What Is Proof of Stake?
Proof of Stake (PoS) is a consensus algorithm used by many blockchains as an alternative to the more commonly known Proof of Work (PoW) algorithm. It was developed as a way to address some of the issues associated with PoW, such as the high energy consumption required to mine new blocks and the centralization of mining power among a small number of large mining pools.
The Ethereum foundation alone, before this network switched to PoS estimated that PoW continuously spent 5.13 gigawatts of energy, while most of the minders are located in China due to cheap electricity
In PoS, instead of miners competing to solve complex mathematical problems to validate transactions and earn new coins, validators are chosen based on the amount of cryptocurrency they hold and are willing to “stake” or lock as collateral.
Validators are randomly selected to create new blocks, and the more certain cryptocurrency they have staked – the bigger the chances to get selected as a validator. In addition, they also receive transaction fees as a reward for creating new blocks.
The idea behind PoS is that validators have a financial incentive to support the network. Trying to cheat the system by so-called double-spending or attempting to create invalid blocks, would result in losing staked assets and being kicked out from node operators.
This is in contrast to PoW, where miners can engage in so-called “51% attacks” if they control a majority of the mining power, something that can undermine the security of the network.
Since validators perform minimal computations while creating new blocks, the process consumes far less energy than PoW. The same aforementioned foundation discovered PoS consumes only 2.62 megawatts continuously.
This makes it more environmentally friendly. PoS is also meant to be more decentralized than PoW, as it is more difficult for large mining pools to accumulate a majority of the network’s staked coins.
Overall, this mechanism was developed as an alternative to PoW to address some of the scalability and environmental issues associated with PoW, while also promoting decentralization and security. Many profitable popular cryptocurrencies, such as Ethereum, Cardano, and Polkadot, have adopted PoS as their consensus algorithm.
What Is Staking?
Staking is the process of locking a certain amount of cryptocurrency on a platform, for a certain period of time, to support the operations of a decentralized network and earn rewards for doing so.
It is an essential component of the Proof of Stake (PoS) consensus algorithm, as it allows participants to actively participate in block validation and transaction processing, without the need for costly and energy-intensive mining hardware.
When you stake your crypto asset, you are essentially locking it up in a “staking wallet” to support the network’s security and validate transactions. In return for staking, you earn rewards in the form of newly minted cryptocurrency or transaction fees.
The amount of rewards you can earn depends on a couple of factors. Generally, the longer and more coins you stake, the higher the rewards you can earn will be. Currently, rewards on the Ethereum network are ~4.4% per year, while on the BNB chain and Polkadot go up to ~7.6 and ~6.6% respectively.
The staked cryptocurrency is typically held in a special staking wallet that is compatible with the specific blockchain and the PoS protocol it operates on. Depending on the platform where users stake, rules may vary and even if assets are locked for a certain period of weeks/months, it can be withdrawn earlier, with some fees for doing so.
To participate in staking, you need to have a certain amount of cryptocurrency to meet the minimum staking requirement. The amount typically ranges from a few hundred to several thousand coins.
It is well known that in order to become a validator on Ethereum, users need to stake 32 ETH, which is not little in dollar value, at the moment. Therefore, users have other options – staking pools or CEX services – where they can pool their assets together and still participate in network security and transaction validation.
Understanding Consensus Mechanisms
A consensus mechanism is practically an agreement among all participants, on how to do things right. In the context of distributed ledger technology (DLT), a consensus mechanism is used to ensure that all nodes have the same copy of the blockchain and that new transactions and blocks can be added to the chain in a secure and trustworthy manner.
There are eight types of consensus mechanisms used in DLT, including:
- Proof of Work (PoW): This is the most commonly used consensus mechanism. It requires participants (known as miners) to solve complex mathematical problems in order to add new blocks to the chain. The first miner to solve the problem and validate the block is rewarded with the blockchain’s native cryptocurrency.
- Proof of Stake (PoS): This consensus mechanism requires participants to stake a certain amount of cryptocurrency on a platform, to validate transactions and add new blocks to the chain.
- Delegated Proof of Stake (DPoS): This is similar to PoS, but only a selected group of participants (known as delegates) can validate transactions and create new blocks. Users can delegate the validator’s power to other participants in the validation process.
- Proof of Authority (PoAu): This consensus mechanism is used in private or permissioned networks. Here only authorized participants can validate transactions and add new blocks to the chain. Authorization typically goes through a formal agreement or a contract.
