What is Proof of Stake? How it Works and What it Means in Crypto
Key Takeaways
- With proof-of-stake (POS), people who own cryptocurrency are responsible for verifying block transactions based on the number of coins they hold.
- Proof-of-stake (POS) was created as an alternative to Proof-of-work (POW), the original way to confirm a blockchain and add new blocks.
- In contrast to PoW mechanisms, where miners solve cryptographic puzzles, PoS validators must hold and “stake” tokens to earn transaction fees.
- Proof-of-stake (POS) is considered less risky for the network since it incentivizes token holders to participate and makes attacking the network less profitable.
- The next block writer on the blockchain is selected randomly, with nodes holding more stake being more likely to be chosen.
What is Proof-of-Stake (PoS)?
The creators of Ethereum knew from the start that using proof of work would have limitations when it came to scalability. As Ethereum-based decentralized finance (DeFi) protocols have become more popular, the blockchain has struggled to keep up, leading to transaction fee spikes.
Unlike Bitcoin, which mostly processes incoming and outgoing transactions, Ethereum’s blockchain has to handle a wide range of DeFi transactions, smart contracts for stablecoins, NFTs, and any innovations developers develop. Proof-of-stake reduces the computational work required to verify blocks and transactions, which previously kept the blockchain secure using proof-of-work.
Instead, proof-of-stake allows machine owners to verify blocks by staking their coins as collateral, reducing the amount of computational work required. Validators are chosen based on the number of coins they hold and earn rewards for validating blocks.
How Does Proof-of-Stake Work?
Although staking in a proof-of-stake system may seem technical, it is accessible to everyday cryptocurrency users with a basic understanding of how it works. Proof of stake serves a similar function to proof of work’s mining, where network participants are selected to add the latest batch of transactions to the blockchain and receive cryptocurrency as a reward.
In general, proof-of-stake blockchains utilize a group of validators who stake their own cryptocurrency in exchange for the opportunity to validate a new transaction, update the blockchain, and earn a reward. The details of staking can vary depending on the project. Still, the basic idea is that validators offer their coins as collateral to participate in the network and earn rewards.
- In a proof-of-stake system, the network chooses a winner based on the amount of cryptocurrency each validator has staked in the pool and the length of time it has been there. This means that the most invested participants are rewarded for their contribution.
- Other validators can verify the accuracy of the most recent block of transactions after the winner has confirmed it. After several confirmations, the network updates the blockchain with the latest block.
- All validators who participate in the network receive a reward in the native cryptocurrency, which is distributed proportionally to each validator’s stake. This means those who have staked more cryptocurrency will receive a larger share of the reward.
Becoming a validator in a proof-of-stake system is a significant responsibility. It requires a certain level of technical expertise. Validators must stake a minimum amount of cryptocurrency, which can be relatively high (32 ETH, for example, in ETH2).
Validators risk losing some of their stakes through slashing if their node goes offline or if they validate a “bad” block of transactions. Therefore, validators should be aware of the risks involved and take appropriate precautions to ensure the stability and accuracy of the network.
What Blockchains Use Proof-of-Stake?
Many blockchains, including Ethereum, have used Proof of Stake consensus mechanisms instead of Proof of Work. Each blockchain typically modifies the consensus mechanism to fit its unique requirements. One notable news item today is that Ethereum is currently in the process of moving to Proof of Stake with the release of Ethereum 2.0. Here are the top 5 networks that the crypto community uses for PoS:
- BNB Chain
- BNB Smart Chain
- Solana
- Avalanche
- Polkadot
How is Proof-of-Stake Different From Proof-of-Work?
Proof of stake and proof of work are the two most common ways cryptocurrencies maintain a secure and accurate ledger. Proof of work was the original method used by early cryptocurrencies like Bitcoin. In contrast, proof of stake was first introduced in 2012 with Peercoin and is now used by many altcoins. While both methods are effective, they have different approaches.
