



Proof of Stake (PoS) has become one of the hottest topics in the cryptocurrency world. But what exactly is Proof of Stake? This guide presents a comprehensive answer to that question.





At the highest level, Proof of Stake is a type of algorithm that helps blockchains achieve consensus via staking, which is based on users’ token ownership, rather than mining. To help you understand what this means, we will start by explaining network consensus, the goal of all PoS systems.





What is Consensus?





Imagine you are planning to have dinner. If you’re alone, you don’t need to agree with anyone about anything. You can freely choose to have McDonald's, KFC or just a healthy salad. But if you are eating with a group of people, you might have to negotiate. The whole group is going to have to come to a consensus on dining options before anybody gets to eat.





Consensus in blockchains works similarly. Because blockchains typically lack centralized leadership, there’s no single authority that can validate transactions. So much like your dining group, the network has to collectively agree on whether blockchain transactions are valid. This collective agreement -- getting a large number of network nodes to agree that a transaction is valid -- is called consensus.





In other words, it typically works just like our dining analogy. If you and your friends can mostly agree on a restaurant, you’ll go to it, and everybody gets to eat. If the network nodes on a blockchain mostly agree that a transaction is valid, there’s consensus and the transaction is entered into the chain. But if you and your friends can’t agree on a restaurant, you won’t go anywhere. Similarly, if enough network nodes don’t agree a transaction is valid, then the transaction won’t go onto the chain.





The Original Consensus: Proof of Work





Bitcoin blazed the trail of crypto consensus with its Proof of Work (PoW) system, which has allowed for the secure operation of a tremendous decentralized system that has never been shut down.





At a basic level, PoW works by having each block creator “sign” blocks with a number that is difficult to find mathematically. Creating those numbers requires so much processing power that inserting a fake one into the chain would take too long; subsequent blocks with the correct number would already have been created. That means that network nodes could compare the single faked block to the many real blocks that will appear in the copies of the chain on other nodes and quickly reach agreement about which block is real.





Block creators, called “miners,” are incentivized to do this complicated and power-intensive mathematical work because when they create a block on the chain they receive new tokens that are “mined” and given to them as a reward for their mining work.





That’s how consensus is achieved on Proof of Work systems. Miners do complex computer calculations to earn crypto rewards, and the nature of these calculations makes it easy for the whole network to agree on what’s real and what isn’t.





Proof of Work consensus systems aren’t perfect, however. The process of establishing consensus is comparatively slow, and requires massive computing resources. Proof of Stake is, in a sense, a response to that. It’s a consensus method that aims to offer blockchain networks the same functions offered by proof of work (secure consensus) without wasting all that energy and without the need for expensive hardware.





The Newcomer: Proof of Stake Consensus





Proof of Stake is a consensus method that essentially replaces mining with token ownership. Instead of having to perform complex calculations, a token holder participates in block creation by “staking” their tokens, i.e. keeping them in a specific location and not spending them. The staker is then granted a reward, which could take the form of transaction fees or a block reward based on the new tokens generated for blocks their stake helped create.





The chance that a staking token holder will earn those rewards is generally proportional to the number of tokens they are staking, so that someone who stakes more tokens has a higher chance of generating blocks and will thus earn more. The staking requirement helps ensure that the people generating blocks have “skin in the game” — the more tokens they have, the more often they’ll earn rewards because their ownership makes it less likely that they’re trying to harm the network.





Proof of Stake systems also typically include an element of randomness in determining who generates blocks, though, so that an uber-wealthy investor wouldn’t necessarily be granted the chance to forge the next block on the chain. This is how PoS networks achieve consensus. And because this all happens in a deterministic way — the outcomes are based on known factors like the amount of tokens staked and time tokens have been staked — running a system like this doesn’t require fancy mining machinery or much in the way of processing power or electricity.









What is Staking?





Staking itself is a unique action that users can take on PoS networks. It typically entails placing staked coins into a bound wallet for a set period of time, during which these coins cannot be sold. This is part of how PoS systems de-incentivize foul play: Any token staker attempting to harm the network would also be putting the value of their own tokens at risk. Staking is the way that PoS network users can participate in and support the network.





Running Nodes in PoS vs. PoW









A node is a network user (an individual or a group that is often elected by other users) that validates and stores transactions on the blockchain. The diagram above depicts how nodes run in PoS consensus. The biggest differences between PoS and PoW come at steps three and four.





