No, Ethereum Shifting to Proof of Stake Is Not Without Risks

If you haven’t heard already, Ethereum (CCC:ETH-USD) is about to implement massive changes that could spark a paradigm shift in the cryptocurrency sector. While many if not most crypto proponents support the transformation, it may have huge implications not only for ETH-USD, but also for the future valuation of Bitcoin (CCC:BTC-USD).

Another stylized version of the Ethereum logo

Source: shutterstock

First, a little background. Early into the digital asset innovation, cryptocurrencies started off utilizing proof-of-work (PoW) protocols. As Bloomberg’s Matthew Leising explained, “In Bitcoin and Ethereum today, transactions are grouped into “blocks” that are verified and published to a public “chain” every few minutes. The proof of work necessary to publish the latest block is done by miners whose computers perform millions of trial and error computations to change a given input into a required output.”

Subsequently, the “first miner who succeeds in producing the required output shares it with the network, which checks to see if it works, and is rewarded for the effort with free cryptocurrency. The system also sets a floor of value on the coins — no one would invest the electricity, computer hardware and other expenses of mining unless coins are worth at least that amount.”

However, one of the major problems with PoW protocols is that they’re energy intensive. With the dramatic uptake of major cryptos like Ethereum, the mining process increased exponentially in difficulty. As Leising wrote, “Bitcoin network’s annual electric bill often exceeds that of countries such as Chile and Bangladesh.”

Proof of Stake to the Rescue for Ethereum?

Before anyone grabs their pitchforks, let me state clearly that the issue of Bitcoin’s energy consumption is an extremely controversial subject. You thought the 2020 election was bad? Try broaching the subject of Bitcoin energy consumption with BTC supporters and you may quickly regret it.

While I don’t have the time to go into every nuance regarding the pros and cons of the PoW mining process, a common counterargument is that compared to other energy intensive endeavors — even those tied to the printing of fiat money — BTC’s consumption profile isn’t nearly as bad as it sounds.

Nevertheless, Bitcoin and Ethereum in their current state do consume plenty of energy — that’s not debatable. Therefore, a much-forwarded solution is proof of stake (PoS), which basically allows only those who have put up or staked their underlying cryptocurrencies to participate in the transaction validation process that replaces the traditional mining process.

Leising wrote that experts believe “switching to proof of stake would cuts Ethereum’s energy use, estimated at 45,000 gigawatt hours by 99.9%. Like any other venture depending on cloud computing, its carbon footprint would then be only be that of its servers.”

“That’s important for Ethereum, which has ambitions of becoming a platform for a vast range of financial and commercial transactions. Currently, Ethereum handles about 30 transactions per second,” Leising added.

So, that settles it, right? Ethereum should move to PoS and we’re good. Well, maybe, but there’s another angle to consider.

You Can’t Cheat Basic Economic Principles

While some rare exceptions may exist, in the lion’s share of cases, anything of economic value is difficult to accomplish. That’s why brain surgeons are compensated more than say sandwich artists. Not to say there’s anything wrong with the culinary skills involved with making a sandwich but one is clearly more difficult than the other.

In the same vein, a major component for gold’s valuation is that it’s incredibly difficult and energy consuming to extract it from the earth. According to a study by DePaul University, the gold industry may be consuming around 265 terrawatt-hours of energy and emitting 145 metric tons of carbon dioxide annually.

Now, we can debate the ethics of mining precious metals all day — and there are serious issues involved. But the point of the matter is that it’s unlikely these metals will enjoy the market value they do if they were much easier or less onerous to extract.

I understand the point that another change in Ethereum — the fee reduction feature called EIP 1559 — may spark a deflationary impact on ETH-USD. Still, for the miners that want to participate in the validation process, the profit margins for an efficient blockchain network will very likely be much smaller than an inefficient one.

I mean, that’s the point of any service-related economy, isn’t it? To deliver efficiencies where there are inefficiencies. But once everything becomes efficient, what would be the point of deliverers of efficiencies?

Going Efficient May End Up Lifting Bitcoin Higher

A few years ago, a similar debate about efficiency took over Bitcoin. As the original cryptocurrency became ultra-popular, many advocates recognized how clunky the underlying blockchain network was. Long story short, many wanted to keep the course while others wanted to improve the protocol.

Failing to reach consensus, proponents of a more efficient and speedier Bitcoin hardforked the network to create Bitcoin Cash (CCC:BCH-USD). Basically, it’s the more efficient Bitcoin.

But did anyone really care in the end? Certainly, there are several BCH advocates but what ended up happening was that the original Bitcoin soared to $64,000 or so — a blistering all-time record. Bitcoin Cash? It has yet to even get close to its prior record high.

This points to yet another supporting argument: Efficiency is the friend of the environment but not so much the economy. Look at it from a cynical perspective. If there were no crime in society, would there really be a need for police officers?

But there is crime in society and sure enough, violent metropolitan areas that have the budget to support it often incentivize law enforcement recruits with higher salaries than what you might find in a safe locale. It’s simple economics — inefficiencies provide relevance for those who can bring systems into equilibrium.

But to start off with equilibrium as the default? I’m not going to guarantee that this would be problematic for Ethereum’s valuation. But personally, I’d look for Bitcoin to rise higher if ETH makes the shift.

On the date of publication, Josh Enomoto held a LONG position in ETH, BTC and BCH. The opinions expressed in this article are those of the writer, subject to the Publishing Guidelines.

A former senior business analyst for Sony Electronics, Josh Enomoto has helped broker major contracts with Fortune Global 500 companies. Over the past several years, he has delivered unique, critical insights for the investment markets, as well as various other industries including legal, construction management, and healthcare.

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