



Proof-of-Stake (“PoS”) is a growing consensus method for approving transactions on the blockchain. It has several advantages over the current status quo, Proof-of-Work (“PoW”). Most notably, PoS is an opportunity for passive investing. The possibilities can grow as more cryptoassets adopt the consensus protocol.

PoS vs. PoW:

PoW and PoS are both blockchain consensus protocols. These protocols are similar in the sense that they ensure that the blockchain operates efficiently and securely. However, PoW and PoS are also very different. The following is a high-level explanation of PoW and PoS.

PoW Explained

PoW is the primary method cryptoassets confirm transactions on the blockchain. This method involves parties conducting transactions and parties verifying those transactions. Transacting parties can be any person or organization using a cryptoasset’s wallet to send that respective cryptoasset to another person or organization.

The verifying parties are the miners. Simply, a miner is the party that: (1) verifies specific information of the transactions (e.g., correct signatures, enough balance, etc.); (2) builds blocks; and (3) races to solve the mathematical problem to have their block be the next block included in the blockchain.

First, the miners verify transactional information. Cryptoasset transactions are occurring every second. These transactions are sent to all miners on the blockchain. The Miners verify that the parties’ signatures and amount balances are correct. Miners verify the transactions immediately so the miners can include the verified transactions in the next block they are currently building.

Second, miners build the block and collect and verify transactions simultaneously. The miners are required to build a block with certain information specified by the cryptoasset’s algorithm. This information is the majority of the information that the miners verify, like transactions’ signatures, transactions’ amounts, a timestamp of the block, and so on.

Finally, the miners have to solve the “mathematical problem” for their block before every other miner. I put “mathematical problem” in quotations because this is where non-technical peoples’ eyes begin to glaze over. The “mathematical problem” is really a race/guessing game. So let’s take a moment to discuss this game.

The most popular analogy for this “mathematical problem” is your standard dice game. Each die has the numbers 1, 2, 3, 4, 5, and 6 on it. So the sum of rolling two dice with those numbers can only be between the numbers 2 and 12.

Now, let’s say I told you to roll a number between 1 and 12 with two dice. It will only take you one roll of the dice because you have a 100% chance to roll a number between 1 and 12. This chance decreases and requires more rolls of the dice s you try to roll numbers lower than 12.

Accordingly, cryptoasset mining is actually like telling you to roll a number 2 with the dice. This is a lot more difficult. Specifically, you have 2.778% chance to roll a number 2 with two dice. You could get lucky and get a 2 on the first try, but you most likely will have to attempt a lot of rolls of the dice. You may blow on the dice for good luck, you may switch up the angle of your arm, or you may change your release point of the dice from your fingers; regardless, you have to do the work (sound familiar). These miners are racing to find a number larger than the number 12 and with a lot more dice.

Also, keep in mind that you are racing against other miners. Thus, the faster you are at guessing numbers, the better your chances of finding it to win the race and add your block to the blockchain.

As a result of winning the race, the winning miner is rewarded with the transaction fees of all the transactions included in the block and the newly minted coins.

Miners do all of the abovementioned actions simultaneously because the software on their computers makes it all possible. It’s just like turning on your washing machine and forgetting about it; the washer will wash, rinse, and spin without you doing anything more.

As you can image, mining consumes a lot of electricity because miners have thousands of computers racing against each other. But only one computer wins the race. PoS is meant to change this.

PoS Explained

PoS is a new method for verifying transactions on the blockchain. How is PoS different than PoW? The PoS algorithm randomly selects a party to verify transactions and create the next block. The algorithm’s selection process is based on the overall amount of the cryptoasset the party has. The more amounts of the cryptoasset a party own, the more likely it will be selected to verify the next block. It is similar to the lottery, whereby your chance of winning the lottery increases as you purchase more tickets. Thus, where PoW has thousands of computers competing for one block, PoS only has one.

In addition, the person will stake his cryptoasset as a safety measure. This staking is simply putting up collateral. It is similar to putting a down payment on a mortgage or a car loan. The party will “lock up” a certain percentage of his coins in a wallet as the stake, just like an escrow. Staking is meant to prevent bad actors from falsifying or stealing transactions’ cryptoassets. Bluntly stated, you better have your skin in the game and risk losing money if you want the privilege of verifying the next block and, thus, earning the next reward.

The PoS reward can be the newly minted coins, the transaction fees, or both, depending on the respective coin.

The rationale behind using PoS on blockchains is because it uses less power and encourages decentralization. PoS uses less power because it eliminates the race from thousands of computers. It also potentially reduces the centralization of cryptoassets by mining pools, because the assets and operations of these mining pools cost millions of dollars.

PoS rewards are a better investment than dividends:

PoS rewards are comparable to corporate dividends. A corporation issues dividends to its stockholders from the corporation’s profits. Roughly, one share equals one dividend payout. Dividends are issued once a year and usually are cash that ranges from a couple of cents to a couple of dollars. This is a lot of money if you hold a lot of shares.

A dividend can also be paid out in-kind where the stockholder receives stocks, not cash, as a dividend. The stockholder can immediately sell the stock dividend for cash or hold the stock for further appreciation. An in-kind dividend is viewed as potentially more favorable than a cash dividend because the stock can appreciate and taxes are not paid until the stock is sold.

PoS rewards are similar to an in-kind dividend. The verifying party will receive the newly minted coins. These new coins are similar to a corporation issuing new shares to the shareholder. In addition, the verifying party will receive the transaction fees from all of the transactions included in the block. Although the word “fees” makes one think of cash, it is not the case for PoS. The transaction fees are paid out in the cryptoasset and not fiat currency. Thus, it is still as if the verifying party is receiving stock.

Unlike dividends, PoS rewards can be received multiple times a year. Let’s look at Bitcoin and Ethereum as examples. (Yes, I know that Bitcoin and Ethereum are currently PoW, but Ethereum initiated Casper in December 2017 and everything is open-sourced, so that could happen to Bitcoin, too.)

Bitcoin processes a block an average every 10 minutes. That processing rate means that there are roughly 52,560 blocks per year give or take. That is 52,560 opportunities to receive a reward should Bitcoin switch from PoW to PoS.

On the other hand, Ethereum has faster block times. Ethereum processes a block every 10-19 seconds. So, let’s use 20 seconds as a block time to be conservative. At that block time, Ethereum processes roughly 1,576,800 blocks per year.

To further benefit the holder, each reward earned increases a person’s chance to receive more rewards because it increases the person’s total holdings of the cryptoasset, which increases the chances of being selected to verify the next block (remember the lottery example). Your holdings get bigger over time as a passive investment. Thus, PoS can yield greater returns than dividends.

Conclusion:

The crypto space is still in its nascent stages. Analysts are still determining methods for valuing cryptoassets. Technical analysis is needed to actually show the true potential of PoS. Nonetheless, the potential for passive investing is a possibility for PoS. Smart investors should be aware of this fact and begin to include PoS cryptoassets in their portfolios. As all things crypto, only time will tell how successful this is and whether it is a viable investing strategy.

Disclaimer: This is not investment advice. Please seek the advice of a licensed investment professional.

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