Refresher

We ended Part 1 of this article discussing some of the key drawbacks of Proof-of-Work (PoW) mining - namely the high electricity costs driven by the cat-and-mouse relationship between computing power, hashing difficulty, and profitability. While PoW has without a doubt been a primary catalyst for the rise of digital assets, that same rapid rise has led to its limitations becoming more starkly evident.

As a result, we’re seeing interest around the Proof-of-Stake (PoS) consensus mechanism intensify more quickly. So as we continue our deep dive, we’ll look at how PoS differentiates itself from PoW, and why it’s important to the overall crypto market’s growth and evolution.

We’ll also take a quick look at Ethereum’s transition from PoW towards PoS called Casper. Considering the popularity of the Ethereum blockchain, their approach and result will have a far-reaching impact on how (and which) consensus mechanisms lead the way longer term.

Finally we’ll call out a few of the latest "Proof-of-" consensus mechanisms that could indicate what lies ahead for this key element of a digital asset’s blockchain ecosystem.

Proof-of-Stake (PoS) Explained

While its popularity is more recent, Proof-of-Stake was first mentioned in 2011 as an alternative method of validating transactions. It was formally introduced in 2012 in response to Bitcoin mining’s high energy cost. With that cost skyrocketing 50x as we fast forward to present day (with more recent data below from Digiconomist), it’s not hard to understand why we’ve seen such a refreshed interest in PoS protocols.

btc-energy

eth-energy

While the underlying intention to provide distributed consensus on the network is the same, the methodology of PoS differs entirely from PoW. Instead of building blocks on the blockchain through energy-sucking computational output, the creator of a new block is determined by their holdings, or ‘stake,’ in that particular cryptocurrency. Part of that stake is then locked away and held as collateral to ensure their validation of a block of transactions is true.

Under this system, block validators are randomly chosen to build blocks based on the monetary value of their stake in the currency along with the age of that stake within the blockchain network. For example, an individual whose held 10K of a currency’s tokens for 2 years has a higher probability of being chosen to validate a block of transactions over an individual also holding 10K tokens but only for 6 months. Conversely, they’d also have higher probability than somebody whose held 5K tokens for the same 2 years.

Since there is no work-centric incentive to outcompete other miners (ie the PoW model), PoS validators are awarded in transaction fees. These fees could then fluctuate based on the supply and demand of validators on the system.

A few well-known cryptocurrencies who validate using PoS include:

  • PeerCoin (1st to leverage in 2012)
  • Cardano
  • OmiseGo
  • QTUM
  • Ardor

Proponents of PoS argue that not only is it far more energy and resource efficient, but the chance of a 51% attack on a PoS backed network is theoretically impossible. To do so, a bad actor (or more likely a collusion of bad actors) would have to purchase the majority of a currency’s supply. The sheer expense of this approach plus safeguards put in place to increase the cost of attack vs PoW hashpower consolidation makes it impractical.

While it may sound promising, not all is positive for the future of PoS. Rewarding those with large stakes held over time has been cited as a flaw that can breed inequality in the community – essentially the rich getting richer while the poor get poorer. There is also a higher potential for more centralized control over the network by the wealthy. PoS simply requires investing money over time, as opposed to PoW where miners need to invest in expertise, hardware, electricity, and other resources over time.

Ethereum: PoW to PoS

One of the most noteworthy developments regarding PoS has been Ethereum developers’ long awaited move to a Proof-of-Stake consensus. In May of this year, the first steps were taken with the release of the Casper protocol which began testing in June.

Once fully implemented, Casper will update the Ethereum blockchain to become a hybrid of PoW and PoS. Vitalik Buterin, Ethereum’s creator, is choosing a conservative approach for its introduction. In its early stages, Casper will continue to place most of the heavy lifting on the established PoW protocol, using PoS to validate checkpoints at periodic intervals.

casper-eth

Casper’s implementation is a major step for the ethereum community, and it will act as the largest real-world test of PoS to date. Proponents of PoS are already praising the decreased electricity ethereum will require to reach agreement on the network. In contrast, detractors are using the hybrid and conservative implementation of Casper as proof that PoS could never fully replace PoW.

Considering the daily value generated by the Ethereum network, that rebuttal turns out to be quite impractical. Initial documentation shows Casper will require validators to put down a minimum deposit (stake) of 1K-1.5K ethers to ensure that participants act in the interests of the community. If the protocol determines that a validator has violated a set of rules, such as signing off on multiple forks, the deposit will be lost.

Many also believe that Casper will reduce Ethereum’s volatility and supply, which could theoretically lead to a more valuable token:

  • "Locking coins away" would decrease supply
  • Block rewards for the current POW protocol will decrease, resulting in fewer new coins being ‘minted’

Proof-of-X & The Future

While PoW and PoS dominate the majority of discussion on the topic, there are some notable and unique derivatives of these core mechanisms. WAVES for example leverages LPoS (Leveraged PoS), allowing those holding a stake to lease their balances to staking nodes and share rewards proportionally. DPoS (Delegated PoS) on the other hand allows holders to elect a list of nodes for validation, a method leveraged by Bitshares (BTS).

NEM’s PoI (Proof-of-Importance) protocol takes PoS a step further and incorporates a number of factors beyond coins held and time to assign members an importance score. And the PBFT (Practical Byzantine Fault Tolerant) approach - currently utilized by Hyperledger, Stellar, & Ripple – takes an even more unique approach that could be covered in series of articles on its own.

Regardless of which mechanism(s) lead the way moving forward, the debate between them is just the latest in a series of technological shifts coming to blockchain. As part of your investment research it’s important to take note of these shifts, including the underlying consensus mechanism, for any digital asset you invest in. All else being equal in terms of technical indicators, this fundamental difference in an asset's ecosystem can provide actionalable insights for longer term valuation.