What is Proof of Stake?

Newbies to the cryptocurrency space often struggle to understand how the mining mechanism works. The idea of having a cryptographic algorithm that mints new coins to reward those who help maintain the blockchain isn’t exactly a natural one, and a long explanation is usually required.

But once this group understands how the traditional proof of work theorem functions, they often find out that there are algorithms different than the one implemented by Satoshi in the beginning.

Where Proof of Work Falls Short

News stories keep surfacing about the growing energy requirements of networks using proof of work algorithms. The enforced scarcity of coins means that as more miners join the network, the amount of computation required continues to increase. Not only is this not sustainable in the future, but it also prices out smaller mining pools that don’t have the capital required, leaving a market structure similar to the oligopoly of the banking industry.

Additionally, from an economic standpoint, the proof of work theorem is vulnerable to the tragedy of the commons. This is an economic scenario where users are incentivized to act in accordance with what is best for them, rather than what is best for the group. Profitability on mining coins like Bitcoin will begin to fall, and that will drive miners out of the market, hurting the whole network.

Proof of Stake as an Alternative

So if proof of work rewards you for the amount of work you do, proof of stake will reward you for the amount of coins you hold. You will mine coins in proportion to the amount you hold, which is much like the traditional interest rate structure.

Our previously described tragedy of the commons issue is solved, because people now have reason to continue holding the coin and are rewarded for it. Additionally, the centralization risks are minimized, as those with the most mining power or capital are no longer in control.

51% attacks are hardly a worry on the Bitcoin network, because you’d need to gain access to more than 51% of the computing power of the network. However, with PoS there is an even smaller risk because of how expensive it would be to buy 51% of a coin, only to devalue it.

Many Cryptocurrencies Using It

Since the incentives are different, proof of stake algorithms essentially change the entire structure of the market for a cryptocurrency. The fact you can earn coins just by holding cryptocurrency would be very appealing as an alternative to using tons of electricity.

Dash, or digital cash, may be the best known cryptocurrency using PoS, but NEO, PIVX, and many more are currently using it. The incentives change when you use these coins, because of all the additional benefits of just holding them. Often the only way to gain this interest is by joining a masternode or having a significant amount of coins yourself, but it is still something worth looking into.

Finally, we are finally starting to see larger cryptocurrencies like Ethereum considering a move to a hybrid algorithm that uses proof of stake as well, it is clear the consensus method will finally get tested at scale.

The Risks of PoS

As with any solution, there are risks involved with the potential implementation of proof of stake algorithms. The biggest risk inherent in a proof of stake system is that the bad actors aren’t pruned out in the same way as with a proof of work system. They can continue to collect “interest” while they vote for “invalid” blocks, and not be harmed in any way. For the proof of stake system to work, this problem will eventually need to be solved, but at the same time, it shows a lot of potential.

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