Consensus mechanisms are pivotal for the success of distributed cryptocurrency networks as they enable them to operate without a central authority.
Proof of Stake or 'PoS', is an alternative to proof of work, the current consensus mechanism used by Bitcoin. Proof of Stake has gained popularity in recent years for its ability to solve some serious problems that plague proof of work networks such as Bitcoin and Ethereum.
Read on to learn about the Proof of Stake (PoS) consensus protocol from how it works to how it differs from other consensus mechanisms and which leading blockchain technology projects have deployed it.
The world’s first cryptocurrency, Bitcoin, utilises a Proof of Work (PoW) protocol to achieve distributed consensus. PoW involves network validators, called miners, deploying computational power to solve complex mathematical problems to verify transactions and secure the network.
Following the launch of altcoins a few years later, forward-thinking developers introduced a range of new consensus protocols to crypto networks. The one that has become the most popular is called Proof of Stake.
Proof of Stake (PoS) is a consensus mechanism that involves network participants staking the network’s token to validate transactions and secure the network. As a reward for helping to secure the integrity of the network, validators receive newly minted tokens.
Proof of Stake was introduced in a research paper titled "PPCoin: Peer-to-Peer Crypto-Currency with Proof-of-Stake", by developers Scott Nadal and Sunny King in 2012. Their goal: to develop an alternative to the energy-intensive and less scalable Proof of Work method. Since then, different cryptocurrencies have implemented a range of Proof of Stake-based algorithms in their networks to achieve scalability and consume less energy.
Crypto staking is the process of locking up funds in a wallet or contract to participate in the operational process of a crypto network to receive staking rewards. Through this process, Proof of Stake and other Proof of Stake-based blockchain networks are able to achieve distributed consensus.
As opposed to PoW mining, which uses computational power in solving cryptographic puzzles, staking allows users to validate transactions based on the number of coins they lock up.
In staking, users are encouraged to invest in internal resources (the currency of a network) and reach consensus without spending too many resources on external hardware. But staking also comes with certain risks as the smart contracts where funds are locked up can be prone to bugs.
In Proof of Stake, owners of a cryptocurrency stake (lock-up) their coins in a contract and set up validator nodes by installing all the necessary software needed. When transactions are ready for validation, the PoS algorithm randomly selects a validator to confirm if the transactions align with previous blocks in the network. After confirmation, the validator distributes the block to other nodes in the network for validation. Upon successful validation, the validator receives the block reward and transaction fees.
Daedalus is a secure wallet for the ADA cryptocurrency, used to stake coins on the Cardano network.
However, when validators act maliciously, they lose a portion of their stake as a penalty and are banned from participating as validators in future transactions.
A validator's chance of being selected is determined by the number of coins staked, the length of the stake, and an element of randomisation. Validators who stake a small number of coins have a lower chance of being selected.
For users with a small number of coins, the barrier of entry may be high depending on the network. Hence, they can join staking pools to increase their odds of validating blocks and earning rewards in the network. The pool providers charge a fee from the staking rewards for their service.
Proof of Stake is a less costly way of reaching consensus and provides even small investors with the ability to earn rewards on the network. However, there are certain risks you must be aware of before staking your funds.
One of the major risks involved in Proof of Stake is the market price volatility that comes with cryptocurrencies. Staking APYs of a network may be attractive but if the network’s cryptocurrency drops in value more than the annual staking reward, you will lose money on your staked holdings.
Tip: APY is an acronym for Annual Percentage Yield, and is the rate of return gained over the course of a year for your crypto investment when being staked.
Moreover, some cryptocurrency networks have fixed lock-up periods that prevent users from accessing their staked coins, meaning if your staked coins are falling in price, you won’t be able to unstake them for sale. To mitigate this risk, be diligent in your research and consider using networks without lock-up periods.
Another concern with Proof of Stake blockchains is the risks involved in running a validator node. Validator nodes may be penalised if they don’t maintain 100% uptime in processing transactions. In the worst-case scenario, they may lose a part of their staked funds.
Also, some staking pools pay rewards at a fixed time, which may reduce the overall profit you make as opposed to using a pool that offers daily payouts.
Lastly, smart contracts where funds are locked up are prone to attacks from malicious actors, so always DYOR on the project you are staking your coins with.
Proof of Stake and Proof of Work are both consensus mechanisms that cryptocurrency protocols use in updating the state of their ledgers.
