The wholesale shift in the fundamental architecture of the Ethereum blockchain will catapult Proof of Stake blockchains to the fore in 2021. All the signs are there.
While Bitcoin will continue to dominate and certainly — in our view — remain the cipher for the cryptocurrency market as a whole, there are other opportunities tied to the rise of this alternate consensus mechanism.
So why all the hype over Proof of Stake? The first stage of ETH 2.0, the Beacon Chain, got up and running on 1 December and the blockchain upgrade has received a lot of support, it’s fair to say.
Let’s briefly consider what is actually changing and why Proof of Stake could rise in the ascendancy.
In Proof of Work — the way that the Bitcoin blockchain is secured — miners compete to verify blocks of transactions by solving cryptographic puzzles of ever-increasing difficulty. It is this difficulty curve which requires more computations per second to be successful, and what has lead to a massive arms race in computing power.
Before the time around 2011, a single home PC was powerful enough to mine Bitcoin. Then came the rise of ASIC chips and specific Bitcoin mining machines.
Now we have entire hydropower plants in China mining Bitcoin, and the Iranian government sanctioning the use of three nuclear power station computers in order to compete to create new Bitcoins and grab a free slice of the cryptocurrency, the supply of which is becoming ever more scarce.
The extent of Bitcoin’s power use has not escaped the attention of nervous cross-governmental bodies and financial regulators. In fact the OECD notes how it favours Proof of Stake, as we covered recently.
There are numerous advantages to this alternative. It’s more energy effective, certainly, than Proof of Work, because there is no need to consume vast amounts of electricity, nor ramp up ever-increasing amounts of computing power to solve cryptographic puzzles.
It’s also thought to encourage longer-term participation in securing the network, because validating nodes must own or put forward a certain amount of the cryptoasset in order to verify blocks.
So Proof of Stake could well overtake Proof of Work blockchains in the long run because of their more economical, scalable and environmentally-friendly nature. Certainly market regulators and policy experts will have these points in their minds when hard laws are finally drafted.
Ethereum’s switch to Proof of Stake is also igniting interest in other blockchain platforms using this mechanism. Tezos (XTZ) , for example.
Tezos is Proof of Stake native: it never transitioned from Proof of Work and hence some describe it as a more effective version of Ethereum. Its applications in the rapidly growing tokenisation of securities are certainly of huge interest. Its use for DeFi projects too, will attract new users and investors. There are legacy issues, however.
The three-year saga with market regulators and early investors over its $232m ICO — which drew in a class-action lawsuit and ended with $25m settlement — still haunts the brand. More broadly, investors tend to look at management first, and the sanctioning of the CEO by FINRA did not help the situation.
Polkadot (DOT) has been on a rocket ride in 2020, leapfogging the likes of EOS into the top 10 coins by market cap. It uses a version of Proof of Stake called Nominated Proof of Stake, grouping and selecting validators according to the level of DOT they have staked.
Instead of investors realising staking rewards into fiat currency, there is a lot of value in re-staking those rewards, generating the kind of compound gains usually reserved for dividend income on equities.
There are downsides, of course. Keeping coins staked — effectively locking them into a smart contract — means they are not available to be traded elsewhere and so this method ties up capital. You can consider the analogue of locking cash into a time-sealed vault, like a bank vault.
Still, Polkadot’s interoperability is a specific benefit: it enables cross-blockchain transfers of any kind of asset, not simply tokens.
Alongside Ethereum, it is certainly one to watch in 2021.