Proof-of-Work and Proof-of-Stake and How Does Staking Work in Blockchain
When Satoshi Nakamoto invented Bitcoin, he had to think about a way to verify transactions in the blockchain without the participation of third parties. So, he created a special way to confirm the transactions and to prevent double-spending of funds. He called this algorithm proof-of-work (PoW).
Now, proof-of-work is used by many cryptocurrencies. Here is how it works.
Proof-of-Work Explained
Here, we will use the Bitcoin example to explain how proof-of-work functions. However, the principle is valid for all cryptocurrencies that use PoW.
The blockchain consists of blocks and blocks are formed by transactions. Every transaction shall be independently confirmed. To confirm a transaction, miners shall use their computational power to solve a cryptographic equation. Once the equation is solved, the transaction is recorded in the blockchain. Once recorded, the transaction cannot be changed or removed.
Miners don’t apply their computational power for free. For every confirmed block, they get a reward. However, not every miner gets a reward for the confirmed transaction but only the one who confirmed the transaction first.
Considering that because of the way a cryptographic puzzle is created, the only way to solve it is by trial and error. The more attempts you make within a specific timeframe to solve the puzzle, the higher your chances are. In other words, the more powerful your mining hardware is, the more devices you have, the higher your chances are. Hence, your potential success in mining, say, Bitcoin, depends directly on how much money you can invest into the mining equipment. It doesn’t seem to be too fair.
All miners participate in transaction verifications but not all miners can solve the cryptographic equations and get their awards.
Proof-of-Stake Explained
Proof-of-stake (PoS) differs from proof-of-work significantly. In the case of proof-of-stake, individuals can create new blocks if they have a specific number of staking coins. The staking coins are held in a special wallet. This wallet “freezes” the coins, the user cannot use them. Every blockchain has a minimum number of coins needed to start staking. If the coin is quite popular, staking coins might be a significant investment.
For example, take Dash. The blockchain where Dash runs requires a stack of at least 1,000 coins if you want to confirm transactions in Dash. During the bullish movement in 2017, the price of one Dash coin reached 1,500 USD. So, to start mining, you would invest 1,500 USD x 1,000 coins = $ 1,5 million.
Staking is not mining. When staking, people who verify transactions (such people are called forgers) don’t get a block reward. Instead, they get a transaction fee. The chances to verify a transaction depend on the number of coins you stake.
For example, if a specific blockchain has 10,000 coins in circulation, and you have 100 staking coins (which is 1% from the circulating amount), you have just 1% chance to verify a transaction and get the transaction fee. The main principle of proof-of-stake is “the more you stake, the more you earn”. And this principle works perfectly because forgers are interested in the blockchain to run properly. If something happens, e.g., if the network is hacked or malicious transactions are processed, forgers lose their coins.
Not all the miners, or forgers, can participate in transaction verifications but those only who have at least the minimum number of staking coins.
What Is Better: Proof-of-Work or Proof-of-Stake?
When deciding about what is better: proof-of-work or proof-of-stake, one shall consider several aspects and compare these protocols based on them:
Centralization
In PoW, those people who have more computational power have higher chances to confirm a block and get a reward. That’s why some companies purchase powerful equipment and create mining pools. Such pools allow users to “pool” their computational power together. In collaboration, they get more chances to win in the cryptographic puzzle competition. Therefore, for one person it is very difficult and, in some cases, (Bitcoin) even impossible to mine coins.
Once more, take the example of Bitcoin. The major part of all the mining hash rate of the network is controlled by five major mining pools located in China:
F2Pool with 15% of hash rate;
BTC.com with 12.9% of hash rate;
AntPool with 12.1% of hash rate;
Binance Pool with 11.29% of hash rate;
ViaBTC with 9.68% of hash rate.
The data is valid for April 2021. These pools are responsible for around half of the Bitcoin network`s total hash. If you have ever heard about a 51% attack, you understand what it means. Once a pool takes control over 51% of the hash rate, it gets control over the network. The cryptocurrency becomes centralized (controlled by an authority, a pool that has 51% of the hashing power), and it leads to the cryptocurrency collapse.
While it is still impossible for one pool to get 51% of the hash rate, such a possibility exists. It makes all cryptocurrencies that work based on proof-of-work protocol potentially vulnerable.
Everything works completely differently if a blockchain uses proof-of-stake to confirm transactions. There, people don’t need to join into groups to solve a cryptographic puzzle faster than other groups of miners. Everybody stakes a specific number of coins, and when a transaction is confirmed and registered in the blockchain, the forgers are rewarded.
If transactions in the network are confirmed based on the proof-of-stake protocol, and somebody decides to gain control over the system, this somebody will not be able to join his/her resources with another user. Instead, this somebody will have to purchase at least 51% of all the coins that circulate in the market. Here, we have two possible scenarios:
The price of the coin will be growing as a result of such massive purchases. It might make it impossible to buy 51% of the coins or the expenses will be so high that the 51% attack becomes unreasonable because the resources spent might exceed the profit that one can get from the attack.
The community will detect the purchases (they are open in the blockchain) and the person might use all his/her staking coins.
Hence, coins that work based on a proof-of-stake algorithm are more protected.
Fairness
To confirm transactions and get rewards in the networks that use proof-of-work algorithm, users need to invest in expensive equipment. The mining results depend directly on the equipment quality and the number of devices. As a result, only those who have money can participate in mining.
in the networks that use a proof-of-stake algorithm, users who have a specific number of staking coins get their part of every transaction fee. This part depends on the number of coins.
Electricity Consumption
For mining, powerful equipment is used that consumes a lot of energy. For example, Bitcoin mining uses more electricity per year than the entire population of Argentina does. It is expensive, not environmentally friendly, and slows down the mass adoption of such coins.
For forging, you don’t use a lot of electricity because the computational power depends not on the equipment but on the number of coins you are staking.
What Is Better: Proof-of-Work or Proof-of-Stake?
Proof-of-stake is better in many regards. It is fair, you don’t depend on equipment to get rewards but only on the real contribution to the network: the number of staking coins. The possibility of 51% attack is reduced to almost zero, and it is environmentally friendly. These are the main reasons why many newer cryptocurrencies with more perspectives prefer proof-of-stake, and Ethereum, one of the major players in the cryptocurrency market, has already started its switch to the proof-of-stake.
Does the proof-of-stake algorithm have any drawbacks? Yes, and they are rather significant. First of all, it makes rich people richer. To stake coins, you would need to make a significant initial investment. And the more you stake, the more you get in rewards.
Another significant disadvantage is the possibility of double-spending. Forgers can confirm transactions on several chains. So, when somebody sends money, this money can be spent before the transaction is confirmed. In the case of the proof-of-work algorithm, it is simply impossible because miners can confirm a transaction on one chain only. This is a significant drawback of proof-of-stake protocol that needs some solution.
All in all, both PoW and PoS have their benefits and drawbacks. But still, PoS is a newer solution that is used by coins with significant potential.