If you want a negative story about Bitcoin, search no further than the electricity costs of Proof Of Work mining. Add the words Climate Change and it is a conversational game over.Proof Of Work is a horribly inefficient way to process payments. Even the most ardent crypto fan has to agree. Theoretically, Proof Of Stake fixes that. The problem is with that word – “theoretically”.

This is Part 1/chapter 17 in The Blockchain Economy book. This serialised book is a practical guidebook for investors, entrepreneurs and employees who want to learn how to prosper during the transition to an economy where value exchange is permissionless and disintermediated. For the index please go here.

Muttering about the human costs of gold mining won’t get you very far in that conversation. Bitcoin fans have to dig deep into unproven technology futures and talk about Lightning Networks and off chain processing.

This goes to the heart of the scaling debate. There are only 4 ways that cryptocurrency scaling can happen:

• 1. Proof Of Work, but with bigger block sizes. This is what Bitcoin Cash is all about and this is what caused the “Bitcoin Civil War”. Disclosure: I do not buy this story (it is only an incremental change), but if you do buy this story, buy some BCH (Bitcoin Cash) tokens and to get validation for your point of view read/watch/listen to anything by Roger Ver.

 

• 2. Directed Acyclic Graphs instead of Blockchains.This is covered in an earlier chapter. TL:DR, this could be a game-changer but it is still bleeding edge unproven technology.

 

• 3. Off chain processing and sidechains.This is covered in an earlier chapter. TL:DR, this could scale Bitcoin payment processing way beyond credit card networks and enable micropayments, but we have to wait to see how this comes to market.

 

• 4. Proof Of Stake. This is the subject of this chapter.

This Chapter covers:

• Proof Of Stake 101.

 

• 4 reasons why Proof Of Stake appeals to the financial establishment. 

 

• The Proof Of XXX alternatives.

 

• The different Proof Of Stake methods.

 

• Private permissioned Blockchains and Proof Of Stake.

 

• Why Proof Of Stake will never happen on the Bitcoin Blockchain.

 

• Why Ethereum has a transition issue with Proof Of Stake.

 

• EOS – the Ethereum competitor without this issue.

 

• And not Or – Proof Of Stake Layer 2 to Proof Of Work Layer 1.

Proof Of Stake 101

Acronym finder: Proof Of Work = POW and Proof Of Stake = POS.

Bitcoin transactions are validated by a combination of “miners” and full nodes using Proof of Work. This is proven to work at scale but is expensive and slow. This led to the development of Proof Of Stake as an alternative.

First, two things that POW and POS have in common:

• the aim is to reach consensus to validate a transaction.

 

• the actors in both networks are referred to as an “economic set”.

Next, here are the differences:

In POW, inclusion into the economic set is almost free (buy some kit at prices that obey Moore’s Law) & verifying a transaction costs money (via electricity). In POS, inclusion into the economic set costs money (you use an asset) & verifying a transaction is free.

• In POS, people tend to talk about “voting” rather then “mining”. Like all analogies, it goes wrong if taken too literally, but as the aim is to get to consensus that a transaction is correct, the analogy does fit.

 

• In POS the economic set vote with their capital (aka their stake) in the form of the internal currency of the platform you use (for example, ETH on Ethereum). 

This 2012 paper by Peercoin is credited with inventing Proof of Stake (although as with so much innovation there is probably earlier work that served as inspiration).

Proof of Stake potentially solves the two big problems with Proof of Work:

• Expensive. Proof of Stake does not waste any more electricity than any other peer to peer internet protocol (eg. BitTorrent).

 

• Slow. Depending on the precise algorithm in question it can potentially allow for much faster blockchains measured in a few seconds; anything under 3 seconds is “human real time”, short enough to impact consumer behaviour (as in “did you get my payment”, “wait, OK I see it, thanks”).

There are plenty of critiques of Proof Of Stake at the theoretical level from credible authorities such as this one from Hugo Nguyen and this one from Tuur Demeester.

 

Most people – who are not entrenched in behavioural economics and game theory – prefer to wait and see how Proof Of Stake plays out in the real world. That makes sense because human beings have a wonderful ability to do what models say they will not do.

 

To see Proof Of Stake in the real world we have to look at what is happening in Ethereum and – interestingly – in EOS.

 

4 reasons why Proof Of Stake appeals to the financial establishment 

• 1.Voting with your capital is how financial governance works today. 

 

• 2. The ROI is easy to figure out; you can deploy capital and calculate yield vs price. 

 

• 3. POS is easy for regulators; it is simply another way to deploy capital. 

 

• 4. Taxation is easy to figure out; you can tax it like a dividend or bond yield.

