October 17, 2022

Proof of Stake; The Complete Beginners Guide

Proof of Stake (PoS) is one of the two most common consensus mechanisms (the method of verifying transactions) used in cryptocurrency. The other is Proof of Work (PoW), more on this later.In PoS, the holders of the cryptocurrency can “stake” their coins in order to help verify transactions on that blockchain (thus creating blocks).

Proof of Stake; The Complete Beginners Guide

Introduction

Although cryptocurrencies have become much more prevalent in the last few years, the majority of people still don't understand what they do and how they work. This lack of understanding is the single biggest barrier to entry into cryptocurrency.


In this series of articles, we demystify the key elements of the crypto world, help you get a solid grasp on what it’s all about and how cryptocurrencies will benefit individuals, organisations and society in general.


A bold claim, but stick with us and you’ll see!


In this article, we will be diving into Proof of Stake (PoS) blockchains.


Don’t fret, we’ve included a glossary of the key terms used at the bottom of this article.


Are you ready?

What is Proof of Stake (PoS)

Proof of Stake (PoS) is one of the two most common consensus mechanisms (the method of verifying transactions) used in cryptocurrency. The other is Proof of Work (PoW), more on this later.

In PoS, the holders of the cryptocurrency can “stake” their coins in order to help verify transactions on that blockchain (thus creating blocks). As an incentive to staking their coins, holders earn a reward for doing so. This reward is usually paid in the same coins as holders have staked, thus earning them a passive income.


Holders can create validator nodes of their own or stake their coins in a “stake pool” node (a group of holders combining their coins for a greater chance of validating nodes and earning rewards).


So, stake your coins and earn more back...simple?


Well, yes, but there are some caveats (depending on the cryptocurrency in question).


Most PoS blockchains require that staked coins be locked for a predetermined length of time, although sometimes they can be unstaked, it is not immediate, thus holders may miss out on price fluctuations in the market if they are planning on making a profit from their held coins.


Depending on the cryptocurrency you hold, the lock-in period, the amount of reward earned (the APY) and the amount needed to be able to stake, are factors to consider when thinking of staking your coins.


Cardano, for example, doesn't require your coins to be locked in at all and anyone, regardless of the amount of ADA (the Cardano native token) they hold, can join a stake pool and earn some juicy rewards (usually around 5% APY).

Proof of Stake (PoS) vs. Proof of Work (PoW)

While both consensus mechanisms aim to do the same thing (protect the decentralisation of the network), they both go about it in a different way.


We’ve talked about PoS blockchains, but what about PoW and what one is best?

PoW; the first generation of blockchains.


PoW blockchains (such as Bitcoin and Ethereum) require new blocks to be mined. It is basically a competition for miners to use computational power to solve a complex mathematical puzzle to earn the right to produce the next block.


The first one to solve the puzzle produces the block and therefore earns the rewards. The bigger the network of computers you have, the higher the chance of earning rewards.


Think of a Ferrari racing your family car; the Ferrari is always going to win but it always has a higher cost.

Disadvantages of PoW

  1. Only miners can earn rewards for solving the puzzles (creating blocks). Many see this as a major downside because it limits regular coin holders to only be able to profit when the market value of the coin goes up.
  2. First past the post! The competition for more mining power and thus higher rewards come at a cost. More computers result in higher energy consumption, therefore, the cost to mine increases. These increases are both financial and environmental.
  3. Financial costs. The cost to buy and run enough computers to mine cost-effectively is so high that it creates a huge barrier to entry for individuals.
  4. Environmental costs. We are fully aware by now that increased energy use contributes heavily to climate change. The amount of electricity required to run such huge computational power is a major flaw in the PoW consensus mechanism.
  5. Coin holders cannot earn staking rewards.
  6. Difficult to scale the network. PoW blockchains have mathematical limitations on the ability of a blockchain to grow. Put simply, the security of PoW blockchains require all miners to work on solving the same block, which in turn limits the speed at which the network can run.

Benefits of PoS

  1. Rewards to everyone! In many ways, PoS fulfils the basic idea of decentralisation. PoS democratises the rewards that you can get from the blockchain.
  2. Regular coin holders can earn staking rewards.
  3. PoS is cheaper to run. From a purely financial perspective, PoS doesn’t require a huge amount of special equipment, so it’s cheaper to set up and cheaper to run (it uses way less energy).
  4. With hugely reduced energy consumption comes the associated reduction in environmental damage caused by “mining” on PoW blockchains.
  5. Another benefit of the cost reduction of PoS blockchains is the resultant reduction in transaction fees on the network.
  6. PoS is faster in terms of transaction time, this also has the added benefit of increasing transaction volume.
  7. The scalability issue with PoW is solved with PoS because less equipment is needed, fewer nodes results in higher transaction volume (because of the associated increase in transaction speed).
  8. Security of larger cryptocurrencies. A hacker would need to own 51% of the total cryptocurrency, to be able to steal. For example, at the time of writing, the market cap of Cardano’s native token ADA is a little over $66 Billion  USD, meaning a hacker would need to own $33 Billion USD worth of ADA! If I owned that much, I wouldn’t be thinking of stealing more...I’d be thinking about which yacht I want to buy next!

Disadvantages of PoS?

  1. Some cryptocurrencies will require coins to be locked for a predetermined amount of time.
  2. Validators with larger holdings (whales) could have excessive influence on transaction verification in some cryptocurrencies.
  3. Security of smaller cryptocurrencies. For the same reason that higher market cap coins are more secure, the 51% required to hack a PoS network with a lower market cap costs a lot less. Even so, it would still require a large amount of upfront cash.


PoS on Cardano

Higher Degree of Decentralisation.

Cardano uses its own version of PoS (Ouroboros Proof of Stake) which allows holders to keep their ADA tokens in their own wallet at the same time as adding them to a stake pool to earn rewards.


The minimum amount of ADA a holder needs to be able to join a stake pool is only 10 ADA (currently around $20USD), making it more accessible for everyone, as opposed to other PoS cryptocurrencies who require a much larger holding for individuals to be able to stake while keeping their coins in their own wallet.


Smaller holders of other PoS coins need to have their holdings on an exchange to be able to stake. This means your coins are more at risk if the exchange is hacked and you are at the whim of the exchange that can, at any point halt withdrawals.


Remember; Your keys, your coins!

Even Greater Energy Savings

Cardano’s Ouroborus PoS is even more efficient than other PoS blockchains; according to Cardano themselves, they can securely scale up the network with up to 4 million times the energy efficiency of Bitcoin!

Final Thoughts

Proof of Stake blockchains are now much more widely found than their Proof of Work predecessors, primarily for the reasons we have outlined in this article:

  • Cost to run.
  • Environmental costs.
  • Scalability.
  • Increased decentralisation.
  • Increased transaction speed.
  • Decreased transaction cost.


We will continue to see refinements in the way the cryptocurrency ecosystem is built but for now, Proof of Stake is the best way to go.

Do you want to learn more about Proof of Burn (PoB)? We got you covered!

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