What is Proof-of-Stake (PoS)? Basic Staking Guide

CONTENTS:

1. What is Proof-of-Stake (PoS)/Staking Summary
2. Understanding Proof-of-Stake (PoS)/Staking
   • A Brief History of Proof-of-Stake (PoS)
   • What is Proof-of-Stake (PoS)?
   • How does Proof-of-Stake (PoS) work?
   • Proof-of-Stake (PoS) Variants
3. Proof-of-Stake Pros & Cons
4. FAQs
   • What is Staking?

1. What is Proof-of-Stake (PoS)/Staking Summary

Proof-of-Stake (PoS) was first proposed by cypherpunk Wei Dai as an alternative way to keep a ledger secure. In his B-money proposal, Wei Dai discussed the use of servers (nodes) and incentives (deposit a certain amount of money) to keep them honest. 

PoS, however, was first implemented by developers Sunny King and Scott Nadal (Peercoin) in 2012 as a solution to Bitcoin’s well-known issues such as energy consumption, scalability, and decentralization. 

Proof-of-Stake (PoS) can be defined as an alternative “consensus mechanism” that seeks to address the energy-efficiency and scalability difficulties that proof-of-work (PoW) has. It achieves this by releasing bandwidth (only selected nodes or validators have a copy of the ledger) and employing “staking (nodes must lock-up a fixed amount of money)” to reward good actors with fees while punishing bad actors by “slashing (confiscating)” their stake.

Proof-of-Stake (PoS) does not rely on miners or hashing functions, but rather on staking power (the number of coins staked) and validators to confirm transactions and reach consensus. Here’s how it works:

• STEP 1: Participants place a particular amount of money (stake) on a network-connected computer (also known as node) or staking pool. 
• STEP 2: When a transaction is requested, an algorithm pseudo-randomly selects the next validator. The algorithm takes into account the amount staked (invested), with the more staked, the greater the probability of being selected, in conjunction with a block selection rule such as coin age or randomized block selection.
• STEP 3: The selected validator checks the validity of transactions (checking digital signatures) and groups them into blocks. 
• STEP 4:  Other validators (with copies of the ledger) verify and approve transactions
• STEP 5: The block is added to the existing blockchain and validators earn crypto rewards for their contribution.
• STEP 6: The transaction is completed

Throughout the years many PoS variants have emerged, such as Delegated Proof-of-Stake (dPoS), Leased Proof-of-Stake (LPoS), Bonded Proof-of-Stake (BPoS), Nominated Proof-of-Stake (NPoS), Liquid Proof-of-Stake (LiPoS), Pure Proof-of-Stake (PPoS), and much more. 

Scalability, energy efficiency, decentralization, price stability, and minimal barriers to entry are all advantages of proof-of-stake (PoS). As a result, a new generation of altcoins and blockchains, such as Ethereum 2.0, are adopting or moving to PoS.

However, PoS is a relatively new “consensus mechanism” with various problems, including security (small attacks), the “nothing at stake” dilemma (NoS), staking period, an unfair advantage to the wealthy, and coins “stuck” in the network.

For a more detailed Proof-of-Stake (PoS) explanation, keep reading this post!

2. Understanding Proof-of-Stake (PoS)/Staking

In this section, we will investigate the origins of proof-of-stake (PoS), learn how it works, and discover its variants.

A Brief History of Proof-of-Stake (PoS)

Wei Dai, B-money version 2 (1998): Wei Dai, a cypherpunk and computer scientist, was the first to suggest proof-of-stake (PoS) as an alternative way to keep a ledger secure, albeit without using the term. In his B-money proposal, which was distributed over the cypherpunks mailing list [1] he described two protocols that will allow a community to exchange money, enforce contracts, and update a ledger. 
In both protocols, Wei Dai assumes the use of digital signatures (public-key cryptography) to encrypt both sender and receiver data to make it untraceable

• B-Money version 1: Proof-of-Work (PoW): In the first version (which he called impractical), Wei Dai suggested a hashcash proof-of-work to create money and secure a distributed ledger. 

“In the first protocol, every participant maintains a (separate) database of how much money belongs to each pseudonym. These accounts collectively define the ownership of money, and how these accounts are updated is the subject of this protocol.

Anyone can create money by broadcasting the solution to a previously unsolved computational problem. The only conditions are that it must be easy to determine how much computing effort it took to solve the problem…” 

Wei Dai

• B-Money version 2: Proof-of-Stake (PoS): In the second version, Wei Dai proposed the use of servers (nodes), which are the only ones that keep copies of the ledger. To keep them honest, each server is required to deposit a certain amount of money (stake) to verify transactions. 

“In the second protocol, the accounts of who has how much money are kept by a subset of the participants (called servers from now on) instead of everyone. These servers are linked by a Usenet-style broadcast channel.

