- You might be wondering “What is Staking”?
THE SIMPLE WAY TO UNDERSTAND WHAT STAKING AND PROOF OF WORK IS?
In this article, you’re going to learn about something called staking but first, you probably want to learn about the proof-of-work consensus model, which is the method that Bitcoin uses to keep track of how much money everyone has. For your better understanding, I will first talk about Proof of Work and then I will try to explain what staking is?
Whether you’re new to cryptocurrency or you’ve been doing research for a while you’ve most likely heard the debate between Proof of Work and its counterpart proof of stake. Now, some investors think PoW is better and while it does have features that aren’t desirable, it was the very first consensus mechanism in the big bad Bitcoin model still uses it. So keep reading to learn exactly what PoW is and why it’s still a leading model for the crypto community. So first, let’s Stand consensus mechanisms. Because to understand what PoW is, we need to know what a consensus model is and why it is needed? In a normal database system that holds information. For example, a medical report cards, a single person or a computer is given the responsibility to manage the entire database. It is only their job to update, maintain, delete and add new patient information to the database. In fact, nobody else has access to it. Technically if they wanted to, they could delete your account or they could say that you owe them $10,000 at their will.
For blockchains, this is completely different. Being what is called a distributed Ledger, this technology is what we call a self-governing which means there isn’t one person who could control it or make changes. Instead, contributions come from all the hundreds of thousands of users who participate in the network to make it function properly. If one person said that you owed them 10,000 dollars, they would be quickly outed as a fraud by the rest of the people on the network that are checking them. This is the first benefit of a consensus model. In an ever-changing system, like the blockchain, you need a reliable, fair, real-time, efficient and transparent mechanism that will ensure that transactions are executed and genuine and that there’s something called a consensus on the network. That was a lot of words. But if you’re curious what consensus means, it means that everyone is on the same page. Essentially, let’s say, Bob pays Alice $10. We want to make sure that everyone knows what actually happened and also that Bob’s account goes down $10 and Alice’s goes up $10. Proof-of-work is one way to make sure that everyone has the same database that they reach consensus.
Now, in the blockchain, instead of one person having a record of those medical records, everyone participating has it. They have their own logs of what is going on. This way the information is public and it can’t be frauded or controlled by one authority. However, as I said earlier, you need a way to make sure everyone is on the same page. This distributed Ledger is how we do that. Everyone has their own record, but how do we make sure everyone has the same record.
Now that we have an idea of what a consensus mechanism is.
Let’s dive into proof-of-work? That solves the problem of everyone having the same record, if you search the word proof of work on Google or other search engines, it be told that proof of work is a consensus mechanism on the Bitcoin Network. And yes, it is a consensus mechanism but there’s a lot more to it. And technical terms proof of work is an algorithm or system that uses a significant amount of effort to deter or eliminate baked uses of computing power. Launched on the Bitcoin Network in 2009, proof-of-work was designed to solve the problems of double-spending, which if unchecked could be a major issue for crypto projects. You might be asking what is double-spending? Well, let’s say that Bob has $10, basically, we want to make sure that Bob doesn’t pay Alice $10 and then go and pay Sally $10 as well. Even when he only had $10 to start with.
One of the jobs of proof of work is to ensure that this does not happen. Well, this is easier on a centralized system because of the central authority or in other words, one person can check and make sure that it didn’t happen just by looking at their records. It is much more difficult and harder and even trickier to solve this problem on the blockchain where millions of people have their own record. Double spinning on a network is bad because it makes duplicate coins it reduces the value of the coin and it basically makes the currency worthless and unpredictable.
So let’s go into how proof-of-work works? Bitcoin like every other crypto project is blockchain based. Now being a decentralized ledger (I will write and article about decentralized finance soon) If you’re curious, what some of these terms mean, this technology is tasked with the responsibility of storing information permanently and safely And as the name implies bought chain comprises blocks which are then verified and then add it to the Network’s chain. Each of the blocks contain information of the recent transactions verified. So basically, what a block is is it is literally just a list of transactions in a specific time period. For example, one block might have Bob pays Alice $10, Alice pays Sally $5 and Alice pays Bob $5. Now, in reality, a real block can contain all the way up to a hundred transactions, but you get the idea. Now, this means you can go back and see every transaction on the blockchain where the very first dollar came from. And the important part is new blocks are directly tied to the previous block which makes it a chain.
