What is proof-of-stake?

Poloniex recently introduced Cosmos staking rewards to non-US customers who hold a Cosmos Atoms balance on Poloniex. This offering is made possible due to Cosmos’s proof-of-stake consensus mechanism.

As with many concepts in crypto, proof-of-stake is new and unfamiliar to most. In this article, we define what proof-of-stake is and how it creates new earning opportunities for crypto investors.

Incentives within crypto networks

Incentive systems are a core component of any crypto-network. Participants are given an incentive to expend resources to secure a network. These resources keep the network functioning. The incentive ensures continuous participation and thus, a continuously functioning network.

Bitcoin has grown from an open-sourced project run by a handful of hobbyists to one of the most powerful distributed networks in the world. This growth can in part be attributed to the incentives behind proof-of-work. “Miners” commit work in the form of computation and are rewarded for it.

In the decade since Bitcoin was introduced, new types of incentive systems to secure crypto-networks have been developed. Proof-of-stake is one such alternative. To understand proof-of-stake, it is helpful to compare it with it’s more familiar predecessor.

Proof-of-work vs proof-of-stake

In both systems, participants are incentivized to commit resources to a network in return for newly-issued cryptocurrency. One of the principal differences between the two is the type of resource one needs to commit. While the type of resource that is committed varies, the end goal is to enable a network of individual participants to agree on a single history of the blockchain.

Proof-of-work requires a commitment of custom hardware and electricity. Proof-of-stake requires the commitment of a digital asset (assets committed = stake). In proof-of-work, the more hardware and electricity one commits, the more rewards they receive. Similarly, in proof-of-stake, the more assets (or stake) committed to the network, the more rewards one can receive.

Proof-of-work involves a competition to solve a mathematical puzzle (essentially guessing a random number), which earns a miner the right to add the next batch of transactions and a mining reward in the process. The more computing power a miner has, the more “guesses” they can make, which is why proof-of-work favors hardware and electricity.

Proof-of-stake replaces the competition to solve a mathematical puzzle with a lottery system. The equivalent of miners (validators) are chosen by a selection algorithm to add the next batch of transactions, earning a reward in the process. The selection algorithm is “probabilistic”, meaning the more one has staked with the network, the better chance they have of being selected. This is why proof-of-stake favors assets committed.

While participants in both systems earn rewards, the networks get something arguably more valuable in return: security. As miners commit electricity and as validators commit assets, each network becomes more secure. This is because in essence, participants are competing to add new, valid transactions to the blockchain. If a bad actor wanted to attack the network by proposing invalid transactions, they would have to outcompete the other participants by expending way more electricity or way more assets. This becomes more expensive to do as more resources are committed.

New opportunities created by proof-of-stake

A key concept for crypto-investors to understand is that the proof-of-stake model introduces new ways for token holders to participate in and earn yield from crypto-networks. Where proof-of-work mining has developed into a highly specified industry that involves expensive equipment and large scale facilities, proof-of-stake validation more simply requires one to acquire a digital asset and lock it into a network for a specified period of time.

While energy intensive hardware is not required, it still takes technical savvy to operate the software needed to participate. The asset minimums for certain proof-of-stake networks can also present a barrier to entry. Given the technical know-how and asset requirements, a trend in specialized VC firms and institutions participating in proof-of-stake networks is developing.

There are also opportunities for smaller holders to participate in proof-of-stake networks. Delegated-proof-of-stake (DPoS) networks like Cosmos, Loom, and Livepeer enable participation through “delegation.” This is a process in which a token holder chooses a validator to stake their tokens with. Using a pool of assets staked by many delegators, a validator runs a staking node. Through this pooling of assets, a validator can earn staking rewards and pass a percentage of those rewards back to the individual who delegated the assets.

Exchange staking

Exchanges make for natural participants in proof-of-stake networks. They have the in-house talent and technical knowhow to interface with proof-of-stake networks. As custodians of a large amount of assets, exchanges can also easily meet the asset minimums of various staking networks.

As demonstrated by Poloniex’s recent Cosmos staking offering, staking as a service is another emerging trend within the industry. Exchange staking, or “soft-staking” offers certain advantages and benefits. For example, staking directly with Cosmos includes a 3 week lock-up period once someone decides they want to transfer and trade their staked assets. When staking on Poloniex, token holders can earn staking rewards while maintaining the flexibility to trade and withdraw at all times.

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