Many cryptocurrencies, especially coins like Bitcoin, rely on proof-of-work. In this process, miners secure the network with their mining hardware by providing proof of work. They verify new transactions and thus create new blocks. Despite some advantages, especially in security and decentralization, there is some criticism. Mining consumes vast amounts of electricity and leads to high transaction fees, they say. However, there has long been an alternative to mining: proof-of-stake.
What exactly is proof-of-stake?
In proof-of-stake (PoS), it is not the miners and their hardware that verify new transactions. Instead, the stake holders deployed what they call their “stake.” This is a quantity of the respective cryptocurrency. This process is also called “staking.” Stake holders in America or England freeze their cryptocurrency for an unspecified period of time and thus become a “validator” (also called a masternode, see explanation box below). They are granted the right to verify transactions and receive rewards for doing so. Stakes are used to build consensus within the network and to secure the blockchain.
Participants can lose the stake
There are many PoS blockchains with their own rules, specifics and details. However, they share some commonalities. For example, reputation systems ensure that participants behave correctly. If they behave in a manipulative or harmful way, they can lose their stake. However, if they behave in a trustworthy manner, they regularly receive a block reward.
Among the validators, the size of the stake then determines how high the probability is of verifying a transaction. The bigger the stake, the better. At the same time, methods have evolved to make this system fairer. However, this varies from cryptocurrency to cryptocurrency. For example, many stake holders do not actively participate in proof-of-stake. Instead, they just “delegate” their stake to a validator who performs important tasks in the network. It then distributes its revenue to the stakeholders. This also means you and other stake-holders don’t have to participate in consensus mechanisms and transaction verification. Someone else takes care of that.
The advantages of proof-of-stake
The number of PoS blockchains is growing, and in the future even Ethereum plans to move to staking. Developers are hoping to gain a number of benefits from this. Primarily, it is blockchains with tokens and smart contracts that prefer Proof-of-Stake to PoW.
The benefits include the following:
- Energy efficiency: staking consumes much less energy than the proof-of-work algorithm. Basically, the only power cost is for the device that connects the Stake to the Internet. For many cryptocurrencies, this is not even necessary. There is no need for additional, energy-hungry hardware and complex cooling processes like those used by miners. There is also no additional amount of electronic waste.
- Low barriers to entry: In most cases, anyone can start staking who can also buy a cryptocurrency. All you need is some startup capital and an internet connection. For some cryptocurrencies, the requirements are higher (DASH), but usually a simple stake is enough to get started. In theory, this should also lead to a democratization of the verification process.
- Fast transactions and high scalability: PoS blockchains can process their transactions much faster than PoW blockchains. Finally, there are no miners to provide proof of work first. Furthermore, PoS networks can theoretically grow much better. This is because they do not rely on more and more hardware and miners to process larger volumes of transactions.
Dangers and risks of staking
Blockchain technology continues to evolve. The goal is for cryptos to become mainstream as a means of payment. There are tokens like the GNU Thaler that don’t need mining or staking at all. It’s up to developers on the front lines to keep negative aspects in mind. The disadvantages, risks and dangers of staking include the following:
- Questionable decentralization: while theoretically anyone can join the network and provide their stake. But in the end, it is the wealthy users who can exert the greatest influence on the network. Because with many PoS blockchains, the size of the stake determines how likely it is to be allowed to verify the next block. In theory, this structure is not only undemocratic, it is also risky. It could open the door to manipulation and hacks.
- Increased complexity: To ensure the security and fairness of the network, additional rules are needed. This also affects the duties and rights of validators. The danger: Additional rules increase complexity and thus the susceptibility to loopholes and errors.
- Security: the immense computing power and power consumption are what protect a PoW network. With Bitcoin, it is now so costly to execute a 51% attack that it is simply not worth it. The same cannot always be said for proof-of-stake. Here, it depends solely on the financial resources – those who have a lot of money have more influence.
Which blockchains allow staking?
