HashKey Capital: A comprehensive explanation of the reasons behind and subsequent impact of Ethereum 2.0 changing its consensus mechanism

Ethereum 2.0 is an important stage in the development of Ethereum. In the long term, the change in the consensus mechanism to Ethereum 2.0 is beneficial for the development of Ethereum.

By: Hao Kai, HashKey Capital Research
Reviewed by: Zou Chuanwei, Chief Economist of Wanxiang Blockchain and PlatON

The consensus mechanism of Ethereum 2.0 will transition from PoW to PoS, which is a significant change. To better understand this major change, we have written this article in the hope of explaining to readers, in simple terms, the reasons for Ethereum 2.0 changing the consensus mechanism, and analyzing the requirements and restrictions for participating in Staking in Ethereum 2.0. In addition, we also analyze the impact of Ethereum 2.0 changing the consensus mechanism on various participants in the ecosystem, as well as potential changes in regulatory policies that may follow.

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We believe that Ethereum 2.0 is an important stage in the development of Ethereum. In the long term, the change in the consensus mechanism to Ethereum 2.0 is beneficial for the development of Ethereum.

According to Ethereum's development roadmap, after going through the Frontier (July 2015), Homestead (March 2016), and Metropolis (October 2017) phases, Ethereum is expected to enter the Serenity phase in 2020, upgrading to Ethereum 2.0. Ethereum 2.0 has many improvements, including:

• Transition of the consensus mechanism from PoW to PoS;
• Transition of the overall architecture from a single chain to sharded chains;
• Replacement of the execution environment with eWASM instead of the original EVM.

Next, let's study the reasons and impacts of the change in the consensus mechanism of Ethereum 2.0.

Ethereum is a global open-source public blockchain platform that aims to be the "world computer." In order to achieve this goal, Ethereum's improvements and upgrades must move towards becoming a public blockchain platform more suitable for building and running DApps. The consensus mechanism of Ethereum 2.0 has transitioned from PoW to PoS, which can better balance the "impossible triangle" problem and strive to achieve a balance between decentralization, scalability, and security.

Decentralization is one of the core features of blockchain technology. Initially, Bitcoin, designed by Satoshi Nakamoto, was a completely decentralized peer-to-peer system where every user could mine using their personal computer. However, with the increasing price of Bitcoin, a large amount of computational power joined, making Bitcoin mining increasingly difficult. Currently, the vast majority of the Bitcoin network's computational power is controlled by a few major mining pools, and the scenario where ordinary users can mine Bitcoin using personal computers is no longer possible.

Bitcoin hashrate distribution chart, data source: btc.com, January 22, 2020

From the chart, it can be seen that the combined hashrate of the top ten mining pools in Bitcoin accounts for over 90% of the network's hashrate, indicating a high level of centralization where users can only participate in mining by choosing to join a mining pool.

Similar to Bitcoin, Ethereum also initially adopted the PoW consensus mechanism. Although Ethereum's mining algorithm includes designs to resist ASIC mining rigs, the current level of centralization in Ethereum is also quite high.

The following chart and table respectively show the distribution of Ethereum's hashrate and the hashrate share of the top ten mining pools, indicating that the combined hashrate share of the top ten Ethereum mining pools is close to 90% of the network's hashrate, with the top five pools accounting for 77%.

Ethereum hashrate distribution chart, data source: etherchain.org, January 22, 2020

Ethereum mining pool hashrate share, data source: etherchain.org, January 22, 2020

From the actual operation of Bitcoin and Ethereum, it can be observed that the PoW consensus mechanism cannot guarantee decentralization but instead fosters mining pools, leading to a trend towards centralization. If the PoW consensus mechanism continues to be used, Ethereum's level of centralization will continue to increase, contradicting the spirit of decentralization in blockchain. Therefore, from this perspective, enhancing decentralization is one of the reasons for Ethereum 2.0 transitioning from the PoW to PoS consensus mechanism.

Of course, many public blockchains that adopt the PoS consensus mechanism, such as EOS and TRON, also face centralization issues. To address this phenomenon, Ethereum 2.0 has adopted other restrictive measures, which will be further discussed later in the article.

Scalability has always been a significant factor affecting Ethereum's development. Ethereum's TPS is approximately around 15, which is far from sufficient to meet its positioning as the "world computer." In December 2017, a simple game called Crypto Kitties congested the entire Ethereum network, with the network usage exceeding 90%, as shown in the red circle in the image below. Currently, Ethereum's usage rate is about 70%, and as the Ethereum ecosystem grows with more DApps deployed on Ethereum, the network needs to address the scalability issue to handle applications with higher transaction speed requirements.

Ethereum usage rate, data source: etherscan

Comparing different public blockchains in the table below, those using the PoS consensus mechanism show significantly better performance compared to those using the PoW consensus mechanism. Therefore, enhancing scalability is also a reason for Ethereum 2.0 transitioning from the PoW to the PoS consensus mechanism.

