Without a central authority like American Express, Visa or PayPal in the middle, decentralized cryptocurrency networks must ensure that no money is spent twice. To accomplish this, networks employ a “consensus mechanism,” a system that allows all computers in a network to agree on which transactions are valid.
Proof of Work vs Proof of Stake
The two major consensus mechanisms used by cryptocurrencies to verify new transactions, add them to a blockchain, and create new tokens are proof of work and proof of stake.
Most cryptocurrencies today use one of two major consensus mechanisms. Proof of work is the older of the two and is used by Bitcoin, Ethereum 1.0, and many other cryptocurrencies. Proof of stake is a newer consensus mechanism that powers Ethereum 2.0, Cardano, Tezos, and other (generally newer) cryptocurrencies.
To understand proof of stake, you must first understand proof of work, so we’ve combined the two in this quick guide.
What exactly is proof of work?
Bitcoin pioneered the use of proof of work as a crypto consensus mechanism. Mining and proof of work are concepts that are closely related. The network necessitates a large amount of processing power, which is why it is referred to as “proof of work.” Proof-of-work blockchains are secured and verified by virtual miners all over the world competing to solve a math puzzle first. The winner gets to update the blockchain with the most recent verified transactions and is rewarded with a predetermined amount of cryptocurrency by the network.
Proof of work has several powerful advantages, particularly for a simple but valuable cryptocurrency like Bitcoin (learn more about Bitcoin mining).
It’s a tried-and-true method of keeping a secure decentralized blockchain. As a cryptocurrency’s value rises, more miners are enticed to join the network, increasing its power and security. Because of the amount of processing power required, it is impractical for any individual or group to interfere with the blockchain of a valuable cryptocurrency.
On the other hand, it is an energy-intensive process that may struggle to scale to accommodate the massive number of transactions that smart-contract compatible blockchains such as Ethereum can generate. As a result, alternatives have emerged, the most popular of which is known as proof of stake.
What exactly is proof of stake?
Ethereum’s developers recognized from the start that proof of work would have scalability limitations that would eventually need to be overcome — and, indeed, as Ethereum-powered decentralized finance (or DeFi) protocols have grown in popularity, the blockchain has struggled to keep up, causing fees to skyrocket.
While the Bitcoin blockchain primarily has to process incoming and outgoing bitcoin transactions, similar to a large checkbook, Ethereum’s blockchain also has to process a wide range of DeFi transactions, stablecoin smart contracts, NFT minting and sales, and whatever future innovations developers come up with.
Their solution was to create an entirely new ETH2 blockchain, which began rolling out in December 2020 and is expected to be completed in 2022. Proof of stake, a faster and less resource-intensive consensus mechanism, will be used in the upgraded version of Ethereum. Proof-of-stake consensus mechanisms are used by cryptocurrencies such as Cardano, Tezos, and Atmos, with the goal of maximizing speed and efficiency while lowering fees.
Staking in a proof of stake system is similar to mining in a proof of work system in that it is the process by which a network participant is chosen to add the most recent batch of transactions to the blockchain and earn some crypto in exchange.
The specifics vary by project, but in general, proof of stake blockchains use a network of “validators” who contribute — or “stake” — their own cryptocurrency in exchange for the chance to validate new transactions, update the blockchain, and earn a reward.
- The network chooses a winner based on how much crypto each validator has in the pool and how long they’ve had it there — literally rewarding the most invested participants
- Once the winner has validated the most recent block of transactions, the block’s accuracy can be attested to by other validators. The blockchain is updated when a certain number of attestations are received
- Every validator who participates receives a reward in the native cryptocurrency, which is distributed by the network in proportion to each validator’s stake
Becoming a validator is a hefty responsibility that demands a crazy-high level of technical knowledge. The minimum amount of crypto that validators must stake is frequently relatively high (for ETH2, for example, it is 32 ETH), and validators can lose some of their stake through a process known as slashing if their node goes offline or if they validate a “bad” block of transactions.
If that sounds like too much pressure, you can still participate in staking by joining a staking pool run by someone else — and earn rewards for crypto that would otherwise sit idle. This is known as delegating, and tools provided by exchanged like Kraken and Binance can make it easy for average folks to put their crypto to work.
What are the key distinctions between PoW and PoS?
One significant difference between the two consensus mechanisms is their use of energy. Proof-of-stake blockchains allow networks to operate with significantly lower resource consumption because miners are not required to spend electricity on duplicative processes -competing to solve the same puzzle.
Both consensus mechanisms have economic ramifications that penalize network disruptions and deter bad actors. The penalty for miners submitting invalid information, or blocks, in proof of work is the sunk cost of computing power, energy, and time.
In proof of stake, the staked crypto funds of the validators serve as an economic incentive to act in the best interests of the network.
If a validator accepts a bad block, they will have a portion of their staked funds cut as a penalty. The amount by which a validator can be reduced is determined by the network.
