What is Proof of Stake?

In the conventional world of finance, when Tom sends Jerry $100, a trusted third-party service (like a bank, credit card or payment company) debits Tom’s account and credits Jerry’s account, so they both have to trust that this third-party will do the right thing.

In a decentralized system like Ethereum, Tom can send Jerry $100, and a computer program called a smart contract handles both ends of the transaction without the need for a third party. Once the transaction is complete, it is recorded in the public blockchain where it can be independently seen and verified.

However, before that transaction is added to the blockchain, it has to pass a significant hurdle called “consensus.” This is an automated system that validates legitimate transactions and blocks fraud, such as somebody trying to spend the same crypto token twice.

The Current Standard: Proof of Work

The most common process for gaining consensus is called Proof of Work (PoW). The “work” in PoW is called mining.

When a new transaction comes down the pike, crypto miners around the world with special computer processors work to solve a difficult mathematical puzzle. Whoever solves it first validates the transaction, adds it to the blockchain, and earns a reward known as a gas fee. This fee is paid in cryptocurrency and is based on the amount of computational effort required to solve the puzzle.

PoW has proved very effective in terms of creating a secure, decentralized network. However, with an ever-growing army of miners competing for each transaction, and the puzzles programmed to become more complex over time, there has been an arms race for computing power - a situation that may not be sustainable from an economic or environmental perspective.

The Emerging Standard: Proof of Stake

This year, Ethereum will adopt a mechanism called Proof of Stake (PoS) that could cut the blockchain’s energy consumption by more than 99%¹. Under this system, people who own at least 32 Ether (worth about $120,000 as of February 2022), can be selected by the network to “stake” them and become a “validator” who authenticates transactions for the blockchain. If their transactions are accepted by a committee of “attestors,” they will earn more Ethereum, but if their transactions are not accepted, they will forfeit their stake.

This carrot-and-stick approach replaces a massive network of hot silicon chips with a simpler process driven by participants who have a vested interest in the success of Ethereum. PoS promises not only a dramatically smaller carbon footprint, but also faster transaction speeds without so much computational work.

A New Yield Opportunity for Investors

Many investors will stake Ethereum and other blockchains as a way to increase the return on their digital assets. Rather than having those assets simply sit in a portfolio, they can earn staking rewards that generate passive income similar to the dividends in a stock market account.

And, as more investors stake their Ethereum, they actually enhance the strength of the blockchain and make it more resistant to attacks.

One potential downside of staking involves liquidity: there is typically a vesting period for staked assets during which time they cannot be sold, even if prices shift. Each coin has unique rules around staking, so it’s important to understand any minimums, time commitments, and vesting restrictions involved.

Learn more about Ethereum and how we’re making it affordable and accessible for every investor.

¹ https://blog.ethereum.org/2021/05/18/country-power-no-more/

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Published February 24, 2022