As early as September, Ethereum may switch to Proof-of-Stake consensus. How will this affect the second-largest blockchain in terms of capitalization and the participants in its ecosystem, from home miners to large businesses?
Political storms and economic crises are not able to stop the life of the cryptocurrency community. One of the hottest topics is once again the future of Ethereum. The transition to PoS is getting closer: the first Ropsten testnet has already been running on PoS since June, and in early July, the merger was carried out in the second Sepolia testnet. If the transition is successful in the third testnet of Goerli, the next one will be the main network. Provided that testing does not reveal critical errors, the first phase of the main network transition will begin as early as September . After almost five years of waiting.
As part of the first phase, the Ethereum 2.0 signal chain – the so-called ” beacon chain ” – will become the leading chain of the Ethereum blockchain. This means that blocks of the main network will be created in it and new coins will be issued through the staking mechanism that is already operating, but so far “mothballed” in the non-public chain. The Ethereum 1.x network familiar to us on the PoW consensus as a result of the merger with the beacon chain will become one of the components of the hybrid system, its further fate has not yet been finally decided. However, she will no longer create new coins, nor be responsible for creating blocks. Mining on Ethereum will go down in history.
The size of the Ethereum economy
Almost seven years after its launch, Ethereum is not just the second largest blockchain by capitalization. It is also the most popular environment for decentralized applications. Hundreds of tokens of large projects are circulating on Ethereum, and more than 20 of them have a capitalization of over $1 billion even during the bear market!
According to Coingecko , as of July 18, 2022, the entire Ethereum ecosystem “weighs” more than $430 billion. Given that the classic stablecoins (USDT, USDC, BUSD) operate on several blockchains, their capitalization on Ethereum is actually significantly lower. But even minus the “extra” tokens, the current market value of the entire Ethereum ecosystem is close to $400 billion. This is a global environment in which millions of users, hundreds of companies and decentralized platforms work and play. Making decisions at the level of the underlying blockchain that affect all users and projects requires a huge responsibility.
Changing the consensus mechanism will not only bring technical changes. It will affect both the structure of the community and the processes of making and implementing decisions on the development of not only the project itself, but the entire wide ecosystem of decentralized applications.
In this article, we will look at the main “groups of influence”, their interests and opportunities. The author will also try to predict what will change after the implementation of the Proof-of-Stake consensus.
Which groups influence decision making in the Ethereum ecosystem
Any open community is heterogeneous, and the interests of at least several groups intersect in it. Ethereum is no exception.
You can often hear the opinion on the net that the development of Ethereum is entirely determined by the team of Vitalik Buterin. Of course, the authority of the founder of the project and the largest group of developers is very high, but they have to listen to those who develop projects with a billion capitalization, funds and exchanges, and even public opinion. But, according to the best traditions of “big politics”, lobbying for financial interests is rarely made public.
Developers: the key to the repository where the ethers are
The Geth full client development team, led by Vitalik Buterin, maintains the project’s main repository on Github. It brings almost all the changes and updates to the Ethereum base protocol, on which the underlying blockchain is based, as well as the Solidity programming language for creating smart contracts. They also review, approve, or reject improvement proposals (EIPs). Thus, no technical change that can affect the operation of the entire ecosystem can pass by this group.
Vitalik Buterin , the creator of Ethereum, is by far one of the most famous figures in the cryptocurrency industry. His credibility suffered little even after the collapse of TheDAO and the forced hard fork with the split of the blockchain in 2017.
The same story showed that the developers at first quite easily followed the lead of the users and were ready to “roll back” the changes in the blockchain to compensate for the losses. But it must be admitted that she was the only one – such dangerous experiments were not repeated again. Obviously, this is due to the maturation and growth of the capitalization of the entire ecosystem. Decisions capable of causing losses in the billions, without the support of an absolute majority, can no longer be carried out unilaterally, even to compensate for other billions in losses. High-profile failures can lead not only to the outflow of users and the departure of projects, but also to serious lawsuits.