Now minors, which are just people using their computers to participate in the network to add new blocks, execute proof of work each time that a new block is added. And it takes roughly 10 minutes on average on the Bitcoin network for miners to find the winning proof of work to validate transactions. You might be wondering what is actually happening when a Bitcoin block gets mine or validated? Well, it is actually some really difficult guesswork. There are essentially a ton of computers around the world guessing randomly until it hits that blocks password and then it’s verified. The passwords can be predicted but they can only be guessed. And you can check it very quickly though, to make sure that it is the right password. Now, this randomly guessing task is actually a hash function, it is very important to prove work but it’s also very technical and it’s not completely needed here.
So by figuring out this really difficult password of a block, we can be sure that you spend a ton of time trying to guess and check it. And this is where proof-of-work comes in. You have proof that you spent a long time trying to find the password that works. And so you get a reward which is a certain amount of Bitcoin and then the transactions that are in that block are then validated and the records of everyone on the network are updated to the new blocks.
So let’s move on the some of the features of the proof-of-work mechanism.
Number 1 is Secure
The singular purpose of integrating this system in a crypto projects is to offer a reliable, safe, permanent, fair and transparent system that will form a consensus based on network participants contributions. So, proof-of-work, like any mechanism consensus is secure. Misbehavior from a minor on a proof-of-work mechanism may result in being cut off from attempting to add new blocks in the future. Also, carrying an attack on the system, would take a ton of money and computing power. For example, to create fradulent transactions, you need to control 51% of the Network’s power which is equal to hundreds of billions of dollars in hardware today. And because it’s so expensive to make fake transactions, we can assume that it’s safe and secure.
Number 2 is Consensus
because miners broadcast the detail of a transaction when they add new blocks to the network. Now once this broadcast is made nodes leave what they’re doing and they double check that transaction to ensure that the asset to be transferred has not been double spent. Remember consensus means everyone has the same records. These miners have to compete with thousands of others to earn rewards in the form of Bitcoin. Now this healthy competition gives birth to what is called a consensus mechanism, what we call proof of work. And this syncs all of these nodes to the same blockchain copy what’s a new block is added. Once a person solves that blocks puzzle, they get a reward and then they give the solution that they found to everyone else to add to their ledger. So that they can start working on the next solution.
Now, inherently flawed proof-of-work has a ton of problems that have made it almost impossible for mass adoption and I’m going to go over some of those problems.
Number 1 is Impact on the Environment
According to a 2019 BBC News article says that proof of work is estimated to have used as much energy as all of Switzerland. And that’s not all. As a network continues to grow and more people begin to jump on the Bitcoin frenzy the energy usage increases. The energy consumption level of this network makes it bad for the environment. However, there are also reports a large majority of miners are starting to use renewable energy such as solar panels to power their mining operations.
Number 2 is Inability to Scale
The crypto Market is growing at an unprecedented rate and it has opened up opportunities for us individuals to make real money either as traitors or minors on these networks. And with a 24 hour of trading volume of around 50 billion dollars, the market is booming. But remember one block is solved around every 10 minutes and these blocks do have a transaction limit. So at peak times, the fee to send money over a proof-of-work blockchain can be very high. Even more than whatever the amount of Money you’re trying to send. For example you might try to send $10 to your friend but you have to pay a $20 transaction fee. It brings the total to $30.
Number 3 is No Penalties
That the proof of work consensus acts as a central authority or sole administrator on a blockchain network. And a traditional authority or administrator tasked for the managing of a database will have strict them penalties that are given out individuals with malicious intent. Unfortunately this consensus mechanism does not have them.Aside from increasing the cost of attempting to add blocks to the chain, we’re preventing them from attempting new blocks. Miners with malicious intent are not really severely punished and this gives them room for further misconduct. Proof of stake however does have a penalty for malicious attempts to create fake transactions.
