Everything you need to know about Ethereum 2.0

By this point you probably have heard about the big upgrade commonly called “Ethereum 2.0” that is poised to massively improve the transaction throughput of the Ethereum network.

If you’ve ever used DeFi or other Ethereum applications you know that today, transactions on the network are slow and expensive.

Why Proof of Work is slow

Right now, the Ethereum network can only handle roughly 15 transactions per second, which is far too little considering the increasing demand of the network. This is because like Bitcoin the Ethereum network currently uses a consensus algorithm called proof-of-work (“PoW”). In proof of work blockchains, miners process pending transactions and are awarded ether (or bitcoin in the Bitcoin blockchain) for doing so. The reward in ether is awarded to the miner who is first to produce a valid block, which requires a very high amount of computational power, according to a difficulty set by the Ethereum network.

This energy expensive process, together with the ‘longest chain rule” ensures that there’s always consensus on the state of the blockchain. To “undo a transaction” one would need to re-compute every block in the transaction history of the blockchain up to the block one wants to modify – all while the rest of the network continues to produce new blocks on the original chain. To pull off this sort of attack one would need to obtain 51% or more of the computing power present in the network, which is close to impossible for networks that are truly decentralized like Bitcoin or Ethereum.

However, these security guarantees come at the cost of scalability. In a distributed network every node in the network needs to be able to store the entire history of the blockchain and verify transactions independently of others. The number of transactions the blockchain can process can never exceed that of a single node that is participating in the network. In a traditional database system, the solution to scalability is to add more servers (i.e. compute power) to handle the added transactions. In the decentralized blockchain world where everynode needs to process and validate everytransaction, it would require adding more computing power to every existing node for the network to get faster. Requiring this from nodes by increasing the block size for instance would make it more costly to run a node in the network and participate in its consensus, effectively pricing out smaller actors and centralizing the network. As you can see, there is an inevitable trade-off in proof-of-work between transaction throughput and decentralization.


What is Proof of Stake and how does it solve this?

Proof of Stake (“PoS”) does not require a great amount of computing power to secure the network like PoW does. Staking means that one is devoting an amount of ether to become a validator on the network. Validators run a software client that confirms and validates transactions and, if they are chosen, create new blocks on the blockchain. These software clients are so lightweight that they can in theory even run on a smartphone. With PoS, anyone can participate in the network, as long as they have 32 ether. Even if you don’t you can pool capital and stake with other people (more on that later). While the security of PoW is mainly derived from the cost of burning energy that an attacker would need to incur, the security in PoS is derived from the deposit of the validator.

If a validator tries to compromise the blockchain and votes wrongly, a portion of their stake – possibly even the entire 32 ETH – gets slashed. In addition, validators don’t know beforehand when it’s their turn to vote, they are picked randomly which makes it even harder to coordinate an attack. One would need to run the majority of validator nodes (each costing 32ETH) to make an attack viable. However, with so much Ether at stake, there is no financial incentive to attack the network as a successful attack would decrease the price of the attackers assets.

One analogy that is used a lot to compare Ethereum 2.0 to the current PoW system is that an attacker would have to burn down their entire mining farm in case of a failed attack, instead of “only” incurring the electricity costs during an attack as is the case in proof-of-work.

Another concept introduced by Ethereum 2.0 to reduce the hardware requirements of nodes is sharding. Sharding refers to splitting the entire Ethereum network into multiple portions called shards. Each shard effectively represents its own standalone blockchain containing its own independent state, a unique set of account balances and smart contracts and so on. All shards are connected to each other by the Ethereum main chain called the beacon chain.

Beacon Chain. article graph.png

The beacon chain acts as the “heart” of the system and creates secure connections between the shards and the main chain ensuring that these different blockchains can interoperate with each other. Effectively, this system solves scalability issues by allowing each shard chain to process transactions in parallel, which significantly increases the aggregate throughput of the system.Sharding reduces the amount of data that each node needs to maintain in order to take part in validating. Most nodes only store their shard’s data while archive nodes store the data of every shard and the main chain.

Why PoS is economically more secure and can help reduce network inflation

In both PoW and PoS, network inflation in the form of block rewards are necessary mechanisms to incentivize network participants to secure the network. In PoW securing the network means buying mining equipment and burning energy while in PoS it means staking 32 ETH or more and voting on blocks.

The art of blockchain architecture design is to create the highest level of security with the lowest level of inflation possible. In Bitcoin, the inflation rewards halve every 4 years until they eventually stop completely. This means that miner revenue will increasingly depend on the transaction fees generated by the network as the block reward part of their revenue decreases. If the transaction fees don’t make up for the decrease in rewards aggregate revenue will fall, which means that for some miners (who live in regions with high energy costs and have less efficient equipment) mining might not be profitable anymore. As a result the hashrate falls and the cost of attacking the network decreases.

Ethereum on the other hand has no monetary policy that is set in stone. There is only a broad consensus in the Ethereum community to follow the principle of “minimum viable issuance”: reduce inflation as much as possible while preserving the highest level of security. A flexible monetary policy with an explicit commitment to reduce inflation is more sustainable for a network like Ethereum, which unlike Bitcoin is constantly evolving.


