What is Proof of Stake (PoS)?
Definition
Proof of Stake is a method used to maintain a Blockchain network’s integrity. It is a more efficient alternative to the Proof of Work method aka Bitcoin mining.
Understanding Proof of Stake (PoS)
Proof of Stake is a less-energy intensive alternative to the original model of Proof of Work/Bitcoin mining. Both Proof of Stake and Proof of Work are what’s called ‘consensus mechanisms’, which is basically a reliable way of reaching an agreement in a group.
These mechanisms are used by Blockchain networks (with no single controlling authority) to ensure that:
- All cryptocurrency transactions are valid & secure
- Blocks (which store transactions) are verified & added to the chain (Learn more about Blockchain).
- Illegitimate transactions & double spending (spending the same coin twice) are prevented
- New coins are put into circulation & trust is created in the network
Basically, cryptocurrencies pay people in their own coin to keep the network secure. In the Proof of Stake method users are rewarded with cryptocurrency for validating transactions and contributing to the network’s security & legitimacy. This is done by ‘locking up’ or ‘staking’ their coins on the network.
- The reward a person earns is linked to the amount staked on the network and is usually paid out from the network’s transaction fees.
- If someone staking tries to hack the system or approve invalid transactions, they will be penalised & lose some or all of their staked coins.
- The core idea behind PoS is that those who stake/lock up their crypto on the network will want to help keep the network secure because their staked crypto depends on it.
And this is why PoS works – The more you stake, the more you earn. But at the same time, the more you stake, the more you lose if you go against the system.
If you’re a little confused about Proof of Stake and haven’t fully grasped what a Blockchain is, check out our super simple explanation here.
Why is proof-of-anything needed?
Before we breakdown how Proof of Stake works, it helps to understand why we need these ‘consensus mechanisms’ in the first place.
In the traditional centralised banking system:
- All transactions & balances are kept on a private ledger that is controlled & verified by the bank.
- We are completely dependent on third parties who we trust to maintain the integrity of the ledger, despite not everyone trusting banks to responsibly protect their savings (as seen in the global financial crisis of 2008).
- The bank’s ledger is stored in a single, centralised location, which also means there is a single point of failure that hackers can target.
And then there’s the world of cryptocurrency and decentralised finance. For a long time, the idea of decentralised money that was owned and powered by people was impossible for several reasons. However, Bitcoin’s Proof of Work method changed the game by providing:
- A reliable & trustworthy way for a ledger of transactions & balances to be maintained among a huge number of people who don’t know each other
- A solution to the problem of double spending, where users can attack the network & spend the same coin twice
- A banking network & ledger that was collectively owned & maintained by people all over the world, making a cyber-attack virtually impossible
- A way for trust to be built into the network itself, removing the need for banks, enabling decentralised money and changing finance forever
Proof of Stake vs Proof of Work
Originally, cryptocurrencies, namely Bitcoin, used Proof of Work to secure its network. This method is commonly known as ‘Bitcoin mining’, and it involves running lots of powerful computers around the globe to create new Bitcoin, validate transactions and keep the network secure.
While this method paved the way for decentralised digital currencies, as networks grew it became incredibly resource intensive (both expensive & taxing on the environment), so a more efficient way in Proof of Stake was born.
How does Proof of Stake (PoS) / Staking actually work?
Proof of Stake makes a Blockchain’s consensus mechanism completely virtual and far more efficient. Instead of using ‘miners’, Proof of Stake uses ‘validators’, ‘stakers’ or ‘forgers’ (used interchangeably) who lock up a portion of their cryptocurrency in a smart contract on the network and are rewarded in cryptocurrency for helping validate transactions.
Once your coins, or ‘stake’ is locked up (meaning you can’t access them for a certain period of time), you enter into a ‘staking agreement’ and vote to approve transactions. Although active participation in the network is recommended, in most cases and for most users, you don’t actually have to ‘vote’ as the process happens automatically.
While staking rules vary by network, the following provides us with a general idea of a staking agreement:
- The staker agrees that they’ll only validate valid transactions on the network, e.g., they will not vote to approve double spend transactions.
- In exchange for approving valid transactions, the network rewards the staker with a staking reward.
- If a staker votes to approve illegal transactions, they may lose some or all of their stake.
