What is Proof of Stake (POS)?

What is Proof of Stake (POS)?

Proof of Stake (PoS) is the most common consensus mechanism in crypto. Although the mechanics vary in the details (which we’ll explore later), the fundamental concept is the same.

In simple terms, PoS works by making members of a network have a vested interest in the health and success of the network, and so are disincentivised to perform malicious actions that damage its health, and a vested interest in ensuring no one else within the network acts maliciously.

Commitment comes in the form of locking tokens into the network, and locking tokens then grants rights to validate transactions. It also compensates token holders for locking coins into a network, paying out rewards and generating passive income.

Why is Proof of Stake Important?

It’s a method of trustlessly securing a network in a decentralised fashion. It’s the second evolution of cryptographic consensus mechanisms that began (in cryptocurrency terms) with Proof of Work (or Nakamoto Consensus). Proof of Work (PoW) is Bitcoin and Ethereum’s consensus mechanism, whereas newer protocols are often PoS and rarely PoW (although some do exist). Ethereum is planning to migrate to PoS, one of the main reasons being that it is vastly more energy efficient. It also, arguably, leads to fairer and more accessible distribution of incentives.

How Does Proof of Stake Work?

Blockchains work by creating new blocks that contain details of transactions made within that block. Consensus mechanisms are the methods by which new entries onto the shared ledger are validated. With Bitcoin, “Miners” are those competing for selection rights to the next block, and earning rewards for doing so. In proof of stake these people are called validators. However, the parlance can be interchangeable for some.

In Proof of Stake, anyone staking a network’s token has a chance to be selected to validate the next block, and approve all the transactions within it. By doing so they are rewarded with a payout, either by way of an inflationary mechanic inherent in the tokenomics, or by fees paid by users of the network.

The more tokens staked, the greater the chance of being selected (and the less likely you are to be out for malicious intent). If someone does act maliciously, or verifies a false transaction, their stake (i.e capital) gets taken from them. Other actors within the network remain vigilant for this and earn rewards for catching perpetrators.

How Does Proof of Stake Pay Rewards?

Proof of Stake consensus mechanisms are built in such a way as to provide validators with rewards, but this process is radically different from chain to chain. It all depends on what mechanisms were put in place by those who coded the chain. In generic proof of stake, the size of stake is important, as the more you have staked, the greater the chance of being selected to validate. How long the tokens have been staked for also affects how likely it is that the token holder is selected, however, the process by which people are selected remains random.

These mechanisms can also be subject to change through the course of input by the holders of the token. This is because PoS gives token holders control – in varying levels dependent on protocol – over the direction of the blockchain. Often this is in the form of a DAO, where members can vote based on their staked holdings about things such as mining/validation rewards.

However, just about every protocol that is PoS offers rewards to those who stake their tokens, sometimes on a block-by-block basis. These rewards are available to anyone and everyone who participates in the network.

What Are the Benefits of Proof of Stake?

As previously stated, Proof of Work is enormously energy intensive. Rank upon rank of ASIC miners competing to solve intrinsically worthless computational problems is very power intensive. The competitive nature means whoever pours the most energy in gets the most money out. This leads to a dangerous, and energy-guzzling arms race of increasing intensity. Proof of Stake is far, far less computational intensive – with some reports suggesting a 99.95% reduction in total energy use after the switch.

Proof of Stake is also – although it is contended – far more secure. Silvio Micali, the designer of Algorand, states that owning 51% of a network’s tokens is economically unfeasible and, even if it were to somehow ever happen, that person would have no desire to destroy the network and thus all the wealth staked within it.

Also, unlike Bitcoin, where getting hold of world-class computer hardware is difficult, anyone with fungible money can purchase a network’s tokens, so it would become ever more difficult – nay, impossible – if one token holder began to creep towards that 51% figure. Putting it another way, it’s so much easier for someone to start a PoS chain’s node than PoW chain’s node, and more nodes mean more decentralisation, and more decentralisation means more security.

What are Validator Pools?

However, If you were to stake entirely independently, and you’re not already wealthy, your chances of being selected would be excessively small, so it’s highly unlikely you would gain any material benefit from locking your tokens. That’s why the majority of PoS consensus happens via validator pools. These pools absorb the voting rights of users who stake their tokens, and then pass on the rewards to the individual after taking a small commission for the work.

This, in essence, is what 99% of crypto holders are doing when they stake their tokens and receive APR for doing so. This is because the computer setups required to verify transactions on even a medium sized blockchain is often of enterprise quality – but nevertheless within range of many (unlike PoW, which requires industrial quality hardware). There is nothing to stop a reasonably wealthy person setting up a validator node for most blockchains and making profit from it, increasing decentralisation and security as they go.

The amount of validator slots available in each protocol varies wildly, but networks incentivise users to move their staked tokens between pools to avoid any one particular validator ever feasibly gaining too much power.

What are the Different Types of Proof of Stake?

Proof of Stake as described in this article is of the generic flavour, so as to give a general overview of the mechanism. However, there are several different types of PoS in use by different protocols. One common complaint about PoS is that it favours large token holders, and so the rich get richer, an outcome that skews and corrupts the importance of decentralisation. Large, rich validators are incentivised to act honestly – but the threat remains. There are several alternatives to Proof of Stake now used by protocols in an attempt to address this imbalance. Here are some:

Delegated Proof of Stake

Network participants can delegate production of new blocks to delegates. Users determine which delegates get to validate new blocks through voting, with their tokens representing votes. Delegators need to act honestly and efficiently to avoid losing support of the voters. As voting for a delegate is an even lower barrier to entry than PoS, the system is more democratic and egalitarian. It’s faster too, as the delegator groups responsible for blocks are small, and little effort is required for consensus and throughput

Liquid Proof of Stake

Is the same as DPoS, except holders can choose to not delegate their tokens at all and compete for validation rights themselves. In LPoS, the number of active validator nodes is dynamic.

Leased Proof of Stake

Users lease crypto tokens to a node who then try to validate blocks and pass on the reward to the users who they borrowed tokens off. In effect it’s similar to a validator pool, but the process is baked into the blockchain itself.

Pure Proof of Stake

Pure Proof of Stake has no built-in sanction mechanism for malicious node activity. However, the barrier to entry is so low that a far larger cohort of validators is in play. As long as 66% percent of the network is behaving honestly, then the network should be Byzantine Fault Tolerant.

Hybrid Proof of Stake

This is a consensus mechanism whereby some features of PoW, where computers work on hashes of data, are maintained – whilst also introducing more democratic PoS features. Miners generate blocks, and validators validate them. WIth this mechanism greater security and democracy is achieved, but scalability is a concern.

A Stake in the Future

To most users, staking is a feature by which you can lock your tokens and receive a financial reward – in the form of the token staked – for doing so. It helps create shared prosperity as users commit longer term to the blockchain projects they are interested in. It works almost like an interest rate on a bank deposit.

Behind the scenes, Proof of Stake is a fundamental consensus mechanism that makes the decentralised feature just that, decentralised, with distributed participants coming together to shape the future of Web 3.0