In step 3, PoS systems require the user to perform the staking action (making their tokens temporarily unavailable for other purposes). At this stage in PoW, by contrast, this is where mining machines would be running their calculations.





Then in step four, PoS chooses a validator according to the algorithm already defined in the system (i.e. stakers of more tokens have a higher chance of being the validator), whereas in PoW systems the miner who correctly finishes the complex calculation first generates the block.





The Proof of Stake Landscape Today





Now that we have a basic understanding of what staking is and how it differs from PoW, let’s take a look at the current state of the staking economy.





According to data on Staking Rewards, as of this writing the total market value of all PoS projects has reached USD$19 billion and the overall stake ratio — the number of tokens currently being staked and thus not available to sell — is about 30%, meaning that there is $6 billion worth of tokens staked in total.





If we assume a 10% return on investment, the tokens currently staked will generate rewards of around $600 million, and the staking market is still growing rapidly.





The future certainly looks bright, but before we consider where PoS is headed, let’s look at how far PoS has come.





The History of Proof of Stake





Proof of Stake hasn’t always been around, and it hasn’t always been presented as a pure alternative to PoW. In simple terms, we can break down the history of PoS networks into four distinct eras:





The Mixing Era (2012): This era saw the first attempt at a transition from PoW to PoS. Peercoin, one of the first projects to propose PoS, wasn’t actually a pure PoS system. In order to make its initial token distribution more fair, Peercoin made use of PoW consensus early on. But it later implemented PoS consensus, and popularized the concept of “coin age,” which is used in PoS systems that place value on the period of time in which someone has staked coins. For example, if Person A and Person B both staked 10 Peercoin, but Person A’s coins had been staked for longer than Person B’s, Person A would be more likely to earn rewards than Person B.





The Pure PoS Era (2013-2014): This era saw the appearance of matured PoS systems, although it also raised some questions about this new technology. A representative implementation for this stage is NXT Coin, which applied pure PoS consensus for initial distribution and all subsequent staking. NXT Coin also did away with the “coin age” concept created by Peercoin, and made no use of PoW at all.





However, both NXT and Blackcoin, another popular PoS project that had used some PoW early in its token distribution, fell out of popularity. During this period, concerns also came to light about a potential problem with PoS: the “Nothing at Stake” problem. This was a problem that could theoretically arise when PoS projects forked. After a fork, PoW miners have a clear incentive to pick a chain, since splitting their mining power earns them half the rewards on either network. But stakers on PoS networks would own tokens on both chains after a fork, and would thus theoretically be incentivized to keep supporting both chains.

The DPoS and PoS+BFT Era (2018-2019): This era saw the ascendance of Delegated Proof of Stake (DPoS) systems like EOS, in which all token holders vote for trusted delegates to operate network nodes, adding a greater degree of decentralization and democracy to the networks. Other projects like Tron and ONT put forward different implementations of DPoS consensus with proxy voting and dividend mechanisms.





At the same time, a version of PoS with Byzantine Fault Tolerance (BFT) emerged in projects such as Cosmos and IRISnet. The variation adds a multi-round voting system after blocks are created in which validators vote on the “true” chain. Signing onto the wrong chain could be punished by the system itself via confiscation of some percentage of staked coins, and this offered a potential solution to the “Nothing at Stake” problem that emerged in the previous era.





There were other innovations, too. Tezos, for example, introduced Liquid Proof of Stake (LPoS), in which token holders can delegate their tokens to network nodes without having to actually transfer the tokens.





The future of PoS consensus (after 2019): No one can predict the future, but the continued interest in PoS systems suggests that there will be more innovations and adjustments to the PoS model as old coins adapt and new PoS coins emerge.





We may see, for example, new token economics created by combining the concept of PoS staking with local businesses. Systems like this are already being built; Livepeer's transcoding service and Nucypher's privacy password all require the server nodes to conduct staking, and the nodes can earn profits in return.





PoS systems and staking promise to bring more decentralization and stability to cryptocurrencies. Because the threshold of staking is typically rather low, it’s possible for more people to get involved. Whereas with PoW systems, mining seriously requires heavy up-front investments, and doing it profitably often means living in an area with low electricity costs. Additionally, PoS payouts are generally more predictable, so token stakers can receive a stable annual return, like profits the profits from a bond.