The largest staking cryptocurrency to date is Cardano (ADA) with a market capitalization of $60,000,000,000 (as of the end of October 2021). This places Cardano in 4th place according to CoinMarketCap. The top PoS cryptocurrencies also include Solana (SOL), Algorand (ALGO) or Tezos (XTZ). Cryptocurrencies looking to move to PoS in the future include Ethereum and possibly Zcash. Especially with Ethereum’s moves, the overall market capitalization of staking cryptocurrencies would increase greatly. So far, Bitcoin and Ethereum (still a PoW cryptocurrency), lead the overall market capitalization
Ethereum’s switch to Proof-of-Stake has been planned for some time and is intended to lighten the load on the network. “Proof-of-stake consists almost only of the investment costs (i.e., the coins deposited),” Vitalik Buterin writes on his blog. “The only operating costs are the costs incurred for the nodes. Now, how much assets will people be willing to freeze to earn $1 per day?”
How exactly can I go about staking?
There are several ways to stake a cryptocurrency. The process varies from cryptocurrency to cryptocurrency. By now, many different ways have been established, which are understandable even for newcomers.
- Exchange Staking: Some exchanges and online trading platforms offer “Staking-as-a-Service”. This means: you buy the cryptocurrency here or transfer it to the exchange’s account. Here you freeze the staking cryptocurrency. The coins and tokens are then in the care of the exchange, which automatically pays out the Block Rewards to your account. Binance, Coinbase, KuCoin, Kraken, Poloniex offer such a service.
- Stakingwallets: some wallets allow staking directly from the wallet. You just need to hold the cryptocurrency in the wallet and activate the staking function. Over time, the block reward moves into the wallet by itself. Staking wallets include Exodus, Atomic Wallet, Trust Wallet, and Trezor and Ledger hardware wallets.
- Masternode Staking: this is the classic type of proof-of-stake. A masternode functions through a server, performing important tasks for the network. Masternodes monitor the blockchain, verify new transactions, and perform other functions depending on the blockchain. In DASH, for example, the nodes enable private transactions. To do this, you also need to keep the server running constantly. Information on masternodes can be found here.
Is the investment in staking worth it?
The revenue for proof-of-stake varies depending on the cryptocurrency. The percentages of passive earnings range from 15% down to 4%. On Staking Rewards you can find an overview of the current prices of PoS cryptocurrencies and the possible returns. The cost of entry is usually just the purchase of the cryptocurrency. Some cryptocurrencies require a minimum stake. For DASH, for example, this is at least 1000 DASH. Furthermore, you need to run a masternode for DASH. Masternodes require a certain technical understanding. With wallet staking or exchange staking, however, things are much simpler.
Overall, this provides a good opportunity to build passive income. Keep in mind that the “income” is from the cryptocurrency. Until you sell the cryptocurrency, you don’t take in any money. And cryptocurrencies have risks: they are sometimes subject to strong price fluctuations. Therefore, look not only at the return, but also at the price trend of the cryptocurrency and the potential with the price.
What is a 51% attack?A 51% attack is an attack on a network with the aim of gaining total control. By taking control of more than half of the network, the attackers can make decisions in their favor. For a PoW blockchain like Bitcoin, this would mean controlling more than half of all miners. With PoS, the attacker would theoretically only need to have a larger stake than all the other participants combined.
FAQ – Frequently Asked Questions
Stake holders deposit their stake, which is then used for network tasks. In return, they receive a block reward over time. The possible returns, requirements and details vary depending on the cryptocurrency.
Basically, anyone with Internet access and start-up capital can participate in staking. Stakeable cryptocurrencies can be staked via a wallet or an exchange, among other things. However, with a masternode blockchain like DASH, you need a server that can run as a masternode. In some cases (DASH again), a high minimum stake is required.
Participating in Proof-of-Stake is perfectly legal, only you have to declare the income correctly for taxes. In general, there are still many uncertainties when it comes to cryptocurrencies and taxes, which are best clarified with financial advice.