In addition to the main group of Vitalik, there are developers of other clients. As a rule, they meekly accept changes in the main protocol and modify their applications in accordance with them.
Miners: Waiting for the End and the Difficulty Bomb
From 2015 to this day, Ethereum has been running on PoW consensus, which is supported by a moderately decentralized community of miners. Among them there are users with 1-2 video cards, and large farmers with thousands of GPUs. The largest farms sometimes take the risk of solo mining, while everyone else connects to pools.
Pools serve as a natural organizing factor for miners by partially centralizing the network. Miners who are dissatisfied with the pool’s policy can always switch their equipment to another, but a large pool can “make trouble” on the network before this happens. As of July 15, 16 pools have over 1% share of the Ethereum hashrate, with the largest one, ethermine.org, serving over 28% of the total hashrate.
Already from the first steps in the development of Ethereum 2.0, developers “tighten the noose around the neck of the miners” in favor of the stakers. Unlike Bitcoin, Ethereum does not have an algorithm for gradually reducing emissions. Initially, 5 ETH was generated in each block, then the block reward was manually reduced to 3 ETH, and then to 2 ETH. Thus, the profitability of miners is gradually decreasing even without taking into account the increase in complexity. But this is not the first and not the last blow to their income.
After the London hard fork rolled out in August last year, miners lost a significant portion of their fees. Despite common interests, the community of miners turned out to be passive, it is difficult to organize it into joint actions even in the event of a direct financial threat. For example, the “strike” of miners scheduled for April 1, 2021 , directed against the introduction of EIP-1559, was not much different from the April Fool’s joke.
In addition, the “difficulty bomb” hangs like a sword of Damocles over miners for many years — an algorithm that repeatedly increases the complexity of mining after reaching a certain block (epoch). Its purpose is that after the transition to PoS, miners leave voluntarily due to a catastrophic drop in profitability, without starting a confrontation with a hard fork and another split into two blockchains. Due to delays in the development of Ethereum 2.0, the activation of the “difficulty bomb” has been repeatedly delayed and most likely it will never work on the mainnet.
Perhaps even after the successful merger of the 1.x and 2.0 branches, some miners will want to keep the old chain viable. To do this, they will need to make changes to the network protocol and client code in order to launch a separate blockchain. Along the way, they will need to disable the “complexity bomb” by removing it from the code.
Technically, this operation is not very difficult: you need to create a copy of the main repository, make changes to the code, and consistently switch to the modified version of the wallet. But will such a blockchain survive and how much will the “old-new” ETH1 cost? The history of Ethereum Classic suggests that “schismatics” can stay afloat for several years, but without the development of the project’s functionality, it will gradually fade away.
Stakers: whales and herrings
The new force that will change Ethereum and subdue it is, of course, stakers , or rather validators. Stakers in general include those who have transferred their ETH to staking pools or to an appropriate exchange account. But the operation of their coins in the blockchain will be the responsibility of the pool / exchange operator, who launches and maintains the transaction validator nodes themselves.
After the final transition to PoS, validators will not only take over the functions of miners to confirm transactions and issue new coins. They will become virtually the only force controlling both the functioning of the blockchain itself and the adoption of architectural changes and technical updates. Stakers are much more dependent on the ETH rate than miners, as they are required to constantly keep coins in their wallet.
At the time of publication, there are about 13.1 million ETH on the Ethereum 2.0 deposit contract , that is, only 11% of the total amount of ETH generated. Thus, if the transition happens now, 11% of the coins will “rule all”. But after the transition to PoS, the share of coins in staking will increase, as staking will become the only way to get new coins, and the controlling share of current validators will be diluted by new ones. At the same time, the withdrawal of coins from active circulation will become a long-term driver for the growth of Ethereum.