Performance comparison of different public blockchains, including PoS consensus mechanisms such as DPoS, Pure PoS, data source: respective official websites and browsers

It should be noted that many public blockchains utilizing the PoS consensus mechanism have high TPS designs but lack developers and users in the actual ecosystem. It's like constructing wide roads in a city without vehicles, which amounts to a waste of resources, rendering the so-called high performance meaningless. Hence, while improving performance, Ethereum 2.0 must also focus on ecosystem development.

In terms of security, it's challenging to determine which is better between the PoW and PoS consensus mechanisms. In the PoW consensus mechanism, malicious actors need to control a significant amount of computational power, while in the PoS consensus mechanism, they need to control a substantial amount of tokens, both of which incur high malicious costs. Currently, Bitcoin remains the most secure blockchain with the highest malicious cost. Therefore, security is not the reason for Ethereum 2.0 changing the consensus mechanism.

Although Ethereum 2.0 adopting the PoS consensus mechanism does not necessarily mean higher security than before, there are three points to explain:

• Firstly, in the PoS consensus mechanism, nodes need to stake a certain amount of tokens, and for malicious actors, their staked tokens can be confiscated, serving as a deterrent.
• Secondly, under the current incentive system, maintaining Ethereum full nodes does not generate profits, resulting in a decreasing number of Ethereum full nodes. In Ethereum 2.0, the number of users participating in mining may increase significantly, potentially increasing the willingness of users to maintain Ethereum full nodes, which, from this perspective, indicates that the increase in the number of full nodes also implies higher decentralization and security for Ethereum.
• Thirdly, compared to the massive energy consumption in the PoW consensus mechanism, Ethereum 2.0 adopting the PoS consensus mechanism is a more environmentally friendly and green choice, as it does not require substantial energy consumption to maintain system operations.

Similar to the role of miners in the current Ethereum ecosystem, validators in Ethereum 2.0 are responsible for processing transactions and packaging blocks. Validators' tasks include proposing new blocks and validating blocks proposed by other validators. Each validator for a block is chosen from a large validator set by the Beacon chain.

In Ethereum 2.0, validators are randomly selected using a random number generator, and the selected 128 validators form a committee responsible for creating new blocks and receiving corresponding block rewards. After every 64 blocks, the Beacon chain will re-randomly select validators. This periodic and random selection of validators maximally prevents collusion among malicious nodes.

It's important to note that Ethereum 2.0 is implemented in several phases, with Phase 0 not designed with shards. Shards will be introduced starting from Phase 1, where the Beacon chain needs to select validator committees for each shard.

To avoid the centralization issues seen in other public blockchains using the PoS consensus mechanism, Ethereum 2.0 significantly reduces the barrier for ordinary users to participate in Staking. Ethereum users only need to stake 32 ETH through smart contracts to become validators. Additionally, 32 ETH is the maximum amount of ETH that each account can stake, and if a user holds more ETH, the excess amount won't bring any additional rewards. Therefore, users must distribute these excess ETH to different accounts, minimizing the benefits of centralized participation. Moreover, Ethereum 2.0 has modest hardware requirements, and a regular personal computer is sufficient to meet the requirements.

Ethereum 2.0 significantly lowers the barrier for ordinary users to participate in Staking, setting it apart from other public blockchains using the PoS consensus mechanism.

The following two tables show the voting status of super nodes in EOS and TRON. From the tables, it can be observed that the voting rate of the top ten super nodes in both EOS and TRON exceeds 1%. While the number of votes does not equate to owning those tokens, ordinary users certainly do not have the funds and resources to obtain so many votes. Therefore, their route to participating in block production is to join Staking pools. Clearly, while these public blockchains also adopt PoS-like consensus mechanisms, their centralization issues are quite pronounced.

EOS super node voting status, data source: EOS Tracker

TRON super node voting status, data source: tronscan

Ethereum 2.0's set of restrictions aims to ensure the system's decentralization as much as possible. These strict requirements, which are somewhat unfavorable for large token holders to participate in Staking, aim to maintain a high level of decentralization. While EOS and TRON adopt the DPoS consensus mechanism, safeguarding the interests of large token holders in the ecosystem. The reasons for Ethereum 2.0 setting numerous restrictive conditions can be explored from the comparison table of mainstream public blockchains.

Comparison of ETH, EOS, and TRON, data source: Blockchain browsers, Coin Metrics, DApp.com, February 6, 2020

It can be seen that Ethereum far surpasses EOS and TRON in terms of address numbers, DApp numbers, daily active users, and market value. Additionally, a report by Electric Capital in 2019 indicated that the number of developers in the Ethereum community is more than 4 times that of any other public blockchain. It is Ethereum's significant advantages and acceptance in the blockchain field that give Ethereum the confidence that even with strict restrictions on Staking, there will still be a substantial number of users willing to participate.

