Reckless – Chapter 18: Proof of Stake | bitmex blog
Chapter 18 of the book Reckless: The Story of Cryptocurrency Interest Rates is published below. The complete book is available on Amazon. The book was written before the bankruptcy of FTX and therefore does not include coverage of this event. However, the book provides useful commentary leading up to the failure of FTX, which ultimately provides context for the disaster.
In early 2011, seventeen-year-old Vitalik Buterin discovered bitcoin. Skeptical at first, he began researching it as the coin rose in price, before covering the topic as a writer for Bitcoin Magazine. By autumn 2013 he was already considering something called “cryptocurrency 2.0”. While anyone could make financial payments with bitcoin, the idea was that the blockchain could be more flexible and support a greater number of features and applications. These ideas included distributed exchanges, domain registries, messaging applications, gaming, and more layers of tokens. Much of this was possible to do on bitcoin, although some in the bitcoin community were inclined to focus solely on financial payments. Furthermore, adding these layers of features to bitcoin was technically very challenging, with normal bitcoin nodes not implementing the rules for these applications or each new type of application requiring a specific upgrade to the bitcoin network rules. It was not practical to build these systems on top of bitcoin. The idea of Cryptocurrency 2.0, later named Ethereum, was that it would support basically any type of application, enabling all kinds of innovative ideas that Vitalik could yet think of. Wasn’t either.
Ethereum held a crowd sale in 2014, raising US$18 million of bitcoin and eventually the new blockchain launched in 2015. Since its inception, Ethereum has always been the opposite of its progenitor system, Bitcoin. However, almost every individual parameter and mechanism in Bitcoin was tweaked or improved for Ethereum. One thing Ethereum supporters made clear during the crowdsale is that they intend to eventually use a different consensus system to Bitcoin. While Bitcoin uses Proof of Work to select valid blockchains to follow, Ethereum was about to move to something called Proof of Stake. Initially, however, Ethereum was to use proof-of-work until researchers could figure out how to build a robust proof-of-stake system.
Proof of Work is a mechanism by which computers perform calculations called hash functions using the data inside a block as input. These hash functions need to be conducted many millions of times, each time randomly changing the inputs so that, incidentally, the output of this hash function is of little substantial value. The more hash functions you do, the more blocks you can generate. These hashes require computational power to operate, which in turn requires electrical energy, a real world resource. Thus it anchors bitcoin to the real world, the world of energy and industry. The valid chain with the most energy spent on it follows a node.
Proof of Stake, on the other hand, occurs when nodes choose the blockchain with the most accumulated stake. For this to work, stakers set aside coins in a pool and then stake, vote, or certify a particular block and the blockchain that follows is the one with the most votes. The chain still has hash functions, which prove the order of blocks by referencing previous blocks, although there is no significant difficulty goal. In a pure proof of stake system the output of the hash can have any value, it doesn’t need to be particularly short. While Proof of Stake technology was not ready in 2014, Vitalik decided to adopt it after further research was done.
The proof-of-stake system had several major technical flaws, the most important of which is called the “nothing at stake” problem. The idea is that it is possible to maliciously use the same stake twice on conflicting competing chains. It was possible to punish the bettors for doing so, but it was perfectly legal to occasionally change their mind and bet on two chains, after all changing one’s mind was to follow the majority of how consent should be obtained. . Ethereum struggled with this problem for years. Eventually it was discovered that organizing the stakeholders into committees helped narrow down the problem. Instead of giving all stakers the opportunity to vote on each block, stakers were organized into groups and only a small subset of stakers were allowed to vote on each occasion. Thus, individual stakers no longer need to change their mind, because if they have made the wrong decision, a different set of stakers will be able to make the decision. By the time the stacker gets a chance to vote again, the “mistake” will already be part of history and fixed by others. There are still other outstanding technical issues and uncertainties regarding Proof of Stake, however, eight years after Ethereum held a crowdsale in September 2022, Ethereum will finally switch to Proof of Stake.
One of the major reasons for switching to Proof of Stake is to avoid environmental externalities from Proof of Work. The Proof of Stake system has no anchor to the real world, it operates entirely within itself. In Proof of Work systems, a significant portion of the rewards are given externally to semiconductor foundries and power producers, whereas in Proof of Stake, the rewards are kept within the system. Therefore, while Proof of Work uses real world resources to secure the chain, Proof of Stake is said to be more efficient.
