Proof of Work vs Proof of Stake
So you already know that a decentralized blockchain is essentially (1) a list of electronic transactions that is (2) constantly updated by computers all over the world.
All decentralized blockchains face a security challenge: Since any participating computer can make updates to the blockchain, how can they verify that each update to the blockchain is legitimate?
This is where a concept called 'Proof of Work' (PoW) comes in.
Any computer that tries to update a PoW blockchain must first carry out some heavy computational work, in order to generate a digital "key" (technically known as a nounce). The "key" must then be verified and accepted by other computers on the network before the update is added to the blockchain.
- Is highly secure
- Has a relatively high barrier to entry (requires expensive hardware)
- Uses up a lot of energy
The last two points are why the Etheruem blockchain will be switching from PoW to 'Proof of Stake' (PoS) sometime in early 2022.
PoS uses much less energy and does not require expensive hardware to run, which helps to further decentralize the network (lower costs means more people around the world can afford to join the blockchain network).
The important thing to remember is that Ethereum's PoS mechanism prevents the blockchain from recording fraudulent transactions.
Here's how it works⁴:
- Anyone with a computer can register to be an Ethereum validator.
- The job of a validator is to process transactions (i.e. update the blockchain) and verify the work done by other validators.
- To be a validator, you need to put up 32 ETH as collateral.
- If the transactions you process are approved by the majority of other validators, you are rewarded with some ETH.
- If the transactions you process are fraudulent (as determined by the majority of other validators), you lose a portion of your collateral.
This incentive system deters malicious actors from trying to post false transactions into the blockchain; If they get caught by other validators (which is likely), they end up losing ETH/money.
"Why do I need to know any of this?"
You need to understand these concepts in order to understand my investment thesis.
Just bear with me and it will all click together soon!
How to attack Ethereum
There is only one reliable way to corrupt the Ethereum blockchain, and that's to control the majority of the Ethereum validators and use them to approve fraudulent transactions. This is called a '51% attack'.
The best way to prevent a 51% attack is to make the cost of attack prohibitively high.
Example: If 20% of all ETH is staked by honest validators, a would-be attacker would need 20.1% to start the attack. At the current price and supply of ETH (Jun 2021), such an attack would cost more than $58 billion.
The security of the Ethereum blockchain thus depends on 3 factors:
- The variety of validators (more variety = more secure)
- The amount of ETH staked (more ETH staked = more secure)
- The price of ETH (higher price = more secure)
Ethereum security and ETH prices
To maintain a secure blockchain, Ethereum developers want more people to become validators and stake their ETH.
And in order to encourage this, they have to regulate the supply of ETH such that the price doesn't fall too much. (If the price falls too much, fewer people will choose to hold ETH and be validators.)
This is the first reason why I'm bullish on Ethereum: The developers are incentivized to restrict ETH supply so the blockchain stays secure.⁴
A secure blockchain, in turn, attracts more investors and people who want to be validators, which has the similar effect of pushing ETH prices up! It's a positive feedback loop that benefits long term investors.
But... this alone is not why I'm betting BIG on Ethereum today.
This is a long term tailwind, sure. But this is not reason enough for me to be betting BIG on Ethereum today.
After going through all this, you are now ready to learn why Ethereum is the biggest bet of my investing career.