In contrast to a Proof of Work algorithm, in which miners must solve a complex mathematical problem in order to attain the privilege of mining a block, Proof of Stake algorithms calculate different metrics in order to randomly choose a valid and trustworthy node.
This new method of validation relies on the so-called coin age, a measurable unit which breaks down to the amount of currency held, multiplied by the duration of time it has been held for. These funds must be pledged as collateral for a node to be able to validate transactions and blocks. A validating machine can thus only be chosen to write a block and claim the reward if it has enough coin age to spend. The coin age used for the transaction is consumed, and consequently represents the investment a validating node is obliged to make. Similar to the power and time consumption in Proof-of-Work mechanisms, coin age is a PoS-chain’s defense mechanism against fraud, since the fraudulently obtained block rewards would not compensate an attacker sufficiently for the amount of time he would need to have held the coins for. In addition to the mere time and investment aspect, a fraudulent node also gets slashed, i.e. a certain amount of currency is removed from the node’s staked balance, which makes an attack even less profitable.
While using proof-of-stake solves problems like the enormous amount of energy used in order to secure a blockchain (Bitcoin uses roughly the same amount of energy as the whole country of Denmark) or the increasingly congested mempools of some chains, it also bears some issues of its own. The biggest concern is the initial distribution of coins, which is needed in order to allow the first nodes to validate transactions, subsequently making the wheels turn. If this distribution is uneven or not spread widely enough, decentralization – one of the centerpieces of DLT – might not be given and the network would become prone to a central entity / a whale acting in their own best interest.
In order to alleviate some of these concerns, pioneer currencies in the field of staking like Peercoin have implemented a PoW-PoS-Hybrid, which uses PoW to launch the network and then gradually switches to PoS as soon as a certain level of decentralization is reached.
For validators, this new type of validation process is also interesting from a monetary perspective, as typically seen in PoW protocols, validators get rewards for adding a block to the blockchain. Often though, the ROI of PoS-chains (without consideration of the value fluctuation of the underlying coin) is higher than most PoW coins, amounting to over 20% in some cases, while the most widely known PoW coins return around 6% p.a. (May 2020). In addition to that, there is basically no initial investment needed, since a PoS validator node can be run on a very rudimentary machine. These low entry barriers and low initial costs facilitate the participation of more users in the network and therefore increases the security and usability of it.
Furthermore, newer protocols like Tezos rely on the so-called delegated proof of stake (dPoS) or leased proof of stake (lPoS), which allows users to delegate their staking/voting power to an address running a validator node. This way the validator receiving a bigger stake is more likely to earn writing rights and can therefore also earn more rewards, which in return will get distributed automatically and proportionally to its delegators, usually deducting a small fee for its efforts.
Most of these protocols steer their reward percentage dynamically, depending on the ratio between coins in circulation and coins staked in the network; the lower the staked percentage, the higher the reward to incentivize users to resume staking.
Other retention mechanism that some protocols use, are the locking/unlocking periods. Locking periods determine the amount of time that must elapse until rewards are paid to the user for the first time. These can range from a couple of days up to 3-4 weeks, embodying the initial investment a user still is obliged to make.
Unlocking periods function in a similar way, locking a user’s funds in the protocol after un-staking for a certain period, before eventually returning them to the user’s address.
While it still needs a fair amount of technical knowledge to run a validator node or to delegate funds to a validator directly on the blockchain, most newer wallet applications already support staking out of the box, facilitating the possibility of staking to different validators (however limited to a short list of chosen parties) with a couple of clicks.
Though still fairly new in the crypto space, staking protocols have already gained quite a lot of attention and value, with Tezos, Tron, Crypto.com Coin and EOS all residing in the Top 20 of all cryptocurrencies with regards to market capitalization (May 2020, coinmarketcap.com). In addition, the Ethereum Network has announced a switch from PoW to PoS in the upcoming months, which will give this type of validation another major boost.