive cryptographic problems are necessary in the former. With PoW, those who work the hardest get rewarded the most with new coins. With PoS, those who stake the most coins to the network get rewarded. Thus, those who work hardest and fastest aren’t rewarded with precious coins, but rather those who have the most coins already. The more coins you have, the more likely it is that you’ll earn a reward for validating the next transaction. Having coins on a network is called staking.
To keep the network secure, multiple validators are needed for each transaction. This is, of course, much more energy efficient because the work is no longer necessary. In addition, transactions might go through quicker; for Ethereum, this is not the case just yet though.
PoS also makes it easier for individuals to earn money. Since The Merge, anyone can buy some Ethereum and earn more of it over time as transactions get validated. Bitcoin, on the other hand, requires massive server farms and maintenance costs that few can afford.
One common criticism of PoS is that the rich get richer while the poor get poorer. Those who already have a lot of Ethereum will get more of it; everyone else will miss out. There are other consensus mechanisms that circumvent this problem or address other issues. At the time of the writing this article, however, these mechanisms are not tested on a large network like Bitcoin or Ethereum yet and are therefore riskier choices.
Proof of Work Versus Proof of Stake
Proof of Work and Proof of Stake are both consensus mechanisms that prevent fraud in decentralized systems where no third party like a state or bank has any oversight. Some cryptocurrencies are moving from PoW to PoS to reduce their carbon footprint.
Other consensus protocols exist but are less widespread than PoW and PoS. The choice of protocol does not impact people who invest in crypto but do not use it for purchases of items or other transactions much unless they wish to stake their coins or otherwise use a consensus protocol to their advantage.