The future of staking is also likely to be bolstered by the eventual transition of Ethereum, currently the world’s second-largest cryptocurrency by market cap, from PoW to PoS. Currently, tokens that use PoS consensus account for less than 10% of the entire cryptocurrency market, but that number may grow to 10% to 20% this year (by rough estimation), and the ETH transition will likely produce an even bigger jump.













Five Things Investors Should Consider



At this point, you may be interested in staking tokens, but making an investment can still be daunting. Different tokens use systemic variations and varying economic rules, which produce different token economies. If you’re going to get involved in staking, here are five aspects of staking economies that you should research before making any investment.

1. Inflation Rate





Just like the central banks print banknotes every year, crypto networks often mint new tokens regularly, which contributes to inflation. Not all PoS networks have inflation; some PoS tokens are entirely pre-mined. But many newer PoS projects intentionally include inflation as part of their economic models, to better reflect real economies and to better reward token stakers and validators. The inflation or issuance model for each project differs, so you’ll want to research the specifics for any project that interests you.





Some projects, such as EOS and Tezos, use a fixed rate for annual issuance. The current issuance rate of these projects is about 5%, but this number can be adjusted through community governance. There are also projects like Cosmos and Livepeer that adjust the issuance rate according to the staking ratio. In this case, the ratio of the holder's participation in staking becomes one of the parameters for the inflation rate.





Fixed-rate models like EOS and Tezos are relatively simple, and you can generally find the details of these models explained in the projects’ white papers. But models that are adjusted in accordance with the current staking ratio vary, and must be calculated manually. Usually, the calculation formula and model will be included in the code of each project, but you’ll still need to check current staking ratios to be able to calculate the current inflation rate.

2. Staking Ratio and Rate of Return





Though the yields for token stakers often come from extra tokens, this doesn’t mean the inflation rate is equal to the rate of return. That’s because staking is an action that requires users to participate and operate by themselves. The corresponding rights only belong to those who stake. This explains why the tokens inflated on each blockchain will only be distributed to the holders who did staking.





The exact formula to calculate the rate of return for stakers should be:





Rate of Return (RoR) = inflation rate / all tokens staked

For example, Tezos' current inflation rate is around 5.5%, but the RoR for token holders is around 7%. Because only 80% of the token holders participate in staking, all extra tokens issued are only awarded to these 80% of users. Thus, the RoR is 5.5% / 80% = ~7%, not 5.5%.

3. Fee





Operating a node on a PoS system requires computer infrastructure and uptime, so if a token staker can’t do this themselves, they can delegate their staked tokens to a given node. The node will reap the rewards of block generation, and return those rewards proportionally to staking users, minus a fee for their sever and labor costs.





These fees vary by node operator and network, but as of this writing, they tend to fall somewhere in the 5% to 20% range on most networks. If you’re planning to stake tokens but don’t want to operate a node yourself, you’ll need to research what fees you’re likely to have to pay, and factor that into your calculations.

4. Lock-up Period





Most PoS projects set a lock-up period for stakers. When someone who has staked tokens wants to exit staking and sell the tokens in the secondary market, they need to wait until the lock-up period expires before they can transfer the tokens.





As mentioned previously, this is intended as a safeguard to prevent malicious block producers (nodes). A fraudulent block or attack could send a token’s price plummeting, but since block creators’ tokens are locked up, they wouldn’t be able to sell, so a block creator inserting a malicious block would essentially be destroying the value of their own tokens.





Lock-up periods are also useful for reducing overall token circulation and reducing market volatility.





Each project has its own lock-up period, normally around 20 days, but you’ll want to look up the specifics in a project’s white paper.

5. Risk Factors





Some common risks in staking are:





A node you select is missing a block. Rewards will be deducted if the node fails to produce a block, which lowers the RoR for nodes and stakers.





A Slashing Penalty. When nodes do nothing, run improperly, or operate maliciously, they can be penalized financially for it. Some PoS implementations directly confiscate stakes (tokens) as a penalty, which is called a negative incentive, while some others set the penalty by not rewarding validators, which is called a positive incentive (the positive incentive is the reward given to validators who follow the rules and thus get a reward).





