Proof-of-Work, Proof-of-Stake & The ETH Merge

DateOctober 18, 2022
Reading Time9 min
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Ollie Armitage
Research, Writer, and Community
What does it all mean?
Intro

The world of crypto has been in a frenzy about the recently successful Ethereum merge.

And rightly so, this is a huge milestone for Ethereum. "The merge" is the most significant upgrade to the Ethereum network since its launch in 2015.

The merge allows the Ethereum blockchain to begin rolling out its roadmap.

A roadmap that will see Ethereum scale to thousands of transactions per second with a much smaller carbon footprint.

Understanding the technicalities of the merge can be quite confusing so that's why we decided to break it down for you!

Expect to learn:

  • What a consensus mechanism is

  • Why a blockchain needs a consensus mechanism 

  • What was "merging" during "the merge"

  • What makes Proof-of-Work (PoW) and Proof-of-Stake (PoS) different 

  • Why Ethereum has decided to change to Proof-of-Stake

TL;DR
TL;DR

TL;DR

  • A consensus mechanism allows distributed computers to work together as one and stay secure. 

  • A blockchain needs a consensus mechanism to determine which transactions are valid and which are not.

  • The original execution layer of Ethereum  merged with the Proof-of-Stake Ethereum consensus layer and the two elements became one blockchain.

  • Proof-of-Work uses 'miners' that expend energy to verify transactions on a blockchain. If they misbehave, they don't get the mining rewards and have worked for nothing.

  • Proof-of-Stake randomly selects 'validators' with staked tokens to verify transactions on a blockchain. If they misbehave, some or all of their "staked" tokens are taken away from them.

  • By moving to Proof-of-Stake Ethereum will use less "real world" resources and be able to scale better.

Consensus mechanism?

What is a consensus mechanism?

A consensus mechanism is a way for networks of computers, like the ones that are used to verify a blockchain, to work together, reach an agreement (or consensus) and stay secure!

A consensus mechanism is a crucial part of any decentralized blockchain like Bitcoin or Ethereum.

Proof-of-Work and Proof-of-Stake are two of the most popular consensus mechanisms in blockchain.

If Ethereum is a house, then a consensus mechanism is its foundation. By switching from Proof-of-Work to Proof-of-Stake Ethereum has essentially upgraded its foundations. Now it just needs to build.

The new Proof-of-Stake foundations will allow Ethereum to construct a skyscraper!

Why have one?

Why does a blockchain need a consensus mechanism?

On its own, a blockchain has no way of agreeing on the correct state of the "ledger", the big book within which all transactions are recorded. This is because it only provides a flexible and secure way of adding transaction data. The crucial ordering of that data is done by the consensus mechanism.

Without a consensus mechanism, the computers maintaining the blockchain cannot agree on the same set of transactions and will eventually split. This is known as a 'fork'.

When Ethereum switched its consensus mechanism to Proof-of-Stake there was a fork. This is because some Ethereum miners did not agree with the change to Proof-of-Stake and wanted to maintain Proof-of-Work as a consensus mechanism.

As a result, there is now another "Ethereum" chain, called EthereumPoW.

The main chain, now using Proof-of-Stake, remained as Ethereum (ETH).

Both Proof-of-Work and Proof-of-Stake use economic incentives to make sure that all parties work together towards the same goal. Just like your boss does with your Christmas bonus!

The difference being that your boss can't also take away part of your December salary if you misbehave. The Proof-of-Stake blockchains can.

The 'Merge'

Why is the change from Proof-of-Work to Proof-of-Stake called "the merge"? What merged?

It's called "the merge" because the original Ethereum blockchain merged with a separate Proof-of-Stake consensus layer called the Beacon Chain. 

Proof-of-Work chain and the Beacon chain merging together to become Proof-of-Stake

Two blockchains quite literally merged to become one, hence the name "the merge".

A black panda labelled ETH1 and a white panda labelled ETH2 merging together to become a panda named Ethereum.

Image from hsiaowei.eth

This panda meme shows the original Proof-of-Work Ethereum blockchain (Eth1), merging with the Proof-of-Stake Beacon Chain (Eth2) to form one Ethereum blockchain.

The Beacon Chain had been running since December 1st 2020 and was in testnet until the merge took place on September 15th 2022.

The merging of the two blockchains was originally called "Caspar". However it was rebranded to "ETH2" and eventually settled on being named "the merge".

Key differences

What are some of the differences between Proof-of-Work and Proof-of-Stake?

There are a few key differences between the Proof-of-Work and Proof-of-Stake consensus mechanisms.

Let's break those down:

1. Number of miners/validators

In Proof-of-Work, every single computer (known as a node or 'miner') competes with one another to solve a cryptographic puzzle. The first miner that solves the puzzle receives the block reward.

In Proof-of-Stake, a few computers (known as 'validators' or "validating nodes") are randomly selected to validate the transactions of each block. If a validator verifies transactions incorrectly it will have its stake in the network cut in a process called 'slashing'.

A validator approving incorrect transactions will lose more from slashing than they will gain in block rewards. So validators are economically incentivised to do a good job when they are selected!

2. Energy expenditure

Proof-of-Work consumes a very large amount of energy running computing equipment as all miners compete for every block reward on the blockchain.

