Beyond Bitcoin: Proof of Stake

Chapter 14:

Previous: Beyond Bitcoin: The Blockchain Trilemma

Proof of stake (PoS) is a consensus algorithm that most blockchains use to achieve distributed consensus. It is an alternative to proof of work (PoW), which Bitcoin and Litecoin use, and previously before the “Merge” upgrade, Ethereum. PoS comes in a few varieties. Here I will explain the basics that most hold in common.

Contents

Which is best PoS or PoW

There is a debate between PoW and PoS about which is “best,” and I believe there are many trade-offs between them. However, if a network is to be a global computer and do many computations requiring lots of electricity, that electricity must be paid for. So, still arguably, but in my view, a winnable argument, keeping the costs as low as possible seems like a good idea. Proof of stake consensus helps achieve this. I am not saying it is better – but it is cheaper.

As we have seen with Bitcoin, in PoW, miners compete to find a computationally unlikely outcome, and the first miner to solve the problem gets to create a new block and add it to the blockchain.

How does PoS work?

In PoS, a new block’s creator is chosen mathematically deterministically, depending on their stake in the network. Stake refers to the tokens they must commit or make available as collateral to participate in the consensus process.

In most PoS systems, the stake is locked and unusable while staking. In others, it is liquid and available to be spent; still others, it is locked, but a receipt token is exchanged for the locked stake, which often has some utility and value. The receipt token, more commonly called the liquidity token, is usually a third-party token and not part of the formal consensus system of the blockchain. We will discuss these topics as we progress throughout the book.

The node/computer system that runs the PoS software as part of the network is often called a validator because it validates the transactions. Typically, a validator is also a staker, but it is also possible, and usually much less technical and more common, to be a staker on someone else’s validating node.

The PoS system uses an algorithm to decide which validator on the network will make the block and receive a reward for himself and those staking to the node. Often, but only in some systems, the probability of being chosen to create a new block is proportional to their stake. For example, if validator “a” hold has more stake than validator “b,” they will have a slightly better chance of creating a new block and, therefore, better rewards over time. Validator and staker rewards are often expressed as a percentage, like interest on a bank deposit. APY stands for annual percentage yield. APY incorporates compounding in the value, whereas traditional finance’s more commonly quoted APR does not.

Energy efficiency with PoS

One advantage of PoS over PoW is that it is more energy efficient, as it does not require miners to perform computationally intensive tasks to create new blocks. It is true, however, that an enthusiastic Bitcoiner would say that the lack of a computationally intensive task makes it less secure, as a very wealthy entity could buy enough of the stake and take over the network. Nevertheless, they are both right, and there is a place for different consensus systems. After all, you wouldn’t pick Grannie up from the station in a Lamborghini.

This energy efficiency can make it more practical for blockchains to scale and support many transactions and make the project and its token more attractive to ESG-compliant corporations. I am not a fan of ESG-focused corporations, I explain why in the afterword at the end of the book, but they are the most significant part of the financial system. So if we want a new economic system, the corporates will need to be part of it; this doesn’t mean we should let them control it! More on that as we progress.

What is the most secure PoS or PoW?

A PoS advocate would say the advantage is that it can be more resistant to certain types of attacks, as an attacker would need to have a significant stake in the network to have a chance of manipulating the consensus process. This is, in fact, true, but it is a simple counterargument that there are indeed many possible bad actors who do have plenty of money and perhaps a vested interest in the failure of one or more PoS systems.

However, PoS systems can also be vulnerable to certain types of attacks, such as “nothing at stake” attacks, in which validators have no inherent incentive to act honestly. This can be mitigated through penalty systems that discourage validators from behaving dishonestly. This usually involves financial punishment for not following the consensus rules precisely. This is called slashing, where some or all of a validator’s stake will be taken either for poor node operation or malicious activity. Note that some networks will also slash the stakers on the node, not just the node operators. Don’t worry about this for now; we will discuss risks carefully as we proceed through the book.

Soon we will see how to participate in staking on the Cardano network, and we will also see how to stake on MultiversX, Cosmos, and Osmosis. As the book expands I will add more as well.

Summary

The preceding discussion on PoS overlooks one rather significant point, although we have alluded more than once to distributed computation. Most networks after Bitcoin added features, not just a new consensus mechanism. Therefore, we need to talk about distributed computation. You don’t just send and receive tokens in a decentralized, permissionless, peer-to-peer way. You can run computer programs, create, own, and use public applications, and have guaranteed correctness, censorship resistance, and pseudo-anonymity that you have with sending tokens. These programs I refer to that are stored and executed on the blockchain are called smart contracts.

We are now familiar with proof of stake consensus, where node operators called validators provide a service where network participants can stake their tokens to play a part in executing the smart contracts, securing and sometimes governing a blockchain network.