Cryptocurrency

It’s Coming! | The Ethereum Merge Demystified | Part 1

September 14, 2022

In the next few weeks, the Ethereum blockchain will undergo a change as significant as a major shift in central bank monetary policy. It’s called the Ethereum Merge, and its implications are going to be big, with huge opportunities for investors, builders, and everyone else in the web3 space.

To get to the bottom of all this, we created a 3-part mini-series to get you up to speed and set you up for success.

In this series, we’ll address:

  • Consensus algorithms, what are they, and why do they matter?
  • The Merge, what is it?
  • And beyond: What’s next in Web3?

The year was 2016. I sat at my desk holed up in a 15 sq ft WeWork office as I called Best Buy asking if they had any AMD RX 480 graphics cards available.

Me on the phone: Yes, any brand will do… No, only the 8 GB one…How many do you have?...I’ll take all of them… No I’m not a wholesaler…I’m going to use them for mining… Yes, GPU mining, it’s called Proof-of-Work…Let me explain…

Consensus

Blockchains enable trustless and permissionless transactions by creating an incorruptible and distributed ledger. It accomplishes this by incentivizing a network of machines to constantly verify and create new blocks of transactions in a sequence… hence blockchain. But how do they decide which transactions to include? This is where the Proof-of-Work consensus mechanism comes into play.

Proof-of-Work

It tells the participants in the network how to agree on the “correct” state of the blockchain with a few simple rules.

  • The blockchain with the most accumulated difficulty is the correct one.
  • The creator of the newest block gets a reward.
  • The difficulty of creating a block is recalibrated to ensure regular time intervals between blocks.

To actually create a block is a little bit of a lottery game. Every “miner” gets a black box that works exactly the same way. The box takes in some text, and spits out a cryptic code, kind of like lottery numbers. If the same text is put in, the same lottery numbers come out.

In order to generate a valid block in the chain, you are required to put into the box: the winning numbers from the previous block, a summary of the new transactions you’d like to include in your new block, and some random text that serves to “tumble” your box, so that you can get random lottery numbers out.

If by chance the lottery numbers match the difficulty set by the network, then you are the winner. All those transactions are now considered part of the latest block on the chain. Broadcasting the random text that generated the winning numbers serves as proof for the rest of the participants. And the game starts again.

As you can see, the process is somewhat silly, but the process of “tumbling” your box is essentially what GPU mining does really well because they are capable of simulating many boxes running in parallel.

This process is the key ingredient in securing the incorruptibility of the blockchain. The more resources you dedicate to mining, the more likely you are to win the lottery for the next block, which in turn causes the difficulty to increase, reducing your chances of winning future blocks. This increase in difficulty prevents attackers from rewriting the history of the blocks. In theory, they’d have to have over 50% of all the resources to be able to generate blocks faster than the rest of the network, which gets very expensive very quickly.

This mechanism works well and is very robust, you don’t need to own any crypto currency to get started, and everyone that has the right hardware can participate anywhere in the world. However, the drawbacks are also fairly obvious. The biggest is that all miners compete to mine the next block, causing increasing amounts of resources to be dedicated to the task.

Wouldn’t it be better if a single node could create each block and everyone simply needs to verify it’s validity?

Proof-of-Stake

That’s essentially the goal of the PoS algorithm. There’s a giant round robin that is organized, and each “staker” gets to create one block at their designated time. That solves the issue of power consumption, but introduces some challenges.

Since it costs “nothing” to create blocks, there’s no reason someone couldn’t create many versions of a prospective block, and coordinate with peers such that they can create various parallel chains that are equally valid, but with certain transactions omitted. There are many mechanisms designed around how to properly mitigate those issues which are beyond the scope of this article, but the key takeaway is that any staker in the blockchain gets a pro rata share of the fees from processing transactions.

Why is this significant?

The key advantages of PoS are:

  1. Efficiency: PoS uses 99.5% less energy.
  2. No Economies of Scale: PoS does not benefit larger participants disproportionately. 
  3. Decentralization: Lower hardware requirements allow a broader set of participants.

Efficiency

The main problem with the economic model that underpins the original proof of work (PoW) mechanism is that it takes too much energy to operate. Specialized machines are built and warehoused in massive facilities that generate huge amounts of heat. This is at best efficient in terms of a consensus mechanism. 

There are valid reasons why PoW was used to bootstrap the system, or why it was a reliable way to ensure decentralization when it was not at all clear 6 years ago whether it would have as much traction as it has today.

But the energy costs were already a big issue 6 years ago, and they have only gone up exponentially since then, meaning that we’d get even larger absolute benefits as the protocol switches over and millions of consumer graphics cards are freed from the mines to go back to their gaming masters.

Meanwhile, running a PoS system simply relies on voting, and spinning up a validator uses about as much power as a small web hosting server, and you do not get extra or more rewards for having a larger server. Which brings us to the next point…

Economies of Scale

The other problem with PoW is that it benefits from economies of scale. Larger miners are able to save money by building larger cooling facilities, negotiate cheaper wholesale graphics card prices and power costs. This makes it so that while “anyone” can become a miner, they will essentially mine at a loss relative to larger more professional entities that do this as a business.

So essentially the “rich” keep getting richer in this scenario as they are able to monopolize most of the profits that are generated from mining.

PoS changes this dynamic. Anyone can stake, and the income you derive is directly proportional to the amount you have “staked”. This means that the smallest PoS validator earns the same returns as the largest. There is a corner case if you have less than the 32 ETH required to spin up a validator, but there are services that will pool your ETH together with others to share a validator, and the proportional earnings.

The last benefit of PoS has to do with decentralization.

Decentralization

While this is related to the energy efficiency of the hardware required for being a validator in PoS vs a miner in PoW, it also makes for a more decentralized system.

Current generation competitive graphics cards for miners such as the RTX 3080 run nearly $1000 now, and well over $1000 when it first launched, frustrating gamers everywhere. In contrast, you can most likely run a validator using any old laptop, or mini pc

This means that Ethereum could become a more decentralized source of income for participants anywhere in the world, not just those in countries with really cheap power costs! Over the long run, this has huge implications as that means better access to financial services, and financial products across the world, especially in countries that have large populations of unbanked simply because they cannot afford the fees or do not meet minimum balance requirements. 

Looking to earn passive income through decentralized finance? Check out PennyWorks and learn how individuals and businesses are turning to this alternative investment platform to offset inflation, increase earnings, and take their money to new heights.