Proof-of-Stake Explained

Decentralisation is at the heart of blockchain technology and cryptocurrency. There’s no central gatekeeper to manage a blockchain’s record of transactions and data. Instead, the network relies on an army of participants to validate incoming transactions and add them as new blocks on the chain.

Proof-of-stake is the consensus mechanism that helps choose which participants get to handle this lucrative task—lucrative because the chosen ones are rewarded with new crypto if they accurately validate the latest data and don’t cheat the system.

“When blockchain participants verify that a transaction is legitimate and add it to the blockchain, we say that participants have achieved consensus,” says US-based Marius Smith, head of business development at digital asset custodian Finoa.

With PoS, participants referred to as “validators” lock up set amounts of cryptocurrency or crypto tokens—their stake, as it were—in a smart contract on the blockchain. In exchange, they get a chance to validate new transactions and earn a reward. However, if validators incorrectly validate transactions, including fraudulent or harmful data, they risk losing a portion or the entirety of their stake as a penalty.

Ethereum recently transitioned from PoW to PoS, cutting the network’s energy consumption by over 99% and placing it as the largest blockchain using PoS as its consensus mechanism.

Related: What Is Crypto Staking?

Staking is the process where individuals willingly put aside or ‘lock up’ a certain amount of their cryptocurrency. In return, they receive the opportunity to validate new data blocks, which will be subsequently added to a blockchain. These validators, or “stakers,” put their crypto into a smart contract that’s held on the blockchain.

The blockchain algorithm selects validators to check each new data block based on how much crypto they’ve staked. The more you stake, the better your chance of being chosen to do the work. When the data that’s been cleared by the validator is added to the blockchain, they get newly minted crypto as a reward.

“The simple way to look at staking is like interest income that requires you to complete a task to earn the interest—checking blockchain transactions,” says Doug Schwenk, chief executive officer of US-based Digital Asset Research. “If I validate only good transactions, I earn interest on my assets. If I include bad transactions, then I’ll be assessed penalties and lose some of my assets.”

If a validator submits bad data or fraudulent transactions, they could be punished by ‘slashing’. Their stake is ‘burned’, meaning it is sent to an unusable wallet address that nobody can access, rendering them useless forever.

According to Smith, PoS works because validators say, “Hey, I have so much faith in the legitimacy of this transaction that I’m willing to back it up with my own money.” And verified transactions earn a cryptocurrency reward in proportion to the size of the stake.

Related: Ethereum Price Prediction

PoW has earned a bad reputation for the massive amounts of computational power—and electricity—it consumes. Given the heightened concern about the environmental impacts of blockchains that use PoW, like Bitcoin, PoS offers potentially better outcomes for the environment.

“On a global scale, proof-of-work is most profitable where energy can be had for the lowest cost,” says Smith.

This concentrates crypto mining in a few regions with the lowest electricity costs. According to Smith, proof-of-stake’s modest energy consumption solves this problem and widely distributes infrastructure, potentially making a blockchain system more robust.

PoS opens the door to more people participating in blockchain systems as validators. There’s no need to buy expensive computing systems and consume massive amounts of electricity to stake crypto. All you need are coins.

Crypto exchanges like Coinbase, Binance and Kraken offer staking as a feature on their platforms. There are even dedicated staking platforms, like Everstake. Depending on the blockchain, crypto owners can earn yields of 5% to even 14% on their holdings by staking.

One additional benefit of PoS blockchains offers potential for the future: they may be more scalable than their PoW counterparts. Smith says that PoS blockchains can, in theory, support more simultaneous transactions without compromising security or decentralisation.

“This is where a great deal of innovation is happening today, and indeed a challenge that blockchains will have to overcome if they are ever to become widely used on a global scale,” he says.

According to Amaury Sechet, founder of US-based eCash, PoS isn’t without cons.

“Proof-of-stake is not as extensively vetted as proof-of-work, which has secured billion-dollar blockchains for over a decade now,” said Sechet.

Certain implementations of PoS could leave blockchains more vulnerable to different kinds of attacks than PoW, such as low-cost bribe attacks. Susceptibility to attacks decreases the overall security of the blockchain.

Validators who hold large amounts of a blockchain’s token or cryptocurrency may have excessive influence on a PoS system.

Migrating a cryptocurrency from PoW to PoS is a complicated and highly deliberate process. Any crypto wanting to change consensus mechanisms will have to go through an arduous planning process to ensure the blockchain’s integrity from start to finish.

Two consensus mechanisms are generally used in cryptocurrency and DeFi applications: PoS and PoW. Whereas the former employs staking, PoW requires miners to solve complicated math puzzles in order to decide which network participants get to validate transactions and expand the blockchain.

Proof-of-Stake

• Requires validators to hold some of the blockchain’s token or cryptocurrency.
• Doesn’t require significant computing power for transaction validation.
• It’s a newer approach than PoW, with less adoption as a consensus mechanism.
• Cryptos that use PoS might be more attractive for an Australian ESG portfolio because of the lower environmental impact.

Proof-of-Work

• PoW has a longer proven history of use as a blockchain consensus mechanism.
• Miners don’t need to hold any of the blockchain’s assets and only need computing power to validate a transaction.
• It may use a very significant amount of electricity. Blockchains, and their associated cryptocurrencies, using PoW are often excluded from ESG portfolios because of the energy demands.

PoS is becoming more prevalent as a consensus mechanism in the cryptocurrency world. There are currently about 80 different cryptocurrencies that use PoS as the consensus mechanism. Some of the most popular coins using PoS include:

• Cardano (ADA)
• Tron (TRX)
• EOS (EOS)
• Cosmos (ATOM)
• Tezos (XTC)

While PoS is still emerging as a consensus mechanism for blockchain, it holds significant potential. With lower energy demands and a higher level of accessibility for everyday people to participate as validators, PoS has many attractive features that could bring it to the mainstream for blockchain security.