Proof of work (PoW) and proof of stake (PoS) are consensus mechanisms used to validate transactions and broadcast new blocks to the blockchain without requiring a third party.
Bitcoin, the world's leading cryptocurrency, introduced the proof-of-work consensus mechanism. Other cryptocurrencies using the proof of work model include Ethereum, Litecoin and Dogecoin.
The need for proof of work was to decide how the blockchain would reach consensus.
In 1998, Nick Szabo proposed Bit Gold, which required a user to allocate computing power to solving puzzles for rewards. Szabo’s Bit Gold never took off due to his inability to solve the double-spending problem (digital data being copied and pasted) without a central authority. Bitcoin would go on to solve this problem with its proof of work consensus mechanism. The proof-of-work concept existed before Bitcoin, but its primary aim was to prevent cyber attacks.
Many cryptocurrencies use a proof of work model, but in this article, we’ll focus on Bitcoin as an example.
The process of creating new Bitcoin is known as mining, which has two objectives:
To mine Bitcoin, miners on the Bitcoin network compete against each other to solve complex computational problems. Mining Bitcoin is very energy-intensive, so you won’t be able to mine it off an everyday computer. The high energy intensity, plus limited transactions per second, that Bitcoin (and all other proof of work cryptocurrencies) suffer from is what incentivised the creation of alternative consensus mechanisms.
And so, up stepped alternative consensus mechanisms. The one in focus in this article is the proof of stake model. The very first cryptocurrency to use the proof of stake model was Peercoin.
Everything on-chain is verified by Bitcoin miners, who record transactions and add them to the blockchain ledger. As new transactions are eventually added, they are put into groups known as blocks. Ultimately, these blocks become ‘full’, and at this point, an additional block is added to the blockchain. In Bitcoins case, it takes 10 minutes for each block to be added to the blockchain (which is the time taken for a transaction to be validated). Rather time-consuming!
Adding one new block is broadcasted to the entire network, meaning every computer is updated to reflect the change. The whole network having information about the new block added, rather than being stored in a central database, makes the blockchain challenging to interfere with.
The ‘challenge’ of solving complex computer problems becomes increasingly difficult (and, therefore, more energy-intensive) as more Bitcoins are mined. Although the reward for mining has, on average, become greater over time, as has the cost of mining, plus the likelihood of miners being unsuccessful in mining. This is due to a combination of Bitcoin’s increased value further incentivising others to mine + fewer Bitcoin available to mine. The end result is more miners competing over fewer Bitcoin.
As mentioned earlier, the proof-of-work model’s main aim is to prevent cyber attacks. To add a malicious block to the Bitcoin network, somebody would require a computer more powerful (greater mining hash rate) than 50% of the network (known as a ‘51% Attack’)!
Unlike proof-of-work, proof of stake does not rely on miners’ ability to solve ‘hash’ puzzles to produce new blocks for the chain. It involves users staking, which means locking-in units of a cryptocurrency. The mechanism aims to create a competitive advantage over proof of work by improving its energy-intensive, often lottery-like, mechanism.
Randomly chosen validators, who ‘stake’ the native network’s token by locking them into the blockchain, create and authorise blocks. Under proof of stake, the system rewards users based on the amount staked.
So, those who stake their cryptocurrency become validators who further secure the blockchain network. The protocol selects users at fixed intervals to generate the next block based on their stake. As a general rule, the higher the stake, the higher the chance of producing the next block.
Others must verify a validator’s proposed block before being added to the blockchain. The validators are incentivised to act in good faith for two main reasons:
Rewards can come in different forms and vary from one cryptocurrency to another:
A straightforward way to be rewarded. Users simply hold their coins in a suitable staking wallet for a specified period. The reward amount varies depending on factors, including how many coins are staked by the validator, how long the validator has been staking, the number of coins staked across the network, and the inflation rate. The distribution of rewards is not always enforced by protocol and may be subject to a user’s action.
Users delegate a portion of their stake to a validator who is responsible for securing the blockchain network. The delegator is rewarded with a share of the validator's revenue. The distribution of rewards is not always enforced by protocol and may be subject to a user’s action. This model may result in the validators being a relatively small pool of nodes, which can result in a low level of decentralisation on the network. These nodes control the operations and overall governance of the blockchain.
A staking pool involves users combining their coins to increase the likelihood of validating blocks and earning rewards. The rewards are divided proportionally relative to the size of the contribution made to the pool.
Establishing a pool is not easy and can require a lot of expertise. Pools are most effective when there are relatively high barriers to entry. In exchange for their time and expertise, pool operators charge a network fee as a % of the staking rewards.
Sometimes, there is a minimum stake balance required to deter ill-mannered behaviour.
If you wish to stake your coins offline, you can do so with a hardware wallet (if the blockchain network supports it). Moving staked coins out of the hardware wallet means they will stop earning rewards. Cold storage is the most secure way of protecting your cryptocurrency, so this method is particularly interesting to those with large holdings.
These wallets store your private keys on a hardware device such as a drive or a USB. Hardware wallets are offline, meaning you are not dependent on internet connectivity. However, you will need to connect it to the internet when wanting to make a transaction. Because they are offline, hardware wallets have greater levels of security than online wallets.
Many exchanges also offer staking services, either for free or in exchange for a service fee. The exchange will perform the staking on your behalf in their network wallet and transfer your rewards. Examples of exchanges offering this service include Binance, Coinbase and Kraken (shown below).
PROOF OF WORK vs PROOF OF STAKE. COMPLETED. ✅
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