The Lock-up Period. This is a safeguard for the chain, but it also means that you during this period you can’t sell any of your staked tokens to take advantage of a bull run, or to avoid heavy losses in a bear market.





Some Exceptions





Not all of the factors described above will apply to every PoS token, of course.





Loom and WanChain currently do not use an inflation model. Instead, they have reserved a portion of the originally-minted tokens for staking rewards.





ChainX applied the concepts of “depositing is mining” and “voting is mining” to its initial token distribution, and conducted the follow-up distribution based on the total weight of daily deposit + voting amount, dividing up tokens generated by the system every day based on those metrics for participation.





For these projects, you so you don’t need to worry about finding the inflation rate, as inflation doesn’t exist on those networks in the traditional sense.





When in doubt, remember: The core of most PoS projects is a positive relationship between the staking yields and the amount of the stakes. In other words, the more you stake, the more you ought to be getting back.





How to choose proper staking tools



Now that you have a better understanding of PoS systems, you know how to calculate your staking yields correctly, and you’re aware of the risks, the next step is to choose a proper staking tool to get your profits.





First, keep in mind that on most networks, staking or delegating coins with a particular node doesn’t mean actually sending them your coins. In most cases, those will stay in your wallet, although you generally won’t be able to spend or transfer them while they’re staked. What you’re actually giving nodes is not tokens, but rather the “mining” rights that your tokens conferred, and the initial right to the profits that activity generates.





That should alleviate some fears about staking, but the specific mechanics of how staking works depends on the chain and the staking tools you choose. There are two basic approaches to the mechanics of staking: centralized tools and decentralized tools.

Centralized Tools





Using a centralized staking tool is like trading in a centralized exchange. Users deposit their tokens with a centralized organization they trust, and in return they receive a certificate of the deposit issued by the organization.





This gives the organization the ownership and delegation rights for those tokens. However, the agreement between the user and the organization stipulates that the organization will provide the user with their return yields, and ultimately return their deposited tokens.

Decentralized Tools





This is like trading on a decentralized exchange. Rather than any organization, what the user trusts is the blockchain itself, or its code. Users keep ownership of their tokens (with public key and private key in hand), and choose to either mine on their own or delegate their mining right to a third party.





After delegating the tokens in this mode, the user still has the ownership of their stake. Only the delegation rights of their tokens are granted (temporarily) to the node. The revenues generated by the node will then be allocated to the user based on the size of their stake and the other rules of the chain.





When choosing between centralized and decentralized, the biggest thing to remember is that choosing a centralized tool requires you to trust the central organization. Conversely, the security of a decentralized tool is dependent on you. If you keep good track of your own keys, you need never send your tokens anywhere outside of your wallet to stake them.

Examples of Centralized Tools





Exchanges: Some exchanges provide relatively easy user staking services. For example, Huobi.com and Gate.io provide channels for users to receive staking yields, and Coinbase enables big clients to stake via cold wallets and may allow ordinary token holders to receive staking yields through its exchange in the future.





Centralized Wallets: Some wallets such as Cobo and Hashquark provide users with depositing and staking functions to make it easier for wallet owners to collect profits.



The merit of a centralized wallet or exchange is the convenience. Users don't need to learn too much about the staking process as long as they trust the third party they choose. The risk is the less transparent rewards allocation; you won’t be able to query your own earned rewards on the chain and thus have to take your centralized tool more or less at its word about what you earned.





Examples of Decentralized Tools





Code (Command line): If you have programming skills, the official team of each PoS project typically provides code to facilitate users staking directly on the blockchain. This is highly secure and controllable, but of course, it requires the user to be able to write code.





Official Wallet and or Ledger: PoS projects often will develop an official wallet (usually a desktop wallet) for users to store, send, and stake tokens. These solutions often integrate Ledger or other hardware wallets into their own systems to enhance their security.





Decentralized Wallets: For decentralized wallets, there are desktop clients like Magum and mobile clients like Trust wallet, imToken, and Wetez. Similar to official wallets, these decentralized wallets support staking delegation to any nodes in the project. The difference is that these third-party wallets are compatible with multiple projects, and users do not need to switch frequently when staking different projects. If you’re concerned with trustless security, the safest tools are cold wallets or a hardware wallet like Ledger.