The format of transaction messages broadcasted on this channel remain the same as in the first protocol, but the affected participants of each transaction should verify that the message has been received and successfully processed by a randomly selected subset of the servers.

Since the servers must be trusted to a degree, some mechanism is needed to keep them honest. Each server is required to deposit a certain amount of money in a special account to be used as potential fines or rewards for proof of misconduct.” 

Wei Dai

Note: B-money was never deployed, although it served as a blueprint for subsequent cryptocurrency developments.

QuantumMechanic, BitcoinTalk thread (2011): On July 11, 2011, an anonymous bitcointalk member proposed proof-of-stake (PoS) and delegated proof-of-stake (dPoS) solutions to Bitcoin’s problems [2]. The responses were quick to suggest applications other than Bitcoin, which remains the case.

• Proof-of-Stake (PoS) suggestion:

“I’m wondering if as bitcoins become more widely distributed, whether a transition from a proof of work based system to a proof of stake one might happen.  What I mean by proof of stake is that instead of your “vote” on the accepted transaction history being weighted by the share of computing resources you bring to the network, it’s weighted by the number of bitcoins you can prove you own, using your private keys.”

QuantumMechanic – Bitcointalk Forum

• DPoS (Delegated Proof-of-Stake) suggestion: 

“For those that don’t want to be actively verifying transactions, and so that not all private keys need to be facing the network, votes could be delegated to other addresses via some kind of nonstandard Bitcoin transaction. In this way, voting power would accumulate with trusted delegates instead of miners. New bitcoins and transaction fees could be randomly and periodically distributed to delgates, weighted by the number of votes they’ve accumulated, thereby incentivising diversity of the delegates and direct voters.”

QuantumMechanic – Bitcointalk Forum

Sunny King and Scott Nadal (2012), Peercoin (PPC): The first PoS implementation didn’t come until developers Sunny King and Scott Nadal published the Peercoin (PPC) white paper in 2012 as a solution to Bitcoin mining’s high energy consumption, which was over $150,000/day at that time (today, February 2022 is around $28 million). 

Sunny and Scott did not abandon PoW completely; rather, they proposed a hybrid solution in which PoW was relegated to minting, and proof-of-stake (staking) was employed to provide the majority of network security. Instead of relying on electricity, peercoin (PPC) used an algorithm to select nodes (servers) based on the number of coins invested (staked). In other words, as stakers “staked” more coins in their wallet, their chances of being picked to add a new block to the ledger (blockchain) increased.

The Hybrid Proof of Stake solution includes notable projects such as Ethereum 2.0 (Casper upgrade), Dash, Decred, etc. 

Original PoS, NXT (2013): Peercoin (PPC) was a hybrid version that still employed PoW, but Nxt (NXT) was the first pure Proof of Stake Blockchain and the blueprint for later PoS developments. Nxt, developed by software company Jelurida [3] is regarded as the start of Blockchain 2.0. Nxt is an open-source blockchain written in Java that serves as a payment network and dApp launching platform for a wide range of business applications. 

Delegated Proof-of-Stake (dPoS), Bitshares (2014): Bitshares (BTS) was the first to deploy delegated proof-of-stake (DPoS), an iteration of the original PoS protocol in which token holders can transfer responsibility for transaction validation to block producers.

DPoS is the most widely used variant of PoS with several major projects such as EOS.IO and TRON. 

Leased Proof-of-Stake (LPoS), Waves (2016): Waves (WAVES), was the first to introduce leased proof-of-stake (LPoS), another iteration of the PoS protocol in which token holders can lease crypto tokens to a node that aims to be the next block producer.

Bonded Proof-of-Stake (BPoS), Cosmos (2016): Cosmos (ATOM) and IRISnet (build on the cosmos SDK/Tendermint). BPoS is similar to LeasedPoS but it is adding “skin in the game (slashing of stake)” for the delegators as well as the validators.

Nominated Proof-of-Stake (NPoS), Polkadot (2017): Polkadot (DOT), the leader in interoperability, introduced nominated proof-of-stake. In NPoS, validators are called nominators which nominate validators among a list of candidates and stake (invest) a number of tokens to support them. 
Nominated proof-of-stake (NPoS) is the standard solution for projects that connect blockchains, such as Kusama or Edgeware.

Liquid Proof-of-Stake (LiPoS), Tezos (2018): Liquid Proof-of-Stake was introduced by Tezos (XTZ) in 2018.Token holders in LPoS can lend their validation rights to other parties without losing token ownership.

