What is Proof of Stake?

The proof of stake system is attracting a lot of attention these days, with Ethereum switching over to this system from the proof of work system. Proof of stake is an alternative process for transaction verification on a blockchain. It is increasing in popularity and being adopted by several cryptocurrencies. To understand proof of stake, it is important to have a basic idea of proof of work. As of this writing, the proof of work method is used by Bitcoin, Ethereum and most other major cryptocurrencies.

Proof of work

Proof of work is a mining process in which a user installs a powerful computer or mining rig to solve complex mathematical puzzles (known as proof of work problems). Once several calculations are successfully performed for various transactions, the verified transactions are bundled together and stored on a new ‘block’ on a distributed ledger or public blockchain. Mining verifies the legitimacy of a transaction and creates new currency units.

The work must be moderately difficult for the miner to perform, but easy for the network to check. Multiple miners on the network attempt to be the first to find a solution for the mathematical problem concerning the candidate block. The first miner to solve the problem announces their solution simultaneously to the entire network, in turn receiving the newly created cryptocurrency unit provided by the protocol as a reward.

As more computing power is added to the network and more coins are mined, the average number of calculations required to create a new block increases, thereby increasing the difficulty level for the miner to win a reward. In proof of work currencies, miners need to recover hardware and electricity costs. This creates downward pressure on the price of the cryptocurrency from newly generated coins, thus encouraging miners to keep improving the efficiency of their mining rigs and find cheaper sources of electricity.

Bitcoin is an example of a cryptocurrency that uses the proof of work system.

Proof of Stake

Unlike the proof of work system, in which the user validates transactions and creates new blocks by performing a certain amount of computational work, a proof of stake system requires the user to show ownership of a certain number of cryptocurrency units.

The creator of a new block is chosen in a pseudo-random way, depending on the user’s wealth, also defined as ‘stake’. In the proof of stake system, blocks are said to be ‘forged’ or ‘minted’, not mined. Users who validate transactions and create new blocks in this system are referred to as forgers.

In most proof of stake cases, digital currency units are created at the launch of the currency and their number is fixed. Therefore, rather than using cryptocurrency units as reward, the forgers receive transaction fees as rewards. In a few cases, new currency units can be created by inflating the coin supply, and forgers can be rewarded with new currency units created as rewards, rather than transaction fees.

In order to validate transactions and create blocks, a forger must first put their own coins at ‘stake’. Think of this as their holdings being held in an escrow account: if they validate a fraudulent transaction, they lose their holdings, as well as their rights to participate as a forger in the future. Once the forger puts their stake up, they can partake in the forging process, and because they have staked their own money, they are in theory now incentivized to validate the right transactions.

This system does not provide a way to handle the initial distribution of coins at the founding phase of the cryptocurrency, so cryptocurrencies which use this system either begin with an ICO and sell their pre-mined coins, or begin with the proof of work system, and switch over to the proof of stake system later.

Cyptocurrencies that currently run the proof of stake system are BlackCoin, Lisk, Nxt and Peercoin, among others.

Proof of work mining versus proof of stake forging.

Block Selection Methods

For a proof of stake method to work effectively, there needs to be a way to select which user gets to forge the next valid block in the blockchain. Selecting the forger by the size of their account balance alone would result in a permanent advantage for the richer forgers who decide to stake more of their cryptocurrency units. To counter this problem, several unique methods of selection have been created. The most popular of these methods are the ‘Randomized Block Selection’ and the ‘Coin Age Based Selection’ methods.

Randomized block selection

In the randomized block selection method of selection, a formula which looks for the user with the combination of the lowest hash value and the size of their stake, is used to select the next forger. Since the size of the stakes are public, each node is usually able to predict which user will be selected to forge the next block. Nxt and BlackCoin are two proof of stake cryptocurrencies that use the randomized block selection method.

Coin Age based selection

The coin age based system selects the next forger based on the ‘coin age’ of the stake the potential forger has put up. Coin age is calculated by multiplying the number of days the cryptocurrency coins have been held as stake by the number of coins that are being staked. Coins must have been held for a minimum of 30 days before they can compete for a block. Users who have staked older and larger sets of coins have a greater chance of being assigned to forge the next block. Once a user has forged a block, their coin age is reset to zero and then they must wait at least 30 days again before they can sign another block. The user is assigned to forge the next block within a maximum period of 90 days, this prevents users with very old and large stakes from dominating the blockchain thereby making the network more secure. Because a forger’s chance of success goes up the longer they fail to create a block, forgers can expect to create blocks more regularly. This mechanism promotes a healthy, decentralized forging community. Peercoin is a proof-of-stake system based cryptocurrency which uses the coin age selection process combined with the randomized selection method. Peercoin’s developers claim that this makes a malicious attack on the network more difficult, since purchasing more than half of the coins is likely costlier than acquiring 51% of proof-of-work hashing power.

Most proof of stake coins that pay a reward in the form of a transaction fee for verifying transactions and creating new blocks, set a target interest rate which users can expect to earn from staking their coins. In the case of cryptocurrencies where forgers create new coins, this rate also becomes the maximum rate at which the currency supply is inflated over time.

Proof of stake systems are more environmentally friendly and efficient, as the electricity and hardware costs are much lower than the costs associated with mining in a proof of work system. A greater number of people are encouraged to run nodes and get involved because it is easy and affordable to participate in this system; this results in more decentralization.

This is only a general guide to the proof of stake system. Each cryptocurrency issuer will most likely customize this system with a unique set of rules and provisions of their own as they issue their currency or switch over from the proof of work system. Additionally, this is a rapidly evolving industry, and apart from proof of work and proof of stake, there are currently several other systems and methodologies of transaction verification and block creation being tested and experimented with.

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