In December 2020, the first step in a multiphase transition of the Ethereum blockchain from “Proof of Work” to “Proof of Stake” was taken. Proof of Stake is a hugely significant milestone for Ethereum and an exciting financial opportunity for potential investors.
So, what is Proof of Stake and why is it so important? In this post, we will describe Proof of Stake, show how it creates a digital bond, and provide context on yields investors might expect.
Proof of Work vs. Proof of Stake
Before we can understand Proof of Stake, we need to understand its precursor: Proof of Work.
Blockchains like Bitcoin and Ethereum use Proof of Work to make sure that everyone who modifies the ledger has mathematically proven to the network that they have “skin in the game.”
To get skin in the game and be allowed to update the ledger, they must invest in mining hardware and related infrastructure. Hence, they are called miners. Their reward for this investment is in the form of an algorithmic “block reward,” which is how the cryptocurrencies Bitcoin and Ether are created.
But, Proof of Work has a serious problem. The blockchain validators, or miners, who invested in hardware and infrastructure, end up selling their tokens to “holders” to finance their mining operations. Over time, the token-holders and miners become two distinct groups of people—sometimes with competing interests.
Proof of Stake is a well-researched solution to this problem. Under Proof of Stake, the mining resources are invested in the cryptocurrency tokens themselves. What this means is that the token-holders are the miners. If this is difficult to imagine, just think of each Ether token giving you the right to operate your own virtual miner.
Token-holders “stake” their tokens, which is just like powering up a Proof-of-Work miner. As a reward for participating in this process, Ether stakers will earn a yield on their staked Ether. What does this mean for holders of Ether? In late 2020, Ether became a yield instrument like a bond.
Ether — Birth of the Digital Bond
A popular narrative around Bitcoin is that it’s a form of digital gold whereas Ether is often likened as a form of digital oil, in that Ether is used as fuel to run applications on the Ethereum platform.
If Bitcoin is digital gold and Ether is digital oil, then staked Ether is a digital bond.
When staked, the Ether you hold isn’t a virtual commodity anymore—it is more like a financial asset on which you’re paid dividends or interest.
Yields on Staked Ether
So the real question is, if staked Ether is a digital version of a bond, what type of yields can we expect?
In the early days of Proof of Stake right after launch in December 2020, there was a perception of “higher risk” in the new system. Consequently, yields were over 20%. However, over the past few months as Ethereum's Proof of Stake blockchain has been live and functioning well, yields have come down as the risk/reward trade off has been attractive in the eyes of many holders of Ether. As Ethereum's Proof of Stake blockchain becomes more mature and battle-tested, a lower risk profile could lead to lower but still extremely attractive yields.
The answer: it depends on the amount of Ether that is staked. The higher the number staked, the lower the yield (and vice versa).
In the early days of Proof of Stake, when there is a perception of “higher risk” in the new system, yields might be high. Conversely, when Proof of Stake becomes more mature and battle-tested, a lower-risk profile could lead to lower yields.
This is an extremely exciting time to hold Ether as we will witness the birth of Ethereum’s digital bond. Look out for Ethereum’s upgrade to Proof of Stake — it could end up paying generous dividends.
Note: A version of this article was originally published by Ether Capital. This article reflects the views of Ether Capital, and not necessarily Purpose Investments.
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