Pure Proof-of-Stake (PPoS), Algorand (2019): Algorand (ALGO) was the first to introduce Pure Proof-of-Stake (PPoS). In PPoS there are no sanctions for misbehaving (slashing), instead the algorithm is designed in a way that make cheating by a minority impossible and by a majority stupid. Furthermore, Algorand does not require users to lock up their “stake” in order to participate in the system; rather, they can spend it whenever they want.

Note: Proof-of-stake is in constant evolution. There are a few more proof-of-stake variants such as Proof-of-Importance (PoI), Proof-of-stake Voting (PoSV), Masternode Staking, Delegated Byzantine Fault Tolerance with ONG "dividends," Delegated Byzantine Fault Tolerance with GAS "dividends," and so on.

Why was Proof-of-Stake (PoS) created?

Proof-of-Stake (PoS) was proposed by Wei Dai and first implemented by Sunny King, in 2011 (PeerCoin). Sunny King and Scott Nadal’s goal was to solve some well-known proof-of-work (PoW) issues, such as:

• Scalability: Scalability refers to a network’s restricted ability to process massive amounts of transaction data on its platform in a short period of time. Proof-of-Work (PoW) blockchains such as Bitcoin and Ethereum, can only handle 7 and 30 transactions per second respectively. This is far below Visa and Mastercard levels at 1,700 and 5,000 transactions per second. For security concerns, Bitcoin and Ethereum can only mine blocks every 10 minutes and 12-14 seconds, respectively, and the entire network must download a copy of the ledger. As a result, the network is extremely slow. Furthermore, when the network is congested (we run out of space in the blocks), miners favor high transaction fees, further rising rates.
• High Energy Consumption: PoW involves the use of computation power (electricity) to solve cryptographic puzzles and update the ledger (blockchain). For instance, Bitcoin electricity costs are in the millions dollars per day, equiparable to countries like Ireland and Thailand. 
• Network Decentralization: As the difficulty of hashing (puzzle difficulty) increases, more and more equipment is required. Mining began as a hobby, and anyone could mine Bitcoins from home, but now you must join mining pools (share your computer power with other miners) to stand a chance of solving the puzzle. As a result, the network has become more centralized. The network is controlled by a few mining pools. Concerns have been raised concerning the risk of 51% attacks as a result of network centralization.
• 51% Attacks: Even though, the probability of 51% attacks (malicious participants controlling more than 51% of computer power) in massive networks such as Bitcoin and Ethereum is close to none, 51% attacks have occurred in low cap altcoins such as the Verge blockchain, with the hacker walking way with $1.75 million. Excessive centralization can lead to 51% attacks. 

What is Proof-of-Stake (PoS)?

The Proof-of-Stake (PoS) model uses a different process to confirm transactions and reach consensus than proof-of-work (PoW). Proof-of-Stake (PoS) is characterized as an alternative “consensus mechanism” for ease of use; nonetheless, it is a Sybil Resistance mechanism, as is Proof-of-Work (PoW).

First, a a quick reminder

• What is Consensus? Consensus occurs when 51% of network participants agree on the next global state of the network. 
• What is a Consensus Mechanism? A consensus mechanism (also known as consensus protocol or consensus algorithm) is a mechanism that allows participants (nodes) to coordinate and secure a distributed system. In the context of cryptocurrencies, to update the ledger (blockchain), the network must reach a “secure consensus” using an algorithm (rules).

Consensus Mechanism = Sybil Resistance Mechanism (e.g., proof-of-stake) + chain selection rule (or block selection rule) applied on a Byzantine Fault Tolerance (BFT) peer-to-peer network. 

• What is a Sybil Resistance Mechanism? A Sybil Resistance mechanism is an algorithm or protocol that discourages bad actors from gaming the system (51% attacks) and rewards honest actors for following the rules.
• What is a chain selection rule (or block selection rule)? A chain or block selection rule is a way of defining the next valid block in any blockchain. 
• What is a Byzantine Fault Tolerant (BFT) peer-to-peer network? This is a fancy way of saying that a consensus mechanism must keep a distributed system fault-tolerant even when some participants disagree. The consensus must be “secure” and hard (almost impossible) to breach. 

Proof-of-Stake (PoS) can be defined as an alternative “consensus mechanism” that seeks to address the energy-efficiency and scalability difficulties that proof-of-work (PoW) has. It achieves this by releasing bandwidth (only selected nodes or validators have a copy of the ledger) and employing “staking (nodes must lock-up a fixed amount of money)” to reward good actors with fees while punishing bad actors by “slashing (confiscating)” their stake.

How does Proof-of-Stake (PoS) work?

Proof-of-Stake (PoS) is far simpler to grasp than Proof-of-Work (PoW), as it does not involve complicated puzzles. Be aware that there are many proof-of-stake variants; the one we will discuss here is the original proof-of-stake.

