To Stake or Not to Stake: Proof of Stake Explained Simply

To Stake or Not to Stake: Proof of Stake Explained Simply

 Proof of stake may overtake proof of work. So what is proof of stake? How does proof of stake work? Here's proof of stake explained simply.

To Stake or Not to Stake: Proof of Stake Explained Simply
Guy Ovadia

Published Feb 4, 2022Updated Feb 5, 2022

Crypto

Crypto

Technology

Technology

Global Markets

Global Markets

If you're into crypto and you haven't heard of staking, then you've got to keep up. Everyone and their mother is staking their token of choice or, rather, locking up their cryptocurrency for a chance to make their bag grow. Is it really so simple? Well, yes and no. To tell you the truth, not all crypto staking mechanisms are created equal. There's native crypto staking—AKA proof of stake—and then there's DeFi staking, along with everything else.

How do you explain proof of stake simply? In a nutshell, proof of stake is a protocol for validating transactions in a decentralized payment network, and it's an alternative to the proof of work system first used by Bitcoin. Both are consensus mechanisms that achieve the same goal, but when it comes to proof of stake vs proof of work, there are some fundamental differences in how the two mechanisms are structured. So, let's get into the nitty-gritty of what proof of stake is.

Proof of stake explained

Proof of stake is a protocol that uses a system of validators to secure a decentralized network. Validators are computers responsible for confirming blocks of transactions in exchange for a reward, usually in the form of transaction fees and newly minted tokens. Anyone can set up a validator by staking a minimum number of tokens, but they must keep their computer on and connected to the internet 24/7 to earn rewards.

This system effectively simulates the electricity-intensive miners of proof of work with a system of cost-effective and energy-efficient validators. This also replaces the hardware requirement of mining with the capital requirement of staking. What this means is that the cost of operating the network and producing new tokens is decoupled from commodities, like the cost of electricity and computer processing power, and is instead tied to the price of the token.

The result is that the wealthiest token-holders with the largest stakes earn the highest rewards and retain the most control over the network. Not only can proof of stake be inequitable, but it can potentially erode decentralization. Part of the solution is including delegators, which are people who stake their tokens with a validator to earn part of their rewards. Delegators don't have a minimum staking requirement, which makes participating in and profiting from proof of stake more accessible.

But wait, what happens if a validator doesn't fulfill their responsibility to the network? Validators have only one job: validate transactions. This includes adding new blocks to the chain (which is also how new tokens are minted) and confirming the work of other validators to prevent each other from defrauding the ledger or orchestrating attacks on the network. Validators who violate the protocol and break consensus must be punished, but this is where proof of stake gets kinda iffy. 

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Problems with proof of stake

Proof of stake comes with benefits, but also flaws. One is that there's no built-in way to enforce the protocol and keep its validators in check, which means blockchain developers must come up with their own rules for how validators are selected to create blocks and dole out punishments for those acting in bad faith. This is just one of the several security vulnerabilities of proof of stake.

Security and centralization

As was said earlier, the rich get richer with proof of stake. While there is a low barrier of entry to participate as a delegator, validators with the largest stakes always reap the highest rewards. One way to stymie this is by randomizing the validator selection lottery to give small-time stakers a chance to propose a block and get that juicy block reward in return. But ultimately, capitalism naturally favors the wealthy, so if token holdings are directly proportional to power and influence over the system, then it's on a slippery slope toward centralization.

An entity that controls over half the supply of a proof-of-stake token is effectively in control of the network. If centralized exchanges like Coinbase, Crypto.com, and Kraken teamed up and controlled half the token supply, they could theoretically commandeer a proof of stake blockchain. This makes proof of stake inferior to proof of work in this regard because it's not as resource-intensive, and thus, easier to hack. While a '51% attack' is unlikely because it would be exorbitantly expensive to carry out, it is more likely realized in a proof-of-stake environment than in proof of work.

kraken
Kraken

Crypto

Forks and the "nothing-at-stake" problem

The biggest issue with proof of stake, however, is how it handles 'forks,' but not the kind you eat with. A fork occurs when a blockchain changes its protocol, requiring validators to form a consensus around new rules. Usually, only a majority of validators are required to agree to a 'soft fork,' meaning the new protocol is gradually adopted by the network. This is opposed to a 'hard fork,' which occurs when validators can't reach a consensus and one blockchain gets split instantly into two separate daughter chains, with one remaining faithful to the protocol while the other diverges from it. 

Although hard forks aren't usually our favorite outcome, they're not inherently problematic. In fact, forking is a feature, not a flaw, and both Bitcoin and Ethereum have forked to become the blockchains they are today. In the context of proof of work, forking is inevitable and miners are incentivized to choose just one of the subsequent daughter chains because validating both would require doubling their computing power. When it comes to proof of stake, however, validators aren't incentivized to choose between the divergent daughter chain or the faithful daughter chain. 

In the event of a hard fork, proof of stake validators are incentivized to participate in both daughter chains rather than just one because, well, why not? Essentially, proof of stake has no built-in mechanism to prevent one validator from participating in both the old and new protocols simultaneously. This is called the "nothing-at-stake" problem because validators risk more by choosing to abide by one protocol over another, thus making it more rational to just abide by both.

The slasher solution

To this end, developers of proof of stake blockchains began coming up with creative solutions. One prescription to the nothing-at-stake problem has been implementing a 'slasher' algorithm. A slasher is a mechanism that punishes validators who simultaneously create blocks on multiple daughter chains by debiting their stake balance. While slashers greatly reduce the risk of validators undermining consensus, it doesn't eliminate all possibility of an attack on the network.

Simply put, there is no sufficiently decentralized solution to the nothing-at-stake problem. The only effective way to ensure that consensus is maintained in a proof-of-stake protocol is by punishing validators who break the rules. This might be the most effective and straightforward solution, but imposing such strict measures is antithetical to crypto's ethos of decentralization. Not to mention that such heavy penalties are equally punitive to honest validators that are met with unavoidable technical issues.

The future for proof of stake

Complex problems require creative solutions, and the rising popularity of proof of stake means developers are coming up with new ways to address its security flaws. Popular platforms like Cardano, Solana, and Binance Smart Chain have all addressed proof of stake's shortcomings by employing different security measures. 

We can see by comparing Cardano with Solana that there is more than one approach to developing a functioning proof of stake protocol. Ethereum is gearing up for a major proof of stake upgrade sometime this year, and even Dogecoin is hopping aboard the proof of stake bandwagon. It might be strange to compare a meme coin like Dogecoin to Cardano, but it shows us which direction the blockchain space is headed in.

The writing on the walls spells a future where all the top cryptos are secured through proof of stake. While we don't know what lies ahead of us, it's safe to assume that proof of stake isn't going away, at least for now. Hopefully, now you know what proof of stake is and you can go teach your friends what it is, how it works, and why it's the best—or worst—thing to happen in crypto.

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