Now that we understand what a staking agreement looks like, here’s how staking actually works:
- First, in order to get the chance to validate transactions, a person must lock up at least the minimum amount in a smart contract on the network.
- Validators who lock up their coins are then randomly selected at specific intervals to create a block (and thus earn a staking reward).
- The ‘stake’ is what incentivises validators to maintain network security. If they fail to do that, the network would be insecure and their entire stake might be at risk.
- Validators lose part or all of their stake if they approve an invalid transaction or attempt to attack the network.
- Participants who stake larger amounts have a higher chance of being chosen as the next block validator. Usually, there is a minimum amount needed to stake your crypto (unless you use a staking pool).
- A staking pool allows multiple stakeholders to combine their initial investment and staking power, increasing their chances of being rewarded.
- Various other methods exist to ensure that the wealthiest people are not constantly winning the rewards. These take into account the staking age of the coins, randomisation and the staker’s wealth.
- While Proof of Work requires a lot of equipment, staking is almost completely virtual, requires minimal upfront costs & is far more accessible to regular people.
So, to recap, instead of competing for the next block by solving a complex algorithm (mining), PoS validators are randomly selected based on the number of coins they are staking, and how long they have been staked.
Earning Passive Income through Staking
From a staker/validator’s perspective, staking is a lot like earning interest through a regular savings account. Like a traditional bank account, the longer you leave your money in there the better, and the more coins you stake the more you will earn back.
However, those interested in staking should know that:
- The period in which you stake your coins can vary. If you want to access your ‘locked’ coins before the agreed upon period, there will be a penalty of some kind.
- Profit is not guaranteed in staking and your coins will essentially be ‘locked’ for a time period, making them subject to market volatility.
- Staking suits long-term holders who will not need to access their coins in the short-term.
Key Takeaways
- Both Proof of Stake & Proof of Work are consensus mechanisms which allow a decentralised network & ledger that is not controlled by an authority to be maintained
- Proof of Stake was created as a more efficient & sustainable alternative to Proof of Work/mining
- PoS serves the same function as mining (maintaining the integrity of the network) but with minimal upfront costs & energy usage
- Stakers/validators are randomly selected to receive a staking reward based primarily on the number of coins they are staking
- PoW-based systems create crypto as rewards for miners, whereas PoS systems usually use transaction fees as the rewards for stakers/validators
- Staking lets you earn passive income off your crypto investments while you help validate transactions & keep the network secure
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How are staking rewards calculated?
Staking rewards differ between Blockchains, but the main factors that influence your staking reward include:
- The number of coins you are ‘locking up’
- The active time period you are staking
- The total amount of coins staked in the network
- The inflation rate
- A few other minor factors in the network
In some Blockchain networks, the rewards are fixed percentages and are given to you, the validator, as compensation for inflation (the need for in-built inflation is explained near the end of the article).
What are the benefits of staking crypto?
- The ability to earn passive income off your crypto investments while helping to keep the network secure by validating transactions
- Compared to mining, there is a lower barrier to entry (depending on the coin) and there is no need to continuously purchase costly hardware and consume unnecessary amounts of energy
- Unlike the Proof of Work system, where coins are rewarded through a random process which gives you a fairly low probability of winning a big reward, staking offers a more steady & predictable source of income
- Digital currencies remove the need for relying on banks, the stock exchange or traditional brokers for earning passive income on an investment
- Mining hardware loses value over time. The value of your s in the market value of that crypto)
Cardano (ADA) is an example of a cryptocurrency that uses staking, while older cryptocurrencies like Bitcoin rely on mining and the Proof of Work method. Other cryptocurrencies (including Ethereum) are currently transitioning from mining (PoW) to a staking (PoS) model.
How does mining (Proof of Work) work?
The Proof of Work method, more commonly known as Bitcoin mining, is the complex process that powers Bitcoin & other cryptocurrencies. Mining involves solving complex mathematical puzzles with powerful computers and serves two primary purposes:
- To verify the legitimacy of a transaction, helping to avoid fraudulent transactions & the problem of double spending
- To create new cryptocurrency by rewarding miners for performing the previous task.
Why is Proof of Stake better than Proof of Work?
