What is Proof of Stake?

Mar 4, 2021 - 6 min read

The number of proof-of-stake (PoS) blockchains has been steadily increasing over the last couple of years, and Ethereum’s highly anticipated move to PoS has generated wide discussions of the topic. PoS blockchains offer numerous opportunities for crypto investors, so it might be useful to understand the mechanism behind it, and how it compares to other protocols such as proof-of-work.

The basics

Simply put, a blockchain is a database where sequential blocks of information are created and subsequently secure by a network of decentralized nodes. As the nodes in blockchain networks are decentralized, there is no single authority that can decide on what information is correct and should be added to the database. There is a need for an alternative way involving uncoordinated network participants. Proof-of-stake in blockchain refers to a particular mechanism that is used to decide who can add and validate new blocks in the blockchain.

Originally, the answer to this was given by Satoshi Nakamoto when he or she (Nakamoto’s identity is still not known) published the Bitcoin white paper and outlined the proof-of-work (PoW) method of validating blocks on the blockchain. In PoW, the right to create new blocks is given to miners who spend their computational power to solve cryptographic puzzles. One often noted downside of PoW is that it uses significant amounts of energy which is needed to support the network’s security. To address this drawback, alternative protocols, such as proof-of-stake have been developed to serve the same function.

The concept of proof-of-stake was introduced by Scott Nadal and Sunny King in 2012, and it was first adopted by Peercoin blockchain in 2013. Peercoin was one of the first altcoins – cryptocurrencies trying to address perceived issues with Bitcoin – and for some time was seen as its rival. It started as PoW but gradually moved to a mixed PoW and PoS setup. As mining peercoins became less attractive the users could switch to “minting” – producing blocks by staking their coins in the network instead of solving puzzles and getting rewards for it.

Proof-of-stake quickly gained supporters. After Peercoin, Nxt was the first to introduce pure PoS in 2013, and then Blackcoin in 2014. In the following years, proof-of-stake evolved into various new forms, such as delegated-proof-of-stake and leased-proof-of-stake. A number of major blockchain projects use some form of proof-of-stake (Polkadot, Tezos, Cardano), and the move of Ethereum to PoS has been long anticipated by market participants.

How it works

In proof-of-stake blockchains, new blocks can be added to the ledger by the participants who stake (bond) their assets (coins) in the network. Such participants are called validators, bakers, or block proposers, depending on the blockchain in question. While in PoW miners compete to add a block, in PoS validators are selected from the pool of validators randomly, or based on a predetermined algorithm. For example, a validator often has a higher chance to get selected if their stake in the network is higher. A selected validator proposes a block, and if other validators agree, the block is added to the network. The validator receives a reward in the form of the blockchain’s native currency.

In the described setup one problem stands out: What will prevent validators from engaging in malicious behavior? For example, in case of two candidate blocks, validators can vote for both, and be sure to receive rewards for whichever block is included in the chain. This problem is often referred to as the “Nothing at Stake” problem. On PoW blockchains, the issue is addressed by the inherent cost of mining. PoS blockchains need to apply additional incentive mechanisms and penalties. Such incentives are most often economic: the network punishes malicious validators by taking away some or all of their stakes – a process known as “slashing”.

As with PoW, PoS blockchains are not immune to attacks such as “51% attack” – when one actor accumulates sufficient influence (through computational power in PoW and capital in PoS) to make selfish decisions in the network. The resilience of a PoS blockchain towards 51% attacks depends on the cost of acquiring enough coins, the initial distribution of coins among participants, and potential wins of the perpetrator. Another factor is the potential loss of coin value that is likely to occur after 51% attack.

Overall, a direct comparison of PoS and PoW is not straightforward. Proof-of-stake blockchains definitively win when it comes to energy-efficiency, since PoS protocols consume negligible amounts of energy. When it comes to the risk of centralization, PoS vary significantly depending on their design. Some have built-in mechanisms that disincentivize centralization (like Polkadot). In terms of security, PoW has a longer and better track record.

Where it is used

The two largest cryptocurrencies to date – Bitcoin and Ethereum – both currently use PoW. However, Ethereum is in the process of moving to proof-of-stake. This has the potential to further elevate the stature and perhaps also the popularity of proof-of-stake.

While not yet at the top, PoS blockchains have gained prominence and increased recognition as their native coins move up to occupy positions among the top 10 by market capitalization. For example, Cardano runs on Ouroboros which is a delegated PoS and positioned as a “sustainable and provably secure” algorithm. Polkadot uses a so-called nominated proof of stake mechanism where all holders of native coins can nominate validators to represent them.

The rise of PoS blockchains, and specifically delegated-proof-of-stake has accelerated the development of a new investment strategy for crypto owners seeking rewards for their holdings with staking. Staking is a rapidly growing market with an estimated $350 billion market cap to date.

Proof-of-stake is a relatively new technology. It has gained popularity quickly as an energy-efficient and novel alternative to proof-of-work. The future PoS developments will depend on how it proves itself in real applications and what alternative solutions appear on the market to address security, scaling, and decentralization.

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