Blockchain technology has evolved significantly since the introduction of Bitcoin in 2009. The foundational premise of blockchain is the use of a decentralized ledger that enables multiple participants to reach a consensus on the outcome of events, such as transactions, without the need to rely on centralized intermediaries.
To ensure participants agree on the state of the network, blockchains use a “consensus mechanism”. Consensus mechanisms are processes followed to achieve agreement across a decentralized network while maintaining trust and security.
Bitcoin utilizes a Proof-of-Work (PoW) consensus mechanism, which relies on computational power to reach consensus, validate transactions, and secure the network. As the blockchain industry has matured, new types of consensus mechanisms emerged. The most popular consensus mechanism in recent years is Proof-of-Stake (PoS), which relies on a process called staking.
What is Proof-of-Stake?
The concept of PoS was first introduced in 2011 by Sunny King and Scott Nadal in their Peercoin whitepaper. It emerged as an alternative to the energy-intensive PoW model, which requires miners to solve complex cryptographic problems to validate transactions and secure the network.
To solve these complex problems, PoW miners need to use massive computational power. Over time, many industry participants argue that the capital expenditure and operational costs of mining Bitcoin have become a barrier for smaller players, leading to the centralization of mining pools. Additionally, PoW as a consensus mechanism also has a challenge in scaling up its transaction throughput. As a result, the majority of newer blockchain networks have decided to adopt a different consensus mechanism than PoW, with PoS being one of the most popular alternatives.
In PoS networks, miners are commonly called “validators”. Validators are responsible for the same actions that miners do in PoW networks, such as validating transactions and securing the network. However, instead of deploying computational power, validators are required to “stake” the native token associated with the underlying blockchain network that they are participating in.
How Staking Works
There are numerous implementations of PoS. At its core, PoS validators are chosen to create new blocks and validate transactions based on the number of tokens they hold and are willing to “stake” as collateral. Validators are then incentivized to do the right thing as their staked tokens can be forfeited if they act maliciously or harm the network.
Instead of risking capital in the form of mining rigs and operational costs as they would in a PoW blockchain, validators in a PoS network risk their capital in the form of the native tokens associated with the underlying blockchain.
In PoW, miners risk USD-denominated capital through operational, electricity, and hardware costs, which does not incentivize miners to keep their mining rewards. PoW miners often sell their rewards to cover expenses or to purchase more mining rigs to scale up their operations and capture market share.
In PoS, validators stake the native token of the blockchain they are validating instead of purchasing mining rigs. As a result, validators are not risking USD-denominated assets. This aligns incentives between the validators and the blockchain network while reducing the need to sell their rewards to cover expenses. The goal is to create a compounding loop that increases their market share (and consequently their rewards) if validators decide to stake their rewards.
Proponents of PoS argue that this compounding loop contributes to the safety of the consensus mechanism as validators have a vested interest in the long-term health of the network due to their staked tokens. This makes it expensive and unprofitable for attackers to compromise the network.
On the other side, those against PoS argue that implementations of PoS often add a layer of centralization. For instance, Delegated Proof-of-Stake is a version of PoS whereby stakers select delegates to validate the network, outsourcing the required work to a third-party for a small fee taken from earned staking rewards.
Yield & Energy Efficiency
There are also two additional benefits of PoS related to yield and energy efficiency.
The rewards generated from PoS networks are a substantial source of yield. Yield generated from staking and participating in a blockchain network is equivalent to a stock dividend that is automatically reinvested in the underlying equity. By contrast, in PoW systems, there is no pathway for an asset owner to receive more of the same asset by participating in the network; PoW assets such as Bitcoin require asset owners to lend out the asset in order to receive yield.
See the table below for details on staking yield on top PoS assets.
Source: Digital Asset Research | Data as of 16 March 2023
PoW requires computational power for miners to effectively do their job. At a large enough scale, the energy consumed can be extremely significant. As the second largest digital asset by market capitalization, Ethereum was using 5.13 gigawatts on a continuing basis with PoW, or roughly equivalent to the same amount of energy consumed by 2,100 American homes. After transitioning to PoS, Ethereum is using 30,000x less energy. Ethereum.org posted data on Ethereum’s energy usage compared to estimates for various industries:
Today, many of the top digital assets by market capitalization are using PoS consensus mechanisms. Ethereum, which has more than $27 billion in Total Value Locked across its DeFi ecosystem, transitioned to PoS in September 2022. Additionally, 11 out of the top 25 digital assets by market capitalization are using PoS. See the table below for details.
Source: Digital Asset Research | Data as of 16 March 2023
In conclusion, PoS and staking activities are significant components of the digital asset market. The majority of top assets by market capitalization with smart contract functionality have adopted PoS in recent years. While there are ongoing discussions and improvements that can be implemented in the existing PoS landscape, PoS is currently the dominant consensus mechanism for Web3 and decentralized applications.