A Guide To Proof of Stake (PoS)

Cryptocurrency was created to decentralize power, allowing people to earn, transact, and govern without central control. But this freedom poses a challenge: maintaining blockchain integrity in a system without authoritative oversight.

Key issues include preventing double-spending, where a user spends the same coin twice, and tracking transactions and balances without central authorities. Bitcoin initially tackled this with its Proof of Work (PoW) mechanism. However, Proof of Stake (PoS) has since emerged as a more efficient and eco-friendly alternative.

Both PoW and PoS are consensus mechanisms, essential for agreeing and maintaining order democratically in cryptocurrency networks. While other mechanisms like Proof of Capacity (PoC) and Delegated Proof of Stake (DPoS) exist, PoS is our focus here.

For cryptocurrency investors, understanding PoS is crucial. We'll go into how it works, its pros and cons, and examples of cryptocurrencies that use PoS, providing you with all you need to know.

What Is Proof of Stake?

Proof of Stake is a consensus mechanism employing a staking method where validators hold a portion of their earned coins in the network to be eligible for adding a block. In this method, participants lock up a certain amount of cryptocurrency in a smart contract on the blockchain. In return, they get the opportunity to validate new transactions and earn rewards.

How Does Proof of Stake Work?

The blockchain algorithm selects validators to verify each new block of data based on their staked amount. The larger the stake, the higher the chance of being chosen to add a new block. Successful validators receive newly minted cryptocurrency as a reward.

This mechanism is effective because by staking their crypto tokens, validators demonstrate significant trust in the transaction's legitimacy, indicating their willingness to back it up with their hard-earned crypto. Verified transactions earn rewards proportional to the size of the stake.

Staking can be seen as earning interest income for a specific task: verifying blockchain transactions. As Doug Schwek, Chief Executive Officer of Digital Asset Research, explains, “If I validate only legitimate transactions, I earn interest on my assets. However, if I validate fraudulent transactions, I face penalties and risk losing some of my assets.”

Participants who submit or validate fraudulent transactions may face 'Slashing', where their stake is 'burned'. This means it's sent to an unusable wallet address, rendering it permanently inaccessible.

For example, Cardano, a notable cryptocurrency, employs the PoS method. Any Cardano holder can stake their coins and set up a validator node. Using its Ouroboros protocol, Cardano selects a validator to verify a block of transactions. If the block is valid, it's added to the blockchain, and the validator is compensated in Cardano for their effort and time.

Proof of Work vs. Proof of Stake

Centralization Concerns: PoW which is best described by Bitcoin has led to centralization concerns, as mining power concentrates among those who can afford advanced hardware. PoS, in contrast, democratizes participation, as it requires staking cryptocurrency rather than expensive computational resources, thereby upholding the decentralized nature of blockchain more effectively.

Energy Consumption: PoW's energy demands are immense due to the competitive nature of mining, with Bitcoin alone consuming more energy annually than some entire countries. PoS addresses this by significantly lowering energy usage, as it doesn't involve energy-intensive mining, aligning better with sustainability goals.

Transaction Throughput: PoW, as in Bitcoin's case, limits transaction throughput to about 7 transactions per second due to its 10-minute block time. In comparison, PoS can potentially handle transactions more quickly and efficiently, as it isn't bound by the computational puzzle-solving process of PoW.

Mining Power Dynamics: In PoW, mining power is directly linked to computational capacity, which can lead to unequal distribution of power. PoS, however, ties mining power to the amount of cryptocurrency staked. This change allows for a more equitable distribution of validation opportunities.

Staking Pools: While PoS allows for a more equitable distribution, the chance of being chosen as a validator can still be low for small stakes. This leads many to join staking pools, where individuals combine their stakes to increase their chances of validating blocks and earning rewards, similar to mining pools in PoW but typically more accessible to average users.

Environmental Impact: The environmental impact of PoW is significant, as highlighted by a White House report stating that crypto mining's energy consumption undermines U.S. sustainability goals. PoS offers a more environmentally friendly alternative by reducing the energy-intensive process of mining.

