On September 15, Ethereum is planning to undergo its long-promised “Merge,” where the protocol will shift from a PoW (proof-of-work) consensus mechanism to a PoS (proof-of-stake) consensus mechanism.
In this report, we will provide details on how the proof-of-stake mechanism works for Ethereum, using technical definitions provided by Ethereum documents. Second, we will evaluate the move to proof-of-stake from the first principles, which will include an explanation as to why much of the reasoning for the move is possibly flawed. Last, we will cover the risk factors of the Ethereum PoS mechanism comparing and contrasting the governance to Bitcoin and a PoW consensus mechanism to articulate the fundamental differences between the systems.
With the shift in consensus mechanisms, Ethereum shifts its block production away from GPU (graphics processing unit) miners over to staking validators. Validators take the role of block production away from miners, and importantly, transfer the power structure away from real-world energy input (in the form of hashes) towards the capital, in the form of staked ether.
The Ethereum website claims that the security will be more robust in a PoS consensus system rather than a PoW consensus system, but we consider this to be highly controversial.
While a proof-of-work protocol relies purely on economic incentives and real-world physical constraints to secure the chain against attackers in the form of an attack, PoS relies on “social governance” through slashing to attempt to keep stakes honest. To clarify further, to 51% attack the Bitcoin network (to execute a double spend), an attacker would need access to an immense amount of physical infrastructure and energy resources in the form of ASIC miners, electrical infrastructure, and (cheap) energy, before an attack is even attempted. To cap it all off, any hypothetical attacker that does gain access to these things will quickly realize it is more economical to be an honest miner simply.
With proof-of-stake, stakes are kept honest through slashing, where hostile peers see their ether get destroyed (for actions such as proposing multiple blocks in the same slot or violating consensus). Similarly, in the case of potential censorship by a dominant majority of stakes (more on this later), there is an option for a minority soft fork.
MEV is an abbreviation of “Miner Extractable Value” that has recently changed to “Maximal Extractable Value” which refers to the profits that can be made by extracting value from Ethereum users through block production.
Given the vast financial application ecosystem built on Ethereum, there is often an arbitrage opportunity in the ordering of transactions. The producers of blocks can reorder, sandwich (the act of front-running a large order, only to use their market order as exit liquidity to profit from the spread), or censor transactions within blocks being produced. It typically affects Defi users interacting with automated market makers and other apps.
Last week, the U.S. Treasury announced that Tornado Cash was added to the U.S. OFAC (Office of Foreign Assets Control) SDN list (the list of specially designated nationals with whom Americans and American businesses are not allowed to transact). The sanctions placed on Tornado Cash were particularly notable because they were placed not on an individual person or particular digital wallet address, but rather on the use of a smart contract protocol, which in the most basic form is just information. The precedent set by these actions is not ideal for open-source software development.