Proof of Work? Proof of Stake? Proof of what?
If these words don't mean much to you, then you’re on the right page because today we’ll dive deep into this topic and clarify things for you.
Any centralised system (let’s say some database) has its centre, as the name suggests. In case its data requires an update, it can only be performed by a central authority that remains the sole entity in-charge of maintaining a genuine record.
Blockchain is a decentralised system which means no centre, no authorities. Does it mean that anyone can add, delete or update the data on a blockchain to one’s liking? Of course not. This way anyone could add a desired amount of Bitcoin to their wallet, making the system less trustworthy, reliable, and therefore less valuable. The strong and secure decentralised system must have some way of proving the data. And instead of making a central authority responsible for this, blockchain creates an agreement between all its users. This agreement can be achieved with consensus mechanisms.
Proof of Work and Proof of Stake are the examples of consensus mechanisms that operate on different principles.
Introducing Proof of Work and Proof of Stake
Proof of Work is a common consensus algorithm used by the most popular cryptocurrency networks like Bitcoin and Litecoin. Basically, Proof of Work requires you to install a copy of the entire blockchain to a local machine. With every new transaction, the blockchain compares the data from every machine and the transaction will be approved if the data matches in 51% of cases. That requires a lot of calculations, computing power and electricity (in other words, it requires a lot of work) which is why it’s called Proof of Work.
Proof of Stake is another common consensus algorithm, but instead of using the power from mining machines, it uses users’ coins staked in frozen wallets to verify transactions. In Proof of Work, the more computing power you own, the more advantage in mining you have, whereas in Proof of Stake, the probability of mining a crypto asset depends on the share of coins (stake) that you have. For example, someone who owns 5% of all coins will create about 5% of new blocks.
Now let’s get more into details and compare the two popular consensus mechanisms.
History of Proof of Work
In the early 90s, IBM Research Department employees Cynthia Dwork and Moni Naor shared the idea of a new anti-spam email algorithm known as Proof of Work. A bit later, in 1997 Adam Beck created a working system based on this idea for his spam-combatting project HashCash. Back then this project used the same cryptography methods that are now used in Blockchain technology, and Satoshi Nakamoto later referred to Beck’s work while working on his own project.
Here’s how it works. Mining is the process of creating new transaction blocks and adding them to the blockchain. The PoW consensus mechanism sets its own set of rules that check that the mining process is correct. A miner’s task is to find a new block for the blockchain, which requires a lot of computing power. The first miner who finds the correct solution receives newly generated coins as a reward. But the complexity of the network always changes and adapts and it requires even more computing power over time. That’s why some miners work together in pools or build large mining farms in order to increase computer capacity. The more computing power you have, the more likely you’ll find the right solution first.
But here’s the downside. With every new computer added to the network, it becomes more complex and requires more calculations. With every new hardware added to boost calculations, the energy consumption grows. The energy costs of mining in the largest blockchains is comparable to the energy consumption of some countries. So there is a constant need to buy new gear and consume more electricity in order to be a successful miner.
Proof of Stake origin
Just like Proof of Work, the idea of Proof of Stake has its origins in the 90s. Wei Dai brought the idea of monetary policy to his b-money currency project. Satoshi Nakamoto later used some of Dai’s developments when working on Bitcoin.
In 2011 bitcointalk.org user with the nickname QuantumMechanic published the description of the PoS algorithm. A year later, the Peercoin cryptocurrency network was launched and worked on this algorithm.
The key difference between Proof of Work and Proof of Stake is the principle of creating a new block in the blockchain. In PoW, the successful generation of a new block relies heavily on computing power, while in PoS it depends on the number of coins the user owns. Like it was said earlier, someone who owns 5% of all coins will create about 5% of new blocks. This method of mining crypto assets is called forging or minting. A fee is received for providing the service of locking the coins.
Over the last few years, staking crypto has become much more popular because it is easier than buying expensive hardware to solve complex mathematical calculations, as is required in PoW. In 2020 Tezos became the largest staking network according to Staking Rewards. Then Coinbase announced that users can stake their Cosmos (ATOM) Tokens. Even Ethereum, one of the most popular crypto assets, moved from the Proof of Work to the Proof of Stake following the long-awaited Merge .
Staking tokens in order to validate PoS protocols transactions has become one of the primary forms of passive income.
PoS solves some PoW problems
And that’s a fact. For example, a PoS network doesn’t consume as much energy because it doesn’t require huge computing power. With a PoW algorithm, there is the possibility of a “51% attack”. This means that anyone who owns more than 50% of the network's mining hash rate can interrupt the recording of new blocks by preventing other miners from completing blocks. It is possible in the early stage of the existence of any crypto asset with the PoW mechanism, but it is not possible with PoS because the attacker has to own more than half of all coins. But even if someone has 51% of all coins, it makes him the largest participant of the network and least interested in the fall of the exchange rate.
Besides, staking is a much easier entry point into the crypto ecosystem for users. Instead of buying tons of expensive hardware and looking for the country with the cheapest electricity price, users can just stake their coins in a dedicated wallet for a certain amount of time.
SwissBorg app and Staking
Thanks to the development of the SwissBorg Earn program, staking has become accessible to every retail investor. Unlike in classic PoS staking, in which stakeholders’ coins are frozen for a period to validate transactions done through the network, app users can enjoy a more flexible approach to staking, liquid staking. Liquid staking is the act of delegating your tokens to a service that stakes for you without losing access to your funds. Liquid staking allows you to access your funds even when you're staking them. The funds remain in escrow, but aren't “locked” and inaccessible, as they would be with PoS staking.
Staking, however, comes with some risks:
- Slashing: Slashing is the act of your validator/backer being punished for a fault he conducted; it is a mechanism by which the network disincentivises abnormal behaviours.The penalties depend on the kind of misbehaviour and on the parameters of the protocol. Most of the time, the validator/backer is punished with a certain percentage of token he has under staking or within a safety deposit.
- Crypto volatility: Probably the most dangerous risk in staking is the volatility. In fact, earning a crypto dividend on your stake could sound nice and be very profitable if the market is in a bull run. On the other side, the staking reward could not cover the loss due to price decline.
- Lock up period: Some staking protocols may require a luck up period for staking. This means that you agree to keep them staked for a minimum period of time before you are eligible to unstake and sell them (or any rewards earned).
Thanks to SwissBorg’s key partnerships with top staking protocols, liquid staking is now available to every app user. As usual, we advise you to do your own research and understand the underlying risks.
Final thoughts
Together, we have learned that:
- Blockchain is a decentralised system that uses consensus mechanisms to validate transactions.
- Proof of Work is a common consensus algorithm the relies on computing power and complex mathematical calculations.
- Proof of Stake is another consensus mechanism that uses the number of coins to validate transactions and generate new blocks; coins are locked up for a period of time.
- Liquid Staking is the act of delegating your tokens to a service that stakes for you without losing access to your funds and with no locking period, that is, funds are redeemable at any time.
Thanks to SwissBorg Earn you can now have access to liquid staking and earn on your cryptos!