In a proof of stake system, validators verify transactions, maintain records, and vote on outcomes. In contrast, miners compete to solve complex mathematical problems to verify transactions and earn rewards in a proof-of-work system. The key difference between the two is energy usage, as proof of work requires significant energy to solve problems.
In contrast, proof of stake requires less energy as validators do not need to compete to solve complex problems.
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Proof of Stake |
Proof of Work |
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In PoS, users who create blocks are known as “validators.” |
In PoW, users who create blocks are known as miners |
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Users in a PoS system must have their own coins before becoming validators. |
Users in a PoW system don’t need to own coins before they can become miners. They just need to buy mining gear. |
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A PoS system is energy efficient. |
A PoW system is not energy efficient. |
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A PoS system uses its community to guarantee safety and security. |
A PoW system depends on the type and level of equipment used. |
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Transaction fees are how validators are paid in a PoS system |
Blocks are how miners are rewarded in a PoW system. |
Understanding What a Consensus Mechanism is
In decentralized systems, a consensus mechanism allows the network to agree on a single version of the truth. Unlike centralized systems, where one controlling entity determines the truth, decentralized systems rely on many independent parties to work together to maintain the network. These nodes need a computational method to agree on the most recent and accurate data record. All nodes in a decentralized network must use the same cryptographic method to reach consensus.
Other Consensus Mechanisms That Build on Proof-of-Stake
Proof of Stake is a flexible consensus mechanism that can be customized to fit a blockchain’s unique requirements. Here are some of the most commonly used variations:
Nominated Proof-of-Stake (NPoS):
Polkadot created a consensus model called Nominated Proof of Stake that is similar to Delegated Proof of Stake but differs in one important way. A nominator (delegator) who supports a dishonest validator risks losing their stake. Up to 16 validators may be chosen by nominees, and the network will equally split its stake among them. To decide who creates a new block, Polkadot uses several game theory and election theory strategies.
Proof-of-Staked Authority (PoSA):
In order to create network consensus, the Binance Smart Chain makes use of Proof-of-Staked Authority. With the use of this consensus process, validators can alternately create blocks by combining Proof of Authority and Proof of Stake. Participants will be chosen from a pool of 21 active validators based on how much BNB they stake or have delegated to them. This group is chosen every day, and the BNB Chain keeps track of the decision.
Delegated Proof-of-Stake (DPoS):
Users can stake coins via delegated proof of stake while being validators. To participate in the block rewards, they might simply stake their coins behind a validator. A possible validator’s odds of getting chosen increase with the number of delegators who endorse it. Validators frequently have the option to change the reward they provide delegators. For delegators, the credibility of a validator is equally crucial.
Understanding What a Blockchain is
Blockchain technology allows for secure and transparent information sharing. At its core, a blockchain is a type of database or ledger where transactions are recorded. However, unlike a traditional centralized database, a blockchain is distributed across a network of computers. This means no single entity has complete control over the database or ledger, making it more secure and resistant to tampering or hacking.
This decentralized approach to database management is known as “distributed ledger technology” (DLT). Incentives in the form of digital tokens or currency are offered to network participants to encourage them to update and maintain the blockchain.
Why is Proof-of-Stake Seen as an Upgrade From Proof-of-Work?
Many experts predict that proof of stake will be the future of many cryptocurrencies. In this consensus mechanism, a miner’s chances of validating a transaction and earning a reward are based on the number of coins they own and the duration of their ownership. Unlike proof of work, which requires high-powered computers to solve puzzles, proof of stake is faster and more energy-efficient, requiring no special computing equipment.
Proof of work has been criticized for its high electricity consumption. Many newer cryptocurrencies and altcoins opt for proof of stake because it addresses these concerns and offers a faster and more accessible validation protocol.
Mining Power in Proof-of-Stake
In proof of stake, the amount of coins a validator stakes determines their mining power. Validators who stake more coins are more likely to be selected to add new blocks. However, each proof-of-stake protocol has its own method of selecting validators. It usually involves an element of randomness and can consider additional factors like the duration of coin staking.
