As current blockchain technology faces accusations of inefficiency and unsustainability, a new technology is finding its way to counteract them.
Crypto blockchains are a highly discussed topic. Blockchain is used by many cryptographic networks (e.g. Bitcoin and Ethereum) to enable different transactions. In this context, transactions are cryptographically signed instructions from participants of the network to update the state of the network. The simplest transaction is transferring the cryptographic value, known as coins from one account to another. A blockchain can be described as a chronological concatenation of blocks. These blocks contain various data. For example, information about the transaction itself, the creation date and other information necessary for the creation and transaction. These blocks are linked together, creating what is known as the blockchain.1
Original Blockchain technology
To create such a blockchain, so-called 'miners' are required. These miners are users of the respective blockchain that expand the chain by creating new blocks. It is necessary to ensure that only legitimate transactions become part of the chain. To create a new block the miners have to solve a cryptographic problem i.e. find the corresponding key (the so-called Hash value) to connect the new block to the blockchain. To create an incentive for the miners to work, the first miner that solves the problem receives a payment in the respective cryptocurrency. As many miners are working in parallel to solve the problem only the winner that has 'worked' the hardest or fastest gets to update the blockchain with the transaction. This original consensus mechanism is called 'Proof of Work' (PoW).2
Disadvantages of ‘Proof of Work'
The proof of work mechanism has one massive disadvantage: Energy consumption. Due to the high processing power needed to carry out the mining as quickly as possible, the energy consumption is enormous. Studies have found that bitcoin alone consumes more than 100TWh per year.3 This equates to twice the annual electricity usage of Switzerland.4 Specifically with regard to Ethereum, an immense increase of the energy consumption has been measured.5
Another point is efficiency. In the PoW mechanism many miners are working at the same time to add the same block to the chain and only the work result of one of these miners can be utilised. Thus, the number of miners could be used to add more blocks in a shorter time period. This would increase the speed of adding of new blocks and would make the mining more efficient. Especially in times of climate change, PoW has met with a great deal of criticism, and the voices of a necessary change have grown ever-louder in recent time.
‘Proof of Stake' instead of ‘Proof of Work'
Apart from proof of work, 'Proof of Stake' (PoS) provides another mechanism to add blocks to the blockchain. In this approach, validators rather than miners are responsible for expanding the chain. This mechanism uses an algorithm that determines the validator to add the next block. To partake in a proof of stake network the validators must have a certain stake of coins on the network. Imagine that the validators deposit a certain amount of tokens in a kind of lottery drum. The algorithm then selects the next validator at random out of these deposited tokens.6 Thus, each token staked on the network represents a chance of being selected. This means the higher the number of stakes, the higher the probability for validation to be selected. To deter misbehaviour, the system punishes improper transaction validations by seizing and destroying all or part of the bad-acting validator's stake.7 The PoS-mechanism has certain advantages over the PoW-mechanism. Due to the fact that miners no longer have to compete with each other, but rather validators are assigned their validation directly, less computer processing power is needed, which in turn reduces energy consumption. This increases the efficiency with which new blocks are attached to the respective blockchain.
‘The Merge' of Ethereum
Because of the energy-intensive negative impact associated with 'proof of work' one of the largest decentralized blockchain networks 'Ethereum' has changed its consensus mechanism from 'proof of work' to 'proof of stake' on 15 of September.8 This update, called 'The Merge', aims to reduce the high computing power. In anticipation of The Merge, the price of Ether9 (the cryptocurrency of the Ethereum network) increased relative to Bitcoin10 (which did not undertake a similar change) in the preceding weeks—though the price of Ether relative to Bitcoin has corrected somewhat in the days following The Merge. In addition, further changes are planned by the Ethereum network to further increase its own efficiency. According to Ethereum co-founder Vitaly Buterin, four more steps are still to come: 'The Surge', 'The Verge', 'The Purge' and 'The Splurge'.11
As the PoW process has had a negative impact on sustainability, it is and will likely remain under political scrutiny.
The White House announced, after a report on the climate impact of the crypto industry that due to the existing climate change and the set climate targets, a drastic reduction of energy in the crypto industry is a goal. If the targets are not met, the PoW process could be banned.12
PoS is not without criticism either. It is generally considered less decentralized—a factor that implicates securities laws under the US Securities and Exchange Commission's (SEC) framework for analysing digital assets. Indeed, within two hours after The Merge, Ethereum already showed signs of increasing centralization, with just two entities approving nearly half of all blocks validated in that period. After testifying before Congress the day of The Merge, SEC Chairman Gary Gensler reiterated the view that staking under PoS could be considered a security.
In Europe, too, the issue of PoW vs. PoS is attracting more and more attention. Accordingly, the draft proposal for the Markets in Crypto-Assets Act (MiCA), at the beginning of this year, still contained regulations on limiting proof of work. The vice chair of ESMA even called for a ban on this system in view of sustainability considerations. The latest draft, however, no longer contains any rules on the limitation of PoW.
It remains to be seen how the change from PoW to PoS will develop. In this context, attention should also be paid to the consequences of the Ethereum changeover and the political developments that will be drawn from it in order to create a crypto industry that is as sustainable as possible. Yet, should there be a ban on PoW, as contemplated by the White House, this will considerably impact the entire blockchain industry, excluding such networks that have upgraded their consensus mechanism to more sustainable practices. However, one thing is certain: blockchain technology will have to change sooner or later in order to meet the requirements of climate-friendly efficiency.
1 The foundation for our digital future
2 Proof-of-Work (POW)
3 DIGITALES GELD NACHHALTIGER MACHEN (PDF)
4 Studie: Digitales Geld nachhaltiger machen - dem quantifizierten Energieverbrauch von Bitcoin auf der Spur
5 Ethereum Energy Consumption Index
6 Proof-of-Stake (POS)
7 Proof-of-Stake (POS)
8 The Merge
9 nasdaq.com - Cryptocurrency Market Activity
10 nasdaq.com - Bitcoin
11 Speech by Vitaly Buterin on the Ethereum Community Conference in Paris on 21 July 2022
12 Fact Sheet: Climate and Energy Implications of Crypto-Assets in the United States
Chanté Eliaszadeh (Associate, White & Case, Los Angeles) and Helena Voege (Legal Trainee, White & Case, Frankfurt) contributed to the development of this publication.
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