Proof-of-Stake consumes far less energy because you don't need specialized hardware - you can do it from a €35 raspberry pie!

3. Barriers to entry

If a Proof-of-Work blockchain is growing in popularity it becomes harder for new participants or 'miners' to enter and remain profitable because they need computers that can do more computations than your average laptop can. This is because the computational power, known as hash-rate, increases alongside the demand for block rewards.

Higher energy demands and hardware requirements result in higher costs for miners..

As a Proof-of-Stake blockchain grows in popularity, the amount of hardware required to run a 'validator' remains the same. 

What might increase is the price of the assets you need to acquire to run a "full" validating node. Today on Ethereum that's 32 ETH. So the cost of admission is different if ETH is worth €1'000 or €10'000.

There are however "liquid staking derivatives" which allow you to start with less than 1ETH. This allows new participants to enter at low costs and should lead to greater decentralization of the network over time as more validators join the network.

4. Economies of scale

It is cheaper per unit to buy hardware in large quantities, this reduces the operational costs of larger miners and gives them an advantage over smaller miners with less resources.

Average cost per item goes down as number of items goes up.

Image from napkinfinance

A Proof-of-Work miner benefits from economies of scale.

With electricity as one of the other main input costs, miners who gain access to cheap electricity can also scale faster than the competition.

In Proof-of-Stake you benefit from having a larger stake in the network because you increase your chances of being selected as a validator.

However, in contrast to Proof-of-Work, Proof-of-Stake does not allow for economies of scale because it does not get meaningfully cheaper per unit if you stake in large quantities.

Chart showing X and Y have a correlation of 1.

Image from statlect

Proof-of-Stake has a linear correlation of 1 and does not benefit from economies of scale.

The cost of electricity is almost a non factor in the cost of running an Ethereum 'validator'. It probably costs around €100 per year to run a laptop 24/7 in Europe. But you can currently expect 1.6 ETH in rewards per year if you stake 32 ETH.

A single computer can run multiple 32ETH 'validators' but the main cost in the exercise remains the 32ETH, not the laptop or energy.

Why did Ethereum decide to change from Proof-of-Work to Proof-of-Stake?

Ethereum co-founder Vitalik Buterin has long preferred the Proof-of-Stake consensus mechanism to Proof-of-Work for these reasons.

1. There is much less ongoing resource consumption.

Most of you will be aware that Bitcoin uses a huge amount of energy but many aren't aware that the hardware needed to run a miner on a Proof-of-Work blockchain like Bitcoin only lasts approximately two years before it becomes outdated.

The result?

Lots of resources are spent on updating this equipment and much of the outdated equipment goes to land-fill sites.

The electricity consumption of Proof-of-Work Ethereum is exponentially higher than that of Proof-of-Stake Ethereum.

Eiffel tower next to a LEGO figurine

Image from Jack Deifenbach

This chart visualizes the difference in energy consumption between Proof-of-Work Ethereum (Eiffel tower) and Proof-of-Stake Ethereum (A LEGO figurine).

It's estimated that the amount of electricity used to run the Ethereum blockchain was reduced by 99.9% with the switch to Proof-of-Stake.

The merge was one of the largest decarbonization events in history, with global energy consumption being reduced by 0.2%!

2. It takes resources away from those who need them

We are in a global energy crisis, and although Bitcoin is not to blame for this, it does still use as much energy as a small country.

Earlier this year, Bitcoin mining farms in Kazakhstan hit headlines as local citizens faced blackouts, causing civil unrest. This was largely due to the power consumption of the Bitcoin mining farms located there.

You can run a Proof-of-Stake validator on a regular laptop, removing the need for mining farms.

While there are arguments that Bitcoin should remain Proof-of-Work and that the electricity expenditure is worth it, the same case cannot be made for all blockchains and it certainly couldn't be made for Ethereum.

3. Proof-of-Stake validators require less network fees

As Proof-of-Stake is more efficient, and cheaper to run, less tokens need to be paid out by the blockchain to the validators running the blockchain. This means there is less inflation of the token supply.

Existing token owners don't get diluted by paying for security so, as an economist will tell you, the price should remain stable if demand remains stable.

4. It will allow Ethereum to scale

By merging to Proof-of-Stake, Ethereum developers have completed the change in consensus mechanism and can turn their attention to increasing the scalability of the network.

The first notable upgrade in scalability is planned in 2023 with sharding (we'll tell you more about that in another article).

Final thoughts

Some final thoughts

It is not an overstatement to call "The Merge" one of the most important events in crypto history: it's completing a key part of the original Ethereum vision, and it's radically changing the token-economics of ETH as an asset.

The merge has been described as like changing the engine of a plane mid-flight. Or, to re-take our "house foundations'' metaphor, switching the foundations from under the house.

Moving from Proof-of-Work to Proof-of-Stake is an incredible engineering feat on its own, let alone when you are doing it for a network that manages over €100 billion in cryptocurrency and countless other digital assets. The margin for error was almost non-existent.

It's a good thing it went smoothly!

Four weeks on from 'The Merge' and there has been no recognisable or publicized faults to the operation of the Ethereum blockchain.

I think we can consider that a success, what do you think?

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Ollie Armitage
Research, Writer, and Community

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