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Where does the money come from? Dollars are printed by the US Mint. For cryptocurrencies, the answer is more complicated. So far, the two most widely used digital tokens, Bitcoin and Ethereum, have only been issued to pay for tasks performed by so-called miners in so-called proof-of-work systems. It is an approach that has drawn increasing criticism due to the large amounts of energy consumed and the pollution produced. Ethereum is moving to a different system, called proof-of-stake, in a process known as a merger. Proponents claim that the approach can reduce Ethereum’s electricity consumption by 99%.

1. What are “proof of” systems used for?

Cryptocurrencies wouldn’t work without blockchain, a new technology that performs the outmoded function of keeping a record of time-ordered transactions. What is different from pen and paper records is that the ledger is shared on computers all over the world. The blockchain must take on another task that is unnecessary in a world of physical money: ensuring that no one can spend a cryptocurrency token more than once while manipulating the digital ledger. Blockchains operate without a central custodian, such as a bank, in charge of the ledger: proof-of-work and proof-of-stake systems rely on group action to create, validate, and save the sequential record of a blockchain.

Today, in the mainnet of Bitcoin and Ethereum, transactions are grouped into “blocks” which are published on a public “chain”, but only after the execution of the “proof of work” command. With Bitcoin’s software, this happens when the system compresses the block’s data into a puzzle that can only be solved through millions of trial-and-error calculations. This work is done by miners who compete to be the first to come up with a solution and are rewarded with free cryptocurrency if other miners agree that it works.

3. What are the disadvantages of proof of work?

When Bitcoin was worth pennies, mining was also cheap. But as the value of the currency rose, something of an arms race took hold, as miners dumped resources in the quest for new coins. Bitcoin’s software responds to increased competition by increasing computational difficulty. The resulting exorbitant electricity consumption has led to calls from environmentally conscious people to avoid bitcoin. The European Union considered banning this practice before deciding that crypto-asset providers should be required to disclose the energy consumption and environmental impact of the assets they choose to list. The proof-of-work system has also led to increasing domination by huge centralized mining farms, a development that has created a new vulnerability for a system designed to be decentralized. In theory, a blockchain could be overwritten by a party that controls the majority of the mining power.

4. What is proof of stake?

The idea behind the proof-of-stake system adopted by Ethereum is that its blockchain can be more easily secured if you give a group of people a carrot-and-stick set of incentives to collaborate. People who have staked or staked 32 Ether (1 Ether traded at around $1,900 in mid-August) will be able to become “validators,” while those with less Ether can become joint validators. Validators are chosen to order transactions in a new block on the Ethereum blockchain. If a block is accepted by a committee whose members are called attesters, the validators receive Ether. But someone who tried to thwart the system could lose the coins staked. Ethereum’s proof-of-stake system is already tested on a blockchain, called Beacon Chain, which is separate from the proof-of-work system; so far, $25 billion worth of Ether has been staked there. The two blockchains are expected to merge in September.

5. What are the advantages of the system?

It is believed that switching to proof-of-stake would reduce Ethereum’s energy consumption, estimated at 45,000 gigawatt hours per year, slightly more than New Zealand’s, by 99.9%. In terms of carbon footprint, it would be essentially like any other Internet operation whose power consumption involves nothing more than operating a network of computers, rather than a business resembling a collection of gigantic digital factories.

6. What are its vulnerabilities?

Proof of stake is less proven than proof of work, which has been under scrutiny for security for more than a decade. Thus, new vulnerabilities could be found. Its proponents believe the risk is worth what would be gained in terms of environmental benefits, as well as involving a wider group of users in the process.

More stories like this are available at bloomberg.com



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