Frequently asked questions for you.
If you know how Bitcoin works, you’re probably familiar with Proof of Work (PoW). It’s the mechanism that allows transactions to be gathered into blocks. Then, these blocks are linked together to create the blockchain. More specifically, miners compete to solve a complex mathematical puzzle, and whoever solves it first gets the right to add the next block to the blockchain.
Proof of Work has proven to be a very robust mechanism to facilitate consensus in a decentralized manner. The problem is, it involves a lot of arbitrary computation. The puzzle the miners are competing to solve serves no purpose other than keeping the network secure. One could argue, this in itself makes this excess of computation justifiable. At this point, you might be wondering: are there other ways to maintain decentralized consensus without the high computational cost?
Enter Proof of Stake. The main idea is that participants can lock coins (their “stake”), and at particular intervals, the protocol randomly assigns the right to one of them to validate the next block. Typically, the probability of being chosen is proportional to the amount of coins – the more coins locked up, the higher the chances.
This way, what determines which participants create a block isn’t based on their ability to solve hash challenges as it is with Proof of Work. Instead, it’s determined by how many staking coins they are holding.
Some might argue that the production of blocks through staking enables a higher degree of scalability for blockchains. This is one of the reasons the Ethereum network is planned to migrate from PoW to PoS in a set of technical upgrades collectively referred to as ETH 2.0.
One of the early appearances of Proof of Stake may be attributed to Sunny King and Scott Nadal in their 2012 paper for Peercoin. They describe it as a “peer-to-peer cryptocurrency design derived from Satoshi Nakamoto’s Bitcoin.”
The Peercoin network was launched with a hybrid PoW/PoS mechanism, where PoW was mainly used to mint the initial supply. However, it wasn’t required for the long-term sustainability of the network, and its significance was gradually reduced. In fact, most of the network’s security relied on PoS.
An alternative version of this mechanism was developed in 2014 by Daniel Larimer called Delegated Proof of Stake (DPoS). It was first used as a part of the BitShares blockchain, but soon after, other networks adopted the model. These include Steem and EOS, which were also created by Larimer.
DPoS allows users to commit their coin balances as votes, where voting power is proportional to the number of coins held. These votes are then used to elect a number of delegates who manage the blockchain on behalf of their voters, ensuring security and consensus. Typically, the staking rewards are distributed to these elected delegates, who then distribute part of the rewards to their electors proportionally to their individual contributions.
The DPoS model allows for consensus to be achieved with a lower number of validating nodes. As such, it tends to enhance network performance. On the other hand, it may also result in a lower degree of decentralization as the network relies on a small, select group of validating nodes. These validating nodes handle the operations and overall governance of the blockchain. They participate in the processes of reaching consensus and defining key governance parameters.
Simply put, DPoS allows users to signal their influence through other participants of the network.
As we’ve discussed before, Proof of Work blockchains rely on mining to add new blocks to the blockchain. In contrast, Proof of Stake chains produce and validate new blocks through the process of staking. Staking involves validators who lock up their coins so they can be randomly selected by the protocol at specific intervals to create a block. Usually, participants that stake larger amounts have a higher chance of being chosen as the next block validator.
This allows for blocks to be produced without relying on specialized mining hardware, such as ASICs. While ASIC mining requires a significant investment in hardware, staking requires a direct investment in the cryptocurrency itself. So, instead of competing for the next block with computational work, PoS validators are selected based on the number of coins they are staking. The “stake” (the coin holding) is what incentivizes validators to maintain network security. If they fail to do that, their entire stake might be at risk
While each Proof of Stake blockchain has its particular staking currency, some networks adopt a two-token system where the rewards are paid in a second token.
On a very practical level, staking just means keeping funds in a suitable wallet. This enables essentially anyone to perform various network functions in return for staking rewards. It may also include adding funds to a staking pool, which we’ll cover shortly.
There’s no short answer here. Each blockchain network may use a different way of calculating staking rewards.
Some are adjusted on a block-by-block basis, taking into account many different factors. These can include:
how many coins the validator is staking
how long the validator has been actively staking
how many coins are staked on the network in total
the inflation rate
For some other networks, staking rewards are determined as a fixed percentage. These rewards are distributed to validators as a sort of compensation for inflation. Inflation encourages users to spend their coins instead of holding them, which may increase their usage as cryptocurrency. But with this model, validators can calculate exactly what staking reward they can expect.
A predictable reward schedule rather than a probabilistic chance of receiving a block reward may look favorable to some. And since this is public information, it might incentivize more participants to get involved in staking.
A staking pool is a group of coin holders merging their resources to increase their chances of validating blocks and receiving rewards. They combine their staking power and share the rewards proportionally to their contributions to the pool.
Setting up and maintaining a staking pool often requires a lot of time and expertise. Staking pools tend to be the most effective on networks where the barrier of entry (technical or financial) is relatively high. As such, many pool providers charge a fee from the staking rewards that are distributed to participants.
Other than that, pools may provide additional flexibility for individual stakers. Typically, the stake has to be locked for a fixed period and usually has a withdrawal or unbinding time set by the protocol. What’s more, there’s almost certainly a substantial minimum balance required to stake to disincentivize malicious behavior.
Most staking pools require a low minimum balance and append no additional withdrawal times. As such, joining a staking pool instead of staking solo might be ideal for newer users.
Cold staking refers to the process of staking on a wallet that’s not connected to the Internet. This may be done using a hardware wallet, but it’s also possible with an air-gapped software wallet.
Networks that support cold staking allow users to stake while securely holding their funds offline. It’s worth noting that if the stakeholder moves their coins out of cold storage, they’ll stop receiving rewards.
Cold staking is particularly useful for large stakeholders who want to ensure maximum protection of their funds while supporting the network.