Proof of Work consensus follows a process where miners use computing power in solving cryptographic problems to enable them to confirm transactions and receive block rewards and transaction fees. Bitcoin is an example of a cryptocurrency that utilises this consensus mechanism.
Initially, the Proof of Work model in Bitcoin was designed to enable anyone with a personal computer to serve as a node in the network. But since then, different energy-intensive hardware has been utilised by miners to enable them to gain the block rewards.
The Bitcoin network’s high energy usage, however, makes the world’s leading cryptocurrency not very environmentally friendly. While research suggests that the energy mix used to mine bitcoin is over 50% based on renewable energy sources and Bitcoin advocates argue that the energy spent on the Bitcoin network is worth it because of the decentralised digital currency’s positive impact on the world, climate-conscious lawmakers have been pushing back against Bitcoin’s high energy consumption.
Proof of Stake aims to solve the problems of the PoW model by replacing the use of computing power with the staking of coins. Hence, reducing the need for intensive energy consumption and ASIC (application-specific integrated circuit) machines used in the Bitcoin network.
The PoS consensus method assigns validators to confirm transactions according to the proportion of coins they put at stake. This means most investments by validators are done internally, as opposed to Proof of Work, where miners invest in external hardware. This process of reaching consensus enables Proof of Stake-based cryptocurrencies to have higher transaction throughput and increased scalability than that of Proof of Work.
Additionally, small-scale investors can easily participate in the consensus process of PoS crypto networks, which is almost impossible with Proof of Work where the barrier to entry is very high. However, Proof of Work is still considered the most secure consensus algorithm and industry standard for reaching Byzantine-fault tolerant consensus.
The Delegated Proof of Stake (DPoS) consensus mechanism, developed by Daniel Larimer in 2014, is an evolution of Proof of Stake. DPoS requires users of a cryptocurrency network to elect delegates who are responsible for validating transactions and generating new blocks.
The amount of voting power per user is based on the number of tokens a user holds. The voting system may differ from network to network, but it usually follows a process where users pool their tokens together in a staking pool to assign their votes to the delegate of their choice.
The chosen delegate receives transaction fees and block rewards from the network. And the reward is shared among users who pooled their tokens for the delegate, according to the share of the pool they contributed.
In the case of an elected node acting maliciously or not working efficiently, the node is expelled with slashed funds as the DPoS algorithm is dependent on a delegate's reputation.
DPoS is considered a more scalable option than PoS due to the use of a limited number of validators. This enables the network to reach consensus faster, boosting its transaction speed. However, DPoS is often criticised for having a limited number of validators that are predetermined. Some crypto enthusiasts consider this as centralisation and prefer sticking with PoS or PoW consensus.
There are benefits and drawbacks of deploying a PoS consensus protocol to secure a crypto network. Let’s dive in and take a look at them.
Now, let’s look at some of the popular Proof of Stake coins in the market.
Cardano (ADA) is a Proof of Stake blockchain protocol that aims to distribute power among individuals securely and transparently. Its native token ADA serves as the utility and governance token of the Cardano ecosystem. It’s the largest cryptocurrency network to have fully implemented a Proof of Stake consensus mechanism.
Algorand (ALGO) is a permissionless blockchain network known for fast transactions, instant transaction finality, and low transaction costs. The chain deploys a Pure Proof of Stake (PPoS) consensus protocol, which is an improvement on PoS that promotes decentralisation.
Tezos (XTZ) is a PoS-based blockchain network that offers smart contract functions. It aims to solve a problem most cryptocurrency networks encounter - the network can upgrade over time without the need for a hard fork. It uses a type of staking known as baking for governance to incentivise users to act honestly.
Celo (CELO) is a cryptocurrency protocol that aims to introduce an increasing number of smartphone users to cryptocurrencies. The protocol also supports decentralised applications with low transaction fees powered by its Proof of Stake security model.
Today, there are numerous variations of Proof of Stake-based protocols as well as a range of hybrid consensus mechanisms that combine both PoW and PoS to secure their blockchains.
Proof of Stake has emerged as a popular consensus protocol because it enables high transaction throughput and low transaction costs. Also, the passive earnings token holders receive from staking are attractive to crypto investors.
Ethereum, the largest smart contract blockchain, is planning a transition from Proof of Work to Proof of Stake, which will further increase the importance of PoS in the global crypto markets.
We hope that this guide on Proof of Stake will help you on your journey to discovering the wonders of blockchain. To start trading cryptocurrency CFDs, sign up for an Axi live trading account today.
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