#36 The simplest possible explanation about Proof of Stake
We could not NOT write about The Merge, so we went for the educational side of things. Also, Carbono's paper on scalability, Starbucks goes Web 3 and Compound goes CeFi.
The only things you need to understand about Proof of Stake
There was no way we could write about anything that wasn’t The Merge, although we would’ve loved that. The best news regarding this great event is that, except for some regulatory question marks and the hesitant start of the new asset, EthPOW, it has mainly been dull and uneventful, so congrats to all those involved.
We thought we might as well take a step back and go for something that can stand the test of time and serve as a common ground of understanding for all. This is, hopefully, the simplest explanation you’ll read about Proof of Stake so that when you read about all the intricacies and implications, you’ll understand where they come from.
We’ll start with a basic, illustrated, ELI-5 recollection of how a blockchain works and what a consensus mechanism is. Then we’ll move on to the most straightforward, briefest reminder of why The Merge is an excellent contribution to the future of Ethereum. If you understand this, you’ll already know a lot.
This is a blockchain. You’ll notice it’s a concatenation of blocks
Below there’s a block: each block contains information. The most typical piece of information is transaction info (Alice sends 1ETH to Bob), but over time that information has gotten more complicated through smart contracts (Alice interacts with MakerDAO’s smart contracts to receive a loan in DAI in exchange for her USDC within a set of conditions)
Blockchain information is distributed among thousands of computers worldwide that work cooperatively. This guarantees that messing with block information (for example, forging transactions to make money) is tricky because you’d have to hack into thousands of computers worldwide to change the data.
Keeping a database such as this well updated and coordinated is easy as long as a central authority decides what gets included and what doesn’t in the blockchain. Also, the central authority pays the bills. But the whole point of blockchain technology is to avoid central points of failure. Blockchain technology creates a new layer of financial freedom precisely because it steers clear away from control coming from financial institutions and public administrations.
What happens when there’s no such central authority? Instead, it is a piece of software what determines the set of rules that will decide what operations are valid and creates incentive mechanisms to invite people to become part of the network.
Enter consensus mechanisms.
Here’s how a blockchain works. It’s elementary, and on a fundamental level, it doesn’t change much, whether it is a Proof of Work or Proof of Stake blockchain.
All operations (from a simple transaction to a complex procedure with a smart contract) go through the same process:
They enter the mempool: a waiting list for all operations
They are added to a block, together with many other transactions from the mempool. At this point, the block is just a suggestion that needs to be approved by the community.
The block gets validated by the community (”miners” in Proof of Work or “validators” in Proof of Stake). Once that happens, the protocol releases a monetary reward from newly minted tokens.
The block is finally added to the blockchain for posterity
Steps 2 and 3 are where consensus happens. The part where “someone” decides what gets added to the new block, the network verifies that everything is ok, and the protocol pays its bills in new coins. The place where the difference between Proof of Work and Proof of Stake consensus mechanisms lies.
In Proof of Work, all miners access the mempool, compose their blocks, and then compete with each other to be the first to solve a mathematical puzzle. Solving that puzzle takes a lot of computational power, which requires a significant investment in hardware and energy (this is why PoW blockchains consume a lot of energy). The miner who solves the puzzle first shows the whole network that they’ve solved it and adds the block to the blockchain. The “winning” miner gets a reward from newly minted native tokens, and everyone moves on to the next race.
Proof of Stake mining is called validation because the process is more of a cooperative game, with some carrots and sticks. Not all validators create blocks and then compete: in PoS, only one validator gets assigned the task or bundling operations in a block and proposes it to the rest. To be eligible for the job, validators need to run a node and lock 32ETH in the network to prove their commitment. The validator is chosen (almost) randomly, and the network reviews its job to check if everything’s ok.
The chosen validator gets freshly minted coins if they finish the task successfully. All other validators who checked the proponent’s work, in a task called attestation, also get a smaller reward. These are PoS’ carrots. But Proof of Stake also has “sticks” embedded in the protocol: the process of attestation might reveal problems. For example, the validating node might try to cheat -unlikely- or they might be lazy or not ready for the task -more probable-. If that is the case, slashing happens: slashing is when the protocol penalizes validators by taking away part of the 32 staked ETH and/or reducing the likelihood of a validator getting the job of minting a block (and therefore accessing block minting rewards).
Hopefully, by now you have a better understanding of the underpinnings of Proof of Stake. Now the three main consequences of PoS you’ve been reading about all month should be easier to understand:
Ethereum after The Merge is much more environmentally friendly. It consumes 99,5% less energy.
Ethereum after The Merge is potentially more decentralized because the requirements for running a node are lower. 32ETH might sound like a lot, but you should see the hardware and electricity costs of running a PoW node. Plus, the industry already offers many options for pooling those 32ETH and sharing the rewards.
Ethereum, after The Merge, creates a new monetary policy. With validators spending much less capital in the process than miners, rewards can also be lower. Less ETH is minted in every block.
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⬡ Six Angles
We select six topics to illustrate the very different angles crypto can be approached from. We could choose dozens, but six is the atomic number of carbon… and otherwise we’d be writing for ages.
1. Scalability | Ethereum’s next challenge
With 15 to 45 transactions per second, and while serving a growing ecosystem of decentralized applications, Ethereum is very far from becoming the global supercomputer it aims to be. Ethereum’s transactions are slow, expensive, or both- a significant obstacle to massive adoption.
