Riches to Riches: How Proof of Stake Works

Proof of stake is another way to secure the immutability of a blockchain. It is a different approach that still uses calculation, but is not as energy-intensive as mining.

The number one rule of the blockchain is this- the next block must be created securely. The question is who does this.

In Proof-of-Work blockchains, the miners verify the next block by discovering the right block hash. To discover a block, they test trillions of hashes and the work they do verifies that the block cannot be forged.

In proof-of-stake blockchains, the coin owners are selected, randomly or by a set of rules, and their computers, through the wallet, make the calculations and certify that the next block cannot be faked.

Who Gets the Reward

In mining, only one miner gets the reward. It is similar in proof-of-stake: only one coin owner will be lucky enough to be selected and calculate the next block. So the lottery principle still applies, but at a different stage. Imagine a lottery was run for Bitcoin miners and the winner would be the only one chosen to mine the next block- the rest would be required to shut down the rigs. Thus, with only one or a handful of persons mining, the actual calculation of the next block is easier, faster and much less energy-intensive.

But there is no block reward, at least not in the general proof-of-stake system. Usually, users that are selected to secure the network only get transaction rewards from the block. The blockchain is set up so that the staking reward works like a small annual interest rate on the coins you own.

Skin in the Game

So what is the reason for proof-of-stake? While it is partially technological, some projects also choose the protocol to encourage users to hold onto the coins. With time, holding and owning coins decreases supply and increases trust.

The rewards of staking coins vary depending on the altcoin. And yet a monopolist entity could buy up enough coins (more than 51% of the supply) to be able to verify most of the transactions. The monopolist could be malevolent and engage in double-spending. But also, a single monopolist could make the network work just fine, solving the problems of consensus and double-spend while still verifying the majority of blocks.

What is Delegated Proof of Stake

Some projects have decided that democratic proof of stake is not enough. To achieve consensus more easily, some form of semi-centralization is required. This is the case of Dash, where a system of Master Nodes with 1,000 DASH coins keep their wallets open to secure the network and approve the right version of the blockchain.

BitShares has a different system. Stakeholders vote to elect a tier of "witnesses"- accounts that will do work to verify the blockchain. The list of witnesses gets an update every day.

Why You Should Pay Attention to Proof-of-Stake

As a buyer, holder or investor, you should be aware of what your chosen coin or token is supposed to do. Proof-of-Stake systems exhibit much more variety than PoW, and there is the potential for community politics and some form of unfairness. When choosing a PoS coin, always look at how consensus would be potentially achieved. Are all accounts equally capable of monitoring consensus, or are there players with more power to potentially even roll back and alter the history of the blockchain?

Stakeholders also work to approve any update in the blockchain software. In theory, some networks could be updated without warning and the need for a new vote. Some networks do this for minor bugs or security purposes. But blockchain technology is still young enough, so solutions are found on the go, and there is no certainty that PoW or PoS is guaranteed to solve the problem.

Also, research the network to see where are the holders of the coin. Ideally, they should be spread out worldwide, acting as a grass-roots movement, not allowing the creation of a cartel. In contrast, even PoW coins can centralize, as miners create large centers and group around the most influential players who can afford the machines, electricity, and logistics.