The advantage of decentralized tools is that the user can keep their own tokens, and all the operations and rewards distributions are viewable on chain, which makes the entire process more transparent and removes the need to trust a centralized organization. Additionally, users often have more control and can choose the nodes to which they prefer to delegate their tokens’ rights.









How to select a good validator?





If you’ve chosen to stake your tokens yourself but you’re not operating your own node, you’ll need to delegate your tokens’ rights to a validator node. Staking yields are closely related to the delegation provider you choose, so here are several criteria to assess when you’re seeking a staking validator.

1. Fees





Generally, the validator will charge a fee ranging from 5% to 20%. If all other factors are relatively equal, token holders should compare different delegation services before staking and choose the validator with the most moderate fee.





That said, choosing a validator isn’t always as simple as just finding the lowest possible fee, because of other factors such as the ones listed below.

2. Block Producer Performance (Rate of Return)





The performance of the validator as a block producer depends mainly on the uptime of the node or nodes, and the slashing penalty the validator receives when they do nothing, run improperly, or perform maliciously. If the node does not perform well, the rewards for the stakers will be reduced, and they may run the risk of losing tokens to penalties if that’s a punishment that’s implemented on the chain. This outcome is quite rare, however, as it can typically be avoided with even minimal attention paid to node maintenance.



In the future, there will be various tools for monitoring the status of nodes, and some such tools, like Baking Bad’s audit tool to watch Tezos’s node performance, already exist.

3. Security and Promise Clause of the Nodes





No one wants their validator to be attacked and shut down. If that did happen, the tokens staked wouldn’t be lost because the token holders are just delegating the rights and not the ownership of their tokens, but rewards to the nodes attacked will decrease. Generally, each validator's official website will introduce its own security architecture and solutions for preventing attacks.



On these sites, you should look for promise clauses, which will include details on the cycle the validator follows to allocate rewards, the valid terms for their fees, and other specifics relating to their services and security offerings. It’s always important to check these details before selecting a validator.

4. Nodes’ Contribution to the Community





Staking is not just about the profits. By staking your tokens with a validator, you are selecting your representatives on the blockchain, and each can contribute to the community with their own capabilities. Good validator teams being selected as validators facilitates project development, which could benefit token holders and raise the price of tokens in the long run.

5. Long-Term Cooperation and Reputation





It is always a good choice for ordinary stakers to set up long-term cooperation with a trustworthy team, which not only reduces the time spent on election but also makes it less likely that the team violates the promise clauses mentioned above.

At this point, we’ve covered how to assess token economies, select staking tools, and choose the best validator. But all PoS investors should also understand the potential risks to PoS networks, and how they compare to risks associated with PoW.





Security Issues on PoS Networks





We have already mentioned some of these risk factors in our more detailed discussions above, but below is a summary of some of the biggest security concerns often raised in discussions of PoS systems.

The Nothing at Stake Problem



Imagine a node produces two blocks at the same block height, making a fork. In theory, it would be possible for any node with sufficient stake to produce blocks to accomplish this. And while it’s best for the network to have one true chain, other nodes could theoretically benefit from this sort of forking, as they can get double rewards by double-signing the original chain and the forked chain.





As mentioned above, this was a serious concern about PoS in its early days, and there was no penalty system in place to prevent this behavior. Now, however, the “Nothing at Stake” problem has been mostly solved by the implementation of staking lock-up periods and slashing penalties. While a temporary stake was once the single cost in block production, now a certain portion of stakes must be locked in the system for a period of time. If nodes act maliciously by doing things like double-signing, these staked tokens will be confiscated by the system, which removes the economic incentive for carrying out these malicious acts in the first place.

Long-Range Attacks

In a Long-Range Attack, the attacker creates a new chain longer than the original one either at or right after the genesis block and falsifies partial or entire records of the main chain in the hopes of making this new and fraudulent chain the main chain.

New nodes and nodes that have been offline for a while won’t be able to tell which chain is the main chain when synchronizing, because the fork starts from the genesis block. And based on the “longest chain is the main chain” principle, these nodes would automatically select the tampered with chain to replace the original one, and subsequent nodes could end up following their lead until the fake chain was recognized by the network as real.

