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Close up of Ethereum ETH cryptocurrency on computer circuit

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By Teunis Brosens, Follow-up Platerink Kosonen, Maureen Schuller

An Ambitious Upgrade to the World’s Second Largest Blockchain

After a long period of anticipation, and if the final tests go well, the world’s second blockchain Ethereum will probably go from “proof of work” (POW) to “proof of stake(POS) later this month. This means that transactions on the Ethereum blockchain will no longer be recorded by miners who spend a lot of computing power to prove that they have worked hard to verify transactions. After “the merge,” transactions will be processed by validators, who have staked Ether (in other words, placed collateral in escrow) who can be forfeited if found to have acted in bad faith.

The discussion of the pros and cons of PoS versus PoW is almost as old as Bitcoin, and we cannot represent all the arguments here. What interests us is that this transition to PoS may over time increase the acceptability of Ethereum, and all applications built on it, for policymakers and regulators. This, in turn, could stimulate the desire of traditional financial institutions to develop services based on Ethereum.

Ethereum is not the first blockchain to adopt PoS. But it is generally considered the most important blockchain after Bitcoin, and Ethereum is a key part of the decentralized finance universe. Additionally, Ethereum will not be down for scheduled maintenance over the weekend to upgrade the network. Instead, like ethereum.org describes it, the new PoS engine will be hot swapped in flight. A flight that hosts a variety of applications, tokens and platforms. What could go wrong?

The upgrade stakes are high

Indeed, while the Ethereum community has spent a lot of time testing PoS (the PoS proving ground called “beacon chain” has been running since December 2020), implementing such a fundamental upgrade during that the network continues to operate is ambitious. As anyone who’s ever tried to quickly upgrade their computer’s operating system knows, there are almost always unexpected issues that end up taking much longer than expected. We expect the core Ethereum developers to have sleepless nights glued to their screens during the upgrade.

Another question when upgrading is how Ethereum miners will react. They have invested in dedicated hardware, usually GPUs, which can no longer be used to mine Ethereum after upgrading to PoS. Some miners may decide to continue the PoW-based blockchain, creating a fork. Such duplication of the blockchain with all its tokens creates a variety of problems, for example for exchanges and traders. Fortunately, the crypto community has gained experience in handling these forks over the years.

A successful update would make Ethereum much more palatable…

By describing all these challenges, you may begin to wonder why Ethereum embarked on this project. Besides improved scalability, the main reason is a drastic reduction in electricity consumption. Ethereum.org claims a 99.95% off electricity consumption following the switch to PoS.

An important non-technical consequence of this sharp reduction in electricity requirements is that it may make Ethereum more acceptable to policymakers and regulators. When the European Parliament discussed the new EU regulation on crypto asset markets earlier this year, sustainability was an important topic. Policy makers are uncomfortable with the high power consumption of the PoW consensus mechanism. Admittedly, the advantages and disadvantages of PoW versus PoS are the subject of a fundamental and often heated debate, which has many more nuances than the – admittedly impressive – kWh figures suggest. We cannot do justice to this debate in this short article. It is clear however that the move to PoS removes power consumption as an issue for regulators. This, in turn, removes a stumbling block for traditional financial institutions and other businesses to offer Ethereum-based services, although other hurdles may remain.

…though proof-of-stake is not the answer to life, the universe, and everything

So what’s not to like about outlets? Besides migration risks, PoS has its own challenges. For example, its code is much more complex than PoW. This can create new vulnerabilities. Hackers will certainly explore the new infrastructure looking for loopholes. Another problem is that PoS creates a new form of inequality. With PoW, there used to be a sense that anyone could join in and start mining. With PoS, on the other hand, the “rich” can stake a lot of Ethereum and reap most of the validation rewards, further increasing their wealth. However, the reality is more nuanced. PoS staking pools provide opportunities for those with less Ether to spare. And with PoW, on the other hand, the days when an old laptop was enough for mining are long gone.

Some people worry about increased possibilities of censorship by PoS validators. Yet, in principle, PoW miners could also apply censorship. Nor is it clear that PoS will lead to a more concentrated validator landscape than PoW, where miners have long cooperated in mining pools. In the end, it is less the technology that makes the difference but rather the attitude – and the regulations – of those who use it. More generally, there is a trade-off between resisting censorship and enforcing anti-money laundering policies and sanctions that are necessary to make cryptocurrency acceptable to regulators. Ultimately, compromises have to be found here.

Ethereum’s upcoming migration from PoW to PoS might be the biggest event expected in cryptoland this year. The migration itself and its aftermath carry risks and will be closely watched within the crypto community. A successful migration would be a compliment to the ability of the Ethereum community to handle large events. It would also remove a significant barrier to the acceptability of Ethereum by regulators and therefore to the development of Ethereum-based services by traditional financial institutions.

Content Disclaimer

This publication has been prepared by ING for information purposes only, regardless of the means, financial situation or investment objectives of any particular user. The information does not constitute an investment recommendation, nor investment, legal or tax advice, nor an offer or solicitation to buy or sell a financial instrument. Read more.

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Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.



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