But the most important thing is that the process of blockchain centralization on PoS will become uncontrollable and even untraceable. Each Ethereum validator deposits 32 ETH as a deposit. Thus, there are already more than 400 thousand active validators in the beacon chain. But who do they belong to? This is unknown. It is impossible to verify who owns a particular wallet unless its owner is willing to reveal it and takes sufficient measures to anonymize it.
Simply put, all >400k wallets can be owned by the same number of users, with one validator node each. This is the best option and maximum decentralization, almost impossible in practice. As frustrating as it may be for small single-node validators, they will be like a giant flock of herring plowing the world’s oceans.
But what if all the validators are owned by a few large holders, called “whales”, and even colluding with each other? Such a network would be completely centralized. How to find out who owns a hundred thousand validators? One whale or a flock of herrings? This is impossible without complete control over the global network, and even the US intelligence agencies can hardly boast of such control.
The Ethereum 2.0 consensus protocol provides for measures to combat unscrupulous validators. Up to their disconnection from the network and withdrawal of the deposit. This operation will be carried out by a “law-abiding majority”. But what if this majority is already under the control of a few “whales”? In this case, they can launch a preemptive attack and kick out anyone who tries to challenge their policies. It is impossible to fight the majority of validators with any technical measures, without the introduction of a “super administrator” directly controlled by developers into the network.
Yes, the dictatorship of large holders will cause a “storm on the network” and lead to a mass exodus of users, a drop in the ETH rate and depreciation of “whale” deposits. This is perhaps the only effective killer whale control available to the general public.
Nothing personal, just business
The crypto-currency industry has already become a significant player in the global economy, although many old-school economists try to deny this, operating on the “insecurity” of cryptocurrencies. In the best of times , the capitalization of the leading companies in the industry amounted to tens of billions of dollars, and the total value of all crypto assets exceeded $2 trillion.
Many companies and banks hold cryptocurrencies and provide various services for working with them. Therefore, business is extremely interested in the stability and growth of large cryptocurrencies, and Ethereum is the second of them. Direct or shadow lobbying of their interests on the part of business is more than justified, and it is foolish to assume that now it does not exist. And most of the potential large stakers are just business: exchanges, pools, funds, and even companies from other industries that have bought ETH for diversification.
Therefore, it is not surprising that for any centralized business, PoS-based consensus is more profitable than mining. It allows you to actively use ETH, now just lying in wallets and, at best, used to issue loans to margin traders. And through wallets-validators, the business automatically becomes a member of the network management.
Of course, legally, validator deposits do not correspond to voting shares, but technically they are similar in many ways. Moreover, in case of force majeure, the exchange operator can use customer deposits for its own purposes. As do stock market brokers [sometimes].
“Ordinary users”: horde or legion
In the end, we should not forget about the majority of us, that is, ordinary users, who are the vast majority in any open project. Of course, each of us is not able to significantly influence the developers or change the policy of large exchanges.
However, united public opinion sometimes has a strong influence on decision makers if it is expressed en masse and in a consolidated manner. For example, it was the public condemnation inspired by the Bitcoin Core developers that forced big business to abandon the SegWit2X hard fork on the Bitcoin blockchain in 2017.
The most difficult thing in influencing the development of the project through the majority of “ordinary users” is to organize sufficiently large groups that aggressively defend their opinion. For example, in the issue of switching to PoS, users are divided. A lot of small miners, who receive modest but stable income from several video cards, oppose the transition, while small stakers who have placed some purchased ETH in a staking contract on exchanges and in pools, on the contrary, want to speed up the transition in order to realize their income faster.
Developers and users of Dapps, especially DEX traders, also benefit from the change in consensus and the introduction of sharding – this will significantly reduce transaction fees in the long term. Thus, broad public opinion is also divided – but with a clear margin in favor of the transition. If it goes well.