If you stake a relatively small amount of coins, your odds of being selected as a validator are very low. This is why most people join staking pools, where the pool’s owner sets up the validator node. A group of individuals pool their coins to increase their chances of winning new blocks. The rewards are then shared among the members of the staking pool, with the pool owner taking a small fee.
What are the Advantages of Proof-of-Stake?
Proof of Stake (PoS) is a consensus mechanism that offers clear advantages over Proof of Work (PoW). Due to these benefits, most new blockchains use PoS. Here is why:
Decentralization:
PoS encourages more users to run nodes since it’s cheaper, making the network more decentralized. Although staking pools exist, an individual still has a much higher chance of successfully adding a new block under PoS. This reduces the need for staking pools.
Adaptability:
PoS is flexible to users’ demands and blockchains, as demonstrated by the abundance of possible modifications. It is simple to adapt to most blockchain applications.
Scalability:
Given that PoS does not depend on actual machines to produce consensus, it becomes more scalable than PoW. Large energy reserves or mining operations are optional. It is more affordable, straightforward, and available to add more validators to the network.
Energy Efficiency:
Compared to PoW, PoS is very electricity-efficient. The financial expense of staking coins determines the cost of participation more so than the computing expense of solving problems. As a result, the energy needed to execute the consensus process is significantly reduced.
Security:
Staking provides validators with a financial incentive to refrain from validating forged transactions. In the event that the community discovers an illicit transaction, the validator will forfeit some of their investment as well as their future participation rights. As a result, if the cost is more than the incentive, the validator will forfeit more coins as a result of fraud than they would earn. The network is safer as a result of this rule of law.
What are the Disadvantages of Proof-of-Stake?
Proof-of-Stake was created to address the issues of Proof-of-Work, such as hardware requirements and energy consumption. However, it also has its challenges:
Vulnerability to Attack:
Given that capital, being more centralized than labor and inexpensive energy, controls the network’s operations, Proof-of-Stake systems are susceptible to centralization and takeover. Anyone with $10 billion to spare can take control of a PoS network worth $100 billion in which 10% of tokens are staked. It is a huge issue that they may easily accomplish this by transferring $10 billion in tokens to a staking contract.
Governance Problems:
Owners of tokens have control over the network in proof-of-stake systems. Staking allows token holders to shape network policies and get access to additional tokens. This beneficial cycle of feedback may cause exchange and other major institutions that handle user assets to become the only custodians of staked funds.
Forking:
Mining both sides of a fork is not disincentivised in a typical Proof of Stake scheme. However, mining both sides would be wasteful under Proof of Work. People may “bet” on both sides of a fork because of Proof of Stake’s cheaper cost. The network can fracture as a result of this thereby causing a loss of consensus.
What are the Goals of Proof-of-Stake?
Proof-of-Stake is a new approach to transaction verification designed to address network congestion issues and sustainability issues arising from Proof-of-Work. The Proof-of-Work mechanism involves miners competing to verify transactions and earn cryptocurrency in return.
However, since miners must pay their expenses in fiat currency, they need to use vast amounts of energy to offset the cost of their operations, leading to an enormous energy consumption problem. In contrast, the PoS mechanism uses a staking system that randomizes the selection of miners to perform transaction verification, reducing the need for massive hardware and energy consumption farms. This makes PoS much more environmentally friendly and cost-effective than PoW.
Final Thoughts About What a Proof-of-Stake is
When considering investing in a cryptocurrency, it’s crucial to compare the two verification methods: proof of stake and proof of work. However, it’s essential to remember that not all proof-of-stake cryptocurrencies are created equal, even if you think they’re better. Always research the specific cryptocurrency you’re interested in and learn about what it aims to accomplish.
Also, check whether there are better alternatives available on the market. Nevertheless, suppose you decide to invest in a proof-of-stake cryptocurrency. In that case, it’s crucial to understand how it works to get the most out of your investment.