The past and future inflation of the Ethereum network

As you can see from the graph above, every change made to the monetary policy of the Ethereum network has led to a reduction of the inflation rate. The transition from PoW to PoS marks another milestone allowing the Ethereum network to reduce inflation forever. This is made possible because PoS is economically more secure.

Let’s think about the punishment for attempting a double-spend attack in each system to see how this is true. Let’s assume both systems have the same absolute inflation.

The PoW blockchain pays out $1000 every 10 minutes or ~$50 million a year. At this issuance rate around $1 billion would be staked in the PoS blockchain if we assume stakers find staking to be worthwhile at a 5% annual return on their capital. To successfully launch a double-spend attack in PoS, you’d then need to control >⅔ of that to be able to produce a conflicting chain (~$670 million), which will be slashed in the event of an attack.

The punishment for double-spending in Proof-of-Work is harder to reason about, but at least under certain circumstances it’s significantly smaller. For instance, imagine that a miner amasses 51% hashrate and recovers a portion or even all of his upfront hardware investment by mining profitably for a given time period before the attack. In this case, the cost of a reorganization attack (of let’s say the last seven blocks) comes nowhere near $670 million. It would cost ~$7000 (7 x $1000) to produce the blocks. And if the reorganization is successful, the attacker would also earn the block rewards from the blocks he mined in the attack (whatever they’re worth after such an attack).

What does it mean for ETH the asset?

The reduction in ETH issuance means there will be less sell pressure caused by miners who in the current PoW system regularly dump their ETH on the market as they need to cover their operating expenditures (electricity, employees etc.).

Moreover, under PoS ETH will become a capital asset, meaning it will produce regular cash flows for ETH holders who stake their capital. In ETH 1 this was not the case as the only way for ETH holders to make a profit on their holding was to hope for a price increase. There was no inherent cash flow in the asset.

This low-risk cash flow means validators have an incentive to accumulate ETH over time as it allows them to spin up more validator nodes earning more ETH. In PoW, ETH is not required in the mining process, so miners mostly sell the ETH they produce.

This creates a cycle where users buy ETH to pay for transactions, miners earn it and sell it back on the market to other buyers who again need it to pay for their transactions. In PoS the activity of validating and generating new ETH is inextricably linked to owning and holding existing ETH which makes the asset much more valuable.

The total amount of ETH staked by all validators determines the yield that each validator receives. As you can see from the table below, if the total ETH staked is low, the return rate per validator increases, but as stake rises, total annual issuance increases to fund those validators, while they individually will receive less rewards.

Screen Shot 2020-10-08 at 7.28.24 pm.png

A final side effect of staking is that a very large amount of ETH will effectively be “locked up”. This ETH being ‘locked’ comes in addition to the ETH being used as collateral in DeFi protocols such as Maker, Synthetix, Aave. With less ETH available on the market to buy, prices tend to rise much faster with the same amount of buying interest.

Take my money, how do I start staking?

From November on, when Phase 0 of the transition to Ethereum 2.0 begins, all of these cash flows from staking will be available to normal people. There are different ways to stake depending on how involved you want to be in the process but overall ETH 2.0 was explicitly designed to make staking available to anyone.

1. Self-hosting the validator node

The process of setting up your own validator node is easy and the hardware you need is pretty standard and inexpensive. However, there are uptime requirements meaning your node can not be offline for long periods and you need to actively maintain it.

If you want to go down that route you can check out this step-by-step guide by beaconcha.in explaining the whole process. If you want to take out some complexity you can buy a Dappnode or Avado node which allow you to set up and manage your node through a super user-friendly interface while maintaining full control of the node.

One thing that you need to be aware of when staking solo is that your deposit will be locked for 1-2 years until Phase 2 of the development cycle of Ethereum 2.0, which is when the network becomes fully functional. Before, you won’t be able to send your ETH to other accounts on the ETH 2.0 network so they are effectively locked. This is also true if you are using a non-custodial service, which we’re going to explore in the next section.

Pros: Full control, Transparency, Decentralized

Cons: Technical Set-up, Connectivity requirements, Long Lockup

Using a non-custodial staking service

If you don’t want to bother about hosting the node yourself you can use services that host the node for you but you keep control over the funds. You remain in possession of the private key that is needed to withdraw the funds but you enjoy a streamlined Eth2 validator set-up and management services.

Most often the way these services work in practice is that you will download the providers key management app on your device, where vour validator private key is generated and stored (encrypted). This app then communicates with the node infrastructure of the provider where your node is hosted. Whenever your node needs to sign a transaction it gets the required signature from the key management app on your device. Screen Shot 2020-10-09 at 5.05.21 pm.pngYou’ll also notice whether a provider is non-custodial if you analyse how you are billed for the service. The only way a provider can tap into your validator rewards to withhold a commission is by owning the private key. If you created your own private keys to spin up your validator via the staking provider, they will have to charge you in a way that’s unrelated to your validator balance (e.g monthly billing), because they have no access to it.

Custodial providers on the other hand, will simply deduct their commission from the rewards because they have access to your balance.

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