A problem of this size brings an equally significant opportunity for improvement. The race towards scalability is currently taking different technical routes that fall into three categories: on-chain improvements through sharding and off-chain optimistic and zero-knowledge rollups. All with innumerable challenges and nuances, that make it hard to predict who will be the winner(s).
We’ve written a deep dive white paper explaining either option's technical and practical differences, some observations on what factors might make one or the other succeed, and where we find some opportunities for investors.
📄 DOWNLOAD PAPER: The State of Ethereum Scalability 📄
2. CBDCs | Cryptocurrencies zero zero
Regulators on both sides of the Atlantic are progressing towards developing a CBDC: a Central Bank Digital Currency. In other words, a cryptocurrency zero zero.
CBDCs are governments’ attempt to embrace the features of cryptocurrencies they are comfortable with, avoiding those they don’t like. They’re particularly fond of the speedy, streamlined, borderless transactions. And sadly, they are probably eager to achieve full transparency and accountability, but without the burden of privacy and pseudonymity.
The Biden administration is bringing the U.S. a step closer to the creation of a digital dollar. At the same time, “(t)he European Central Bank has revealed its selected partners to collaborate on the digital euro prototype.” A list of partners that includes Amazon, to name just one.
Decentralization is one of the main contributions of blockchain technology and cryptocurrencies. Without decentralization, we are just moving towards a new peak in the age of surveillance and a drastic increase in the powers of politicians. A statement that sounds more or less like a threat, depending on where you’re sitting while you read this newsletter, but that we probably all agree is something we should consider carefully before moving forward.
3. NFTs | Starbucks conceals Web 3
Starbucks has officially introduced its Web 3 reward program, Starbucks Odyssey: the result of their venture into crypto, together with Polygon. Starbucks Odyssey has many elements of what crypto should start looking like. In its official communications, the company has avoided overwhelming technical jargon. Instead, it sticks to the initiative's purpose: to reward regular customers with digital goods interchangeable for exclusive benefits, avoiding the burden of interacting with Web 3 interfaces such as wallets or cryptocurrencies.
“It happens to be built on blockchain and web3 technologies, but the customer — to be honest — may very well not even know that what they’re doing is interacting with blockchain technology. It’s just the enabler”. Starbucks unveils its blockchain-based loyalty platform and NFT community
The big question remains unanswered: why use web 3, then? Nothing Starbucks has announced (the collectibles, the ability to purchase or exchange them, etc.) necessarily requires blockchain technology or benefits from decentralization. Maybe just the fact that users will be able to trade collectibles directly on the blockchain.
But who are we, crypto natives, to judge a project because it looks immature, anyway? The initiative seems directionally correct (web 3 with minimized hassle). Starbucks has been right in the past when onboarding new tech trends. If there’s an excellent first step that caters to the technology for its features, not its reputation, this looks like it.
4. Crime | Do Kwon on the loose
We have a new chapter in the Terra drama. Do Kwon, Megamind behind the Terra ecosystem, has become a fugitive after the South Korean authorities issued an arrest warrant on him. Kwon supposedly resides in Singapore, a place with no extradition agreements with South Korea, and claims to be fully available if authorities ask for him.
South Korean authorities refute this claim and have escalated the warrant to the Interpol.
Terra collapsed after its stablecoin, the UST, lost its peg to the dollar and pushed the whole ecosystem down a death spiral with the blockchain’s cryptocurrency, LUNA. Besides the damage inflicted on thousands of people worldwide, affected by the massive losses of an ecosystem that turned into dust in a matter of weeks, Kwon is being investigated for suspicious activity that includes siphoning funds into personal wallets.
5. NFT blue chips | Doodles
We should all welcome Doodles into NFT aristocracy. Descendants of the Crypto Kitties (their founders come from Crypto Kitties’ parent company Dapper Labs) they’ve earned the right to share the podium with Bored Apes and Cryptopunks, thanks to a unique take on the current recipe for success and a recent $54M investment round in the middle of the harshest crypto winter.
It seems like Doodles is an example of Darwinism in the NFT space. The recently appointed CEO, former president of Billboard Julian Holguin, has expressed the goal to turn Doodles into ”a fully fledged tech and media company.” A plan they share with their predecessor, Bored Ape Yacht Club, but one that they seem to have more time to think through and execute.
A colorful and friendly PFP collection, generously funded and godfathered by celebrities (Pharrell was recently appointed as Doodles’ head of brand) and with a careful take on community building and nurturing, Doodles feels like the most evolved animal of a species.
6. DeFi | Compound goes CeFi
The crash of Celsius and the ensuing chain reaction taught us the differences between Centralized and Decentralized finance. While Celsius tried to deal with insolvency behind closed doors, decentralized DeFi platforms like Uniswap, MakerDAO, Aave, or Compound stayed put and provided service without a glitch (although certainly struggling to deal with the lack of liquidity).
Today Compound, one of the members of the DeFi team, is considering crossing the road into CeFi, in an attempt to fish in the seas of institutional investment. So how is Compound’s take on CeFi different (read “safer”) than the one we saw fail in the case of Celsius? Well, Compound plans to respect the principles of DeFi, offering fully transparent and over-collateralized loans to institutional investors.