The Proof Of XXX alternatives

With Proof Of Stake looking like an alternative to Proof Of Work, it did not take long for a myriad of Proof Of XXX alternatives to appear out of that meme factory known as the Internet:

• Proof of Importance (POI)
• Proof of Storage
• Proof of Stake Time (PoST)
• Proof of Stake Velocity (PoSV)
• Proof of Activity
• Proof of Burn (PoB)
• Proof of Capacity (PoC)
• Proof of Checkpoint (PoC)

There is a lot of hype and speculation in cryptocurrencies, with “investors” veering madly between fear and greed and this ignorance is exploited by scammers. Be wary. A simple golden rule is “if you don’t understand it, don’t invest”. If you see a pitch implying, that only brilliant people can understand this – run, don’t walk from the opportunity.

The different Proof Of Stake methods

This is where we go from 101 to a bit more advanced:

• Transparent Forging. Although the node which forges a block is random in the long term, in the immediate future it is highly predictable. This means the network knows where the next block should be forged. If a node does not forge the block it is expected to (perhaps because it is working to build a fraudulent chain instead), it is excluded from the network for a period of time. The likelihood of that node being chosen is instead redistributed across the remaining members of the network.

 

• Delegated Proof Of Stake. The equivalent of a notary verifies signatures and timestamps transactions (see later for EOS, which uses this variant).

 

• Proof of Stake Anonymous (PoSA). Users receive a reward for aiding in the anonymization of the transaction. See this chapter for more on privacy.

In short, Proof Of Stake is at the bleeding edge stage where behavioural economists and game theory experts like to geek out.

Private permissioned Blockchains and Proof Of Stake

Private permissioned Blockchains can revolutionise many enterprise markets. But there is a huge difference in scale. A private permissioned Blockchain might have thousands of nodes; imagine for example all 8,000 plus SWIFT Members on private permissioned Blockchain. However a public permissionless Blockchain can be measured in millions of nodes.

Proof Of Stake translates easily to private permissioned Blockchains.The employees can be given Stakes to deploy.

Although one can use Proof Of Stake in enterprise Blockchains it is not necessary. Enterprise Blockchains are now being offered by all the usual enterprise vendors (Microsoft, Google, IBM, HP, Baidu, Huawei, SAP, Oracle etc) and the key point is that they are private and permissioned and so they do NOT need an incentivised ecosystem of transaction validators – employees will do what they are told to do because they get a pay check.

If Proof Of Stake rolls out in inter-enterprise private permissioned Blockchains, those networks will need to communicate with consumers and those consumers will be on private permissioned Blockchains that operate on Proof Of Work. That integration is like to happen through Sidechains. In that scenario, the future won’t be Proof Of Work or Proof Of Stake. It will be Proof Of Work and Proof Of Stake.

Next we look at whether Proof Of Stake is likely to replace Proof Of Work in a public, permissionless Blockchain such as Bitcoin, Ethereum or EOS.

Why Proof Of Stake will never happen on the Bitcoin Blockchain

This is simple. Proof Of Work is the proven model for Bitcoin, Lightning Network is the scalability solution and if you destroyed the mining business by destroying Proof Of Work, Bitcoin would collapse.Which brings us onto Ethereum.

Why Ethereum has a transition issue with Proof Of Stake

Ethereum, the number two cryptocurrency after Bitcoin, also uses Proof Of Work, but has been working hard on Proof Of Stake. If Proof Of Stake is proven on Ethereum, it will be seen as a proven scalable alternative to Proof Of Work.

Ethereum can be used for both private, permissioned (enterprise) networks and public, permissionless networks. In this section, we only consider the latter.

The transition issue is simple – how does Ethereum move transaction validation from Proof Of Work to Proof Of Stake? It is an economic incentive issue not a technical issue. If you make money mining ETH using Proof Of Work, are you incentivised to switch to Proof Of Stake voting?

The fact that Ethereum is also working on scaling Proof Of Work using a technology similar to Lightning Network (Raiden) indicates they are hedging their bets.

EOS – the Ethereum competitor without this issue.

EOS, billed as an Ethereum competitor (see Daily Fintech coverage here) uses Proof Of Stake (the variant known as Delegated Proof Of Stake, see detailed explainer here). Unlike Ethereum, they went to Proof Of Stake from the start. In short, EOS has no transition issue – which could make EOS a powerful contender if they can prove Proof Of Stake at scale.

 

And not Or – Proof Of Stake Layer 2 to Proof Of Work Layer 1.

There are two possible scenarios:

• Scenario 1: A Blockchain Layer 1 platform that uses Proof Of Stake beats the Blockchain Layer 1 platforms that use Proof Of Work. If you buy this scenario, buy a Token such as EOS.

 

• Scenario 2: Platforms that use Proof Of Stake become Layer 2 middleware on top of  Blockchain Layer 1 platforms that use Proof Of Work. If you buy this scenario, buy BTC or ETH or any other cryptocurrency that uses Proof Of Work.

I am inclined to Scenario 2 because Proof Of Stake is so easy to implement and so low cost to run but it is hard to imagine people using it for real money any time soon without the security of Proof Of Work.

This is where we need to watch the Ethereum Casper rollout, which could go to either Scenario.

Bernard Lunn is a Fintech deal-maker, investor, entrepreneur and advisor. He is the author of The Blockchain Economy and CEO of Daily Fintech.

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