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What Is Proof of Stake in Crypto & How Does It Work?

January 31, 2022
6
min

Proof of Stake has the potential to address one of the most challenging problems confronting the cryptocurrency market: the ever-increasing amount of electricity needed to process transactions on blockchains.

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Ever since Bitcoin was introduced in 2009, miners have used computers to solve complex mathematical problems as quickly as possible and add data to the digital ledger that forms a blockchain. In return, miners who solve the problems first are rewarded with tokens. Known as proof of work, or PoW, this race drove miners to industrialize and harness vast amounts of computing power. The faster they solved the problems, the more Bitcoin they pocketed in this never-ending contest.

But criticism is mounting that the mining industry’s appetite for electricity is worsening global warming, especially in nations where power plants burn coal and other fossil fuels for energy. The Bitcoin network alone consumes about 14 gigawatts of power a day and is on course to match the annual electricity use of Sweden, according to the Cambridge University Bitcoin Electricity Consumption Index.

By making fundamental changes in the design of the consensus protocol, PoS is poised to demonstrate that the cryptocurrency industry can be sustainable. If that proves to be the case, PoS would be a potential turning point in a market that was valued at more than $2 trillion at the start of 2022.

What is proof of stake?

Proof of stake, or PoS, is a newer method for processing and recording cryptocurrency transactions. Under PoS, major stakeholders in tokens such as Ethereum’s ETH 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, which would undermine the credibility of a cryptocurrency.

PoS works by letting token holders, called validators, stake at least 32 ETH (about $125,000) as collateral. They will work 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 chain. 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 ETH, according to Ethereum.org’s primer on PoS.

PoS is starting to be more widely adopted by a number of cryptocurrencies. It is primarily designed to make the vast networks of computers that support blockchains more energy efficient and less dependent on computational power required in the PoW process.

What are the potential benefits and risks associated with proof of stake?

PoS enables token holders, rather than 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 tokenholders 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. They are also motivated by the opportunity to act as stewards of the blockchain. Community values are a big part of the ethos of cryptocurrencies.

Here are the potential benefits of proof of stake:

  • Sustainability. PoS weakens the profit motive that’s driven the development of blockchains for more than a decade. With less incentive for miners to deploy vast server farms to mine cryptocurrencies, the hope is that PoS will minimize the cryptocurrency industry’s carbon footprint.
  • Mainstream adoption. The PoS regime would also make it easier for institutional investors and mainstream companies to justify holding or adopting cryptocurrencies. The ESG movement, which calls for companies and investment firms to comply with environmental, social, and governance criteria, is reshaping the deployment of trillions of dollars of capital worldwide. If Bitcoin and its ilk are branded as ESG laggards, that probably will shrink the institutional and corporate cash flowing into crypto ventures, while leading companies to balk at accepting payment in crypto for goods and services.
  • Greater speed and scalability. For years, skeptics have argued that Bitcoin will never be a viable alternative to traditional payment systems because it takes too long—10 minutes to an hour—to process transactions on its network. Ethereum and other tokens also take a long time to handle activity under PoW. Newly upgraded payment systems in the UK, Australia, and other nations now process transactions almost instantaneously on existing technology. PoS will also let ordinary Ethereum token holders use standard computer hardware to take part in validating the chain. There won’t be the need for expensive, state-of-the-art machines to participate in managing the blockchain.  

Here’s a potential risk of proof of stake:

  • Security. There is concern that a consensus mechanism reliant on a limited number of stakeholders would be more vulnerable to hackers than PoW, which is entirely decentralized. The Bitcoin blockchain, for example, has yet to be successfully hacked and has demonstrated its resilience. PoS will have to prove that it can match that record.

While security could be a risk, attackers of a PoS system would probably have to control at least 51% of all the tokens of, say, Ethereum, which would be prohibitively expensive considering that its market capitalization at the start of 2022 was about $400 billion—more than all but the 20 largest companies in the world.

What does Proof of Stake mean for Ethereum 2.0?

The Ethereum network plans to switch to PoS from PoW in 2022. The new iteration will be called Ethereum 2.0. It could mark a great leap forward for the Ethereum ecosystem by demonstrating that there won’t be a need for industrial-scale computing power—just willing investors. Researchers estimate that PoS may cut electricity use by 99.99%. If that proves true, then Ethereum will have executed the most significant modification of cryptocurrency structure since the advent of Bitcoin.

There’s a cultural dimension, too. Ethereum 2.0 is coming at a time when cryptocurrency mining has morphed into a major industry dominated by a few big companies, undermining the grassroots ethos of Bitcoin and other digital assets. By vesting individual investors in the management of blockchains, PoS promotes decentralization and collaboration, two central ideas driving adoption of cryptocurrencies. PoS also may help Ethereum distinguish itself from its more valuable and hierarchical sibling, Bitcoin.

Which cryptocurrencies already use Proof of Stake?

Polkadot and Cardano are the two biggest and best-known types of cryptocurrencies that operate on a PoS basis. Gavin Wood, a computer scientist and cofounder of Ethereum, created Polkadot to experiment with integrating multiple blockchains into one interoperable ecosystem. Polkadot, a top-10 cryptocurrency by market value, is emerging as a potent alternative to Ethereum. So, too, is fellow top-10 cryptocurrency Cardano, which was founded in 2015 by Charles Hoskinson, another Ethereum alum.

The bottom line

Proof of Stake has the potential to address one of the most challenging problems confronting the cryptocurrency market: the ever-increasing amount of electricity needed to process transactions on blockchains. With criticism mounting that Bitcoin and its ilk are accelerating global warming, Ethereum is preparing to embrace this new approach in a bid to dramatically reduce its carbon footprint.

In shifting to PoS, Ethereum may also vest token holders in the management of its blockchain instead of the crypto miners who have been gaining more power and wealth by operating vast computer farms. If processing cryptocurrencies can truly be sustainable, PoS has the potential to open a new phase in the industry’s growth.

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