- Proof of Capacity (PoC): Works on the so-called plotting principle, where block validators store answers to mathematical problems on their hard drives. Again, the quickest to solve a problem gets rewarded. Therefore, users with the biggest storage capacity have an advantage here.
- Proof of Elapsed Time (PoET): In this option, software randomly assigns waiting time to different node operators. Participants whose waiting time expires first will be the one that gets rewarded. Downside of this method is that the system needs to confirm no user will operate multiple nodes, and that assigned time is actually random.
- Proof of Activity (PoA): Here participants search for a solution to get a reward. Blocks are seen as templates, with the header and address of a validator who is receiving reward. The more assets you have in stake, the bigger are chances you can deploy the next header. Once a chosen validator signs a transaction, it enters into the blockchain. In case a transaction is not signed, it will be rejected with the new block being used.
- Proof of Identity (PoI): In PoI, a user’s private key is related to a specific transaction. Any authenticated user can generate a block, and other network participants can see it. If that identity is confirmed as real, the transaction is confirmed as well. One of the main use cases for this mechanism would be to verify citizenships in the smart cities.
As you can see, consensus mechanisms are important because they enable decentralized networks to operate. By ensuring that all nodes have the same copy of the blockchain, consensus mechanisms help to prevent fraud, double-spending, and other malicious activities. They also provide a way for users to be rewarded for their contributions, which helps to incentivize participation and maintain the security and integrity of the blockchain.
How Is Proof-of-Stake Different From Proof-of-Work?
There are 3 main differences between PoW and PoS: transaction confirmation, creating new blocks, and energy expenditure.
It’s time to say something about security and scalability as well…
Proof of Work
More secure – a high hash rate means harder to attack the network. The likelihood of attacking the PoW system is well explained here, I highly recommend you watch it.
Less scalable – computational power limits the number of processed transactions. At the moment, the Bitcoin network can support only 7 transactions per second, in contrast to Visa’s 24,000 TPS.
Proof of Stake
Less secure (at least considered that way by some individuals) – possibility to buy the majority of coins and control the network.
More scalable – faster and cheaper transactions. The goal for the Ethereum network is to handle 100,000 TPS, once all upgrades have been implemented.
Proof-of-Stake Security
One of the most commonly raised questions about PoS systems is about security, where people claim that it is less secure than PoW.
In PoS, validators are chosen to create blocks based on their stake, which is the amount of cryptocurrency they hold as collateral. You can’t become a validator on a network unless you stake its native cryptocurrency.
With the bigger staked amount, the greater are chances of being chosen to create a block and earn rewards. Validators are incentivized to act honestly and keep the ledger secure because their stake is at risk if they try to cheat.
If a validator is found to be acting maliciously, they would lose their stake in so-called slashing, which creates a financial disincentive to cheat. Additionally, validators in a PoS system are usually required to stake a significant amount of cryptocurrency,
which makes it financially impractical for them to attack the network. With this simple rule, PoS prevents Sybil attacks where a malicious actor creates multiple identities to take control of the network.
For example, you need 32 ETH to become a validator on Ethereum network, 10 DOT for Polkadot, 10,000 BNB for Binance Smart Chain. Since you are already spending money to get this right, it wouldn’t make any sense to attack the network.
First, other participants would For example, you need 32 ETH to become a validator on Ethereum network, 10 DOT for Polkadot, 10,000 BNB for Binance Smart Chain. Since you are already spending money to get this right, it wouldn’t make any sense to attack the network.
First, other participants would discover you easily, everything is transparent. Second, if you do that, you will lose your stake and get kicked out, while the chain continues to operate normally. Third, you are financially incentivized to act fair, since the longer and more assets you stake, the bigger the rewards will be.
So far no bad actors were reported on any chain that operates on the PoS mechanism.
Proof of Stake Benefits
Despite constant attacks on this consensus mechanism, its benefits are numerous… To understand it better, below is the breakdown of it.
| Criteria | Proof of Work (PoW) | Proof of Stake (PoS) |
|---|---|---|
| Security | High. Miners spend significant resources to validate transactions. | High. Validators are incentivized to act honestly and keep the network secure. |
| Environment impact | High carbon footprint. | Lower carbon footprint. |
| Decentralization | Decentralization may decrease over time. Mining power in the hands of large mining pools. | Decentralization is more sustainable. Not affected by the concentration of mining power. |
| Entry cost | High. Need for expensive mining equipment. | Low. Staking requires only a significant amount of cryptocurrency. |
| Energy consumption | High. Miners solve complex mathematical problems to validate transactions. | Low. Validators stake their own cryptocurrency as collateral to validate transactions. |
| Transaction time | Slower transactions. Confirmation takes time due to the time required for miners to solve complex mathematical problems. | Faster transactions. Validators are chosen based on their stake, which makes the validation process faster and more efficient. |
Proof of Stake Drawbacks
As with every system, PoS is not ideal. It does have some undoubtful disadvantages, some of which are:
- Centralization: It can lead to centralization since it favors those who have a lot of coins. This creates a situation where a few large holders can control the network.
