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When an open ledger is distributed across the globe, and anyone can contribute to it, how does one determine what is true and what is false? Through leveraging the work of those before, stretching all the way back to 1993, from Cynthia Dwork and Moni Naor to Adam Back and Hal Finney. This is the problem Satoshi managed to solve. The pseudonymous creator managed to implement their ideas around Proof of Work (PoW) and create Bitcoin. The first fully decentralised PoW network.
Since Bitcoin's creation, there have been many new, and novel approaches that have been proposed. This article will explore Proof of Stake (PoS), arguably the second most well-known.
Consensus Mechanisms
Consensus mechanisms stipulate the rules of how truth is determined by any given blockchain network. There are many different approaches to determining truth, and each one comes with its own benefits and drawbacks. Proof of Work is an example of a consensus mechanism, and before we get to Proof of Stake, it is worthwhile taking the time to understand Proof of Work so you can understand the key differences.
Proof of Work
Proof of Work was initially created to help reduce spam email. The idea behind it was that computers were required to perform a small amount of computational work before sending an email. This would be trivial for any computer sending a few emails at a time, but it would be impractical for those sending a large number. It was, however, Satoshi Nakamoto who first applied it in a large-scale commercial sense to digital money.
In Satoshi's system, individuals could buy expensive computational hardware and direct it towards mining. Mining at its most basic is expending computational energy to "find" or propose valid blocks that meet the rules of the network. This is the proof of "work" you are doing in the system. If the nodes of the network agree that it is, in fact, a valid block and it meets the consensus rules of the network, they will accept it and add it to the chain and blocks that have come before. If the new block doesn't agree with the consensus rules (which is easy to prove), you forfeit your chance to receive the block reward.
As you can probably guess by now, Proof of Stake differs in the "proof" you have to provide to the network.
Proof of Stake
Proof of Stake was created to address some of the perceived shortcomings within a Proof of Work system. Peercoin, which launched in 2012, was the first project to implement Proof of Stake consensus, and since then, its popularity and use have risen immensely.
As described above, in Proof of Work, miners have to purchase expensive computational hardware and expend electricity to order and propose blocks to secure the network. In a Proof of Stake system, miners or "validators", as they are known, use their crypto holdings as collateral and must put it up as a "stake" in order to earn the right to validate blocks according to the networks consensus rules. Just how miners in Proof of Work broadcast the newly mined blocks to the network and they are checked against their consensus rules by the nodes, so too are the blocks in Proof of Stake. However, in this system, if you are found to be "lying" about the transactions within the block by the network's nodes, you get your stake or collateral "slashed" or taken away.
These financial incentives are what inspire people to act honestly in the system; they have rules enforced by code that means at any point in time, it is in your own best interest to contribute positively to the system as a whole. This is what makes it possible to reach a global consensus on an open ledger without any centralised coordinating entity, something not possible before Satoshi's creation.
Proof of Stake Advantages and Disadvantages
There are several reasons why projects have been adopting a Proof of Stake consensus. It offers several benefits over Proof of Work; however, it does also have its drawbacks:
Advantages
No need to invest in expensive computer hardware (some projects may require this though)
Staking can allow more people to participate in the validation process
Staking allows for increased throughput or transactions per second through sharding
Less energy-intensive
Disadvantages
More complex to implement
Some projects have very high minimum stakes, which can price people out
Not proven over time
If not staking, lose out on network inflation
Proof of Stake does come with its drawbacks. However, there are valid reasons why it has become one of the go-to consensus mechanisms. As it is further tested in the field and real-time production environments, these intricacies will slowly start to work themselves out. We have already seen various projects adopt alternative implementations of Proof of Stake, such as Delegated Proof of Stake, Tower BFT, Tendermint or GRANDPA, to name just a few.
Staking also comes with another benefit. Staking and the way it is implemented can create productive assets within the digital asset space, something more akin to traditional assets as we understand them.
Staking and Its Effect on Crypto as an Asset Class
Staking also has an interesting influence on what asset class the tokens of these Proof of Stake projects fall into. We have covered this in detail here, and explain how something like ETH in Ethereum 2.0 will become one of the first examples of what we classify as a Triple Point Asset. ETH, once successfully transitioned to Ethereum 2.0, will resemble a commodity as it must be used to pay for transactions on the network; it will have Store of Value like properties as it is used as collateral in the system; and finally, it will also have capital like properties as you will be able to stake it and earn a yield for doing so.
