Letter #66: The Fatal Flaw of Proof-of-Stake (PoS)
Read now to learn why Proof-of-Stake redistributes wealth from the poor to the rich, not unlike our current financial system.
Growth is fundamental to the long-term survival and development of cryptocurrencies and their underlying blockchains. In simple terms, a cryptocurrency grows as more people use it. But even more important to the growth of a cryptocurrency is that the number of committed long-term users and hodlers continues to grow from cycle to cycle. After all, demand is the primary driver of value accretion in every market and no one drives demand like a cryptocurrency’s devotees.
It should come as no surprise then, that cryptocurrencies often find themselves at odds with one another in their quest to grow. The cryptocurrency space has been rife with debate and intrigue since its earliest days. It’s common for cryptocurrencies and protocols to outright copy one another in order to steal the predecessor’s user base rather than starting from scratch when building a community. As an example, the Shiba Inu cryptocurrency was created as a “Dogecoin” killer and has as its mascot the same Doge-based meme that made the rounds on the internet in the early 2010s. And who can forget the PancakeSwap Decentralized Exchange (DEX) on the Binance Smart Chain that is a literal clone of the Ethereum-based Uniswap DEX?
While many debates in the space can seem relatively lighthearted, many devolve into a make-or-break fight for survival. The block wars that culminated in 2017 provide a prime example in that the two combatants, Bitcoin and Bitcoin Cash, have followed extraordinarily different paths in the time since. The price of the winner, Bitcoin, is up over 2000% since 2017 and it has been adopted by corporations, nations, and millions of users around the world. Bitcoin Cash’s price meanwhile sits a mere 12% higher than its price at creation as of this writing per the cryptocurrency exchange Coinbase’s price charts.
That said, the outcome of the block wars is still fiercely debated in certain corners of the internet. However, another all-out brawl has been shaping up for months and will likely dominate cryptocurrency conversations for many years to come: Proof-of-Work vs. Proof-of-Stake.
The Secret Sauce of Proof-of-Stake
Proof-of-Work (PoW) is the original blockchain consensus mechanism, is arguably the most secure mechanism in existence, and is used by Bitcoin, Ethereum, and many of the other most widely used blockchains. So why the competition with Proof-of-Stake (PoS)? Simply put, many of PoS’ proponents believe that PoW’s massive energy footprint is a flaw rather than a feature and see PoS as a logical method for reducing the cryptocurrency space’s carbon output.
It would be hard to argue that PoS doesn’t use less energy than PoW. PoW systems use specialized mining computers to solve complex algorithms, which requires an immense amount of electricity. Plus, as the value of PoW-based cryptocurrencies increases, the amount of computing power on their networks, which naturally is the primary driver of energy consumption, increases in tandem.
PoS on the other hand eliminates the vast majority of electricity use by not requiring mining computers at all, although nodes are still required to manage the blockchain. PoS instead relies on validators to support the network and establish consensus, and a participant’s success as a validator is determined by the amount of the native cryptocurrency they hold. In other words, small holders of the PoS crypto will have a small impact and the blockchain’s consensus will primarily be driven by large holders.
Proponents will tell you that a built-in carbon reduction makes PoS the obvious choice over PoW. However, there is much less talk about PoS’ innate redistribution of wealth from small holders to large holders, which could be the system’s fatal flaw.
Proof-of-Stake: Rob the Poor, Give to the Rich
Block rewards, whether on PoW or PoS networks, are basically just cryptocurrency’s version of inflation. After all, the added supply released with each block decreases the value of all pre-existing coins, all else equal. In PoW systems, miners are incentivized to compete on electricity costs and computational power in order to maximize profitability. Meanwhile, for PoS systems, participants are incentivized to acquire as much of the cryptocurrency’s supply as possible since the percentage of the new supply they’ll earn will typically correspond to the percentage of the current supply that they own.
Sounds like a winning strategy for PoS, right? Holders are driven to acquire more of the token in order to gain more of the future rewards, which increases demand and should increase price. But of course, token inflation by itself doesn’t create value (and it actually decreases the per-coin price). Case in point, if you own 100% of a PoS coin’s supply, you’ll win 100% of the block rewards, but nothing will have changed about your net worth since the new coins simply dilute the value of the coins you owned before. So there must be something else that incentivizes people to compete to own more PoS coins…
The truth is that not everyone in a PoS system is on an equal footing when it comes to staking or is even able to participate in staking. And users in both groups subsidize the rewards of everyone else by sacrificing the value of their unstaked or unequally staked coins to inflation.
Let’s use ETH 2.0 as an example: a minimum of 32 ETH are required in order for a participant to set themselves up as a validator for staking the PoS chain. At current prices, 32 ETH will set you back over $128,000 USD. Certainly the vast majority of Ethereum users aren’t able to afford to become a validator on their own. And while it’s true that any user can delegate their ETH to a staking pool, the pool operator will take a portion of each user’s staking rewards as a fee.
Perhaps you see where this is going: Participants who can afford to validate on their own (i.e., without a staking pool) are able to keep inflation at bay by accruing a percentage of the new supply that matches their percentage of the current supply. Staking pool operators on the other hand are able to acquire part of the token supply of others by managing small amounts of ETH for everyone who can’t afford the 32 ETH required to become a solo validator.
Let me lay it out there in plain terms: who’s able to afford to become their own validator or become a staking pool operator? Rich individuals and rich corporations who have resources. And who can’t afford to become their own validator or even to lock up their ETH holdings long enough to earn staking rewards? Small investors who don’t have tens of thousands of dollars lying around or who need the ability to sell their holdings at a moment’s notice to fund life’s necessities.
Don’t get me wrong. I have no problem with rich people and corporations building wealth, as long as it’s by bringing desirable products and services to market. Capitalism works and I’m a firm believer in it. But inflation typically destroys value rather than creating it. As a result, an inflationary PoS system that inherently rewards wealthy participants at the expense of everyone else is not a viable system over the long-term, nor is it really any different than the financial system and world order under which we currently live.
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Into the Twitterverse 🐥
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