If you’re familiar with Bitcoin, you’ve most likely come across Proof of Work. It’s a way for bitcoin transactions to be verified on the network. Transactions need to be verified to avoid people from cheating the system.
Thus, dedicated people (miners) perform work to ensure the transactions on the network are legitimate. While doing so, these “miners” earn a reward for validating transactions. The reward is bitcoin.
This Proof of Work system has proven to be robust for Bitcoin. It enables consensus amongst a distributed network of participants (you and I) on “who owns what” on the Bitcoin network.
However, Proof of Work is not perfect. It has a few disadvantages. One of them is the immense amount of power consumption needed by miners to verify transactions. The annual total energy consumption used in Bitcoin’s Proof of Work system is currently on par with the power consumption of small countries, such as Venezuela. That’s a lot of energy.
This led to criticism of the Proof of Work system. People began looking for alternative methods to verify transactions while maintaining decentralization (not relying on one entity to verify transactions). This is when Proof of Stake was discovered.
Proof of Stake was first proposed in a Bitcoin reddit forum. Since then, its application has been found in other cryptocurrencies. One of the first being Peercoin. Its popularity has grown over recent years with the announcement of Ethereum switching from Proof of Work to Proof of Stake.
Proof of Stake works by requiring participants to lock up (“”stake”) their coins. By staking your coins, you allow the network to pick you to validate transactions on the network. Participants that stake larger amounts have a greater chance of being selected to validate. As a reward, the participant selected receives the transaction fees associated with validating the transactions inside that block.
If a participant tries to validate a fraudulent transaction, they lose what they stake, as well as their right to participate in the future. Most participants would not want to do this as they would experience a loss if they misbehaved. Therefore, it is in the best interest of the staker to validate legitimate transactions.
With this system, there is no need for dedicated miners. Avoiding the very expensive hardware investment and electricity costs to operate a miner. By enabling more people to participate in validating transactions, they create a more decentralized system.
In practice, staking only requires you to keep your coins in a specific wallet that you cannot spend for a certain amount of time. This allows anyone with a computer and internet access to participate in staking. Making is more accessible to participate then compared to mining (Proof of Work system).
Proof of Work is the original consensus mechanism invented by Satoshi Nakamoto. For more than a decade it has secured Bitcoin and done an admirable job of it. Despite the billions of dollars on the line, there has never been a major hack or 51% attack. POW has a couple of flaws, however.
Proof of Stake solves both of these problems. In the first case, it is environmentally friendly. Staking requires negligible amounts of electricity which makes it exponentially greener than Bitcoin. POS is also more democratic as anyone can purchase a small amount of cryptocurrency and start staking. Here’s how it works.
A person who wants to stake must buy a certain amount of cryptocurrency. Once they have those coins they can stake them. Simply put, staking involves sending coins to a special smart contract that validates transactions on the network. So long as the staker validates “lawful” transactions they will receive a reward. If a staker votes for “unlawful” transactions (I.e. a double-spend transaction) they can have their stake slashed.
When a stake is slashed the smart contract permanently claims a portion of the investor’s staked coins. If a staker continues attempting to validate unlawful transactions they may lose their entire balance of staked coins. POS networks assume that based on their own economic interest a majority of people will validate lawful transactions and the network will function as it has been designed to.
Although Proof of Stake brings numerous advantages over Proof of Work, this system is not perfect.
One of the disadvantages is certain cryptocurrencies require a minimum to stake. For example, Ethereum’s Proof of Stake system will require 32 Ether to stake. Using current prices, this will cost approximately $10,000 USD. Not necessarily accessible for all participants. To help make staking more accessible, “staking pools” have been developed to have multiple participants split the cost of becoming a staker.
Another criticism is that selecting participants by the size of their account more frequently will provide a permanent advantage for the richer coin holders. Consequently, the wealthiest coin holders will have the most influence on the network – making the network less decentralized. To help combat this problem, a couple of unique methods for selection have been developed.
One of these methods is coin age selection. This gives priority to participants who stake their coins longer. Once coins have been staked for a minimum of 30 days, participants with older and larger stakes are given a greater chance at earning a reward. If a reward is won, the stake length gets reset. There is a maximum stake length of 90 days to avoid very old stakes from dominating the network.
The staking reward depends on the network. Currently, the Tezos network offers some of the highest staking rewards with a 6 to 7% annual yield. When Ethereum transitions to POS it’s estimated that the staking reward will be between 6 to 8%. For those who want to see staking returns for various coins Binance is a great resource.
Generally staking follows economics 101: the more stakers the lower the reward. The fewer the stakers the higher the reward. Also, as alluded to already staking really only makes sense (at least for now) for cryptocurrency investors who want to hold a coin for the long term. An 8% return sounds good but it’s nothing if the value of the coin drops 40% in a month.
Proof of Stake is an alternative consensus system to Proof of Work. It fixes some of the issues found in Proof of Work but is still not a perfect system. It’s green, it’s democratic, it even offers a healthy ROI for those willing to subject themselves to the volatility of the crypto market.
What’s needed now is simply time. Time to work out the bugs, time to find out what works and what doesn’t. At this stage it’s too early to make any sweeping pronouncements about POS, it’s better to sit back and watch what happens in the coming years. Projects, in particular, to keep your eye on including Ethereum, Cardano and Tezos.
Here are the key takeaways: