RV Blog What is Proof-of-Stake?

What is Proof-of-Stake?

What is Proof-of-Stake?

Consensus mechanisms on blockchains

Cryptocurrencies owe their successes to the financial incentives that underlie their various consensus mechanisms. Most consensus mechanisms fall into the categories of Proof-of-Work (PoW) or Proof-of-Stake (PoS). To understand both mechanisms, it is important to understand the basic concept of consensus. Consensus is a method for validating entries into a distributed database and keeping the database secure. The goal is to create an immutable, decentralized transaction history that every network participant can agree to.

In the case of cryptocurrencies, this mechanism helps to secure the blockchain. Different computers have to come to a consensus regarding whether a transaction on the blockchain is valid or not. Usually, the threshold for a consensus is 51%, but with PoS this number can be chosen arbitrarily. Consensus manipulation is a constant risk that blockchains are facing, therefore the cryptocurrency consensus mechanisms have built-in financial incentives to ensure only valid transactions are confirmed.

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How does Proof-of-Stake work?

In 2011, a Bitcoin Talk forum user under the name of QuantumMechanic proposed a technique that he called “Proof-of-Stake.” The basic idea is that allowing everyone to compete against each other with mining (as with PoW) is a waste of resources. PoW, as used for Bitcoin and other early blockchains, requires a huge amount of computational work and energy to validate transactions. In contrast, PoS reduces this amount drastically.

QuantumMechanic proposed to use the computers of coin owners (called “nodes”) to verify transactions and blocks. To gain the chance to validate blocks and earn block rewards, coin owners offer their coins as collateral by staking (locking) their coins in a smart contract on the blockchain. By doing this they become validators. The time a cryptocurrency must be staked to process and verify transactions can vary, as can the minimum number of coins a coin owner must lock up as their stake. The more coins a coin owner stakes, the more likely he or she is to be chosen to process transactions and create blocks.

There is also the option to participate in the validation process through staking pools. Users who do not want to run a validator node on their computer 24/7, or who do not have the minimum stake required to join the network, can lend their coins to another validator to earn a cut of their rewards. This is called delegated staking.

How does Proof-of-Stake verify transactions?

To validate a new block and add (also referred to as mint or forge) it on a blockchain, validators are randomly selected by an algorithm. The size of the stake determines a validator’s chances to be chosen to forge the next block. In most cases it is a linear correlation, so the more coins a validator stakes, the more likely he or she is to be selected.

To subsequently verify the newly created block on the blockchain, several more validators are needed. The exact number or percentage is hardcoded into the blockchain’s source code.

If a node is chosen to validate the next block, it will check if all the transactions within the block are indeed valid (follow the network’s rules). When a specific number or percentage of a network’s validators verifies that block’s correctness, it is finalized and closed. As a reward, the nodes that are involved receive the fees that are associated with each transaction, and depending on the blockchain, additional block rewards.

Does Proof-of-Stake require mining?

PoS does not require mining (solving a mathematical problem to be selected) like PoW for adding new blocks to a blockchain. In PoS, nodes that validate and add new blocks to the blockchain are selected randomly by the blockchain algorithm. These nodes are called validators. The mechanism that decides who gets to add the next block is not called mining but is dependent on an algorithm that chooses the next block validator according to predetermined parameters.

How secure is Proof-of-Stake?

The requirement for coin owners to stake coins to participate in the building of the blockchain has been put in place to ensure that validators work honestly and correctly. Validators will lose a part of their stake if they approve fraudulent transactions. This mechanism is a financial motivator and holds up as long as the stake is higher than the sum of all the transaction fees they can earn.

In order to effectively control the network and approve fraudulent transactions, an attacker would have to own a majority of the stake in the network, also known as the majority attack. With some PoS blockchains, at least 66% of the nodes would have to be under the control of the attacker to approve malicious transactions, while with other blockchains the threshold is 51% or some other arbitrary number. Depending on the value of the cryptocurrency, such an attack is extremely costly. To acquire a majority of the circulating coin supply, a huge amount of money would be needed, which makes such an attack highly unlikely but not impossible.

In the event that a node stops their work as a validator, the stake plus all the transaction fees that have been earned will be released only after a certain time period. This cooldown period is needed because the network still needs to be able to punish the validator should it discover that some of the validated blocks have been fraudulent.

Proof-of-Stake Benefits

  • Participating in blockchain systems as validators has a low entry barrier. There is no need to buy expensive computing hardware and consume massive amounts of electricity when staking crypto. The only requirement is to buy and stake the coins.
  • PoS blockchains are fast in processing transactions.
  • An additional benefit of PoS blockchains is that they are more scalable than their PoW counterparts. Blockchains that run with PoS are often able to support a higher transaction throughput.
  • The more coins are locked, the less the supply of the cryptocurrency is available on the open market. This can have a stabilizing effect on the price. The lock-off period prevents large amounts of coins from being sold quickly.
  • PoS also makes it easy to create an on-chain governance system that allows stakers to vote on proposals concerning a network’s future.
  • By staking, coin holders can earn income through staking rewards.

Proof-of-Stake Downsides

  • Although it is relatively easy to set up a node and participate in a PoS network, some PoS blockchains have high thresholds when it comes to the minimum stake users need to put down to connect to the network as an independent node.
  • PoS algorithms have to be carefully designed on how they select the next validator. The size of the stake has to be factored in. Therefore, it cannot be completely random. But the stake amount alone cannot be the only criteria because this would favor big investors that can afford to buy a large number of coins. These investors would be chosen more frequently, would collect more transaction fees, and therefore accumulate even more coins. This would also increase their chances of being chosen as validators again and eventually lead to centralization.
  • The annual inflation rate of most PoS cryptocurrencies is much higher than with PoW currencies because inflation is used to incentivize staking. In essence, this turns staking into a requirement because anyone who only hodls these coins will see their share get diluted over time.
  • Inflationary staking rewards also open the door to taxation. In most countries, cryptocurrencies earned from staking are taxed as capital gains. If the value of the cryptocurrency happens to fall by the end of the year, the coin holder could still owe the dollar amount earned when the inflationary rewards were credited to them earlier and the price was higher.

Does Proof-of-Stake lead to more centralization?

The core focus of blockchain technology and cryptocurrency is decentralization. On one hand, the PoS network relies on a huge number of nodes and has a low entry barrier to become a validator, theoretically leading to greater decentralization. On the other hand, most PoS blockchains had a ‘pre-mine,’ in which a large number of coins were minted in advance to be distributed to the team and early investors, who provide staking pools. Due to a high threshold and a high minimum stake that is needed to participate, the average coin holder is forced to join these staking pools, ultimately leading to greater centralization. Also, many investors stake their coins through centralized exchanges, which also fosters centralization.

Another point, when it comes to centralization, is this: Most PoS blockchain ledgers are many times larger than with PoW. Instead of every single node storing a copy of the entire ledger, most PoS cut off older parts of their blockchain to reduce storage requirements. They then rely on archive nodes or centralized cloud storage to store their full blockchain history.

Which blockchain uses Proof-of-Stake?

Proof-of-Stake is becoming more prevalent as a consensus mechanism in the cryptocurrency world. Some of the most popular blockchains using PoS are:

Solana (SOL), Cardano (ADA), Tron (TRX), EOS (EOS), Cosmos (ATOM), Tezos (XTC), among many other projects. Ethereum, the second-largest cryptocurrency after Bitcoin, is in the process of transitioning from PoW to PoS.