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Austin Jacob Sam Klemens • May 20th, 2020

What is Proof of Stake?

A cryptocurrency is a giant network and like any network, it must be secured. There are a couple of ways to do that. IOTA uses a mechanism they call the tangle, Bitcoin uses Proof of Work, NEO has a dBFT mechanism.

Each has its own set of advantages but they’re all topics for another day. In this article, we’ll cover Proof of Stake (POS) which is one of the most common consensus mechanisms in crypto. In a sentence: with POS users put up their coins as collateral and are rewarded by the network for voting to approve transactions.

Key Points

  • While Proof of Stake has a lot of promise it’s not quite as well tested as Proof of Work. It may be several years before POS is fully understood and all of the largest vulnerabilities are worked out.
  • Proof of Stake is much more environmentally friendly than Proof of Work, which requires ASIC miners which are notorious for their electricity usage.
  • While POS does have a fairly high ROI for many coins an investor must hold a potentially volatile asset in order to stake. Thus, from a financial point of view POS only makes sense for people who want to invest in a project anyways.

The Argument for POS

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.

  • High energy usage. Some estimate that the Bitcoin network uses as much energy as Denmark. While much of that comes from renewable sources, plenty doesn’t.
  • Mining is undemocratic. Thanks to ASICs, crypto enthusiasts, by and large, can’t mine profitably in their basement or garage. Instead hundred-million-dollar mining farms with tens of thousands of ASIC dominate the landscape.

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.

How Much Can You Earn from Staking?

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 Advantages

It is hoped that POS will increase the decentralization of networks. Since more people can participate in network security without needing to spend millions of dollars on ASIC miners. Becoming a staker is also (ideally) technically simpler than setting up a roomful of ASICs.

Some coins have a minimum amount of coins that must be held in order to stake. For example, when Ethereum becomes a Proof of Stake coin the minimum amount of Ethereum an investor will need to hold in order to stake is 32. Even at a low price of $150 per coin that equates to $4,800.

Should Ethereum double in value it could cost $10,000 to stake. However there is a solution: a staking pool. Investors who don’t own enough coins to take will still be able to pool their coins together in order to stake with others. This is a similar concept as the very popular mining pools for the Bitcoin network.

In some cases POS can offer other tertiary benefits like faster confirmation times and faster throughput than Proof of Work. However, these benefits can change on a coin by coin basis.

Proof of Stake Disadvantages

At this time the largest disadvantage of Proof of Stake is simply that it’s a largely unproven technology. Bitcoin has more than ten years of smooth and continual operation, illustrating the merits of POW. On the other hand POS has only become popular in the last couple of years. There could still be fundamental flaws in the technology that have not yet been realized. This is especially true given that POS is quite a bit more complex than the beautiful simplicity of POW.

Another large concern is that staking may centralize with large exchanges. Both Coinbase and Binance, among others, allow users to stake their coins through the exchange.

The benefit for the user is that it’s much simpler to stake in this manner and often exchanges have insurance that can cover losses in the event that something goes wrong.

The concern though is that if everyone stakes with an exchange the exchanges may become “whales” capable of exerting too much control over the network. As of yet this has not happened but it’s certainly a concern going forward.

There is some concern that as people stake through large exchanges the exchanges may gain undue control over the network

Among some communities, Bitcoin maximalists in particular, there is also some debate about whether a Proof of Stake network can be considered truly secure given that no “effort” is being expended in securing it. This debate however is outside of realm of this article.

Conclusion

Proof of Stake is an extremely promising technology. 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 include Ethereum, Cardano and Tezos.

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