There’s a big change underway in the design of cryptocurrencies. It has the potential to determine whether they remain exotic, speculative assets or develop into a lasting system for managing financial products and money. The change is called proof of stake, and it’s aimed at fixing major problems in the proof of work approach that has supported Bitcoin and many other cryptocurrencies for the past 13 years.
If nothing else, this change will separate Bitcoin and Ethereum into two very different markets. Each will have its own method of processing and recording transactions on their respective blockchains, the decentralized digital ledgers that support the cryptocurrencies.
There are several reasons for this shift, but the biggest is energy efficiency. By requiring vast banks of high-powered computers to operate, proof of work consumes enormous amounts of electricity. Criticism is mounting that Bitcoin and other cryptocurrencies, because of their energy consumption, are worsening global warming and climate change. The communities supporting Ethereum and other cryptocurrencies are now racing to adopt a more sustainable alternative.
What is proof of work?
A proof of work system (PoW) prevents what’s known as double spending or forgery of cryptocurrencies. That’s a major concern in a digital world where it’s easy to replicate sent datafiles, including payments.
Imagine if Bitcoin tokens could be copied and pasted—they would have little value to investors or users because they could be created at will by anyone. That’s what PoW is—it’s a control mechanism that preserves the uniqueness of every single one of the 21 million Bitcoins that will eventually circulate in the marketplace. It enables the blockchain to show that every Bitcoin transaction and newly minted token is an original, and not a copy. That gives the system integrity.
How does PoW work?
PoW functions by requiring Bitcoin miners—organizations devoted to minting new tokens—to solve complicated mathematical puzzles. To do this, miners harness overwhelming computing power. Miners want to be the first in the race to solve these equations and win the right to “hash,” or create a block of Bitcoin transactions. Those miners who prove their work receive new Bitcoins for their labor. But the operations take quite a toll—Bitcoin now consumes more energy on an annual basis than many countries.
What are the top coins that use PoW?
Some of the best-known cryptocurrencies rely on PoW.
- Bitcoin tops the list and accounts for about 40%—or more than $800 billion— of the market capitalization of cryptocurrencies.
- Ethereum, the No. 2 asset with 19% of the market, also uses PoW, though that’s going to change in 2022.
- Litecoin, one of the oldest cryptocurrencies, uses a variation of PoW.
- Dogecoin, the joke token famed for its Shiba Inu dog logo, is a top PoW user.
What is proof of stake?
The proof of stake system (PoS) is a newer method for processing and recording cryptocurrency transactions. Under PoS, major stakeholders in tokens such as Ethereum’s ETH, or ether, have the option to review and validate transactions and add them to the blockchain. This consensus protocol is used to manage digital assets and prevent the double spending or forging of tokens.
PoS enables token holders, rather than proof-of-work miners, to manage the expansion of blockchains. It does so by getting them to collaborate on adding new blocks to a chain instead of competing to first solve equations. The PoS approach incentivizes token holders to participate by rewarding them with tokens—a contrast to the vast banks of costly computers used to solve the complex math puzzles needed to earn Bitcoins.
Ethereum is in the midst of shifting from PoW to PoS and has published detailed rules setting out how token holders can participate. A number of Ethereum challengers have already embraced PoS to set up faster and more sustainable blockchains.
How does PoS work?
Under the plan for Ethereum, PoS will work by letting token holders become so-called validators by staking a minimum 32 ETH (about $125,000) as collateral. They will join with dozens or hundreds of other validators in staking pools to approve and add transactions to the blockchain.
The validators must affirm a new block is accurate and in compliance with Ethereum’s rules before it is added to the blockchain. In return, the validators earn rewards in the form of ETH, probably paid as interest on their staked coins.
Those who nominate a block for validation that has bogus data or transaction activity will be penalized by losing some of their staked ETH. Neglecting to take part in the validation process after signing on also will be sanctioned. Validators who attack the system could lose all their staked coins, according to Ethereum.org’s primer on PoS.
What are the top coins that use PoS?
The cryptocurrencies that now rely on PoS may not be as well-known as those using PoW, but several are among the most important and innovative.
- Cardano, a top-10 cryptocurrency created by an Ethereum cofounder, uses PoS.
- Solana is another Ethereum competitor building a faster, more scalable blockchain.
- Algorand is using a PoS variation.
- Tezos has been gaining traction with its PoS-based blockchain.
PoW vs. PoS: key similarities and differences
The two systems share certain attributes, but also have important differences.
- Both consensus mechanisms are decentralized. This means independent miners or token holders manage their respective blockchains rather than hierarchical leadership teams.
- Stewards must contribute. Specifically, they must contribute something valuable to take part in managing the respective blockchains. For PoW, it’s computing power; for PoS, it’s tokens.
- Both reward participants with cryptocurrencies. This applies to miners and token holders. Both systems are also designed to mint new coins.
- PoW is competitive; PoS is collaborative. Pow is organized as a contest between miners racing to create blocks for the chain and collecting tokens as a reward. They often join forces in mining pools to leverage their computational power. PoS is set up as a collaboration between stakeholders to create new blocks for the chain, collecting tokens as a reward. A group of stakeholders may number several dozen, and to take part they must agree to obey rules established by the Ethereum community.
- PoS is more energy-efficient. PoW miners utilize industrial-scale computer farms in the race to be first to solve equations and create blocks. This means tapping a lot of energy, often from power plants that burn fossil fuels. PoS token holders, liberated from having to be first, can use smaller, conventional computers to do their work and consume a fraction of the power of PoW.
- PoW has proven itself; PoS has not. Over 13 years, PoW has proven a resilient and secure method for processing Bitcoin. While there have been numerous hacks of Bitcoin wallet providers, where token holders store their coins, the blockchain itself has remained intact. PoS has yet to demonstrate that it, too, can rely on its decentralized structure to protect itself over the long term. But hackers would still have to take control of a majority of the tokens processing PoS blocks in a so-called 51 attack to do real damage.
The bottom line
In its embrace of PoS, the Ethereum community wants to demonstrate that cryptocurrencies can be a sustainable decentralized system of managing finance. Ethereum’s supporters are eager to show that a PoS-backed Ethereum isn’t just an improvement on traditional finance but on Bitcoin itself.
If PoS does prove to be a leap forward, Ethereum and its rivals would go a long way toward answering critics who argue that cryptocurrencies are a damaging development for the planet. While PoS replaces competition between miners with collaboration between stakeholders, its rise would separate Ethereum from Bitcoin at a fundamental level. With two distinctive processes for managing their blockchains in play, the contest between the two biggest cryptocurrencies may finally begin in earnest.