Proof of Stake - How PoS Works at Exchanges

Proof of Stake or PoS for short, is a term widely used in cryptocurrency trades. It represents the consensus mechanism that stakers use to confirm blockchain transactions. This is done in order to maintain the decentralized nature of the exchange. All transactions on the blockchain are stored within blocks, and all the members of the network verify these records.

This way of transaction validation was created as the alternative to Proof of Work (PoW) protocols. This model was previously used by Bitcoin, but it’s considered obsolete due to the high energy dependence.

Proof of Stake is a much more convenient method and not that dependent on energy. In this article, we’ll talk more about PoS, explore its origins and show you a few use case examples that will provide more information about it.

Proof of Stake Explained

The proof of stake mechanism is pretty complex, but we’ll try and explain in simple terms. It was designed to provide an alternative way to validate transactions on the blockchain. To understand it, you’ll first need to take a look at the previous one – proof of work, or PoW.

This decentralized system means that no central or single controlling authority keeps a record of transactions. All transactions are stored on the blockchain, a publicly distributed ledger.

The blockchain has blocks of data which store transactions. All transactions are stored within several blocks. In order for a transaction to be successful, it goes through a consensus mechanism – proof of work or proof of stake. In simple terms, it fact checks the data stored on the network. With PoW, any party with a computer connected to the blockchain becomes a node. The node completes a puzzle through mining that essentially verifies each transaction.

PoS eliminates the computational power of PoW. Users just need to stake their coins to the network and in that way become a validator.

How Does Proof of Stake Work?

There are several parts to the PoS mechanism that are essential to complete transactions. These include crypto staking as the pillar of this mechanism.

Staking Cryptocurrency

As mentioned earlier, with PoS, you don’t need miners to complete puzzles to validate transactions. Instead, users stake their own coins – this is called staking. They will then be able to validate blocks of data on the network, after which the transaction is recorded on the blockchain.

The amount of the coins staked determines the chances for a node (or staker/validator) to complete the process faster. The more coins you stake, the better your chances of being selected as a validator via the blockchain algorithm.

Illustrating the process of staking

Once you stake your coins on the network, you won’t be able to withdraw them. The lock-up period lasts for 1-2 years. Staking comes with a minimum fee on some networks. For example, with Ethereum, you must stake a minimum of 32 ETH to become a node.

Validating Transactions

Once selected as a node by the blockchain, you can validate transactions. The selection of choosing nodes is random. This protects the integrity of the network and its decentralized aspect. As soon as a transaction block has been created, a committee of nodes verifies it.

They ensure that the information is correct, and was previously completed by solving a mathematical problem between miners. However, due to the fact that PoW requires a lot of electricity and computational power, it was clear that an alternative was required. That’s who the PoS mechanism was created.

Rewards & Penalties

With the PoW mechanism, miners were rewarded when they completed transactions. It’s similar with proof of stake, with the rewards coming in the form of newly minted crypto. But, in order for this to happen, the block needs to be validated in an allotted time, or a period of completion.

If the validator (node) is not present during the verification, they receive a penalty. If a validator attempts to make a fraudulent verification, their stake will be seized and sent to a wallet they can’t use to recover their coins.

What Are the Advantages of PoS?

There are many advantages of the PoS mechanism when compared to others. Despite the obvious fact that it has a lower carbon footprint, it’s also more secure to use.

Superior Energy Efficiency and Lower Environmental Impact

As opposed to mining, PoS is more energy efficient. Its carbon footprint is minimal, so it has as much lower environmental impact. According to experts, Bitcoin mining may be responsible for 65.4 megatons of CO2 per year. The high carbon footprint has led entrepreneurs such as Elon Musk to stop using Bitcoin. PoS was created shortly after, as an alternative that’s safer for the environment.

In most cases, Ethereum uses this mechanism in its network. After the switch to Proof of Stake, energy consumption has been down by almost 100% when it comes to crypto transactions.

Unique Approach to Network Security

It’s not just that it’s a finer alternative to PoW. The Proof of Stake mechanism is also safer. According to the Bureau of Economic Research, around 10% of miners (the top ones) control 90% of the Bitcoin mining capacity.

The validation process is more evenly distributed with PoS, which leads to much better security. With validators staking their own coins to the network and a minimum network fee, they risk losing the crypto they stake.

In short, they’re always aiming to be online for the validation. Attacks are drastically less possible with this mechanism. Attacks are nearly impossibly as hackers need to acquire a high number of nodes to win control, which isn’t likely to happen.

What Are the Disadvantages of PoS?

No consensus mechanism for crypto transactions is bulletproof. That’s the case with Proof of Stake, which has a few disadvantages you should be aware of.

Risk of Centralization

As a decentralized mechanism, the future of Proof of Stake should be bulletproof. However, it isn’t, and that’s because of the risk of centralization.