Real-World Example: Cardano which uses PoS, illustrates this mechanism's potential. Any ADA holder can stake and become a validator, democratically validating transactions and maintaining the network's integrity with much lower energy consumption compared to PoW systems.

Pros and Cons of Proof of Stake

The advantages of PoS have led to its wide adoption in the cryptocurrency space, while its drawbacks explain why established networks like Bitcoin still prefer the Proof of Work (PoW) consensus.

Pros of of Proof of Stake

Energy Efficiency: PoS networks generally consume less energy than PoW systems. Validators in PoS are chosen based on criteria like the amount staked and duration, requiring less hardware and energy than PoW mining operations.

Quick and Inexpensive Transactions: Some PoS chains offer faster and more efficient transaction processing, ideal for decentralized applications (dApp) and modern blockchain uses. However, not all PoS systems result in lower fees, as seen with Ethereum.

Change Flexibility: In PoS, validators can vote to implement changes, making it adaptable to evolving network needs. This flexibility is often more challenging in PoW systems due to their established technological frameworks.

Cons of Proof of Stake

Relative Infancy: Being relatively new, PoS and its recent variations haven't been tested extensively over time. Concerns about potential unique vulnerabilities remain as it gains wider adoption.

Security Concerns: PoS networks, which base their security on the underlying currency's value, can be vulnerable to attacks. There's also a need to prevent wealthy users from exerting disproportionate influence, which can complicate monitoring and auditing.

Risk of Centralization: Wealthier participants in PoS networks can potentially become more dominant, leading to increased centralization. Those with substantial stakes might exert undue influence over transaction validation.

Strict Exit Regulations: Some PoS chains enforce lock-up periods for staked coins, restricting validators' ability to respond to market changes and potentially causing significant losses.

Regulatory Scrutiny: PoS services have drawn attention from regulatory bodies like the SEC. For instance, when Kraken was charged for its staking service, the SEC highlighted the need for compliance in PoS protocols. The SEC's classification of certain PoS tokens (ALGO, OMG, TKN) as securities in a case against Bittrex was based on centralization concerns and the expectation of profit by token holders, a key aspect of the Howey Test.

Examples of Cryptocurrencies Employing Proof of Stake Mechanism

Many cryptocurrencies, especially those supporting decentralized applications, have adopted PoS as their consensus method. Here's a list of notable PoS cryptocurrencies:

Ethereum: In 2022, Ethereum, the second-largest cryptocurrency network by market capitalization, transitioned to PoS with its Ethereum 2.0 update. This shift from PoW was part of a larger strategy to enhance the network's scalability and energy efficiency.

Cardano: Introduced in 2017, Cardano operates on its unique Ouroboros protocol for PoS. Contrary to the statement about its network performance being slower, Cardano is actually recognized for its strong focus on sustainability, scalability, and interoperability.

Solana: Known for its high-speed and low-cost transactions, Solana integrates PoS with its novel Proof of History (PoH) mechanism. Despite some challenges related to network stability, Solana remains a popular choice among PoS cryptocurrencies.

Polkadot: Polkadot employs a variation of PoS called Nominated Proof of Stake (NPoS), where validators are selected based on their stake and performance. This unique approach enhances network security and efficiency.

BNB Chain (Formerly Binance Smart Chain): This network uses a consensus mechanism known as Proof of Staked Authority (PoSA), combining elements of PoS and delegated authority. While this model offers scalability, it tends to be more centralized compared to other PoS systems.

Conclusion

Proof of Stake (PoS) chains are popular and preferred for their energy efficiency and scalability. However, they can encounter security and censorship challenges if validator diversity is insufficient. Similar risks are also inherent in Proof of Work (PoW) and other consensus mechanisms.

The advancement of PoS has enabled various innovative blockchain applications, previously considered unfeasible. This development has significantly facilitated user and developer onboarding in the blockchain space.