Energy Consumption
You’ve probably heard about how Bitcoin mining sucks as much power as some small countries. While there is A LOT of misinformation around this topic, the energy consumption of Bitcoin mining is no joke – even if many mining rigs do run primarily on renewable energy.
Proof of Stake does not require complex mathematical problems to be solved by super computers. Instead, it takes its consensus mechanism completely virtual by requiring validators to lock up their coins in the network in order to validate transactions and earn a reward. PoS is far more environmentally friendly and accessible for the everyday person, which is why so many cryptos are moving to the PoS model.
Less Centralisation
Proof of Work Blockchains give people who purchase powerful hardware devices a greater chance of winning the mining reward, which opens the system up to be manipulated and centralised. For example, several centralised organisations have invested in a huge amount of high-tech mining equipment to create powerful ‘mining pools’ which allows them to pool their resources together to get a very high chance of solving the puzzle first.
This is not at all what Bitcoin envisioned when it began and too much mining power in a single group could prove dangerous for the legitimacy of the network (though it hasn’t yet). On top of the centralisation of what should be a decentralised system, there are a handful of mining pools that possess more than half the total Bitcoin mining power, the majority of which are in China.
This means regular people have very little chance of earning the mining reward, which is hardly what Satoshi Nakamoto had in mind when Bitcoin was first created! Proof of Stake on the other hand does not allow this kind of centralisation to occur as people are individually rewarded proportionate to the amount they have staked. No monopolies here!
Protection against 51% attacks
A allowing them to authorise invalid transactions, alter blocks and essentially steal money and destroy the trust in the network.
When using a Proof of Stake consensus mechanism, for a 51% attack to be achieved, the attacker would need to stake at least 51% of the total amount of cryptocurrency in circulation. The only way to do this is to purchase the coins on the open market which does not make financial sense.
Given that buying an amount this substantial on the market would also send the price of the asset up, the amount they would need to spend would far outweigh what they could gain from trying a 51% attack in the first place! On top of that, if the network realised that the attacker was approving invalid transactions, they would lose their entire stake.
What is double spending?
Double spending is one of the main challenges faced by all cryptocurrencies. It is essentially where a unit of crypto can potentially be spent twice, meaning false and illegitimate transactions could occur.
If double spending was to occur successfully, it would completely undermine the security & trust of the entire network, destroying any value that digital currency had.
This problem is why digital currencies like Bitcoin use Blockchain technology combined with complex cryptographic algorithms to secure and uphold their ledger of transactions & balances. Bitcoin was the first digital currency to solve the problem of double spending through its Blockchain’s Proof of Work mechanism, more commonly known as ‘Bitcoin mining’.
How does the Proof of Stake randomisation process work?
Assuming you have staked the minimum amount required by the network, your chances of winning the reward (usually paid for by the network’s transaction fees) is dependent on the amount of coins you have staked and the percentage that your stake makes up of the network’s total circulation of coins.
EXAMPLE
- You want to stake coins to earn some Proof of Stake rewards on a particular cryptocurrency network.
- The network has a total of 5000 coins in circulation.
- You buy 500 coins and stake them all.
- You have now staked 10% of the total coins in circulation, giving you a 10% chance of winning the staking reward each time a new block is added to the chain.
To sum it up, while Proof of Work and mining requires all miners to attempt to solve a complex sum (which isn’t efficient), with the winner determined by who has the most powerful hardware, Proof of Stake randomly chooses a winner based predominantly on the amount they have staked.
How does the Proof of Stake method stop the wealthiest stakers from constantly winning the reward?
One criticism of the Proof of Stake method is that it is very similar to mining as those with the most resources get the biggest rewards (like any capitalist market). However, this idea of the rich getting richer is not ideal for a currency that attempts to give power back to regular people.
For PoS to not favour only the wealthiest nodes in the network, other methods have been added to the selection process. Two of the most popular methods are ‘Randomised Block Selection’ and ‘Coin Age Selection’.
Coin Age Selection
This method chooses nodes based on how long their tokens have been staked for, rather than just how big their stake is. Coin age is the time coins have been staked multiplied by the number of coins that are staked.
Once a staker has been chosen to add a new a block of transactions, their coin age resets to zero and they must wait a period of time before being able to add another block. This helps to stop stakers with big stakes from dominating the staking rewards.