- Security risks: PoS is vulnerable to certain types of attacks that can compromise its security. For example, a user with a large number of coins can perform a “51% attack” where they control the majority of the blockchain and can manipulate transactions.
- Wealth inequality: This mechanism rewards those who already have a lot of coins. This can lead to a situation where a minority of validators reap most of the rewards.
- Lack of participation: In PoS, users are required to stake their coins to participate in the network and earn rewards. This means that those who do not have enough coins to stake are excluded from participating. For example, only approximately 15% of ETH is staked at the moment.
“Nothing at stake” problem
One scenario worth covering in depth is around the so-called “nothing-at-stake” problem. Let’s debunk it.
Although this problem never occurred, it might happen when validators decide to fork the chain. Because they are not spending electricity nor invested in expensive equipment, they have nothing to lose.
Therefore they would continue to validate newly created blocks on both chains, the old one and the new, forked one, in order to receive rewards from both branches. If two, or even more chains exist, and new blocks are being added, it opens the door for security risks and attacks on specific chains.
There are proposed solutions to this problem. One would be to penalize participants that are validating blocks on different chains, by slashing the portion of their staked assets and kicking them out of the validator’s position.
And the other one would be to include some computational work in this process, by mixing PoW and PoS mechanisms, in order to create an energy cost associated with block production.
Which Cryptocurrencies Use Proof of Stake?
Different platforms use PoS as their consensus mechanism. Some from its inception like Cardano and Polkadot, while some did a transition from PoW to staking in order to improve scalability issues, like Ethereum.
Below you can find the comparison between the most popular PoS systems.
| Cryptocurrency | PoS algorithm | Consensus mechanism | Other features |
|---|---|---|---|
| Ethereum (ETH) | Beacon Chain (Casper) | Validator deposits, slashing | Smart contract platform |
| Cardano (ADA) | Ouroboros | Stakeholder voting, verifiable random function | Third-generation blockchain |
| Polkadot (DOT) | Nominated Proof of Stake (NPoS) | Nominators, validators | Multi-chain platform |
| Binance Coin (BNB) | Byzantine Fault Tolerance (BFT) | Validators | Native token of Binance exchange |
| Tezos (XTZ) | Liquid Proof of Stake (LPoS) | Delegation system | Smart contract platform |
Speaking of security, all of these are considered to be relatively secure, but there are some differences in their implementation.
Ethereum, Cardano, and Polkadot all use relatively complex algorithms that have been designed with a focus on security and decentralization.
Binance Coin and Tezos, on the other hand, use simpler proof of stake algorithms that are designed for high performance and flexibility.
Key Takeaways
Summarizing everything written above, PoS has various benefits:
- Energy-efficient and nature friendly
- Faster and cheaper transactions;
- More inclusive for regular users.
Naturally, there are some drawbacks to this system:
- With increased centralization, users/institutions lock enormous amounts of coins and get favoured for rewards
- Security risks if big players decide to collude and attack the network
- Lack of participants that don’t have enough native cryptocurrency.
Nevertheless, Proof of Stake is a promising technology that is gaining more attention and adoption in the cryptocurrency industry, especially after The Merge, and Shanghai upgrades on Ethereum that made the transition from mining to staking.
Big centralized organizations saw their chance here, and they are offering pooling services for users that don’t have enough assets to stake. By simply staking on their platforms, users get a chance to support their favourite blockchain and earn rewards while doing so.
In case you decide to stake alone, in a pool, or on some CEX, make sure to do proper research in terms of regulations in your country. It is well known that governments love taxing almost everything, so you need as much information as possible before you cash out your rewards.
The Bottom Line
With all being said, it remains to be seen whether PoS will become the dominant consensus mechanism in the future. Mining Bitcoin becomes harder every day and is reserved for big players with expensive equipment. Staking comes as an alternative for enthusiasts that wish to participate in this ecosystem.
When choosing a platform for staking, and raising funds for startups, it is crucial to consider all positive and negative sides. Take advantage of resources like staking calculators and community forums to learn more about Proof of Stake and cryptocurrency investments. Having multiple options benefits everyone since we all have different needs.