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- Proof of Stake (PoS) is a system of agreement used to validate cryptocurrency transactions.
- PoS redefines how blockchain nodes verify transactions and improves upon the Proof of Work system.
- PoS validates tokens through staking, while PoW requires miners to solve a cryptographic puzzle.
Proof-of-Stake (PoS) is a consensus mechanism for blockchain networks. A consensus mechanism is a set of rules or agreements among all of the nodes in a blockchain network to validate cryptocurrency transactions. PoS was created to improve upon perceived flaws of Bitcoin's Proof of Work (PoW).
Some of the largest and fastest-growing coins have implemented this protocol. However, in recent years, the SEC began cracking down on crypto staking as it believes that some cryptocurrencies are securities. So, the best cryptocurrency exchanges in the US that offer staking services must comply with certain rules and regulatory practices.
Understanding PoS is key to understanding cryptocurrency and how it works.
How Proof of Stake works
Blockchain is a decentralized distributed ledger of transactions. Because there's no single server controlling the network, there has to be some way for everyone to agree on which transactions are valid. Otherwise, it would be possible for people to create fake transactions.
PoS nodes
Nodes are computers or other devices that store and verify blockchain data. Some nodes can add blocks of transactions to the chain, maintaining and growing the ledger.
PoS staking
In Proof-of-Stake, the network nodes commit "stakes" of tokens for a set time in exchange for a chance at being selected to produce the next block of transactions. The node that's chosen — referred to as the "validator" — will receive the block rewards in the form of the native token of the network.
PoS validators
Validators are responsible for verifying transactions on a blockchain. Each validator has a chance at being selected to write the next block and receive its rewards.
It's like a lottery – the larger the stake of tokens committed, the greater the odds that node has of being chosen. "The choice of the next block writer, the next validator, is a pseudo-random process determined by the size of the stake that you as the user have dedicated to the network," says Daniel Gould, managing director of Morgiou Ltd.
PoS security
In general, crypto exchanges offering staking services must comply with SEC regulations, including registering as securities issuers/broker-dealers and meeting all four parts of the Howey test. The four parts are:
- There is an investment of money
- There is an expectation of profit
- Profit comes from the effort of others
- There is a common enterprise
PoS network is primarily tied to two things:
- The value of its token
- The extent to which the token's supply is decentralized
That said, Proof of Work (PoW) is considered the more secure option between the two networks. If security is your No. 1 priority, you may prefer a PoW network.
Benefits of Proof of Stake
- Energy efficiency: Proof-of-stake networks require less energy than Proof-of-work networks, as significantly less computer power is needed. PoS transactions can be validated with computers with 8 GM of RAM (compared to the 830kWh energy cost required for PoW), making PoS both more cost-effective and more environmentally friendly.
- Scalability: PoS networks can scale more easily than PoW networks. Since validating requires less computer power, PoS can process transactions at a faster pace.
- Staking rewards: You can earn staking rewards for validating transactions and maintaining the security of the blockchain. Rewards earned through PoS are often newly minted cryptocurrencies or a share of transaction fees.
Proof of Stake vs. Proof of Work
Both Proof of Stake and Proof of Work mechanisms achieve the same end goal by different means. The main difference between these networks is how the network achieves consensus for its blockchain.
Gould notes that PoS is easiest to understand "if it's contrasted to Proof-of-Work." He explains that "in Proof-of-Work, the consensus is achieved by allowing a single participant to write the next block in the blockchain and be rewarded in the native cryptocurrency of that blockchain for their efforts."
Miners effectively spend large amounts of computing power and electricity as they work on "solving a very hard cryptographic puzzle." This approach has been criticized as requiring too much energy, making scaling or growing the network difficult, and not providing enough throughput (the ability to process many transactions).
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Examples of cryptocurrencies using Proof of Stake
A growing number of the most popular cryptocurrencies use some variation of the Proof of Stake protocol. Here's a partial list:
- Ethereum 2.0 (ETH 2.0)
- Cardano (ADA)
- Solana (SOL)
- Polkadot (DOT)
Because PoS does not involve " mining," PoS networks often start with a "pre-mine," where the entire supply of tokens is created at once.
How to make money with Proof of Stake
You can make money with Proof of Stake (PoS) by staking tokens and being selected as a validiator. Validators have the opportunity to win the next block reward of new tokens for their network of choice. But not just anyone can become a validator.
"You have to have a certain [number] of coins to become a validator that actually moves the chain forward," says Drew Beaudry, who worked at Tendermint. "Most people can become a validator node if they want, but they won't actually have votes on moving the chain forward, and they won't be rewarded for participating."
The number of tokens needed to become a validator varies according to the network. For some networks, the price could be small, while others could require quite a large sum. Ethereum (ETH), for example, plans to require a stake of 32 ETH to become validators.
Proof of Stake through crypto exchanges
Some of the best exchanges have become validators themselves rather than having to set up their own validator node. These exchanges then offer to stake tokens on behalf of users who hold PoS tokens in their exchange wallets (in exchange for a hefty fee of the profits). There's usually no minimum amount required.
Some of the largest exchanges, like Binance and Coinbase, offer staking for various tokens like Cosmos (ATOM), Tezos (XTZ), VeChain (VET), and others. Users simply buy or deposit coins and hold them in their exchange wallet to participate. Staking rewards will then be paid out to that wallet regularly.
However, some have criticized this approach as being too centralized. If big exchanges become the majority of validator nodes for any given proof-of-stake token, then most of the network will be concentrated in the hands of a small oligarchy.
FAQs about Proof of Stake
Risks of staking cryptocurrencies with PoS include the lack of liquidity while your coins are staked, lack of regulatory practices with crypto, price volatility, and the fact that you have no guarantee of future returns on the cryptocurrency you're staking.
You can stake your cryptocurrency on a Proof of Stake network by owning the native cryptocurrency of that blockchain and then transferring your digital coins to the staking address. Compatible crypto wallets provide investors with access to the staking function.
The future of Proof of Stake looks promising. Many crypto investors believe that a PoS network will become the dominant consensus mechanism for blockchain because it requires significantly less energy and computer power than Proof of Work networks. Still, there's no guarantee that PoS will continue to become popular, as it is considered less secure than PoW.
