As a fan of cryptocurrency, you’ve probably heard the terms “Proof of Work,” “Proof of Stake,” and maybe even “Proof of Burn” before, but what do they really mean, and what is a “proof,” anyway? Without getting into too much technical detail, we will explain each concept one at a time over a series of articles, so you can have a better understanding of what they refer to the next time you see it in a potential investment. This week we examine the next big thing to happen in cryptocurrency after Proof of Work: Proof of Stake.

What’s the Difference Between Proof of Work and Proof of Stake?

The biggest difference between Proof of Work (PoW, bitcoin) and Proof of Stake (PoS) is that PoS does not require computationally intensive puzzles to be solved in order for news coins to be generated and blocks added to the blockchain. Instead, it uses a formula that uses random numbers and the size of coin amounts held by each address (“stake”) to determine the next recipient of newly generated coins, while simultaneously adding a new block to the blockchain. Basically, with PoS, the more coins you hold in a wallet address, the more likely you are to be awarded new coins. Different PoS coins have different ways of going about this: sometimes the coins are rewarded to “stakers” randomly, sometimes they are rewarded in an equally distributed fashion, and often they are awarded in different amounts proportional to the size of the coins being staked.

PoS was originally invented to solve a problem, which was how to reduce the amount of energy wasted in PoW. The Bitcoin Network now requires a tremendous amount of energy to sustain itself, a number quickly approaching 1% of the world’s total power supply. As there are several different mining operations currently attempting to solve the same task and only 1 miner can successfully receive each block reward of newly-generated coins, the rest of the energy used by the competing miners is simply “wasted,” as in nothing useful was achieved by expending energy resources. PoS does away with all the wastefulness by simply using a formula to determine who gets the next batch of new coins.

Years before the launch of Ethereum, co-founder Vitalik Buterin published an extremely thorough and well-written piece on PoS in which he described how this new reward system was not only beneficial to the environment (as it required less energy consumption for its operation) but also offered an enhanced level of blockchain security not seen with the likes of the traditional, pre-existing PoW blockchain models. He described the problem with PoS as such:

“…Proof of work is highly wasteful. Six hundred trillion SHA256 computations are being performed by the Bitcoin network every second, and ultimately these computations have no practical or scientific value; their only purpose is to solve proof of work problems that are deliberately made to be hard so that malicious attackers cannot easily pretend to be millions of nodes and overpower the network. Of course, this waste is not inherently evil… the wastefulness of proof of work may well be a small price to pay for the reward of a decentralized and semi-anonymous global currency network that allows anyone to instantly send money to anyone else in the world for virtually no fee. And in 2009 proof of work was indeed the only option.” – Vitalik Buterin

Another powerful component of PoS is the introduction of an “interest-bearing” reward system, which basically means that coin holders can receive a fixed amount of “interest” on the number of coins they are currently staking, in the form of new coins. This also has the effect of encouraging coin owners to continue holding their coins for long periods of time. With many PoS reward systems, addresses with staked coins are not even eligible for rewards until after they have been held for a designated period of time, further encouraging stakers to hold their coins in their wallets.

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Peercoin

The world’s first cryptocurrency to use PoS is called Peercoin (PPC), developed by Sunny King and Scott Nadal in 2012. In order to solve the problem of how to generate initial coins in the absence of coins that could be staked, Peercoin implemented a hybrid PoW/PoS model of mining, borrowing heavily from bitcoin’s code but adding its own tweaks that rendered it ultimately a vastly different breed of coin. In order to decide which addresses should be rewarded first in terms of first to receive new coins generated via PoS, King and Nadal employed the idea of prioritization by coin age, which is a simple formula that equals the number of coins staked times the number of blocks for which the coins had been staked. Thus, if someone held 10 coins for 60 blocks, their address would have a coin age of 600, and they would be more likely to receive a PoS-based reward than someone who held 5 coins for 10 blocks (coin age = 50). This idea was first mentioned in the Abstract section of the original Peercoin whitepaper:

“Under this hybrid design proof-of-work mainly provides initial minting and is largely non-essential in the long run. Security level of the network is not dependent on energy consumption in the long term thus providing an energy efficient and more cost-competitive peer-to-peer crypto-currency. Proof-of-stake is based on coin age and generated by each node via a hashing scheme bearing similarity to Bitcoin’s but over limited search space.” – Sunny King, Scott Nadal

The average interest rate for Peercoin stakes was developed to be about 1% a year with no set maximum number of coins to be generated, thus separating it from bitcoin’s production schedule and mimicking the new production of a physical resource like gold. Less than a year after its launch, Peercoin was the 5th most successful coin by market capitalization value, leading the way for future PoS coins to follow. In January 2014, it was one of the first altcoins to successfully break the $100 million mark in market cap. Although King and Nadal are no longer active with the project, it still retains a tremendous degree of popularity and enjoys one of the longer-standing, tightly-knit community bases of all cryptocurrencies.

Top 5 coins by market cap, late 2013. Source: coinmarketcap.com

 

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Nxt

One of the first truly PoS coins to ever be developed was Nxt (NXT), launched in early 2014, exactly 5 years after the launch of bitcoin. Far different from Peercoin’s approach, Nxt solved their initial coin generation problem by minting all their (one billion) coins at once, distributing them among 73 bitcoin contributors based on the size of their contribution. Instead of generating new coins, Nxt would use fees collected from transactions as PoS rewards to coin holders in increments of 1 minute blocks. In essence, Nxt was the first Initial Coin Offering (ICO), before the process ever had a name. However, unlike most ICOs, Nxt’s anonymous developer, BCNext only requested “a few satoshis” from each participant in order to put finishing touches on the project, capping the maximum contribution at 1 BTC.

Nxt is also arguably the first “platform coin,” meaning “plug-ins” (now referred to as DApps) can easily be built to interface with its blockchain and network in a non-sandbox type environment. In addition, Nxt features a token (originally referred to as “colored coin”) creation service and built-in decentralized exchange, rendering it far more complicated than bitcoin. The network security provided by the Nxt PoS mechanism has proven itself to be quite robust over the last four and a half years as the Nxt blockchain has never been successfully hacked or tampered with. While Nxt’s main criticism as a cryptocurrency was its rather “centralized” initial distribution in which only 73 holders controlled 100% of the coins, it went on to achieve great success, responsible for hosting some of the first Digitally Autonomous Corporations (DACs, later known as DAOs) and its Asset Exchange is still used to launch ICOs today.

When BCNext was pressed to guess at Nxt’s price in a few month’s time after launch, he offered the following response:

“I can not give you exact numbers. Try to assess them taking into account some facts:

  1. Nxt does not require to waste electricity (no centralization of mining power around pro-miners)…
  2. Colored coins will lead to a revolution in finances (decentralized exchange of property in atomic transactions)…
  3. Instant transactions (I can’t find words to explain how it’s cool)…

Nxt collected 1,500 USD worth bitcoins.  I’ll eat my hat if in half a year they won’t be worth a couple of millions.” – BCNext

BCNext’s prediction turned out to be right and then some, as NXT surpassed a market cap of $70 million only 3 months after hitting the cryptocurrency exchanges. After this point, there was little doubt that not only could PoS be a reliable form of blockchain security but a very popular one as well.

Some other notable PoS coins include BlackCoin (BLK), Qtum (QTUM), NEO (NEO), Stratis (STRAT), Potcoin (POT) and ReddCoin (RDD).

Do you have more questions about Proof of Stake? Feel free to ask them in the comment box below and we’ll be sure to get back to you as soon as we can.