Hey, in this post, you’re going to learn about something called staking, but first, you probably want to read our blog post on the proof of work consensus model, which is the method that bitcoin uses to keep track of how much money everyone has.
It’s a bit difficult to understand, but once you get it, this proof of stake model, which is very similar, will be much easier to understand.
What is Proof of Stake?
Well, here’s a textbook answer first, and then I’ll explain it so easy that a five-year-old could understand.
Proof of stake is a blockchain verification method that is much more energy-efficient and less risky than the more common proof of work method. Only one miner is chosen at a time to validate the blockchain, but that miner must lock up some of their coins as collateral to be selected.
The miner is punished for creating any fraudulent transactions by losing their collateral and rewarded for good transactions by the creation of new coins and possibly with the transaction fees the senders paid.
If you understood that, you probably don’t need to read this article, but if you don’t understand it read this article, and you’ll understand it by the end.
It took me a while to fully understand what proof-of-stake is, and I’ll try my best to put it into layman’s terms for you guys.
Proof of Stake vs. Proof of Work
First, I’m going to tell you why proof-of-work sucks. In fact, we have proof-of-stake to fix the things that proof-of-work sucks at.
So think of it like this, in proof-of-work let’s say you have runners lining up for a race, all eight racers are racing to the finish line, but you have some racers that have an advantage given the number of resources they have; kind of like they have more muscular legs, or they weigh less, or they’ve trained longer even though all racers get to the finish line.
Eventually, only one person wins, and they get the reward which might be a shiny Bitcoin, while the other runners still had to run down the track, and those who didn’t win essentially wasted their energy for no reward.
And with proof of stake, all the runners would line up at the starting line, and then only a single racer would be selected based on a few factors, which I’ll talk about here soon.
This way, we don’t waste electricity or energy, and nobody runs without getting a reward. When it comes to coins that use proof of work like bitcoin, many large mining companies compete to solve a blocks reward.
The fastest proof of work also isn’t fair to the DIY miners who don’t have access to very powerful machines or supercomputers that can win the puzzle-solving task the quickest.
With cryptocurrencies, we want there to be lots of miners so that the coin is truly decentralized and so that the blockchain is safe.
If those large mining companies join together, they could actually start making fake transactions because the blockchain is a majority vote.
If they get even 51%, you can kiss your bitcoins goodbye. This is a big problem, and proof of stake attempts to fix this by only selecting one validator, which is the word that proof-of-stake cryptocurrencies call miners.
The validator or the miner then solves the puzzle and earns the reward while other validators double-check them. It’s a lot fairer.
This way, one key thing when it comes to proof of stake is that since only one validator is selected, it’s very important that they solve it correctly because otherwise, they’ll have to choose someone else, wait for them to solve it correctly. It just takes a lot of time, and in the crypto space, time is money.
To solve this problem, we make sure that those participators lock up some of their coins, and then other validators can actually double-check their work, and if those validators were wrong, we penalize them and take some of the coins that they locked up.
This process of locking up their coins as collateral is called staking.
In short, to participate in a proof of work coin, you have to own some of that coin, then you lock it up so you can’t use it, and you wait so that the network will pick you to mine.
When you get picked, and you mine correctly, you get what’s called a staking reward. Usually, if you mine incorrectly, some of the coins get penalized, and you lose some of the coins that you initially locked up.
Moving on, the way that we select who gets to be the validator is essential too because in many cases, proof of stake coins will bias those who are staking the most coins because they have the most to lose.
But sometimes, we also calculate how long they have been locking up those coins because they have them and they haven’t lost them. They’re probably making lots of good calculations.
If we only select them based on the age of their stake, though, or who has the most stake, we would probably also secretly be biasing the extensive and rich mining facilities again.
To solve this, we also add in a bit of a random number picker, and I’m not going to go much into that in this post. This is a factor in the validator selection process.
You might understand there’s a good incentive for validators to correctly verify the blockchain and a good selection process to reduce energy waste, and I hope this clears things up a little bit.
If it doesn’t clear things up, leave a comment below and let us know what’s confusing, so maybe we can break it down even further in a future blog post.
But now that you kind of know how it works, let’s go over the risks and rewards.
There are a few risks when it comes to staking your cryptocurrency.
Risks Involved in Staking
- Locking Period
When you go to stake your coin, it’ll be moved into what is called a locked state, and during this time, you will not be able to move your coins, you can’t send them, and you can’t cash them out, sometimes you have to lock them up for a certain amount of time; maybe ten days minimum all the way up to a year.
This is a risk.
- Technical Knowledge
In almost every case, it’s not as easy as just downloading some software and then pushing a button.
Sometimes you usually have to know how to code (not compulsory), how to set up your computer to validate, and how to accept rewards into a wallet, and if there’s an issue, you are responsible for fixing it.
- Validator Commission
If you don’t want to, you don’t have to set up the validation process yourself. You can give your coins to someone else who has the knowledge and equipment to do it.
These platforms usually require a validator commission for the use of their computers, and this commission could cut into your profit. They could run away with your deposit at any time.
- Rewards Duration
Depending on the network that you choose, it could take minutes, days, and sometimes even weeks to see the payout of your staking position.
This is why it’s crucial to see the network’s reward payout time.
- Bad Behavior
Proof of stake is built on validators, and if the validation turns out to be bad, you’ll lose some of that stake. There’s a very, very small chance that you actually have a true good validation, but the network says that you’re wrong.
Nobody really mentions this because the likelihood is very low, but it is still a risk.
Lastly, I want to go over the reason that we would stake because you do get staking rewards.
Currently, I’m going to go over four of the most popular staking cryptocurrencies:
The first one is Tezos which rewards you around six percent of what you stake per year, and Coinbase does it for you. You don’t have to set up any of that process, but they take around one and a half percent of it, which lowers your yearly return to 4.6%
Cardano is another coin that does staking. They will give out around four to five percent.
The Algo coin rewards you with around eight to ten percent a year.
Lastly, Ethereum, which is actually switching to Ethereum 2.0, could be up to fifteen percent but, more reliably, probably around four to seven percent. But this won’t happen for at least another year.
To minimize the risks mentioned above, you will need to choose the best Crypto Exchange.
Proof of stake has quite a few benefits over proof of work, but it has downsides, too, as it can invalidate DIY GPU miners who want to participate without owning a whole bunch of the coin.
I hope this article helped you understand what proof-of-stake is, and if you liked it, be sure to subscribe newsletter. We were planning to release many similar helpful blog posts soon. I’ll see
you in the next blog post.