Consensus Mechanisms: The Heart Of Your Blockchain Investment

Proof of stake is a consensus mechanism used to verify new cryptocurrency transactions. Since blockchains lack any centralized governing authorities, proof of stake is a method to guarantee that data saved on the network is valid.

What Is Proof of Stake?

Decentralization is at the heart of blockchain technology and cryptocurrency. There’s no central gatekeeper to manage a blockchain’s record of transactions and data. Instead, the network relies on an army of participants to validate incoming transactions and add them as new blocks on the chain.

Proof of stake is the consensus mechanism that helps choose which participants get to handle this lucrative task—lucrative because the chosen ones are rewarded with new crypto if they accurately validate the new data and don’t cheat the system.

“When blockchain participants verify that a transaction is legitimate and add it to the blockchain, we say that participants have achieved consensus,” says Marius Smith, head of business development at digital asset custodian Finoa.

With proof of stake, participants referred to as “validators” lock up set amounts of cryptocurrency or crypto tokens—their stake, as it were—in a smart contract on the blockchain. In exchange, they get a chance to validate new transactions and earn a reward. But if they improperly validate bad or fraudulent data, they may lose some or all of their stake as a penalty.

Solana, Terra and Cardano are among the biggest cryptocurrencies that use proof of stake. Ethereum, the second-largest crypto by market capitalization after Bitcoin, is in the midst of a transition from proof of work to proof of stake.

What Is Staking?

Staking is when people agree to lock up an amount of cryptocurrency in exchange for the chance to validate new blocks of data to be added to a blockchain. These validators, or “stakers,” put their crypto into a smart contract that’s held on the blockchain.

The blockchain algorithm selects validators to check each new block of data based on how much crypto they’ve staked. The more you stake, the better your chance of being chosen to do the work. When the data that’s been cleared by the validator is added to the blockchain, they get newly minted crypto as a reward.

“The simple way to look at staking is like interest income that requires you to complete a task to earn the interest—checking blockchain transactions,” says Doug Schwenk, chief executive officer of Digital Asset Research. “If I validate only good transactions, I earn interest on my assets. If I include bad transactions, then I’ll be assessed penalties and lose some of my assets.”

If a validator submits bad data or fraudulent transactions, they could be punished by “slashing.” Their stake is “burned,” meaning it is sent to an unusable wallet address where nobody has access, rendering them useless forever.

According to Smith, proof of stake works because validators are saying “Hey, I have so much faith in the legitimacy of this transaction that I’m willing to back it up with my own money.” And verified transactions earn a cryptocurrency reward in proportion to the size of the stake.

Proof of Stake Benefits

Proof of work has earned a bad reputation for the massive amounts of computational power—and electricity—it consumes. Given heightened concern about the environmental impacts of blockchains that use proof of work, like Bitcoin, proof of stake offers potentially better outcomes for the environment.

“On a global scale, proof of work is most profitable where energy can be had for the lowest cost,” says Smith.

This concentrates crypto mining in a few regions where electricity costs are lowest. According to Smith, proof of stake’s modest energy consumption solves this problem and widely distributes infrastructure, potentially making a blockchain system more robust.

Proof of stake opens the door to more people participating in blockchain systems as validators. There’s no need to buy expensive computing systems and consume massive amounts of electricity to stake crypto. All you need are coins.

Crypto exchanges like Coinbase, Binance and Kraken offer staking as a feature on their platforms. There are even dedicated staking platforms, like Everstake. Depending on the blockchain, crypto owners can earn yields of 5% to even 14% on their holdings by staking.

One additional benefit of proof of stake blockchains offers potential for the future: they may be more scalable than their proof of work counterparts. Smith says that proof of stake blockchains can, in theory, support more simultaneous transactions without compromising security or decentralization.

“This is where a great deal of innovation is happening today, and indeed a challenge that blockchains will have to overcome if they are ever to become widely used on a global scale,” he says.

Proof of Stake Drawbacks

According to Amaury Sechet, founder of eCash, proof of stake isn’t without cons.

“Proof of stake is not as extensively vetted as proof of work, which has secured billion-dollar blockchains for over a decade now,” said Sechet.

Certain implementations of proof of stake could leave blockchains more vulnerable to different kinds of attacks than proof of work, such as low-cost bribe attacks. Susceptibility to attacks decreases the overall security of the blockchain.

Validators who hold large amounts of a blockchain’s token or cryptocurrency may have an outsized amount of influence on a proof of stake system.

Migrating a cryptocurrency from proof of work to proof of stake is a complicated and highly deliberate process. Any crypto that wants to change consensus mechanisms will have to go through an arduous planning process to ensure the blockchain’s integrity from start to finish and beyond.

Proof of Stake Vs. Proof of Work

There are two consensus mechanisms that are generally used in cryptocurrency and defi applications: proof of stake and proof of work. Whereas the former employs staking, proof of work requires miners to solve complicated math puzzles in order to decide which network participants get to validate transactions and expand the blockchain.

Proof of Stake

  • Requires validators to hold some of the blockchain’s token or cryptocurrency.
  • Doesn’t require significant computing power for transaction validation.
  • It’s a newer approach than proof of work, with less adoption as a consensus mechanism.
  • Cryptos that use proof of stake might be more attractive for an ESG portfolio because of the lower environmental impact.

Proof of Work

  • Proof of work has a longer proven history of use as a blockchain consensus mechanism.
  • Miners don’t need to hold any of the blockchain’s assets, and only need computing power to validate a transaction.
  • May use a very significant amount of electricity. Cryptos using proof of work are often excluded from ESG portfolios because of the energy demands.

Which Cryptocurrencies Use Proof of Stake?

Proof of stake is becoming more prevalent as a consensus mechanism in the cryptocurrency world. There are currently about 80 different cryptocurrencies that use PoS as the consensus mechanism. Some of the most popular coins using proof of stake include:

  • Cardano (ADA)
  • Tron (TRX)
  • EOS (EOS)
  • Cosmos (ATOM)
  • Tezos (XTC)

The Bottom Line

While proof of stake is still emerging as a consensus mechanism for blockchain, it holds significant potential. With lower energy demands and a higher level of accessibility for everyday people to participate as validators, proof of stake has many attractive features that could bring it to the mainstream for blockchain security.