Before finish, Let’s go over some proof-of-work powered projects. Because aside from being the sole mechanism on the Bitcoin and Ethereum networks, proof-of-work powers a couple of other networks as well, like Litecoin,
Monero, Bitcoincash, Dash and Zcash and many cryptocurrencies use proof of work because it does solve the consensus and double spending problem. So in conclusion, consensus mechanisms have proven to be quite helpful whenever it comes to maintaining the piece of crypto networks and eliminating double spending which are huge problems. So in conclusion, proof of work has many benefits and many drawbacks but it’s working great right now.
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.
So what is proof of stake?
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 minor is chosen at a time to validate the blockchain but that minor must lock up some of their coins as collateral to be chosen. The minor 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 sender’s paid.
So if you understood that, you probably don’t need to keep reading this article. But if you don’t understand it, please keep reading this article and you’ll understand 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. First, I’m gonna 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 8 racers are racing to the finish line but you have some racers that have an advantage given the amount of resources they have. Kind of like they have stronger 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 we’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 are super computers that can win the puzzle solving tasks 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 joined 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.
So, this is a big problem. And Proof of Stake attempts to fix this by only selecting one validator which is the A word that proof of stake cryptocurrencies call miners. The validator word of the minor then gets to solve the puzzle and earn the reward. While other validators, double-check them. It’s a lot more fair this way. One key thing when it comes to proof of stake is that since only one validator is selected, it’s very important because they solve a correctly because otherwise, they’ll have to select someone else, wait for them to solve it correctly, and it just takes a lot of time and in the crypto space time is money.
So 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. So, 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 mind. When you get picked, If you mind correctly, you get what’s called a staking reward. Usually some of the coin. And if you mind incorrectly, you actually get penalized and lose some of the coin that you initially locked up.
Moving on the way that we select who gets to be the validator is important 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 and 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 steak though, or who has the most steak we would probably also secretly be biasing. The Big and Rich mining facilities again. And to solve this, we also had in a bit of a random number picker and I’m not going to go much into that in this article because honestly, I’m not completely sure about it either, but it is a factor in the validator selection process.
So now 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.
Let’s go over the risks and rewards. So there’s a few risks when it comes to staking your crypto currency risk.
Risk number 1 is 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 walk them up for a certain amount of time, like maybe a month minimum all the way up to a year. This is a risk.
Risk number 2 is Technical Knowledge
in almost every case, It is easy as just downloading some software and then pushing a button, you’re usually have to know how to code 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 to fix it.
Risk number 3 is Validator Commission
So 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 is commission could cut into your profit and they could run away with your deposit at any time.
Risk Number 4 is Reward Duration
So depending on the network that you choose, it could take minutes, days and sometimes even weeks to see the payout of you’re staking position. This is why it’s crucial to see the network’s reward payout time.
Risk Number 5 is Bad Behavior
So proof of stake is built on validators in at the validation turns out to be bad, you will lose some of that steak. There’s a very, very small chance that you actually have a true, a 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.
And 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 4 of the most popular staking cryptocurrency.
First one is Tezos which rewards you are 6% of what you stake per year. In Coinbase, 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 %.Second Cardano is another coin that does staking. They will give out around 4 to 5%. The algo coin rewards you with around 8 to 10% a year. And lastly Ethereum which is actually switching to Ethereum 2.0 could be up to 15% but more reliably probably around four to 7% but this won’t happen for at least another year.
So proof of stake has quite a few benefits over proof of work. But it has downsides to, like it can invalidate DIY GPU miners who want to participate without owning a whole bunch of the coin. But maybe I’ll go over more of long-term downsides of proof of stake in another article.
All the content converted from Whiteboard Crypto“What is Staking in Crypto (Definition + Rewards + Risks) and What is Proof of Work? (Cryptocurrency Explanation)” video after got the whole permissions.
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- Date of publication:
- Fri, 06/11/2021 - 06:36
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