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Digital Assets Decoded: What are Consensus Algorithms — Proof-of-Stake

January 7, 2021

Kelvin Ting, Head of Blockchain Strategy

This is the fourth article of our Digital Assets Decoded series which aims to give you a fundamental understanding of the cryptocurrency space.

By Kelvin Ting, Head of Blockchain Strategy

This is the fourth article of our Digital Assets Decoded series which aims to give you a fundamental understanding of the cryptocurrency space. In our previous article, “What are Consensus Algorithms”, we discussed what a Proof-of-Work consensus algorithm is. In this article, we will be exploring another type of consensus algorithm, called Proof of Stake.

As you may recall, Proof-of-Work algorithms are those where computers, called miners[1], are auditors who verify that cryptocurrency transactions are valid by solving complex mathematical puzzles. One of the main problems about this system is energy expenditure – as many miners compete to solve a problem, only one will be given the reward for finding the solution. 

Proof-of-Stake Mechanism 

Instead of having nodes validate transactions by solving computationally expensive puzzles, Proof-of-Stake (PoS) blockchains afford nodes that hold a minimum amount of cryptocurrency the capability to validate nodes and be rewarded with a block reward. Examples of Proof-of-Stake protocols include Tezos (XTZ), Algorand (ALGO), Tron (TRX), Cosmos (ATOM), and soon, Ethereum 2.0 (ETH2). These protocols allow nodes to validate the network based on a fluctuating ROI, subject to network conditions. In the context of this article, only general PoS concepts will be discussed, and the specific details of each PoS blockchain will be discussed in detail once their coins are listed on EQUOS.   

In order for a node to become a validator, they would have to lock up their assets in a fashion similar to a security deposit. This process is called Staking, where you show the network that you have a stake in the network, hence the name. 

Once the node has its stake whose size is at least the minimum required amount to be locked up and pledged to the network, the node is now eligible to validate transactions on the network. The network then randomly selects a validator for the next block – the node which is given authority to propose the transactions in the next block and will receive fees for their contribution to the networkThe entire flow is shown in Figure 1. 

However, the probability of how likely it is for a block to be chosen to become a validator is dependent on the amount of cryptocurrency a block has staked relative to the entire network. Generally speaking, nodes with higher amounts staked will have a higher probability of being chosen as a validator for a particular block. This is, however, different in ETH2 where there is no incentive for staking more than 32 ETH (I.e. the minimum requirement to become a validator) in a node. 

Economic Incentives 

As with every cryptocurrency, there are rewards and punishment mechanisms to force actors to behave well. 

The economic incentives for Proof-of-Stake blockchains are very different from those of Proof-of-Work ones, where all the incentives belong to the miners, who compete with each other to obtain block rewards, with the intention of making it hard enough for people to break the system. 

Proof-of-Stake behaves in quite a different way – rewarding people who have large holdings of the native token of the blockchain to secure the network by contributing to validation. Those who say that they believe in a cryptocurrency are given an opportunity to play a part in the ongoing maintenance and development of the blockchain network. Those who are eligible to become validators are also likely to control large portions of the native token network. 

On the other hand, validators who behave maliciously by attempting to fake transactions may be punished. This may be done by removing the malicious validator’s stake or security deposit from their node, or by not allowing them to further validate transactions, depriving them from future and/or already earned income. 

Advantages and Disadvantages of PoS systems 

Due to the nature of the PoS systems where computations are not heavy, they technically hold the following advantages over PoW systems: 

  • Better performance – As nodes do not need to use up electricity to compute puzzles, PoS systems allows for higher transaction throughput, allowing for transactions to be confirmed very quickly, increasing suitability for real-world applications 

  • Security – Nodes that hold a stake in the network are much more incentivised to keep the network secure 

  • Environmental Friendliness – The overall energy consumption is lower 

  • Lower hardware cost– As nodes do not need to perform expensive operations, expensive mining equipment is not necessary 

 

There is one possible disadvantage of PoS systems, where it may be possible for one to purchase a majority share of tokens in the ecosystem, stake a majority control of tokens in the network, and then attack the network by rewriting history in their favour. However, this is only feasible for small market cap coins, which may not pass other safety factors at well. Currencies listed on EQUOS are vetted by an independent research team and committee, and as a result, such tokens will not be listed on our platform. 

 

Conclusion 

Instead of using cryptographic puzzles, Proof-of-Stake networks select nodes based on how much they have staked or locked up in the network, allowing for a greener and more scalable network.  

[1]  A miner is a subset of a node. The word “miner” is applicable only for Proof-of-Work cryptocurrencies, where they mine transactions by performing complex calculations.  

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