Ethereum Transition to Proof of Stake

Sometime later this year, Ethereum is set to make the biggest change in its near-decade history, an event that’s certain to ripple through the entire ecosystem of cryptocurrencies and digital assets. The Ethereum blockchain will transition from a proof of work system to a proof of stake system.

Ethereum has become the most popular blockchain for a growing array of applications, including those for NFTs, Defi, and gaming. Ethereum isn’t owned by anyone but built and refined by a community of developers, and it runs on a decentralized network of nodes and miners around the world. These “miners” order transactions that are posted to Ethereum’s blockchain. In return for their work of verifying transactions, these miners get paid in Ether. The current system has been dubbed “proof of work.”

Developers who work on refining the Ethereum software roll out periodic upgrades, but none has been as major as the one expected this year. Named “the Merge,” it will replace miners with so-called stakers. Miners order transactions by solving calculations using purpose-built processors—a system that’s been criticized for its heavy use of electricity.

The proof of stake system by contrast, will verify transactions by having miners stake their own Ether on a new system, which has been in testing since December 2020. Rewards for verifying transactions will be allocated to those staking their Ether. Attempt to verify a fraudulent transaction and your Ether will be lost. People can already use their digital wallets to stake Ether on this test system, called the Beacon Chain; after the Merge they will start to be selected at random to become what are known as validators, ordering transactions on the Ethereum digital ledger into blocks and getting paid with new Ether. This is called “proof of stake.”

Ethereum’s $400 billion market capitalization depends on the transition to proof of stake going smoothly, but so do the thousands of businesses that operate on the blockchain, plus millions of users. Some $120 billion of capital is locked in Ethereum’s decentralized finance applications today.

Once the transition to proof of stake occurs, transaction costs on the Ethereum blockchain will likely fall dramatically. Some predict transaction costs and electricity use will decline by 99%. This would mean Defi applications such as exchanges like Uniswap will become a lot cheaper to use. This could in turn drive greater volume to the Ethereum blockchain and drive up the value of Ether.

Another factor that could be bullish for the price of Ether if a proof of stake system of validation is successful is that the number of Ether tokens locked into staking protocols will reduce the circulating supply.

There are also great risks for Ethereum to make the change to proof of stake. Open source development can expose blockchains to glitches that humans may initially overlook. This is a risk with most open source blockchain applications, and hacks do occur. The danger for users is the change being made to the Ethereum blockchain is at a core level and will impact all applications and users running on it.

Blockchains present many opportunities for investors, but they also carry great risks. Before deciding to invest in cryptocurrencies and other digital assets, investors should create an investment policy that defines their objectives and describes the strategies they will take to achieve their goals and manage the risks. Your family office should be helping you focus your portfolio on investments that will help you achieve your goals.