Proof-of-Stake (PoS) uses staking power (number of coins) and validators, instead of computing power and miners, to confirm transactions and reach consensus. 

These are the features of Proof-of-Stake (PoS)

• Sybil Resistance Mechanism: The system freezes participant funds for a set length of time. In order to participate, most proof-of-stake blockchains have a minimum requirement of coins. For instance, ETH requires 32 ETH. If malicious participants wish to take over the system, they must control 51% of the entire staked coin. If they decide to spend such a large sum, the real value of the currency will rise along the way, and they will wind up spending more than they will get from the attack. Not only that, but if the bad actor is found, they will lose all of their stakes (also known as slashing).
• Block Selection Rule (chain selection rule): An algorithm randomly picks a winner (validator) which will add the next block to the blockchain. Validators don’t mine blocks, they “forge” them. They are usually compensated with transaction fees. This is analogous to an interest-bearing account earning passive income.
  
  The algorithm takes into account several factors: 
  
  
  • Amount Staked: Amount of money that is being invested or staked. As more coins are staked, the chances of being chosen grow (linearly). 

• Determining the forger only based on the number of coins staked may result in a significant advantage for the wealthier users. To address this issue, two mechanisms are proposed:
  
  
  • Mechanism 1 – Coin Age: How long coins are being kept in a digital online wallet. Coins at stake multiplied by the number of days that have been held. 
  • Mechanism 2 – Randomized Block Selection: As a selection mechanism, uses a hashing function (easy) and selects the lowest value in conjunction with the size of the stake

• Byzantine Fault-tolerant peer-to-peer network: The ledger is kept by a subset of the participants (validators or nodes) instead of everyone. This releases bandwidth and allows to reach decisions faster than pow. 

The easiest way to explain this process would be with an example: 

Assume you are a member of a network of 1000 investors. A first group (A) of 100 investors hold 1000 coins apiece from that network. A second group (B) of 50 investors each has 2500 coins, and a third group (C) of 30 investors each owns 10000 coins.

Group C has the highest participation rate (57.14% ). Now, an algorithm chooses a new validator at random depending on numerous parameters such as the amount staked in conjunction with coin age or the lowest hash value (in case of randomized block selection). Grup C has a better chance of being chosen. However, in order to avoid monopolies and maintain a healthy level of decentralization, such attributes do not guarantee that Grup C will be chosen every time.

This is how it works step-by-step: 

• Step 1: Participants place a particular amount of money (stake) on a network-connected computer (also known as node) or staking pool. 
• Step 2: When a transaction is requested, an algorithm pseudo-randomly (taking into account several factors) selects the next validator.
• Step 3: The selected validator checks the validity of transactions (checking digital signatures) and group them into blocks. 
• Step 4: Other validators (with copies of the ledger) verify and approve transactions
• Step 5: The block is added to the existing blockchain and validators earn crypto rewards for their contribution.
• Step 6: The transactions are completed

Proof-of-Stake (PoS) Variants

There are several types of PoS, the most important of which are as follows:

3. Proof-of-Stake Pros & Cons

Proof-of-Stake (PoS) was developed to address some of the issues associated with proof-of-work (PoW), such as energy efficiency, scalability, high entry barriers, and centralization. A new generation of altcoins and blockchains (Blockchains 3.0) are embracing PoS or some of its variants described above. 

Ethereum, the second-largest cryptocurrency and the mother of Altcoins, intends to fully implement PoS by the end of 2022 or 2023.

However, the technological challenges of PoS protocols are greater than those of PoW protocols and demand special attention.

Here are the pros and cons of PoS.

4. FAQs

What is Staking? 

Staking means locking your funds (stake) for a certain period of time in order to support a cryptocurrency network. If your computer (node) is selected as a validator you can earn “sweet” passive income. Some cryptocurrencies offer high-interest rates for staking. 

Staking can be done in a variety of ways:

• Running your own node: Setting up your own node involves technical knowledge, a dedicated computer, and the bare minimum required to validate transactions. Ethereum, for example, requires 32 ETH. This is not for beginners.
• Exchanges: This is the easiest and most beginner-friendly. Exchanges such as Binance, KuCoin, or Coinbase offer staking services. The only drawback is that it is a centralized solution, and your money must be placed on the exchange. 
• Staking Pools: Staking pools, like mining pools, are groups of people that pool their resources in order to increase their chances of forging a block. Because your stake is shared with others, you can invest less than the minimum amount required to run a node. 
• Preconfigured validator: You always can buy a preconfigured validator. The only drawback is that maintenance requires basic technical skills. This is a middle-of-the-road solution.
• Validator as a service (Cloud Staking): There are companies that will let you run your own validator on their machines without requiring you to set it up or manage it. This is also a middle-of-the-road solution.