Proof-of-Work vs Proof-of-Stake Explained

In this article, we explain the difference between proof-of-work, which is used by Bitcoin (BTC), and proof-of-stake which is used by many other cryptocurrencies.  

But before we get to that, the first question you may be asking yourself, is why do cryptocurrencies need proof of anything?  The answer lies in the fundamental difference between fiat currencies, regulated by financial institutions, and decentralized cryptocurrencies, recorded on the blockchain.  As cryptocurrencies do not have an administering body, another method is required to verify transactions and prevent double-spending.

Proof-of-Work Algorithm

Bitcoin's method of mitigating the risk of double-spending is to authenticate transactions via a Proof-of-Work (PoW) mechanism, the 'work' being completed by miners. When a crypto user sends a transaction from their crypto wallet, it is placed in a pool of unconfirmed transactions called the mempool. Bitcoin miners then compete to verify transactions. If the transaction is valid, it gets added to the blockchain. Otherwise, it is rejected, as if it never occurred in the first place.

Bitcoin mining requires enormous computing resources, and those who invest in this strategy do so in order to be rewarded with bitcoin when they successfully verify the transaction. In the early Bitcoin years, everyday enthusiasts on home computers competed for these mining rewards, which at first were relatively easy to come by.  But now, mining operations are dominated by companies that run powerful server farms using enormous amounts of electricity.  While it is claimed that 70% of this power is sourced from renewable energy, proof-of-work's potential negative climate effects have come under scrutiny.

On the plus side, proof-of-work networks are advantageous as they are highly secure and difficult to compromise.  In theory, anyone who could gain control of 51% of Bitcoin’s network could initiate double-spend attacks and prevent transactions from being processed. However, the tremendous amount of computing power required to do this renders this type of attack almost impossible to carry out.

Proof-of-Stake Algorithm

In a proof-of-stake system, the blockchain employs a network of “validators” who ' stake' their crypto in order to have a chance of being selected to validate new transactions and update the blockchain. Staking is similar to putting funds on term deposit - the investor moves their idle cryptocurrency to a special wallet, node, or platform for staking and agrees not to access it for a period of time. 

  • The most invested participants are rewarded - a winner is selected based on the amount of crypto each validator has in the pool and the length of time they’ve had it there.
  • When the winner has validated the block of transactions, other validators can confirm that the block is accurate. With confirmation or 'attestation' made, the blockchain is then updated.
  • Participating validators receive a reward in the native cryptocurrency, usually distributed in proportion to each validator’s stake. 

Just as it sounds, becoming a validator requires a high level of technical knowledge and so is not for every crypto investor.  Plus, the amount of crypto that winning validators need to stake is quite high and there are risks if they do not complete the work correctly. So, the majority of investors participate by joining a staking pool and earn rewards for crypto they do not need to access in the short to medium term.  Crypto exchanges and investment platforms are set up to make this possible.

Ethereum Proof-of-Stake Use Case

In the past, Ethereum used a Proof-of-Work verification mechanism just like Bitcoin, however, since 2020, Ethereum has been transitioning to the proof-of-stake (PoS) consensus mechanism with Ethereum 2.0. The goal of the transition is to make the network more scalable, secure, and sustainable and is expected to be complete in 2022. 

What is Better Proof-of-Work or Proof-of-Stake?

Unlike Proof-of-Work, Proof-of-Stake is not an energy-intensive process, and the right to add a new block to the chain and collect a reward typically goes to the nodes with the largest cryptocurrency wallets. The larger the stake a node holds, the greater chance it has to win. 

Both algorithms have certain downsides. While Proof-of-Work is a very energy-intensive process, and there has been much debate about the potential climate effects of bitcoin mining, Proof-of-Stake can be inequitable as people who can afford to purchase large stakes will win most of the rewards. Proof-of-Work proponents claim that 70% of the energy used for mining comes from renewable sources. 

What we can say is that both methods are highly effective as no one has ever managed to successfully double-spend their funds on either cryptocurrency network 

Read our next article in this series on Staking your Cryptocurrency to Earn a Return to find out more about how Proof of Stake can provide an investment opportunity.

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