Worth mentioning here, and to elaborate on the above, is the current situation Ethereum finds itself in as it moves to a Proof of Stake system. It still uses Proof of Work, but due to the limitations they have encountered, mostly with transaction throughput, they decided years ago to change consensus mechanisms. This is the first time we have seen a project implement such a vast change at this scale, which obviously comes with immense complexities. The Ethereum developers have decided to implement the change by running two chains in parallel. They have their Proof of Work Mainnet, but they also have a Proof of Stake Beacon Chain. They have allowed users to stake on this chain and add new blocks; however, they are not processing mainnet transactions. This allows the team to test the chain in a real-time production environment and work out the problems before fully transitioning to a Proof of Stake system and the Ethereum mainnet merges with the Beacon Chain. However, the one caveat is that once you move your Ethereum over to the new Proof of Stake chain, you cannot move it back. It is locked up there until the chains merge. Since the launch of the Beacon Chain, we have seen an increasing number of ETH being locked up on the Proof of Stake chain, currently sitting close to 8 million ETH. This is more than likely a function of two things, confidence in transition to Ethereum 2.0 and demand for yield-bearing ETH.
Ethereum isn't the only yield-bearing network with many notable projects already running purely on Proof of Stake. The yields on offer differ depending on the project; they are a function of a few inputs, often including network inflation and the number of people staking within the network; however, this varies from project to project. It is also worth mentioning that yields are dynamic within projects and change day to day. At the time of writing, current yields on some of the largest Proof of Stake networks range from 3.81% to 13.33%.
These are attractive yields for most people. However, the actual process of staking can be highly complex and risky, especially for those without the technical know-how. This does vary from project to project, but small problems like an unstable internet connection or electricity providers not meeting demands such as Eskom in South Africa could invariably lead to you also having your stake slashed if you are selected as a validator and don't fulfil your role.
This has led to companies like Staked offering Staking as a Service, where they take on all the complex behind the scenes work and take a cut of the yield they produce. These services again come with their own risks that should be well understood before you use them and their services.
Conclusion
Staking and Proof of Stake networks are increasing in popularity. They have opened up new opportunities and use cases that were not possible before, and they have fundamentally changed the asset class into which crypto projects can fall. That being said, they still have a lot to prove; yet, some of the brightest minds in the world are working on these problems, and we believe that over time they will excel in a live production environment and open up new frontiers previously thought impossible. Only time will tell.
Notable Articles and News Stories This Week:
Bill Miller is 'Willing to Go Over the Waterfall' with Bitcoin
The risk of bitcoin is going down as crypto adoption rises, renowned value investor Bill Miller said in a recent conversation with author William Green, as Miller is investing in a space he said has "enormous potential."
Miller, the founder, chairman and chief investment officer of Miller Value Partners, was among the first big believers in the potential of Amazon.
"I thought you might bring up Amazon … which is the reason I have my bitcoin hat on right now," he told Green. "I'm willing to go over the waterfall with this one too."
Read the full story here
Coinbase Plans to Launch NFT Marketplace
Coinbase announced the upcoming launch of a non-fungible token (NFT) marketplace on Tuesday.
Dubbed 'Coinbase NFT', the soon-to-be product offering allows users to purchase, mint, showcase and discover the crypto assets on a peer-to-peer marketplace, according to the company. Additionally, users can join a waitlist for early access to the offering.
Coinbase NFT will have "social features that open new avenues for conversation and discovery" and an "intuitive design built on top of a decentralised marketplace," according to the company's new marketplace web page.
Read more about the announcement here
Stripe Is Hiring a Crypto Team 3 Years After Ending Bitcoin Support
Payments company Stripe has begun assembling a crypto engineering team to chart its future in digital assets. The team – described in LinkedIn posts and job listings – will be run by Guillaume Poncin, Stripe's former head of engineering for banking and financial products. He is looking to hire at least four staffers to help plot Stripe's crypto strategy.
Those engineers "will design and build the core components that we need to support crypto use cases," the job posts said. "Crypto is a brand new team at Stripe."
Read more here
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This is not financial advice. All opinions expressed here are our own. We encourage investors to do their own research before making any investments.