With the obvious absence of attempts to organize groups of influence, all the activity of “ordinary users” is mainly spent on sluggish squabbles in social networks. Passivity actually excludes the most numerous and most disparate force from the decision-making mechanism. Now it is nothing more than a huge but disorganized horde. Will a leader emerge from the depths of the network, able to build it under his banner? And what will be written on them?
What will change after the transition of Ethereum to PoS
With such a diversity of influencers and an even more scattered system of validators, achieving consensus will be a challenge. The simplest option really looks like “Vitalik’s dictatorship”, that is, the maximum pushing through by the developers of their own solution. Of course, with the support of most active validators. And those who stand behind this majority. Probably, over time, the scheme of direct voting of validators will be implemented in Ethereum.
The scheme of spheres of mutual influence of various parts of the community given here may not be entirely true. But the fact that it will change significantly – we can say with confidence. So, what will happen to the groups described above?
The developers will not disappear anywhere and will continue to improve the protocol and wallet programs. It is likely that their role will even increase. And they will definitely get more work.
The transition to new versions of wallets, especially requiring a hard fork, will be very complicated. It’s one thing to upgrade two dozen pools to get most of the updated wallets involved in block creation, and quite another to upgrade hundreds of thousands of individual validators. It remains to be hoped that the developers will improve the scheme of gradual updates and will manage exclusively with soft forks. But if a critical bug is discovered that requires the immediate application of the patch by most validators, even the most ideal scheme can fail.
Miners will be completely out of the game, but the current large pools will be able to use their reserves to create validators and stay in the game, on their own or by opening staking pools. Similarly, small miners can join staking pools, and those with 32 ETH can become validators.
Stakers (validators) will become the most influential group. However, its composition will remain unclear, and the intentions of the active majority (in terms of the number of nodes involved, but not necessarily people) will rarely be discussed publicly.
A business that owns large amounts of ETH on its own or under the guarantee of clients will be able to use them for staking and participating in network management. But his influence will mostly remain hidden.
The majority of “ordinary users” will obviously remain a massive but passive market factor. They will accept the new rules of the game and will enjoy low fees and staking that does not bring super income, but eliminates the hassle with equipment and the risk of damage or theft.
inflation or deflation
In the aforementioned London hard fork, which took place a year ago, the possibility of a deflationary economy for the ether was laid. If the amount of ETH burned from commissions exceeds the amount mined by miners, the total amount of ETH will begin to decrease, and the rate will rise. That’s how it was intended. However, it was not possible to achieve deflation – due to combustion, the actual emission actually decreased, but did not go into the red. According to Watchtheburn.com , a little over 20% of emissions have been burned in the last month, although more than half were burned in the first months after the launch of EIP-1559. This is due to a drop in user activity during a market crisis.
In addition, EIP-1559 only works in the PoW model so far and does not affect staking in any way. This means that “deferred inflation” occurs – all ETH mined by stakers on a deposit contract is frozen and does not affect the price. But when the contract is unlocked, they will all go on the market. The expected unlocking of the staking contract for Ethereum withdrawal will probably not happen before 2024, as it is associated with the second stage of the transition, and even the first has not yet begun. The approximate amount of income for stakers by this time will be 3-4 million ETH.
Thus, now we are even dealing with double inflation – both at the expense of miners and at the expense of stakers. But the first is reduced by burning, and the second is frozen. How long will this continue?
A decrease in the amount of ether in circulation leads to an increase in its price. This means that the deflationary model is beneficial for long-term holders of the asset, but not beneficial for those who conduct many transactions. When ETH deflates, active users — traders, players, NFT collectors, and others — will pay more fees in fiat terms. Thus, there is a contradiction between stakers and active users. These groups will be forced to seek a compromise.
Consent is a product
The transition of Ethereum to PoS will bring with it not only faster transactions and lower fees, but also a lot of new problems and a completely new governance model. Implicit [de]centralization will add ambiguity to both the life of the community and the business model. All interested parties will have to negotiate, and the counterparty can often be anonymous, and its real capabilities are unknown. In the coming years, no one will be bored.