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What is the Proof-of-Stake Consensus Mechanism?

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Written by   10
8 months ago

With the year coming to an end, a period of self-reflection is upon us. Some of us are looking at the goals we've achieved or failed during this year, while others are analyzing deeper issues like global instability and the volatility of financial markets in 2021.

What we can all agree though, is that crypto has continued on its trajectory to reach mass adoption. I mean, we've witnessed headlines straight out of a simulation: "The President of El Salvador Buys the Dip... Again!" or "Elon Musk Tweets About DogeCoin for the 6th Time".

Welcome to the new normal.

Q4 2021 was especially hectic with the rise of the metaverse. You have blue chips like Facebook rebranding to Meta to mark their entry into this vastly unexplored world. You also have big names like Adidas and Nike releasing NFT drops to streetwear and sportswear fans.

What a crazy time to be alive.

Aside from all the small bits of crypto and metaverse news, one of the most discussed topics was Tesla's purchase of Bitcoin as a store of value, investment, and transaction method.

In February of 2021, Elon bought $1.5 million worth of Bitcoin on Tesla's balance sheet. This marked another stunt in the automaker's long list of disruptive moves.

And it was primarily based on a decision to invest a portion of Tesla's cash in alternative reserve assets. The problem with the decision was the flak Elon Musk received for choosing BTC as a holding asset.

As you can see here, the problem with BTC and other networks that run on a Proof-of-Work (PoW) consensus mechanism is two-fold. For one, specialized hardware is required to perform crypto mining.

The more power an individual, organization, or mining pool has in terms of hardware capability, the more rewards they will reap. The more they mine, the more control they have over the price of the PoW network.

PoW is too centralized for Satoshi's original whitepaper. The whole point of blockchain technology is to eliminate centralization and create a world run on equal opportunity.

This isn't saying that PoW cannot be a solution to centralization. It's just that at the moment, PoW is inferior to other consensus mechanisms when it comes to scalability.

The other problem with the PoW consensus mechanism it's inefficient energy consumption, as seen here:

According to data released in 2019 by the scientific journal Joule, Bitcoin's carbon footprint is between 22 and 22.9 metric tons of CO2... comparable to Jordan or Sri Lanka's emission rates.

With climate change being a striking issue, especially this year with the harsher wildfires, extreme heat, droughts, floodings, and an unprecedented amount of snowfall, we cannot build a decentralized world with energy-inefficient cryptos.

So how can this be solved?

What is Proof-of-Stake (PoS)?

Queue PoS, a consensus mechanism that aims to solve the key issues of PoW. Instead of relying on a competitive validation method that requires powerful hardware to run mathematical operations, PoS uses randomly selected validators to validate new transactions and create new blocks.

It accomplishes this by requiring investors to lock up their coins within the network. You can think of it as if the network were a bank and you are the individual putting money into your savings account.

The bank needs to use your lent money to run its operations. It pays out loans to other entities, provides funding, and it does a whole host of other things with your money.

Since you choose to store your money with your favourite bank, the bank will pay you interest for your troubles. It's a win-win. The bank can operate, and you earn passive income.

So, why stake?

Quite simply, staking, or the strategy of yield farming, provides passive income to crypto-investors. This allows investors to create a safety net during a bear market and snowball their investments to reach parabolic gains.

Here is a list of the other benefits and pros staking provides:

  • You don't need a significant initial investment, unlike crypto mining

  • You Don't need specialized hardware to run the validation of nodes

  • You can support the crypto ecosystem by helping the network function

Different layer 1s use different PoS mechanisms to validate blocks. Take Cardano for example. The Cardano PoS consensus protocol (called Ouroboros) uses stake pools in which investors can delegate their stake.

In plain English, this means that once you lock up your $ADA (Cardano's coin), you will allocate a portion of your holdings to a staking pool. This entity will then combine all of the other delegators' holdings and stakes on your behalves.

You can think of a staking pool as a mutual fund. Mutual funds pool money from individual investors and invest in stocks according to the fund's expertise, research, and experience. Mutual funds are a trusted entity.

On the other hand, staking pools are a trusted entity because they are crucial in the protocol's transaction process. Staking pools provide ledger maintenance and keep the network running.

Incentivization comes from the size and desirability of the pool you choose to stake with. Larger pools with a higher amount of $ADA holdings have a higher chance of being elected as the validator for the next block; albeit, larger stake pools also come with issues like pool saturation: A parameter that creates diminishing rewards to larger pools. This keeps the network decentralized.

Cardano isn't the only player in the push towards PoS adoption. Recently, Ethererum's Beacon Chain introduced the PoS mechanism to the network. Once The Merge occurs, Ethereum's Mainnet will run on PoS instead of a PoW mechanism.

And so on and so forth. There's are so many options out there for staking in the cryptosphere. You just have to do your own due diligence and see which coin fits your needs.

Sources:

https://medium.com/cardanorss/choosing-a-stake-pool-and-delegating-your-ada-113d71b0963f

https://docs.cardano.org/core-concepts/stake-pools

https://docs.cardano.org/new-to-cardano/proof-of-stake

https://www.investopedia.com/tech/bitcoin-vs-bitcoin-cash-whats-difference/

https://www.cnn.com/2021/02/08/investing/tesla-bitcoins/index.html

https://www.investopedia.com/terms/p/proof-stake-pos.asp

https://docs.rocketpool.net/guides/staking/overview.html#how-eth2-staking-works

I am not a financial advisor. Please do your own due diligence before making a decision based on my article, as I am not responsible or liable for your investment decisions.

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Written by   10
8 months ago
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