The decentralized nature of cryptocurrency is a huge benefit when it comes to improving the speed and accessibility of financial services. On the flip side, a common worry when it comes to the decentralization of money of any kind is, of course, security.
So, how can we ensure it’s safe to make transactions on blockchains like Ethereum or Bitcoin?
Right now, blockchains use something called “consensus mechanisms” to verify transactions and create new tokens. If you’ve read our Bitcoin whitepaper, you know that currently the most popular consensus mechanism—and the one used by Bitcoin—is called proof of work. But another consensus mechanism called proof of stake, or “staking,” has begun to threaten proof of work’s monopoly. In this article, we’ll explain why.
Key takeaways
-The original way to validate transactions on a cryptocurrency blockchain was through a consensus mechanism called proof of work.
-Staking offers a more energy-efficient and potentially more scalable and decentralized alternative to proof of work.
What’s proof of work again?
As a reminder, proof of work is a way to verify the transactions on cryptocurrency blockchains that does not require the overview or authority of a central entity like a bank or government.
A decentralized group of people knows as “miners” use computing power to compete with each other and solve cryptographic puzzles. The first miners to solve a puzzle are 1) allowed to add new transactions to the blockchain and 2) awarded some cryptocurrency for their efforts.
The high cost of mining equipment and the electricity used to run it, coupled with the rewards they receive, incentivize miners to add only correct information to the blockchain. That, at a very high level, is how proof of work works.
How staking fits in
While proof of work is the oldest and most battle-tested consensus mechanism, it’s not without issue.
For one, it benefits heavily from economies of scale. The better equipment you have and the cheaper the energy, the more likely it is that you can be a profitable miner. This has led to the centralization of proof-of-work mining operations over time, as evidenced by the football-field-sized, multi-million-dollar mining operations that are now common in places like Texas. (1)(2) But, of course, this poses some difficult questions for an asset class that generally touts decentralization as something to strive for. (3)
Proof-of-work blockchains also tend to have more rigid scalability issues and, by design, use a massive amount of energy. (1) The later in particular is something that has caused consternation among many politicians and ESG-minded institutions whose reactions to the energy consumption of cryptocurrencies like Bitcoin have been anything but favourable.
To address these perceived shortcomings, a new consensus mechanism called proof of stake was developed.
How staking works
In proof of stake, “miners” get replaced by “validators.” Validators run nodes that verify and record transactions on the blockchain.
While proof of work requires miners to spend a lot of money on computing power and energy to dissuade fraudulent activity, proof of stake relies on collateral.
Validators are required to put cryptocurrency up as collateral to the network. This is called “staking.” Validators are then randomly selected by the network to verify and add new transactions. However, your chances of being selected as a validator are usually proportional to the amount of cryptocurrency you have staked. So, if you stake one percent of a certain cryptocurrency on a proof-of-stake blockchain, you’ll be chosen roughly one percent of the time to validate a block. Sometimes the length of time that you have had your cryptocurrency staked will also influence how many times you will be chosen by the network to validate transactions. (5)
Upon the successful addition and verification of a block of transactions by a validator, they are rewarded with newly minted cryptocurrency. (5)
On the flip side, if the network notices that you are not undertaking your job as a validator with the proper amount of diligence or are seen to be trying to add fraudulent transactions, it will take some or all of your collateralized crypto. (6)
The prospect of getting rewarded for validating transactions, coupled with the fear of losing your crypto if you are not seen to be undertaking your job as a validator properly, act as ways to ensure that the blockchain remains secure and trustworthy.
Why proof of stake is exciting
Because proof-of-stake validators are picked based on passive crypto deposits as opposed to computational power, proof of stake uses much less energy than proof of work. Some estimates state that proof-of-stake blockchains reduce their energy expenditure by as much as 99.95% as compared with their proof-of-work counterparts. (1) (4) Good news for the environmentally-conscious crypto investors, and the planet.
Further, because proof of stake does not require specialized hardware, it largely eliminates the technical barrier inherent in proof-of-work mining operations. (1) This, in theory, makes validating the network more accessible to a wider degree of people and institutions. The more people involved in validating the network, the more decentralized and robust the network is likely to become.
Many proof-of-stake blockchains are also structured in a way that allows them to scale more efficiently than their proof-of-work counterparts. Proof-of-work blockchains are known for their rigidity and it is often cited that this rigidity can get in the way of these blockchains from scaling up in a way that could see mass adoption. In proof-of-stake networks, it is easier to incorporate scaling solutions, such as “sharding.” (5)
Proof of stake and beyond
The proof-of-stake consensus mechanism has been adopted by dozens of new cryptocurrencies. While it is not as old or as proven as proof of work, it is addressing serious concerns over environmental impact, decentralization, and the scalability of cryptocurrencies. And we believe it will likely play an increasingly important role in the cryptocurrency space as the technology is refined.
Sources
- “Varieties of Proof of Stake: LPoS, PPoS, HPoS, PoV,” Gemini: https://www.gemini.com/cryptopedia/proof-of-stake-delegated-proof-of-stake-consensus-mechanism#section-original-proof-of-stake-consensus-mechanism
- “How Texas is becoming a bitcoin mining hub,” Tech Crunch: https://techcrunch.com/2022/02/11/how-texas-is-becoming-a-bitcoin-mining-hub/
- “Why Centralized Cryptocurrency Mining Is a Growing Problem,” Investopedia: https://www.investopedia.com/investing/why-centralized-crypto-mining-growing-problem/
- “Ethereum's energy usage will soon decrease by 99.95%,” Ethereum Foundation: https://blog.ethereum.org/2021/05/18/country-power-no-more/ “Proof-of-Work vs. Proof-of-Stake for Scaling Blockchains,” Coin Telegraph: https://cointelegraph.com/news/proof-of-work-vs-proof-of-stake-for-scaling-blockchains
- “Sharding,” Investopedia: https://www.investopedia.com/terms/s/sharding.asp
- “What is Staking,” Binance Academy: https://academy.binance.com/en/articles/what-is-staking
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