This article, originally published May 9, 2022, has been updated following the launch of the Purpose Ether Staking Corp. ETF.
Cryptocurrencies such as Bitcoin and Ethereum operate on decentralized networks, allowing users to conduct transactions without relying on intermediaries like banks or governments. To achieve this, they employ consensus mechanisms, which ensure the validity and execution of transactions. Proof-of-stake (PoS), currently used by the Ethereum network, is one of the most popular consensus mechanisms. It is an alternative to the more energy-intensive proof-of-work (PoW) method used by Bitcoin.
Key features of proof-of-stake
- Energy efficiency: Unlike PoW, which requires substantial amounts of electrical power and hardware, PoS relies on an economic stake, which significantly reduces energy consumption.
- Reduced hardware requirements: Validators in a PoS system do not need high-powered computational equipment, thus lowering the entry barriers compared to PoW systems.
- Scalability: PoS allows for faster transaction validation and higher throughput, making it suitable for larger networks.
- Earning yield: Staking effectively amounts to earning interest on crypto and can be viewed as another means to generate yield in a portfolio.
First, there was proof-of-work
Proof-of-work was the first cryptocurrency consensus mechanism. It was invented by Bitcoin's original developers and is still used by the Bitcoin network today. In PoW, miners compete to solve complex mathematical puzzles. The first miner to find a valid hash broadcasts it to the network, and once verified, the new block is added to the blockchain, earning the miner a reward.
Solving these mathematical puzzles requires a large amount of energy, resources, and hardware. The high cost of mining equipment and the electricity used to run it, coupled with the rewards miners receive, incentivize miners to add only correct information to the blockchain. That, at a very high level, is how proof-of-work works.
The major issue with PoW is that it uses massive amounts of energy, which comes with valid environmental concerns. Another issue is that by its nature, proof-of-work can be very slow. This means that proof-of-work blockchains have inherent limitations to how much they can scale.
How does proof-of-stake work?
Validators and staking
Transactions on PoS networks are verified and recorded by "validators." Validators are required to pledge a certain amount of their cryptocurrency as collateral – also known as "staking" – to the network in exchange for the opportunity to validate transactions, update the blockchain, and earn rewards.
On Ethereum, becoming a validator is a serious responsibility. It requires a high level of technical sophistication and a minimum of 32 ether (ETH) staked on the network. If an investor would like to take part in the upkeep of the network and earn a yield on their crypto but does not want the responsibility of being a validator or does not have 32 ether, they may delegate their coins to a "staking pool" run by an exchange or business.
How validators are chosen
Validators are randomly selected by the network to verify and add new transactions. The chances of being selected as a validator and the amount of crypto you earn as a reward for validating a new entry into the blockchain are often proportional to the amount of cryptocurrency you have staked.
As an example, if you are a validator staking one percent of the total ETH being staked, you'll be chosen roughly one percent of the time to validate a blockchain entry. Sometimes, the length of time that you have had your cryptocurrency staked will also influence how many times the network chooses you to validate transactions.
Upon the successful addition and verification of a block of transactions, a validator will be rewarded with newly minted ether.
If the network notices that a validator is not doing their job with the proper diligence and timeliness, or if they are deemed to have entered fraudulent transactions, it will take some or all of the validator's staked crypto as a penalty.
The chance to earn rewards coupled with the chance of losing staked crypto due to malpractice disincentivizes validators from writing down fraudulent transactions.
Why staking is exciting
Because proof-of-stake validators are picked based on passive crypto deposits instead of computational power, proof-of-stakes uses much less energy than proof-of-work. Some estimates state that proof-of-stake blockchains reduce their energy expenditure by as much as 99.9% as compared with their proof-of-work counterparts. This is good news for environmentally conscious crypto investors and the planet.
Many proof-of-stake blockchains are also structured in a way that allows them to scale more efficiently than their proof-of-work counterparts. Proof-of-work blockchains are known for their rigidity, and it is often cited that this rigidity can get in the way of these blockchains from scaling up in a way that could see mass adoption. In proof-of-stake networks, it is easier to incorporate scaling solutions like "sharding."
The practical implications of staking for the average investor
On a practical investment level, staking effectively amounts to earning interest or yield on an investor's cryptocurrency. In staking, you lock up cryptocurrencies to help maintain the network's security and operations, and in return, you receive rewards, much like earning interest by depositing money in a savings account or investing in interest-bearing instruments. In this sense, it can be viewed as another tool for generating income in a portfolio outside of traditional dividend investing, money-market funds, bonds, etc.
Final thoughts
Dozens of new cryptocurrencies have adopted the proof-of-stake consensus mechanism. While it is not as old or as proven as proof of work, it is addressing serious concerns over the environmental impact, decentralization, and scalability of cryptocurrencies. We believe it will likely play an increasingly important role in the cryptocurrency space as the technology is refined.
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