This sort of attack can seem simple, since there is almost no cost to produce blocks on a fork chain — only the stake is needed. Plus, it doesn’t take long to confirm the block for the attacker, so the fake fork chain can soon overtake the main chain. In practice, however, Long-Range Attacks are incredibly difficult to carry out. The reasons for this are technical and beyond the scope of this article, but there’s an extended explanation available here for anyone interested in the details.

The two problems cited above are the two most common security issues raised with PoS chains. They are not the only potential problems, and there there are more types like Simple Attack, Posterior Corruption, Stake Bleeding, Cartel Attack, Sybil Attack, Grind Attack, etc. But to date, there are solutions to each of these problems, and none should be considered particularly likely on any popular PoS network.





Why is PoS a Good Strategy for Securing a Network?





One of blockchain’s big advantages over centralized systems is precisely that it isn’t centralized. Whereas a central bank could be robbed if its systems were compromised, a distributed blockchain with nodes all over the world won’t be affected at all when a node is compromised. As long as most nodes are secure, the data on the chain is safe.

To compromise a PoW network, for example, the attacker would need to control over 51% of nodes on the network, which would cost a fortune thanks to the cost of mining. Similarly, in PoS, the value of tokens maintains security, so the attacker would need to spend a huge sum of money acquiring tokens to achieve that level of control over network nodes.

However, PoS has been doubted by PoW proponents for a long time.





Security is the biggest area of concern. Typically in computer science, we might assume that the more concise a program or a product is, the less vulnerable it may be. This is because a relatively short, simple program should be comparatively easy to audit, and flaws would be easier to spot than they would in a sprawling system with millions of lines of code.

This logic also applies to PoW consensus. Although the mathematical calculations required are highly complex, the coding involved to create a PoW system is comparatively simple. In contrast, the code used for PoS consensus is complicated, as it contains a large amount of calculations such as staking amounts, validator elections, rewards distributions, etc. In theory, this might increase the probability of attack.

There’s also a psychological aspect: People tend to think that something that costs more is more valuable. PoW mining is expensive, both in terms of hardware and electricity. PoS costs nothing beyond whatever spending is required to acquire the initial tokens for staking. Because PoW costs more, some PoW supporters believe that attacking a PoW network is more expensive.

A 51% attack on a PoW network does cost a lot, since attackers would need enough mining power to control half the network. Carrying out a similar attack on PoS would require acquiring 51% of all tokens.

This might appear cheaper at first, since there are no other costs, whereas to mine 51% of a PoW currency you’d have to buy mining machines, warehouse space, air conditioning, electricity, etc. But it’s important to remember that in real crypto economies, buying tokens raises the price. In a 51% attack on a PoS system, the attacker needs to buy a lot of tokens, and the more they buy, the higher the price of those tokens will become. Even if the attack succeeds, the benefits are unlikely to outweigh the costs, since when the attacker’s buying flurry dies down, the token price will drop back down to earth, too.

The nature of PoS chains simply makes attacks on them difficult because:

The community will notice some addresses are buying large amounts of tokens, which can be regarded as an attack, and a warning is likely to spread well before the attack can actually be carried out.

The token price will continue going up during the attacker’s buy-in, which makes attacks unpredictably expensive.

If the attack succeeds, the value of the blockchain itself will drop significantly, bringing great losses to the attacker, who by necessity has just spent a huge sum of money to acquire 51% of the network’s tokens. It’s highly unlikely that any kind of benefit garnered from tampering with the chain could offset these losses.

Conclusion





The advent of PoS has brought attention to the inefficiencies of PoW systems. In PoS, through staking and validator election, blockchains can achieve the same secure consensus they get from PoW systems with much greater efficiency. It also makes participation easier for token holders, and gives them an easier way into the staking economy.

PoS projects will still face trials and challenges, of course. As new projects attract public attention, additional security issues may come to light. But in the long run, more attention is likely to bring even better security and stability to PoS systems. And while centralization and governance are problems that currently plague all consensus mechanisms, PoS offers an improvement over PoW (at least in theory) because the barriers to participating in the network are far lower. It may not be easy, but it’s easier to run a node on PoS than it is to set up a full-fledged Bitcoin mining operation.

We hope this article has served as a helpful guide to Proof of Stake and the staking economy, and that you now have a clearer picture of what PoS means for the future of blockchain technology.

Jeff Chang is COO at Wetez.