There’s no question that those with a higher amount of capital are favored in PoS. The blockchain chooses nodes with more crypto staked. In short, the more coins you commit, the better the chances of being selected as a node.

Over time, this may result in centralization. This is because the concentration of power leans toward those who have invested more into the network.

In the future, we may see larger exposure to governance and possibly censorship. Of course, those are the things you never like to see when it comes to cryptocurrencies, but are a reality we should be aware of. The only preventive measure for this is the randomized choice of validators, which counters many credible threats.

Wealth Inequality

Since there’s slight favoritism when it comes to the Proof of Stake mechanism, it can lead to growing inequality over time. Those who stake more will receive the lion’s share of rewards, which might lead to a wealth gap between participants.

What Are Some Real-World Applications of PoS Systems?

The Proof of Stake mechanism has many real-world use cases. It’s the preferred consensus mechanism on the Ethereum network, which is one of it earlier adopters.

Ethereum

Ethereum is one of the earliest adopters of the PoS mechanism. The switch occurred in 2022 with Ethereum 2.0.

The network went from PoW to PoS. In order to become a node, you need to stake at least 32 ETH. You receive crypto as a reward for your staking, and around 2.84% annual percentage yield for staking Ethereum on ETH platforms.

Ethereum 2.0 has significantly reduced its carbon footprint. Right now, it’s a much more environmentally friendly platform. The power demand after the consensus switch went from 235 kw to 2.44 GW. That’s a notable difference, especially when compared to the carbon footprint of Bitcoin and other crypto.

Additionally, the number of transactions per second has increased as well. It went from 15-20 per second to over 100,000. While there’s risk of centralization, the PoS mechanism will continue to be favored in the near future.

Tezos

Tezos was one of the original blockchains to use PoS. It was founded in 2018, processing through millions of transactions at the time. This was done with the help of those who ‘bake’, which are essentially investors who stake the native Tezos token – XTZ.

Tezos actually uses an advanced PoS mechanism named liquid proof of stake, where the bakers verify all transactions on each block. However, the differences include no lockup period, allowing for more flexibility and allowing stakers to withdraw their tokens anytime.

Staking Pools and Community Governance

If you’re not familiar with the term staking pools, we’ll detail more about them below. A staking pool is a community or a group of stakes. They usually gather to stake collectively. The staking process is conducted by the pool’s operators.

They’re also responsible for distributing rewards to participants based on their contribution. These pools were created in order to support validators who don’t have the necessary capital. While a good idea, it has also been a driver of centralization.

The community’s governance is considered an overall centralization of the blockchain. This is because small groups of validators control a major portion of the network. In the future, these kinds of pools might be pressured to block transactions from certain addresses. That could prove a problem and ruins the overall nature of the blockchain.

The Future of Proof-of-Stake

The PoS mechanism isn’t perfect, but it has a bright future ahead of it. Below we’ll mention a few ways in which it could improve and grow further in the future.

Scalability and Performance

One of the blockchain’s biggest challenges is scalability. PoS is a better alternative than PoW for this. However, there are still some obstacles to overcome.

For example, as transactions grow, the mechanism will need to find a way to handle scalability and improve its performance. This is easier said than done, as the current number of transactions has a maximum capacity of 100,000. It could grow several times in the future as more capacity is needed.

At the moment, the community has found a quick solution with sharding. It splits the blockchain in several parts, with each shard processing transactions simultaneously. This boosts the overall flow, but it’s not a final solution to the problem.

Sidechains such as Polygon can also be used to boost scalability on the Ethereum network. It does this via the Polygon PoS sidechain, a 2-layer blockchain that works together with Ethereum to improve speeds and lower fees. However, both are makeshift solutions, and a finer one is required in order to improve scalability and performance.

Regulation and Compliance

In order for the consensus mechanism to work as expected, regulation and compliance are required. Which could prove a challenge considering most governments’ current stance on cryptocurrencies. It’s not that they’re all against crypto. It’s just that they’re looking at ways to structure and add safeguards within the system, which gradually introduces centralization.

Strict rules might be applied to every staker and exchange. Regulators may require staking pools to form tougher rules, including AML and KYC. All of this defeats the purpose of cryptocurrencies and PoS, so crypto fans are hoping it never comes to it.

Conclusion

The Proof of Stake consensus mechanism is an environmentally-friendly alternative to Proof of Work, and possibly the future of crypto investments. It’s a more scalable system which has already been adopted by the likes of Ethereum and Tezos.

Experts are adamant that Bitcoin should make the switch too. It may never happen, but such a move could have drastic consequences for the world of crypto.

The biggest problem with PoS is the scalability and its performance in the future, which could suffer from issues. There’s also a risk of centralization with community pools and eventual regulation.

For now, the system will continue growing as more and more crypto fans look to become stakers. We’re excited to see what the future holds, and how the PoS consensus mechanism looks like in the future.