Randomised Block Selection
With this method, stakers are selected by looking for nodes with a combination of the lowest hash value (staking power) and the highest stake.
However, these methods are not full-proof and the rich still do get richer in many ways. At the end of the day, each PoS network has their own rules and methods for what they think will provide them and their users with the best outcome.
Which coins use the Proof of Stake method?
Many coins now use the PoS method and many others, including Ethereum, are transitioning from Proof of Work to Proof of Stake. A few notable coins already running on the Proof of Stake method include:
Binance coin – BNB is the native coin of popular exchange Binance.
Cardano – A decentralised public blockchain that is based on a scientific philosophy and a research-driven approach.
Tezos – A multipurpose blockchain with on-chain governance.
Raydium – An automated market maker on Solana platforms, which boasts high transactions per second and fast settlement.
NEO – The first Chinese open-source Blockchain project, labelling itself as a ‘distributed network for the smart economy’.
Flow Token – Flow is an independent Layer 1 blockchain for games and NFT.
What is a staking pool?
A staking pool is where a group of stakeholders of a coin pool their stakes together to increase the chance of receiving staking rewards. Some coins require a fairly high minimum staked amount, so this can be handy for new & casual investors.
Staking Pools provide more flexibility for each individual staker in the network. Thus, joining in the stake pool may be better for new users than staking solo. Essentially, users combine their staking to more effectively validate new transactions/blocks, increasing their collective probability of earning consistent rewards.
Why do Proof of Stake networks have built-in inflation?
PoS cryptocurrencies have a built-in inflation mechanism that increases the supply of coins/tokens. These new coins are created and distributed proportionally to the coins that have been staked.
If every person in the network were to participate in staking, everyone’s stake would remain the same because the new supply is distributed proportionally to those who are staking (in this case everyone). With the PoS system, anyone who does not stake their coins is not helping secure the network and is effectively punished with token dilution.
Thus, staking is designed to encourage every owner of a crypto to participate in the network. They are incentivized by the fact that their token ownership will be diluted through the built-in inflation mechanism if they do not. The process of inflation also encourages users to spend their crypto coins rather than only holding them, increasing their usage and flow through the system.
What are some of the risks of staking cryptocurrency?
While staking can be a great way to earn passive income on your cryptocurrency, by locking your coins up on a network you open yourself up to the possibility of the value of your assets rising/falling with the market.
As your coins will be in a locked state for a period of time (the longer you stake the higher the gains), the amount earned through staking may not be enough to cover the price depreciation during a strong downwards trend, and some market volatility is always to be expected.
There are also other minor risks and drawbacks that include:
- A lack of liquidity of your staked asset
- Lockup periods where your coins are inaccessible
- Delayed rewards (having to wait for rewards to be paid out)
- Vulnerability of the platform you are staking on
- Minimal rewards (rewards for staking are comparably less than the usual rewards for blocks earned through mining)
Even though staking on a well-established network is fairly a low-risk-low-reward strategy, there are no guarantees of returns for staking, and you should always DYOR before locking up your coins! For a guide on how to stay safe while trading crypto, click here.
How do I make money from staking?
The options for staking are endless, with more and more cryptocurrencies offering this feature. A good place to start is StakingRewards.com. Staking on Ethereum is becoming increasingly common but it is well worth doing a bit of research and finding out what the staking return for a certain coin is and what the minimum staking investment is (it is currently 32 ETH for the Ethereum network (though there are always staking pools)).
Another great resource is the Best Proof of Stake Coins which tells you which coins have the highest staking reward and the easiest way that you can stake them in order to start earning passive income.
Which cryptocurrencies can you stake & earn passive income from?
There are now a number of well-established cryptocurrencies you can stake to earn passive income. Some of the most notable ones include:
- Binance coin
- Polkadot
- Cardano
- Stellar
- Solana
- Cosmos
- Flow
- Raydium
- Kusama
- Neo
Digital Surge is the easiest way for Australians to buy, sell & store over 250+ cryptocurrencies. With extremely low fees, a uniquely user-friendly interface and a customer-support team you can rely on, getting involved in crypto has never been easier. Sign up today and enjoy safe, stress-free trading.
Crypto-curious? The time you spend here will be the best investment you ever make.
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