Some have pushed back on the idea, arguing that the argument, claiming Proof of Stake is more efficient, is economically flawed. The argument is that by betting coins, this capital is not being used for other productive purposes. For example, perhaps one is delaying consumption or forgoing investment in productive assets. Hence this may be an inefficiency of the Proof of Stake system. Therefore it can be extremely difficult to compare the level of efficiency between a Proof of Work system and a Proof of Stake system. The difference is that Proof of Stake obscures the waste, while Proof of Work does not. Perhaps, the first person to criticize Proof of Stake in this way is Paul Ztork, who in 2015.
A reasonable analogy may be made here with an argument made by the French economist Frederic Bastiat in his 1850 essay “The Parable of the Broken Window”. In Bastiat’s essay a little boy breaks a pane of glass and the economic consequences are discussed. The same Bastiat who had argued in favor of the legitimacy of interest a year earlier in a debate with Proudhon.
Suppose the damage costs six francs to repair, and you say that the accident brings six francs to the glazier’s trade—that it encourages that trade to the amount of six francs—I admit it; I have not a word to say against it; You make a fair argument. The glazier comes in, does his job, receives his six francs, rubs his hands, and blesses the carefree child in his heart. All this is visible.
But, on the other hand, if you come to the conclusion, as is often the case, that breaking windows is a good thing, that it spreads money, and that that will result in encouragement to industry in general about it, You would force me to call out, “Stop there! Your theory is limited to what is seen; What is not visible, no one keeps account of it.
It is not seen that as our shopkeeper has spent six francs on one thing, he cannot spend them on another. It does not appear that if he had not had a window to change into, he would probably have changed his old shoes, or added another book to his library. In short, he must have employed his six francs in some way which this accident has prevented.
Perhaps it is easier to see the environmental cost of proof-of-work mining, while the delayed consumption or capital investment associated with large investment flows into Ethereum, attracted by staking yields, would be overlooked. The logic here is somewhat controversial. It seems almost impossible that we will find universal agreement on these explicit costs of proof of stake, just as we cannot agree on whether central banks keep rates too low for too long, Due to which the cycle of economic boom has been broken. Can we really get all these economic benefits for free? Be it an invincible distributed consensus system or strong sustainable economic growth and continuous asset price appreciation, or is there always some unseen hidden cost that eventually emerges as a crisis?
Some proponents of proof-of-stake systems have argued that Paul Ztork’s argument is flawed, as capital can only be locked up for a short period of time. In Ethereum, at the time of writing, funds are virtually locked in staking and cannot be withdrawn until the network is upgraded. However, once it is upgraded, it should be able to withdraw funds within perhaps a few months, depending on a number of factors such as the length of the exit queue. Other alternative proof-of-stake systems allow for even faster withdrawals in a matter of weeks. Therefore, proponents of these proof-of-stake systems argue, nothing is locked and there are no externalities. Paul Ztork has a retort to this as well, in any competitive system, he insists, marginal cost will tend towards marginal revenue. In other words, if there are prizes to be wagered, people will continue to spend more and more costs to earn those prizes until the profit margin is low, regardless of what those costs are. Anyway, even if the funds are not locked, they are not used to invest in productive projects until they are deployed in the staking protocol.
Ethereum’s adoption of Proof of Stake, or “merge” as it is called, is a significant development for the cryptocurrency space. One possible result is that it could attract many new yield-hungry investors. The higher yield could make Ethereum a more attractive asset to hold, which could drive the price higher. This can also be said to make Ethereum even more speculative. Even though merges are often cited as positive for Ethereum price, as coin supply growth may be more constrained than proof of work, the positive impact of yield on price may be underestimated. The switch to proof of stake is also believed to boost Ethereum’s appeal to environmental, social, and governance (ESG)-minded investors, who are reluctant to invest in bitcoin due to the perceived high carbon footprint of proof of work. may be concerned about. While this environmental argument may attract an influx of investors into Ethereum, it also may not have a significant impact in terms of yield.
Ethereum’s native yield could create a huge influx of money into Ethereum from outside the cryptocurrency world. Of course, there are other proof of stake coins, though outside investors are probably rightly skeptical of these other high yields, wondering where the yields come from. Ethereum has far more legitimacy than these other coins and has a more powerful marketing infrastructure and more real users. Ethereum developers are smarter than developers of other proof-of-stake coins and have therefore designed a robust system, which is more flexible. The combination of these factors could send Ethereum price to stratospheric levels in some future cycles.