the issues presented by Coinhouse

the European Parliament has just voted on MiCA, a law that will eventually regulate the market for crypto-assets on the scale of the European Union. And if the content of the bill did not cause any particular surprises, a provision was fiercely debated: some parliamentarians proposed the prohibition of proof of work on EU territory, which would have led to no only the prohibition of mining, but also the prohibition of the assets themselves. With, in the forefront, Bitcoin (BTC) and Ethereum (ETH).

If this provision was finally rejected, it is indicative of a general state of mind in our societies according to which crypto-assets are harmful to the environment, mainly because of the quantity of electricity necessary for their operation, for example through mining. Calls have also been made for a few months not to use NFTs that operate on the Ethereum blockchain, since this encourages the development of its use, and therefore the corresponding electricity consumption.

While it is true that estimates are often very imprecise, even exaggerated, and that an increasing share of the energy used by mining is non-carbon, we must not forget what this activity is used for on a blockchain in proof of job: to validate transactions and make them immutable on the corresponding ledger. If we can do the same job, with the same level of security, using other processes that consume much less electricity, we should not hesitate to make the switchover.

And that is precisely what the Ethereum blockchain is about. In June 2022, it is planned to switch to proof of stake on this network, which amounts to reducing electricity consumption by more than 99%. The question that arises is of course what we lose in exchange.

Ethereum’s decision should be highlighted in the face of its current competition: Solana, Avalanche, Fantom and other Tezos are all already working today as proof of stake. And some actors in the world of traditional finance have already decided to use these alternative networks for their blockchain projects instead of Ethereum, justifying their decision mainly by the induced energy consumption: in addition to the public relations problem that this means that these companies could eventually be forced to pay the bill through carbon credits corresponding to their use of the network.

Ethereum is therefore only following the trend here. No major blockchain has emerged in the last three years that works via proof of work. It is therefore likely that the entire market will gradually switch to this new transaction validation process.

However, it should be noted that proof of stake also poses a number of problems. In a proof-of-work model, the miners with the best-performing hardware are the ones most likely to validate transactions, and therefore receive the corresponding rewards. In proof of stake, those who have the largest number of tokens of the considered blockchain are those who have the best chance of validating transactions.

However, as we know, in many blockchain networks the tokens are extremely concentrated in the hands of the project creators and early investors. There is therefore an obvious danger of concentration of decision-making in very small hands, which threatens the very principle of decentralization that makes public blockchains work.

Ethereum managers assessed this risk and decided that the alternative, remaining in proof of work, posed more problems. A number of technical safeguards have already been put in place to prevent a small number of validators from taking over the entire network.

There is another implication of the decision to switch: in a proof-of-work network, constant monetary inflation is necessary to keep the network secure. Indeed, miners must have a remuneration to be able to continue to operate their machines. This remuneration comes from monetary creation, as on Bitcoin.

In proof of stake, this mechanism is no longer necessary. The market therefore expects a sharp drop in the creation of ether money to take place at the time of the switch to this transaction verification process. Ethereum could then become clearly deflationary, which would mechanically lead to upward pressure on prices over the long term.

The decision to switch the operation of Ethereum was carefully considered, taking into account the advantages and disadvantages it presents. For the reasons we have stated, the whole market expects Ethereum to rise sharply once this change takes place. Ethereum could then more than ever assert its dominance over its competitors managing smart-contracts, or even over the entire ecosystem of crypto-assets.

This text is written by Valente Manualdirector of research at Coinhouse and does not constitute investment advice. Do your own research before investing.

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