Market value and developer numbers of blockchain projects, data source: Electric Capital

For public blockchains using the PoS consensus mechanism, the more tokens a user stakes in Staking, the higher the malicious cost for bad actors, resulting in a more secure network. This holds true for Ethereum 2.0 as well; the more validators and the higher the amount of staked ETH in the ecosystem, the more secure Ethereum becomes.

The block rewards in Ethereum 2.0 serve as an incentive for users to participate in Staking. Ethereum will issue additional tokens through block rewards. In the PoW consensus mechanism phase, ordinary users lacked the ability to mine themselves, resulting in a loss of benefits for token holders due to ETH issuance. However, with the adoption of the PoS consensus mechanism, ordinary users can participate in Staking to offset the losses from ETH issuance. To attract more users to participate in Staking, Ethereum 2.0 links the validators' annual return rate to the amount of staked ETH. When there is a low amount of staked ETH in the system, the annual return rate for validators is high. As the amount of staked ETH increases, the annual return rate for validators decreases.

The table below shows the annual ETH issuance, with the values representing the maximum. If validators are penalized, the actual issuance will be lower than this data.

ETH issuance, data source: EthHub

From the table, it can be seen that when there is a low amount of staked ETH, the maximum annual return for validators can reach 18%, which is a very appealing return that will attract more users to participate. When there is a higher amount of staked ETH, the maximum annual return for validators drops to below 2%, which may not be as attractive to some large token holders, thus preventing them from staking a large amount of tokens for profit. According to a rough estimate by Vitalik Buterin, Ethereum 2.0 might lock about 10 million ETH.

ETH inflation rate, data source: etherscan, calculated annually on January 1

The ETH inflation rate is decreasing year by year, with a rate of 4.76% in 2019. As shown in the table "ETH issuance," with the adoption of the PoS consensus mechanism, the inflation rate of ETH will further decrease.

Ethereum has a significant influence in the blockchain field, and the transition of Ethereum 2.0 from PoW to PoS will impact all participants in the ecosystem, including miners, node service providers, exchanges, and regulatory bodies.

The change in Ethereum 2.0's consensus mechanism will have the most significant impact on miners. While Ethereum 2.0 will not immediately cease PoW mining and will run both chains concurrently for a period, the mining difficulty will gradually increase, prompting miners to abandon mining. Ultimately, Ethereum will fully transition to the PoS consensus mechanism. At that point, the mining equipment, constructed mining farms, and other devices held by miners will no longer be functional in the Ethereum ecosystem.
Miners may choose one of three paths:

• 1. Completely abandon mining and find a new role in the new Ethereum 2.0 play, resulting in substantial losses;
• 2. Mine tokens similar to ETC (Ethereum Classic) using their existing mining equipment and move away from the Ethereum community;
• 3. Unite and hard fork Ethereum to continue mining under the PoW consensus mechanism on the forked chain.

Ethereum 2.0 presents a significant opportunity and a considerable challenge for all PoS node service providers.

From the table below, Ethereum's market value surpasses the sum of the market values of popular PoS projects like EOS, TRON, Tezos, and Cosmos. Ethereum 2.0 will directly become the highest market value PoS project and will likely attract a substantial number of users participating in Ethereum Staking. Therefore, Ethereum 2.0 is an opportunity that PoS node service providers cannot afford to miss.

Market value of popular PoS projects, data source: CoinMarketCap

However, as mentioned earlier, Ethereum 2.0 requires each account to stake 32 ETH, posing a significant limitation for node service providers. For other PoS projects, node service providers only need a few large servers to operate. In contrast, for Ethereum 2.0, node service providers may need to run hundreds or thousands of machines and accounts simultaneously, demanding high operational capabilities.

Additionally, node service providers need to offer different services to various clients. For large clients with a substantial amount of ETH, service providers need to help them distribute ETH to multiple accounts. For small clients with less than 32 ETH, service providers need to assist them in consolidating their ETH. Large and reputable node service providers can handle these tasks in a centralized manner, while smaller providers need to attract users through smart contracts. Moreover, there is intense competition among node service providers. Therefore, Ethereum 2.0 poses a significant challenge for all PoS node service providers.

The change in Ethereum 2.0's consensus mechanism will not have a significant impact on exchanges. Many exchanges have established their PoS pools where users can stake their digital assets for profit. After the transition of Ethereum 2.0's consensus mechanism, these exchange pools will undoubtedly participate in Staking.

Regarding Ethereum, the U.S. Securities and Exchange Commission (SEC) has clearly stated that ETH is not a security-type digital asset. In Singapore, Japan, and Europe, ETH has always been considered a payment-type digital asset or application-type digital asset. ETH faces minimal regulatory policy risks.