Crypto for the Rest of Us, Part II: What is Proof of Stake and Why Should You Care?

In a prior post I wrote about the basics of blockchain and proof-of-work Bitcoin mining. One topic omitted from that post was the alternative consensus mechanism, proof-of-stake. Last week, the EU turned down a proposal purporting to outlaw the use of proof-of-work cryptocurrencies in the EU. Also, Ethereum–the world’s second most popular crypto blockchain–is in the process of moving from proof-of-work to proof-of-stake. So this week, I am looking at the difference between these methods of consensus, and why proof-of-stake is likely to eclipse proof-of-work in the future.

Problems with Proof of Work

The main problems with proof-of-work are that it requires a great deal of power, as well as specialized computing equipment. Power requirements are an environmental problem, and specialized equipment is an access problem–particularly during a time when semiconductors are in short supply. If you want to know more about how proof-of-work mining happens, take a look at my last post.

But proof-of-work is also designed to have a limited throughput and pace. New blocks on Bitcoin are designed to be created about once every 10 minutes, and that means transactions take 10 minutes to happen. That may sound fast, but in the world of globalized currency exchange, it is not fast enough for everyday transactions.

These, and other concerns about proof-of-work, have led cryptocurrency communities to consider an alternative called proof-of-stake.

What is Proof of Stake?

Proof-of-stake is a method of reaching consensus on the validity of new blocks in a blockchain. Adding new blocks must happen via consensus because blockchains are distributed databases with no central authority to certify them. Proof-of-stake validates new blocks via a process known as staking. Staking is similar to voting, but because different validators can stake different amounts, voting power is not equally distributed among validators. In this way, it’s more like the way voting works in corporate shares than in democratic elections.

As with proof-of-work, proof-of-stake consensus is a two-step process. First, validators compete to propose a new block based on the transactions in the queue to be cleared. Then, once a validator wins the right to propose the new block, all the validators must reach consensus that the new block is correct.

In a proof-of-stake system, any validator can propose to add a new block to add to the blockchain, and must choose the amount of coins to stake. There is a minimum stake required, like an ante to play a round of poker. (Ethereum’s new proof-of-stake system will require a minimum stake of 32 ETH, which is about $3,000 as of this writing in March 2022.) The system chooses a validator at random to propose the new block, but the random choice is weighted by the amount of coins staked by each validator. This means those offering a larger stake are more likely to win the validating competition. The winning validator then proposes a new block to add to the chain.

All validators are responsible for attesting the blocks created by other validators. When the minimum required validators attest that the block is accurate, the block is added to the chain. (For ETH, the approval of 128 validators will be necessary to validate a new block.) The winning validator then adds the block and populates it to the nodes on the blockchain, and the system moves on to the next block.

Any validator who proposes a bad transaction or block would be slashed, meaning the validator would forfeit the stake. Also validators will lose their entire stake if they later attempt a 51% attack to the validity of the chain. This means validators have a high incentive to maintain the blockchain and protect its integrity. Validators can also be penalized for failing to fulfill their validating duty for other validators, but these penalties are relatively smaller.

Why is Proof of Stake Important?

Every technology needs a killer app, and for proof-of-work, Bitcoin was the killer app. But there are lots of cryptocurrencies these days, and each has its own rules and validation requirements. The killer app for proof-of-stake is likely to be Ethereum. Ethereum is different from Bitcoin in many ways. Ethereum is capable of executing smart contracts, and significantly, is the main blockchain on which NFTs are minted and sold.

Ethereum is currently mined via proof-of-work, but is in the process of transition to validation via proof-of-stake. It will do this as part of its lengthy 2.0 release process, and initial efforts to make the change have been ongoing for some time now.

Which is Better, Proof-of-Work or Proof-of-Stake?

Keep in mind that the purpose of each consensus paradigm is to create scarcity of the minted currencies, and ensure the integrity of the blockchain. That means the consensus requirements must provide incentives for participants to validate, and disincentives for validators to corrupt the blockchain. (For a tutorial on different consensus mechanisms, here is a good video.) Here is how the two methods compare:

  • Security. There seem to be differing opinions as to which method is more secure to avoid 51% attacks or spoofed chains. But most of the opinions I found say proof-of-stake is better, because the risks for validators of violating the rules are higher, so the expected costs of an attack will outweigh the expected benefits. Others call proof-of-work more secure. So, it seems the jury is still out on this point. Proof-of-work is battle-tested via its current use in Bitcoin and Ethereum. Proof-of-stake is at a more experimental stage, though some cryptocurrencies already use it.
  • Speed. Proof-of-stake is potentially faster. Blockchains like the one for Bitcoin are designed to create new blocks about every ten minutes. This is actually so slow, in computing terms, that it’s considered a reason why Bitcoin is not suitable for everyday transactions. Ethereum’s current proof-of-work pace is much faster than this, due to its different design, but all proof-of-work systems are limited by the time it takes to mine the block. Moreover, proof-of-stake architectures enable a technique called sharding, which allows the blockchain to be split into shard chains, each of which is capable of processing blocks in parallel.┬áThis increases the potential speed of proof-of-stake systems.
  • Environmental Impact. Proof-of-stake consumes much less energy. Staking doesn’t require the extensive computing resources of proof-of-work, which is specifically designed to be difficult and expensive to do.
  • Barriers to Entry. Proof-of-stake can be viewed as having lower barriers to entry, because the minimum stake is less than the cost of equipment required to successfully perform proof-of-work. However, each system favors validators with more resources, who are more likely to win the rewards for validation.
  • Concentration. Proof-of-stake can more easily become concentrated. Validators with the most can afford to risk more, and thereby get more rewards. However, proof-of-work has also become concentrated, as currently more than half the mining rewards for both Bitcoin and Ethereum are won by a few mining pools. So the relative level of concentration remains to be seen.

The EU Proposal

The EU recently considered a proposal to create a broad legislative framework for digital assets. The Markets in Crypto Assets (MiCA) proposal was a detailed plan for regulating crypto in the EU. Among many other topics, it sought to prohibit those in the EU from using proof-of-work currencies. That element of the proposal was highly controversial, given the two most popular cryptocurrencies still use a proof-of-work consensus. As soon as the proposal was made, cryptocurrency advocates started lobbying against it. On March 14, 2022, the EU Parliament voted against the proposal. However, EU is expected to create a revised proposal by January 2025.

Regardless of the ultimate success of a revised EU proposal, and whether it includes a ban on proof-of-work cryptocurrencies, the existence of this plank in the proposal shows that the winds are changing. Environmentalist criticism of the power requirements for proof-of-work have been eroding the reputation of cryptocurrencies, already tarnished for enabling illegal transactions such as ransomware. If Ethereum’s new proof-of-stake is successful, it seems likely to eclipse proof-of-work as the consensus mechanism of choice for new cryptocurrencies.

Author: heatherjmeeker

Technology licensing lawyer, drummer, dancer

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