How Will Proof of Stake Affect Ethereum’s Price?
Ethereum appears to be entering what some are now calling a crypto-recession with prices reflecting a decline in onchain transactions (usage) that has not been seen since the Bitcoin bubble of January 2014. Those who endured the first major cryptocurrency crash will remember (if they were patient enough to stick it out) that it was not until 3 years later – almost to the day – that prices reached new all time highs. However, the idea that this recession will also last 3 years seems enormously unlikely; the ecosystem has matured in myriad ways since 2014, with Bitcoin futures markets now trading in the US and an Exchange Traded Fund (ETF) seemingly closer than ever. Financial derivatives aside, the sheer volume of development in both onchain and offchain protocols over the past 4 years are well and truly creating the foundation for a new global economy. But yet here we are, Ethereum’s price is dipping to a low not seen in 5 months and a rapid recovery looks to be unlikely. There is however a fundamental change to the Ethereum protocol on the horizon that – in the build up to its launch – has the potential to usher in the next ravenous investment into the space.
Proof of Stake
Proof of Stake (PoW) is an alternative to the Proof of Work (PoW) mechanism for achieving consensus on the ledger. Rather than having electricity-intensive miners process transactions by solving a difficult mathematical problem, transactions are instead processed through the staking of Ether in specialized smart contracts. There is plenty of information available online to those interested in diving deep into PoW and PoS consensus, however for the purposes of this article the focus will be on the higher level implications for the price of Ethereum. Firstly, a very quick introduction to Proof of Stake versus Proof of Work:
- Proof of Work requires significantly more computation (electricity) which typically increases with blockchain usage. On the other hand, Proof of Stake requires a comparatively negligible amount of electricity regardless of usage. Proof of Stake is a dramatically more green mechanism for securing a blockchain.
- Proof of Work is dominated by expensive and specialized hardware which favors a very specific group of people: those with access to chip manufacturers, low electricity costs and government subsidies. Theoretically, Proof of Stake promotes far greater decentralization of transaction processing as it remains accessible to anyone, anywhere in the world regardless of the factors above. The only barrier is a significant minimum stake amount (although this may reduce over time). As an aside, the specialized hardware (ASIC chips) that have somewhat centralized Bitcoin mining have recently been developed to work on Ethereum. These ASIC chips would become redundant for Ethereum mining following a move to PoS.
The two key points here are that Proof of Stake is more green and more decentralized than Proof of Work. Decentralization does not yet resonate well with a mainstream audience (centralized protocols work “just fine”) however – at least in the near-term – the greener nature of PoS could be an enormous boon for investment in the Ethereum space.
How will this affect the price?
Being green and decentralized may provide some token demand however the real price movements will come from some major changes to the supply growth rate of Ethereum. Vitalik Buterin recently proposed a way to compute “rent fees” on the Ethereum blockchain and in doing so gave a little more insight into expectations about the Proof of Stake mechanism (dubbed “Casper”) in which two key points were made:
- 10M Ethereum are expected to be staked
- Supply inflation of 500,000 ETH per year (~0.5%)
10M ETH is equivalent to roughly 10% of the current total supply of Ethereum. Given the time-locked nature of staking and the demand to stake, these tokens will effectively be permanently removed from circulation.
Currently with 3 ETH rewarded to miners every ~15 seconds, a total of ~6.3M ETH enter the ecosystem each year. This would equate to a ~90% reduction in coin supply inflation.
The supply implications of a Proof of Stake model are the most dramatic. Last year, the Ethereum software firm Parity lost 513,000 ETH due to a bug in one of their smart contracts – enough (under a Proof of Stake system) to create a supply-deflationary year on its own account. Combine this with a series of smaller private losses, “dust” and burnt coins and Ethereum’s supply may become long-run deflationary (à la Bitcoin) or at most only slightly inflationary. The price implications of limiting Ethereum’s supply are dramatic, and on the demand side there may be equally powerful forces that could drive the price upwards. Decentralized applications (dApps) that begin to attract a mainstream audience over the next few years will be required to buy and hold large quantities of Ether to pay for storage (see rent fees above) and gas fees (analogous to server costs). If Ethereum is to become ubiquitous as the decentralized smart contract platform of choice, then simple demand and supply economics would suggest a very significant upward pressure on the price over the next few years.