A primer on Proof-of-Stake and why it matters for the future of blockchains

There is a major, multi-faceted shift happening right now in the world of crypto. It’s difficult to see given how noisy, complex, disjointed, and interdisciplinary the information flow and topics are in the community; but new consensus protocols combined with a maturing regulatory landscape are setting the stage to unify four groups that are often in conflict within a blockchain project:

1. Core developers
2. People who operate the underlying nodes
3. Users of a network
4. Major token holders

In an ideal world these groups would have closely aligned incentives, but for a wide variety of reasons most blockchains have two or more of these groups in gridlock, slowing project evolution to a halt. (The massive speculation that occurred in 2017 turned up the volume and made the tension between these groups more prevalent across the board.)

Thankfully, there are emerging models that better align incentives within a project and offer new opportunities for those involved.

Below I’m going to briefly introduce the variants of Proof-of-Stake (PoS) consensus protocols arising in the market today and how/why they not only tackle many of the underlying challenges associated with Proof-of-Work (PoW), but also pave the way for a future of token economics that can better align political forces within a decentralized network.

FYI, given the relatively complex topics we’re going to dive into here, I’m assuming that as a baseline you have either read my primer on blockchains, protocols, and token sales and/or are reasonably up to speed with the basic industry topics and conversations.

What is Proof-of-Work and what problems are associated with it?

Thus far, the dominant consensus protocol for blockchains has been proof-of-work (PoW), which solves reliability and security concerns by requiring mining nodes to solve computationally intensive puzzles. This creates an environment of “essentially one-CPU-one-vote” to achieve block consensus, making it nearly impossible for attackers to acquire enough computational power to hack the network.

However, there are a number of important problems associated with this approach:

1. Enormous energy consumption. In December 2017, the Bitcoin and Bitcoin Cash networks alone used 0.14% of the total energy consumption in the world, which is considerably more than many whole countries. Six months later, that amount has more than doubled to 0.29%, bringing the amount of energy expended in a single transaction equivalent to powering ~29 US households for an entire day. In fact, even assuming an average energy cost of $0.1/kWh (FYI the average global price is about twice that at $0.2/kWh), it costs ~$18m/day to run just these two networks.
2. Wasted energy consumption. The energy used to power and secure PoW networks is spent solving computationally heavy puzzles. While there are teams working on establishing PoW systems that could put all that energy consumption to good use (e.g. machine learning to help find cures for diseases), for now the miners on the network that don’t “win” a given block puzzle are just converting electricity to heat.
3. Lack of accessibility. Not everywhere in the world has cheap electricity. This means that the most competitive mining pools are congregated in a relatively small number of geographic areas. In addition, the high cost of buying quality processors, cooling mining rigs, maintaining infrastructure, etc… excludes most of the world from participating. Indeed, less than 15 bitcoin mining pools, for example, occupy the vast majority of that network’s hashrate.
4. Misaligned incentives. In a PoW network, miners are not required to hold any of the native coin and are incentivized to make as much money as possible from fees and block rewards. This sets up politically divisive scenarios such as miners voting against the implementation of Segwit and the Lightning Network that would be beneficial for users of the network.
5. Ironic ties to fiat. This is a bit of an aside (and a nuanced argument), but because consensus within PoW networks is achieved through a distribution of processors, and these processors require sizable fiat transactions to acquire electricity to operate, sizable (i.e. not trivial) fiat transactions are essentially the backbone that secures PoW blockchains. This is ironic given that blockchains and cryptocurrencies promise to give us a new economic system.

What is Proof-of-Stake, what problems does it pose, and what variants of it are used in practice?

First proposed in a paper by Sunny King and Scott Nadal in 2012, PoS was designed to address the mounting costs of of PoW blockchains and their reliance on energy-intensive processes to secure transactions. Instead of grinding away at useless puzzles, PoS blockchains delegate nodes based on algorithms related to “staking” of coins.

To better understand how PoS blockchains work before we dive into them, it’s important to keep in mind the four core problems that they need to address (in addition to the problems listed above for PoW):

1. Initial distribution — how does a team determine who gets the coins first to stake them?
2. 51% attack — if a PoS node (or cartel of nodes) has 51% stake weight, this is a problem.
3. Monopolization — if you hold a ton of coins, you’ll dominate the rewards.
4. Nothing at Stake (NoS) — Nascent forks of blocks within a blockchain are common during everyday operations. While PoW incentivizes miners to focus their resources on the chain of blocks that is more valuable (because of the high external cost of participation), PoS nodes can immediately start signing chain forks without disincentive and potentially double-spend without anything at stake to prevent this behavior.

And, not surprisingly given how active this space is, there are now multiple implementations of Proof-of-Stake today in practice (or proposed) to address these problems:

• Coin-age selection. Blockchains like Peercoin (the first PoS chain), start out with PoW to distribute the coins, use coin age to help prevent monopolization and 51% attacks (by setting a time range when the probability of being selected as a node is greatest), and implement checkpoints initially to prevent NoS problems.
• Randomized block selection. Chains like NXT and Blackcoin also use checkpoints, but believe that coin-age discourages staking. After an initial distribution period (either via PoW or otherwise), these chains use algorithms to randomly select nodes that can create blocks.
• Ethereum’s Casper protocol(s). Being already widely distributed, Ethereum doesn’t have to worry about the initial distribution problem when/if it switches to PoS. Casper takes a more Byzantine Fault Tolerant (BFT) approach and will punish nodes by taking away (“slashing”) their stake if they do devious things. In addition, consensus is formed by a multi-round process where every randomly assigned node votes for a specific block during a round.
• Delegated Proof-of-Stake (DPoS). Invented by Dan Larimer and first used in Bitshares (and then in Steem, EOS, and many others), DPoS tackles potential PoS problems by having the community “elect” delegates that will run nodes to create and validate blocks. Bad behavior is then punished by the community simply out-voting the delegated nodes.
• Delegated Byzantine Fault Tolerance (DBFT). Similar to DPoS, the NEO community votes for (delegates) nodes, but instead of each node producing blocks and agreeing on consensus, only 2 out of 3 nodes need to agree on what goes in every block (acting more like bookkeepers than validators).
• Tendermint. As a more sophisticated form of DBFT and a precursor to Casper, Jae Kwon introduced tendermint in 2014, which leverages dynamic validator sets, rotating leader elections, and voting power (i.e. weight) that is proportional to the self-funding and community allocation of tokens to a node (i.e. a “validator”).
• Masternodes. First introduced by DASH, a masternode PoS system requires nodes to stake a minimum threshold of coins in order to qualify as a node. Often this comes with requirements to provide “service” to a network in the form of governance, special payment protocols, etc…
• Proof of Importance (POI). NEM takes a slightly different approach by granting an “importance calculation” to masternodes staking at least 10,000 XEM. This POI system then rewards active nodes that act in a positive way over time to impact the community.
• “Proof-of-X”. And finally, there is no lack of activity in the PoS world to come up with clever approaches and variants of staking (some are more elaborate than others). In addition to BFT protocols such as Honeybadger, Ouroboros, and Tezos, for further reading, also check out “Proof-of-”: Stake Anonymous, Storage, Stake Time, Stake Velocity, Activity, Burn, and Capacity.

What Proof-of-Stake approach is most compelling for the future of blockchains?

It is often said that a blockchain cannot simultaneously solve for scalability, security, and decentralization (aka the Scalability Trilemma). At best, a chain can be exceptionally good at two of these.

When determining which PoS approach is most compelling, obviously the answer is “it depends” on what problem is being addressed. Personally, I think we’ve learned enough about the scalability pains (especially in 2017, including the famous example of Cryptokitties slowing the ETH network) to strongly consider flavors of DPoS, DBFT, Tendermint, and Casper as the most prudent way for mainstream blockchains to proceed (if they can technically and politically pull it off, which is easier for newer chains).

Why are these flavors most promising? Simply put, the transaction speeds of most chains are too slow for major applications to be built on them, and major applications are needed to bring the crypto ecosystem to the next level for widespread adoption.

Therefore, on the short list of chains I think we (i.e. the subset of the crypto community that has strong interest in the next generation of staking) should be following closely include Ethereum, DASH, EOS, NEM, NEO, STEEM, ZenCash, ZeroCoin, and the Cosmos Network.

In fact, if you are interested in joining a group that is devoted specifically to researching and discussing chains use DPoS, let me know; some colleagues and I are inviting in like-minded people and we’d love to hear from you.

How do compelling variants of Proof-of-Stake pave the way for unifying token economics?

To realize a future where core developers, node operators, major token holders, and the everyday users of a network come together to advance the progress a blockchain, an important first step is the PoS approaches discussed above. These new consensus algorithms require node operators (aka validators, masternodes, minters, forgers, delegates, and/or witnesses, depending on the chain) to own — and/or be delegated — significant amounts of token. This means that the people operating the nodes will be economically incentivized to ensure the long-term growth of the network, rather than incentivized to quickly convert crytpo to fiat and/or switch between PoW chains for short-term profits.

In addition, the balance between the developers, token holders. and validators in DPoS/Tendermint chains is supported by a constant “voting” environment where the staking component isn’t the only factor; parties must act in a way to benefit the network or they’ll be voted out.

This foundation of aligned incentives, then, paves the way for networks that can rely on more meta-level token economics to ensure all parties involved in a network “do work” (governance, computation, storage, etc…) to support the community’s activities, rather than simply speculate on a pre-product ICO and/or mine the coin for sole purpose of fiat gains. Importantly, this future aligns with the changing regulatory landscape in most countries that recognize that most (if not all) pre-product, public ICOs are securities offerings and will be enforced as such.

On this topic, I’d highly recommend listening to Chris Burniske’s interview last month with Laura Shin:

“Chris Burniske, partner at Placeholder and author of Cryptoassets, discusses why he thinks initial coin offerings may not always be the best token distribution model, why he’s more interested in projects that enable users to earn tokens through contributing to the network, and how token distribution models can be designed to take advantage of the democratizing potential of blockchains.”

Combined with the emerging models of PoS to more closely align incentives with all parties involved, the future is bright for teams that think smartly about how to distribute their tokens accordingly to grow their networks.

Author’s note: Thanks in advance for any corrections/updates to what I’ve written here. I very much welcome feedback. Subscribe to my newsletter and I’ll let you know when I write more about topics related to crypto and distributed ledger technology (FYI I also write about entrepreneurship, health science, and other technology topics). As a reminder to the note above, let me know if you are interested in joining a group that is devoted specifically to researching and discussing chains that use DPoS, DBFT, Tendermint, Casper, and/or masternodes. Special thanks to Tony, Andy, Matt, and Lorien for review, feedback, and insightful conversations around the topics of this article. And finally, feel free to comment below (or inline above), hit the clap button, and/or share this article with a friend if you’ve found it helpful. Thanks!